Table of Contents

 

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: June 30, 2012                  

OR

     
  ¨   

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 ¨

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 ¨

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 ¨      Non-accelerated filer ¨      Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ 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   79,262,705 shares outstanding as of August 3, 2012

 

 

 


Table of Contents

REDWOOD TRUST, INC.

2012 FORM 10-Q REPORT

TABLE OF CONTENTS

 

        

    Page    

 

PART I

    
Item 1.   Financial Statements     1
  Consolidated Balance Sheets at June 30, 2012 (Unaudited) and December 31, 2011     1
  Consolidated Statements of Income for the Three and Six Months Ended June 30, 2012 and 2011 (Unaudited)     2
  Statements of Consolidated Comprehensive Income for the Three and Six Months Ended June 30, 2012 and 2011 (Unaudited)     3
  Consolidated Statements of Changes in Equity for the Six Months Ended June 30, 2012 and 2011 (Unaudited)     4
  Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2012 and 2011 (Unaudited)     5
  Notes to Consolidated Financial Statements     6
Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations     56
Item 3.   Quantitative and Qualitative Disclosures About Market Risk     109
Item 4.   Controls and Procedures     109
PART II     
Item 1.   Legal Proceedings     110
Item 1A.   Risk Factors     112
Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds     113
Item 3.   Defaults Upon Senior Securities     113
Item 4.   Mine Safety Disclosures (Not Applicable)     113
Item 5.   Other Information     113
Item 6.   Exhibits     114
Signatures       116

 

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Table of Contents

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

REDWOOD TRUST, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

 

(In Thousands, Except Share Data)

(Unaudited)

          June 30, 2012           December 31, 2011    
ASSETS      

Residential loans, held-for-sale

     $ 256,077        $ 395,237    

Residential loans, held-for-investment

      3,215,737         3,799,648    

Commercial loans (includes $12,176 and $12,129 at fair value)

      258,959         169,855    

Real estate securities, at fair value

      1,311,728         981,837    

Cash and cash equivalents

      69,519         267,176    
   

 

 

   

 

 

 

Total earning assets

      5,112,020         5,613,753    
   

 

 

   

 

 

 

Restricted cash

      18,512         14,987    

Accrued interest receivable

      15,850         15,840    

Derivative assets

      2,963         2,373    

Deferred securities issuance costs

      6,846         8,083    

Other assets

      90,108         88,262    
   

 

 

   

 

 

 

Total Assets (1)

     $ 5,246,299        $ 5,743,298    
   

 

 

   

 

 

 
LIABILITIES AND EQUITY      

Liabilities

     

Short-term debt

     $ 455,419        $ 428,056    

Accrued interest payable

      6,800         8,134    

Derivative liabilities

      114,473         127,564    

Accrued expenses and other liabilities

      15,056         8,105    

Asset-backed securities issued (includes $244,073 and $209,381 at fair value)

      3,563,873         4,139,355    

Long-term debt

      139,500         139,500    
   

 

 

   

 

 

 

Total liabilities (1)

      4,295,121         4,850,714    

Equity

     

Common stock, par value $0.01 per share, 125,000,000 shares authorized; 79,262,828 and 78,555,908 issued and outstanding

      793         786    

Additional paid-in capital

      1,705,711         1,697,979    

Accumulated other comprehensive income (loss)

      28,212         (13,151)    

Cumulative earnings

      551,273         501,283    

Cumulative distributions to stockholders

      (1,334,811)         (1,294,313)    
   

 

 

   

 

 

 

Total stockholders’ equity

      951,178         892,584    

Noncontrolling interest

      -               -          
   

 

 

   

 

 

 

Total equity

      951,178         892,584    
     
   

 

 

   

 

 

 

Total Liabilities and Equity

     $                  5,246,299        $             5,743,298    
   

 

 

   

 

 

 

 

 

(1)

Our consolidated balance sheets include assets of consolidated variable interest entities (“VIEs”) that can only be used to settle obligations of these VIEs and liabilities of consolidated VIEs for which creditors do not have recourse to the primary beneficiary (Redwood Trust, Inc.). At June 30, 2012 and December 31, 2011, assets of consolidated VIEs totaled $3,844,607 and $4,408,350, respectively, and liabilities of consolidated VIEs totaled $3,626,035 and $4,209,124, respectively. See Note 4 for further discussion.

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

 

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Table of Contents

REDWOOD TRUST, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

 

(In Thousands, Except Share Data)       Three Months Ended June 30,     Six Months Ended June 30,  

(Unaudited)

      2012     2011     2012     2011  

Interest Income

         

Residential loans

     $ 21,243        $ 18,904        $ 44,622         $ 37,372     

Commercial loans

      5,534          1,800          10,881          3,025     

Real estate securities

      32,732          32,234          62,726          66,859     

Cash and cash equivalents

      14          17          35          32     
   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest income

      59,523          52,955          118,264          107,288     

Interest Expense

         

Short-term debt

      (2,299)         (7)         (4,126)         (189)    

Asset-backed securities issued

      (24,203)         (21,251)         (50,655)         (40,675)    

Long-term debt

      (2,379)         (2,375)         (4,755)         (4,742)    
   

 

 

   

 

 

   

 

 

   

 

 

 

Total interest expense

      (28,881)         (23,633)         (59,536)         (45,606)    
   

 

 

   

 

 

   

 

 

   

 

 

 

Net Interest Income

      30,642          29,322          58,728          61,682     

Reversal of (provision for) loan losses

      1,340          (1,581)         1,065          (4,389)    

Other market valuation adjustments

      (5,146)         (9,681)         (5,382)         (12,799)    

Other-than-temporary impairments (1)

      (303)         (1,466)         (635)         (4,088)    
   

 

 

   

 

 

   

 

 

   

 

 

 

Other market valuation adjustments, net

      (5,449)         (11,147)         (6,017)         (16,887)    
   

 

 

   

 

 

   

 

 

   

 

 

 

Net Interest Income After Provision and Other Market Valuation Adjustments

      26,533          16,594          53,776          40,406     

Mortgage banking activities, net

      1,756          -              5,998          -         

Operating expenses

      (15,165)         (12,087)         (29,799)         (23,600)    

Realized gains, net

      6,995          5,834          20,615          9,699     
   

 

 

   

 

 

   

 

 

   

 

 

 

Net income before provision for income taxes

      20,119          10,341          50,590          26,505     

Provision for income taxes

      (592)         (14)         (600)         (28)    
   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

      19,527          10,327          49,990          26,477     

Less: Net income (loss) attributable to noncontrolling interest

      -              888          -              (1,127)    
   

 

 

   

 

 

   

 

 

   

 

 

 

Net Income Attributable to Redwood Trust, Inc.

     $ 19,527         $ 9,439         $ 49,990         $ 27,604     
   

 

 

   

 

 

   

 

 

   

 

 

 

Basic earnings per common share

     $ 0.24         $ 0.12         $ 0.62         $ 0.34     

Diluted earnings per common share

     $ 0.24         $ 0.11         $ 0.61         $ 0.34     

Regular dividends declared per common share

     $ 0.25         $ 0.25         $ 0.50         $ 0.50     

Basic weighted average shares outstanding

            78,815,313                78,324,057                78,606,336                78,176,767     

Diluted weighted average shares outstanding

      78,815,313          79,477,504          79,965,406          79,425,360     

 

 

(1)

For the three months ended June 30, 2012, other-than-temporary impairments were $411 of which $108 were recognized in Accumulated Other Comprehensive Income. For the three months ended June 30, 2011, other-than-temporary impairments were $2,655, of which $1,189 were recognized in Accumulated Other Comprehensive Income.

For the six months ended June 30, 2012, other-than-temporary impairments were $892 of which $257 were recognized in Accumulated Other Comprehensive Income. For the six months ended June 30, 2011, other-than-temporary impairments were $5,967, of which $1,879 were recognized in Accumulated Other Comprehensive Income.

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

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

STATEMENTS OF CONSOLIDATED COMPREHENSIVE INCOME

 

(In Thousands)          Three Months Ended June 30,         Six Months Ended June 30,    

(Unaudited)

        2012      2011      2012      2011  

Net Income

       $ 19,527          $ 9,439          $ 49,990          $ 27,604     

Other comprehensive income:

              

Net unrealized gain (loss) on available-for-sale securities

        1,374           (38,107)          42,075           (30,519)    

Reclassification of other-than-temporary impairments to net income

        337           579           414           2,349     

Net unrealized loss on interest rate agreements

        (16,453)          (5,418)          (3,260)          (1,528)    

Reclassification of unrealized loss on interest rate agreements to net income

        1,098           1,080           2,134           2,144     
     

 

 

    

 

 

    

 

 

    

 

 

 

Total other comprehensive (loss) income

                (13,644)                  (41,866)                  41,363                   (27,554)    
     

 

 

    

 

 

    

 

 

    

 

 

 

Total comprehensive income (loss)

        5,883           (32,427)          91,353           50     

Less: Comprehensive (loss) income attributable

          to noncontrolling interest

        -               (375)          -               4,164     
     

 

 

    

 

 

    

 

 

    

 

 

 

Comprehensive Income (Loss) Attributable to Redwood Trust, Inc.

       $ 5,883          $ (32,052)         $ 91,353          $ (4,114)    
     

 

 

    

 

 

    

 

 

    

 

 

 

 

 

 

 

 

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

 

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Table of Contents

REDWOOD TRUST, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY

For the Six Months Ended June 30, 2012

 

                          Accumulated                          
        Common Stock     Additional     Other           Cumulative              
(In Thousands, Except Share Data)                   Paid-In     Comprehensive     Cumulative     Distributions     Noncontrolling        

(Unaudited)

      Shares     Amount     Capital     Income     Earnings     to Stockholders     Interest     Total  

December 31, 2011

      78,555,908         $ 786         $ 1,697,979         $ (13,151)        $ 501,283         $ (1,294,313)        $     -             $ 892,584     

Net income

      -              -              -              -              49,990          -              -              49,990     

Other comprehensive income

      -              -              -              41,363          -              -              -              41,363     

Issuance of common stock:

                 

Dividend reinvestment & stock purchase plans

      384,005          4          4,429          -              -              -              -              4,433     

Employee stock purchase and incentive plans

      322,915          3          (1,914)         -              -              -              -              (1,911)    

Non-cash equity award compensation

      -              -              5,217          -              -              -              -              5,217     

Distributions to noncontrolling interest, net

      -              -              -              -              -              -              -              -         

Common dividends declared

      -              -              -              -              -              (40,498)         -              (40,498)    
   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

June 30, 2012

        79,262,828         $ 793         $     1,705,711         $ 28,212         $ 551,273         $ (1,334,811)        $ -             $       951,178     
   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

For the Six Months Ended June 30, 2011

 

                          Accumulated                          
        Common Stock     Additional     Other           Cumulative              
(In Thousands, Except Share Data)                   Paid-In     Comprehensive     Cumulative     Distributions     Noncontrolling        

(Unaudited)

      Shares     Amount     Capital     Income     Earnings     to Stockholders     Interest     Total  

December 31, 2010

      78,124,668         $ 781         $ 1,689,851         $ 112,339         $ 474,940         $ (1,213,158)        $ 10,839         $ 1,075,592     

Net income

      -              -              -              -              27,604          -              (1,127)         26,477     

Other comprehensive (loss) income

      -              -              -              (31,718)         -              -              4,164          (27,554)    

Issuance of common stock:

                 

Dividend reinvestment & stock purchase plans

      158,028          2          2,349          -              -              -              -              2,351     

Employee stock purchase and incentive plans

      272,269          3          (2,929)         -              -              -              -              (2,926)    

Non-cash equity award compensation

      -              -              4,806          -              -              -              -              4,806     

Distributions to noncontrolling interest, net

      -              -              -              -              -              -              (11,770)         (11,770)    

Common dividends declared

      -              -              -              -              -              (40,360)         -              (40,360)    
   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

June 30, 2011

        78,554,965         $ 786         $     1,694,077         $ 80,621         $ 502,544         $ (1,253,518)        $ 2,106         $     1,026,616     
   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

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

 

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Table of Contents

REDWOOD TRUST, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

          Six Months Ended June 30,  

(In Thousands, Except Share Data)

                      2012                                   2011                 

Cash Flows From Operating Activities:

        

Net income attributable to Redwood Trust, Inc.

       $ 49,990          $ 27,604     

Adjustments to reconcile net income to net cash (used in) provided by operating activities:

        

Amortization of premiums, discounts, and securities issuance costs, net

        (12,953)          (17,462)    

Depreciation and amortization of non-financial assets

        1,612           515     

Purchases of loans - mortgage banking

        (998,906)          -         

Proceeds from sales of loans - mortgage banking

        754,175           -         

Principal payments on loans - mortgage banking

        4,102           -         

Net settlements of derivatives - mortgage banking

        (17,160)          -         

(Reversal of) provision for loan losses

        (1,065)          4,389     

Non-cash equity award compensation

        5,217           4,806     

Market valuation adjustments, net

        12,959           16,887     

Realized gains, net

        (33,452)          (9,699)    

Net change in:

        

Accrued interest receivable

        (916)          (199)    

Deferred tax asset

        -               3,487     

Other assets

        215           123     

Accrued interest payable

        9,655           6,851     

Accrued expenses and other liabilities

        6,951           (4,351)    
     

 

 

    

 

 

 

Net cash (used in) provided by operating activities

        (219,576)          32,951     
     

 

 

    

 

 

 

Cash Flows From Investing Activities:

        

Purchases of loans

        (95,508)          (293,445)    

Proceeds from sales of loans (1)

        386,143           1,857     

Principal payments on loans

        287,996           181,840     

Purchases of real estate securities

        (409,788)          (46,498)    

Proceeds from sales of real estate securities

        101,662           85,701     

Principal payments on real estate securities

        95,536           88,677     

Proceeds from deconsolidation

        6,386           -         

Net increase in restricted cash

        (3,566)          (11,149)    
     

 

 

    

 

 

 

Net cash provided by investing activities

        368,861           6,983     
     

 

 

    

 

 

 

Cash Flows From Financing Activities:

        

Proceeds from borrowings on short-term debt

        707,051           -         

Repayments on short-term debt

        (679,688)          (3,246)    

Proceeds from issuance of asset-backed securities

        96           281,456     

Repayments on asset-backed securities issued

        (322,000)          (214,950)    

Deferred securities issuance costs

        -               (1,695)    

Net settlements of derivatives

        (12,195)          (14,733)    

Net proceeds from (payments for) issuance of common stock

        292           (580)    

Dividends paid

        (40,498)          (40,250)    

Change in noncontrolling interests

        -               (12,896)    
     

 

 

    

 

 

 

Net cash used in financing activities

        (346,942)          (6,894)    
     

 

 

    

 

 

 

Net (decrease) increase in cash and cash equivalents

        (197,657)          33,040     

Cash and cash equivalents at beginning of period

        267,176           46,937     
     

 

 

    

 

 

 

Cash and cash equivalents at end of period

       $ 69,519          $ 79,977     
     

 

 

    

 

 

 

Supplemental Disclosures:

        

Cash paid for interest

       $ 59,152          $ 36,404     

Cash paid for taxes

        155           45     

Dividends declared but not paid at end of period

        -               19,640     

Transfers from residential loans to real estate owned

        3,406           5,966     

 

 

(1)

For the six months ended June 30, 2012, the proceeds from sales of loans included in investing activities relates to loans that were reclassified from loans held-for-investment to loans held-for-sale during the fourth quarter of 2011.

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

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(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 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 June 30, 2012 and December 31, 2011, and for the three and six months ended June 30, 2012 and 2011. 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.

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. Redwood’s consolidated subsidiaries include both qualifying REIT subsidiaries and taxable subsidiaries. References to the 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.

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 an ongoing involvement, as well as an entity formed in connection with a resecuritization transaction we engaged in during 2011 (“Resecuritization”). Prior to the fourth quarter of 2011, we also consolidated the assets, liabilities, and noncontrolling interests of the Opportunity Fund (“Fund”) that we managed. 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.

For financial reporting purposes, the underlying loans and securities owned at the Sequoia entities, Acacia entities, and Resecuritization entity are shown under residential and commercial loans and real estate securities on our consolidated balance sheets. 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 at these entities and interest expense on the ABS issued by these entities. We also recorded interest income on the securities owned at the Fund and any income attributable to noncontrolling interest holders during prior periods.

See Note 4 for further discussion on principles of consolidation.

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

Note 3. Summary of Significant Accounting Policies

Use of Estimates

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

Fair Value Measurements

Our financial statements include assets and liabilities that are measured at their estimated fair values in accordance with GAAP. A fair value measurement represents the price at which an orderly transaction would occur between willing market participants at the measurement date. We develop fair values for financial assets or liabilities based on available inputs and pricing that is observed in the marketplace. Examples of market information that we attempt to obtain include the following:

 

   

Quoted prices for the same or similar securities;

 

   

Relevant reports issued by analysts and rating agencies;

 

   

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

 

   

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

 

   

Indicative prices or yields from broker/dealers; and,

 

   

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

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

The markets for many of the loans and 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 internal assumptions about future cash flows and appropriate risk-adjusted discount rates. Regardless of the valuation inputs we apply, the objective of fair value measurement is unchanged from what it would be if markets were operating at normal activity levels and/or transactions were orderly; that is, to determine the current exit price.

See Note 5 for further discussion on fair value measurements.

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

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

 

Fair Value Option

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

Our decision to apply the fair value option for new financial instruments is generally based upon our funding strategy for the specific financial asset acquired. For example, securities that we anticipate funding with equity will generally be accounted for as available-for-sale (“AFS”) securities. Securities that we anticipate funding with a combination of debt and equity or those financed through the issuance of asset-backed liabilities will generally be accounted for in a manner consistent with the associated liabilities. Additionally, we may elect to apply the fair value option for financial instruments that may not perform similarly to our traditional real estate investments or are particularly volatile or complex in structure.

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

Residential and Commercial Loans

Residential and Commercial Loans — Fair Value

Residential and commercial 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 other market valuation adjustments, net.

Residential and Commercial Loans — Held-for-Sale

Residential and commercial loans held-for-sale include loans that we are marketing for sale to third parties, including transfers to securitization entities that we plan to sponsor and expect to be accounted for as sales for financial reporting purposes. These loans are carried at the lower of their cost or fair value, as measured on an individual basis or, in the case of the loans we intend to pool for securitization based upon similar underwriting characteristics, on an aggregate basis. If the fair value of an individual loan or pool of loans 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 residential or commercial loans are based on the specific identification method for loans measured on an individual basis or in aggregate for those loans measured on a pool basis.

Residential and Commercial Loans — Held-for-Investment

Loans held-for-investment include residential loans owned at Sequoia entities and commercial loans owned by us 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 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. Residential 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. Alternately, loans that have been individually impaired may be placed back on accrual status if restructured and after the loan is considered reperforming. A restructured loan is considered reperforming when the loan has been current for at least 12 months.

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(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 residential loans acquired after July 1, 2004, we use the initial coupon interest rate of the loans (without regard to future changes in the underlying indices) and anticipated principal payments, 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 or transferred 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 loans. See Note 7 for further discussion on commercial loans.

Residential Loans — Allowance for Loan Losses

For residential 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 loan or pools of loans.

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

 

   

Ongoing analyses of loans, including, but not limited to, the age of loans and year of origination, underwriting standards, business climate, economic conditions, and other observable data;

 

   

Historical loss rates and past performance of similar loans;

 

   

Relevant environmental factors;

 

   

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

 

   

Trends in delinquencies and charge-offs;

 

   

Effects and changes in credit concentrations;

 

   

Information supporting a borrower’s ability to meet obligations;

 

   

Ongoing evaluations of fair values of collateral using current appraisals and other valuations; and,

 

   

Discounted cash flow analyses.

Once we determine the amount of defaults, the timing of the defaults, and severity of losses upon the defaults, we estimate expected losses for each individual loan or pool of loans over its expected life. We then estimate the timing of these losses and the losses probable to occur over an appropriate loss confirmation period. This period is defined as the range of time between the occurrence of a credit loss (such as the initial deterioration of the borrower’s financial condition) and the confirmation of that loss (the actual impairment or charge-off of the loan). The losses expected to occur within the estimated loss confirmation period are the basis of our allowance for loan losses, since we believe these losses exist at the reported date of the financial statements. We re-evaluate the adequacy of our allowance for loan losses quarterly.

As part of the loss mitigation efforts undertaken by servicers of residential loans owned by Sequoia securitization entities, a growing number of loan modifications have been completed to help make mortgage loans more affordable for certain borrowers. Loan modifications may include, but are not limited to: (i) conversion of a floating rate mortgage loan into a fixed rate mortgage loan; (ii) reduction in the contractual interest rate of a mortgage loan; (iii) forgiveness of a portion of the contractual interest and/or principal 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 (“TDRs”) according to GAAP. If a loan is determined to be a TDR, it is removed from the general loan pools used for

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

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

 

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 reversal of (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 fair value of the property, based on estimated net proceeds from the sale of the property (including servicer advances and other costs). To the extent that the fair value of the property is below the recorded investment of the loan, we record a charge against the allowance for loan losses for the difference. 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 that would require the establishment of such a reserve. We do not originate residential loans and believe that the risk of loss due to loan repurchases (i.e., due to a 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 repurchase demand 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 loans.

Commercial Loans — Allowance for Loan Losses

For commercial loans classified as held-for-investment, we establish and maintain a general allowance for loan losses inherent in our portfolio at the reporting date and, where appropriate, a specific allowance for loan losses for loans we have determined to be impaired at the reporting date. An individual loan is considered 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.

Our methodology for assessing the adequacy the allowance for loan losses begins with a formal review of each commercial loan in the portfolio and the assignment of an internal impairment status. Reviews are performed at least quarterly. We consider the following factors in evaluating each loan:

 

   

Loan to value ratios upon origination or acquisition of the loan;

 

   

The most recent financial information available for each loan and associated properties, including net operating income, debt service coverage ratios, occupancy rates, rent rolls, as well as any other loss factors we consider relevant, such as, but not limited to, specific loan trigger events that would indicate an adverse change in expected cash flows or payment delinquency;

 

   

Economic trends, both macroeconomic as well as those directly affecting the properties associated with our loans, and the supply and demand of competing projects in the sub-market in which the subject property is located; and,

 

   

The loan sponsor or borrowing entity’s ability to ensure that properties associated with the loan are managed and operated sufficiently.

Loan reviews are completed by asset management and finance personnel and reviewed and approved by senior management.

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

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

 

Based on the assigned impairment status, a loan is categorized as “Pass,” “Watch List,” or “Workout.” Pass loans are defined as loans that are performing in accordance with the contractual terms of the loan agreement. Watch List loans are defined as performing loans for which the timing of cost recovery is under review. Workout loans are defined as loans that we believe have a credit impairment that may lead to a realized loss. Workout loans are typically assessed for impairment on an individual basis. Where an individual commercial loan is impaired, we record an allowance to reduce the carrying value of the loan to the current present value of expected future cash flows discounted at the loan’s effective rate, with a corresponding charge to our consolidated statement of income.

For all commercial loans that are not individually impaired, we assess the commercial loan portfolio in aggregate for loan losses based on our expectation of credit losses inherent in the portfolio at the reporting date. Our expectation of credit losses is informed by, among other things:

 

   

Historical loss rates and past performance of similar loans in our own portfolio, if any;

 

   

Publicly available third-party reference loss rates on similar loans; and,

 

   

Trends in delinquencies and charge-offs in our own portfolio and among industry participants.

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

Real Estate Securities, at Fair Value

We classify our real estate securities as trading or available-for-sale securities. We use the “prime” or “non-prime” designation to categorize our residential securities 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 loan-to-value (“LTV”) ratios at the time the loan was originated, and are made to borrowers with higher Fair Isaac Corporation (“FICO”) scores. Non-prime residential loans are generally characterized by higher LTV ratios at the time the loan was originated and may have been made to borrowers with lower credit scores or impaired credit histories (while exhibiting the ability to repay their loans) at the time the loan was originated. Regardless of whether or not the loans underlying a residential 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.

Trading Securities

Trading securities may 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 other 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 consolidated Acacia entities as trading securities, at fair value.

AFS Securities

AFS securities may 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 changes in equity. Coupon interest is recognized as interest income when earned and deemed collectible, and the interest method is used to determine an effective yield to amortize purchase premiums, discounts, and fees associated with these securities into income over time. This requires us to project cash flows over the remaining life of each security and make assumptions with regards to interest rates, prepayment rates, the timing and amount of credit losses, and other factors. We review our cash flow projections on an ongoing basis and monitor these projections based on input and analyses received from external sources, internal models, and our own judgment and experience.

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

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

 

For an AFS security where its estimated fair value at the reporting date is 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 are met, we analyze the expected cash flows, or cost recovery of the security, to determine what, if any, OTTI is recognized through our consolidated statements of income. This analysis includes an assessment of any changes in the regulatory and/or economic environment that might affect the performance of the security.

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

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 June 30, 2012, 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 June 30, 2012, 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 we currently utilize include contractual interest rate agreements, financial futures contracts, and “To Be Announced” (“TBA”) contracts. All derivative financial instruments are recorded at fair value in our consolidated balance sheets. Derivatives with positive fair values to us are reported as assets and derivatives with negative fair values to us are reported as liabilities. We classify each of our derivative financial

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

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

 

instruments as either (i) a trading instrument (no specific hedging designation for financial reporting purposes) 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 the fair values of derivatives accounted for as trading instruments, including any associated interest income or expense, are recorded in our consolidated statements of income through other market valuation adjustments, net. The valuation changes related to derivatives used to manage certain risks associated with the residential loans we own or plan to acquire and sell or securitize are excluded from other market valuation adjustments, net, and included in mortgage banking activities, net, on our consolidated statements of income. Changes in the fair values 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 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 liability.

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 and the associated hedged item continues to exist, any unrealized gain or loss 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.

Interest Rate Agreements

Interest rate agreements that we currently utilize include swaps, swaptions, and caps. Interest rate swaps are agreements in which (i) one counterparty exchanges a stream of fixed interest payments for another counterparty’s stream of variable interest cash flows; or, (ii) each counterparty exchanges variable interest cash flows that are referenced to different indices. Interest rate swaptions are agreements that provide the owner the right but not the obligation to enter into an underlying interest rate swap with a counterparty in the future. Interest rate caps are agreements in which the owner receives payments at the end of each period for which the prevailing interest rate exceeds an agreed upon strike price. We enter into interest rate agreements 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.

Eurodollar Futures, Treasury Futures, and TBA Contracts

Eurodollar futures are futures contracts on time deposits denominated in U.S. dollars at banks outside the United States. Eurodollar futures, 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 that is typically higher than our other derivatives. Treasury futures are futures contracts on benchmark U.S. Treasury rates. TBA contracts are forward contracts to purchase mortgage-backed securities that will be issued by a U.S. government sponsored enterprise (“GSE”) in the future. We purchase or sell these derivatives to offset — to varying degrees — changes in the values of mortgage products for which we have exposure.

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

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

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

 

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. We did not have a deferred tax asset at June 30, 2012 or December 31, 2011.

Deferred Securities Issuance Costs

Securities issuance costs are expenses associated with the issuance of long-term debt, the resecuritization we engaged in during 2011, and the ABS from the Sequoia securitization entities we sponsor and consolidate for financial reporting purposes. 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 securities 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 securities issued.

Other Assets

Other assets include mortgage servicing rights (“MSRs”), REO, margin receivable, fixed assets, principal receivable, and other prepaid expenses. REO property acquired through, or in lieu of, foreclosure is initially recorded at fair value, and subsequently reported at the lower of its 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 other market valuation adjustments, net. Margin receivable reflects cash collateral we have posted with various counterparties relating to our derivative and lending agreements with those counterparties, as applicable.

See Note 10 for further discussion on other assets.

MSRs

We recognize MSRs through the acquisition of servicing rights released by third parties or through the retention of MSRs associated with residential loans that we have acquired and subsequently transferred to third parties. Typically, our MSRs are directly acquired from loan originators or created through the transfer of loans to a Sequoia residential securitization sponsored by us that meets the GAAP criteria for sale accounting.

Our MSRs are held and managed at Redwood Residential Acquisition Corporation, a wholly-owned subsidiary of RWT Holdings, Inc., which is a taxable REIT subsidiary of ours. MSRs are initially recognized and carried at their estimated fair values. Changes in the fair value of MSRs are reported in mortgage banking activities, net, a component of our consolidated statements of income.

See Note 17 for further discussion on MSRs.

Short-Term Debt

Short-term debt includes borrowings under master repurchase agreements 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

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

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

 

we have elected the fair value option, the associated accrued interest on these liabilities is measured at fair value. For financial liabilities where we have not elected the fair value option, the associated accrued interest carrying values approximate fair values.

Asset-Backed Securities Issued

The majority of the liabilities reported on our consolidated balance sheets represents 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 other 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 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 designated as cash flow hedges are reported as components of accumulated other comprehensive income on our consolidated statements of changes in equity and our statements of consolidated 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 represented the aggregate limited partnership interests in the Fund held by third parties and may appear in financial statements for periods prior to the first quarter of 2012. The portion of income allocable to third parties is shown as net income (loss) attributable to noncontrolling interest in our consolidated statements of

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

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

 

income. Equity attributable to noncontrolling interest is disclosed in our consolidated statements of changes in equity and our statements of consolidated comprehensive income.

Earnings Per Common Share

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

Accounting guidance on EPS defines unvested share-based payment awards containing nonforfeitable rights to dividends or dividend equivalents 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 or dividend equivalents.

See Note 15 for further discussion on equity.

Incentive Plans

In May 2012, 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 consolidated financial statements.

Employee Stock Purchase Plan

In May 2012, 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 a

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

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

 

liability on our consolidated balance sheets. The EDCP allows for the investment of deferrals in either an interest crediting account or DSUs.

401(k) Plan

We offer a tax-qualified 401(k) Plan to all employees for retirement savings. Under this Plan, employees are allowed to defer and invest up to 100% of their cash earnings, subject to the maximum 401(k) Plan 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 19 for further discussion on taxes.

Note 4. Principles of Consolidation

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 – for example, certain legal entities often used in securitization and other structured finance transactions – should be included in our consolidated financial statements. The GAAP principles 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 consolidated financial statements during subsequent reporting periods.

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

Note 4. Principles of Consolidation — (continued)

 

Analysis of Consolidated VIEs

The VIEs we are required to consolidate include certain Sequoia and Acacia securitization 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 June 30, 2012

 

June 30, 2012

(Dollars in thousands)

        Sequoia
       Entities      
     Acacia
       Entities      
      Resecuritization               Total          

Residential loans, held-for-investment

       $ 3,215,737          $ -          $ -          $ 3,215,737     

Commercial loans, at fair value

        -           12,176           -           12,176     

Real estate securities, at fair value

        -           254,951           323,039           577,990     

Restricted cash

        246           18,167           -           18,413     

Accrued interest receivable

        6,865           1,848           916           9,629     

Derivative assets

        -           1,349           -           1,349     

Deferred securities issuance costs

        4,692           -           935           5,627     

Other assets

        3,635           51           -           3,686     
     

 

 

    

 

 

    

 

 

    

 

 

 

Total Assets

       $     3,231,175          $     288,542          $     324,890          $     3,844,607     
     

 

 

    

 

 

    

 

 

    

 

 

 

Accrued interest payable

       $ 3,352          $ 1,803          $ 48          $ 5,203     

Derivative liabilities

        -           56,674           -           56,674     

Accrued expenses and other liabilities

        5           280           -           285     

Asset-backed securities issued

        3,126,482           244,073           193,318           3,563,873     
     

 

 

    

 

 

    

 

 

    

 

 

 

Total Liabilities

       $ 3,129,839          $ 302,830          $ 193,366          $ 3,626,035     
     

 

 

    

 

 

    

 

 

    

 

 

 

Noncontrolling interest

       $ -              $ -              $ -          $ -     

Number of VIEs

        34           10           1           45     

We consolidate the assets and liabilities of certain Sequoia securitization entities, as we did not meet the GAAP sale criteria at the time we transferred financial assets to these entities. Our involvement in consolidated Sequoia entities continues in the following ways: (i) we continue to hold subordinate investments in each entity, and for certain entities, more senior investments; (ii) we maintain certain discretionary rights associated with our sponsorship of, or subordinate investments in, each entity; and, (iii) we continue to hold a right to call the assets of certain entities (once they have been paid down below a specified threshold) at a price equal to, or in excess of, the current outstanding principal amount of the entity’s asset-backed securities issued. These factors have resulted in our continuing to consolidate the assets and liabilities of these Sequoia entities in accordance with ASC 860-10.

We consolidate the assets and liabilities of the Acacia entities, as we did not meet the GAAP sale criteria at the time we transferred financial assets to these entities. Our involvement in these entities continues in the following ways: (i) we continue in the role of collateral manager for all but one Acacia entity; (ii) we continue to hold a right to call the assets of each entity at a price equal to, or in excess of, the current outstanding principal amount of the entity’s asset-backed securities issued; and (iii) we continue to hold subordinate investments, and in some cases, more senior investments in each entity. These factors have resulted in our continuing to consolidate the assets and liabilities of the Acacia entities in accordance with ASC 860-10. However, our role as collateral manager has, under the terms of the applicable management agreements, been significantly curtailed or eliminated with respect to the Acacia entities, many of which have experienced an event of default. In addition, the estimated fair values of our call rights and investments in the Acacia entities have significantly diminished, or been effectively eliminated, over time.

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

Note 4. Principles of Consolidation — (continued)

 

We consolidate the assets and liabilities of the Resecuritization entity as we did not meet the GAAP sale criteria at the time the financial assets were transferred to this entity based on our role in the entity’s inception and design. We transferred residential senior residential securities to Credit Suisse First Boston Mortgage Securities Corp., which subsequently sold them to CSMC 2011-9R, the Resecuritization entity. In connection with this transaction, we acquired certain senior and subordinate securities that we continue to hold. We engaged in this resecuritization primarily for the purpose of obtaining permanent non-recourse financing on a portion of our senior residential securities portfolio.

During the first quarter of 2012, we sold variable interests in certain Sequoia securitization entities issued between 2001 and 2003 and determined that upon completion of an accounting analysis we should derecognize the associated assets and liabilities of these secured borrowings for financial reporting purposes. We deconsolidated $307 million of residential loans and other assets and $307 million of ABS issued and other liabilities, for a realized gain of $7 million, which was recorded on our consolidated statement of income for the three months ended March 31, 2012. These gains were comprised of both recoveries of provisions for loan losses that exceeded our recorded investment in these entities as well as cash raised from the sale of our investment interests. We maintained our intent to hold our economic interests in all remaining consolidated Sequoia entities at June 30, 2012.

Analysis of Unconsolidated VIEs with Continuing Involvement

During the six months ended June 30, 2012, we transferred residential loans to three Sequoia securitization entities sponsored by us and accounted for these transfers as sales for financial reporting purposes, in accordance with ASC 860. We also determined we were not the primary beneficiary of these VIEs as we lacked the power to direct the activities that will have the most significant economic impact on the entities. For the transferred loans where we held the servicing rights prior to the transfer, we recorded MSRs on our consolidated balance sheet at June 30, 2012, and classified those MSRs as Level 3 assets. We also retained senior and subordinate securities in these securitizations that we classified as Level 3 assets.

The following table presents information related to the Sequoia securitization transactions that occurred during the three and six months ended June 30, 2012.

Securitization Activity Related to Unconsolidated VIEs Sponsored by Redwood

 

 (Dollars in Thousands)

   Three Months Ended 
 June 30, 2012 
      Six Months Ended  
  June 30, 2012  
 
   

 Principal balance of loans transferred

   $ 293,590         $ 1,036,856     

 Trading securities retained, at fair value

    5,610          26,786     

 AFS securities retained, at fair value

    17,267          56,717     

 Gains on sale

    4,243          11,609     

 MSRs recognized

    1,029          2,608     

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

Note 4. Principles of Consolidation — (continued)

 

Our continuing involvement in these securitizations is limited to customary servicing obligations associated with retaining residential MSRs (for which we contract with a third-party servicer) and the receipt of interest income associated with the securities we retained. The following table summarizes the cash flows between us and the three unconsolidated Sequoia VIEs sponsored by us for the three and six months ended June 30, 2012.

Cash Flows Related to Unconsolidated VIEs Sponsored by Redwood

 

(Dollars in Thousands)

    Three Months Ended 
June 30, 2012
       Six Months Ended 
June 30, 2012
 

Cash proceeds

    $ 277,269          $ 972,073     

Servicing fees received

     124           138     

Servicing advances

     -               -         

Cash flows received on retained securities

     2,071           3,099     

The following table presents the key weighted-average assumptions to measure MSRs at the date of securitization.

MSR Assumptions Related to Unconsolidated VIEs Sponsored by Redwood

 

     Issued During  

At Date of Securitization

   Three Months Ended 
June 30, 2012
       Six Months Ended 
June 30, 2012
 
     

Prepayment speeds

     5 - 21  %         5 - 19  %   

Discount rates

     10  %         9  %   

The following table presents additional information related to unconsolidated Sequoia securitizations sponsored by us during the six months ended June 30, 2012.

Unconsolidated VIEs Sponsored by Redwood at June 30, 2012

 

(Dollars in Thousands)

      June 30, 2012      

On-balance sheet assets, at fair value

 

Interest-only securities, classified as trading

   $ 16,301     

Subordinate securities, classified as AFS

    58,166     

Maximum loss exposure (1)

    74,467     

Principal balance of loans outstanding

    993,942     

 

(1)

Maximum loss exposure from our involvement with unconsolidated VIEs pertains to the carrying value of our securities retained from these VIEs and represents estimated losses that would be incurred under severe, hypothetical circumstances, such as if the value of our interests and any associated collateral declines to zero. This does not include any potential exposure to representation and warranty claims associated with our initial transfer of loans into a securitization.

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

Note 4. Principles of Consolidation — (continued)

 

The following table presents key economic assumptions and the sensitivity of the current fair value to immediate adverse changes in those assumptions at June 30, 2012.

Key Assumptions and Sensitivity Analysis for Unconsolidated VIEs Sponsored by Redwood

 

June 30, 2012           Senior
    Interest-only    
         Subordinate      

(Dollars in Thousands)

           MSRs              Securities      Securities  

Fair value at June 30, 2012

    $ 2,064              $ 16,301              $ 58,166         

Expected weighted-average life (in years)

     3               3               12         

Prepayment speed assumption (annual CPR)

     25  %         18  %         19  %   

Decrease in fair value from:

        

10% adverse change

    $ 157             $ 1,100              $ 489         

25% adverse change

     363               2,539               1,132         

Discount rate assumption

     10  %         13  %         7  %   

Decrease in fair value from:

        

100 basis point increase

    $ 54              $ 387              $ 4,947         

200 basis point increase

     106               757               9,303         

Credit loss assumption

     N/A               0.46  %         0.49  %   

Decrease in fair value from:

        

10% higher losses

     N/A              $ 6              $ 150         

25% higher losses

     N/A               14               350         

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 June 30, 2012, grouped by collateral type and ownership interest.

Third-Party VIE Summary

 

June 30, 2012

(Dollars in Thousands)

           Fair Value                   Number of VIEs      

Real estate securities at Redwood

     

Residential

     

Senior

    $ 432,733          $ 48     

Re-REMIC

     147,438           16     

Subordinate

     73,275           144     

Commercial

     5,761           7     

CDO

     64           6     
  

 

 

    

 

 

 

Total Third-Party Real Estate Securities

    $ 659,271          $ 221     
  

 

 

    

 

 

 

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

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

Note 4. Principles of Consolidation — (continued)

 

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 determine the fair value of financial instruments. 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 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 required to be 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 at which the fair value measurement 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.

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 June 30, 2012 and December 31, 2011.

 

     June 30, 2012      December 31, 2011  

(In Thousands)

       Carrying    
Value
     Fair
    Value    
         Carrying    
Value
     Fair
    Value    
 

Assets

           

Residential loans, held-for-sale

    $ 256,077          $ 259,659          $ 395,237          $ 401,909     

Residential loans, held-for-investment

       3,215,737             2,830,600             3,799,648             3,306,441     

Commercial loans, at fair value

     12,176           12,176           12,129           12,129     

Commercial loans, held-for-investment

     246,783           248,667           157,726           158,780     

Trading securities

     294,799           294,799           253,142           253,142     

Available-for-sale securities

     1,016,929           1,016,929           728,695           728,695     

Cash and cash equivalents

     69,519           69,519           267,176           267,176     

Restricted cash

     18,512           18,512           14,987           14,987     

Accrued interest receivable

     15,850           15,850           15,840           15,840     

Derivative assets

     2,963           2,963           2,373           2,373     

Mortgage servicing rights (1)

     2,064           2,064           -           -     

REO (1)

     3,550           4,335           5,669           5,669     

Margin receivable (1)

     72,110           72,110           71,976           71,976     

Liabilities

           

Short-term debt

     455,419           455,419           428,056           428,056     

Accrued interest payable

     6,800           6,800           8,134           8,134     

Derivative liabilities

     114,473           114,473           127,564           127,564     

ABS issued

     3,563,873           3,117,075           4,139,355           3,467,054     

Long-term debt

     139,500           72,540           139,500           57,195     

 

(1)

These assets are included in Other Assets on our consolidated balance sheets.

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

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

 

We elected the fair value option for $9 million and $31 million of residential senior securities that we acquired during the three and six months ended June 30, 2012, respectively. We have historically elected the fair value option for all commercial loans, trading securities, and ABS issued at Acacia entities, as well as certain third-party residential securities and CDOs.

The following table presents the assets and liabilities recorded that are reported at fair value on our consolidated balance sheets on a recurring basis as well as the fair value hierarchy of the valuation inputs used to measure fair value.

Assets and Liabilities Measured at Fair Value on a Recurring Basis at June 30, 2012

 

June 30, 2012    Carrying      Fair Value Measurements Using  

(In Thousands)

   Value          Level 1              Level 2              Level 3      

Assets

           

Commercial loans, at fair value

    $ 12,176            $ -              $ -             $ 12,176     

Trading securities

     294,799             -               -               294,799     

Available-for-sale securities

       1,016,929             -               -               1,016,929     

Derivative assets

     2,963             -               2,963           -         

MSRs

     2,064             -               -               2,064     

Liabilities

           

Derivative liabilities

     114,473             450           95,023           19,000     

ABS issued - Acacia

     244,073             -               -               244,073     

The following table presents additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the six months ended June 30, 2012.

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

 

     Assets      Liabilities  
       Commercial        Trading      AFS             Derivative       ABS Issued-   

(In Thousands)

   Loans        Securities          Securities          MSRs          Liabilities        Acacia  

Beginning balance - December 31, 2011

    $ 12,129           $ 253,142           $ 728,695           $ -              $ 19,500           $ 209,381      

Transfer to Level 3

     -                -                -                -               -               -         

Principal paydowns

     (75)           (27,449)           (68,087)           -               -               (21,216)     

Gains (losses) in net income, net

     122            45,150            29,226            (544)           1,090            45,026      

Unrealized gains in OCI, net

     -                -                42,489            -               -               -         

Acquisitions

     -                30,249            379,539            2,608            -               -         

Sales

     -                (6,670)           (94,992)           -               -               -         

Other settlements, net

     -                377            59            -               (1,590)           10,882      
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Ending Balance - June 30, 2012

    $ 12,176           $ 294,799           $ 1,016,929           $   2,064           $ 19,000           $ 244,073      
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

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

 

The following table presents the portion of gains or losses included in our consolidated statements of income that were attributable to Level 3 assets and liabilities recorded at fair value on a recurring basis and held at both June 30, 2012 and 2011. Gains or losses incurred on assets or liabilities sold, matured, called, or fully written down during the three and six months ended June 30, 2012 and 2011 are not included in this presentation.

Portion of Net Gains (Losses) Attributable to Level 3 Assets and Liabilities Still Held at June 30, 2012 and 2011 Included in Net Income

 

     Included in Net Income      Included in Net Income  
       Three Months Ended June 30,         Six Months Ended June 30,    

 (In Thousands)

   2012      2011      2012      2011  

 Assets

           

 Commercial loans, at fair value

   $ 111          $ 1,323          $ 122          $ 1,542      

 Trading securities

     10,585            (9,557)           43,019            1,070      

 Available-for-sale securities

     (303)           (1,446)           (635)           (2,469)     

 Derivative assets

     -                -                -                -          

 Mortgage servicing rights

     (476)           -                (482)           -          

 Liabilities

           

 Derivative liabilities

     (195)           -                (1,090)           -          

 ABS issued - Acacia

     (12,973)           17,380            (45,026)           (6,757)     

The following table presents information on assets and liabilities recorded at fair value on a non-recurring basis at June 30, 2012.

Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis at June 30, 2012

 

                                  Gain (Loss)  

 June 30, 2012

 (In Thousands)

     Carrying  
Value
      Fair Value Measurements Using       Three Months Ended        Six Months Ended    
      Level 1      Level 2      Level 3      June 30, 2012      June 30, 2012  

 Assets

                 

 Residential loans, held-for-sale

    $ 942           $ -            $ -            $ 942           $ 3           $ 45      

 REO

     373            -             -             373            (65)           (29)     

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

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

 

The following table presents the components of market valuation adjustments, net, recorded in our consolidated statements of income for the three and six months ended June 30, 2012 and 2011.

Market Valuation Adjustments, Net

 

      Three Months Ended June 30,      Six Months Ended June 30,  

(In Thousands)

   2012      2011      2012      2011  

Other market valuation adjustments

           

Residential loans, held-for-sale

    $ 405          $ 8          $ 498          $ 11     

Commercial loans, at fair value

     111           1,323           122           1,542     

Trading securities

     10,986           (9,594)          45,150           10,322     

Impairments on AFS securities

     (303)          (1,466)          (635)          (4,088)    

REO

     (162)          (244)          (144)          (1,162)    

Other derivative instruments, net

     (3,513)          (18,554)          (5,982)          (16,755)    

ABS issued - Acacia

     (12,973)          17,380           (45,026)          (6,757)    
  

 

 

    

 

 

    

 

 

    

 

 

 

Other market valuation adjustments, net

     (5,449)          (11,147)          (6,017)          (16,887)    
  

 

 

    

 

 

    

 

 

    

 

 

 

Mortgage banking activities market valuation adjustments

           

MSRs

     (527)          -           (544)          -     

Derivative instruments, net

     (3,282)          -           (6,398)          -     
  

 

 

    

 

 

    

 

 

    

 

 

 

Mortgage banking activities market valuation adjustments, net

     (3,809)          -           (6,942)          -     
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Market Valuation Adjustments, Net

    $ (9,258)         $ (11,147)         $ (12,959)         $ (16,887)    
  

 

 

    

 

 

    

 

 

    

 

 

 

Valuation Process

We estimate fair values for financial assets or liabilities based on available inputs and pricing that are observed in the marketplace. We primarily use two pricing valuation techniques: market comparable pricing and discounted cash flow analysis. Market comparable pricing is used to determine the estimated fair value of certain instruments by incorporating known inputs and performance metrics, such as observed prepayment rates, delinquencies, credit support, recent transaction prices, pending transactions, or prices of other similar instruments. Discounted cash flow valuation techniques generally consist of developing an estimate of future cash flows that are expected to occur over the life of an instrument and then discounting those cash flows at a rate of return that results in an estimate of fair value. 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. For certain instruments, we also consider counterparty credit quality and risk as part of our fair value assessments.

We maintain a valuation policy that identifies the methodology used to value different types of financial instruments. Any changes to the valuation process or methodology are reviewed by members of senior management to confirm the changes are appropriate and reasonable. Valuations based on external sources are performed on an instrument by instrument basis with the resulting amounts analyzed individually against internal calculations as well as in aggregate by product type classification. Initial valuations are performed by our portfolio management group using the valuation techniques described above. A subset of our finance department then independently reviews all fair values estimates using available market, portfolio, and industry information to ensure they are reasonable. Finally, members of senior management review all fair value estimates, including an analysis of valuation changes from prior reporting periods. We continually assess the appropriateness of our valuation techniques and, as market conditions warrant, adjust our internal valuation processes accordingly.

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

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

 

The following table provides quantitative information about the significant unobservable inputs used in the valuation of our Level 3 assets and liabilities measured at fair value.

Fair Value Methodology for Level 3 Financial Instruments

 

June 30, 2012    Fair                  Weighted  

(In Thousands)

   Value     

Unobservable Input

   Range      Average  

Assets

           

Commercial loans, at fair value

    $ 12,176       

 Discount rate

     14 - 16  %         14  %   
     

 Debt coverage ratio

     1.52 - 1.59               1.54         
     

 Occupancy

     89 - 91  %         89  %   

Trading and AFS securities

       1,311,728       

 Discount rate

     6 - 25  %         8  %   
     

 Prepayment speed

     2 - 55  %         12  %   
     

 Default rate

     2 - 80  %         21  %   
     

 Loss severity

     25 - 100  %         62  %   
     

 Credit support

     0 - 100  %         6  %   

MSRs

     2,064       

 Discount rate

     10 - 10  %         10  %   
     

 Prepayment rate

     12 - 60  %         25  %   

Residential loans, held-for-sale

     942       

 Loss severity

     30 - 43  %         34  %   

REO

     373       

 Historical loss adjustment

     20 - 35  %         27  %   

Liabilities

           

Derivative liabilities

     19,000       

 Collateral cash-flow

     N/A               N/A         

ABS issued - Acacia

     244,073       

 Discount rate

     6 - 25  %         12  %   
     

 Prepayment speed

     2 - 55  %         7  %   
     

 Default rate

     5 - 80  %         37  %   
     

 Loss severity

     25 - 100  %         74  %   

Determination of Fair Value

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 herein. We generally use both market comparable information and discounted cash flow modeling techniques to determine the fair value of our Level 3 assets and liabilities. Use of these techniques requires determination of relevant inputs and assumptions, some of which represent significant unobservable inputs as indicated in the preceding table. Accordingly, a significant increase or decrease in any of these inputs – such as anticipated credit losses, prepayment speeds, interest rates, or other valuation assumptions – in isolation, would likely result in a significantly lower or higher fair value measurement.

Residential loans

Estimated fair values for residential loans are determined based on either an exit price to securitization or the whole loan market. For loans valued based on an exit to securitization, significant inputs in the valuation analysis are predominantly Level 3 in nature, due to the limited availability of market quotes on newly issued residential mortgage-backed securities (“RMBS”) and related inputs. Relevant market indicators that are factored into the

 

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Table of Contents

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

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

 

analyses include third-party RMBS sales, pricing points for secondary sales of RMBS we have issued in past periods, yields for RMBS issued by government sponsored enterprises, indexed swap yields, credit rating agency guidance on expected credit enhancement levels for newly issued RMBS transactions, interest rates, and prepayment speeds (Level 3).

For loans valued based on an exit to the whole loan market, significant inputs in the valuation analysis are predominantly Level 3 in nature. Relevant market indicators that are factored into the analyses include prices on recent sales of our own whole loans, indexed swap yields, interest rates, prepayment speeds, and loss severities (Level 3). These assets and liabilities would generally decrease in value based upon an increase in the loss severity assumption and would generally increase in value if the loss severity assumption were to decrease.

Commercial loans

Estimated fair values for commercial loans are determined by both market comparable pricing and discounted cash flow analysis valuation techniques (Level 3). The availability of market quotes for our commercial loans is limited. Any changes in fair value are primarily a result of instrument specific credit risk. Our discounted cash flow models utilize certain significant unobservable inputs including prepayment rate and debt coverage ratio assumptions. An increase in these unobservable inputs will reduce the fair value of the commercial loans and alternatively, a decrease in these inputs would result in the commercial loans increasing in value.

Real estate securities

Real estate securities include residential, commercial, CDO, and other asset-backed securities that are generally illiquid in nature and trade infrequently. For real estate securities, we utilize both market comparable pricing and discounted cash flow analysis valuation techniques. Significant inputs in the valuation analysis are predominantly Level 3 in nature, due to the lack of readily available market quotes and related inputs. Relevant market indicators that are factored into the analyses include bid/ask spreads, credit losses, interest rates, and prepayment speeds. Estimated fair values are based on applying the market indicators to generate discounted cash flows (Level 3). These cash flow models use significant unobservable inputs such as discount rate, prepayment rate, default rate, loss severity and credit support. The fair value of our securities would generally decrease in value based upon an increase in serious delinquencies. Conversely, the fair value of our securities would generally increase if the prepayment rate or credit support inputs were to increase.

As part of our securities valuation process, we request and consider indications of value from third-party securities dealers. For purposes of pricing our securities at June 30, 2012, we received dealer price indications on 48% of our securities. In the aggregate, our internal valuations of the securities for which we received dealer price indications were 2% lower than the aggregate dealer valuations. Once we receive the price indications from dealers, they are compared to other relevant market inputs, such as actual or comparable trades, and the results of our discounted cash flow analysis. In circumstances where relevant market inputs cannot be obtained, increased reliance on discounted cash flow analysis and management judgment are required to estimate fair value.

Derivative assets and liabilities

Our derivative instruments include interest rate agreements, TBAs, and financial futures. Fair values of derivative instruments are determined using quoted prices from active markets, when available, or valuation models and are supported by valuations provided by dealers active in derivative markets. TBA and financial futures fair values are generally obtained using quoted prices from active markets (Level 1). Our derivative valuation models require a variety of inputs, including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates, and correlations of certain inputs. Model inputs for interest rate agreements can generally be verified and model selection does not involve significant management judgment (Level 2).

For other derivatives, valuations are based on various factors such as liquidity, bid/offer spreads, and credit considerations for which we rely on available market inputs In the absence of such inputs, management’s best estimate is used (Level 3). At June 30, 2012, derivative instruments classified as Level 3 consisted of certain interest

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

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

 

rate swaps held at our Acacia securitization entities. These derivatives are only entitled to cash flows generated from assets held within their respective securitization entity. Consequently, to the extent that the value of the estimated cash flows of the assets within the entity is less than the estimated fair value of the derivative, an adjustment to the carrying value of the derivative is made. Any change in estimated cash flows of assets within a securitization entity that result in the value of those cash flows being less than the estimated fair value of the derivative will result in an adjustment to the carrying value of the derivative.

Cash and cash equivalents

Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less. Fair values equal carrying values (Level 1).

Restricted cash

Restricted cash primarily includes interest-earning cash balances in ABS entities for the purpose of distribution to bondholders or limited partners, and reinvestment. Due to the short-term nature of the restrictions, fair values approximate carrying values (Level 1).

Accrued interest receivable and payable

Accrued interest receivable and payable includes interest due on our assets and payable on our liabilities. Due to the short-term nature of when these interest payments will be received or paid, fair values approximate carrying values (Level 1).

MSRs

MSRs include the rights to service mortgage loans for others. Significant inputs in the valuation analysis are predominantly Level 3, due to the nature of these instruments and the lack of readily available market quotes. These inputs include market discount rates, prepayment speeds and default rates of serviced loans, and the market cost of servicing. Changes in the fair value of MSRs occur primarily due to the collection/realization of expected cash flows, as well as changes in valuation inputs and assumptions. Estimated fair values are based on applying the inputs to generate the net present value of estimated MSR income, which is what we believe market participants would use to estimate fair value (Level 3). These discounted cash flows models utilize certain significant unobservable inputs including prepayment rate and discount rate assumptions. An increase in these unobservable inputs will reduce the fair value of the MSRs and alternatively, a decrease in these inputs would result in the MSRs increasing in value. Additionally, if prepayments occur at a rate greater than our estimate, the fair value of the MSRs will decrease accordingly.

REO

REO includes properties owned in satisfaction of foreclosed loans. Fair values are determined using available market quotes, appraisals, broker price opinions, comparable properties, or other indications of value (Level 3).

Margin receivable

Margin receivable reflects cash collateral Redwood has posted with our various derivative and lending counterparties as required to satisfy the minimum margin requirements. Fair values approximate carrying values (Level 1).

Short-term debt

Short-term debt includes our credit facilities that mature within one year. Short-term debt is generally at an adjustable rate. Fair values approximate carrying values (Level 1).

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

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

 

ABS issued

ABS issued includes asset-backed securities issued through our Sequoia, Acacia, and Resecuritization entities. These instruments are illiquid in nature and trade infrequently, if at all. For ABS issued, we utilize both market comparable pricing and discounted cash flow analysis valuation techniques. Significant inputs in the valuation analysis are predominantly Level 3, due to the nature of these instruments and the lack of readily available market quotes. Relevant market indicators factored into the analyses include dealer price indications to the extent available, bid/ask spreads, external spreads, collateral credit losses, interest rates, default rates, loss severities, and collateral prepayment speeds. Estimated fair values are based on applying the market indicators to generate discounted cash flows (Level 3). These liabilities would generally increase in value based upon a decrease in serious delinquencies and would generally decrease in value if the prepayment rate or credit support input were to decrease.

As part of our ABS issued valuation process, we request and consider indications of value from third-party securities dealers. For purposes of pricing our ABS issued at June 30, 2012, we received dealer price indications on 52% of our ABS issued. In the aggregate, our internal valuations of the ABS issued for which we received dealer price indications were 7% higher (i.e., more conservative) than the aggregate dealer valuations. Once we receive the price indications from dealers, they are compared to other relevant market inputs, such as actual or comparable trades, and the results of our discounted cash flow analysis. In circumstances where relevant market inputs cannot be obtained, increased reliance on discounted cash flow analysis and management judgment are required to estimate fair value.

Long-term debt

Long-term debt includes subordinated notes and trust preferred securities. Estimated fair values are determined discounted cash flow analysis valuation techniques. Significant inputs in the valuation analysis are predominantly Level 3, due to the nature of these instruments and the lack of readily available market quotes. Estimated fair values are based on applying the market indicators to generate discounted cash flows (Level 3).

Note 6. Residential Loans

We acquire residential loans from third-party originators. During the three and six months ended June 30, 2012, we purchased $336 million and $995 million (principal value), respectively, of residential loans primarily in connection with our Sequoia securitization program. The following table summarizes the classifications and carrying value of the residential loans owned at Redwood and at consolidated Sequoia entities at June 30, 2012 and December 31, 2011.

 

June 30, 2012                       

(In Thousands)

               Redwood                     Sequoia                       Total             

Held-for-sale

      $ 256,077        $ -         $ 256,077     

Held-for-investment

       -          3,215,737          3,215,737     
    

 

 

   

 

 

   

 

 

 

Total Residential Loans

      $ 256,077         $ 3,215,737         $ 3,471,814     
    

 

 

   

 

 

   

 

 

 

 

December 31, 2011                       

(In Thousands)

               Redwood                     Sequoia                       Total             

Held-for-sale

      $ 395,237         $ -         $ 395,237     

Held-for-investment

       -          3,799,648          3,799,648     
    

 

 

   

 

 

   

 

 

 

Total Residential Loans

      $ 395,237         $ 3,799,648         $ 4,194,885     
    

 

 

   

 

 

   

 

 

 

We do not currently service any residential loans, although at June 30, 2012, we did maintain MSRs that provided us with the rights to service $132 million (principal value) of consolidated residential loans purchased from third-party originators.

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

Note 6. Residential Loans — (continued)

 

Residential Loans Held-for-Sale

At June 30, 2012, there were 293 residential loans held-for-sale with $253 million in outstanding principal value and a lower of cost or fair value of $256 million. During the three months ended June 30, 2012 and 2011, we recorded valuation adjustments for residential loans held-for-sale of $405 thousand and $8 thousand, respectively. During the six months ended June 30, 2012 and 2011, we recorded valuation adjustments for residential loans held-for-sale of $498 thousand and $11 thousand, respectively. On December 31, 2011, we reclassified $393 million (recorded investment) of loans previously classified as held-for-investment to held-for-sale. We did not record a valuation adjustment related to this reclassification. At December 31, 2011, loans held-for-sale had an outstanding principal value of $395 million and a lower of cost or fair value of $395 million.

Residential Loans Held-for-Investment

The following table details the carrying value for residential loans held-for-investment at June 30, 2012 and December 31, 2011. These loans are owned at Sequoia securitization entities that we consolidate for financial reporting purposes.

 

 (In Thousands)

         June 30, 2012             December 31, 2011   

 Principal balance

    $ 3,238,543          $ 3,829,847     

Unamortized premium, net

     32,643           36,682     
  

 

 

    

 

 

 

 Recorded investment

     3,271,186           3,866,529     

Allowance for loan losses

     (55,449)          (66,881)    
  

 

 

    

 

 

 

 Carrying Value

    $ 3,215,737          $ 3,799,648     
  

 

 

    

 

 

 

Of the $3.24 billion of principal value and $33 million of unamortized premium on loans held-for-investment at June 30, 2012, $1.17 billion of principal value and $20 million of unamortized premium relate to residential loans acquired prior to July 1, 2004. During the first six months of 2012, 4% of these residential loans prepaid and we amortized 7% of the premium based upon the accounting elections we apply. For residential loans acquired after July 1, 2004, the principal value was $2.07 billion and the unamortized premium was $13 million. During the first six months of 2012, 10% of these loans prepaid and we amortized 7% of the premium. During the first quarter of 2012, we derecognized $308 million of loan principal value and $1 million of unamortized premium related to the deconsolidation of five Sequoia securitization entities.

Of the $3.8 billion of principal value and $37 million of unamortized premium on loans held-for-investment at December 31, 2011, $1.5 billion of principal value and $23 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 $2.3 billion and the unamortized premium was $14 million.

Credit Characteristics of Residential Loans Held-for-Investment

As a percentage of our recorded investment, 98% of residential loans held-for-investment at June 30, 2012, were first lien, predominately prime-quality loans at the time of origination. The remaining 2% of loans were second lien, home equity lines of credit. The weighted average original LTV ratio for our residential loans held-for-investment outstanding at June 30, 2012, was 66%. The weighted average FICO score for the borrowers of these loans was 737 at the time the loans were originated.

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

Note 6. Residential Loans — (continued)

 

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 have often possessed similar product and credit characteristics. The following table displays our recorded investment in residential loans held-for-investment at June 30, 2012 and December 31, 2011, organized by year of origination.

 

 (In Thousands)

         June 30, 2012           December 31, 2011   

 2003 & Earlier

    $ 1,381,078          $ 1,771,111     

 2004

     1,006,032           1,045,815     

 2005

     128,005           129,163     

 2006

     177,015           181,017     

 2007

     59,379           63,301     

 2008

     -           -     

 2009

     96,286           144,116     

 2010

     271,433           343,278     

 2011

     151,958           188,728     
  

 

 

    

 

 

 

 Total Recorded Investment

    $ 3,271,186          $ 3,866,529     
  

 

 

    

 

 

 

Allowance for Loan Losses on Residential Loans

For residential loans held-for-investment, we establish and maintain an allowance for loan losses. The allowance includes a component for pools of residential loans owned at Sequoia securitization entities that we collectively evaluated for impairment, and a component for loans individually evaluated for impairment that includes restructured residential loans at 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 six months ended June 30, 2012 and 2011.

 

       Three Months Ended June 30,          Six Months Ended June 30,    

(In Thousands)

   2012      2011      2012      2011  

 Balance at beginning of period

    $ 59,155          $ 62,922          $ 66,881          $ 62,432     

 Charge-offs, net

     (1,991)          (2,197)          (5,139)          (4,515)   

 (Reversal of) provision for loan losses

     (1,715)          1,581           (1,715)          4,389    

 Deconsolidation adjustment

     -               -               (4,578)          -         
  

 

 

    

 

 

    

 

 

    

 

 

 

 Balance at End of Period

    $ 55,449          $ 62,306          $ 55,449          $ 62,306    
  

 

 

    

 

 

    

 

 

    

 

 

 

During both the three months ended June 30, 2012 and 2011, there were $2 million of charge-offs of residential loans that reduced our allowance for loan losses. These charge-offs arose from $4 million and $7 million of defaulted loan principal, respectively. During both the six months ended June 30, 2012 and 2011, there were $5 million of charge-offs of residential loans that reduced our allowance for loan losses. These charge-offs arose from $14 million and $15 million of defaulted loan principal, respectively.

Residential Loans Collectively Evaluated for Impairment

We establish the collective component of 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

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

Note 6. Residential Loans — (continued)

 

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.

The following table summarizes the balances for loans collectively evaluated for impairment at June 30, 2012 and December 31, 2011.

 

 (In Thousands)

         June 30, 2012             December 31, 2011   

 Principal balance

    $ 3,223,009          $ 3,815,010     

 Recorded investment

     3,256,409           3,852,455     

 Related allowance

     52,717           64,069     

The following table summarizes the recorded investment and past due status of residential loans collectively evaluated for impairment at June 30, 2012 and December 31, 2011.

 

 (In Thousands)

       30-59 Days    
Past Due
         60-89 Days    
Past Due
         90+ Days    
Past Due
         Current              Total    
Loans
 

 June 30, 2012

    $ 54,277          $ 20,276          $       114,495          $       3,067,361          $       3,256,409     

 December 31, 2011

     58,954           20,938           135,671           3,636,892           3,852,455     

Residential Loans Individually Evaluated for Impairment

As part of the loss mitigation efforts undertaken by servicers of residential loans owned at Sequoia securitization entities, an increasing number of loan modifications have been completed to help make mortgage loans more affordable for qualifying borrowers and potentially reduce a future impairment. For the six months ended June 30, 2012 and 2011, all of the loan modifications determined to be TDRs were either: (i) conversions of a floating rate mortgage loan into a fixed rate mortgage loan; (ii) reductions in the contractual interest rates of a mortgage loan paired with capitalization of accrued interest; or (iii) principal forgiveness paired with interest rate reductions.

The following table presents the details of the loan modifications determined to be TDRs for the three and six months ended June 30, 2012 and 2011.

 

       Three Months Ended June 30,            Six Months Ended June 30,      

 (Dollars in Thousands)

   2012      2011      2012      2011  

 Number of TDRs

     2            5            6            6      

 Pre-TDR outstanding recorded investment

    $ 884           $ 2,794           $ 2,672           $ 3,410      

 Post-TDR outstanding recorded investment

     626            2,790            2,425            3,298      

 TDR effect on Net Interest Income After Provision and Other MVA

     (118)           (334)           (597)           (464)     

 TDRs that Subsequently Defaulted

           

 Number of TDRs

     2            1            4            1      

 Recorded investment

    $ 603           $ 534           $ 1,702           $ 534      

If we determine that a restructured loan is a TDR, we remove it from the general loan pools used for determining the allowance for residential loan losses and assess it for impairment on an individual basis. This assessment is based primarily on whether an adverse change in the expected future cash flows resulted from the restructuring. The average recorded investment of loans individually evaluated for impairment for the three months ended June 30, 2012 and 2011, was $15 million and $12 million, respectively. For the three months ended June 30,

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

Note 6. Residential Loans — (continued)

 

2012 and 2011, we recorded $149 thousand and $128 thousand interest income, respectively, on individually impaired loans. The average recorded investment of loans individually evaluated for impairment for the six months ended June 30, 2012 and 2011, was $15 million and $12 million, respectively. For the six months ended June 30, 2012 and 2011, we recorded $259 thousand and $169 thousand interest income, respectively, on individually impaired loans.

The following table summarizes the balances for loans individually evaluated for impairment, all of which had an allowance, at June 30, 2012 and December 31, 2011.

 

(In Thousands)

        June 30, 2012            December 31, 2011   

Principal balance

    $ 15,534          $ 14,837     

Recorded investment

     14,777           14,074     

Related allowance

     2,732           2,812     

The following table summarizes the recorded investment and past due status of residential loans individually evaluated for impairment at June 30, 2012 and December 31, 2011.

 

(In Thousands)

           30-59 Days    
Past Due
         60-89 Days    
Past Due
         90+ Days    
Past Due
           Current            Total
         Loans        
 

June 30, 2012

      $ 1,175          $ 1,000          $ 2,365          $ 10,237          $ 14,777     

December 31, 2011

       768           2,222           2,026           9,058           14,074     

Note 7. Commercial Loans

We invest in commercial loans that we originate and service as well as loans that we acquire from third-party originators. Some of these loans are financed through the Acacia entities that we sponsor. The following table summarizes the classifications and carrying value of commercial loans at June 30, 2012 and December 31, 2011.

 

June 30, 2012

(In Thousands)

          Redwood                      Acacia                     Total Loans       

Fair value

    $ -          $ 12,176          $ 12,176     

Held-for-investment

     246,783           -           246,783     
  

 

 

    

 

 

    

 

 

 

Total Commercial Loans

    $ 246,783          $ 12,176          $ 258,959     
  

 

 

    

 

 

    

 

 

 

 

December 31, 2011

(In Thousands)

          Redwood                      Acacia                     Total Loans       

Fair value

    $ -          $ 12,129          $ 12,129     

Held-for-investment

     157,726           -           157,726     
  

 

 

    

 

 

    

 

 

 

Total Commercial Loans

    $ 157,726          $ 12,129          $ 169,855     
  

 

 

    

 

 

    

 

 

 

Commercial Loans at Fair Value

Commercial loans at fair value are owned at the consolidated Acacia securitization entities. At both June 30, 2012 and December 31, 2011, there were three commercial loans at fair value with an aggregate outstanding principal value of $14 million and an aggregate fair value of $12 million.

Commercial Loans Held-for-Investment

Commercial loans held-for-investment include loans we originate and preferred equity investments we make or, in either case, acquire from third parties. The loans are typically mezzanine loans that are secured by a borrower’s ownership interest in a single purpose entity that owns commercial property, rather than a lien on the commercial

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

Note 7. Commercial Loans — (continued)

 

property. The preferred equity investments are typically preferred equity interests in a single purpose entity that owns commercial property and are included within, and referred to herein, as commercial loans held-for-investment due to the fact that their risks and payment characteristics are nearly equivalent to commercial mezzanine loans.

The following table provides additional information for our commercial loans held-for-investment at June 30, 2012 and December 31, 2011.

 

(In Thousands)

         June 30, 2012              December 31, 2011    

Principal balance

    $ 251,686          $ 158,847     

Unamortized discount, net

     (3,645)          (513)    
  

 

 

    

 

 

 

Recorded investment

     248,041           158,334     

Allowance for loan losses

     (1,258)          (608)    
  

 

 

    

 

 

 

Carrying Value

    $ 246,783          $ 157,726     
  

 

 

    

 

 

 

At June 30, 2012, there were 27 commercial loans held-for-investment with an outstanding principal value of $252 million and a carrying value of $247 million. Of the $248 million of recorded investment in commercial loans held-for-investment at June 30, 2012, 39% was originated in 2012, 49% was originated in 2011, 12% was originated in 2010, and less than 1% was acquired in 2004. At December 31, 2011, there were 15 commercial loans held-for-investment with an outstanding principal value of $159 million and a carrying value of $158 million. Of the $158 million of recorded investment in commercial loans held-for-investment at December 31, 2011, 81% was originated in 2011, 19% was originated in 2010, and less than 1% was acquired in 2004.

Allowance for Loan Losses on Commercial Loans

For commercial loans classified as held-for-investment, we establish and maintain an allowance for loan losses. The allowance includes a component for loans collectively evaluated for impairment and a component for loans individually evaluated for impairment.

Activity in the Allowance for Loan Losses on Commercial Loans

The following table summarizes the activity in the allowance for commercial loan losses for the three and six months ended June 30, 2012 and 2011.

 

       Three Months Ended June 30,           Six Months Ended June 30,  

(In Thousands)

   2012      2011      2012      2011  

Balance at beginning of period

    $ 882          $ -              $ 608          $ -         

Charge-offs, net

     -               -               -               -         

Provision for loan losses

     376           -               650           -         
  

 

 

    

 

 

    

 

 

    

 

 

 

Balance at End of Period

    $ 1,258          $ -              $ 1,258          $ -         
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

Note 7. Commercial Loans — (continued)

 

Commercial Loans Collectively Evaluated for Impairment

We record an allowance for loan losses based on our estimate of credit losses inherent in our portfolio at the reporting date. Our estimate of credit losses is informed by loss rates and delinquency trends. At June 30, 2012 and December 31, 2011, all of the commercial loans collectively evaluated for impairment were current and were assigned an impairment status of “Pass.” The following table summarizes the balances for loans collectively evaluated for impairment at June 30, 2012 and December 31, 2011.

 

(In Thousands)

       June 30, 2012            December 31, 2011    

Principal balance

    $ 251,686          $ 158,847     

Recorded investment

     248,041           158,334     

Related allowance

     1,258           608     

Commercial Loans Individually Evaluated for Impairment

We did not have any loans individually evaluated for impairment for either of the six months ended June 30, 2012 and 2011.

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 June 30, 2012 and December 31, 2011.

 

June 30, 2012

(In Thousands)

           Redwood                      Acacia              Total
      Securities      
 

Residential

    $ 1,050,952          $ 173,106          $ 1,224,058     

Commercial

     5,761           66,754           72,515     

CDO

     64           15,091           15,155     
  

 

 

    

 

 

    

 

 

 

Total Real Estate Securities

    $ 1,056,777          $ 254,951          $ 1,311,728     
  

 

 

    

 

 

    

 

 

 

 

December 31, 2011

(In Thousands)

           Redwood                      Acacia              Total
      Securities      
 

Residential

    $ 744,281          $ 175,062          $ 919,343     

Commercial

     5,445           37,923           43,368     

CDO

     1,010           18,116           19,126     
  

 

 

    

 

 

    

 

 

 

Total Real Estate Securities

    $ 750,736          $ 231,101          $ 981,837     
  

 

 

    

 

 

    

 

 

 

Senior securities are those interests in a securitization that have the first right to cash flows and are last in line to absorb losses. Re-REMIC securities, as presented herein, were created through the resecuritization of certain senior interests to provide additional credit support to those interests. These re-REMIC securities are therefore subordinate to the remaining senior interest, but senior to any subordinate tranches of the securitization from which they were created. Subordinate securities are all interests below senior and re-REMIC interests.

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

Note 8. Real Estate Securities — (continued)

 

Trading Securities

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 trading securities was $973 million and $1.11 billion at June 30, 2012 and December 31, 2011, respectively. The following table presents trading securities by collateral type and ownership entity at June 30, 2012 and December 31, 2011.

 

      June 30, 2012      December 31, 2011  

(In Thousands)

       Redwood              Acacia                Total                Redwood              Acacia                Total        

Senior Securities

                 

Residential prime

    $ 16,301          $ 3,195          $ 19,496          $ -              $ 3,019          $ 3,019     

Residential non-prime

     22,962           87,030           109,992           20,608           88,280           108,888     

Commercial

     -               11,684           11,684           -               11,216           11,216     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Senior Securities

     39,263           101,909           141,172           20,608           102,515           123,123     

Subordinate Securities

                 

Residential prime

     468           32,790           33,258           343           31,718           32,061     

Residential non-prime

     103           50,091           50,194           130           52,045           52,175     

Commercial

     -               55,070           55,070           -               26,707           26,707     

CDO

     14           15,091           15,105           960           18,116           19,076     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Subordinate Securities

     585           153,042           153,627           1,433           128,586           130,019     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total Trading Securities

    $ 39,848          $ 254,951          $ 294,799          $ 22,041          $ 231,101          $ 253,142     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

AFS Securities

The following table presents the fair value of our available-for-sale securities held at Redwood by collateral type at June 30, 2012 and December 31, 2011.

 

(In Thousands)

         June 30, 2012              December 31, 2011    

Senior Securities

     

Residential prime

    $ 490,802          $ 278,240     

Residential non-prime

     242,008           255,724     
  

 

 

    

 

 

 

Total Senior Securities

     732,810           533,964     

Re-REMIC Securities

     147,437           119,366     

Subordinate Securities

     

Residential prime

     123,004           58,717     

Residential non-prime

     7,867           11,153     

Commercial

     5,761           5,445     

CDO

     50           50     
  

 

 

    

 

 

 

Total Subordinate Securities

     136,682           75,365     
  

 

 

    

 

 

 

Total AFS Securities

    $ 1,016,929          $ 728,695     
  

 

 

    

 

 

 

Of the senior securities shown above at June 30, 2012 and December 31, 2011, $176 million and $175 million, respectively, of prime securities, and $147 million and $150 million, respectively, of non-prime securities were financed through the Resecuritization entity, as discussed in Note 4.

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

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

Note 8. Real Estate Securities — (continued)

 

purchase discount. We designate any amount of unpaid principal balance that we do not expect to receive and thus do not expect to earn or recover as a credit reserve on the security. Any remaining net unamortized discounts or premiums on the security are amortized into income over time using the interest method.

At June 30, 2012, 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.

The following table presents the components of carrying value (which equals fair value) of AFS securities at June 30, 2012 and December 31, 2011.

Carrying Value of AFS Securities

 

June 30, 2012

(In Thousands)

      Residential     Commercial     CDO     Total  

Principal balance

     $     1,362,729         $       42,602         $         7,275         $     1,412,606     

Credit reserve

      (221,426)         (33,013)         (7,275)         (261,714)    

Unamortized discount, net

      (224,824)         (5,532)         -              (230,356)    
   

 

 

   

 

 

   

 

 

   

 

 

 

Amortized cost

      916,479          4,057          -              920,536     

Gross unrealized gains

      107,384          2,329          50          109,763     

Gross unrealized losses

      (12,745)         (625)         -              (13,370)    
   

 

 

   

 

 

   

 

 

   

 

 

 

Carrying Value

     $ 1,011,118         $ 5,761         $ 50         $ 1,016,929     
   

 

 

   

 

 

   

 

 

   

 

 

 

 

December 31, 2011

(In Thousands)

      Residential     Commercial     CDO     Total  

Principal balance

     $     1,148,952         $       50,499         $       10,717         $     1,210,168     

Credit reserve

      (242,261)         (43,012)         (10,717)         (295,990)    

Unamortized discount, net

      (235,833)         (3,554)         -              (239,387)    
   

 

 

   

 

 

   

 

 

   

 

 

 

Amortized cost

      670,858          3,933          -              674,791     

Gross unrealized gains

      85,360          1,702          50          87,112     

Gross unrealized losses

      (33,018)         (190)         -              (33,208)    
   

 

 

   

 

 

   

 

 

   

 

 

 

Carrying Value

     $ 723,200         $ 5,445         $ 50         $ 728,695     
   

 

 

   

 

 

   

 

 

   

 

 

 

The following table presents the changes for the three and six months ended June 30, 2012, 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 June 30, 2012   Residential     Commercial     CDO  

(In Thousands)

  Credit
Reserve
    Unamortized
Discount, Net
    Credit
Reserve
    Unamortized
Discount, Net
    Credit
Reserve
    Unamortized
Premium, Net
 

Beginning balance - March 31, 2012

   $     235,618         $     238,533         $ 33,668         $ 5,651         $ 7,244         $ -         

Amortization of net discount

    -              (8,198)         -              (150)         -              31     

Realized credit losses

    (11,786)         -              (624)         -              -              -         

Acquisitions

    4,870          8,392          -              -              -              -         

Sales, calls, other

    (10,598)         (10,884)         -              -              -              -         

Impairments

    303          -              -              -              -              -         

Transfers to (release of) credit reserves

    3,019          (3,019)         (31)         31          31          (31)    
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Ending Balance - June 30, 2012

   $ 221,426         $ 224,824         $       33,013         $       5,532         $       7,275         $         -         
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

Note 8. Real Estate Securities — (continued)

 

Six Months Ended June 30, 2012       Residential     Commercial     CDO  

(In Thousands)

      Credit
Reserve
    Unamortized
 Discount, Net 
    Credit
Reserve
    Unamortized
 Discount, Net 
    Credit
Reserve
    Unamortized
 Premium, Net 
 

Beginning balance - December 31, 2011

     $     242,261         $     235,833         $      43,012         $      3,554         $      10,717         $         -         

Amortization of net discount

      -              (16,398)         -              (235)         -              58     

Realized credit losses

      (25,908)         -              (7,897)         -              (3,500)         -         

Acquisitions

      11,552          43,998          -              -              -              -         

Sales, calls, other

      (16,156)         (29,456)         -              -              -              -         

Impairments

      524          -              111          -              -              -         

Transfers to (release of) credit reserves

      9,153          (9,153)         (2,213)         2,213          58          (58)    
   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Ending Balance - June 30, 2012

     $ 221,426         $ 224,824         $ 33,013         $ 5,532         $ 7,275         $ -         
   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Credit Characteristics of AFS Securities

Of the $221 million of credit reserve on our residential securities at June 30, 2012, $54 million was related to residential senior securities, $58 million was related to residential re-REMIC securities, and $109 million was related to residential subordinate securities. The loans underlying our residential senior securities totaled $16 billion at June 30, 2012, and consisted of $11 billion prime and $5 billion non-prime credit quality at time of origination. Serious delinquencies at June 30, 2012, were 10.74% of outstanding principal balances. The loans underlying our residential re-REMIC securities totaled $7 billion at June 30, 2012, and were all prime credit quality at time of origination. Serious delinquencies at June 30, 2012, were 10.27% of outstanding principal balances. The loans underlying our residential subordinate securities totaled $19 billion at June 30, 2012, and consisted of $18 billion prime and $1 billion non-prime credit quality at time of origination. Serious delinquencies at June 30, 2012, were 5.68% of outstanding principal balances.

The loans underlying our commercial subordinate securities totaled $8 billion at June 30, 2012, and consisted primarily of office (21%), retail (36%), and multifamily (13%) loans. Serious delinquencies (60+ days, in foreclosure or REO) at June 30, 2012 were 4.6% of current principal balances.

AFS Securities with Unrealized Losses

The following table presents the components comprising the total carrying value of AFS securities that were in a gross unrealized loss position at June 30, 2012 and December 31, 2011.

 

June 30, 2012       Less Than 12 Consecutive Months     12 Consecutive Months or Longer  

(In Thousands)

       Amortized 
Cost
     Unrealized 
Losses
    Fair
Value
     Amortized 
Cost
     Unrealized 
Losses
    Fair
Value
 

Residential

     $     99,900         $       (3,056)        $ 96,844         $     123,701         $       (9,689)        $     114,012     

Commercial

      991          (435)         556          1,128          (190)         938     

CDO

      -              -              -              -              -              -         
   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Securities

     $ 100,891         $ (3,491)        $       97,400         $ 124,829         $ (9,879)        $ 114,950     
   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

December 31, 2011       Less Than 12 Consecutive Months     12 Consecutive Months or Longer  

(In Thousands)

       Amortized 
Cost
     Unrealized 
Losses
    Fair
Value
     Amortized 
Cost
     Unrealized 
Losses
    Fair
Value
 

Residential

     $   242,595         $     (21,976)        $     220,619         $       75,245         $     (11,042)        $       64,203     

Commercial

      151          (38)         113          1,090          (152)         938     

CDO

      -              -              -              -              -              -         
   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Securities

     $ 242,746         $ (22,014)        $ 220,732         $ 76,335         $ (11,194)        $ 65,141     
   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

At June 30, 2012, after giving effect to purchases, sales, and extinguishments due to credit losses, our consolidated balance sheet included 399 AFS securities, of which 89 were in an unrealized loss position and 51

 

38


Table of Contents

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2012

(Unaudited)

 

Note 8. Real Estate Securities — (continued)

 

were in a continuous unrealized loss position for twelve consecutive months or longer. At December 31, 2011, our consolidated balance sheet included 425 AFS securities, of which 139 were in an unrealized loss position and 26 were in a continuous unrealized loss position for twelve consecutive months or longer.

Evaluating AFS Securities for Other-than-Temporary Impairments

When the fair value of an AFS security is below its cost basis, we evaluate the security for OTTI. Part of this evaluation is based upon adverse changes in the assumptions used to value the security. The table below summarizes the significant valuation assumptions we used for our AFS securities at June 30, 2012.

Significant Valuation Assumptions

 

                                                                                      
    Range for Securities  

June 30, 2012

          Prime                   Non-prime               Commercial      

Prepayment rates

    4 -19 %          3 - 8 %          N/A          

Loss severity

    17 -57 %          19 - 61 %          33 -50 %     

Projected losses

    0 -37 %          6 - 41 %          2 - 9 %     

For an AFS security where its fair value has declined below its amortized cost basis, we evaluate the security for OTTI. The credit component of OTTI is recognized through our consolidated statements of income as a component of other market valuation adjustments, net, while the non-credit component of OTTI is recognized through accumulated other comprehensive income, a component of equity. The following table details the activity related to the credit component of OTTI (i.e., OTTI in either current earnings or retained earnings) for AFS securities that also had a non-credit component and were still held at June 30, 2012 and 2011. The balance of the credit component of OTTI at June 30, 2012, includes all market valuation adjustments recorded through the income statement for securities still held on our balance sheet at June 30, 2012 and 2011 as well as a portion of OTTI previously recognized in other comprehensive income.

Activity of the Credit Component of Other-than-Temporary Impairments

 

         Three Months Ended June 30,      Six Months Ended June 30,  

(In Thousands)

      2012     2011     2012     2011  

Balance at beginning of period

     $         73,698         $       100,948         $         78,126         $       121,016     

Additions

         

Initial credit impairments

      55          449          161          463     

Subsequent credit impairments

      91          754          91          935     

Reductions

         

Securities sold, or expected to sell

      -              -              -              (12,317)    

Securities with no outstanding principal at period end