UNITED STATES OF AMERICA
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
| x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the Fiscal Year Ended: December 31, 2014
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)
Securities Registered Pursuant to Section 12(b) of the Act:
| Title of Each Class: |
Name of Exchange on Which Registered: | |
| Common Stock, par value $0.01 per share | New York Stock Exchange |
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x
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 Website, 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
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. (Check one):
| 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
At June 30, 2014, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $1,594,415,726 based on the closing sale price as reported on the New York Stock Exchange.
The number of shares of the registrant’s Common Stock outstanding on February 24, 2015 was 83,426,979.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s definitive Proxy Statement to be filed with the Securities and Exchange Commission under Regulation 14A within 120 days after the end of registrant’s fiscal year covered by this Annual Report are incorporated by reference into Part III.
REDWOOD TRUST, INC.
2014 ANNUAL REPORT ON FORM 10-K
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PART I
Introduction
Redwood Trust, Inc., together with its subsidiaries, focuses on investing in mortgage- and other real estate-related assets and engaging in residential and commercial mortgage banking activities. We seek to invest in real estate-related assets that have the potential to generate attractive cash flow returns over time and to generate income through our residential and commercial mortgage banking activities. We operate our business in three segments: residential mortgage banking, residential investments, and commercial mortgage banking and investments.
Our primary sources of income are net interest income from our investment portfolios and noninterest income from our mortgage banking activities. Net interest income consists of the interest income we earn on investments less the interest expense we incur on borrowed funds and other liabilities. Income from mortgage banking activities consists of the profit we seek to generate through the acquisition or origination of loans and their subsequent sale or securitization. References herein to “Redwood,” the “company,” “we,” “us,” and “our” include Redwood Trust, Inc. and its consolidated subsidiaries, unless the context otherwise requires.
Redwood Trust, Inc. has elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Internal Revenue Code”), beginning with its taxable year ended December 31, 1994. We generally refer, collectively, to Redwood Trust, Inc. and those of its subsidiaries that are not subject to subsidiary-level corporate income tax as “the REIT” or “our REIT.” We generally refer to subsidiaries of Redwood Trust, Inc. that are subject to subsidiary-level corporate income tax as “our operating subsidiaries” or “our taxable REIT subsidiaries” or “TRS.” Our mortgage banking activities and investments in MSRs are generally carried out through our taxable REIT subsidiaries, while our portfolio of mortgage- and other real estate-related investments is primarily held at our REIT. We generally intend to retain profits generated and taxed at our taxable REIT subsidiaries, and to distribute as dividends at least 90% of the taxable income we generate at our REIT.
Redwood Trust, Inc. 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.
Financial information concerning our business, both on a consolidated basis and with respect to each of our segments, is set forth in Financial Statements and Supplementary Data as well as in Management’s Discussion and Analysis of Financial Condition and Results of Operations which are included in Part II, Items 8 and 7 of this Annual Report on Form 10-K.
Our Business Segments
Our residential mortgage banking segment primarily consists of operating a mortgage loan conduit that acquires residential whole loans from third-party originators for subsequent sale, securitization, or transfer to our investment portfolio, Jumbo loans we acquire are typically sold through our Sequoia securitization program or to institutions that acquire pools of whole loans. Conforming loans we acquire are generally sold to Fannie Mae and Freddie Mac (the “Agencies”). Our residential loan acquisitions are usually made on a flow basis, after origination by banks or mortgage companies, and are periodically augmented by bulk acquisitions. This segment also includes various derivative financial instruments and interest only securities retained from our Sequoia securitizations that we utilize to manage certain risks associated with residential loans we acquire. Our residential mortgage banking segment’s main source of revenue is mortgage banking income, which includes valuation increases (or gains) on the loans we acquire for sale or securitization as well as valuation changes in associated derivatives and IO securities that are used in part to manage risks associated with our mortgage banking activities. Additionally, this segment may generate interest income on loans held for future sale or securitization and interest income from IO securities. Interest expense on short-term debt used to fund the purchase of residential loans, direct operating expenses and tax provisions associated with these activities are also included in the residential mortgage banking segment.
Our residential investments segment includes a portfolio of investments in residential mortgage-backed securities retained from our Sequoia securitizations, as well as residential mortgage-backed securities issued by third parties. This segment also includes residential loans held for investment as well as mortgage servicing rights (“MSRs”) associated with residential loans securitized through our Sequoia program or purchased from third parties. The residential investment segment’s main sources of revenue are interest income from investment portfolio securities and residential loans held-for-investment, as well as the realized gains recognized upon sales of these securities and income from MSRs. This
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segment also includes derivative financial instruments that we utilize to manage certain risks associated with our residential investment portfolio. Also included in this segment is interest expense on the short-term debt and asset-backed securities (“ABS”) used to partially finance certain of these securities, as well as direct operating expenses and tax provisions associated with these activities.
Our commercial mortgage banking and investments segment consists of our commercial mortgage banking operations as well as our portfolio of commercial real estate loans. We operate as a commercial real estate lender by originating mortgage loans and providing other forms of commercial real estate financing. This may include senior or subordinate mortgage loans, mezzanine loans, and other forms of financing, such as preferred equity interests in special purpose entities that own commercial real estate. We typically sell the senior loans we originate to third parties for securitization and the mezzanine and subordinate loans we originate are generally held for investment. This segment also includes derivative financial instruments that we utilize to manage certain risks associated with our commercial loan origination activity. Our commercial mortgage banking and investments segment’s main sources of revenue are interest income from our commercial loan investments as well as income from mortgage banking activities, which includes, valuation increases (or gains) on the senior commercial loans we originate for sale, and valuation changes in risk management derivatives. Interest expense from a commercial securitization we engaged in during 2012 (“Commercial Securitization”) and from short-term debt used to fund the purchase of commercial loans, operating expenses, and tax provisions associated with these activities are also included in this segment.
Sponsored, Managed, and Consolidated Entities
Throughout our history we have sponsored or managed other investment entities, including a private limited partnership fund that we managed, the Redwood Opportunity Fund, LP (the “Fund”), as well as Acacia securitization entities, certain of which we continue to manage. The Fund was primarily invested in residential securities and the Acacia entities are primarily invested in a variety of real estate-related assets.
During the third quarter of 2011, we engaged in a transaction in which we resecuritized a pool of senior residential securities (the “Residential Resecuritization”) primarily for the purpose of obtaining permanent non-recourse financing on a portion the residential securities we hold in our investment portfolio at the REIT. Similarly, during the fourth quarter of 2012, we engaged in a transaction in which we securitized a pool of commercial loans (the “Commercial Securitization”) primarily for the purpose of obtaining permanent non-recourse financing on a portion of the commercial loans we hold.
Information Available on Our Website
Our website can be found at www.redwoodtrust.com. We make available, free of charge through the investor information section of our website, access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the U.S. Securities Exchange Act of 1934, as well as proxy statements, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the U.S. Securities and Exchange Commission (“SEC”). We also make available, free of charge, access to our charters for our Audit Committee, Compensation Committee, and Corporate Governance and Nominating Committee, our Corporate Governance Standards, and our Code of Ethics governing our directors, officers, and employees. Within the time period required by the SEC and the New York Stock Exchange, we will post on our website any amendment to the Code of Ethics and any waiver applicable to any executive officer, director, or senior officer (as defined in the Code). In addition, our website includes information concerning purchases and sales of our equity securities by our executive officers and directors, as well as disclosure relating to certain non-GAAP financial measures (as defined in the SEC’s Regulation G) that we may make public orally, telephonically, by webcast, by broadcast, or by similar means from time to time. Through the Commercial link on our website, we also disclose information about our recent originations and acquisitions of commercial loans and other commercial investments. We believe that this information may be of interest to investors in Redwood, although we may not always disclose on our website each new commercial loan or other new commercial investment we originate or acquire due to, among other reasons, confidentiality obligations to the borrowers of those loans or counterparties to those investments. The information on our website is not part of this Annual Report on Form 10-K.
Our Investor Relations Department can be contacted at One Belvedere Place, Suite 300, Mill Valley, CA 94941, Attn: Investor Relations, telephone (866) 269-4976.
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Cautionary Statement
This Annual Report on Form 10-K and the documents incorporated by reference herein contain forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve numerous risks and uncertainties. Our actual results may differ from our beliefs, expectations, estimates, and projections and, consequently, you should not rely on these forward-looking statements as predictions of future events. Forward-looking statements are not historical in nature and can be identified by words such as “anticipate,” “estimate,” “will,” “should,” “expect,” “believe,” “intend,” “seek,” “plan” and similar expressions or their negative forms, or by references to strategy, plans, or intentions. These forward-looking statements are subject to risks and uncertainties, including, among other things, those described in this Annual Report on Form 10-K under the caption “Risk Factors.” Other risks, uncertainties, and factors that could cause actual results to differ materially from those projected are described below and may be described from time to time in reports we file with the SEC, including reports on Forms 10-Q and 8-K. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.
Statements regarding the following subjects, among others, are forward-looking by their nature: (i) statements we make regarding Redwood’s business strategy and strategic focus, including statements relating to our confidence in our overall market position, strategy and long-term prospects, and our belief in the long-term efficiency of private label securitization as a form of mortgage financing; (ii) statements we make regarding our plan to acquire eligible residential loans from Federal Home Loan Bank members through the Federal Home Loan Bank of Chicago’s (FHLBC) mortgage partnership finance program, our expectations regarding the timing for commencing the acquisition program, our statements relating to quantifying the acquisition opportunity, and our hope to explore similar arrangements with other FHLB member banks; (iii) statements we make regarding our captive insurance subsidiary’s membership in the FHLBC, its access to financing in such capacity, and our expectations regarding the amount of financing from the FHLB that will be outstanding during 2015; (iv) statements we make regarding our risk-sharing arrangement with Fannie Mae, including our belief that this arrangement has the potential to enhance the profitability of transacting in conforming loans that we sell to Fannie Mae pursuant to this arrangement, as well as our expectations of entering into additional risk-sharing transactions in 2015; (v) statements we make regarding the outlook for the residential mortgage market, including expectations relating to industry-wide residential loan originations in 2015; (vi) statements related to our residential mortgage banking activities, including our expectations to acquire $8 billion of conforming loans and $7 billion of jumbo loans in 2015, while maintaining loan sale profit margins within our long-term target range of 25-to-50 basis points, and expectations regarding improving investment conditions for MSRs; (vii) statements we make regarding the outlook for our commercial business, including our positioning to benefit from a substantial wave of refinance opportunities set to begin in 2015, industry estimates relating to industry-wide CMBS issuance in 2015, our target to increase total origination activity to $1.5 billion for 2015 at margins averaging 150 basis points, and our expectations with respect to the timing of origination volume during 2015; (viii) statements relating to acquiring residential mortgage loans in the future that we have identified for purchase or plan to purchase, including the amount of such loans that we identified for purchase during the fourth quarter of 2014 and at December 31, 2014, and statements relating to expected fallout and the corresponding volume of residential mortgage loans expected to be available for purchase; (ix) statements relating to our estimate of our investment capacity (including that we estimate our investment capacity at December 31, 2014 to be approximately $198 million); (x) statements we make regarding our dividend policy, including our intention to pay a regular dividend of $0.28 per share per quarter in 2015; and (xi) statements regarding our expectations and estimates relating to the characterization for income tax purposes of our dividend distributions, our expectations and estimates relating to tax accounting, tax liabilities and tax savings, and GAAP tax provisions, our estimates of REIT taxable income and TRS taxable income, and our anticipation of additional credit losses for tax purposes in future periods (and, in particular, our statement that, for tax purposes, we expect an additional $34 million of tax credit losses on residential securities we currently own to be realized over an estimated three- to five-year period).
Important factors, among others, that may affect our actual results include: general economic trends, Federal Reserve monetary policy, the performance of the housing, commercial real estate, mortgage, credit, and broader financial markets, and their effects on the prices of earning assets and the credit status of borrowers; federal and state legislative and regulatory developments, and the actions of governmental authorities, including those affecting the mortgage industry or our business (including, but not limited to, the Federal Housing Finance Agency’s notice of proposed rulemaking relating to FHLB membership requirements and the potential implications for our captive insurance subsidiary’s membership in the FHLB); our exposure to credit risk and the timing of credit losses within our portfolio; the concentration of the credit risks we are exposed to, including due to the structure of assets we hold and the geographical concentration of real estate underlying assets we own; the efficacy and expense of our efforts to manage or hedge credit risk, interest rate risk, and other financial and operational risks; changes in credit ratings on assets we own and changes in the rating agencies’ credit rating methodologies; changes in interest rates; changes in mortgage prepayment rates; the availability of assets for purchase at attractive prices and our ability to reinvest cash we hold; changes in the values of assets we own; changes in liquidity in the market for real estate securities and loans; our ability to finance the acquisition of real estate-related assets with short-term debt; the ability of counterparties to satisfy their obligations to us; our involvement in securitization transactions, the timing and profitability of those transactions, and the risks we are exposed to in engaging in securitization transactions; exposure to claims and litigation, including litigation arising from our involvement in securitization transactions; whether we have sufficient liquid assets to meet short-term needs; our ability to successfully compete and retain or attract key personnel; our ability to adapt our business model and strategies to changing circumstances; changes in our investment, financing, and hedging strategies and new risks we may be exposed to if we expand our business activities; exposure to environmental liabilities and the effects of global climate change; failure to comply with applicable laws and regulations; our failure to maintain appropriate internal controls over financial reporting and disclosure controls and procedures; the impact on our reputation that could result from our actions or omissions or from those of others; changes in accounting principles and tax rules; our ability to maintain our status as a REIT for tax purposes; limitations imposed on our business due to our REIT status and our status as exempt from registration under the Investment Company Act of 1940; decisions about raising, managing, and distributing capital; and other factors not presently identified.
This Annual Report on Form 10-K may contain statistics and other data that in some cases have been obtained from or compiled from information made available by servicers and other third-party service providers.
Certifications
Our Chief Executive Officer and Chief Financial Officer have executed certifications dated February 25, 2015, as required by Sections 302 and 906 of the Sarbanes-Oxley Act of 2002, and we have included those certifications as exhibits to this Annual Report on Form 10-K. In addition, our Chief Executive Officer certified to the New York Stock Exchange (NYSE) on June 9, 2014 that he was unaware of any violations by Redwood Trust, Inc. of the NYSE’s corporate governance listing standards in effect as of that date.
Employees
As of December 31, 2014, Redwood employed 221 people.
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General economic developments and trends and the performance of the housing, commercial real estate, mortgage finance, and broader financial markets may adversely affect our business and the value of, and returns on, real estate-related and other assets we own or may acquire and could also negatively impact our business and financial results.
Our level of business activity and the profitability of our business, as well as the values of, and the cash flows from, the assets we own, are affected by developments in the U.S. economy and the broader global economy. As a result, negative economic developments are likely to negatively impact our business and financial results. There are a number of factors that could contribute to negative economic developments, including, but not limited to, high unemployment, rising government debt levels, U.S. fiscal and monetary policy changes, including Federal Reserve policy shifts, changing U.S. consumer spending patterns, negative developments in the housing and commercial real estate markets, and changing expectations for inflation and deflation. Personal income and unemployment levels affect borrowers’ ability to repay residential mortgage loans underlying residential real estate-related assets we own, and there is risk that economic growth and activity could be weaker than anticipated or negative.
The economic downturn that began in 2007 and the significant government interventions into the financial markets and fiscal stimulus spending that occurred in subsequent years have contributed to significantly increased U.S. budget deficits and overall debt levels. These increases can put upward pressure on interest rates and could be among the factors that could lead to higher interest rates over the long-term future. Higher long-term interest rates could adversely affect our overall business, income, and our ability to pay dividends, as discussed further below under “Interest rate fluctuations can have various negative effects on us and could lead to reduced earnings and increased volatility in our earnings.” Furthermore, our business and financial results may be harmed by our inability to accurately anticipate developments associated with changes in, or the outlook for, interest rates. In addition, near-term and long-term U.S. economic conditions are likely to be impacted by the ability of Congress and the President to effectively address policy differences regarding the U.S. federal budget, budget deficit, and debt level.
Real estate values, and the ability to generate returns by owning or taking credit risk on loans secured by real estate, are important to our business. Over the last several years, government intervention has been important to support real estate markets, the overall U.S. economy, capital markets, and mortgage markets. We expect the government will continue to gradually withdraw some of this support, although we remain uncertain about the extent, timing, process, and implications of any withdrawal. Mortgage markets have also received substantial U.S. government support. In particular, the government’s support of mortgage markets through its support of Fannie Mae and Freddie Mac expanded in late 2008, as the U.S. Treasury Department chose to backstop these government-sponsored enterprises. The governmental support for these entities has contributed to Fannie Mae’s and Freddie Mac’s continued dominance of residential mortgage finance and securitization activity, inhibiting the return of private mortgage securitization. This support may continue for some time and could have potentially negative consequences to us, since we have traditionally taken an active role in assuming credit risk in the private sector mortgage market, including through investments in Sequoia securitizations we sponsor.
Expectations of rising benchmark interest rates, and the Federal Reserve’s actions and statements regarding monetary policy, can affect the fixed income and mortgage finance markets in ways that could adversely affect our future business and financial results and the value of, and returns on, real estate-related investments and other assets we own or may acquire.
Statements by the Federal Reserve regarding monetary policy and the actions it takes to set or adjust monetary policy may affect the expectations and outlooks of market participants in ways that disrupt our business and adversely affect our financial results and the value of, and returns on, our portfolio of real-estate related investments and the pipeline of residential mortgage loans we own or may acquire. For example, during 2013 and 2014, statements made by the Chair and other members of the Board of Governors of the Federal Reserve System and by other Federal Reserve Bank officials regarding the U.S. economy, future economic growth, and the Federal Reserve’s future open market activity (and the so-called “tapering” of its asset purchase program relating to Treasury securities and mortgage-backed securities (MBS), which concluded in late 2014) and monetary policy had a significant impact on, among other things, benchmark interest rates, the value of residential mortgage loans, and, more generally, the fixed income markets. These statements, the actions of the Federal Reserve, and other factors also significantly impacted many market participants’ expectations and outlooks regarding future levels of benchmark interest rates and the expected yields these market participants would require to invest in fixed income instruments, including most residential mortgages and residential mortgage-backed securities (RMBS).
One of the immediate potential impacts of rising benchmark interest rates on our business would be a reduction in the overall value of the pool of residential mortgage loans that we own and the overall value of the pipeline of residential mortgage loans that we have identified for purchase. Rising benchmark interest rates also generally have a negative impact on the overall cost of short-term borrowings we use to finance our acquisitions and holdings of residential mortgage loans, including as a result of the requirement to
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post additional margin (or collateral) to lenders to offset any associated decline in value of the mortgage loans we finance with short-term borrowings. The short-term borrowings we use to finance our acquisitions and holdings of residential mortgage loans are uncommitted and have a limited term, which could result in these types of borrowings not being available in the future to fund our acquisitions and holdings and could result in our being required to sell holdings of residential mortgage loans and incur losses. Similar impacts would also be expected with respect to the short-term borrowings we use to finance our acquisitions and holdings of RMBS. In addition, any inability to fund acquisitions of mortgage loans could damage our reputation as a reliable counterparty in the mortgage finance markets.
Rising benchmark interest rates would also likely impact the volume of residential mortgage loans available for purchase in the marketplace and our ability to compete to acquire residential mortgage loans as part of our residential mortgage banking activities. These impacts could result from, among other things, a lower overall volume of mortgage refinance activity by mortgage borrowers and an increased level of competition from large commercial banks that may operate with a lower cost of capital than we do, including as a result of Federal Reserve monetary policies that impact banks more favorably than us and other non-bank institutions. These and other impacts of developments of the type described above have had, and may continue to have, a negative impact on our business and results of operations and we cannot accurately predict the full extent of these impacts or for how long they may persist.
Federal and state legislative and regulatory developments and the actions of governmental authorities and entities may adversely affect our business and the value of, and the returns on, mortgages, mortgage-related securities, and other assets we own or may acquire in the future.
As noted above, our business is affected by conditions in the residential and commercial real estate markets and the broader financial markets, as well as by the financial condition and resources of other participants in these markets. These markets and many of the participants in these markets are subject to, or regulated under, various federal and state laws and regulations. In some cases, the government or government-sponsored entities, such as Fannie Mae and Freddie Mac, directly participate in these markets. In particular, because issues relating to residential real estate and housing finance can be areas of political focus, federal, state and local governments may be more likely to take actions that affect residential real estate, the markets for financing residential real estate, and the participants in residential real estate-related industries than they would with respect to other industries. As a result of the government’s statutory and regulatory oversight of the markets we participate in and the government’s direct and indirect participation in these markets, federal and state governmental actions, policies, and directives can have an adverse effect on these markets and on our business and the value of, and the returns on, mortgages, mortgage-related securities, and other assets we own or may acquire in the future, which effects may be material.
As an example, based on published data, we believe that through financing or guarantees Fannie Mae, Freddie Mac, the Federal Housing Administration, and other governmental agencies accounted for more than 75% of the financing for new residential mortgage loans from 2009 through September 2014. As a result, most of the market for housing finance in the U.S. is effectively controlled by the federal government and can be materially affected by decisions of federal policy makers, the President, and Congress. In addition, the Federal Reserve has taken certain actions (e.g., implementing a program to acquire Treasury securities and MBS, which concluded in late 2014) and may take other actions that could have significant implications for mortgage-related securities pricing and the returns we expect on our mortgage-related assets. Financial regulators globally are coordinating the implementation of capital regulations under the Basel III accord in an attempt to better coordinate and set capital standards for certain types of regulated financial institutions and appropriately account for risk, which may also have indirect impacts on our business and financial results.
If the federal government determines to maintain or expand its current role in the markets for financing residential mortgage loans, it may adversely affect our business or our ability to effectively compete. Even if the federal government determines to decrease its role in the markets for financing residential mortgage loans, it may establish regulations for other market participants that have an adverse effect on our ability to effectively participate or compete or which may diminish or eliminate the returns on mortgages, mortgage-related securities, and other assets we own or may acquire in the future. For example, see the risk factor below titled “Proposed Federal regulations may limit, eliminate, or reduce the attractiveness of our subsidiary’s ability to use borrowings from the Federal Home Loan Bank of Chicago to finance the mortgage loans and securities it holds and acquires, which could negatively impact our business and operating results.”
Changes to income tax laws and regulations, or other tax laws or regulations, which may be enacted at the federal or state level, could also negatively impact residential and commercial real estate markets, mortgage finance markets, and our business and financial results. For example, an elimination or reduction in the current personal income tax deduction for interest payments on residential mortgage debt, which is one of the mechanisms that lawmakers have discussed in connection with resolving the U.S. federal budget deficit, could negatively impact real estate values, our business, and our financial results.
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Furthermore, the credit crisis and subsequent financial turmoil prompted the federal government to put into place new statutory and regulatory frameworks and policies for reforming the U.S. financial system. These financial reforms are aimed at, among other things, promoting robust supervision and regulation of financial firms, establishing comprehensive supervision of financial markets, protecting consumers and investors from financial abuse, providing the U.S. government with additional tools to manage financial crises, and raising international regulatory standards and improving international cooperation, but their scope could be expanded beyond what has been currently enacted, implemented, and proposed. Certain financial reforms focused specifically on the issuance of asset-backed securities through securitization transactions have not been fully implemented or have not yet become effective, but include or are expected to include significantly enhanced disclosure requirements, risk retention requirements, and rules restricting a broad range of conflicts of interests in regard to these transactions. Implementation of financial reforms, whether through law, regulations, or policy, including changes to the manner in which financial institutions, financial products, and financial markets operate and are regulated and any related changes in the accounting standards that govern them, could adversely affect our business and financial results by subjecting us to regulatory oversight, making it more expensive to conduct our business, reducing or eliminating any competitive advantage we may have, or limiting our ability to expand, or could have other adverse effects on us.
During and since 2008, the federal government has also made available programs designed to provide homeowners with assistance in avoiding residential mortgage loan foreclosures, including through loan modification and refinancing programs. In addition, certain mortgage lenders and servicers have voluntarily, or as part of settlements with law enforcement authorities, established loan modification programs relating to the mortgages they hold or service and adopted new servicing standards intended to protect homeowners. Changes to servicing standards, whether resulting from a settlement or a change in regulation, are likely to have the effect of lengthening the time it takes for a servicer to foreclose on the property underlying a delinquent mortgage loan. Loan modification programs and changes to servicing standards and regulations, as well as future law enforcement and legislative or regulatory actions, may adversely affect the value of, and the returns on, the mortgage loans and mortgage securities we currently own or may acquire in the future.
In January 2014, new regulations promulgated by the Consumer Financial Protection Bureau (“CFPB”) under the Dodd-Frank Act became effective that require mortgage lenders, prior to originating most residential mortgage loans, to make a determination of a borrower’s ability to repay the loan and establish protections from liability under this requirement for mortgages that meet certain criteria, so-called “qualified mortgages.” Under these regulations, if a mortgage lender does not appropriately establish a borrower’s ability to repay the loan, the borrower may be able to assert against the originator of the loan or any subsequent transferee, as a defense to foreclosure by way of recoupment or setoff, a violation of the ability-to-repay regulations. The long-term impact of these ability-to-repay regulations on the availability of mortgage credit, the mortgage finance market, and our ability to securitize residential mortgage loans remains unclear. The actual short- and long-term impact of these ability-to-repay regulations on us will depend, in large part, on how the credit rating agencies, triple-A securitization investors, warehouse lenders we borrow from, and other mortgage market investors assess the investment risks that result from the new regulations, including, for example, how they assess investment risks associated with residential mortgage loans that have an interest-only payment feature or loans under which the borrower has a debt-to-income ratio of more than 43% (as these types of loans have historically accounted for a portion of the loans we have securitized, but they are not considered “qualified mortgages” under the ability-to-repay regulations). If these and other regulations have a negative impact on the volume of mortgage loan originations or on our ability to finance, sell, or securitize residential mortgage loans, it could adversely affect our business and financial results.
Over the course of 2012, 2013 and 2014, certain counties, cities and other municipalities took steps to begin to consider how the power of eminent domain could be used to acquire residential mortgage loans from private-label securitization trusts and additional municipalities may be similarly considering this matter or may do so in the future. To the extent municipalities or other governmental authorities proceed to implement and carry out these or similar proposals and acquire residential mortgage loans from securitization trusts in which we hold an economic interest, there would likely be a negative impact on the value of our interests in those securitization trusts and a negative impact on our ability to engage in future securitizations (or on the returns we would otherwise expect to earn from executing future securitizations), which impacts could be material.
Ultimately, we cannot assure you of the impact that governmental actions may have on our business or the financial markets and, in fact, they may adversely affect us, possibly materially. We cannot predict whether or when such actions may occur or what unintended or unanticipated impacts, if any, such actions could have on our business and financial results. Even after governmental actions have been taken and we believe we understand the impacts of those actions, we may not be able to effectively respond to them so as to avoid a negative impact on our business or financial results.
Proposed Federal regulations may limit, eliminate, or reduce the attractiveness of our subsidiary’s ability to use borrowings from the Federal Home Loan Bank of Chicago to finance the mortgage loans and securities it holds and acquires, which could negatively impact our business and operating results.
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In June 2014, we announced that our wholly-owned captive insurance company subsidiary, RWT Financial, LLC, was approved as a member of the Federal Home Loan Bank of Chicago (“FHLBC”). This membership provides RWT Financial with access to attractive long-term and short-term collateralized financing for mortgage loans and securities it holds and acquires. RWT Financial is currently using long-term borrowings from the FHLBC to finance certain jumbo residential mortgage loans. At December 31, 2014, RWT Financial had approximately $496 million of long-term borrowings outstanding from the FHLBC, which were collateralized by residential mortgage loans. RWT Financial currently intends to increase its borrowings from FHLBC, including borrowings to finance holdings of residential mortgage loans it acquires that may not be eligible for long-term financing from other sources of debt financing available to Redwood.
The Federal Housing Finance Agency (“FHFA”) is the Federal agency that regulates the FHLBC and the other Federal Home Loan Banks (“FHLBs”) that comprise the Federal Home Loan Banking System, including through regulations relating to membership in each of the FHLBs (“FHLB Membership Regulations”). On September 12, 2014, the FHFA published a notice of proposed rulemaking and request for comments (“NPR”) proposing to revise the FHLB Membership Regulations. Among other things, the NPR includes a proposal to amend the FHLB Membership Regulations to exclude additional captive insurance companies from membership in an FHLB. The NPR also proposes to address existing captive insurance company members in FHLBs, like our wholly-owned subsidiary RWT Financial, by allowing them to remain members for five years following the effective date of the amended regulations with certain restrictions on their ability to obtain and renew borrowings from FHLBs during that five-year period.
As a practical matter, if the NPR is adopted as proposed, the FHLB Membership Regulations would be amended in a manner that would prevent RWT Financial from obtaining additional borrowings from the FHLBC (or renewing existing borrowings) with a term that extended beyond the five year membership grace period and would prevent RWT Financial from obtaining additional borrowings or renewing existing borrowings from the FHLBC if after doing so the total advances to RWT Financial would exceed 40% of its total assets. In addition, amendments to the FHLB Membership Regulations could also be made that are not set forth in the NPR that could further limit or increase the cost of RWT Financial’s borrowings from the FHLBC. If the NPR is adopted as proposed, RWT Financial would lose access (in the manner and over the time periods set forth in the amended FHLB Membership Regulations) to a source of attractive long-term and short-term collateralized financing for mortgage loans and securities it holds and acquires. The loss of this source of financing could also negatively impact us in a number of other different ways, including, without limitation, by limiting our ability to acquire (or the attractiveness of acquiring) residential mortgage loans to hold as long-term investments, or by exposing us to risks of the type described below in Part II, Item 7 of this Annual Report on Form 10-K under the heading, “Risks Relating to Debt Incurred Under Short- and Long-Term Borrowing Facilities.” To the extent the NPR is adopted or the FHLB Membership Regulations are otherwise amended in a manner that would limit, eliminate, or reduce the attractiveness of RWT Financial’s ability to use borrowings from the FHLBC to finance the mortgage loans and securities it holds and acquires, it could negatively impact our business and operating results.
The nature of the assets we hold and the investments we make expose us to credit risk that could negatively impact the value of those assets and investments, our earnings, dividends, cash flows, and access to liquidity, and otherwise negatively affect our business.
Overview of credit risk
We assume credit risk primarily through the ownership of securities backed by residential and commercial real estate loans and through direct investments in residential and commercial real estate loans. We may also assume similar credit risks through other types of transactions with counterparties who are seeking to reduce their exposure to credit risk. Credit losses on residential real estate loans can occur for many reasons, including: fraud; poor underwriting; poor servicing practices; weak economic conditions; increases in payments required to be made by borrowers; declines in the value of homes; earthquakes, the effects of climate change (including flooding, drought, and severe weather) and other natural events; uninsured property loss; over-leveraging of the borrower; costs of remediation of environmental conditions, such as indoor mold; changes in zoning or building codes and the related costs of compliance; acts of war or terrorism; changes in legal protections for lenders and other changes in law or regulation; and personal events affecting borrowers, such as reduction in income, job loss, divorce, or health problems. In addition, the amount and timing of credit losses could be affected by loan modifications, delays in the liquidation process, documentation errors, and other action by servicers. Weakness in the U.S. economy or the housing market could cause our credit losses to increase beyond levels that we currently anticipate.
In addition, rising interest rates may increase the credit risks associated with certain residential real estate loans. For example, the interest rate is adjustable for many of the loans held at securitization entities we have sponsored and for a portion of the loans underlying residential securities we have acquired from securitizations sponsored by others, as well as for a portion of the loans
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pledged by our subsidiary, RWT Financial, to secure long-term borrowings from the FHLBC. Accordingly, when short-term interest rates rise, required monthly payments from homeowners will rise under the terms of these adjustable-rate mortgages, and this may increase borrowers’ delinquencies and defaults.
Credit losses on commercial real estate loans can occur for many of the reasons noted above for residential real estate loans. Losses on commercial real estate loans can also occur for other reasons including decreases in the net operating income from the underlying property, which could be adversely affected by a weak U.S. or international economy. Moreover, at any given time, most or all of our commercial real estate loans are not fully amortizing and, therefore, the borrower’s ability to repay the principal when due may depend upon the ability of the borrower to refinance or sell the property at maturity.
Commercial real estate loans are particularly sensitive to changes in the local economy, so even minor local adverse economic events may adversely affect the performance of commercial real estate assets. We are typically exposed to credit risk associated with both senior and subordinated commercial loans, and much of our exposure to credit risk associated with commercial loans is in the form of subordinate financing (e.g., mezzanine loans, b-notes, preferred equity, and subordinated interests in securitized pools). We directly originate commercial loans and may participate in loans originated by others (including through ownership of commercial mortgage-backed securities). Directly originating commercial loans exposes us to credit, legal, and other risks that may be greater than risks associated with loans we acquire or participate in that are originated by others. We may incur losses on commercial real estate loans and securities for reasons not necessarily related to an adverse change in the performance of the property (or properties) associated with any such loan or the loan (or loans) underlying any such security. This includes bankruptcy by the owner of the property, issues regarding the form of ownership of the property, poor property management, origination errors, inaccurate appraisals, fraud, and non-timely actions by servicers. If and when these problems become apparent, we may have little or no recourse to the borrower, issuer of the securities, or seller of the loan and we may incur credit losses as a result.
We may have heightened credit losses associated with certain securities and investments we own.
Within a securitization of residential or commercial real estate loans, various securities are created, each of which has varying degrees of credit risk. We may own the securities in which there is more (or the most) concentrated credit risk associated with the underlying real estate loans.
In general, losses on an asset securing a residential or commercial real estate loan included in a securitization will be borne first by the owner of the property (i.e., the owner will first lose any equity invested in the property) and, thereafter, by mezzanine or preferred equity investors, if any, then by a cash reserve fund or letter of credit, if any, then by the first-loss security holder, and then by holders of more senior securities. In the event the losses incurred upon default on the loan exceed any equity support, reserve fund, letter of credit, and classes of securities junior to those in which we invest (if any), we may not be able to recover all of our investment in the securities we hold. In addition, if the underlying properties have been overvalued by the originating appraiser or if the values subsequently decline and, as a result, less collateral is available to satisfy interest and principal payments due on the related security, then the first-loss securities may suffer a total loss of principal, followed by losses on the second-loss and then third-loss securities (or other residential and commercial securities that we own). In addition, with respect to residential securities we own, we may be subject to risks associated with the determination by a loan servicer to discontinue servicing advances (advances of mortgage interest payments not made by a delinquent borrower) if they deem continued advances to be unrecoverable, which could reduce the value of these securities or impair our ability to project and realize future cash flows from these securities.
For loans or other investments we own directly (not through a securitization structure), we will most likely be in a position to incur credit losses – should they occur – only after losses are borne by the owner of the property (e.g., by a reduction in the owner’s equity stake in the property). We may take actions available to us in an attempt to protect our position and mitigate the amount of credit losses, but these actions may not prove to be successful and could result in our increasing the amount of credit losses we ultimately incur on a loan.
The nature of the assets underlying some of the securities and investments we hold could increase the credit risk of those securities.
For certain types of loans underlying securities we may own or acquire, the loan rate or borrower payment rate may increase over time, increasing the potential for default. For example, securities may be backed by residential real estate loans that have negative amortization features. The rate at which interest accrues on these loans may change more frequently or to a greater extent than payment adjustments on an adjustable-rate loan, and adjustments of monthly payments may be subject to limitations or may be limited by the borrower’s option to pay less than the full accrual rate. As a result, the amount of interest accruing on the remaining principal balance of the loans at the applicable adjustable mortgage loan rate may exceed the amount of the monthly payment. To the extent we are exposed to it, this is particularly a risk in a rising interest rate environment. Negative amortization occurs when the resulting excess (of interest owed over interest paid) is added to the unpaid principal balance of the related adjustable mortgage loan. For certain
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loans that have a negative amortization feature, the required monthly payment is increased after a specified number of months or after a maximum amount of negative amortization has occurred in order to amortize fully the loan by the end of its original term. Other negative amortizing loans limit the amount by which the monthly payment can be increased, which results in a larger final payment at maturity. As a result, negatively amortizing loans have performance characteristics similar to those of balloon loans. Negative amortization may result in increases in delinquencies, loan loss severity, and loan defaults, which may, in turn, result in payment delays and credit losses on our investments. Other types of loans and investments to which we are exposed, such as hybrid loans and adjustable-rate loans, may also have greater credit risk than more traditional amortizing fixed-rate mortgage loans.
Most or all of the commercial real estate loan assets we own are only partially amortizing or do not provide for any principal amortization prior to a balloon principal payment at maturity. Commercial loans that only partially amortize or that have a balloon principal payment at maturity may have a higher risk of default at maturity than fully amortizing loans. In addition, since most of the principal of these loans is repaid at maturity, the amount of loss upon default is generally greater than on other loans that provide for more principal amortization.
We have concentrated credit risk in certain geographical regions and may be disproportionately affected by an economic or housing downturn, natural disaster, terrorist event, climate change, or any other adverse event specific to those regions.
A decline in the economy or difficulties in certain real estate markets, such as a high level of foreclosures in a particular area, are likely to cause a decline in the value of residential and commercial properties. This, in turn, will increase the risk of delinquency, default, and foreclosure on real estate underlying securities and loans we hold with properties in those regions. This may then adversely affect our credit loss experience and other aspects of our business, including our ability to securitize (or otherwise sell) real estate loans and securities.
The occurrence of a natural disaster (such as an earthquake, tornado, hurricane, or flood), or the effects of climate change (including flooding, drought, and severe weather), may cause decreases in the value of real estate (including sudden or abrupt changes) and would likely reduce the value of the properties collateralizing commercial and residential real estate loans we own or those underlying the securities or other investments we own. Since certain natural disasters may not typically be covered by the standard hazard insurance policies maintained by borrowers, the borrowers may have to pay for repairs due to the disasters. Borrowers may not repair their property or may stop paying their mortgage loans under those circumstances, especially if the property is damaged. This would likely cause foreclosures to increase and lead to higher credit losses on our loans or investments or on the pool of mortgage loans underlying securities we own.
A significant number of residential real estate loans that underlie the securities we own are secured by properties in California and, thus, we have a higher concentration of credit risk within California than in other states. Additional states where we have concentrations of residential loan credit risk are set forth in Note 6 to the Financial Statements within this Annual Report on Form 10-K. Balances on commercial loans we originate or otherwise acquire are larger than residential loans and we may continue to have a geographically concentrated commercial loan portfolio until our portfolio increases in size. While we intend to originate commercial loans throughout the country, our commercial loans are generally concentrated in or near major metropolitan areas. Additional information on geographic distribution of our commercial loan portfolio is set forth in Note 7 to the Financial Statements within this Annual Report on Form 10-K.
The timing of credit losses can harm our economic returns.
The timing of credit losses can be a material factor in our economic returns from residential and commercial loans, investments, and securities. If unanticipated losses occur within the first few years after a loan is originated, an investment is made, or a securitization is completed, those losses could have a greater negative impact on our investment returns than unanticipated losses on more seasoned loans, investments, or securities. In addition, higher levels of delinquencies and cumulative credit losses within a securitized loan pool can delay our receipt of principal and interest that is due to us under the terms of the securities backed by that pool. This would also lower our economic returns. The timing of credit losses could be affected by the creditworthiness of the borrower, the borrower’s willingness and ability to continue to make payments, and new legislation, legal actions, or programs that allow for the modification of loans or ability for borrowers to get relief through bankruptcy or other avenues.
Our efforts to manage credit risks may fail.
We attempt to manage risks of credit losses by continually evaluating our investments for impairment indicators and establishing reserves under GAAP for credit and other risks based upon our assessment of these risks. We cannot establish credit reserves for tax accounting purposes. The amount of reserves that we establish may prove to be insufficient, which would negatively impact our financial results and would result in earnings volatility. In addition, cash and other capital we hold to help us manage credit
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and other risks and liquidity issues may prove to be insufficient. If these increased credit losses are greater than we anticipated and we need to increase our credit reserves, our GAAP earnings might be reduced. Increased credit losses may also adversely affect our cash flows, ability to invest, dividend distribution requirements and payments, asset fair values, access to short-term borrowings, and ability to securitize or finance assets.
Despite our efforts to manage credit risk, there are many aspects of credit risk that we cannot control. Our quality control and loss mitigation policies and procedures may not be successful in limiting future delinquencies, defaults, and losses, or they may not be cost effective. Our underwriting reviews may not be effective. The securitizations in which we have invested may not receive funds that we believe are due from mortgage insurance companies and other counterparties. Loan servicing companies may not cooperate with our loss mitigation efforts or those efforts may be ineffective. Service providers to securitizations, such as trustees, loans servicers, bond insurance providers, and custodians, may not perform in a manner that promotes our interests. Delay of foreclosures could delay resolution and increase ultimate loss severities, as a result.
The value of the homes collateralizing or underlying residential loans or investments may decline. The value of the commercial properties collateralizing or underlying commercial loans or investments may decline. The frequency of default and the loss severity on loans upon default may be greater than we anticipate. Interest-only loans, negative amortization loans, adjustable-rate loans, larger balance loans, reduced documentation loans, subprime loans, alt-a loans, second lien loans, loans in certain locations, residential mortgage loans that are not “qualified mortgages” under regulations promulgated by the CFPB, and loans or investments that are partially collateralized by non-real estate assets may have increased risks and severity of loss. If property securing or underlying loans become real estate owned as a result of foreclosure, we bear the risk of not being able to sell the property and recovering our investment and of being exposed to the risks attendant to the ownership of real property.
Changes in consumer behavior, bankruptcy laws, tax laws, regulation of the mortgage industry, and other laws may exacerbate loan or investment losses. Changes in rules that would cause loans owned by a securitization entity to be modified may not be beneficial to our interests if the modifications reduce the interest we earn and increase the eventual severity of a loss. In some states and circumstances, the securitizations in which we invest have recourse as owner of the loan against the borrower’s other assets and income in the event of loan default. However, in most cases, the value of the underlying property will be the sole effective source of funds for any recoveries. Other changes or actions by judges or legislators regarding mortgage loans and contracts, including the voiding of certain portions of these agreements, may reduce our earnings, impair our ability to mitigate losses, or increase the probability and severity of losses. Any expansion of our loss mitigation efforts as we grow our portfolio could increase our operating costs and the expanded loss mitigation efforts may not reduce our future credit losses.
Credit ratings assigned to debt securities by the credit rating agencies may not accurately reflect the risks associated with those securities. Furthermore, downgrades in the credit ratings of bond insurers or any downgrades in the credit ratings of mortgage insurers could increase our credit risk, reduce our cash flows, or otherwise adversely affect our business and operations.
We generally do not consider credit ratings in assessing our estimates of future cash flows and desirability of our investments (although our assessment of the quality of an investment may prove to be inaccurate and we may incur credit losses in excess of our initial expectations). The assignment of an “investment grade” rating to a security by a rating agency does not mean that there is not credit risk associated with the security or that the risk of a credit loss with respect to such security is necessarily remote. Many of the securities we own do have credit ratings and, to the extent we securitize loans and securities, we expect to retain credit rating agencies to provide ratings on the securities created by these securitization entities (as we have in the past).
Rating agencies rate debt securities based upon their assessment of the safety of the receipt of principal and interest payments. Rating agencies do not consider the risks of fluctuations in fair value or other factors that may influence the value of debt securities and, therefore, any assigned credit rating may not fully reflect the true risks of an investment in securities. Also, rating agencies may fail to make timely adjustments to credit ratings based on available data or changes in economic outlook or may otherwise fail to make changes in credit ratings in response to subsequent events, so that our investments may be better or worse than the ratings indicate. Credit rating agencies may change their methods of evaluating credit risk and determining ratings on securities backed by real estate loans and securities. These changes may occur quickly and often. The market’s ability to understand and absorb these changes and the impact to the securitization market in general are difficult to predict. Such changes may have an impact on the amount of investment-grade and non-investment-grade securities that are created or placed on the market in the future. Downgrades to the ratings of securities could have an adverse effect on the value of some of our investments and our cash flows from those investments.
Currently, and in the future, some of the loans we own or that underlie mortgage-backed securities we own may be insured in part by mortgage insurers, bond insurers, or financial guarantors. Mortgage insurance protects the lender or other holder of a loan up to a specified amount, in the event the borrower defaults on the loan. Mortgage insurance is generally obtained only when the principal amount of the loan at the time of origination is greater than 80% of the value of the property (loan-to-value), although it may
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not always be obtained in these circumstances. Any downgrade to the credit rating of a mortgage insurer, bond insurer, or financial guarantor that supports the creditworthiness of investments we hold could negatively impact the value of those investments. Any inability of the mortgage insurers to pay in full the insured portion of the loans that we hold would adversely affect the value of the securities we own that are backed by these loans, which could increase our credit risk, reduce our cash flows, or otherwise adversely affect our business.
Changes in prepayment rates of residential mortgage loans could reduce our earnings, dividends, cash flows, and access to liquidity. Similarly, with respect to commercial real estate loans, borrowers’ decisions to prepay or extend loans could reduce our earnings, dividends, cash flows, and access to liquidity.
The economic returns we earn from most of the residential real estate securities and loans we own (directly or indirectly) are affected by the rate of prepayment of the underlying residential mortgage loans. Prepayments are difficult to accurately predict and adverse changes in the rate of prepayment could reduce our cash flows, earnings, and dividends. Adverse changes in cash flows would likely reduce the fair values of many of our assets, which could reduce our ability to borrow against our assets and may cause market valuation adjustments for GAAP purposes, which could reduce our reported earnings. While we estimate prepayment rates to determine the effective yield of our assets and valuations, these estimates are not precise and prepayment rates do not necessarily change in a predictable manner as a function of interest rate changes. Prepayment rates can change rapidly. As a result, changes can cause volatility in our financial results, affect our ability to securitize assets, affect our ability to fund acquisitions, and have other negative impacts on our ability to generate earnings.
We own a number of securities backed by residential loans that are particularly sensitive to changes in prepayments rates. These securities include interest-only securities (IOs) that we acquire from third parties and from our Sequoia entities. Faster prepayments than we anticipated on the underlying loans backing these IOs will have an adverse effect on our returns on these investments and may result in losses. Similarly, we own mortgage servicing rights, or MSRs, associated with residential mortgage loans that are particularly sensitive to changes in prepayments rates. As the owner of an MSR, we are entitled to a portion of the interest payments made by the borrower in respect of the associated loan and we are responsible for hiring and compensating a sub-servicer to directly service the associated loan. Faster prepayments than we anticipate on loans associated with MSRs we own will have an adverse effect on our returns from these MSRs and may result in losses.
Some of the commercial real estate loans we originate or hold may allow the borrower to make prepayments without incurring a prepayment penalty and some may include provisions allowing the borrower to extend the term of the loan beyond the originally scheduled maturity. Because the decision to prepay or extend a commercial loan is controlled by the borrower, we may not accurately anticipate the timing of these events, which could affect the earnings and cash flows we anticipate and could impact our ability to finance these assets.
Interest rate fluctuations can have various negative effects on us and could lead to reduced earnings and increased volatility in our earnings.
Changes in interest rates, the interrelationships between various interest rates, and interest rate volatility could have negative effects on our earnings, the fair value of our assets and liabilities, loan prepayment rates, and our access to liquidity. Changes in interest rates can also harm the credit performance of our assets. We generally seek to hedge some but not all interest rate risks. Our hedging may not work effectively and we may change our hedging strategies or the degree or type of interest rate risk we assume.
Some of the loans and securities we own or may acquire have adjustable-rate coupons (i.e., they may earn interest at a rate that adjusts periodically based on an interest rate index). The cash flows we receive from these assets may vary as a function of interest rates, as may the reported earnings generated by these assets. We also acquire loans and securities for future sale, as assets we are accumulating for securitization, or as a longer term investment. We expect to fund assets with a combination of equity, fixed rate debt and adjustable rate debt. To the extent we use adjustable rate debt to fund assets that have a fixed interest rate (or use fixed rate debt to fund assets that have an adjustable interest rate), an interest rate mismatch could exist and we could, for example, earn less (and fair values could decline) if interest rates rise, at least for a time. We may or may not seek to mitigate interest rate mismatches for these assets with hedges such as interest rate agreements and other derivatives and, to the extent we do use hedging techniques, they may not be successful.
Additionally, in recent periods our residential mortgage banking results have been affected by the combination of estimated market valuation adjustments on our pipeline of jumbo residential loans identified for purchase, but not yet purchased, and changes in the value of interest rate hedges relating to that pipeline, which may impact our reported financial results in different reporting periods. See the discussion under the risk factor titled “The performance of the assets we own and the investments we make will vary and may not meet our earnings or cash flow expectations. In addition, the cash flows and earnings from, and market values of, securities, loans, and other assets we own may be volatile.” Interest rate volatility, particularly at the beginning or end of a reporting period, tends to exacerbate these impacts on our reported financial results and may contribute to earnings volatility.
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Higher interest rates generally reduce the fair value of many of our assets, with the exception of our adjustable-rate assets. This may affect our earnings results, reduce our ability to securitize, re-securitize, or sell our assets, or reduce our liquidity. Higher interest rates could reduce the ability of borrowers to make interest payments or to refinance their loans. Higher interest rates could reduce property values and increased credit losses could result. Higher interest rates could reduce mortgage originations, thus reducing our opportunities to acquire new assets.
When short-term interest rates are high relative to long-term interest rates, an increase in adjustable-rate residential loan prepayments may occur, which would likely reduce our returns from owning interest-only securities backed by adjustable-rate residential loans.
It is difficult to predict the impact on interest rates of any change in the credit rating of the U.S. government, the United Kingdom, or one or more Eurozone nations; however, any change in the outlook for, or rating of, the creditworthiness of the U.S. government, the United Kingdom, or Eurozone nations may have adverse impacts on, among other things, the U.S. economy, financial markets, the cost of borrowing, the financial strength of counterparties we transact business with, and the value of assets we hold. Any such adverse impacts could negatively impact the availability to us of short-term debt financing, our cost of short-term debt financing, our business, and our financial results.
We have significant investment and reinvestment risks.
New assets we originate or acquire may not generate yields as attractive as yields on our current assets, which could result in a decline in our earnings per share over time.
Assets we originate or acquire may not generate the economic returns and GAAP yields we expect. Realized cash flow could be significantly lower than expected and returns from new asset originations and acquisitions could be negative. In order to maintain our portfolio size and our earnings, we must reinvest in new assets a portion of the cash flows we receive from principal, interest, and sales. We receive monthly payments from many of our assets, consisting of principal and interest. In addition, occasionally some of our residential securities are called (effectively sold). We may also sell assets from time to time as part of our portfolio and capital management strategies. Principal payments, calls, and sales reduce the size of our current portfolio and generate cash for us.
If the assets we acquire in the future earn lower GAAP yields than do the assets we currently own, our reported earnings per share could decline over time as the older assets are paid down, are called, or are sold, assuming comparable expenses, credit costs, and market valuation adjustments. Under the effective yield method of accounting that we use for GAAP purposes for some of our assets, we recognize yields on assets based on our assumptions regarding future cash flows. A portion of the cash flows we receive may be used to reduce our basis in these assets. As a result of these various factors, our basis for GAAP amortization purposes may be lower than their current fair values. Assets with a lower GAAP basis than current fair values generate higher GAAP yields, yields that are not necessarily available on newly acquired assets. Future economic conditions, including credit results, prepayment patterns, and interest rate trends, are difficult to project with accuracy over the life of the assets we acquire, so there will be volatility in the reported returns over time.
Our growth may be limited if assets are not available or not available at attractive prices.
To reinvest proceeds from principal repayments and deploy capital we raise, we must originate or acquire new assets. If the availability of new assets is limited, we may not be able to originate or acquire assets that will generate attractive returns. Generally, asset supply can be reduced if originations of a particular product are reduced or if there are few sales in the secondary market of seasoned product from existing portfolios. In particular, assets we believe have a favorable risk/reward ratio may not be available for purchase.
We do not originate residential loans; rather, we rely on the origination market to supply the types of loans we seek to invest in. At times, due to increases in interest rates, heightened credit concerns, strengthened underwriting standards, increased regulation, and/or concerns about economic growth or housing values, the volume of originations may decrease significantly. For example, in recent years residential mortgage interest rates were generally declining, with the result that a significant portion of industry-wide origination volumes have been related to residential borrowers refinancing existing mortgage loans. To the extent interest rates increase or remain steady, the volume of refinance loans is likely to decline significantly and this volume may not return to previous levels. A reduced volume of loan originations may make it difficult for us to acquire loans and securities.
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We originate commercial loans, but we may not be willing to provide the level of loan proceeds to the borrower or interest rate that borrowers find acceptable or that matches our competitors. While the overall industry-wide volume of commercial real estate loan originations and financings is increasing from prior low levels, it is not at the volume the industry has experienced in the past. And, the high-quality commercial assets we seek to finance are highly sought after by numerous lenders.
The supply of new issue RMBS collateralized by jumbo mortgage loans available for purchase could be adversely affected if the economics of executing securitizations are not favorable or if the regulations governing the execution of securitizations discourage or preclude certain potential market participants from engaging in these transactions. In addition, if there is not a robust market for triple-A rated securities, the supply of real estate subordinate securities could be significantly diminished.
Investments in diverse types of assets and businesses could expose us to new, different, or increased risks.
We have invested in and may in the future invest in a variety of real estate and non-real estate related assets that may not be closely related to the types of investments we have traditionally made. Additionally, we may enter into or engage in various types of securitizations, transactions, services, and other operating businesses that are different than the types we have traditionally entered into or engaged in. For example, since 2012 and continuing through 2014 we have increased our holdings of MSRs associated with residential mortgage loans. As another example, in 2014 our FHLBC-member subsidiary established a borrowing facility with the FHLBC that provides a source of long-term financing for residential mortgage loans that our subsidiary buys and holds, as a result of which its holdings of residential whole loans may be increased. Also in 2014, we entered into a risk-sharing arrangement with Fannie Mae under which we can enhance the profitability of transacting in conforming loan products by committing to absorb the first one percent of credit losses on new conforming loans that we sell to Fannie Mae. Any of these actions may expose us to new, different, or increased investment, operational, financial, or management risks. We may invest in non-real estate asset-backed securities (ABS), corporate debt, or equity. We have invested in diverse types of IOs from residential and commercial securitizations sponsored by us or by others. The higher credit and prepayment risks associated with these types of investments may increase our exposure to losses. We may invest in non-U.S. assets that may expose us to currency risks (which we may choose not to hedge) and different types of credit, prepayment, hedging, interest rate, liquidity, legal, and other risks. We originate first mortgage commercial loans primarily for the sale to others (while, in some cases, retaining a subordinate interest in these loans or retaining subordinate financing for the same property) and this exposes us to certain representation and warranty, aggregation, market value, and other risks on loan balances in excess of our potential investments.
In addition, when investing in assets or businesses we are exposed to the risk that those assets, or interest income or revenue generated by those assets or businesses, result in our not meeting the requirements to maintain our REIT status or our status as exempt from registration under the Investment Company Act of 1940, as amended (Investment Company Act), as further described in the risk factors titled “Redwood has elected to be a REIT and, as such, is required to meet certain tests in order to maintain its REIT status. This adds complexity and costs to running our business and exposes us to additional risks” and “Conducting our business in a manner so that we are exempt from registration under, and in compliance with, the Investment Company Act may reduce our flexibility and could limit our ability to pursue certain opportunities. At the same time, failure to continue to qualify for exemption from the Investment Company Act could adversely affect us.”
We may change our investment strategy or financing plans, which may result in riskier investments and diminished returns.
We may change our investment strategy or financing plans at any time, which could result in our making investments that are different from, and possibly riskier than, the investments we have previously made or described. A change in our investment strategy or financing plans may increase our exposure to interest rate and default risk and real estate market fluctuations. Decisions to employ additional leverage could increase the risk inherent in our investment strategy. Furthermore, a change in our investment strategy could result in our making investments in new asset categories or in different proportions among asset categories than we previously have. For example, we could in the future determine to invest a greater proportion of our assets in securities backed by subprime residential mortgage loans. These changes could result in our making riskier investments, which could ultimately have an adverse effect on our financial returns. Alternatively, we could determine to change our investment strategy or financing plans to be more risk averse, resulting in potentially lower returns, which could also have an adverse effect on our financial returns.
The performance of the assets we own and the investments we make will vary and may not meet our earnings or cash flow expectations. In addition, the cash flows and earnings from, and market values of, securities, loans, and other assets we own may be volatile.
We seek to manage certain of the risks associated with acquiring, originating, holding, selling, and managing real estate loans and securities and other real estate-related investments. No amount of risk management or mitigation, however, can change the variable nature of the cash flows of, fair values of, and financial results generated by these loans, securities, and other assets. Changes in the credit performance of, or the prepayments on, these investments, including real estate loans and the loans underlying these
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securities, and changes in interest rates impact the cash flows on these securities and investments, and the impact could be significant for our loans, securities, and other assets with concentrated risks. Changes in cash flows lead to changes in our return on investment and also to potential variability in and level of reported income. The revenue recognized on some of our assets is based on an estimate of the yield over the remaining life of the asset. Thus, changes in our estimates of expected cash flow from an asset will result in changes in our reported earnings on that asset in the current reporting period. We may be forced to recognize adverse changes in expected future cash flows as a current expense, further adding to earnings volatility.
Changes in the fair values of our assets, liabilities, and derivatives can have various negative effects on us, including reduced earnings, increased earnings volatility, and volatility in our book value.
Fair values for our assets and liabilities, including derivatives, can be volatile and our revenue and income can be impacted by changes in fair values. The fair values can change rapidly and significantly and changes can result from changes in interest rates, perceived risk, supply, demand, and actual and projected cash flows, prepayments, and credit performance. A decrease in fair value may not necessarily be the result of deterioration in future cash flows. Fair values for illiquid assets can be difficult to estimate, which may lead to volatility and uncertainty of earnings and book value.
For GAAP purposes, we may mark to market some, but not all, of the assets and liabilities on our consolidated balance sheet. In addition, valuation adjustments on certain consolidated assets and many of our derivatives are reflected in our consolidated statement of income. Assets that are funded with certain liabilities and hedges may have differing mark-to-market treatment than the liability or hedge. If we sell an asset that has not been marked to market through our consolidated statement of income at a reduced market price relative to its cost basis, our reported earnings will be reduced.
Our loan sale profit margins are generally reflective of gains (or losses) over the period from when we identify a loan for purchase until we subsequently sell or securitize the loan. These profit margins may encompass elements of positive or negative market valuation adjustments on loans, hedging gains or losses associated with related risk management activities, and any other related transaction expenses; however, under GAAP, the differing elements may be realized unevenly over the course of one or more quarters for financial reporting purposes, with the result that our financial results may be more volatile and less reflective of the underlying economics of our business activity. For example, at the end of a quarterly or annual financial reporting period, estimated market valuation adjustments on our pipeline of jumbo residential loans identified for purchase, but not yet purchased, may be a negative amount that, in accordance with GAAP, is not reflected in our financial results for that period (but would generally be reflected in a subsequent period when the associated loans are acquired). At the same time, certain offsetting hedging gains may, in accordance with GAAP, have been recorded during that period – with the result that hedging gains and offsetting negative market valuation adjustments may impact our reported financial results in different reporting periods.
Our calculations of the fair value of the securities, loans, MSRs, derivatives, and certain other assets we own or consolidate are based upon assumptions that are inherently subjective and involve a high degree of management judgment.
We report the fair values of securities, loans, MSRs, derivatives, and certain other assets at fair value on our consolidated balance sheets. In computing the fair values for these assets we may make a number of market-based assumptions, including assumptions regarding future interest rates, prepayment rates, discount rates, credit loss rates, and the timing of credit losses. These assumptions are inherently subjective and involve a high degree of management judgment, particularly for illiquid securities and other assets for which market prices are not readily determinable. For further information regarding our assets recorded at fair value see Note 5 to the Financial Statements within this Annual Report on Form 10-K. Use of different assumptions could materially affect our fair value calculations and our financial results. Further discussion of the risk of our ownership and valuation of illiquid securities is set forth in the immediately following risk factor.
Investments we make, hedging transactions that we enter into, and the manner in which we finance our investments and operations expose us to various risks, including liquidity risk, risks associated with the use of leverage, market risks, and counterparty risk.
Many of our investments have limited liquidity.
Many of the residential and commercial securities we own are generally illiquid — that is, there is not a significant pool of potential investors that are likely to invest in these, or similar, securities. This illiquidity can also exist for the residential loans we hold and commercial loans we originate. At times, the vast majority of the assets we own are illiquid. In turbulent markets, it is likely that the securities, loans, and other assets we own may become even less liquid. As a result, we may not be able to sell certain assets at opportune times or at attractive prices or we may incur significant losses upon sale of these assets, should we want or need to sell them.
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Our level of indebtedness and liabilities could limit cash flow available for our operations, expose us to risks that could adversely affect our business, financial condition and results of operations and impair our ability to satisfy our obligations under our convertible notes and other debt instruments.
At December 31, 2014, our total consolidated liabilities (excluding indebtedness associated with asset-backed securities issued by consolidated Sequoia entities, a residential resecuritization entity, and a commercial securitization entity, for which we are not liable) was $3.1 billion, including $493 million of outstanding convertible notes and exchangeable securities. We may also incur additional indebtedness to meet future financing needs. Our indebtedness could have significant negative consequences for our business, results of operations and financial condition, including:
| • | increasing our vulnerability to adverse economic and industry conditions; |
| • | limiting our ability to obtain additional financing; |
| • | requiring the dedication of a substantial portion of our cash flow from operations to service our indebtedness, thereby reducing the amount of our cash flow available for other purposes; |
| • | limiting our flexibility in planning for, or reacting to, changes in our business; |
| • | dilution experienced by our existing stockholders as a result of the conversion of the convertible notes or exchangeable securities into shares of common stock; and |
| • | placing us at a possible competitive disadvantage with less leveraged competitors and competitors that may have better access to capital resources. |
We cannot assure you that we will be able to continue to maintain sufficient cash reserves or continue to generate cash flow from operations at levels sufficient to permit us to pay principal, premium, if any, and interest on our indebtedness, or that our cash needs will not increase. If we are unable to generate sufficient cash flow or otherwise obtain funds necessary to make required payments, or if we fail to comply with the various requirements of our indebtedness then outstanding, we would be in default, which would permit the holders of the affected indebtedness to accelerate the maturity of such indebtedness and could cause defaults under our other indebtedness. Any default under any indebtedness could have a material adverse effect on our business, results of operations and financial condition. For an additional discussion of our outstanding indebtedness, see Part II, Item 7 of this Annual Report on Form 10-K under the heading “Risks Relating to Debt Incurred Under Short- and Long-Term Borrowing Facilities”.
Our use of financial leverage could expose us to increased risks.
We fund the residential and commercial loans we acquire in anticipation of a future sale or securitization with a combination of equity and short-term debt. In addition, we also make investments in securities and loans financed with short- and long-term debt. By incurring this debt (i.e., by applying financial leverage), we expect to generate more attractive returns on our invested equity capital. However, as a result of using financial leverage (whether for the accumulation of loans or related to longer-term investments), we could also incur significant losses if our borrowing costs increase relative to the earnings on our assets and costs of any related hedges. Financing facility creditors may also force us to sell assets pledged as collateral under adverse market conditions to meet margin calls, for example, in the event of a decrease in the fair values of the assets pledged as collateral. Liquidation of the collateral could create negative tax consequences and raise REIT qualification issues. Further discussion of the risk associated with maintaining our REIT status is set forth in the risk factor titled “Redwood has elected to be a REIT and, as such, is required to meet certain tests in order to maintain its REIT status. This adds complexity and costs to running our business and exposes us to additional risks.” In addition, we make financial covenants to creditors in connection with incurring short- and long-term debt, such as covenants relating to our maintaining a minimum amount of tangible net worth or stockholders’ equity and/or a minimum amount of liquid assets. If we fail to comply with these financial covenants we would be in default under our financing facilities, which could result in, among other things, the liquidation of collateral we have pledged pursuant to these facilities under adverse market conditions and the inability to incur additional borrowings to finance our business activities. A further discussion of financial covenants we are subject to and related risks associated with our use of short-term debt is set forth in Part II, Item 7 of this Annual Report on Form 10-K under the heading, “Risks Relating to Debt Incurred Under Short- and Long-Term Borrowing Facilities.”
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The inability to access financial leverage through warehouse and repurchase facilities, credit facilities, or other forms of debt financing may inhibit our ability to execute our business plan, which could have a material adverse effect on our financial results, financial condition, and business.
Our ability to fund our business and our investment strategy depends on our securing warehouse, repurchase, or other forms of debt financing (or leverage) on acceptable terms. For example, pending the sale or securitization of a pool of mortgage loans or other assets we generally fund the acquisition of those mortgage loans or other assets through borrowings from warehouse, repurchase, and credit facilities, and other forms of short-term financing.
We cannot assure you that we will be successful in establishing sufficient sources of short-term debt when needed. In addition, because of its short-term nature, lenders may decline to renew our short-term debt upon maturity or expiration, and it may be difficult for us to obtain continued short-term financing. During certain periods, lenders may curtail their willingness to provide financing, as liquidity in short-term debt markets, including repurchase facilities and commercial paper markets, can be withdrawn suddenly, making it difficult or expensive to renew short-term borrowings as they mature. To the extent our business or investment strategy calls for us to access financing and counterparties are unable or unwilling to lend to us, then our business and financial results will be adversely affected. In addition, it is possible that lenders who provide us with financing could experience changes in their ability to advance funds to us, independent of our performance or the performance of our investments, in which case funds we had planned to be able to access may not be available to us. Additionally, proposed federal regulations, if adopted as currently proposed, would amend the FHLB Membership Regulations in a manner that would limit, eliminate, or reduce the attractiveness of RWT Financial’s ability to borrow from the FHLBC, as further described under the risk factor titled “Proposed Federal regulations may limit, eliminate, or reduce the attractiveness of our subsidiary’s ability to use borrowings from the Federal Home Loan Bank of Chicago to finance the mortgage loans and securities it holds and acquires, which could negatively impact our business and operating results.”
Hedging activities may reduce earnings, may fail to reduce earnings volatility, and may fail to protect our capital in difficult economic environments.
We attempt to hedge certain interest rate risks (and, at times, prepayment risks and fair values) by balancing the characteristics of our assets and associated (existing and anticipated) liabilities with respect to those risks and entering into various interest rate agreements. The number and scope of the interest rate agreements we utilize may vary significantly over time. We generally seek to enter into interest rate agreements that provide an appropriate and efficient method for hedging certain risks related to changes in interest rates.
The use of interest rate agreements and other instruments to hedge certain of our risks may well have the effect over time of lowering long-term earnings to the extent these risks do not materialize. To the extent that we hedge, it is usually to seek to protect us from some of the effects of short-term interest rate volatility, to lower short-term earnings volatility, to stabilize liability costs or fair values, to stabilize our economic returns from or meet rating agency requirements with respect to a securitization transaction, or to stabilize the future cost of anticipated issuance of securities by a securitization entity. Hedging may not achieve our desired goals. Hedging with respect to the pipeline of loans we plan to purchase may not be effective due to loan fallout or other reasons. Using interest rate agreements as a hedge may increase short-term earnings volatility, especially if we do not elect certain accounting treatments for our hedges. Reductions in fair values of interest rate agreements may not be offset by increases in fair values of the assets or liabilities being hedged. Conversely, increases in fair values of interest rate agreements may not fully offset declines in fair values of assets or liabilities being hedged. Changes in fair values of interest rate agreements may require us to pledge significant amounts of cash or other acceptable forms of collateral.
We also may hedge by taking short, forward, or long positions in U.S. Treasuries, mortgage securities, or other cash instruments. We may take both long and short positions in credit derivative transactions linked to real estate assets. These derivatives may have additional risks to us, such as: liquidity risk, due to the fact that there may not be a ready market into which we could sell these derivatives if needed; basis risk, which could result in a decline in value or a requirement to make a cash payment as a result of changes in interest rates; and the risk that a counterparty to a derivative is not willing or able to perform its obligations to us due to its financial condition or otherwise.
Our earnings may be subject to fluctuations from quarter to quarter as a result of the accounting treatment for certain derivatives or for assets or liabilities whose terms do not necessarily match those used for derivatives, or as a result of our inability to meet the requirements necessary to obtain specific hedge accounting treatment for certain derivatives.
We enter into derivative contracts that may expose us to contingent liabilities and those contingent liabilities may not appear on our balance sheet. We may invest in synthetic securities, credit default swaps, and other credit derivatives, which expose us to additional risks.
We enter into derivative contracts, including interest rate swaps, options, and futures, that could require us to make cash payments in certain circumstances. Potential payment obligations would be contingent liabilities and may not appear on our balance sheet. Our ability to satisfy these contingent liabilities depends on the liquidity of our assets and our access to capital and cash. The need to fund these contingent liabilities could adversely impact our financial condition.
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We may in the future invest in synthetic securities, credit default swaps, and other credit derivatives that reference other real estate securities or indices. These investments may present risks in excess of those resulting from the referenced security or index. These investments are typically contractual relationships with counterparties and not acquisitions of referenced securities or other assets. In these types of investments, we have no right directly to enforce compliance with the terms of the referenced security or other assets and we have no voting or other consensual rights of ownership with respect to the referenced security or other assets. In the event of insolvency of a counterparty, we will be treated as a general creditor of the counterparty and will have no claim of title with respect to the referenced security.
Hedging activities may subject us to increased regulation.
Under the Dodd-Frank Act, there is increased regulation of companies, such as Redwood and certain of its subsidiaries, that enter into interest rate hedging agreements and other hedging instruments and derivatives. This increased regulation could result in Redwood or certain of its subsidiaries being required to register and be regulated as a commodity pool operator or a commodity trading advisor. If we are not able to maintain an exemption from these regulations, it could have a negative impact on our business or financial results. Moreover, rules requiring central clearing of certain interest rate swap and other transactions, as well as rules relating to margin and capital requirements for swap transactions and regulated participants in the swap markets, as well as other swap market regulatory reforms, may increase the cost or decrease the availability to us of hedging transactions, and may also limit our ability to include swaps in our securitization transactions.
Our results could be adversely affected by counterparty credit risk.
We have credit risks that are generally related to the counterparties with which we do business. There is a risk that counterparties will fail to perform under their contractual arrangements with us and this risk is usually more pronounced during an economic downturn. Counterparties may seek to eliminate credit exposure by entering into offsetting, or “back-to-back,” hedging transactions, and the ability of a counterparty to settle a synthetic transaction may be dependent on whether the counterparties to the back-to-back transactions perform their delivery obligations. Those risks of non-performance may differ materially from the risks entailed in exchange-traded transactions, which generally are backed by clearing organization guarantees, daily mark-to-market and settlement of positions, and segregation and minimum capital requirements applicable to intermediaries. Transactions entered into directly between parties generally do not benefit from those protections, and expose the parties to the risk of counterparty default. Furthermore, there may be practical and timing problems associated with enforcing our rights to assets in the case of an insolvency of a counterparty.
In the event a counterparty to our short-term borrowings becomes insolvent, we may fail to recover the full value of our pledged collateral, thus reducing our earnings and liquidity. In the event a counterparty to our interest rate agreements, credit default swaps, or other derivatives becomes insolvent or interprets our agreements with it in a manner unfavorable to us, our ability to realize benefits from the hedge transaction may be diminished, any cash or collateral we pledged to the counterparty may be unrecoverable, and we may be forced to unwind these agreements at a loss. In the event a counterparty that sells us residential mortgage loans becomes insolvent or is acquired by a third party, we may be unable to enforce our loan repurchase rights in connection with a breach of loan representations and warranties and we may suffer losses if we must repurchase delinquent loans. In the event that one of our servicers becomes insolvent or fails to perform, loan delinquencies and credit losses may increase and we may not receive the funds to which we are entitled. We attempt to diversify our counterparty exposure and (except with respect to loan representations and warranties) attempt to limit our counterparty exposure to counterparties with investment-grade credit ratings, although we may not always be able to do so. Our counterparty risk management strategy may prove ineffective and, accordingly, our earnings and cash flows could be adversely affected.
Through certain of our wholly-owned subsidiaries we have engaged in the past, and plan to continue to engage, in acquiring residential mortgage loans and originating commercial mortgage loans with the intent to sell these loans to third parties or hold them as investments. Similarly, we have engaged in the past, and plan to continue to engage, in acquiring residential MSRs. These types of transactions and investments expose us to potentially material risks.
Acquiring and originating mortgage loans with intent to sell these loans to third parties generally requires us to incur short-term debt, either on a recourse or non-recourse basis, to finance the accumulation of loans or other assets prior to sale. This type of debt may not be available to us, or may only be available to us on an uncommitted basis, including in circumstances where a line of credit had previously been made available or committed to us. In addition, the terms of any available debt may be unfavorable to us or impose restrictive covenants that could limit our business and operations or the violation of which could lead to losses and inhibit our ability to borrow in the future. We expect to pledge assets we acquire to secure the short-term debt we incur. To the extent this debt is recourse to us, if the fair value of the assets pledged as collateral declines, we would be required to increase the amount of collateral
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pledged to secure the debt or to repay all or a portion of the debt. In addition, when we originate or acquire assets for a sale, we make assumptions about the cash flows that will be generated from those assets and the market value of those assets. If these assumptions are wrong, or if market values change or other conditions change, it could result in a sale that is less favorable to us than initially assumed, which would typically have a negative impact on our financial results.
Furthermore, if we are unable to complete the sale of these types of assets, it could have a negative impact on our business and financial results. We have a limited capacity to hold residential and commercial loans on our balance sheet as investments, and our business is not structured to buy-and-hold the full volume of loans that we routinely acquire or originate with the intent to sell. If demand for buying whole-loans weakens, we may be forced to incur additional debt on unfavorable terms or may be unable to borrow to finance these assets, which may in turn impact our ability to continue acquiring loans over the short or long term.
Prior to originating or acquiring loans or other assets for sale, we may undertake underwriting and due diligence efforts with respect to various aspects of the loan or asset. When underwriting or conducting due diligence, we rely on resources and data available to us, which may be limited, and we rely on investigations by third parties. We may also only conduct due diligence on a sample of a pool of loans or assets we are acquiring and assume that the sample is representative of the entire pool. Our underwriting and due diligence efforts may not reveal matters which could lead to losses. If our underwriting process is not robust enough or if we do not conduct adequate due diligence, or the scope of our underwriting or due diligence is limited, we may incur losses. Losses could occur due to the fact that a counterparty that sold us a loan or other asset (or that is the obligor or a party related to an obligor of a commercial loan we originate) refuses or is unable (e.g., due to its financial condition) to repurchase that loan or asset or pay damages to us if we determine subsequent to purchase that one or more of the representations or warranties made to us in connection with the sale or origination was inaccurate.
In addition, when selling commercial or residential mortgage loans or acquiring servicing rights associated with residential mortgage loans, we typically make representations and warranties to the purchaser or to other third parties regarding, among other things, certain characteristics of those assets, including characteristics we seek to verify through our underwriting and due diligence efforts. If our representations and warranties are inaccurate with respect to any asset, we may be obligated to repurchase that asset or pay damages, which may result in a loss. We generally only establish reserves for potential liabilities relating to representations and warranties we make if we believe that those liabilities are both probable and estimable, as determined in accordance with GAAP. As a result, we may not have reserves relating to these potential liabilities or any reserves we may establish could be inadequate. Even if we obtain representations and warranties from the counterparties from whom we acquired the loans or other assets, they may not parallel the representations and warranties we make or may otherwise not protect us from losses, including, for example, due to the fact that the counterparty may be insolvent or otherwise unable to make a payment to us at the time we claim damages for a breach of representation or warranty. Furthermore, to the extent we claim that counterparties we have acquired loans from have breached their representations and warranties to us, it may adversely impact our business relationship with those counterparties, including by reducing the volume of business we conduct with those counterparties, which could negatively impact our ability to acquire loans and our business. To the extent we have significant exposure to representations and warranties made to us by one or more counterparties we acquire loans from, we may determine, as a matter of risk management, to reduce or discontinue loan acquisitions from those counterparties, which could reduce the volume of residential loans we acquire and negatively impact our business and financial results.
Through certain of our wholly-owned subsidiaries we have engaged in the past, and continue to engage in, securitization transactions relating to residential mortgage loans. We have in the past also engaged in, and may in the future engage in, other types of securitization transactions or similar transactions, including securitization transactions relating to commercial real estate loans and other types of commercial real estate investments. In addition, we have invested in and continue to invest in mortgage-backed securities and other ABS issued in securitization transactions sponsored by other companies. These types of transactions and investments expose us to potentially material risks.
Engaging in securitization transactions and other similar transactions generally requires us to incur short-term debt, either on a recourse or non-recourse basis, to finance the accumulation of loans or other assets prior to securitization. If demand for investing in securitization transactions weakens, we may be unable to complete the securitization of loans accumulated for that purpose, which may hurt our business or financial results. In addition, in connection with engaging in securitization transactions, we engage in due diligence with respect to the loans or other assets we are securitizing and make representations and warranties relating to those loans and assets. The risks associated with incurring this type of debt in connection with securitization activity, the risks related to our ability to complete securitization transactions after we have accumulated loans for that purpose, and the risks associated with the due diligence we conduct, and the representations and warranties we make, in connection with securitization activity are similar to the risks associated with acquiring and originating loans with the intent to sell them to third parties, as described in the immediately preceding risk factor titled “Through certain of our wholly-owned subsidiaries we have engaged in the past, and plan to continue to
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engage, in acquiring residential mortgage loans and originating commercial mortgage loans with the intent to sell these loans to third parties or hold them as investments. Similarly, we have engaged in the past, and plan to continue to engage, in acquiring servicing rights associated with residential mortgage loans. These types of transactions and investments expose us to potentially material risks.”
When engaging in securitization transactions, we also prepare marketing and disclosure documentation, including term sheets and prospectuses, that include disclosures regarding the securitization transactions and the assets being securitized. If our marketing and disclosure documentation are alleged or found to contain inaccuracies or omissions, we may be liable under federal and state securities laws (or under other laws) for damages to third parties that invest in these securitization transactions, including in circumstances where we relied on a third party in preparing accurate disclosures, or we may incur other expenses and costs in connection with disputing these allegations or settling claims. We may also sell or contribute commercial real estate loans to third parties who, in turn, securitize those loans. In these circumstances, we may also prepare marketing and disclosure documentation, including documentation that is included in term sheets and prospectuses relating to those securitization transactions. We could be liable under federal and state securities laws (or under other laws) for damages to third parties that invest in these securitization transactions, including liability for disclosures prepared by third parties or with respect to loans that we did not sell or contribute to the securitization. Additionally, we typically retain various third-party service providers when we engage in securitization transactions, including underwriters or initial purchasers, trustees, administrative and paying agents, and custodians, among others. We frequently contractually agree to indemnify these service providers against various claims and losses they may suffer in connection with the provision of services to us and/or the securitization trust. To the extent any of these service providers are liable for damages to third parties that have invested in these securitization transactions, we may incur costs and expenses as a result of these indemnities.
In recent years there has also been debate as to whether there are defects in the legal process and legal documents governing transactions in which securitization trusts and other secondary purchasers take legal ownership of residential mortgage loans and establish their rights as first priority lien holders on underlying mortgaged property. To the extent there are problems with the manner in which title and lien priority rights were established or transferred, securitization transactions that we sponsored and third-party sponsored securitizations that we hold investments in may experience losses, which could expose us to losses and could damage our ability to engage in future securitization transactions.
In connection with our operating and investment activity, we rely on third parties to perform certain services, comply with applicable laws and regulations, and carry out contractual covenants and terms, the failure of which by any of these third parties may adversely impact our business and financial results.
In connection with our business of acquiring and originating loans, engaging in securitization transactions, and investing in third-party issued securities and other assets, we rely on third party service providers to perform certain services, comply with applicable laws and regulations, and carry out contractual covenants and terms. As a result, we are subject to the risks associated with a third party’s failure to perform, including failure to perform due to reasons such as fraud, negligence, errors, miscalculations, or insolvency. For example, many loan servicers are experiencing higher volumes of delinquent loans than they have in the past and, as a result, there is a risk that their operational infrastructures cannot properly process this increased volume. Many loan servicers have been accused of improprieties in the handling of the foreclosure process with respect to residential mortgage loans that have gone into default. To the extent a third party loan servicer fails to fully and properly perform its obligations, loans and securities that we hold as investments may experience losses and securitizations that we have sponsored may experience poor performance, and our ability to engage in future securitization transactions could be harmed.
For some of the loans that we hold and for some of the loans we sell or securitize, we hold the right to service those loans and we retain a sub-servicer to service those loans. In these circumstances we are exposed to certain risks, including, without limitation, that we may not be able to enter into subservicing agreements on favorable terms to us or at all, or that the sub-servicer may not properly service the loan in compliance with applicable laws and regulations or the contractual provisions governing their sub-servicing role, and that we would be held liable for the sub-servicer’s improper acts or omissions. Additionally, in its capacity as a servicer of residential mortgage loans, a sub-servicer will have access to borrowers’ non-public personal financial information, and we could incur liability in connection with a data breach relating to a sub-servicer, as discussed further below under the risk factor titled “Our technology infrastructure and systems are important and any significant disruption or breach of the security of this infrastructure or these systems could have an adverse effect on our business. We also rely on technology infrastructure and systems of third parties who provide services to us and with whom we transact business.” When we retain a sub-servicer we are generally also obligated to fund any obligation of the sub-servicer to make advances on behalf of a delinquent loan obligor. We have historically relied on one sub-servicer counterparty to service the majority of the loans with respect to which we own the servicing rights and, as a result, the risks associated with our use of a sub-servicer have been concentrated around this single sub-servicer counterparty. To the extent that there are significant amounts of advances that need to be funded in respect of loans where we own the servicing right, it could have a material adverse effect on our business and financial results.
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We also rely on corporate trustees to act on behalf of us and other holders of ABS in enforcing our rights as security holders. Under the terms of most ABS we hold, we do not have the right to directly enforce remedies against the issuer of the security, but instead must rely on a trustee to act on behalf of us and other security holders. Should a trustee not be required to take action under the terms of the securities, or fail to take action, we could experience losses. In the context of our commercial mortgage banking and investment activities, we rely on third parties to manage and operate the properties that directly or indirectly collateralize our commercial loans, to generate operating results and cash flow sufficient to service our loans and support the repayment or refinancing of our loans at maturity, and to mitigate the risk of losses.
Our ability to execute or participate in future securitization transactions, including, in particular, securitizations of residential mortgage loans, could be delayed, limited, or precluded by legislative and regulatory reforms applicable to asset-backed securities and the institutions that sponsor, service, rate, or otherwise participate in or contribute to the successful execution of a securitization transaction. Other factors could also limit, delay, or preclude our ability to execute securitization transactions. These legislative, regulatory, and other factors could also reduce the returns we would otherwise expect to earn in connection with executing securitization transactions.
In July 2010, the Dodd-Frank Act was enacted. Provisions of the Dodd-Frank Act require, among other things, significant revisions to the legal and regulatory framework under which ABS, including residential mortgage-backed securities (RMBS), are issued through the execution of securitization transactions. Some of the provisions of the Dodd-Frank Act have become effective or been implemented, while others are in the process of being implemented or will become effective soon. In addition, prior to the passage of the Dodd-Frank Act, the Securities and Exchange Commission (SEC) and the Federal Deposit Insurance Corporation had already published proposed and final regulations under already existing legislative authority relating to the issuance of ABS, including RMBS. Additional federal or state laws and regulations that could affect our ability to execute future securitization transactions could be proposed, enacted, or implemented. In addition, various federal and state agencies and law enforcement authorities, as well as private litigants, have initiated and may, in the future, initiate additional broad-based enforcement actions or claims, the resolution of which may include industry-wide changes to the way residential mortgage loans are originated, transferred, serviced, and securitized, and any of these changes could also affect our ability to execute future securitization transactions. For an example, please refer to the risk factor titled “Federal and state legislative and regulatory developments and the actions of governmental authorities and entities may adversely affect our business and the value of, and the returns on, mortgages, mortgage-related securities, and other assets we own or may acquire in the future.”
Rating agencies can affect our ability to execute or participate in a securitization transaction, or reduce the returns we would otherwise expect to earn from executing securitization transactions, not only by deciding not to publish ratings for our securitization transactions (or deciding not to consent to the inclusion of those ratings in the prospectuses or other documents we file with the SEC relating to securitization transactions), but also by altering the criteria and process they follow in publishing ratings. Rating agencies could alter their ratings processes or criteria after we have accumulated loans or other assets for securitization in a manner that effectively reduces the value of those previously acquired loans or requires that we incur additional costs to comply with those processes and criteria. For example, to the extent investors in a securitization transaction would have significant exposure to representations and warranties made by us or by one or more counterparties we acquire loans from, rating agencies may determine that this exposure increases investment risks relating to the securitization transaction. Rating agencies could reach this conclusion either because of our financial condition or the financial condition of one or more counterparties we acquire loans from, or because of the aggregate amount of residential loan-related representations and warranties (or other contingent liabilities) we, or one or more counterparties we acquire loans from, have made or have exposure to. If, as a result, rating agencies place limitations on our ability to execute future securitization transactions or impose unfavorable ratings levels or conditions on our securitization transactions, it could reduce the returns we would otherwise expect to earn from executing these transactions and negatively impact our business and financial results. In addition, the actual short- and long-term impact on our ability to securitize residential mortgage loans in the future will depend, in large part, on how the rating agencies assess the investment risks that result from the ability-to-repay regulations promulgated by the CFPB that first became effective in January 2014, including, for example, how they assess investment risks associated with residential mortgage loans that have an interest-only payment feature or loans under which the borrower has a debt-to-income ratio of more than 43% (as these types of loans have historically accounted for a significant amount of the loans we have securitized, but they are not considered “qualified mortgages” under the ability-to-repay regulations).
Furthermore, other matters, such as (i) accounting standards applicable to securitization transactions and (ii) capital and leverage requirements applicable to banks’ and other regulated financial institutions’ holdings of ABS, could result in less investor demand for securities issued through securitization transactions we execute or increased competition from other institutions that originate, acquire, and hold commercial real estate loans, residential mortgage loans, and other types of assets and execute securitization transactions.
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Our ability to profitably execute or participate in future securitizations transactions, including, in particular, securitizations of residential mortgage loans, is dependent on numerous factors and if we are not able to achieve our desired level of profitability or if we incur losses in connection with executing or participating in future securitizations it could have a material adverse impact on our business and financial results.
There are a number of factors that can have a significant impact on whether a securitization transaction that we execute or participate in is profitable to us or results in a loss. One of these factors is the price we pay for (or cost of originating) the mortgage loans that we securitize, which, in the case of residential mortgage loans, is impacted by the level of competition in the marketplace for acquiring residential mortgage loans and the relative desirability to originators of retaining residential mortgage loans as investments or selling them to third parties such as us. Another factor that impacts the profitability of a securitization transaction is the cost to us of the short-term debt that we use to finance our holdings of mortgage loans prior to securitization, which cost is affected by a number of factors including the availability of this type of financing to us, the interest rate on this type of financing, the duration of the financing we incur, and the percentage of our mortgage loans for which third parties are willing to provide short-term financing.
After we acquire or originate mortgage loans that we intend to securitize, we can also suffer losses if the value of those loans declines prior to securitization. Declines in the value of a residential mortgage loan, for example, can be due to, among other things, changes in interest rates, changes in the credit quality of the loan, and changes in the projected yields required by investors to invest in securitization transactions. To the extent we seek to hedge against a decline in loan value due to changes in interest rates, there is a cost of hedging that also affects whether a securitization is profitable. Other factors that can significantly affect whether a securitization transaction is profitable to us include the criteria and conditions that rating agencies apply and require when they assign ratings to the mortgage-backed securities issued in our securitization transactions, including the percentage of mortgage-backed securities issued in a securitization transaction that the rating agencies will assign a triple-A rating to, which, in the case of residential mortgage loans is also referred to as a rating agency subordination level. Rating agency subordination levels can be impacted by numerous factors, including, without limitation, the credit quality of the loans securitized, the geographic distribution of the loans to be securitized, and the structure of the securitization transaction and other applicable rating agency criteria. All other factors being equal, the greater the percentage of the mortgage-backed securities issued in a securitization transaction that the rating agencies will assign a triple-A rating to, the more profitable the transaction will be to us.
The price that investors in mortgage-backed securities will pay for securities issued in our securitization transactions also has a significant impact on the profitability of the transactions to us, and these prices are impacted by numerous market forces and factors. In addition, the underwriter(s) or placement agent(s) we select for securitization transactions, and the terms of their engagement, can also impact the profitability of our securitization transactions. Also, transaction costs incurred in executing transactions impact the profitability of our securitization transactions and any liability that we may incur, or may be required to reserve for, in connection with executing a transaction can cause a loss to us. To the extent that were are not able to profitably execute future securitizations of residential mortgage loans or other assets, including for the reasons described above or for other reasons, it could have a material adverse impact on our business and financial results.
Our past and future securitization activities or other past and future business or operating activities or practices could expose us to litigation, which may adversely affect our business and financial results.
Through certain of our wholly-owned subsidiaries we have in the past engaged in or participated in securitization transactions relating to residential mortgage loans, commercial mortgage loans, commercial real estate loans, and other types of assets. In the future we expect to continue to engage in or participate in securitization transactions, including, in particular, securitization transactions relating to residential mortgage loans and commercial mortgage loans, and may also engage in other types of securitization transactions or similar transactions. Sequoia securitization entities we sponsored issued ABS backed by residential mortgage loans held by these Sequoia entities. In Acacia securitization transactions we participated in, Acacia securitization entities issued ABS backed by securities and other assets held by these Acacia entities. As a result of declining property values, increasing defaults, changes in interest rates, and other factors, the aggregate cash flows from the loans held by the Sequoia entities and the securities and other assets held by the Acacia entities may be insufficient to repay in full the principal amount of ABS issued by these securitization entities. We are not directly liable for any of the ABS issued by these entities. Nonetheless, third parties who hold the ABS issued by these entities may try to hold us liable for any losses they experience, including through claims under federal and state securities laws or claims for breaches of representations and warranties we made in connection with engaging in these securitization transactions.
For example, as discussed below in Part I, Item 3 of this Annual Report on Form 10-K, on December 23, 2009, the Federal Home Loan Bank of Seattle filed a claim in the Superior Court for the State of Washington against us and our subsidiary, Sequoia Residential Funding, Inc. The complaint relates in part to residential mortgage-backed securities that were issued by a Sequoia securitization entity and alleges that, at the time of issuance, we, Sequoia Residential Funding, Inc. and the underwriters made various misstatements and omissions about these securities in violation of Washington state law. We have also been named in other similar lawsuits. A further discussion of these lawsuits is set forth in Note 15 to the Financial Statements within this Annual Report on Form 10-K.
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Other aspects of our business operations or practices could also expose us to litigation. In the ordinary course of our business we enter into agreements relating to, among other things, loans we acquire and investments we make, assets and loans we sell, financing transactions, third parties we retain to provide us with goods and services, and our leased office space. We also regularly enter into confidentiality agreements with third parties under which we receive confidential information. If we breach any of these agreements, we could be subject to claims for damages and related litigation. We are also subject to various laws and regulations relating to our business and operations, including, without limitation, privacy laws and regulations and labor and employment laws and regulations, and if we fail to comply with these laws and regulations we could also be subjected to claims for damages and litigation. In particular, if we fail to maintain the confidentiality of consumers’ personal or financial information we obtain in the course of our business (such as social security numbers), we could be exposed to losses.
Defending a lawsuit can consume significant resources and may divert management’s attention from our operations. We may be required to establish or increase reserves for potential losses from litigation, which could be material. To the extent we are unsuccessful in our defense of any lawsuit, we could suffer losses which could be in excess of any reserves established relating to that lawsuit) and these losses could be material.
Our cash balances and cash flows may be insufficient relative to our cash needs.
We need cash to make interest payments, to post as collateral to counterparties and lenders who provide us with short-term debt financing and who engage in other transactions with us, for working capital, to fund REIT dividend distribution requirements, to comply with financial covenants and regulatory requirements, and for other needs and purposes. We may also need cash to repay short-term borrowings when due or in the event the fair values of assets that serve as collateral for that debt decline, the terms of short-term debt become less attractive, or for other reasons. In addition, we may need to use cash to post in response to margin calls relating to various derivative instruments we hold as the values of these derivatives change.
Our sources of cash flow include the principal and interest payments on the loans and securities we own, asset sales, securitizations, short-term borrowing, issuing long-term debt, and issuing stock. Our sources of cash may not be sufficient to satisfy our cash needs. Cash flows from principal repayments could be reduced if prepayments slow or if credit quality deteriorates. For example, for some of our assets, cash flows are “locked-out” and we receive less than our pro-rata share of principal payment cash flows in the early years of the investment.
Our minimum dividend distribution requirements could exceed our cash flows if our income as calculated for tax purposes significantly exceeds our net cash flows. This could occur when taxable income (including non-cash income such as discount amortization and interest accrued on negative amortizing loans) exceeds cash flows received. The Internal Revenue Code provides a limited relief provision concerning certain items of non-cash income; however, this provision may not sufficiently reduce our cash dividend distribution requirement. In the event that our liquidity needs exceed our access to liquidity, we may need to sell assets at an inopportune time, thus reducing our earnings. In an adverse cash flow situation, we may not be able to sell assets effectively and our REIT status or our solvency could be threatened. Further discussion of the risk associated with maintaining our REIT status is set forth in the risk factor titled “Redwood has elected to be a REIT and, as such, is required to meet certain tests in order to maintain its REIT status. This adds complexity and costs to running our business and exposes us to additional risks.”
We are subject to competition and we may not compete successfully.
We are subject to competition in seeking investments, originating commercial loans, acquiring and selling residential loans, engaging in securitization transactions, and in other aspects of our business. Our competitors include commercial banks, other mortgage REITs, Fannie Mae, Freddie Mac, regional and community banks, broker-dealers, insurance companies, and other financial institutions, as well as investment funds and other investors in real estate-related assets. In addition, other companies may be formed that will compete with us. Some of our competitors have greater resources than us and we may not be able to compete successfully with them. Furthermore, competition for investments, making loans, acquiring and selling loans, and engaging in securitization transactions may lead to a decrease in the opportunities and returns available to us.
In addition, there are significant competitive threats to our business from governmental actions and initiatives that have already been undertaken or which may be undertaken in the future. Sustained competition from governmental actions and initiatives could have a material adverse effect on us. For example, Fannie Mae and Freddie Mac are, among other things, engaged in the business of acquiring loans and engaging in securitization transactions. Until 2008, competition from Fannie Mae and Freddie Mac was limited to some extent due to the fact that they were statutorily prohibited from purchasing loans for single unit residences in the continental United States with a principal amount in excess of $417,000, while much of our business had historically focused on acquiring
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residential loans with a principal amount in excess of $417,000. In February 2008, Congress passed an economic stimulus package that temporarily increased the size of certain loans these entities could purchase to up to $729,750, if the loans were made to secure real estate purchases in certain high-cost areas of the U.S. As of December 31, 2014, this $729,750 loan size limit had been reduced to $625,500, which is an amount that continues to be above the historical $417,000 loan size limit. In addition, in September 2008, Fannie Mae and Freddie Mac were placed into conservatorship and have become, in effect, instruments of the U.S. federal government. As long as there is governmental support for these entities to continue to operate and provide financing to a significant portion of the mortgage finance market, they will represent significant business competition due to, among other things, their large size and low cost of funding.
To the extent that laws, regulations, or policies governing the business activities of Fannie Mae and Freddie Mac are not changed to limit their role in housing finance (such as a change in these loan size limits or in the guarantee fees they charge), the competition from these two governmental entities will remain significant. In addition, to the extent that property values decline while these loan size limits remain the same, it may have the same effect as an increase in this limit, as a greater percentage of loans would likely be within the size limit. Any increase in the loan size limit, or in the overall percentage of loans that are within the limit, allows Fannie Mae and Freddie Mac to compete against us to a greater extent than they had been able to compete previously and our business could be adversely affected. Additionally, the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA) guarantee qualified residential mortgages, and FHA and VA loans accounted for approximately 20% of the aggregate dollar value of residential loans originated in the U.S. in 2014. The federal government’s ability to provide financing to a significant portion of the mortgage finance market through these entities represents significant business competition due to, among other things, their size and low cost of funding.
Our business model and business strategies, and the actions we take (or fail to take) to implement them and adapt them to changing circumstances involve risk and may not be successful.
Due to the recent financial crisis and downturn in the U.S. real estate markets and the economy, the mortgage industry and the related capital markets are still undergoing significant changes, including due to the significant governmental interventions in these areas and changes to the laws and regulations that govern the banking and mortgage finance industry. Our methods of, and model for, doing business and financing our investments are changing and if we fail to develop, enhance, and implement strategies to adapt to changing conditions in the mortgage industry and capital markets, our business and financial results may be adversely affected. Furthermore, changes we make to our business to respond to changing circumstances may expose us to new or different risks than we were previously exposed to and we may not effectively identify or manage those risks.
Similarly, the competitive landscape in which we operate and the products and investments for which we compete are also affected by changing conditions. There may be trends or sudden changes in our industry or regulatory environment, changes in the role of government-sponsored entities, such as Fannie Mae and Freddie Mac, changes in the role of credit rating agencies or their rating criteria or processes, or changes in the U.S. economy more generally. If we do not effectively respond to these changes or if our strategies to respond to these changes are not successful, our ability to effectively compete in the marketplace may be negatively impacted, which would likely result in our business and financial results being adversely affected.
We have historically depended upon the issuance of mortgage-backed securities by the securitization entities we sponsor as a funding source for our residential real estate-related business. However, due to market conditions, we did not engage in residential mortgage securitization transactions in 2008 or 2009 and we only engaged in one residential mortgage securitization transaction in 2010 and two residential mortgage securitization transactions in 2011. While we engaged in numerous residential mortgage securitization transactions over the course of 2012, 2013 and 2014, we do not know if market conditions will allow us to continue to regularly engage in these types of securitization transactions and any disruption of this market may adversely affect our earnings and growth. For example, in 2014, we completed four securitization transactions, as compared to four securitizations in the second half of 2013, and eight securitizations in the first half of 2013. We expect our pace of securitization activity in 2015 to be similar to 2014. Even if regular residential mortgage securitization activity continues among market participants other than government-sponsored entities, we do not know if it will continue to be on terms and conditions that will permit us to participate or be favorable to us. Even if conditions are favorable to us, we may not be able to return to or sustain the volume of securitization activity we previously conducted.
Similarly, our commercial lending platform relies on a healthy and active commercial mortgage securitization market in order to provide a source of financing for commercial mortgage loans we originate. We do not know if market conditions in commercial mortgage securitization markets will allow us to continue to regularly participate in these types of securitization transactions and any disruption of this market may also adversely affect our earnings and growth. Even if regular commercial mortgage securitization activity continues among market participants, we do not know if it will continue to be on terms and conditions that will permit us to participate or be favorable to us.
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Initiating new business activities or significantly expanding existing business activities may expose us to new risks and will increase our cost of doing business.
Initiating new business activities or significantly expanding existing business activities are two ways to grow our business and respond to changing circumstances in our industry; however, they may expose us to new risks and regulatory compliance requirements. We cannot be certain that we will be able to manage these risks and compliance requirements effectively. Furthermore, our efforts may not succeed and any revenues we earn from any new or expanded business initiative may not be sufficient to offset the initial and ongoing costs of that initiative, which would result in a loss with respect to that initiative. For example, efforts we have made and continue to make to significantly expand our investing activity in commercial real-estate related assets and to develop new methods and channels for acquiring, securitizing, and selling residential and commercial real estate-related investment assets may expose us to new risks, may not succeed, and may not generate sufficient revenue to offset our related costs. We have also engaged in increasing our holdings of residential MSRs, and we recently began acquiring residential mortgage loans for sale to Fannie Mae and Freddie Mac, which enables us to create our own investments in MSRs and has positioned us to be involved in a risk-sharing arrangement with Fannie Mae, but these efforts could expose us to new risks or not succeed, and may not generate sufficient revenue to offset our related costs.
In connection with initiating new business activities or expanding existing business activities, or for other business reasons, we may create new subsidiaries. Generally, these subsidiaries would be wholly-owned, directly or indirectly, by Redwood. The creation of those subsidiaries may increase our administrative costs and expose us to other legal and reporting obligations, including, for example, because they may be incorporated in states other than Maryland or may be established in a foreign jurisdiction. Any new subsidiary we create may be designated as a taxable subsidiary. Taxable subsidiaries are wholly-owned subsidiaries of a REIT that pay corporate income tax on the income they generate. That is, a taxable subsidiary is not able to deduct its dividends paid to its parent in determining its taxable income and any dividends paid to the parent are generally recognized as income at the parent level.
Our future success depends on our ability to attract and retain key personnel.
Our future success depends on the continued service and availability of skilled personnel, including members of our executive management team such as our Chief Executive Officer, our President, our Chief Investment Officer, our Chief Financial Officer, and our General Counsel. To the extent personnel we attempt to hire are concerned that economic, regulatory, or other factors could impact our ability to maintain or expand our current level of business, it could negatively impact our ability to hire the personnel we need to operate our business. We cannot assure you that we will be able to attract and retain key personnel.
We may not be able to obtain or maintain the governmental licenses required to operate our business and we may fail to comply with various state and federal laws and regulations applicable to our business of acquiring residential mortgage loans and servicing rights and originating commercial real estate loans. We are a seller/servicer approved to sell residential mortgage loans to Freddie Mac and Fannie Mae and failure to maintain our status as an approved seller/servicer could harm our business.
While we are not required to obtain licenses to purchase mortgage-backed securities, the purchase of residential mortgage loans in the secondary market may, in some circumstances, require us to maintain various state licenses. Acquiring the right to service residential mortgage loans may also, in some circumstances, require us to maintain various state licenses even though we currently do not expect to directly engage in loan servicing ourselves. Similarly, certain commercial real estate lending activities that we engage in also require us to obtain and maintain various state licenses. As a result, we could be delayed in conducting certain business if we were first required to obtain a state license. We cannot assure you that we will be able to obtain all of the licenses we need or that we would not experience significant delays in obtaining these licenses. Furthermore, once licenses are issued we are required to comply with various information reporting and other regulatory requirements to maintain those licenses, and there is no assurance that we will be able to satisfy those requirements or other regulatory requirements applicable to our business of acquiring residential mortgage loans on an ongoing basis. Our failure to obtain or maintain required licenses or our failure to comply with regulatory requirements that are applicable to our business of acquiring residential mortgage loans or originating commercial loans may restrict our business and investment options and could harm our business and expose us to penalties or other claims.
For example, under the Dodd-Frank Act, the CFPB also has regulatory authority over certain aspects of our business as a result of our residential mortgage banking activities, including, without limitation, authority to bring an enforcement action against us for failure to comply with regulations promulgated by the Bureau that are applicable to our business. One of the Bureau’s areas of focus has been on whether companies like us take appropriate steps to ensure that business arrangements with service providers do not present risks to consumers. The sub-servicer we retain to directly service residential mortgage loans (when we own the associated MSRs) is one of our most significant service providers with respect to our residential mortgage banking activities and our failure to take steps to ensure that this sub-servicer is servicing these residential mortgage loans in accordance with applicable law and regulation could result in enforcement action by the Bureau against us that could restrict our business, expose us to penalties or other claims, negatively impact our financial results, and damage our reputation.
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In addition, we are a seller/servicer approved to sell residential mortgage loans to Freddie Mac and Fannie Mae. As an approved seller/servicer, we are required to conduct certain aspects of our operations in accordance with applicable policies and guidelines published by Freddie Mac and Fannie Mae and we are required to pledge a certain amount of cash to Freddie Mac and Fannie Mae to collateralize potential obligations to Freddie Mac and Fannie Mae. Failure to maintain our status as an approved seller/servicer would mean we would not be able to sell mortgage loans to these entities, could result in our being required to repurchase loans previously sold to these entities, or could otherwise restrict our business and investment options and could harm our business and expose us to losses or other claims. Fannie Mae or Freddie Mac may, in the future, require us to hold additional capital or pledge additional cash or assets in order to obtain or maintain approved seller/servicer status, which, if required, could adversely impact our financial results.
With respect to mortgage loans we own, or which we have purchased and subsequently sold, we may be subject to liability for potential violations of truth-in-lending or other similar consumer protection laws and regulations, which could adversely impact our business and financial results.
Federal consumer protection laws and regulations have been enacted and promulgated that are designed to regulate residential mortgage loan underwriting and originators’ lending processes, standards, and disclosures to borrowers. These laws and regulations include the CFPB’s “ability-to-repay” and “qualified mortgage” regulations. In addition, there are various other federal, state, and local laws and regulations that are intended to discourage predatory lending practices by residential mortgage loan originators. For example, the federal Home Ownership and Equity Protection Act of 1994 (HOEPA) prohibits inclusion of certain provisions in residential mortgage loans that have mortgage rates or origination costs in excess of prescribed levels and requires that borrowers be given certain disclosures prior to origination. Some states have enacted, or may enact, similar laws or regulations, which in some cases may impose restrictions and requirements greater than those in place under federal laws and regulations. In addition, under the anti-predatory lending laws of some states, the origination of certain residential mortgage loans, including loans that are classified as “high cost” loans under applicable law, must satisfy a net tangible benefits test with respect to the borrower. This test, as well as certain standards set forth in the “ability-to-repay” and “qualified mortgage” regulations, may be highly subjective and open to interpretation. As a result, a court may determine that a residential mortgage loan did not meet the standard or test even if the originator reasonably believed such standard or test had been satisfied. Failure of residential mortgage loan originators or servicers to comply with these laws and regulations could subject us, as an assignee or purchaser of these loans (or as an investor in securities backed by these loans), to monetary penalties and defenses to foreclosure, including by recoupment or setoff of finance charges and fees collected, and could result in rescission of the affected residential mortgage loans, which could adversely impact our business and financial results.
Environmental protection laws that apply to properties that secure or underlie our loan and investment portfolio could result in losses to us. We may also be exposed to environmental liabilities with respect to properties we become direct or indirect owners of or to which we take title, which could adversely affect our business and financial results.
Under the laws of several states, contamination of a property may give rise to a lien on the property to secure recovery of the cleanup costs. In certain of these states, such a lien has priority over the lien of an existing mortgage against the property, which could impair the value of an investment in a security we own backed by such a property or could reduce the value of such a property that underlies loans we have made or own. In addition, under the laws of some states and under the federal Comprehensive Environmental Response, Compensation and Liability Act of 1980, we may be liable for costs of addressing releases or threatened releases of hazardous substances that require remedy at a property securing or underlying a loan we hold if our agents or employees have become sufficiently involved in the hazardous waste aspects of the operations of the borrower of that loan, regardless of whether or not the environmental damage or threat was caused by us or the borrower.
In the course of our business, we may take title to residential or commercial real estate or may otherwise become direct or indirect owners of real estate. If we do take title or become a direct or indirect owner, we could be subject to environmental liabilities with respect to the property, including liability to a governmental entity or third parties for property damage, personal injury, investigation, and clean-up costs. In addition, we may be required to investigate or clean up hazardous or toxic substances or chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. If we ever become subject to significant environmental liabilities, our business and financial results could be materially and adversely affected.
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Our technology infrastructure and systems are important and any significant disruption or breach of the security of this infrastructure or these systems could have an adverse effect on our business. We also rely on technology infrastructure and systems of third parties who provide services to us and with whom we transact business.
In order to analyze, acquire, and manage our investments, manage the operations and risks associated with our business, assets, and liabilities, and prepare our financial statements we rely upon computer hardware and software systems. Some of these systems are located at our offices and some are maintained by third party vendors or located at facilities maintained by third parties. We also rely on technology infrastructure and systems of third parties who provide services to us and with whom we transact business. Any significant interruption in the availability or functionality of these systems could impair our access to liquidity, damage our reputation, and have an adverse effect on our operations and on our ability to timely and accurately report our financial results.
In addition, any breach of the security of these systems could have an adverse effect on our operations and the preparation of our financial statements. Steps we have taken to provide for the security of our systems and data may not effectively prevent others from obtaining improper access to our systems data. Improper access could expose us to risks of data loss, reputational damage, increased regulatory scrutiny, litigation, and liabilities to third parties, and otherwise disrupt our operations. For example, when we own residential mortgage loans, or the rights to service residential mortgage loans, we come into possession of borrower non-public personal information that an identity thief could utilize in engaging in fraudulent activity or theft. We may share this information with third party service providers, including loan sub-servicers, or with third parties interested in acquiring such loans from us. We currently own 8,401 residential mortgage loans and the rights to service 41,062 mortgage loans. We may be liable for losses suffered by individuals whose identities are stolen as a result of a breach of the security of these systems, and any such liability could be material.
Our business could be adversely affected by deficiencies in our disclosure controls and procedures or internal controls over financial reporting.
The design and effectiveness of our disclosure controls and procedures and internal controls over financial reporting may not prevent all errors, misstatements, or misrepresentations. While management continues to review the effectiveness of our disclosure controls and procedures and internal controls over financial reporting, there can be no assurance that our disclosure controls and procedures or internal controls over financial reporting will be effective in accomplishing all control objectives all of the time. Deficiencies, particularly material weaknesses or significant deficiencies, in internal controls over financial reporting which have occurred or which may occur in the future could result in misstatements of our financial results, restatements of our financial statements, a decline in our stock price, or an otherwise material and adverse effect on our business, reputation, financial results, or liquidity and could cause investors and creditors to lose confidence in our reported financial results.
Our risk management efforts may not be effective.
We could incur substantial losses and our business operations could be disrupted if we are unable to effectively identify, manage, monitor, and mitigate financial risks, such as credit risk, interest rate risk, prepayment risk, liquidity risk, and other market-related risks, as well as operational risks related to our business, assets, and liabilities. Our risk management policies, procedures, and techniques may not be sufficient to identify all of the risks we are exposed to, mitigate the risks we have identified, or to identify additional risks to which we may become subject in the future. Expansion of our business activities may also result in our being exposed to risks that we have not previously been exposed to or may increase our exposure to certain types of risks and we may not effectively identify, manage, monitor, and mitigate these risks as our business activity changes or increases.
We could be harmed by misconduct or fraud that is difficult to detect.
We are exposed to risks relating to misconduct by our employees, contractors we use, or other third parties with whom we have relationships. For example, our employees could execute unauthorized transactions, use our assets improperly or without authorization, perform improper activities, use confidential information for improper purposes, or mis-record or otherwise try to hide improper activities from us. This type of misconduct could also relate to assets we manage for others through our investment advisory subsidiary. This type of misconduct can be difficult to detect and if not prevented or detected could result in claims or enforcement actions against us or losses. Accordingly, misconduct by employees, contractors, or others could subject us to losses or regulatory sanctions and seriously harm our reputation. Our controls may not be effective in detecting this type of activity.
Inadvertent errors, including, for example, errors in the implementation of information technology systems, could subject us to financial loss, litigation, or regulatory action.
Our employees, contractors we use, or other third parties with whom we have relationships may make inadvertent errors that could subject us to financial losses, claims, or enforcement actions. These types of errors could include, but are not limited to, mistakes in executing, recording, or reporting transactions we enter into for ourselves or with respect to assets we manage for others. Errors in the implementation of information technology systems or other operational systems and procedures could also interrupt our business or subject us to financial losses, claims, or enforcement actions. Inadvertent errors expose us to the risk of material losses until the errors are detected and remedied prior to the incurrence of any loss. The risk of errors may be greater for business activities that are new for us or have non-standardized terms, for areas of our business that we are expanding, or for areas of our business that rely on new employees or on third parties that we have only recently established relationships with.
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Our business may be adversely affected if our reputation is harmed.
Our business is subject to significant reputational risks. If we fail, or appear to fail, to address various issues that may affect our reputation, our business could be harmed. Issues could include real or perceived legal or regulatory violations or be the result of a failure in governance, risk-management, technology, or operations. Similarly, market rumors and actual or perceived association with counterparties whose own reputation is under question could harm our business. Lawsuits brought against us (or the resolution of lawsuits brought against us), claims of employee misconduct, claims of wrongful termination, adverse publicity, conflicts of interest, ethical issues, or failure to maintain the security of our information technology systems or to protect private information could also cause significant reputational damages. Such reputational damage could result not only in an immediate financial loss, but could also result in a loss of business relationships, the ability to raise capital, and the ability to access liquidity through borrowing facilities.
Our financial results are determined and reported in accordance with generally accepted accounting principles (and related conventions and interpretations), or GAAP, and are based on estimates and assumptions made in accordance with those principles, conventions, and interpretations. Furthermore, the amount of dividends we are required to distribute as a REIT is driven by the determination of our income in accordance with the Internal Revenue Code rather than GAAP.
Our reported GAAP financial results differ from the taxable income results that drive our dividend distribution requirements and, therefore, our GAAP results may not be an accurate indicator of taxable income and dividend distributions.
Generally, the cumulative income we report relating to an investment asset will be the same for GAAP and tax purposes, although the timing of this recognition over the life of the asset could be materially different. There are, however, certain permanent differences in the recognition of certain expenses under the respective accounting principles applied for GAAP and tax purposes and these differences could be material. Thus, the amount of GAAP earnings reported in any given period may not be indicative of future dividend distributions. A further explanation of differences between our GAAP and taxable income is presented in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which is set forth in Part II, Item 7 of this Annual Report on Form 10-K.
Our minimum dividend distribution requirements are determined under the REIT tax laws and are based on our taxable income as calculated for tax purposes pursuant to the Internal Revenue Code. Our Board of Directors may also decide to distribute more dividends than required based on these determinations. One should not expect that our retained GAAP earnings will equal cumulative distributions, as the Board of Directors’ dividend distribution decisions, permanent differences in GAAP and tax accounting, and even temporary differences may result in material differences in these balances.
Over time, accounting principles, conventions, rules, and interpretations may change, which could affect our reported GAAP and taxable earnings and stockholders’ equity.
Accounting rules for the various aspects of our business change from time to time. Changes in GAAP, or the accepted interpretation of these accounting principles, can affect our reported income, earnings, and stockholders’ equity. In addition, changes in tax accounting rules or the interpretations thereof could affect our taxable income and our dividend distribution requirements. Predicting and planning for these changes can be difficult.
Redwood has elected to be a REIT and, as such, is required to meet certain tests in order to maintain its REIT status. This adds complexity and costs to running our business and exposes us to additional risks.
Failure to qualify as a REIT could adversely affect our net income and dividend distributions and could adversely affect the value of our common stock.
We have elected to qualify as a REIT for federal income tax purposes for all tax years since 1994. However, many of the requirements for qualification as a REIT are highly technical and complex and require an analysis of particular facts and an application of the legal requirements to those facts in situations where there is only limited judicial and administrative guidance. Thus, we cannot assure you that the Internal Revenue Service (the “IRS”) or a court would agree with our conclusion that we have qualified as a REIT historically, or that changes to our business or the law will not cause us to fail to qualify as a REIT in the future. Furthermore, in an environment where assets may quickly change in value, previous planning for compliance with REIT qualification rules may be disrupted. If we failed to qualify as a REIT for federal income tax purposes and did not meet the requirements for statutory relief, we would be subject to federal income tax at regular corporate rates on our income, and we would not be allowed a deduction for distributions to shareholders in computing our taxable income. In such a case, we may need to borrow money or sell
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assets in order to pay the taxes due, even if the market conditions are not favorable for such sales or borrowings. In addition, unless we are entitled to relief under applicable statutory provisions, we could not elect to be taxed as a REIT for four years thereafter. Failure to qualify as a REIT could adversely affect our dividend distributions and could adversely affect the value of our common stock.
Maintaining REIT status and avoiding the generation of excess inclusion income at Redwood Trust, Inc. and certain of our subsidiaries may reduce our flexibility and could limit our ability to pursue certain opportunities. Failure to appropriately structure our business and transactions to comply with laws and regulations applicable to REITs could have adverse consequences.
To maintain REIT status, we must follow certain rules and meet certain tests. In doing so, our flexibility to manage our operations may be reduced. For instance:
| • | Compliance with the REIT income and asset rules may limit the type or extent of financing or hedging that we can undertake. |
| • | Our ability to own non-real estate related assets and earn non-real estate related income is limited, and the rules for classifying assets and income are complicated. Our ability to own equity interests in other entities is also limited. If we fail to comply with these limits, we may be forced to liquidate attractive investments on short notice on unfavorable terms in order to maintain our REIT status. |
| • | We generally use taxable subsidiaries to own non-real estate related assets and engage in activities that may give rise to non-real estate related income under the REIT rules. However, our ability to invest in taxable subsidiaries is limited under the REIT rules. Maintaining compliance with this limit could require us to constrain the growth of our TRSs in the future. |
| • | Meeting minimum REIT dividend distribution requirements could reduce our liquidity. We may earn non-cash REIT taxable income due to timing and/or character mismatches between the computation of our income for tax and our book purposes. Earning non-cash REIT taxable income could necessitate our selling assets, incurring debt, or raising new equity in order to fund dividend distributions. |
| • | We could be viewed as a “dealer” with respect to certain transactions and become subject to a 100% prohibited transaction tax or other entity-level taxes on income from such transactions. |
Furthermore, the rules we must follow and the tests we must satisfy to maintain our REIT status may change, or the interpretation of these rules and tests by the IRS may change.
In addition, our stated goal has been to not generate excess inclusion income at Redwood Trust, Inc. and certain of its subsidiaries that would be taxable as unrelated business taxable income (“UBTI”) to our tax-exempt shareholders. Achieving this goal has limited, and may continue to limit, our flexibility in pursuing certain transactions or has resulted in, and may continue to result in, our having to pursue certain transactions through a taxable subsidiary, which would reduce the net returns on these transactions by the associated tax liabilities payable by such subsidiary. Despite our efforts to do so, we may not be able to avoid creating or distributing UBTI to our shareholders.
To maintain our REIT status, we may be forced to borrow funds during unfavorable market conditions, and the unavailability of such capital on favorable terms at the desired times, or at all, may cause us to curtail our investment activities and/or to dispose of assets at inopportune times, which could adversely affect our financial condition, results of operations, cash flow and per share trading price of our common stock.
To qualify as a REIT, we generally must distribute to our shareholders at least 90% of our net taxable income each year (excluding any net capital gains), and we will be subject to regular corporate income taxes to the extent that we distribute less than 100% of our net taxable income each year. In addition, we will be subject to a 4% nondeductible excise tax on the amount, if any, by which distributions we pay in any calendar year are less than the sum of 85% of our ordinary income, 95% of our net capital gains, and 100% of our undistributed income from prior years. To maintain our REIT status and avoid the payment of federal income and excise taxes, we may need to borrow funds to meet the REIT distribution requirements, even if the then-prevailing market conditions are not favorable for these borrowings. These borrowing needs could result from differences in timing between the actual receipt of income and inclusion of income for federal income tax purposes. For example, we may be required to accrue interest and discount income on mortgage loans, MBS, and other types of debt securities or interests in debt securities before we receive any payments of interest or principal on such assets. Our access to third-party sources of capital depends on a number of factors, including the market’s
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perception of our growth potential, our current debt levels, the market price of our common stock, and our current and potential future earnings. We cannot assure you that we will have access to such capital on favorable terms at the desired times, or at all, which may cause us to curtail our investment activities and/or to dispose of assets at inopportune times, and could adversely affect our financial condition, results of operations, cash flow and per share trading price of our common stock.
Dividends payable by REITs, including us, generally do not qualify for the reduced tax rates available for some dividends.
“Qualified dividends” payable to shareholders that are individuals, trusts and estates generally are subject to tax at preferential rates. Subject to limited exceptions, dividends payable by REITs are not eligible for these reduced rates and are taxable at ordinary income tax rates. The more favorable rates applicable to regular corporate qualified dividends could cause investors who are individuals, trusts and estates to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the value of the shares of REITs, including the shares of our capital stock.
The failure of mortgage loans or MBS subject to a repurchase agreement or a mezzanine loan to qualify as a real estate asset would adversely affect our ability to qualify as a REIT.
When we enter into short-term financing arrangements in the form of repurchase agreements, we will sell certain of our assets to a counterparty and simultaneously enter into an agreement to repurchase the sold assets. We believe that we will be treated for U.S. federal income tax purposes as the owner of the assets that are the subject of any such agreements notwithstanding that such agreements may transfer record ownership of the assets to the counterparty during the term of the agreement. It is possible, however, that the IRS could assert that we did not own the assets during the term of the repurchase agreement, in which case we could fail to qualify as a REIT.
In addition, we have and may continue to acquire and originate mezzanine loans, which are loans secured by equity interests in a partnership or limited liability company that directly or indirectly owns real property. In Revenue Procedure 2003-65, the IRS provided a safe harbor pursuant to which a mezzanine loan, if it meets each of the requirements contained in the Revenue Procedure, will be treated by the IRS as a real estate asset for purposes of the REIT asset tests, and interest derived from the mezzanine loan will be treated as qualifying mortgage interest for purposes of the REIT 75% gross income test. Although the Revenue Procedure provides a safe harbor on which taxpayers may rely, it does not prescribe rules of substantive tax law. We believe that the mezzanine loans that we treat as real estate assets generally meet all of the requirements for reliance on this safe harbor, however, there can be no assurance that the IRS will not challenge the tax treatment of these mezzanine loans, and if such a challenge were sustained, we could in certain circumstances be required to pay a penalty tax or fail to qualify as a REIT.
Changes in tax rules could adversely affect REITs and could adversely affect the value of our common stock.
The rules addressing federal income taxation are constantly under review by persons involved in the legislative process and by the IRS and the U.S. Department of the Treasury. Any such future changes in the regulations or tax laws applicable to REITs or to mortgage related financial products could negatively impact our operations or reduce any competitive advantages we may have relative to non-REIT entities, either of which could reduce the value of our common stock.
The application of the tax laws to our business is complicated, and we may not interpret and apply some of the rules and regulations correctly. In addition, we may not make all available elections, which could result in our not being able to fully benefit from available deductions or benefits. Furthermore, the elections, interpretations and applications we do make could be deemed by the IRS to be incorrect and could have adverse impacts on our GAAP earnings and potentially on our REIT status
The Internal Revenue Code may change and/or the interpretation of the rules and regulations by the IRS may change. In circumstances where the application of these rules and regulations affecting our business is not clear, we may have to interpret them and their application to us. We seek the advice of outside tax advisors in arriving at these interpretations, but our interpretations may prove to be wrong, which could have adverse consequences.
Our tax payments and dividend distributions, which are intended to meet the REIT distribution requirements, are based in large part on our estimate of taxable income which includes the application and interpretation of a variety of tax rules and regulations. While there are some relief provisions should we incorrectly interpret certain rules and regulations, we may not be able to fully take advantage of these provisions, and this could have an adverse effect on our REIT status. In addition, our GAAP earnings include tax provisions and benefits based on our estimates of taxable income and should our estimates prove to be wrong, we would have to make an adjustment to our taxable provisions and this adjustment could be material.
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Our decisions about raising, managing, and distributing our capital may adversely affect our business and financial results. Furthermore, our growth may be limited if we are not able to raise additional capital.
We are required to distribute at least 90% of our REIT taxable income as dividends to shareholders. Thus, we do not generally have the ability to retain all of the earnings generated by our REIT and, to a large extent, we rely on our ability to raise capital to grow. We may raise capital through the issuance of new shares of our common stock, either through our direct stock purchase and dividend reinvestment plan or through public or private offerings. We may also raise capital by issuing other types of securities, such as preferred stock, convertible or exchangeable debt, or other types of debt securities. As of January 1, 2015, we had approximately 97 million unissued shares of stock authorized for issuance under our charter (although approximately 36 million of these shares are reserved for issuance under our equity compensation plans, dividend reinvestment and stock purchase plan, and outstanding convertible notes and exchangeable securities). The number of our unissued shares of stock authorized for issuance establishes a limit on the amount of capital we can raise through issuances of shares of stock or securities convertible into, or exchangeable for, shares of stock, unless we seek and receive approval from our shareholders to increase the authorized number of our shares in our charter. Also, certain stock change of ownership tests may limit our ability to raise significant amounts of equity capital or could limit our future use of tax losses to offset income tax obligations if we raise significant amounts of equity capital.
In addition, we may not be able to raise capital at times when we need capital or see opportunities to invest capital. Many of the same factors that could make the pricing for investments in real estate loans and securities attractive, such as the availability of assets from distressed owners who need to liquidate them at reduced prices, and uncertainty about credit risk, housing, and the economy, may limit investors’ and lenders’ willingness to provide us with additional capital. There may be other reasons we are not able to raise capital and, as a result, may not be able to finance growth in our business and in our portfolio of assets. If we are unable to raise capital and expand our business and our portfolio of investments, our growth may be limited, we may have to forgo attractive business and investment opportunities, and our operating expenses may increase significantly relative to our capital base.
To the extent we have capital that is available for investment, we have broad discretion over how to invest that capital and our shareholders and other investors will be relying on the judgment of our management regarding its use. To the extent we invest capital in our business or in portfolio assets, we may not be successful in achieving favorable returns.
Conducting our business in a manner so that we are exempt from registration under, and in compliance with, the Investment Company Act may reduce our flexibility and could limit our ability to pursue certain opportunities. At the same time, failure to continue to qualify for exemption from the Investment Company Act could adversely affect us.
Under the Investment Company Act, an investment company is required to register with the SEC and is subject to extensive restrictive and potentially adverse regulations relating to, among other things, operating methods, management, capital structure, dividends, and transactions with affiliates. However, companies primarily engaged in the business of acquiring mortgages and other liens on and interests in real estate are generally exempt from the requirements of the Investment Company Act. We believe that we have conducted our business so that we are not subject to the registration requirements of the Investment Company Act. In order to continue to do so, however, Redwood and each of our subsidiaries must either operate so as to fall outside the definition of an investment company under the Investment Company Act or satisfy its own exclusion under the under the Investment Company Act. For example, to avoid being defined as an investment company, an entity may limit its ownership or holdings of investment securities to less than 40% of its total assets. In order to satisfy an exclusion from being defined as an investment company, other entities, among other things, maintain at least 55% of their assets in certain qualifying real estate assets (the 55% Requirement) and also maintain an additional 25% of their assets in such qualifying real estate assets or certain other types of real estate-related assets (the 25% Requirement). Rapid changes in the values of assets we own, however, can disrupt prior efforts to conduct our business to meet these requirements.
If Redwood or one of our subsidiaries fell within the definition of an investment company under the Investment Company Act and failed to qualify for an exclusion or exemption, including, for example, if it failed to meet the 55% Requirement or the 25% Requirement, we could, among other things, be required either (i) to change the manner in which we conduct our operations to avoid being required to register as an investment company or (ii) to register as an investment company, either of which could adversely affect us by, among other things, requiring us to dispose of certain assets or to change the structure of our business in ways that we may not believe to be in our best interests. Legislative or regulatory changes relating to the Investment Company Act or which affect our efforts to qualify for exclusions or exemptions, including our ability to comply with the 55% Requirement and the 25% Requirement, could also result in these adverse effects on us.
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If we were deemed an unregistered investment company, we could be subject to monetary penalties and injunctive relief and we could be unable to enforce contracts with third parties and third parties could seek to obtain rescission of transactions undertaken during the period we were deemed an unregistered investment company, unless the court found that under the circumstances, enforcement (or denial of rescission) would produce a more equitable result than no enforcement (or grant of rescission) and would not be inconsistent with the Investment Company Act.
An SEC review, initiated in 2011, of one section of the Investment Company Act and the regulations and regulatory interpretations promulgated thereunder that we rely on to exempt us from registration and regulation as an investment company under the Investment Company Act could eventually result in legislative or regulatory changes, which could require us to change our business and operations in order for us to continue to rely on that exemption or operate without the benefit of that exemption.
In August 2011, the SEC published a Concept Release within which it reviewed interpretive issues under the Investment Company Act relating to the status under the Investment Company Act of companies that are engaged in the business of acquiring mortgages and mortgage-related instruments and that rely on the exemption set forth in Section 3(c)(5)(C) of the Investment Company Act from requirements under the Investment Company Act. Among other things, the SEC expressed in the Concept Release that it was “concerned that certain types of mortgage-related pools today appear to resemble in many respects investment companies such as closed-end funds and may not be the kinds of companies that were intended to be excluded from regulation under the Investment Company Act by Section 3(c)(5)(C).” To the extent we rely on Section 3(c)(5)(C) of the Investment Company Act to exempt us from regulation under the Investment Company Act, we believe that our reliance is proper. However, this SEC review could eventually lead to legislative or regulatory changes that could affect our ability to rely on that exemption or could eventually require us to change our business and operations in order for us to continue to rely on that exemption. Even if the SEC’s review of this exemption does not eventually have these effects on us, in the interim, while the SEC’s Concept Release is outstanding, any uncertainty created by the SEC’s review process could negatively impact the ability of companies, such as us, that rely on this exemption to raise capital, borrow money, or engage in certain other types of business transactions, which could negatively impact our business and financial results.
Provisions in our charter and bylaws and provisions of Maryland law may limit a change in control or deter a takeover that might otherwise result in a premium price being paid to our shareholders for their shares in Redwood.
In order to maintain our status as a REIT, not more than 50% in value of our outstanding capital stock may be owned, actually or constructively, by five or fewer individuals (defined in the Internal Revenue Code to include certain entities). In order to protect us against the risk of losing our status as a REIT due to concentration of ownership among our shareholders and for other reasons, our charter generally prohibits any single shareholder, or any group of affiliated shareholders, from beneficially owning more than 9.8% of the outstanding shares of any class of our stock, unless our Board of Directors waives or modifies this ownership limit. This limitation may have the effect of precluding an acquisition of control of us by a third party without the consent of our Board of Directors. Our Board of Directors has granted a limited number of waivers to institutional investors to own shares in excess of this 9.8% limit, which waivers are subject to certain terms and conditions. Our Board of Directors may amend these existing waivers to permit additional share ownership or may grant waivers to additional shareholders at any time.
Certain other provisions contained in our charter and bylaws and in the Maryland General Corporation Law (“MGCL”) may have the effect of discouraging a third party from making an acquisition proposal for us and may therefore inhibit a change in control. For example, our charter includes provisions granting our Board of Directors the authority to issue preferred stock from time to time and to establish the terms, preferences, and rights of the preferred stock without the approval of our shareholders. Provisions in our charter and the MGCL also restrict our shareholders’ ability to remove directors and fill vacancies on our Board of Directors and restrict unsolicited share acquisitions. These provisions and others may deter offers to acquire our stock or large blocks of our stock upon terms attractive to our shareholders, thereby limiting the opportunity for shareholders to receive a premium for their shares over then-prevailing market prices.
The ability to take action against our directors and officers is limited by our charter and bylaws and provisions of Maryland law and we may (or, in some cases, are obligated to) indemnify our current and former directors and officers against certain losses relating to their service to us.
Our charter limits the liability of our directors and officers to us and to shareholders for pecuniary damages to the fullest extent permitted by Maryland law. In addition, our charter authorizes our Board of Directors to indemnify our officers and directors (and those of our subsidiaries or affiliates) for losses relating to their service to us to the full extent required or permitted by Maryland law. Our bylaws require us to indemnify our officers and directors (and those of our subsidiaries and affiliates) to the maximum extent permitted by Maryland law in the defense of any proceeding to which he or she is made, or threatened to be made, a party because of his or her service to us. In addition, we have entered into, and may in the future enter into, indemnification agreements with our directors and certain of our officers and the directors and certain of the officers of certain of our subsidiaries and affiliates which obligate us to indemnify them against certain losses relating to their service to us and the related costs of defense.
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Investing in our common stock may involve a high degree of risk. Investors in our common stock may experience losses, volatility, and poor liquidity, and we may reduce our dividends in a variety of circumstances.
An investment in our common stock may involve a high degree of risk, particularly when compared to other types of investments. Risks related to the economy, the financial markets, our industry, our investing activity, our other business activities, our financial results, the amount of dividends we distribute, the manner in which we conduct our business, and the way we have structured and limited our operations could result in a reduction in, or the elimination of, the value of our common stock. The level of risk associated with an investment in our common stock may not be suitable for the risk tolerance of many investors. Investors may experience volatile returns and material losses. In addition, the trading volume of our common stock (i.e., its liquidity) may be insufficient to allow investors to sell their common stock when they want to or at a price they consider reasonable.
Our earnings, cash flows, book value, and dividends can be volatile and difficult to predict. Investors in our common stock should not rely on our estimates, projections, or predictions, or on management’s beliefs about future events. In particular, the sustainability of our earnings and our cash flows will depend on numerous factors, including our level of business and investment activity, our access to debt and equity financing, the returns we earn, the amount and timing of credit losses, prepayments, the expense of running our business, and other factors, including the risk factors described herein. As a consequence, although we seek to pay a regular common stock dividend that is sustainable, we may reduce our regular dividend rate, or stop paying dividends, in the future for a variety of reasons. We may not provide public warnings of dividend reductions prior to their occurrence. Although we have paid special dividends in the past, we have not paid a special dividend since 2007 and we may not do so in the future. Changes to the amount of dividends we distribute may result in a reduction in the value of our common stock.
A limited number of institutional shareholders own a significant percentage of our common stock, which could have adverse consequences to other holders of our common stock.
As of February 20, 2015, based on filings of Schedules 13D and 13G with the SEC, we believe that eight institutional shareholders each owned approximately 5% or more of our outstanding common stock and we believe based on data obtained from other public sources that, overall, institutional shareholders owned, in the aggregate, more than 90% of our outstanding common stock. Furthermore, one or more of these investors or other investors could significantly increase their ownership of our common stock, including through the conversion of outstanding convertible notes or exchangeable securities into shares of common stock. Significant ownership stakes held by these individual institutions or other investors could have adverse consequences for other shareholders because each of these shareholders will have a significant influence over the outcome of matters submitted to a vote of our shareholders, including the election of our directors and transactions involving a change in control. In addition, should any of these significant shareholders determine to liquidate all or a significant portion of their holdings of our common stock, it could have an adverse effect on the market price of our common stock.
Although, under our charter, shareholders are generally precluded from beneficially owning more than 9.8% of our outstanding common stock, our Board of Directors may amend existing ownership-limitation waivers or grant waivers to other shareholders in the future, in each case in a manner which may allow for increases in the concentration of the ownership of our common stock held by one or more shareholders.
Future sales of our common stock by us or by our officers and directors may have adverse consequences for investors.
We may issue additional shares of common stock, or securities convertible into, or exchangeable for, shares of common stock, in public offerings or private placements, and holders of our outstanding convertible notes or exchangeable securities may convert those securities into shares of common stock. In addition, we may issue additional shares of common stock to participants in our direct stock purchase and dividend reinvestment plan and to our directors, officers, and employees under our employee stock purchase plan, our incentive plan, or other similar plans, including upon the exercise of, or in respect of, distributions on equity awards previously granted thereunder. We are not required to offer any such shares to existing shareholders on a preemptive basis. Therefore, it may not be possible for existing shareholders to participate in future share issuances, which may dilute existing shareholders’ interests in us. In addition, if market participants buy shares of common stock, or securities convertible into, or exchangeable for, shares of common stock, in issuances by us in the future, it may reduce or eliminate any purchases of our common stock they might otherwise make in the open market, which in turn could have the effect of reducing the volume of shares of our common stock traded in the marketplace, which could have the effect of reducing the market price and liquidity of our common stock.
At February 19, 2015, our directors and executive officers beneficially owned, in the aggregate, approximately 1.4% of our common stock. Sales of shares of our common stock by these individuals are generally required to be publicly reported and are tracked by many market participants as a factor in making their own investment decisions. As a result, future sales by these individuals could negatively affect the market price of our common stock.
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There is a risk that you may not receive dividend distributions or that dividend distributions may decrease over time. Changes in the amount of dividend distributions we pay, in the tax characterization of dividend distributions we pay, or in the rate at which holders of our common stock are taxed on dividend distributions we pay, may adversely affect the market price of our common stock or may result in holders of our common stock being taxed on dividend distributions at a higher rate than initially expected.
Our dividend distributions are driven by a variety of factors, including our minimum dividend distribution requirements under the REIT tax laws and our REIT taxable income as calculated for tax purposes pursuant to the Internal Revenue Code. We generally intend to distribute to our shareholders at least 90% of our REIT taxable income, although our reported financial results for GAAP purposes may differ materially from our REIT taxable income.
For 2014, we maintained our regular dividend at a rate of $0.28 per share per quarter and in November 2014 our Board of Directors announced its intention to continue to pay regular dividends during 2015 at a rate of $0.28 per share per quarter. Our ability to pay a dividend of $0.28 per share per quarter in 2015 may be adversely affected by a number of factors, including the risk factors described herein. These same factors may affect our ability to pay other future dividends. In addition, to the extent we determine that future dividends would represent a return of capital to investors, rather than the distribution of income, we may determine to discontinue dividend payments until such time that dividends would again represent a distribution of income. Any reduction or elimination of our payment of dividend distributions would not only reduce the amount of dividends you would receive as a holder of our common stock, but could also have the effect of reducing the market price of our common stock.
The rate at which holders of our common stock are taxed on dividends we pay and the characterization of our dividends – as ordinary income, capital gains, or a return of capital – could have an impact on the market price of our common stock. In addition, after we announce the expected characterization of dividend distributions we have paid, the actual characterization (and, therefore, the rate at which holders of our common stock are taxed on the dividend distributions they have received) could vary from our expectation, including due to errors, changes made in the course of preparing our corporate tax returns, or changes made in response to an IRS audit), with the result that holders of our common stock could incur greater income tax liabilities than expected.
The market price of our common stock could be negatively affected by various factors, including broad market fluctuations.
The market price of our common stock may be negatively affected by various factors, which change from time to time. Some of these factors are:
| • | Our actual or anticipated financial condition, performance, and prospects and those of our competitors. |
| • | The market for similar securities issued by other REITs and other competitors of ours. |
| • | Changes in the manner that investors and securities analysts who provide research to the marketplace on us analyze the value of our common stock (for example, if, at a time when the market price of our common stock is significantly above book value per share, investors and analysts change their method of analyzing the value of our common stock and take the position that our common stock should not be valued at a significant premium to book value per share, which could occur if investors and analysts do not believe there is reason to have a positive outlook on the prospects for our business and financial results). |
| • | Changes in recommendations or in estimated financial results published by securities analysts who provide research to the marketplace on us, our competitors, or our industry. |
| • | General economic and financial market conditions, including, among other things, actual and projected interest rates, prepayments, and credit performance and the markets for the types of assets we hold or invest in. |
| • | Proposals to significantly change the manner in which financial markets, financial institutions, and related industries, or financial products are regulated under applicable law, or the enactment of such proposals into law or regulation. |
| • | Other events or circumstances which undermine confidence in the financial markets or otherwise have a broad impact on financial markets, such as the sudden instability or collapse of large financial institutions or other significant corporations (whether due to fraud or other factors), terrorist attacks, natural or man-made disasters, or threatened or actual armed conflicts. |
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Furthermore, these fluctuations do not always relate directly to the financial performance of the companies whose stock prices may be affected. As a result of these and other factors, investors who own our common stock could experience a decrease in the value of their investment, including decreases unrelated to our financial results or prospects.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
Our principal executive and administrative office is located in Mill Valley, California and we have additional administrative offices throughout the United States. We do not own any properties and lease the space we utilize for our offices. Additional information on our leases is included in Note 15 to the Financial Statements within this Annual Report on Form 10-K. The following table presents the locations and remaining lease terms of our primary offices.
Executive and Administrative Office Locations and Lease Expirations
| Location |
Lease | |
| One Belevedere Place, Suite 300 Mill Valley, CA 94941 |
2018 | |
| 8310 South Valley Highway, Ste. 425 Englewood, CO 80112 |
2021 | |
| 1114 Avenue of the Americas, Ste. 2810 New York, NY 10036 |
2021 | |
| 225 W. Washington St., Suite 1440 Chicago, IL 60606 |
2019 | |
On or about December 23, 2009, the Federal Home Loan Bank of Seattle (the “FHLB-Seattle”) filed a complaint in the Superior Court for the State of Washington (case number 09-2-46348-4 SEA) against Redwood Trust, Inc., our subsidiary, Sequoia Residential Funding, Inc. (“SRF”), Morgan Stanley & Co., and Morgan Stanley Capital I, Inc. (collectively, the “FHLB-Seattle Defendants”) alleging that the FHLB-Seattle Defendants made false or misleading statements in offering materials for a mortgage pass-through certificate (the “Seattle Certificate”) issued in the Sequoia Mortgage Trust 2005-4 securitization transaction (the “2005-4 RMBS”) and purchased by the FHLB-Seattle. Specifically, the complaint alleges that the alleged misstatements concern the (1) loan-to-value ratio of mortgage loans and the appraisals of the properties that secured loans supporting the 2005-4 RMBS, (2) occupancy status of the properties, (3) standards used to underwrite the loans, and (4) ratings assigned to the Seattle Certificate. The FHLB-Seattle alleges claims under the Securities Act of Washington (Section 21.20.005, et seq.) and seeks to rescind the purchase of the Seattle Certificate and to collect interest on the original purchase price at the statutory interest rate of 8% per annum from the date of original purchase (net of interest received) as well as attorneys’ fees and costs. The Seattle Certificate was issued with an original principal amount of approximately $133 million, and, as of December 31, 2014, the FHLB-Seattle has received approximately $115.8 million of principal and $11.1 million of interest payments in respect of the Seattle Certificate. As of December 31, 2014, the Seattle Certificate had a remaining outstanding principal amount of approximately $17.5 million. The claims were subsequently dismissed for lack of personal jurisdiction as to Redwood Trust and SRF. Redwood agreed to indemnify the underwriters of the 2005-4 RMBS for certain losses and expenses they might incur as a result of claims made against them relating to this RMBS, including, without limitation, certain legal expenses. The FHLB-Seattle’s claims against the underwriters of this RMBS were not dismissed and remain pending. Regardless of the outcome of this litigation, Redwood could incur a loss as a result of these indemnities.
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On or about July 15, 2010, The Charles Schwab Corporation (“Schwab”) filed a complaint in the Superior Court for the State of California in San Francisco (case number CGC-10-501610) against SRF and 26 other defendants (collectively, the “Schwab Defendants”) alleging that the Schwab Defendants made false or misleading statements in offering materials for various residential mortgage-backed securities sold or issued by the Schwab Defendants. Schwab alleged only a claim for negligent misrepresentation under California state law against SRF and sought unspecified damages and attorneys’ fees and costs from SRF. Schwab claims that SRF made false or misleading statements in offering materials for a mortgage pass-through certificate (the “Schwab Certificate”) issued in the 2005-4 RMBS and purchased by Schwab. Specifically, the complaint alleges that the misstatements for the 2005-4 RMBS concern the (1) loan-to-value ratio of mortgage loans and the appraisals of the properties that secured loans supporting the 2005-4 RMBS, (2) occupancy status of the properties, (3) standards used to underwrite the loans, and (4) ratings assigned to the Schwab Certificate. On November 14, 2014, Schwab voluntarily dismissed with prejudice its negligent misrepresentation claim, which resulted in the dismissal with prejudice of SRF from the action. The Schwab Certificate was issued with an original principal amount of approximately $14.8 million, and, as of December 31, 2014, Schwab has received approximately $12.9 million of principal and $1.3 million of interest payments in respect of the Schwab Certificate. As of December 31, 2014, the Schwab Certificate had a remaining outstanding principal amount of approximately $1.9 million. Redwood agreed to indemnify the underwriters of the 2005-4 RMBS, which underwriters were also named and remain as defendants in the action, for certain losses and expenses they might incur as a result of claims made against them relating to this RMBS, including, without limitation, certain legal expenses. Regardless of the outcome of this litigation, Redwood could incur a loss as a result of these indemnities.
In October 2010, a complaint was filed in Illinois state court against SRF and more than 45 other named defendants alleging that the defendants made false or misleading statements in offering materials for various RMBS sold or issued by the defendants or entities controlled by them. The plaintiff subsequently amended the complaint to name Redwood Trust, Inc. and another one of our subsidiaries, RWT Holdings, Inc., as defendants. With respect to Redwood Trust, Inc., RWT Holdings, Inc., and SRF (the “Redwood Defendants”), the plaintiff alleged that there were false or misleading statements in the offering materials for two mortgage pass-through certificates issued in the Sequoia Mortgage Trust 2006-1 securitization transaction. In October 2014, the plaintiff and the Redwood Defendants agreed to settle the complaint on mutually satisfactory terms. In November 2014, in accordance with the settlement terms, the complaint against the Redwood Defendants was dismissed. The terms of the agreed-upon settlement remain confidential.
In accordance with GAAP, we review the need for any loss contingency reserves and establish reserves when, in the opinion of management, it is probable that a matter would result in a liability and the amount of loss, if any, can be reasonably estimated. Additionally, we record receivables for insurance recoveries relating to litigation-related losses and expenses if and when such amounts are covered by insurance and recovery of such losses or expenses are due. At December 31, 2014, the aggregate amount of loss contingency reserves established in respect of the FHLB-Seattle and Schwab litigation matters described above was $2.0 million. We review our litigation matters each quarter to assess these loss contingency reserves and make adjustments in these reserves, upwards or downwards, as appropriate, in accordance with GAAP based on our review.
In the ordinary course of any litigation matter, including certain of the above-referenced matters, we have engaged and may continue to engage in formal or informal settlement communications with the plaintiffs. Settlement communications we have engaged in relating to certain of the above-referenced litigation matters are one of the factors that have resulted in our determination to establish the loss contingency reserves described above. We cannot be certain that any of these matters will be resolved through a settlement prior to trial and we cannot be certain that the resolution of these matters, whether through trial or settlement, will not have a material adverse effect on our financial condition or results of operations in any future period.
Future developments (including resolution of substantive pre-trial motions relating to these matters, receipt of additional information and documents relating to these matters (such as through pre-trial discovery), new or additional settlement communications with plaintiffs relating to these matters, or resolutions of similar claims against other defendants in these matters) could result in our concluding in the future to establish additional loss contingency reserves or to disclose an estimate of reasonably possible losses in excess of our established reserves with respect to these matters. Our actual losses with respect to the above-referenced litigation matters may be materially higher than the aggregate amount of loss contingency reserves we have established in respect of these litigation matters, including in the event that any of these matters proceeds to trial and the plaintiff prevails. Other factors that could result in our concluding to establish additional loss contingency reserves or estimate additional reasonably possible losses, or could result in our actual losses with respect to the above-referenced litigation matters being materially higher than the aggregate amount of loss contingency reserves we have established in respect of these litigation matters include that: there are significant factual and legal issues to be resolved; information obtained or rulings made during the lawsuits could affect the methodology for calculation of the available remedies; and we may have additional obligations pursuant to indemnity agreements, representations and warranties, and other contractual provisions with other parties relating to these litigation matters that could increase our potential losses.
ITEM 4. MINE SAFETY DISCLOSURES NOT APPLICABLE
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PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is listed and traded on the NYSE under the symbol RWT. At February 20, 2015, our common stock was held by approximately 789 holders of record and at January 8, 2015 the total number of beneficial stockholders holding stock through depository companies was approximately 48,670. At February 24, 2015, there were 83,426,979 shares of common stock outstanding.
The high and low sales prices of shares of our common stock, as reported by the Bloomberg Financial Markets service, and the cash dividends declared on our common stock for each full quarterly period during 2014 and 2013 were as follows:
| Stock Prices | Common Dividends Declared | |||||||||||||||||||||||
| High | Low | Record Date |
Payable Date |
Per Share |
Dividend Type |
|||||||||||||||||||
| Year Ended December 31, 2014 |
||||||||||||||||||||||||
| Fourth Quarter |
$ | 20.36 | $ | 15.97 | 12/15/2014 | 12/29/2014 | $ | 0.28 | Regular | |||||||||||||||
| Third Quarter |
$ | 20.09 | $ | 16.53 | 9/15/2014 | 9/30/2014 | $ | 0.28 | Regular | |||||||||||||||
| Second Quarter |
$ | 21.90 | $ | 18.82 | 6/13/2014 | 6/30/2014 | $ | 0.28 | Regular | |||||||||||||||
| First Quarter |
$ | 21.32 | $ | 18.20 | 3/14/2014 | 3/31/2014 | $ | 0.28 | Regular | |||||||||||||||
| Year Ended December 31, 2013 |
||||||||||||||||||||||||
| Fourth Quarter |
$ | 19.95 | $ | 17.00 | 12/13/2013 | 12/27/2013 | $ | 0.28 | Regular | |||||||||||||||
| Third Quarter |
$ | 20.20 | $ | 16.28 | 9/13/2013 | 9/30/2013 | $ | 0.28 | Regular | |||||||||||||||
| Second Quarter |
$ | 23.42 | $ | 16.40 | 6/14/2013 | 6/28/2013 | $ | 0.28 | Regular | |||||||||||||||
| First Quarter |
$ | 23.71 | $ | 17.00 | 3/15/2013 | 3/29/2013 | $ | 0.28 | Regular | |||||||||||||||
All dividend distributions are made with the authorization of the board of directors at its discretion and will depend on such items as our GAAP net income, REIT taxable earnings, financial condition, maintenance of REIT status, and other factors that the board of directors may deem relevant from time to time. The holders of our common stock share proportionally on a per share basis in all declared dividends on common stock. As reported on our Current Report on Form 8-K on January 27, 2015, for dividend distributions made in 2014, we expect 90% of our dividends paid in 2014 to be characterized as ordinary income and 10% to be characterized as a return of capital for income tax purposes. None of the dividend distributions made in 2014 is expected to be characterized for federal income tax purposes as long-term capital gain dividends.
We announced a stock repurchase plan on November 5, 2007, for the repurchase of up to a total of 5,000,000 shares. This plan replaced all previous share repurchase plans and has no expiration date. We did not repurchase any shares under this plan during the year ended December 31, 2014. At December 31, 2014, 4,005,985 shares remained available for repurchase under our stock repurchase plan.
Information with respect to compensation plans under which equity securities of the registrant are authorized for issuance is set forth in Part II, Item 12 of this Annual Report on Form 10-K.
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Performance Graph
The following graph presents a cumulative total return comparison of our common stock, over the last five years, to the S&P Composite-500 Stock Index and the National Association of Real Estate Investment Trusts, Inc. (“NAREIT”) Mortgage REIT index. The total returns reflect stock price appreciation and the reinvestment of dividends for our common stock and for each of the comparative indices, assuming that $100 was invested in each on December 31, 2009. The information has been obtained from sources believed to be reliable; but neither its accuracy nor its completeness is guaranteed. The total return performance shown on the graph is not necessarily indicative of future performance of our common stock.
Five Year — Cumulative Total Return Comparison
December 31, 2009 through December 31, 2014
| 2009 | 2010 | 2011 | 2012 | 2013 | 2014 | |||||||||||||||||||
| Redwood Trust, Inc. |
100.00 | 110.37 | 81.31 | 145.45 | 176.63 | 190.25 | ||||||||||||||||||
| NAREIT Mortgage REIT Index |
100.00 | 122.62 | 119.56 | 143.51 | 140.48 | 165.56 | ||||||||||||||||||
| S&P Composite-500 Index |
100.00 | 115.06 | 117.48 | 136.27 | 180.39 | 205.07 | ||||||||||||||||||
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ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data are qualified in their entirety by, and should be read in conjunction with, the more detailed information contained in the Consolidated Financial Statements and Notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Annual Report on Form 10-K and in our Annual Reports on Form 10-K as of and for each of the years ended December 31, 2014, 2013, 2012, 2011, and 2010. Certain amounts for prior periods have been reclassified to conform to the 2014 presentation.
| (In Thousands, Except Per Share Data) |
2014 | 2013 | 2012 | 2011 | 2010 | |||||||||||||||
| Selected Statement of Operations Data: |
||||||||||||||||||||
| Interest income |
$ | 242,070 | $ | 226,156 | $ | 231,384 | $ | 217,179 | $ | 230,054 | ||||||||||
| Interest expense |
(87,463 | ) | (80,971 | ) | (120,705 | ) | (98,978 | ) | (84,664 | ) | ||||||||||
|
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|
|
|
|
|
|
|
|
|
|||||||||||
| Net interest income |
154,607 | 145,185 | 110,679 | 118,201 | 145,390 | |||||||||||||||
| Provision for loan losses |
(961 | ) | (4,737 | ) | (3,648 | ) | (16,151 | ) | (24,135 | ) | ||||||||||
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|
|
|
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|
|
|||||||||||
| Net interest income after provision |
153,646 | 140,448 | 107,031 | 102,050 | 121,255 | |||||||||||||||
| Noninterest income |
||||||||||||||||||||
| Mortgage banking activities |
34,938 | 102,494 | 36,593 | — | — | |||||||||||||||
| Mortgage servicing rights income (loss) |
(4,261 | ) | 20,309 | (1,391 | ) | — | — | |||||||||||||
| Other market valuation adjustments |
(10,146 | ) | (5,709 | ) | 1,539 | (40,017 | ) | (19,554 | ) | |||||||||||
| Realized gains, net |
15,478 | 25,259 | 54,921 | 10,946 | 63,496 | |||||||||||||||
|
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|
|
|
|
|
|
|
|||||||||||
| Total noninterest income, net |
36,009 | 142,353 | 91,662 | (29,071 | ) | 43,942 | ||||||||||||||
| Operating expenses |
(90,123 | ) | (86,607 | ) | (65,633 | ) | (47,741 | ) | (53,715 | ) | ||||||||||
| Other income (expense) |
1,781 | (12,000 | ) | — | — | — | ||||||||||||||
| Provision for income taxes |
(744 | ) | (10,948 | ) | (1,291 | ) | (42 | ) | (280 | ) | ||||||||||
|
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|
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|
|
|
|
|
|
|||||||||||
| Net income |
100,569 | 173,246 | 131,769 | 25,196 | 111,202 | |||||||||||||||
| Less: Net (loss) income attributable to noncontrolling interest |
— | — | — | (1,147 | ) | 1,150 | ||||||||||||||
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|
|
|
|
|||||||||||
| Net Income Attributable to Redwood Trust, Inc. |
$ | 100,569 | $ | 173,246 | $ | 131,769 | $ | 26,343 | $ | 110,052 | ||||||||||
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|
|
|||||||||||
| Average common shares – basic |
82,837,369 | 81,985,897 | 79,529,950 | 78,299,510 | 77,841,634 | |||||||||||||||
| Earnings per share – basic |
$ | 1.18 | $ | 2.05 | $ | 1.61 | $ | 0.31 | $ | 1.37 | ||||||||||
| Average common shares – diluted |
85,098,579 | 93,694,924 | 80,673,682 | 78,299,510 | 78,810,949 | |||||||||||||||
| Earnings per share – diluted |
$ | 1.15 | $ | 1.94 | $ | 1.59 | $ | 0.31 | $ | 1.36 | ||||||||||
| Regular dividends declared per common share |
$ | 1.12 | $ | 1.12 | $ | 1.00 | $ | 1.00 | $ | 1.00 | ||||||||||
| Selected Balance Sheet Data: |
||||||||||||||||||||
| Earning assets |
$ | 5,753,753 | $ | 4,519,775 | $ | 4,343,628 | $ | 5,613,753 | $ | 5,049,254 | ||||||||||
| Total assets |
$ | 5,918,966 | $ | 4,608,528 | $ | 4,444,098 | $ | 5,743,298 | $ | 5,143,688 | ||||||||||
| Short-term debt |
$ | 1,793,825 | $ | 862,763 | $ | 551,918 | $ | 428,056 | $ | 44,137 | ||||||||||
| Asset-backed securities issued – Resecuritization |
$ | 45,044 | $ | 94,934 | $ | 164,746 | $ | 219,551 | $ | — | ||||||||||
| Asset-backed securities issued – Commercial |
$ | 83,313 | $ | 153,693 | $ | 171,714 | $ | — | $ | — | ||||||||||
| Asset-backed securities issued – Sequoia |
$ | 1,416,762 | $ | 1,694,335 | $ | 2,193,481 | $ | 3,710,423 | $ | 3,458,501 | ||||||||||
| Asset-backed securities issued – Acacia |
$ | — | $ | — | $ | — | $ | 209,381 | $ | 303,077 | ||||||||||
| Long-term debt |
$ | 1,194,567 | $ | 476,467 | $ | 139,500 | $ | 139,500 | $ | 139,500 | ||||||||||
| Total liabilities |
$ | 4,662,824 | $ | 3,362,745 | $ | 3,303,934 | $ | 4,850,714 | $ | 4,068,096 | ||||||||||
| Noncontrolling interest |
$ | — | $ | — | $ | — | $ | — | 10,839 | |||||||||||
| Total stockholders’ equity |
$ | 1,256,141 | $ | 1,245,783 | $ | 1,140,164 | $ | 892,584 | $ | 1,064,753 | ||||||||||
| Number of common shares outstanding |
83,443,141 | 82,504,801 | 81,716,416 | 78,555,908 | 78,124,668 | |||||||||||||||
| Book value per common share |
$ | 15.05 | $ | 15.10 | $ | 13.95 | $ | 11.36 | $ | 13.63 | ||||||||||
| Other Selected Data: |
||||||||||||||||||||
| Average assets |
$ | 5,848,856 | $ | 4,681,989 | $ | 5,318,442 | $ | 5,357,065 | $ | 5,196,293 | ||||||||||
| Average debt and ABS issued outstanding |
$ | 4,322,907 | $ | 3,333,439 | $ | 4,130,216 | $ | 4,148,421 | $ | 4,011,855 | ||||||||||
| Average stockholders’ equity |
$ | 1,250,627 | $ | 1,200,461 | $ | 987,330 | $ | 1,003,523 | $ | 1,008,126 | ||||||||||
| Net income/average stockholders’ equity |
8.0 | % | 14.4 | % | 13.3 | % | 2.6 | % | 10.9 | % | ||||||||||
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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION
Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in six main sections:
| • | Overview |
| • | Results of Operations |
| • | Liquidity and Capital Resources |
| • | Off Balance Sheet Arrangements and Contractual Obligations |
| • | Critical Accounting Policies and Estimates |
| • | New Accounting Standards |
Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data of this Annual Report on Form 10-K. The discussion in this financial review contains forward-looking statements that involve substantial risks and uncertainties. Our actual results could differ materially from those anticipated in these forward looking statements as a result of various factors, such as those discussed in the Cautionary Statement in Part 1, Item 1, Business and in Part 1, Item 1A, Risk Factors of this Annual Report on Form 10-K.
OVERVIEW
Our Business
Redwood Trust, Inc., together with its subsidiaries, focuses on investing in mortgage- and other real estate-related assets and engaging in residential and commercial mortgage banking activities. We seek to invest in real estate-related assets that have the potential to generate attractive cash flow returns over time and to generate income through our residential and commercial mortgage banking activities. We operate our business in three segments: residential mortgage banking, residential investments, and commercial mortgage banking and investments.
Our primary sources of income are net interest income from our investment portfolios and income from our mortgage banking activities. Net interest income consists of the interest income we earn less the interest expense we incur on borrowed funds and other liabilities. Income from mortgage banking activities consists of the profit we seek to generate through the acquisition or origination of loans and their subsequent sale or securitization. For tax purposes, Redwood Trust, Inc. is structured as a real estate investment trust (“REIT”).
For additional information on our business, refer to Part I, Item 1, Business of this Annual Report on Form 10-K.
Our Strategy
Our business has evolved substantially since the onset of the financial crisis, driven in part by our desire to build a franchise with a value-producing business model positioned to capitalize on the evolution of the mortgage finance markets. Specifically, we strive to be highly competitive in a post-crisis era of greater regulatory and capital requirements for all mortgage market participants, particularly for more heavily regulated banks. We have invested in and expanded our residential and commercial mortgage banking platforms to act as intermediaries between borrowers and investors in the mortgage capital markets, with the shared goal of creating our own steady sources of attractive investments and fee-generating opportunities. We believe that our business activities, as outlined below, take advantage of the strength of our balance sheet and the talents and extensive relationships of the professionals who make up our residential and commercial teams.
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Our residential business activities have been driven by our expectation that large bank originators with excess liquidity would be more likely to retain their jumbo residential loan originations for their own investment portfolios rather than sell those loans to aggregators such as Redwood. Therefore our primary focus has been on purchasing loans from smaller bank and non-bank originators. Since mid-2010, we have acquired prime, jumbo mortgages and the related mortgage servicing rights from these sellers and distributed those loans through private-label securitizations and whole-loan bulk-sales. In order to further leverage our platform and to participate in risk-sharing transactions contemplated under Fannie Mae and Freddie Mac reform proposals, in late 2013 we entered the conforming segment of the residential market (defined as loans eligible for sale to these government sponsored enterprises) and we began to acquire conforming loans and the related servicing rights from many of our existing jumbo loan sellers and new conforming-only loan sellers. Conforming loans we acquire are generally sold in bulk to Fannie Mae or Freddie Mac. In addition, in mid-2014, we established a new subsidiary that is a member of the Federal Home Loan Bank of Chicago (FHLBC) and can access attractive long-term financing from the FHLBC for residential mortgage loans. This subsidiary acquires residential mortgage loans to hold as long-term investments.
Our commercial business activities have been driven by our expectation that a significant wave of commercial loan refinancing demand would result from the pre-financial crisis era of high-leverage lending. In 2010, we identified an immediate need for mezzanine capital that could bridge the gap between commercial borrowers’ funding needs and what traditional senior lenders would provide in refinancing transactions. We subsequently positioned our platform to become an originator of senior commercial loans, offering value through greater flexibility and certainty of execution for borrowers. We are now a nationally recognized originator of commercial loans, generally retaining the mezzanine and subordinate loans we originate as long-term investments and selling senior loans we originate into the CMBS market.
Redwood Trust is structured as a REIT for federal tax purposes. Our REIT holds most of our mortgage-related investments, which are generally tax advantaged and created through our residential and commercial business activities or purchased through the mortgage capital markets. Our mortgage-banking activities are conducted through taxable REIT subsidiaries that pay corporate income taxes and, therefore, can generally retain earnings and reinvest the cash flows back into our business.
Business Update
In this update we discuss the highlighted operating milestones we achieved in 2014, as well as our outlook for each of our businesses in 2015. Additionally, in light of the recent high volatility in the interest rate and credit markets, we discuss our approach to hedging our financial risks and provide an overview of how we evaluate the results of our hedging strategy.
Residential Business
The residential mortgage banking market experienced a challenging year in 2014. Industry loan origination volumes declined by 39% from 2013 levels as refinance activity waned and loan sale margins remained under pressure as industry overcapacity adjusted to lower mortgage demand. Additionally, during 2014, private label securitization volume declined 39% and the number of issuers declined 19%. Redwood completed four securitizations in 2014, down from 12 in 2013. The decline in the industry’s and Redwood’s issuance volume was due to a strong whole loan bid by the banking industry that resulted in better execution relative to securitization.
Mortgage and treasury rates were volatile throughout 2014, declined sharply in the fourth quarter, and through mid-February of 2015 were still lower than at the end of 2014. This decrease in rates negatively impacted our mortgage servicing rights (MSRs) at year-end, causing their values to decline as prepayment expectations increased.
Despite the headwinds, we made good financial and operational progress in our residential businesses during 2014. Some of our residential business accomplishments included:
| • | After obtaining GSE approval at the end of 2013, we successfully completed our first year of conforming residential business with acquisition volume of $4.0 billion in 2014. For all of 2014, combined jumbo and conforming loan acquisition volume was $9.0 billion, a 27% increase from 2013. |
| • | We entered into two new key business relationships with the Federal Home Loan Bank of Chicago (FHLBC) that should benefit Redwood going forward and also contribute to the Federal Home Loan Bank (FHLB) system’s mission. The first relationship gives us a three-year period during which we will be the sole acquirer of high-balance loans through the FHLBC’s mortgage partnership finance (MPF) program. There are approximately 750 members of the FHLB system that are eligible to participate in the MPF program and thereby become sellers of high-balance loans to Redwood. We expect to purchase our first loans under this program during the first quarter of 2015, and to meaningfully increase the purchase volume from this channel throughout 2015. In addition, once we exit the pilot phase with the FHLBC, we hope to explore similar arrangements with other FHLB member banks. In the other relationship, a Redwood subsidiary became a member of the FHLBC giving that subsidiary access to collateralized financing for mortgage loans and securities. Using FHLBC financing, this subsidiary can acquire residential mortgage loans to hold as long-term investments and we currently anticipate this subsidiary will have up to $1 billion of financing from the FHLBC outstanding at mid-year 2015. |
| • | We entered into our first risk sharing arrangement with Fannie Mae, which has the potential to enhance our conforming loan profitability through our commitment to absorb up to the first one percent of losses on a designated pool of newly originated loans sold to Fannie Mae. We continue to actively work with both Fannie Mae and Freddie Mac on subsequent risk-sharing transactions and we expect to enter into additional transactions in 2015. |
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| • | We completed four private residential mortgage securitization (PLS) transactions, bringing our total completed PLS transactions since 2010 to 25 transactions, which represents a market-leading 36% market share. |
| • | We increased our number of loan sellers to 169 at December 31, 2014 from 118 at the end of 2013. |
Through the broader seller base and strategic relationships we forged in 2014, our plan for the next few quarters is to continue to gain market share while focusing on increasing the efficiency and operating leverage of our platform. With mortgage rates currently at 18 month lows, we expect refinance activity to provide a modest boost to industry origination volumes. Our expectation is to acquire $8 billion of conforming loans and $7 billion of jumbo loans in 2015, a 67% increase from total 2014 acquisitions. However, our primary focus will be to achieve our maximum purchase volume potential while maintaining loan sale profit margins within our long-term target range of 25 to 50 basis points. With respect to mortgage servicing rights (MSRs), while existing MSRs have declined in value as rates have fallen, improving market yield profiles and reduced industry capacity could make this asset class a much more attractive place to deploy capital in the coming quarters.
Commercial Business
Through the first three quarters of 2014, the commercial mortgage-backed securities (CMBS) market was on the upswing, exhibiting strong participation by both institutional triple-A investors as well as subordinate CMBS “B-piece” buyers. During the fourth quarter, market conditions worsened as volatility reigned across global markets. The impact was felt through a sharp reduction of available capital for these CMBS “B-pieces”, pressuring bond credit spreads as well as loan sale executions for senior loan contributors such as Redwood. The result was a negative impact on our commercial operating results in the fourth quarter. Early in the first quarter of 2015, commercial loan sale margins appear to be recovering with improved liquidity in the CMBS market. However, industry origination activity has slowed since the fourth quarter, consistent with seasonal patterns for this market. The anticipated seasonal decline in volume will likely factor into our first quarter of 2015 results from commercial mortgage banking activities. Despite this setback, we have distributed our available inventory of senior commercial loans originated in the fourth quarter and our balance sheet is ready to take advantage of new commercial opportunities.
Some of our 2014 commercial business accomplishments included:
| • | We originated and distributed nearly $1 billion of senior loans and originated $57 million of mezzanine and subordinate investments. |
| • | We generated $13 million of mortgage banking income and $32 million of net interest income. |
| • | Our credit performance continued to remain strong, with zero delinquencies or credit losses on over $420 million of mezzanine investments. |
| • | We continued to grow our team and expand our market breadth, hiring experienced originators in New York and Los Angeles. |
With additional capacity, a correction in spreads, and a growing market, our commercial business has the momentum for a very successful 2015. Market participants are expecting as much as $120 billion in CMBS issuance in 2015, as compared to $94 billion in 2014, as loans from the 2005-2007 period of record-setting origination volume begin to mature and refinance. The opportunity is particularly attractive for Redwood given our approach to credit and risk management, and our ability to offer mezzanine and other forms of subordinate financing. Our primary focus will be to increase total origination activity from $1 billion in 2014 to $1.5 billion in 2015, at margins averaging 150 basis points. We do not expect a linear ramp in originations, however, given our historical experience and seasonal factors that impact the pace of industry origination activity.
Financial Risk Management
Beginning in late 2014, we observed the rising global unrest and financial instability that has led to financial market volatility, a strengthening dollar, and widening of fixed-income credit spreads. Given the associated volatility in U.S. benchmark interest rates, the emphasis we place on sound financial risk management continues to be of primary importance.
We take an enterprise-wide view toward financial risk management. Our objective is to manage risks that are a necessary by-product of our business (such as interest rate risk, prepayment risk, and liquidity risk) while assuming those risks that are core to our business model and earnings – e.g., credit risk associated with our residential and commercial mortgage-related investments.
From a tactical standpoint, our approach is to first look at our different balance sheet investments, which can move in opposite directions as interest rates change. An example would be for us to view investment securities that typically increase in value as benchmark rates decline as a natural offset against MSRs that characteristically decline in value in a similar environment. We would also look to derivatives to supplement our balance sheet offsets or to manage other risks for which there are no natural offsets. Outside of our investments, we also manage our interest rate exposure from certain floating-rate long-term debt in order to effectively fix its cost of capital.
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The price movements of some of our hedges impact earnings and book value while others impact book value only. That’s why we typically analyze our cumulative hedging results through their impact on book value. In the fourth quarter of 2014, our book value per share declined from $15.21 to $15.05 per share. Our net income of $0.31 per share plus the net effect of unrealized market value changes on securities and other items nearly equaled our fourth quarter dividend of $0.28 per share. The remaining $0.15 per share decline represents the change in value of the above-described hedges associated with long-term debt.
This approach to financial risk management does not protect us from occasional periods of GAAP earnings volatility, and we continue to look for ways to better align our GAAP results with the economics of our business. Ultimately, we believe that we continue to manage these risks appropriately and consistently.
2014 Financial Overview
This section includes an overview of some of the significant factors impacting our 2014 financial results. A detailed discussion of our results of operations is presented in the next section of this MD&A.
The following table presents selected financial highlights from 2014 and 2013.
Table 1 – Selected Financial Highlights
| December 31, | ||||||||
| (Dollars in thousands, except per share) |
2014 | 2013 | ||||||
| GAAP net income |
$ | 100,569 | $ | 173,246 | ||||
| Net income per diluted common share |
$ | 1.15 | $ | 1.94 | ||||
| REIT taxable income per share |
$ | 0.76 | $ | 0.88 | ||||
| Dividends per share |
$ | 1.12 | $ | 1.12 | ||||
| Book value per share |
$ | 15.05 | $ | 15.10 | ||||
| Return on equity |
8.0 | % | 14.4 | % | ||||
For the full-year 2014, we generated an 8.0% return on GAAP equity and earned net income in excess of our dividend. The decline in net income from the prior year was primarily driven by a reduction in mortgage banking income, declines in the market value of our MSR investments, and higher operating costs as we continued to invest in growing our operating platforms.
The decline in our net income in 2014 was primarily driven by a $67 million reduction in income from mortgage banking activities, which was mostly associated with our residential business. As discussed in the business overview above, industry-wide residential loan origination volumes decreased significantly in 2014, putting pressure on margins and impacting the profitability of our residential mortgage banking operations. Our overall margins were also impacted by the significant growth in our conforming loan acquisitions in 2014, which accounted for $4.0 billion of our $9.0 billion of total residential loan acquisitions. Early in the year, we accepted lower profitability as we established ourselves in this market and built-out our platform for conforming loans. These margins improved throughout the year and we expect them to continue to improve into 2015 as we further leverage our platform.
Another significant contributor to the decline in net income was the $21 million of negative market valuation adjustments on our MSR investments that resulted from the sharp drop in mortgage interest rates in the fourth quarter of 2014. As discussed in the business overview above, we seek to manage our exposure to interest rate movements, including those arising from our MSR investments, across our business as a whole. While we believe our hedging strategy during 2014 was effective from an economic perspective, since some of our assets that serve as natural offsets to the MSRs are marked-to-market through our balance sheet, this result is not reflected in our GAAP net income.
42
The following table presents the changes in book value per share for the year ended December 31, 2014.
Table 2 – Changes in Book Value per Share
| Year Ended | ||||
| (In Dollars, per share basis) |
December 31, 2014 | |||
| Beginning book value |
$ | 15.10 | ||
| Net income |
1.15 | |||
| Change in unrealized gains on securities, net |
0.28 | |||
| Change in unrealized losses on derivatives, net |
(0.36 | ) | ||
| Equity award distributions |
(0.18 | ) | ||
| Other, net |
0.18 | |||
| Dividends |
(1.12 | ) | ||
|
|
|
|||
| Ending Book Value per Share |
$ | 15.05 | ||
|
|
|
|||
GAAP book value per share declined during 2014, despite our earnings more than covering our 2014 dividends paid to shareholders. This decline was primarily due to unrealized losses recorded on derivatives we use to hedge our floating rate interest exposure from certain of our long-term debt in order to fix its cost of capital. While the change in value of these derivatives runs through shareholders’ equity, we do not mark the associated debt to market and there was not a balance sheet offset to the $0.36 per share negative impact of these cash flow hedges on our book value.
The following table presents our new capital investments in 2014.
Table 3 – Investment Activity
| Year Ended | ||||
| (In Millions) (1) |
December 31, 2014 | |||
| Residential |
||||
| Sequoia RMBS |
$ | 150 | ||
| Third-party RMBS |
168 | |||
| Less: Short-term debt/Other liabilities |
(213 | ) | ||
|
|
|
|||
| Total RMBS |
106 | |||
| Agency risk sharing transaction |
10 | |||
| Loans, net - FHLBC(2) |
94 | |||
| MSR investments |
96 | |||
|
|
|
|||
| Total residential |
306 | |||
| Commercial |
||||
| Mezzanine and subordinate loans |
61 | |||
| Less: Borrowings |
(4 | ) | ||
|
|
|
|||
| Total commercial |
57 | |||
|
|
|
|||
| Capital Invested |
$ | 363 | ||
|
|
|
|||
| (1) | Certain totals may not foot, due to rounding. |
| (2) | Includes loans pledged to FHLBC and FHLBC stock acquired, less FHLBC borrowings. |
Our allocations of capital invested in 2014 shifted away from Sequoia and third party RMBS, and into MSRs and residential loans held-for investment and financed through the FHLBC. The reduction in Sequoia RMBS investments in 2014 was attributable to the reduction in securitizations we sponsored this year as whole loan sales were a more attractive distribution alternative for our residential loans. Our increase in MSR investments mostly resulted from Agency loan sales as we significantly increased our conforming loan volumes in 2014. Additionally, the establishment of our borrowing arrangement with FHLBC gave our FHLB member subsidiary the ability to invest capital in residential mortgage loans during 2014.
43
Capital and Liquidity
During 2014, we raised $205 million through an offering of exchangeable notes issued by one of our taxable subsidiaries and our FHLB member subsidiary borrowed $496 million of long-term debt from the FHLBC, which together increased our total capital to $2.4 billion at December 31, 2014. Total capital included $1.3 billion of equity capital and $1.1 billion of long term debt, comprised of $140 million of debt due in 2037, $288 million of convertible debt due in 2018, $205 million of exchangeable debt due in 2019, and $496 million of FHLB borrowings with an average maturity of 9.4 years. It did not include $1.2 billion of loan warehouse debt, which we primarily use to finance our inventory of residential and commercial loans, or $609 million of repurchase financing for securities.
In addition, during the fourth quarter, we closed a new commercial warehouse facility, adding $150 million in additional borrowing capacity, bringing our total available commercial warehouse capacity to $400 million at December 31, 2014.
At December 31, 2014, we held $270 million in cash, and our investment capacity (defined as the approximate amount of capital we had readily available for long-term investments) was estimated to be approximately $198 million.
RESULTS OF OPERATIONS
The following table presents the components of our GAAP net income for the years ended December 31, 2014, 2013, and 2012.
Table 4 – Net Income
| Years Ended December 31, | Changes | |||||||||||||||||||
| (In Millions, Except per Share Data) (1) |
2014 | 2013 | 2012 | ’14/’13 | ’13/’12 | |||||||||||||||
| Interest income |
$ | 242 | $ | 226 | $ | 231 | $ | 16 | $ | (5 | ) | |||||||||
| Interest expense |
(87 | ) | (81 | ) | (121 | ) | (6 | ) | 40 | |||||||||||
|
|
|
|
|
|
|
|
|
|
|
|||||||||||
| Net Interest Income |
155 | 145 | 111 | 10 | 34 | |||||||||||||||
| Provision for loan losses |
(1 | ) | (5 | ) | (4 | ) | 4 | (1 | ) | |||||||||||
|
|
|
|
|
|
|
|
|
|
|
|||||||||||
| Net Interest Income After Provision |
154 | 140 | 107 | 14 | 32 | |||||||||||||||
| Noninterest Income |
||||||||||||||||||||
| Mortgage banking activities |
35 | 102 | 37 | (67 | ) | 65 | ||||||||||||||
| MSR income (loss) |
(4 | ) | 20 | (1 | ) | (24 | ) | 21 | ||||||||||||
| Other market valuation adjustments |
(10 | ) | (6 | ) | 2 | (4 | ) | (8 | ) | |||||||||||
| Realized gains, net |
15 | 25 | 55 | (10 | ) | (30 | ) | |||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|||||||||||
| Total noninterest income, net |
36 | 142 | 92 | (106 | ) | 50 | ||||||||||||||
| Operating expenses |
(90 | ) | (87 | ) | (66 | ) | (3 | ) | (21 | ) | ||||||||||
| Other income (expense) |
2 | (12 | ) | — | 14 | (12 | ) | |||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|||||||||||
| Net income before provision for income taxes |
101 | 184 | 133 | (83 | ) | 51 | ||||||||||||||
| Provision for income taxes |
(1 | ) | (11 | ) | (1 | ) | 10 | (10 | ) | |||||||||||
|
|
|
|
|
|
|
|
|
|
|
|||||||||||
| Net Income |
$ | 101 | $ | 173 | $ | 132 | $ | (72 | ) | $ | 41 | |||||||||
|
|
|
|
|
|
|
|
|
|
|
|||||||||||
| Diluted earnings per common share |
$ | 1.15 | $ | 1.94 | $ | 1.59 | ||||||||||||||
| (1) | Certain totals may not foot, due to rounding. |
We are required under GAAP to consolidate the assets and liabilities of certain securitization entities we have sponsored for financial reporting purposes. However, each of these entities is independent of Redwood and of each other and the securitized assets of these entities are not legally ours and we own only the securities and interests that we acquired from these securitization entities. Similarly, the liabilities of these entities are obligations payable only from the cash flows generated by their securitized assets and are not obligations of Redwood. Together, we refer to certain of these securitization entities that were created prior to 2012, including Sequoia securitizations and Acacia securitizations, as “Legacy Consolidated Entities,” and where applicable, in analyzing our results of operations we distinguish results from current operations “at Redwood” and from Legacy Consolidated Entities. For additional detail on results from Legacy Consolidated Entities, see the “Results from Legacy Consolidated Entities” section below. Results at Redwood include all activities from our three business segments.
44
Net Interest Income
The $10 million increase in net interest income in 2014 was primarily attributable to higher average balances of securities and loans held-for-investment in 2014 at our residential investments segment, which contributed $12 million to the increase, as well as higher average balances of loans held-for-sale during 2014 at both our residential and commercial mortgage banking segments, which together contributed $4 million to the increase. These increases in net interest income were offset by a $4 million increase in interest expense from corporate borrowings, primarily resulting from convertible and exchangeable debt issued in the first quarter of 2013 and the fourth quarter of 2014, respectively. In addition, we earned $3 million less net interest income from our Legacy Consolidated Entities in 2014 as the loans in these securitizations continue to pay down.
The $35 million increase in net interest income in 2013 was primarily attributable to higher average balances of loans held-for-sale during 2013 related to both our residential and commercial mortgage banking segments, in addition to higher average balances of securities in our residential investments segment, offset by higher interest expense resulting from convertible debt issued in the first quarter of 2013. In addition, net interest income in 2012 included $11 million of interest expense related to the deconsolidation of certain Legacy Consolidated Entities.
Additional detail on changes in net interest income at Redwood is provided in the “Net Interest Income” section below.
Provision for Loan Losses
We maintain an allowance for loan losses for both our commercial loan investment portfolio and for residential loans held-for-investment in Legacy Consolidated Entities. Nearly all of the $4 million decrease in 2014 was attributable to our commercial loan investment portfolio, as we recorded a reversal of provision for loan losses that primarily resulted from $71 million of commercial loan repayments.
Additional information on the allowance for loan losses on our consolidated Sequoia entities is provided in the “Results of Legacy Consolidated Entities” section of this MD&A.
Mortgage Banking Activities
Income from mortgage banking activities includes results from both our residential and commercial mortgage banking operations. The $68 million decrease in 2014 included a $56 million decrease from our residential mortgage banking operations and a $12 million decrease from our commercial mortgage banking operations.
The $56 million decrease in 2014 from residential mortgage banking activities is primarily attributable to lower loan sale profit margins which were experienced across the industry as overcapacity adjusted to lower mortgage demand. In addition we began purchasing and selling conforming loans, which comprised a more significant portion of our originations in 2014 and typically generate margins that are lower than on jumbo loans. During 2014, we acquired $5.0 billion of jumbo loans and $4.0 billion of conforming loans, as compared to 2013 when nearly all of the $7.1 billion of acquisitions were jumbo loans.
The $12 million decrease in 2014 from commercial mortgage banking activities is primarily attributable to lower loan sale profit margins primarily resulting from increased competition for commercial loan originations in 2014, which was only partially offset by higher origination volumes. We originated $904 million of senior commercial loans in 2014, as compared to $659 million in 2013.
The $66 million increase in mortgage banking activities in 2013, as compared to 2012, resulted from a $43 million increase from our residential mortgage banking operations and a $23 million increase from commercial mortgage banking operations. The increase in 2013 was predominately due to higher residential loan purchase volume and higher commercial loan origination volume.
Additional detail on mortgage banking activities is included in the Residential Mortgage Banking and Commercial Mortgage Banking and Investment portions of the “Segment Results” section below.
MSR Income
MSR income is comprised of both the net fee income we earn from our MSR investments as well as changes in their market value. In 2014, MSR income was comprised of $17 million of net fee income and $21 million of negative market valuation changes, as compared to $8 million in fee income and $12 million of positive market valuation changes in 2013. The negative market valuation changes in 2014 were primarily due to declining mortgage interest rates during 2014 which resulted in higher actual and projected prepayment speeds and lower MSR values. The net fees we received from our MSRs steadily increased in 2014 due to the addition of $96 million of MSR investments retained from both the sale of jumbo loans we securitized and an increasing amount retained from the sale of conforming loans we sold to the Agencies, as well as bulk purchases of conforming MSRs.
45
In 2012, MSR income was comprised of $1 million of net fee income, offset by $2 million of negative market valuation adjustments.
Additional detail on MSR investments is included in the Residential Investments portion of the “Segment Results” section below.
Other Market Valuation Adjustments
In 2014, the $10 million of negative other market valuation adjustments was primarily comprised of $8 million of negative market value changes of derivative instruments used to hedge certain risks associated with interest rate sensitive assets held at our residential investments segment and $1 million of negative market value changes of REO. The remaining $1 million of adjustments resulted from market value changes of trading securities and residential loans held at the lower of cost or market, as well as from impairments on available-for-sale securities, all of which were negative.
In 2013, the $6 million of negative other market valuation adjustments primarily resulted from $4 million of negative market value changes of trading securities and $2 million of other-than-temporary impairments of AFS securities.
In 2012, the $2 million of positive other market valuation adjustments primarily resulted from $6 million of net positive valuation adjustments from assets at Legacy Consolidated Entities, partially offset by $3 million of negative market valuation adjustments on trading securities at Redwood.
Realized Gains, Net
In 2014, realized gains, net, of $15 million primarily resulted from the sale of $440 million of AFS securities during the year. In 2013, realized gains, net, of $25 million primarily resulted from the sale of $176 million of AFS securities during the year. Realized gains of $55 million during 2012 primarily resulted from the sale of $167 million of AFS securities for a net realized gain of $32 million and also included $22 million of gains from the deconsolidation of certain Legacy Consolidated Entities during 2012. The amount of the gains or losses in a period depends on several factors including the amount of sales and the unrealized gain or loss on the securities prior to sale.
Additional detail on realized gains is included in the Residential Investments portion of the “Segment Results” below.
Operating Expense
The $3 million and $21 million increases in operating expenses in 2014 and 2013, respectively, were both primarily driven by additional costs associated with the expansion of our residential and commercial mortgage banking operations during the last two years. This expansion included an increase in year-end headcount to 221 in 2014, from 141 in 2013 and 86 in 2012. Although fixed compensation expenses increased $6 million in 2014, total compensation expense decreased $2 million, due to $4 million of severance expense in 2013 as well as $4 million less variable compensation expense in 2014, primarily resulting from a lower return on equity achieved in 2014 relative to 2013. Total compensation expense increased $11 million in 2013 primarily due to increased head count. Additionally, as we expanded our mortgage banking operations during the last two years our systems and consulting costs also increased, accounting for $5 million of the increases in operating expense in both 2014 and 2013.
Other Income (Expense)
Other income of $2 million in 2014 resulted from a reduction in our aggregate litigation reserve relating to three legacy Sequoia RMBS-related cases, for which we initially recorded a $12 million reserve expense in 2013. In 2014, we settled one of the three suits. For additional detail on pending litigation matters, refer to “Legal Proceedings” in Part II, Item 3 of this Annual Report on Form 10-K and Note 15 in Part II, Item 8 of this Annual Report on Form 10-K.
Provision for Income Taxes
Our provision for income taxes is primarily based on the GAAP income earned at our taxable REIT subsidiaries. The higher tax provision in 2013, as compared to 2014 and 2012, was primarily the result of higher GAAP income earned from residential mortgage banking operations and market valuation adjustments related to mortgage servicing rights during 2013, both of which are performed in taxable REIT subsidiaries.
46
Additional detail on provision for income taxes is included in the “Taxable Income” section below.
Net Interest Income
The following table presents the components of net interest income on a consolidated basis for the years ended December 31, 2014, 2013, and 2012.
Table 5 – Net Interest Income – Consolidated
| Years Ended December 31, | ||||||||||||||||||||||||||||||||||||
| 2014 | 2013 | 2012 | ||||||||||||||||||||||||||||||||||
| Interest | Interest | Interest | ||||||||||||||||||||||||||||||||||
| Income/ | Average | Income/ | Average | Income/ | Average | |||||||||||||||||||||||||||||||
| (Dollars in Millions)(1) |
(Expense) | Balance (2) | Yield | (Expense) | Balance (2) | Yield | (Expense) | Balance (2) | Yield | |||||||||||||||||||||||||||
| Interest Income (3) |
||||||||||||||||||||||||||||||||||||
| Residential loans - HFS - FVO |
$ | 39 | $ | 993 | 3.9 | % | $ | 33 | $ | 823 | 4.1 | % | $ | 15 | $ | 392 | 3.9 | % | ||||||||||||||||||
| Residential loans - HFI - FVO |
4 | 119 | 3.8 | % | — | — | — | — | — | — | ||||||||||||||||||||||||||
| Residential loans - HFI (4) |
26 | 1,605 | 1.6 | % | 34 | 1,980 | 1.7 | % | 67 | 3,182 | 2.1 | % | ||||||||||||||||||||||||
| Commercial loans - HFS - FVO |
6 | 132 | 4.7 | % | 4 | 60 | 5.9 | % | 1 | 13 | 6.5 | % | ||||||||||||||||||||||||
| Commercial loans - HFI |
41 | 398 | 10.4 | % | 40 | 337 | 11.9 | % | 26 | 233 | 11.1 | % | ||||||||||||||||||||||||
| Trading securities (4) |
23 | 136 | 16.8 | % | 25 | 118 | 21.0 | % | 37 | 262 | 14.0 | % | ||||||||||||||||||||||||
| Available-for-sale securities |
103 | 1,308 | 7.8 | % | 91 | 1,036 | 8.8 | % | 86 | 860 | 10.0 | % | ||||||||||||||||||||||||
| Other interest income |
— | 156 | — | — | 155 | — | — | 143 | — | |||||||||||||||||||||||||||
|
|
|
|
|
|
|
|||||||||||||||||||||||||||||||
| Total interest income |
242 | 4,848 | 5.0 | % | 226 | 4,508 | 5.0 | % | 231 | 5,085 | 4.5 | % | ||||||||||||||||||||||||
| Interest Expense |
||||||||||||||||||||||||||||||||||||
| Short-term debt |
(26 | ) | 1,523 | (1.7 | )% | (17 | ) | 989 | (1.8 | )% | (9 | ) | 488 | (1.9 | )% | |||||||||||||||||||||
| ABS issued - Redwood |
(10 | ) | 191 | (5.4 | )% | (14 | ) | 284 | (4.9 | )% | (6 | ) | 205 | (2.9 | )% | |||||||||||||||||||||
| ABS issued - Sequoia (4) |
(21 | ) | 1,541 | (1.4 | )% | (26 | ) | 1,904 | (1.4 | )% | (50 | ) | 3,092 | (1.6 | )% | |||||||||||||||||||||
| ABS issued - Acacia (4) |
— | — | — | — | — | — | (46 | ) | 208 | (21.9 | )% | |||||||||||||||||||||||||
| Long-term debt |
(30 | ) | 616 | (4.9 | )% | (24 | ) | 395 | (6.1 | )% | (10 | ) | 139 | (6.9 | )% | |||||||||||||||||||||
|
|
|
|
|
|
|
|||||||||||||||||||||||||||||||
| Total interest expense |
(87 | ) | 3,871 | (2.3 | )% | (81 | ) | 3,572 | (2.3 | )% | (121 | ) | 4,131 | (2.9 | )% | |||||||||||||||||||||
|
|
|
|
|
|
|
|||||||||||||||||||||||||||||||
| Net Interest Income |
$ | 155 | $ | 145 | $ | 111 | ||||||||||||||||||||||||||||||
|
|
|
|
|
|
|
|||||||||||||||||||||||||||||||
| (1) | Certain totals may not foot, due to rounding. |
| (2) | Average balances for residential and commercial loans, trading securities, and debt are calculated based upon carrying values. Average balances for available-for-sale securities are calculated based upon amortized cost. |
| (3) | For loans presented above, HFS indicates held-for-sale, HFI indicates held-for-investment and FVO indicates loans carried at fair value. |
| (4) | The interest income from residential loans held-for-investment and the interest expense from ABS issued – Sequoia represent activity from our Legacy Consolidated Entities. In 2012, $25 million of interest income from trading securities, $1 million of interest income from commercial HFS FVO loans, and $46 million of interest expense from ABS issued – Acacia represent activity from our Legacy Consolidated Entities. |
47
The following table details how net interest income changed on a consolidated basis as a result of changes in average investment balances (“volume”) and changes in interest yields (“rate”).
Table 6 – Net Interest Income — Volume and Rate Changes
| Change in Net Interest Income | ||||||||||||
| For the Years Ended December 31, 2014 and 2013 | ||||||||||||
| (In Millions) (1) |
Volume | Rate | Total | |||||||||
| Net Interest Income for the Year Ended December 31, 2013 |
$ | 145 | ||||||||||
| Impact of Changes in Interest Income |
||||||||||||
| Residential loans - HFS |
$ | 7 | $ | (2 | ) | 5 | ||||||
| Residential loans - HFI - FVO |
4 | — | 4 | |||||||||
| Residential loans - HFI |
(6 | ) | (1 | ) | (8 | ) | ||||||
| Commercial loans - HFS |
4 | (2 | ) | 3 | ||||||||
| Commercial loans - HFI |
7 | (6 | ) | 1 | ||||||||
| Trading securities |
4 | (6 | ) | (2 | ) | |||||||
| Available-for-sale securities |
24 | (12 | ) | 12 | ||||||||
|
|
|
|
|
|
|
|||||||
| Net changes in interest income |
44 | (28 | ) | 16 | ||||||||
| Impact of Changes in Interest Expense |
||||||||||||
| Short-term debt |
(9 | ) | 1 | (9 | ) | |||||||
| ABS issued - Redwood |
5 | (1 | ) | 3 | ||||||||
| ABS issued - Sequoia |
5 | 0 | 5 | |||||||||
| Long-term debt |
(13 | ) | 7 | (6 | ) | |||||||
|
|
|
|
|
|
|
|||||||
| Net changes in interest expense |
(13 | ) | 7 | (6 | ) | |||||||
| Net changes in interest income and expense |
31 | (22 | ) | 10 | ||||||||
|
|
|
|||||||||||
| Net Interest Income for the Year Ended December 31, 2014 |
$ | 155 | ||||||||||
|
|
|
|||||||||||
| Change in Net Interest Income | ||||||||||||
| For the Years Ended December 31, 2013 and 2012 | ||||||||||||
| (In Millions) (1) |
Volume | Rate | Total | |||||||||
| Net Interest Income for the Year Ended December 31, 2012 |
$ | 111 | ||||||||||
| Impact of Changes in Interest Income |
||||||||||||
| Residential loans, at fair value |
$ | 17 | $ | 1 | 18 | |||||||
| Residential loans - HFI |
(25 | ) | (8 | ) | (33 | ) | ||||||
| Commercial loans - HFS |
3 | — | 3 | |||||||||
| Commercial loans - HFI |
11 | 3 | 14 | |||||||||
| Trading securities |
(20 | ) | 8 | (12 | ) | |||||||
| Available-for-sale securities |
18 | (12 | ) | 5 | ||||||||
|
|
|
|
|
|
|
|||||||
| Net changes in interest income |
4 | (9 | ) | (5 | ) | |||||||
| Impact of Changes in Interest Expense |
||||||||||||
| Short-term debt |
(10 | ) | 2 | (8 | ) | |||||||
| ABS issued - Redwood |
(2 | ) | (6 | ) | (8 | ) | ||||||
| ABS issued - Sequoia |
19 | 5 | 24 | |||||||||
| ABS issued - Acacia |
46 | — | 46 | |||||||||
| Long-term debt |
(18 | ) | 3 | (14 | ) | |||||||
|
|
|
|
|
|
|
|||||||
| Net changes in interest expense |
35 | 4 | 40 | |||||||||
| Net changes in interest income and expense |
39 | (5 | ) | 34 | ||||||||
|
|
|
|||||||||||
| Net Interest Income for the Year Ended December 31, 2013 |
$ | 145 | ||||||||||
|
|
|
|||||||||||
| (1) | Certain totals may not foot, due to rounding. |
48
The following table presents the components of net interest income by segment for the years ended December 31, 2014, 2013 and 2012.
Table 7 – Net Interest Income — Segment
| Years Ended December 31, | ||||||||||||
| (In Millions) |
2014 | 2013 | 2012 | |||||||||
| Net interest income |
||||||||||||
| Residential Mortgage Banking |
$ | 45 | $ | 42 | $ | 17 | ||||||
| Residential Investments |
99 | 86 | 82 | |||||||||
| Commercial Mortgage Banking and Investments |
32 | 31 | 25 | |||||||||
| Corporate/Other |
(21 | ) | (14 | ) | (13 | ) | ||||||
|
|
|
|
|
|
|
|||||||
| $ | 155 | $ | 145 | $ | 111 | |||||||
2014 versus 2013
Net interest income increased $10 million to $155 million in 2014. This increase was primarily due to higher net interest income at our operating segments, resulting from higher average balances of earning assets across each of our segments in 2014 as compared to 2013.
Our residential mortgage banking segment contributed $3 million of the increase in net interest income, primarily resulting from higher average balances of loans held for sale or securitization during 2014 as we increased our acquisition volume to $9.0 billion in 2014 from $7.1 billion in 2013. The increase in net interest income from higher average balances was partially offset by lower weighted average interest rates on our held-for-sale loans, as mortgage rates declined throughout 2014. In addition, we financed the higher balances of loans with similar relative levels of short-term warehouse debt, for which the weighted average interest rate was consistent between 2014 and 2013.
Our commercial mortgage banking and investments segment contributed $1 million of the increase in net interest income, primarily resulting from higher average balances of senior loans held-for-sale during 2014. In 2014, we originated $904 million of senior commercial mortgage loans, as compared to $659 million in 2013. The increase in net interest income from higher average balances was partially offset by lower weighted average interest rates on our held-for-sale loans, as increased competition in 2014 led to lower rates. In addition, in 2014, we utilized a greater amount of short-term warehouse debt to finance our commercial loans held-for-sale, but experienced lower weighted average interest rates on these borrowings.
The amount of interest income earned from both residential and commercial loans held-for-sale is dependent on many factors, including the amount of loans originated during a period, the length of time they are on our balance sheet and their interest rates.
Our residential investment portfolio contributed $13 million of the increase in net interest income in 2014. Net interest income in our residential investment portfolio is derived from both our portfolio of investment securities and our portfolio of residential mortgage loans held-for-investment at fair value. In 2014, our securities portfolio contributed $8 million of the increase in net interest income, primarily resulting from higher average balances of investment securities outstanding in 2014 as we retained subordinate investments in Sequoia securitizations we sponsored in 2013 and 2014. The increase in net interest income from higher average balances was partially offset by lower weighted average interest rates on our available-for-sale securities, which was primarily attributable to the changing composition of our portfolio as higher yielding legacy senior and subordinate securities purchased in past years pay down and are replaced by new issue Sequoia and third-party subordinate securities and seasoned third-party senior securities that have lower relative yields.
The remainder of the change in net interest income resulted from changes in corporate debt that is not allocated to our operating segments and from Legacy Consolidated Entities. Interest expense from corporate debt increased $4 million to $26 million in 2014. This increase was primarily attributable to convertible and exchangeable debt we issued in the first quarter of 2013 and the fourth quarter of 2014, respectively. Net interest income from our Legacy Consolidated Entities decreased $3 million to $5 million in 2014 as loans held in these consolidated securitizations continued to pay down.
Additional detail regarding the activities impacting net interest income at each of our business segments is included the “Segment Results” section below.
49
The following table presents the spread between the yield on unsecuritized loans and securities and their specific debt financing costs at December 31, 2014.
Table 8 – Interest Expense — Specific Borrowing Costs
| December 31, 2014 |
Residential Loans |
Commercial Loans |
Residential Securities |
|||||||||
| Asset yield |
4.06 | % | 7.46 | % | 6.47 | % | ||||||
| Short-term debt yield |
1.74 | % | 3.66 | % | 1.38 | % | ||||||
|
|
|
|
|
|
|
|||||||
| Net spread |
2.32 | % | 3.80 | % | 5.09 | % | ||||||
|
|
|
|
|
|
|
|||||||
For additional discussion on short-term debt at Redwood, including information regarding margin requirements and financial covenants see “Risks Relating to Debt Incurred Under Short- and Long-Term Borrowing Facilities” in the “Liquidity and Capital Resources” section below.
2013 versus 2012
Net interest income increased $35 million to $145 million in 2013 from 2012. This increase was primarily driven by higher net interest income at our operating segments, primarily resulting from higher average balances of earning assets across each of our segments in 2013. The increase in net interest income from our operating segments was partially offset by higher interest expense on our corporate debt, which increased $12 million to $26 million in 2013, primarily as a result of the convertible debt that we issued in the first quarter of 2013. In addition, net interest income from our Legacy Consolidated Entities increased $12 million to $8 million in 2013, as compared to net interest expense of $4 million in 2012. In 2012, we deconsolidated our Acacia Securitizations, which resulted in net interest expense of $20 million related to those entities in 2012. This was partially offset by $16 million of net interest income earned in 2012 from our consolidated Sequoia securitizations.
50
Segment Results
The following is a discussion of the results of operations for our three business segments for the years ended December 31, 2014, 2013, and 2012. For additional information on our segments, refer to Note 21 in Part II, Item 8 and Item 1 of this Annual Report on Form 10-K.
Residential Mortgage Banking
The following table presents the components of direct segment profit for the residential mortgage banking segment for the years ended December 31, 2014, 2013 and 2012.
Table 9 – Residential Mortgage Banking Segment Contribution
| Years Ended December 31, | ||||||||||||
| (In Thousands) |
2014 | 2013 | 2012 | |||||||||
| Interest income |
$ | 58,272 | $ | 52,517 | $ | 19,714 | ||||||
| Interest expense |
(12,776 | ) | (10,167 | ) | (3,179 | ) | ||||||
|
|
|
|
|
|
|
|||||||
| Net interest income |
45,496 | 42,350 | 16,535 | |||||||||
| Other market valuation adjustments |
56 | 38 | 623 | |||||||||
| Mortgage banking activities |
21,498 | 79,393 | 35,438 | |||||||||
| Direct operating expenses |
(37,664 | ) | (22,880 | ) | (13,214 | ) | ||||||
| Provision for income taxes |
(1,774 | ) | (5,947 | ) | — | |||||||
|
|
|
|
|
|
|
|||||||
| Segment Contribution |
$ | 27,612 | $ | 92,954 | $ | 39,382 | ||||||
|
|
|
|
|
|
|
|||||||
The following table provides the activity of residential loans in this segment during the years ended December 31, 2014 and 2013.
Table 10 – Residential Loans Held-for-sale — Activity
| Years Ended December 31, | ||||||||
| (In Thousands) |
2014 | 2013 | ||||||
| Balance at beginning of period |
$ | 404,267 | $ | 562,658 | ||||
| Acquisitions |
9,027,455 | 7,107,503 | ||||||
| Sales |
(7,514,316 | ) | (7,235,643 | ) | ||||
| Transfers between portfolios (1) |
(596,076 | ) | — | |||||
| Principal repayments |
(30,124 | ) | (18,755 | ) | ||||
| Changes in fair value, net |
51,313 | (11,496 | ) | |||||
|
|
|
|
|
|||||
| Balance at End of Period |
$ | 1,342,519 | $ | 404,267 | ||||
|
|
|
|
|
|||||
| (1) | During the year ended December 31, 2014 we transferred loans from held-for-sale at fair value at our Residential Mortgage Banking segment to our Residential Investments segment and reclassified them as held-for-investment at fair value. As of December 31, 2014, these loans were financed through the FHLBC borrowing agreement and our current intention is to hold these loans for investment. |
51
The following table provides the activity of our retained Sequoia senior securities for the years ended December 31, 2014 and 2013.
Table 11 – Sequoia Securities Activity
| Years Ended December 31, | ||||||||
| (In Thousands) |
2014 | 2013 | ||||||
| Beginning fair value |
$ | 110,505 | $ | 10,409 | ||||
| Acquisitions |
77,160 | 105,320 | ||||||
| Sales |
(64,098 | ) | (48,633 | ) | ||||
| Effect of principal payments (1) |
(5,989 | ) | — | |||||
| Change in fair value, net |
(23,776 | ) | 43,409 | |||||
|
|
|
|
|
|||||
| Ending Fair Value (2) |
$ | 93,802 | $ | 110,505 | ||||
|
|
|
|
|
|||||
| (1) | The effect of principal payments reflects the change in fair value due to principal payments, which is calculated as the cash principal received on a given security during the period multiplied by the prior quarter ending price or acquisition price of the security. |
| (2) | At December 31, 2014, balance includes $88 million of IO senior securities and $6 million of non-IO senior Sequoia securities carried at fair value. |
Overview
During the year ended December 31, 2014, we acquired over $9 billion in residential mortgage loans, completed four jumbo loan securitizations for a total of $1.4 billion, sold $2.4 billion of jumbo loans through whole loan sales to third parties, sold $3.7 billion of conforming loans to the Agencies and transferred $596 million of jumbo loans to our Residential Investments segment and financed these loans on a long-term basis with the FHLBC. In total, our residential mortgage banking activities created $139 million of investments during 2014. Of these investments, $7 million of IO securities were retained in our Residential Mortgage Banking segment and $6 million of senior securities, $78 million of subordinate securities and $48 million of MSRs were retained in our Residential Investment segment. At December 31, 2014, we had loan purchase commitment derivatives on our balance sheet valued at $1 million that were associated with commitments to purchase an additional $316 million of conforming loans. In addition, at December 31, 2014, we had identified $848 million of jumbo residential loans for purchase that are not recorded on our balance sheet as they do not qualify as derivatives under GAAP.
Segment contribution from residential mortgage banking decreased $65 million to $28 million in 2014, primarily due to a decline in income from mortgage banking activities, resulting from lower profit margins experienced in 2014. This decrease was partially offset by an increase in net interest income from higher average loan balances, as loan purchase volume increased to $9.0 billion in 2014 from $7.1 billion in 2013. In addition, direct operating expenses increased due to a combination of the higher loan purchase volume and the expansion of our conforming loan platform. All residential mortgage banking activities are performed in taxable subsidiaries and the provision for income taxes generally changes in relation to the amount income earned at this segment. As such, our provision for income tax was lower in 2014, as compared to 2013, due to lower segment contribution in 2014.
Net Interest Income
Net interest income from residential mortgage banking is primarily comprised of interest income earned on residential loans from the time we purchase the loans to when we sell them or securitize them, offset by interest expense incurred on short-term warehouse debt used in part to finance the loans while we hold them on balance sheet. Net interest income also includes interest income from Sequoia IOs that are used to hedge certain risks on our loan pipeline related to interest rate movements.
In 2014, our net interest income from loans held on balance sheet prior to sale was $26 million and interest income from Sequoia senior securities was $19 million. The amount of net interest income we earn on loans held on balance sheet is dependent on many variables, including the amount of loans and the time they are outstanding on balance sheet and their interest rates, as well as the amount of leverage we employ through the use of short-term debt to finance the loans and the interest rates on that debt. These factors will impact interest income in future periods. During 2014, we sold $64 million of Sequoia senior securities in this segment, and in the future we may sell additional Sequoia senior securities, which would reduce interest income in this segment.
52
Mortgage Banking Activities
Mortgage banking activities include the changes in market value associated with the loans we hold on balance sheet prior to sale, as well as derivative instruments and Sequoia IO securities we use to manage risks associated with our residential loan pipeline. Our loan sale profit margins are measured over the period from which we identify a loan for purchase and subsequently sell or securitize the loan. Accordingly, these profit margins may encompass positive or negative market valuation adjustments on loans, hedging gains or losses associated with our loan pipeline, and any other related transaction expenses, and may be realized over the course of one or more quarters for financial reporting purposes.
The following table presents the components of mortgage banking activities, net from residential mortgage banking. Amounts presented below represent changes in market value for loans that were sold and associated derivative positions that were paired-out during the periods presented as well as changes in market values of loans, derivatives and Sequoia IOs outstanding as of the end of each year presented.
Table 12 – Components of Residential Mortgage Banking Activities
| Years Ended December 31, | ||||||||||||
| (In Thousands) |
2014 | 2013 | 2012 (1) | |||||||||
| Changes in fair value of: |
||||||||||||
| Residential loans, at fair value |
$ | 51,256 | $ | (10,493 | ) | $ | 37,762 | |||||
| Sequoia securities |
(23,839 | ) | 42,451 | (11,702 | ) | |||||||
| Risk management derivatives |
(23,277 | ) | 47,786 | (10,609 | ) | |||||||
| Purchase and forward sale commitments |
13,891 | (399 | ) | — | ||||||||
| Net gains on loan sales/securitizations |
— | — | 19,713 | |||||||||
| Other (2) |
3,467 | 47 | 274 | |||||||||
|
|
|
|
|
|
|
|||||||
| Total Residential Mortgage banking activities |
$ | 21,498 | $ | 79,392 | $ | 35,438 | ||||||
|
|
|
|
|
|
|
|||||||
| (1) | In 2012, we sold loans classified under lower of cost or market, and beginning in 2013 we elected to use the fair value option for all residential loans. |
| (2) | Amounts in this line item include other fee income and the provision for repurchase expenses, presented net. |
Our income from residential mortgage banking activities can experience volatility between periods resulting from timing differences related to our jumbo mortgage pipeline (defined as those loans we have identified for purchase), and the hedging for those loans. We record changes in the value of hedges associated with our jumbo mortgage pipeline in earnings in the period they occur. However, the corresponding changes in value of the jumbo mortgage loan pipeline outstanding at any quarter-end are not reflected in earnings until the loans are purchased, which is typically in the following quarter. These timing differences are most pronounced when there is interest rate volatility during a period.
Income from residential mortgage banking activities, net, decreased $58 million to $21 million in 2014. The decline in 2014 was attributable to a combination of reduced jumbo loan acquisition volumes, primarily due to lower industry origination volumes resulting from higher mortgage rates during most of 2014, as well as lower loan sale profit margins in 2014. The reduced margins primarily resulted from increased competition, particularly for conforming loans, which have become a larger portion of our overall loan acquisitions during 2014 and have lower margins than our jumbo loans.
Income from residential mortgage banking activities, net, increased $44 million to $79 million in 2013 as compared to 2012. The increase in income year over year was predominately due to higher loan acquisition volume which increased to $7.1 billion in 2013 from $2.3 billion in 2012.
At December 31, 2014, we had repurchase reserves of $3 million outstanding related to residential loans sold through our mortgage banking operations, $1 million of which was recorded in 2014 in mortgage banking activities on our consolidated statements of income. As of December 31, 2014, there had been no loan-level repurchase claims made to Redwood where the entity that originated the associated loan was insolvent. We review our loan repurchase reserves each quarter and will adjust them as necessary based on current information available at each reporting date.
53
The following table details outstanding principal balances and weighted average coupon for our residential loans held-for-sale by product type at December 31, 2014.
Table 13 – Characteristics of Residential Loans Held-for-sale
| December 31, 2014 (Dollars In Thousands) |
Principal Value | Weighted Average Coupon |
||||||
| First Lien Prime |
||||||||
| Fixed - 30 year |
$ | 1,128,035 | 4.15 | % | ||||
| Fixed - 15, 20, & 25 year |
91,932 | 3.46 | % | |||||
| Hybrid |
81,843 | 3.33 | % | |||||
| ARM |
3,683 | 2.95 | % | |||||
|
|
|
|||||||
| Total Outstanding Principal |
$ | 1,305,493 | 4.05 | % | ||||
|
|
|
|||||||
Residential Investments
Our residential investments segment is comprised of our residential securities portfolio, residential mortgage loans held-for-investment and financed through the FHLBC, and our MSR investment portfolio. Sequoia senior securities that are included as a component of senior prime trading securities in our consolidated financial statements are included in our Residential Mortgage Banking segment for reporting purposes. As such, they are excluded from any amounts or tables in this section and such amounts and tables will not agree to amounts presented in our consolidated financial statements for securities.
The following table presents the components of direct segment profit for the residential investments segment for the years ended December 31, 2014, 2013, and 2012.
Table 14 – Residential Investments Segment Contribution
| Years Ended December 31, | ||||||||||||
| (In Thousands) |
2014 | 2013 | 2012 | |||||||||
| Interest income |
$ | 110,433 | $ | 96,399 | $ | 93,266 | ||||||
| Interest expense |
(11,848 | ) | (10,067 | ) | (11,065 | ) | ||||||
|
|
|
|
|
|
|
|||||||
| Net interest income |
98,585 | 86,332 | 82,201 | |||||||||
| Noninterest income |
||||||||||||
| MSR income (loss) |
(4,261 | ) | 20,309 | (1,391 | ) | |||||||
| Other market valuation adjustments |
(9,178 | ) | (5,134 | ) | (5,228 | ) | ||||||
| Realized gains, net |
13,777 | 24,765 | 32,451 | |||||||||
|
|
|
|
|
|
|
|||||||
| Total noninterest income, net |
338 | 39,940 | 25,832 | |||||||||
| Direct operating expenses |
(3,681 | ) | (4,035 | ) | (5,711 | ) | ||||||
| Other income |
181 | — | — | |||||||||
| Benefit from (provision for) income taxes |
1,340 | (3,027 | ) | — | ||||||||
|
|
|
|
|
|
|
|||||||
| Total Segment Contribution |
$ | 96,763 | $ | 119,210 | $ | 102,322 | ||||||
|
|
|
|
|
|
|
|||||||
54
The following table provides real estate securities activity in our residential investments segment for the years ended December 31, 2014 and 2013.
Table 15 – Real Estate Securities Activity
| Years Ended December 31, | ||||||||
| (In Thousands) |
2014 | 2013 | ||||||
| Beginning fair value |
$ | 1,572,356 | $ | 1,098,344 | ||||
| Acquisitions |
246,873 | 789,671 | ||||||
| Sales |
(445,616 | ) | (185,299 | ) | ||||
| Gains on sales and calls, net |
13,917 | 24,765 | ||||||
| Effect of principal payments (1) |
(164,269 | ) | (147,602 | ) | ||||
| Change in fair value, net |
62,167 | (7,523 | ) | |||||
|
|
|
|
|
|||||
| Ending Fair Value |
$ | 1,285,428 | $ | 1,572,356 | ||||
|
|
|
|
|
|||||
| (1) | The effect of principal payments reflects the change in fair value due to principal payments, which is calculated as the cash principal received on a given security during the period multiplied by the prior quarter ending price or acquisition price for that security. |
The following table presents MSR activity in our residential investments segment for the years ended December 31, 2014 and 2013.
Table 16 – MSR Activity
| Years Ended December 31, | ||||||||
| (In Thousands) |
2014 | 2013 | ||||||
| Beginning fair value |
$ | 64,824 | $ | 5,315 | ||||
| Additions |
95,550 | 47,514 | ||||||
| Change in fair value, net |
(21,081 | ) | 11,995 | |||||
|
|
|
|
|
|||||
| Ending Fair Value |
$ | 139,293 | $ | 64,824 | ||||
|
|
|
|
|
|||||
The following table presents activity of our residential loans held-for-investment at fair value for the years ended December 31, 2014 and 2013.
Table 17 – Residential Loans Held-for-Investment at Fair Value Activity
| Years Ended December 31, | ||||||||
| (In Thousands) |
2014 | 2013 | ||||||
| Balance at beginning of period |
$ | — | $ | — | ||||
| Acquisitions |
453 | — | ||||||
| Transfers between portfolios (1) |
596,076 | — | ||||||
| Principal repayments |
(14,151 | ) | — | |||||
| Changes in fair value, net |
(710 | ) | — | |||||
|
|
|
|
|
|||||
| Balance at End of Period |
$ | 581,668 | $ | — | ||||
|
|
|
|
|
|||||
| (1) | During the year ended December 31, 2014, we transferred loans from held-for-sale at fair value at our Residential Mortgage Banking segment to our Residential Investments segment and reclassified them as held-for-investment at fair value. As of December 31, 2014, these loans were held by our FHLB member subsidiary and financed under its FHLBC borrowing agreement. Our current intention is to hold these loans for investment. |
55
Overview
During 2014, assets in our residential investments portfolio increased $366 million to $2.0 billion and included $1.3 billion of residential securities, $582 million of residential loans held-for-investment, and $139 million of MSR investments. During 2014, we acquired $948 million of investments for our residential investments portfolio, including $596 million of loans held-for-investment that were financed by the FHLBC, $247 million of real estate securities, $96 million of MSRs, and invested $10 million in our first risk sharing arrangement with Fannie Mae. These investments were funded in part with short-term debt, long-term debt from the FHLBC, and Redwood equity. Of the investments acquired in 2014, over 75% were created from our residential mortgage banking operations. Over time we expect the majority of our investments will continue to be sourced from our internal operations.
Segment contribution from residential investments declined $23 million to $97 million in 2014, primarily resulting from a decline in non-interest income of $40 million, which was partially offset by a $12 million increase in net interest income and a $4 million positive change in provision for income taxes. Segment contribution from residential investments increased $17 million to $119 million in 2013, as compared to 2012, primarily resulting from an increase in MSR income of $21 million, as these investments benefited from increasing interest rates in the second half of 2013 as well as an increase in net interest income. These changes are discussed in further detail below.
During 2014, declining interest rates had an adverse effect on the valuation of our MSR investments and a positive net effect to changes in the fair value of our fixed rate securities. While the change in value of our MSRs flow through the income statement, the change in value of our securities portfolio flow through other comprehensive income on the balance sheet. We use derivatives to hedge our net exposure in this portfolio from changes in interest rates. For most of 2014, our net exposure was to fixed rate securities, which increased in value during 2014 and resulted in a net decline in value of the derivatives used to hedge this net exposure.
Net Interest Income
Net interest income from Residential Investments includes interest income from our securities portfolio and residential loans held-for-investment as well as the associated interest expense from short-term debt, ABS issued and FHLBC borrowings. Net interest income from our residential investments portfolio increased $12 million to $99 million in 2014, including an $8 million increase from our securities portfolio and a $4 million increase from our portfolio of residential loans held-for-investment.
The increase in net interest income from our Residential Investments securities portfolio was primarily due to higher average balances of securities, which was partially offset by lower yields on the portfolio. Our Residential Investments securities portfolio had an average balance of $1.3 billion and an average yield of 8.0% in 2014 and an average balance of $1.1 billion and an average yield of 9.2% in 2013. The increase in average balances primarily resulted from higher balances of subordinate securities that we retained from Sequoia securitizations we sponsored in 2014 and 2013. The decrease in yield is primarily attributable to the changing composition of our portfolio as higher yielding legacy senior and subordinate securities purchased in past years at deeper discounts pay down and are replaced by new-issue Sequoia and third-party subordinate securities and seasoned third-party senior securities. In addition, during 2014, we financed a greater portion of our securities portfolio with short-term debt as the securities associated with our ABS issued from the Residential Resecuritization continued to pay down. During 2014, the average rate on these short-term borrowings was 1.36% as compared to an average rate of 2.70% on the ABS issued.
During 2014, loans held-for-investment had an average balance of $119 million and an average yield of 3.8% and were financed with borrowings from the FHLBC that had an average balance of $100 million and an average yield of 0.3%. We had no investments in loans held-for-investment in this segment prior to 2014.
MSR Income
MSR Income decreased $24 million to a loss of $4 million in 2014. In 2014, our income from MSRs included $18 million of net cash income and $21 million from decreases in market value. This compared to $8 million of net cash income and $12 million from changes in market value in 2013. The market value changes in 2014 were primarily due to a decline in mortgage interest rates during 2014, particularly in the second half of the year, which resulted in an increase in the expected prepayment speeds of our MSRs and a resulting decrease in fair value.
56
MSR income increased $22 million to income of $21 million in 2013 primarily due to rising mortgage rates in 2013, which reduced expected prepayment speeds on our MSRs during that period and increased their value.
Other market valuation adjustments
Other market valuation adjustments in this segment includes gains and losses from the changes in value of our loans held-for-investment, trading securities, and derivatives used to hedge our exposure in this segment to certain risks related to interest rate movements, as well as impairments on available-for-sale securities.
In 2014, other market valuation adjustments was primarily comprised of $8 million of negative market valuation adjustments on derivatives, $1 million of negative market valuation adjustments combined on trading securities and residential loans held-for-investment, and $1 million of impairments on available-for-sale securities. In 2013, other market valuation adjustments was primarily comprised of $3 million of negative market valuation adjustments on trading securities and $2 million of impairments on available-for-sale securities.
Residential Securities Portfolio
During 2014, our residential securities portfolio declined $287 million to $1.29 billion. During 2014, we sold $446 million of mostly senior securities which were financed in part with short-term debt, for a net gain on sale of $14 million, as we looked to redeploy capital into other investments. The decrease from these sales was partially offset by $247 million of new acquisitions, and a $62 million increase in the fair value of our securities portfolio, primarily resulting from a decrease in market interest rates in the second half of 2014. At December 31, 2014, our residential securities (as a percentage of their current market value) consisted of fixed-rate assets (54%), adjustable-rate assets (21%), hybrid assets that reset within the next year (24%), and hybrid assets that reset between 12 and 36 months (1%).
The following table provides the activity of our real estate securities by collateral type in our residential investments segment for the years ended December 31, 2014 and 2013.
Table 18 – Real Estate Securities Activity by Collateral Type
Year Ended December 31, 2014
| (In Thousands) |
Senior | Re-REMIC (1) | Subordinate | Total | ||||||||||||
| Beginning fair value |
$ | 864,762 | $ | 176,376 | $ | 531,218 | $ | 1,572,356 | ||||||||
| Acquisitions |
||||||||||||||||
| Sequoia securities |
— | — | 78,219 | 78,219 | ||||||||||||
| Third-party securities |
116,260 | 10,200 | 42,194 | 168,654 | ||||||||||||
| Sales |
||||||||||||||||
| Sequoia securities |
(3,074 | ) | — | (54,348 | ) | (57,422 | ) | |||||||||
| Third-party securities |
(354,544 | ) | (25,632 | ) | (8,018 | ) | (388,194 | ) | ||||||||
| Gains (losses) on sales and calls, net |
2,571 | 6,114 | 5,232 | 13,917 | ||||||||||||
| Effect of principal payments (2) |
(145,615 | ) | (66 | ) | (18,588 | ) | (164,269 | ) | ||||||||
| Change in fair value, net |
15,148 | 1,355 | 45,664 | 62,167 | ||||||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Ending Fair Value |
$ | 495,508 | $ | 168,347 | $ | 621,573 | $ | 1,285,428 | ||||||||
|
|
|
|
|
|
|
|
|
|||||||||
57
| Year Ended December 31, 2013 (In Thousands) |
Senior | Re - REMIC (1) | Subordinate | Total | ||||||||||||
| Beginning fair value |
$ | 733,923 | $ | 163,035 | $ | 201,386 | $ | 1,098,344 | ||||||||
| Acquisitions |
||||||||||||||||
| Sequoia securities |
3,403 | — | 297,669 | 301,072 | ||||||||||||
| Third-party securities |
419,522 | — | 69,077 | 488,599 | ||||||||||||
| Sales |
||||||||||||||||
| Sequoia securities |
— | — | — | — | ||||||||||||
| Third-party securities |
(163,986 | ) | — | (21,313 | ) | (185,299 | ) | |||||||||
| Gains (losses) on sales and calls, net |
8,397 | — | 16,368 | 24,765 | ||||||||||||
| Effect of principal payments (2) |
(128,694 | ) | — | (18,908 | ) | (147,602 | ) | |||||||||
| Change in fair value, net |
(7,803 | ) | 13,341 | (13,061 | ) | (7,523 | ) | |||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Ending Fair Value |
$ | 864,762 | $ | 176,376 | $ | 531,218 | $ | 1,572,356 | ||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| (1) | Re-REMIC securities, as presented herein, were created by third parties through the resecuritization of certain senior interests to provide additional credit support to those interests. |
| (2) | The effect of principal payments reflects the change in fair value due to principal payments, which is calculated as the cash principal received on a given security during the period multiplied by the prior quarter ending price or acquisition price for that security. |
The following table presents real estate securities at December 31, 2014, categorized by portfolio vintage (the years the securities were issued), by priority of cash flows (senior, re-REMIC, and subordinate), and by quality of underlying loans (prime and non-prime).
Table 19 – Securities by Vintage and as a Percentage of Total Securities (1)
| Sequoia Securities 2012-2014 |
Third-party Securities | |||||||||||||||||||||||
| December 31, 2014 (Dollars In Thousands) |
2005 & Earlier |
2006 - 2008 |
2012 - 2014 |
Total | % of Total Securities |
|||||||||||||||||||
| Senior |
||||||||||||||||||||||||
| Prime |
$ | — | $ | 243,863 | $ | 63,950 | $ | — | $ | 307,813 | 24 | % | ||||||||||||
| Non-prime |
— | 183,422 | 4,273 | — | 187,695 | 15 | % | |||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
| Total Senior |
— | 427,285 | 68,223 | — | 495,508 | 39 | % | |||||||||||||||||
| Re-REMIC |
— | 59,978 | 108,369 | — | 168,347 | 13 | % | |||||||||||||||||
| Subordinate |
||||||||||||||||||||||||
| Prime Mezzanine (2) |
371,706 | — | — | 77,132 | 448,838 | 35 | % | |||||||||||||||||
| Subordinate (3) |
89,284 | 54,225 | 1,157 | 28,069 | 172,735 | 13 | % | |||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
| Total Subordinate |
460,990 | 54,225 | 1,157 | 105,201 | 621,573 | 48 | % | |||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
| Total Securities |
$ | 460,990 | $ | 541,488 | $ | 177,749 | $ | 105,201 | $ | 1,285,428 | 100 | % | ||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
| Sequoia Securities 2012-2014 |
Third-party Securities | |||||||||||||||||||||||
| December 31, 2014 (Dollars In Thousands) |
2005 & Earlier |
2006 - 2008 |
2012 - 2014 |
Total | % of Total Securities |
|||||||||||||||||||
| Residential |
||||||||||||||||||||||||
| Senior |
||||||||||||||||||||||||
| Prime |
$ | 2,911 | $ | 446,223 | $ | 213,172 | $ | — | $ | 662,306 | 42 | % | ||||||||||||
| Non-prime |
— | 197,384 | 5,072 | — | 202,456 | 13 | % | |||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
| Total Senior |
2,911 | 643,607 | 218,244 | — | 864,762 | 55 | % | |||||||||||||||||
| Re-REMIC |
— | 73,606 | 102,770 | — | 176,376 | 11 | % | |||||||||||||||||
| Subordinate |
||||||||||||||||||||||||
| Prime Mezzanine (2) |
334,980 | — | — | 49,869 | 384,849 | 24 | % | |||||||||||||||||
| Subordinate (3) |
67,523 | 60,094 | 1,718 | 17,034 | 146,369 | 9 | % | |||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
| Total Subordinate |
402,503 | 60,094 | 1,718 | 66,903 | 531,218 | 34 | % | |||||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
| Total Securities |
$ | 405,414 | $ | 777,307 | $ | 322,732 | $ | 66,903 | $ | 1,572,356 | 100 | % | ||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|||||||||||||
| (1) | The securities and interests that we acquired from the Residential Resecuritization entity (which are eliminated for consolidation purposes) were $168 million at December 31, 2014. As a result, to adjust at December 31, 2014, for the legal and economic interests that resulted from the Residential Resecuritization, total residential senior securities would be decreased by $222 million to $274 million, total re-REMIC residential securities would be increased by $168 million to $336 million, and total residential securities would be reduced by $54 million to $1.23 billion. |
58
| (2) | Mezzanine includes securities initially rated AA, A, and BBB- and issued in 2012 or later. |
| (3) | Subordinate securities included less than $1 million of non-prime securities at both December 31, 2014 and 2013. |
The following tables present the components of the interest income we earned on AFS securities for the years ended December 31, 2014 and 2013.
Table 20 – Interest Income — AFS Securities
| Year Ended December 31, 2014 | Yield as a Result of | |||||||||||||||||||||||||||
| (Dollars in Thousands) |
Interest Income |
Discount (Premium) Amortization |
Total Interest Income |
Average Amortized Cost |
Interest Income |
Discount (Premium) Amortization |
Total Interest Income |
|||||||||||||||||||||
| Residential |
||||||||||||||||||||||||||||
| Senior |
$ | 22,894 | $ | 25,554 | $ | 48,448 | $ | 676,399 | 3.4 | % | 3.8 | % | 7.2 | % | ||||||||||||||
| Re-REMIC |
10,481 | 6,246 | 16,727 | 111,590 | 9.4 | % | 5.6 | % | 15.0 | % | ||||||||||||||||||
| Subordinate |
||||||||||||||||||||||||||||
| Mezzanine (1) |
16,976 | 3,876 | 20,852 | 411,119 | 4.1 | % | 0.9 | % | 5.1 | % | ||||||||||||||||||
| Subordinate |
9,412 | 7,159 | 16,571 | 109,265 | 8.6 | % | 6.6 | % | 15.2 | % | ||||||||||||||||||
|
|
|
|
|
|
|
|
|
|||||||||||||||||||||
| Total AFS Securities |
$ | 59,763 | $ | 42,835 | $ | 102,598 | $ | 1,308,373 | 4.6 | % | 3.3 | % | 7.8 | % | ||||||||||||||
|
|
|
|
|
|
|
|
|
|||||||||||||||||||||
| Year Ended December 31, 2013 | Yield as a Result of | |||||||||||||||||||||||||||
| (Dollars in Thousands) |
Interest Income |
Discount (Premium) Amortization |
Total Interest Income |
Average Amortized Cost |
Interest Income |
Discount (Premium) Amortization |
Total Interest Income |
|||||||||||||||||||||
| Residential |
||||||||||||||||||||||||||||
| Senior |
$ | 23,892 | $ | 20,887 | $ | 44,779 | $ | 566,620 | 4.2 | % | 3.7 | % | 7.9 | % | ||||||||||||||
| Re-REMIC |
10,938 | 4,110 | 15,048 | 101,319 | 10.8 | % | 4.1 | % | 14.9 | % | ||||||||||||||||||
| Subordinate |
||||||||||||||||||||||||||||
| Mezzanine (1) |
11,403 | 2,457 | 13,860 | 276,810 | 4.1 | % | 0.9 | % | 5.0 | % | ||||||||||||||||||
| Subordinate |
9,758 | 7,464 | 17,222 | 91,232 | 10.7 | % | 8.2 | % | 18.9 | % | ||||||||||||||||||
|
|
|
|
|
|
|
|
|
|||||||||||||||||||||
| Total AFS Securities |
$ | 55,991 | $ | 34,918 | $ | 90,909 | $ | 1,035,981 | 5.4 | % | 3.4 | % | 8.8 | % | ||||||||||||||
|
|
|
|
|
|
|
|
|
|||||||||||||||||||||
| (1) | Mezzanine includes securities initially rated AA, A, and BBB- and issued in 2012 or later. |
59
The following tables present the components of carrying value at December 31, 2014 and 2013 for our AFS residential securities.
Table 21 – Carrying Value of AFS Residential Securities
| December 31, 2014 (In Thousands) |
Senior | Re-REMIC | Subordinate | Total | ||||||||||||
| Principal balance |
$ | 507,831 | $ | 195,098 | $ | 742,150 | $ | 1,445,079 | ||||||||
| Credit reserve |
(13,304 | ) | (15,202 | ) | (41,561 | ) | (70,067 | ) | ||||||||
| Unamortized discount, net |
(66,273 | ) | (79,611 | ) | (150,458 | ) | (296,342 | ) | ||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Amortized cost |
428,254 | 100,285 | 550,131 | 1,078,670 | ||||||||||||
| Gross unrealized gains |
60,662 | 68,062 | 63,026 | 191,750 | ||||||||||||
| Gross unrealized losses |
(1,359 | ) | — | (1,437 | ) | (2,796 | ) | |||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Carrying Value |
$ | 487,557 | $ | 168,347 | $ | 611,720 | $ | 1,267,624 | ||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| December 31, 2013 (In Thousands) |
Senior | Re-REMIC | Subordinate | Total | ||||||||||||
| Principal balance |
$ | 888,654 | $ | 214,046 | $ | 706,292 | $ | 1,808,992 | ||||||||
| Credit reserve |
(23,984 | ) | (30,429 | ) | (62,457 | ) | (116,870 | ) | ||||||||
| Unamortized discount, net |
(81,015 | ) | (80,188 | ) | (137,266 | ) | (298,469 | ) | ||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Amortized cost |
783,655 | 103,429 | 506,569 | 1,393,653 | ||||||||||||
| Gross unrealized gains |
73,634 | 72,947 | 41,205 | 187,786 | ||||||||||||
| Gross unrealized losses |
(1,597 | ) | — | (21,536 | ) | (23,133 | ) | |||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Carrying Value |
$ | 855,692 | $ | 176,376 | $ | 526,238 | $ | 1,558,306 | ||||||||
|
|
|
|
|
|
|
|
|
|||||||||
At December 31, 2014, credit reserves for our securities portfolio totaled $70 million, or 4.9% of the principal balance of our residential securities, down from $117 million, or 6.5%, at December 31, 2013. The decrease in the balance of the credit reserve primarily resulted from the transfer of $37 million of credit reserves to accretable unamortized discount in 2014, based on sustained improvements in the credit performance of loans underlying our securities that reduced our estimate of future losses on these loans. The decrease as a percentage was also impacted by the sales and repayments of older vintage securities with larger credit reserves and the acquisition of newer vintage securities with minimal credit reserves. The increase in accretable unamortized discount will be recognized into income prospectively over the remaining life of the associated loans. During the year ended December 31, 2014, realized credit losses on our residential securities totaled $12 million. Volatility in income recognition for these securities is generally due to changes in prepayment rates and, to varying degrees, credit performance and interest rates.
Senior Securities
The fair value of our senior AFS securities was equal to 96% of their principal balance at December 31, 2014, while our amortized cost was equal to 84% of the principal balance. The fair value of our senior securities accounted for as trading securities in this segment was $8 million. We expect future losses will extinguish a portion of the outstanding principal of these securities, as reflected by the $13 million of credit reserves we have provided for on the $508 million principal balance of those securities.
Re-REMIC Securities
Our re-REMIC portfolio consists primarily of prime residential senior securities that were pooled and re-securitized in 2009 and 2010 by third parties to create two-tranche structures. We own support (or subordinate) securities within those structures. The fair value of our re-REMIC AFS securities was equal to 86% of the principal balance of the portfolio at December 31, 2014, while our amortized cost was equal to 51% of the principal balance. Credit losses totaled $2 million in our re-REMIC portfolio during 2014, as compared to $2 million of losses during 2013. We expect future losses will extinguish a portion of the outstanding principal of these securities, as reflected by the $15 million of credit reserves we have provided for on the $195 million principal balance of those securities.
Subordinate Securities
The fair value of our subordinate AFS securities was equal to 82% of the principal balance at December 31, 2014, while our amortized cost was equal to 74% of the principal balance. Credit losses totaled $8 million in our residential subordinate portfolio during 2014, as compared to $19 million of losses during 2013. We expect future losses will extinguish a portion of the outstanding principal of these securities, as reflected by the $42 million of credit reserves we have provided for on the $742 million principal balance of those securities.
Mortgage Servicing Rights Investments
The residential investments segment includes our investments in mortgage servicing rights. Our MSRs are held and managed at our taxable REIT subsidiary and typically are acquired together with loans from originators and then separately recognized under GAAP when the MSR is retained and the associated loan is sold to a third party or transferred to a Sequoia residential securitization sponsored by us that meets the GAAP criteria for sale. In addition, we also purchase MSRs on a flow basis from third-parties that sell the associated loans directly to the agencies and we may also purchase portfolios of MSRs on a bulk basis. Although we own the rights to service loans, we employ sub-servicers to perform these activities. Our receipt of MSR income is not subject to any covenants other than customary performance obligations associated with servicing residential loans. For loans that we have transferred into securitizations while maintaining the associated servicing rights, the sub-servicers we contract with to perform servicing activities
60
may be terminated if they fail to perform under the applicable contractual terms. If a sub-servicer is terminated for a breach of contract, a new sub-servicer would need to be approved by the Master Servicer and assume the servicing responsibilities in accordance with the applicable pooling and servicing agreement. If a sub-servicer we contract with was to default, we would evaluate our MSR asset for impairment at that time.
The following table presents characteristics of the loans associated with our MSR investments at December 31, 2014.
Table 22 – Characteristics of MSR Investments
| December 31, 2014 | ||||||||||||
| Jumbo | Conforming | Total | ||||||||||
| Unpaid principal balance (in thousands) |
$ | 5,962,784 | $ | 7,705,146 | $ | 13,667,930 | ||||||
| Number of loans |
8,173 | 30,017 | 38,190 | |||||||||
| Average coupon |
3.99 | % | 3.93 | % | 3.96 | % | ||||||
| Average loan age (months) |
21 | 14 | 17 | |||||||||
| Average loan size (in thousands) |
$ | 808 | $ | 313 | $ | 529 | ||||||
| Average original loan-to-value |
67 | % | 72 | % | 70 | % | ||||||
| Average original FICO |
771 | 760 | 765 | |||||||||
| 60+ day delinquencies |
0.03 | % | 0.04 | % | 0.03 | % | ||||||
61
The following tables provide the activity for MSRs by portfolio for the years ended December 31, 2014 and 2013.
Table 23 – MSR Activity by Portfolio
| Year Ended December 31, 2014 (In Thousands) |
Jumbo | Conforming | Total MSRs | |||||||||
| Balance at beginning of period |
$ | 61,493 | $ | 3,331 | $ | 64,824 | ||||||
| MSRs retained from Sequoia securitizations |
8,518 | — | 8,518 | |||||||||
| MSRs retained from third-party loan sales |
488 | 38,995 | 39,483 | |||||||||
| Purchased MSRs |
— | 47,549 | 47,549 | |||||||||
| Market valuation adjustments due to: |
||||||||||||
| Changes in assumptions |
(5,379 | ) | (7,088 | ) | (12,467 | ) | ||||||
| Other changes (1) |
(7,128 | ) | (1,486 | ) | (8,614 | ) | ||||||
|
|
|
|
|
|
|
|||||||
| Balance at End of Period |
$ | 57,992 | $ | 81,301 | $ | 139,293 | ||||||
|
|
|
|
|
|
|
|||||||
| Loans associated with MSRs (2) |
5,962,784 | 7,705,146 | 13,667,930 | |||||||||
| MSR values as percent of loans (3) |
0.97 | % | 1.06 | % | 1.02 | % | ||||||
| Year Ended December 31, 2013 (In Thousands) |
Jumbo | Conforming | Total MSRs | |||||||||
| Balance at beginning of period |
$ | 5,315 | $ | — | $ | 5,315 | ||||||
| MSRs retained from Sequoia securitizations |
42,921 | — | 42,921 | |||||||||
| MSRs retained from third-party loan sales |
1,090 | 52 | 1,142 | |||||||||
| Purchased MSRs |
— | 3,451 | 3,451 | |||||||||
| Market valuation adjustments due to: |
||||||||||||
| Changes in assumptions |
15,853 | (134 | ) | 15,719 | ||||||||
| Other changes (1) |
(3,686 | ) | (38 | ) | (3,724 | ) | ||||||
|
|
|
|
|
|
|
|||||||
| Balance at End of Period |
$ | 61,493 | $ | 3,331 | $ | 64,824 | ||||||
|
|
|
|
|
|
|
|||||||
| Loans associated with MSRs (2) |
5,483,500 | 308,258 | 5,791,758 | |||||||||
| MSR values as percent of loans (3) |
1.12 | % | 1.08 | % | 1.12 | % | ||||||
| (1) | Represents changes due to realization of expected cash flows. |
| (2) | Amounts represent the principal balance of loans associated with MSRs outstanding at December 31, 2014. |
| (3) | Amounts represent the carrying value of MSRs at December 31, 2014 divided by the outstanding balance of the loans associated with these MSRs. |
Our portfolio of MSR investments grew significantly in 2014 as we retained MSRs from a growing volume of conforming loans we sold to the Agencies. During 2014, our conforming loan originations increased to $4.0 billion from $17 million in 2013. In addition, during 2014, we made an opportunistic bulk acquisition of conforming MSRs that grew our portfolio significantly. We expect that the majority of our future growth in this portfolio will result from MSRs retained from conforming loans we acquire and sell to the Agencies, supplemented by MSRs we purchase on a flow basis from third-parties that sell loans directly to the agencies.
62
The following table presents the components of MSR income for the years ended December 31, 2014 and 2013.
Table 24 – MSR Income
| Years Ended December 31, | ||||||||||||
| (In Thousands) |
2014 | 2013 | 2012 | |||||||||
| Servicing income |
$ | 19,362 | $ | 9,239 | $ | 807 | ||||||
| Cost of sub-servicer |
(1,834 | ) | (925 | ) | (184 | ) | ||||||
|
|
|
|
|
|
|
|||||||
| Net servicing income |
17,528 | 8,314 | 623 | |||||||||
| Market valuation adjustments |
(21,081 | ) | 11,995 | (2,014 | ) | |||||||
| Provision for repurchases |
(708 | ) | — | — | ||||||||
|
|
|
|
|
|
|
|||||||
| Income from MSRs, Net |
$ | (4,261 | ) | $ | 20,309 | $ | (1,391 | ) | ||||
|
|
|
|
|
|
|
|||||||
The $9 million increase in net servicing income resulted from the higher average balances of loans associated with MSRs owned in 2014, as the notional value of loans associated with our MSRs increased to $13.7 billion at December 31, 2014 from $5.8 billion at December 31, 2013. The negative market valuation adjustments in 2014 were primarily due to a decrease in mortgage interest rates during 2014, which resulted in an increase to the expected prepayment speeds of the loans associated with our MSRs and a decrease in their fair value. Mortgage rates declined throughout the second half of 2014, hitting an 18-month low in December. This compares with increasing interest rates during most of 2013, which benefited the valuation of our MSR portfolio during that year.
Commercial Mortgage Banking and Investments
The following table presents the components of segment contribution for the commercial mortgage banking and investments segment for the years ended December 31, 2014, 2013, and 2012.
Table 25 – Commercial Mortgage Banking and Investments Segment Contribution
| Years Ended December 31, | ||||||||||||
| (In Thousands) |
2014 | 2013 | 2012 | |||||||||
| Interest income |
$ | 47,567 | $ | 43,420 | $ | 26,048 | ||||||
| Interest expense |
(15,836 | ) | (12,677 | ) | (1,123 | ) | ||||||
|
|
|
|
|
|
|
|||||||
| Net interest income |
31,731 | 30,743 | 24,925 | |||||||||
| Provision for loan losses |
(84 | ) | (3,288 | ) | (3,477 | ) | ||||||
| Mortgage banking activities |
13,440 | 23,101 | 1,155 | |||||||||
| Realized gains, net |
— | 210 | — | |||||||||
| Direct operating expenses |
(11,324 | ) | (9,579 | ) | (11,085 | ) | ||||||
| Provision for income taxes |
(234 | ) | (3,827 | ) | (13 | ) | ||||||
|
|
|
|
|
|
|
|||||||
| Total Segment Contribution |
$ | 33,529 | $ | 37,360 | $ | 11,505 | ||||||
|
|
|
|
|
|
|
|||||||
63
The following table provides the activity of commercial loans during the years ended December 31, 2014 and 2013.
Table 26 – Commercial Loans — Activity
| Year Ended December 31, 2014 | Year Ended December 31, 2013 | |||||||||||||||
| (In Thousands) |
Held-for-Sale (1) | Held-for- Investment |
Held-for-Sale (1) | Held-for- Investment |
||||||||||||
| Balance at beginning of period |
$ | 89,111 | $ | 343,344 | $ | 8,500 | $ | 304,510 | ||||||||
| Originations/acquisitions |
903,500 | 87,001 | 658,569 | 65,771 | ||||||||||||
| Sales |
(807,809 | ) | — | (586,308 | ) | (230 | ) | |||||||||
| Transfers between portfolios (2) |
(37,631 | ) | 37,631 | — | — | |||||||||||
| Principal repayments |
(584 | ) | (71,045 | ) | (336 | ) | (24,083 | ) | ||||||||
| Discount amortization |
— | 671 | — | 665 | ||||||||||||
| Provision for loan losses |
— | (84 | ) | — | (3,289 | ) | ||||||||||
| Changes in fair value, net |
19,647 | 3,175 | 8,686 | — | ||||||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| Balance at End of Period |
$ | 166,234 | $ | 400,693 | $ | 89,111 | $ | 343,344 | ||||||||
|
|
|
|
|
|
|
|
|
|||||||||
| (1) | Beginning in the second quarter of 2013 and through the current period, we elected the fair value option for all of senior commercial loans we originated and we anticipate electing the fair value option for all future senior commercial loans that we originate and intend to sell to third parties. |
| (2) | During 2014, we sold three senior A-note commercial mortgages to third parties that did not qualify as sales under GAAP, and were not derecognized from our balance sheet. These loans and the associated B-note mortgage loans we retained were transferred from held-for-sale to held-for-investment classification and are carried at fair value on our consolidated balance sheets. |
64
Overview
We experienced strong growth in loan originations in 2014, as we continued to grow our commercial platform. During 2014, we originated $1.0 billion of commercial loans, including $904 million of senior mortgage loans and $87 million of subordinate loans. This compares to $725 million of loan originations in 2013, including $659 million of senior mortgage loans and $66 million of subordinate loans.
Segment contribution from commercial mortgage banking and investments decreased $4 million to $34 million in 2014, primarily resulting from a decline in income from mortgage banking activities as we saw profit margins decline during the year as well as from higher operating expenses as we added personnel. These decreases were partially offset by an increase in net interest income from higher average loan balances, a decline in provisions for loan losses resulting from loans held-for-investment that prepaid with no associated credit issues, and a decrease in provisions for income taxes. Within this segment, commercial mortgage banking activities are performed in taxable subsidiaries, whereas our commercial investments are held at the REIT. As such, lower income from mortgage banking activities resulted in a lower provision for income tax in 2014.
Segment contribution from commercial mortgage banking and investments increased $26 million to $37 million in 2013, as compared to 2012, primarily resulting from a $22 million increase in income from mortgage banking activities and a $6 million increase in net interest income, as we expanded our commercial platform and increased our senior loan originations to $659 million in 2013, from $24 million in 2012.
Net Interest Income
Net interest income from our commercial mortgage banking and investments segment is generated from senior loans we originate and hold for sale to third-party CMBS aggregators, and our portfolio of commercial investments, which is comprised of mezzanine and other subordinate commercial loans.
Net interest income from this segment increased $1 million to $32 million in 2014, primarily due to a $2 million increase in net interest income from a higher average balance of senior loans held-for-sale during 2014. This increase was partially offset by a $1 million decrease in net interest income from our commercial investment portfolio as the average balance of loans and the average yield of the portfolio both decreased slightly. Interest income from commercial loans held-for-investment included $2 million in 2014 and $3 million in 2013, related to prepayment penalties for loans that prepaid.
Mortgage Banking Activities
Commercial income from mortgage banking activities includes the changes in fair value of commercial loans held-for-sale and the derivatives used to hedge these loans while they are being accumulated for sale to the CMBS market. The following table presents the components of commercial mortgage banking activities for the years ended December 31, 2014, 2013, and 2012.
Table 27 – Components of Commercial Mortgage Banking Activities (1)
| Years Ended December 31, | ||||||||||||
| (In Thousands) |
2014 | 2013 | 2012 | |||||||||
| Changes in fair value of: |
||||||||||||
| Commercial loans, at fair value |
$ | 20,789 | $ | 8,694 | $ | — | ||||||
| Risk management derivatives |
(7,890 | ) | 3,376 | — | ||||||||
| Other fees |
541 | 1 | — | |||||||||
| Net gains on commercial loan sales and originations |
— | 11,031 | 1,155 | |||||||||
|
|
|
|
|
|
|
|||||||
| Total Mortgage banking activities |
$ | 13,440 | $ | 23,102 | $ | 1,155 | ||||||
|
|
|
|
|
|
|
|||||||
| (1) | We elected the fair value option for all held-for-sale commercial senior loans originated subsequent to March 31, 2013. Amounts reported as net gains on loan sales for 2013 and 2012 relate to the sale of loans held at the lower of cost or fair value that were purchased or originated prior to the dates we began to elect the fair value option for these loans and represent the net benefit of the gross proceeds from the sale of the loans, less the carrying value of the loans and any related issuance costs. |
Commercial mortgage banking activities decreased $10 million to $13 million in 2014, primarily due to lower loan sale profit margins, resulting from increased competition for loan originations in 2014. The decline in margins was partially offset by higher senior loan originations, which increased to $903 million in 2014 from $659 million in 2013.
65
Commercial Investments
Our commercial investments portfolio is comprised of mezzanine and other subordinate loans that we originated and hold for investment. The carrying value of our held-for-investment commercial loans increased to $401 million at December 31, 2014, from $343 million at December 31, 2013. However, excluding $67 million of senior A-notes that we have classified as held-for-investment, the carrying value of loans in this portfolio decreased to $334 million. Although we sold the A-notes, they did not meet criteria for sale treatment under GAAP and we recorded the transfer of the loans as a secured borrowing.
During 2014, we originated 16 loans for $57 million, as compared to 19 loans for $66 million in 2013. In addition, during 2014, we received repayments of $71 million. At December 31, 2014, this portfolio included 40 non-securitized loans with a carrying value of $139 million and 23 loans with a carrying value of $195 million that are included in our Commercial Securitization with $83 million of associated ABS long-term debt. At December 31, 2014, we had borrowings of $50 million under a short-term debt facility secured by loans with an unpaid principal balance of $80 million pledged as collateral.
The following table presents the characteristics of our commercial loans held-for-investment at December 31, 2014.
Table 28 – Characteristics of Commercial Loans Investments
| December 31, 2014 (Dollars In Thousands) |
Number of Loans |
Average Loan Size |
Principal Balance |
Percent of Total Principal |
Weighted Average DSCR (1) |
Weighted Average LTV (2) |
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| Multi-family |
27 | $ | 3,907 | $ | 105,476 | 30 | % | 1.33 | 78 | % | ||||||||||||||
| Hospitality |
11 | 7,551 | 83,064 | 24 | % | 1.42 | 63 | % | ||||||||||||||||
| Office |
11 | 7,186 | 79,044 | 23 | % | 1.22 | 76 | % | ||||||||||||||||
| Retail |
8 | 6,721 | 53,769 | 16 | % | 1.17 | 76 | % | ||||||||||||||||
| Self storage |
3 | 6,333 | 19,000 | 5 | % | 1.39 | 75 | % | ||||||||||||||||
| Industrial |
3 | 1,984 | 5,952 | 2 | % | 1.41 | 73 | % | ||||||||||||||||
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| Total |
63 | $ | 5,497 | $ | 346,305 | 100 | % | 1.31 | 74 | % | ||||||||||||||
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| (1) | The debt service coverage ratio (“DSCR”) is defined as the property’s annual net operating income divided by the annual principal and interest payments. The weighted average DSCRs in this table are based on the ratios at the time the loans were originated and are not based on subsequent time periods during which there may have been increases or decreases in each property’s operating income. |
| (2) | The loan-to-value (“LTV”) calculation is defined as the sum of the senior and all subordinate loan amounts divided by the value of the property at the time the loan was originated. |
On average, our commercial held-for-investment loans have a maturity of more than four years, an unlevered yield of approximately 10% per annum before credit costs.
At December 31, 2014, we had an allowance for loan losses of $7 million, which represented 2.2% of the carrying value of our commercial loans held-for-investment at amortized cost. During 2014, we did not have any charge-offs and recorded less than $1 million of net provisions for loan losses related to our commercial investments portfolio, as provisions added in 2014 were almost entirely offset by reductions to our allowance from loans that repaid during 2014.
At December 31, 2014, we had no loans designated as impaired and had one loan with a carrying value of $25 million on our watch-list. At December 31, 2014, the loan on our watch-list was current on all payments and we continue to believe we will receive all amounts due according to the contractual terms of the loan. However, in our judgment, certain conditions warrant specific attention going forward. Improvements in these conditions would result in the asset being upgraded back to pass status and deterioration could warrant further downgrades and potential evaluation for impairment.
Results of Legacy Consolidated Entities
Throughout our history we have sponsored or managed investment entities, primarily Sequoia and Acacia securitization entities. Many of these entities are currently, or have been historically, recorded on our consolidated balance sheets for financial reporting purposes in accordance with GAAP. However, each of these entities is independent of Redwood and of each other and the assets and liabilities of these entities are not, respectively, owned by us or legal obligations of ours, although we are exposed to certain financial risks associated with our role as the sponsor or manager of these entities and, to the extent we hold securities issued by, or other investments in, these entities, we are exposed to the performance of these entities and the assets they hold. Collectively, we refer to these consolidated Sequoia and Acacia entities completed prior to 2012 as Legacy Consolidated Entities.
66
The estimated carrying value of our investments in the Legacy Consolidated Entities was $64 million, or 5% of our equity capital, at December 31, 2014. The carrying value reflects the estimated book value of our retained investments in these entities based on the difference between the consolidated assets and liabilities of the entities in the aggregate according to their GAAP carrying amounts. In 2014, cash flow generated by our investments in these entities totaled $15 million.
To show the impact of the Legacy Consolidated Entities to our consolidated financial results, we have included the following tables that present our consolidated GAAP income statements and balance sheets split between Legacy Consolidated Entities and the remainder of our operations, which we refer to as results “at Redwood.” Results at Redwood include all activities from our three business segments.
Table 29 – Consolidating Income Statement (1)
| At Redwood | Legacy Consolidated Entities | Redwood Consolidated | ||||||||||||||||||||||||||||||||||
| (In Millions) |
2014 | 2013 | 2012 | 2014 | 2013 | 2012 | 2014 | 2013 | 2012 | |||||||||||||||||||||||||||
| Interest income |
$ | 216 | $ | 192 | $ | 139 | $ | 26 | $ | 34 | $ | 92 | $ | 242 | $ | 226 | $ | 231 | ||||||||||||||||||
| Interest expense |
(67 | ) | (55 | ) | (25 | ) | (21 | ) | (26 | ) | (96 | ) | (87 | ) | (81 | ) | (121 | ) | ||||||||||||||||||
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| Net interest income (loss) |
150 | 137 | 114 | 5 | 8 | (4 | ) | 155 | 145 | 111 | ||||||||||||||||||||||||||
| Provision for loan losses |
— | (3 | ) | (3 | ) | (1 | ) | (1 | ) | — | (1 | ) | (5 | ) | (4 | ) | ||||||||||||||||||||
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| Net interest income (loss) after provision |
150 | 134 | 111 | 4 | 6 | (4 | ) | 154 | 140 | 106 | ||||||||||||||||||||||||||
| Noninterest income |
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| Mortgage banking activities |
35 | 102 | 37 | — | — | — | 35 | 102 | 37 | |||||||||||||||||||||||||||
| MSR income (loss) |
(4 | ) | 20 | (1 | ) | — | — | — | (4 | ) | 20 | (1 | ) | |||||||||||||||||||||||
| Other market valuation adjustments |
(9 | ) | (5 | ) | (5 | ) | (1 | ) | (1 | ) | 6 | (10 | ) | (6 | ) | 2 | ||||||||||||||||||||
| Realized gains, net |
14 | 25 | 32 | 2 | — | 22 | 15 | 25 | 55 | |||||||||||||||||||||||||||
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| Total noninterest income, net |
35 | 142 | 63 | 1 | — | 29 | 36 | 142 | 92 | |||||||||||||||||||||||||||
| Operating expenses |
(90 | ) | (87 | ) | (66 | ) | — | — | — | (90 | ) | (87 | ) | (66 | ) | |||||||||||||||||||||
| Other income (expense) |
2 | (12 | ) | — | — | 2 | (12 | ) | — | |||||||||||||||||||||||||||
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| Net income before provision for taxes |
97 | 178 | 108 | 5 | 6 | 25 | 102 | 184 | 132 | |||||||||||||||||||||||||||
| Provision for income taxes |
(1 | ) | (11 | ) | (1 | ) | — | — | — | (1 | ) | (11 | ) | (1 | ) | |||||||||||||||||||||
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| Net Income (Loss) |
$ | 96 | $ | 167 | $ | 107 | $ | 5 | $ | 6 | $ | 25 | $ | 101 | $ | 173 | $ | 132 | ||||||||||||||||||
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| (1) | Certain totals may not foot, due to rounding. |
Table 30 – Consolidating Balance Sheet (1) (2)
| At Redwood(3) | Legacy Consolidated Entities |
Redwood Consolidated | ||||||||||||||||||||||
| (In Millions) |
2014 | 2013 | 2014 | 2013 | 2014 | 2013 | ||||||||||||||||||
| Residential loans |
$ | 1,924 | $ | 404 | $ | 1,474 | $ | 1,762 | $ | 3,399 | $ | 2,166 | ||||||||||||
| Commercial loans |
567 | 432 | — | — | 567 | 432 | ||||||||||||||||||
| Real estate securities |
1,379 | 1,683 | — | — | 1,379 | 1,683 | ||||||||||||||||||
| MSRs |
139 | 65 | — | — | 139 | 65 | ||||||||||||||||||
| Cash and cash equivalents |
270 | 173 | — | — | 270 | 173 | ||||||||||||||||||
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| Total earning assets |
4,279 | 2,758 | 1,474 | 1,762 | 5,754 | 4,520 | ||||||||||||||||||
| Other assets |
158 | 81 | 8 | 8 | 165 | 89 | ||||||||||||||||||
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| Total Assets |
$ | 4,437 | $ | 2,838 | $ | 1,482 | $ | 1,770 | $ | 5,919 | $ | 4,609 | ||||||||||||
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| Short-term debt |
$ | 1,794 | $ | 863 | $ | — | $ | — | $ | 1,794 | $ | 863 | ||||||||||||
| Other liabilities |
128 | 79 | 1 | 1 | 129 | 81 | ||||||||||||||||||
| Asset-backed securities issued |
128 | 249 | 1,417 | 1,694 | 1,545 | 1,943 | ||||||||||||||||||
| Long-term debt |
1,195 | 476 | — | — | 1,195 | 476 | ||||||||||||||||||
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| Total liabilities |
3,245 | 1,667 | 1,418 | 1,696 | 4,663 | 3,363 | ||||||||||||||||||
| Stockholders’ equity |
1,192 | 1,171 | 64 | 75 | 1,256 | 1,246 | ||||||||||||||||||
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| Total Liabilities and Equity |
$ | 4,437 | $ | 2,838 | $ | 1,482 | $ | 1,770 | $ | 5,919 | $ | 4,609 | ||||||||||||
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| (1) | Certain totals may not foot, due to rounding. |
67
| (2) | We are required under GAAP to consolidate the assets and liabilities of certain securitization entities we have sponsored for financial reporting purposes. However, the securitized assets of these entities are not legally ours and we own only the securities and interests that we acquired from these securitization entities. Similarly, the liabilities of these entities are obligations payable only from the cash flow generated by their securitized assets and are not obligations of Redwood. |
| (3) | Included in the “At Redwood” column are the assets and liabilities of the Residential Resecuritization and Commercial Securitization transactions we completed in 2011 and 2012, respectively. These transactions are treated as secured borrowings under GAAP. At December 31, 2014, the Residential Resecuritization accounted for $222 million of assets ($222 million of available-for-sale securities and less than $1 million of other assets) and $45 million of asset-backed securities issued. Our $177 million investment in this resecuritization, as estimated for GAAP, equals the difference between these assets and liabilities. At December 31, 2014, the Commercial Securitization accounted for $198 million of assets ($195 million of commercial loans at historical cost and $3 million of other assets) and $83 million of asset-backed securities issued (at amortized cost). Our $115 million investment in this securitization, as estimated for GAAP, equals the difference between these assets and liabilities. |
Net Interest Income at Legacy Consolidated Entities
In 2014, net interest income at Legacy Consolidated Entities decreased $3 million to $5 million, primarily resulting from continued paydowns of assets at these entities. In 2013, net interest income at Legacy Consolidated Entities increased $11 million to $8 million, primarily resulting from activities related to certain entities that were deconsolidated in 2012. In the fourth quarter of 2012, we sold our economic interests in and subsequently deconsolidated all of our Acacia entities and 15 legacy Sequoia entities. As part of the deconsolidation of our Acacia entities we accelerated certain hedging expenses and recorded a one-time charge of $11 million to net interest income. In addition, in 2012 net interest income at the Acacia entities cumulatively declined by $15 million due to a decline in interest income on the collateral supporting the Acacia entities’ liabilities.
Net interest income at consolidated entities will vary from period to period and depend primarily on changes in the levels of delinquencies and loss severities for loans held-for-investment, and changes in the rates of principal repayments or the investments held at these entities. As the loans and associated liabilities pay down, net interest income will decline over time.
Loan Loss Provision at Consolidated Sequoia Entities
Each quarter we utilize a loan loss reserving methodology that has been established to provide management with a reasonable and adequate estimate of loan loss reserving needs. This methodology is disclosed in Note 3 and Note 6 to the financial statements included in Part II, Item 8 of this Annual Report on Form 10-K.
The provision for loan losses at legacy consolidated Sequoia entities was $1 million in both 2014 and 2013 and less than $1 million in 2012. The decrease in the provision from 2013 to 2014 was primarily attributable to a decrease in observed loss severities driven by an improving economy and continued housing price increases in 2014. Additionally, serious delinquencies (loans 90+ days delinquent) decreased to $70 million at the end of 2014 from $79 million at the end of 2013 as a result of efforts employed by new servicers to move loans through the loss mitigation process more quickly than had been observed in the past. Loss mitigation efforts resulted in an increase in loan modifications of 28 loans during 2014 as compared to 12 loan modifications completed in 2013. The 2014 provision for loan losses was less than the net charge-offs of $5 million (or 0.33% of outstanding loan balances) for the year ended December 31, 2014, and the 2013 provision for loan losses was less than the net charge-offs of $5 million (or 0.26% of outstanding loan balances) for the year ended December 31, 2013. This resulted in a decrease of $4 million and $3 million in our allowance for loan losses for the years ended 2014 and 2013, respectively. Charge-offs were generated by $23 million and $14 million of defaulted loan principal during 2014 and 2013, respectively, for average implied loss severities of 22% and 32%, respectively.
The increase in the provision from 2012 to 2013 was primarily attributable to an increase in serious delinquencies (loans 90+ days delinquent) to $79 million at the end of 2013 from $63 million at the end of 2012. The majority of this increase was associated with previously delinquent loans being foreclosed upon, which we believe can be attributed to a change in servicers on a large subset of our loan portfolio during 2013. Additionally, this amount increased as a greater amount of loans entered foreclosure than were resolved. The increase was partially offset by a decrease in observed loss severities, primarily driven by an improving economy and continued housing price increases in 2013. The 2012 provision for loan losses was greater than the net charge-offs of $12 million (or 0.52% of outstanding loan balances) for the year ended December 31, 2012. This resulted in a decrease of $12 million in our allowance for loan losses for the year ended 2012. Charge-offs were generated by $33 million of defaulted loan principal during 2012, for an average implied loss severity of 36%.
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During 2014, the allowance for loan losses decreased to $21 million (or 1.44% of outstanding residential loans held-for-investment balances), from $25 million (or 1.44% of outstanding residential loans held-for-investment balances) at December 31, 2013. Serious delinquencies on loans held at consolidated Sequoia entities (90+ days delinquent) decreased to $70 million (or 4.69% of outstanding loan balances) at December 31, 2014, from $79 million (or 4.45% of outstanding loan balances) at December 31, 2013. Loans originated in Florida, New Jersey, North Carolina, Pennsylvania and Maryland accounted for 23% of total loans held by Sequoia entities and made up 46% of the serious delinquent loan balance at December 31, 2014.
At December 31, 2014, we estimate that there were four Sequoia entities that we consolidated for which the carrying value of the entity’s liabilities exceeded the corresponding carrying value of the entity’s assets. This is primarily attributable to the continued building of loan loss allowances in accordance with GAAP, resulting in lower asset carrying values. The aggregate estimated net assets (or equity) at these consolidated entities was negative $2 million at December 31, 2014, an amount we expect to reverse through positive adjustments to earnings in future periods as the entity is retired or deconsolidated for financial reporting purposes.
Real Estate Loans at Sequoia Entities
The following table provides details of residential loan activity at Legacy Consolidated Entities for the years ended December 31, 2014 and 2013.
Table 31 – Residential Loans at Sequoia Entities — Activity
| Years Ended December 31, | ||||||||
| (In Thousands) |
2014 | 2013 | ||||||
| Balance at beginning of period |
$ | 1,762,167 | $ | 2,272,812 | ||||
| Principal repayments |
(278,902 | ) | (500,151 | ) | ||||
| Charge-offs, net |
4,965 | 4,526 | ||||||
| Premium amortization |
(4,280 | ) | (6,456 | ) | ||||
| Transfers to REO |
(8,687 | ) | (7,116 | ) | ||||
| Provision for loan losses |
(877 | ) | (1,448 | ) | ||||
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| Balance at End of Period |
$ | 1,474,386 | $ | 1,762,167 | ||||
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Loan Characteristics
The following table highlights unpaid principal balances for loans at consolidated Sequoia entities by product type at December 31, 2014. First lien adjustable rate mortgage (ARM) and hybrid loans comprise 91% of the consolidated Sequoia loan portfolio and were primarily originated in 2005 or prior. Fixed-rate loans, which make up 8% of the portfolio, were primarily originated in 2009 or later. Of the $46 million of hybrid loans held at Sequoia securitization entities at December 31, 2014, $33 million (or 72%) had reset as of December 31, 2014, and now act as ARM loans.
Table 32 – Loan Characteristics at Sequoia Entities
| December 31, 2014 | ||||||||
| (Dollars In Thousands) |
Principal Balance | Percent of Total | ||||||
| First Lien |
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| ARM |
$ | 1,300,281 | 87.67 | % | ||||
| Fixed |
125,390 | 8.45 | % | |||||
| Hybrid (years to reset) |
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| Reset(1) |
33,266 | 2.24 | % | |||||
| 0-4 |
3,199 | 0.22 | % | |||||
| 5-8 |
9,844 | 0.66 | % | |||||
| Second Lien |
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| ARM |
11,233 | 0.76 | % | |||||
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| Total Outstanding Principal |
$ | 1,483,213 | 100.00 | % | ||||
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| (1) | These loans represent hybrid loans that have reached the initial interest rate reset date and are currently adjustable rate mortgages. |
69
For outstanding loans at Sequoia entities consolidated by us at December 31, 2014, the weighted average FICO score (at origination) of borrowers backing these loans was 733 and the weighted average original LTV ratio of Sequoia loans was 66%.
The majority of hybrid loans and all of the fixed-rate loans at the consolidated Sequoia entities were securitized since 2010. At December 31, 2014, fixed-rate loans had a weighted average coupon of 4.62%. At December 31, 2014, LIBOR ARM loans had a weighted average coupon of 1.60% and hybrid loans had a weighted average coupon of 3.20% at consolidated Sequoia entities.
Taxable Income
The following table summarizes our taxable income (loss) and distributions to shareholders for the years ended December 31, 2014, 2013, and 2012. For each of these years, we had no undistributed REIT taxable income.
Table 33 – Taxable Income
| Years Ended December 31, | ||||||||||||
| (In Thousands) |
2014 est. (1) | 2013 | 2012 | |||||||||
| REIT taxable income |
$ | 63,578 | $ | 72,429 | $ | 60,541 | ||||||
| Taxable REIT subsidiary income (loss) |
(18,007 | ) | 16,978 | (7,627 | ) | |||||||
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| Total Taxable Income |
$ | 45,571 | $ | 89,407 | $ | 52,914 | ||||||
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| Distributions to shareholders |
$ | 92,935 | $ | 92,005 | $ | 80,134 | ||||||
| (1) | Our tax results for the year ended December 31, 2014 are estimates until we file tax returns for this year. |
Our estimated total taxable income for the year ended December 31, 2014, was $46 million ($0.55 per share) and included $7 million in realized credit losses on investments. This compared to taxable income for the year ended December 31, 2013, of $89 million ($1.09 per share) and included $13 million in realized credit losses on investments. Taxable income for the year ended December 31, 2012, was $53 million ($0.66 per share) that included $26 million in credit losses.
For the year ended December 31, 2014, we recorded a tax provision for GAAP of $1 million compared to a tax provision of $11 million for the year ended December 31, 2013. Our tax provision is primarily derived from the activities at our TRS as we do not book a material tax provision associated with income generated at our REIT. Therefore, the reduction of our tax provision year over year was primarily the result of lower GAAP income earned from residential mortgage banking operations and market valuation adjustments related to mortgage servicing rights at our TRS in 2014 compared to 2013. Nearly all of the tax provision represents a future tax obligation while only a minimal amount represents a current corporate level tax liability that will be paid for 2014. We are currently benefiting from favorable timing differences between when income associated with our mortgage banking activities is recognized for GAAP purposes versus when it is recognized for tax purposes, thus deferring a significant portion of the tax liability on that income. The income earned at our TRS is not expected to be excess inclusion income and will not affect the tax characterization of our 2014 dividends.
70
Taxable Income Distribution Requirement
As a REIT, we are required to distribute at least 90% of our taxable income, after the application of federal net operating loss carryforwards (“NOLs”), to our shareholders. For 2014, our estimated REIT taxable income of $64 million was less than our available NOLs by $6 million, and therefore we did not have a minimum dividend distribution requirement. The following table details our federal NOLs and capital loss carryforwards available as of December 31, 2014.
Table 34 – Federal Net Operating and Capital Loss Carryforwards
| Loss Carryforward Expiration by Period | ||||||||||||||||||||
| (In Thousands) |
1 to 3 Years |
3 to 5 Years |
5 to 15 years Years |
After 15 Years |
Total | |||||||||||||||
| REIT Loss Carryforwards |
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| Net operating loss |
$ | — | $ | — | $ | — | $ | (69,819 | ) | $ | (69,819 | ) | ||||||||
| Capital loss |
(219,804 | ) | — | — | — | (219,804 | ) | |||||||||||||
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| Total REIT Loss Carryforwards |
$ | (219,804 | ) | $ | — | $ | — | $ | (69,819 | ) | $ | (289,623 | ) | |||||||
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| TRS Loss Carryforwards |
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| Net operating loss |
$ | — | $ | — | $ | — | $ | (55,190 | ) | $ | (55,190 | ) | ||||||||
| Capital loss |
(19,667 | ) | (3,577 | ) | — | — | (23,244 | ) | ||||||||||||
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| Total TRS Loss Carryforwards |
$ | (19,667 | ) | $ | (3,577 | ) | $ | — | $ | (55,190 | ) | $ | (78,434 | ) | ||||||
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As of December 31, 2014, we maintained $70 million of NOLs at the REIT level. In order to utilize these carryforwards, taxable income must exceed our dividend distributions. During 2014, we distributed $93 million to shareholders and exceeded our estimated taxable income of $64 million. We do not expect to report any REIT taxable income on our 2014 federal income tax return after the application of a dividends paid deduction. As a result, we do not expect any of our federal NOLs at the REIT level to be utilized in 2014. Federal NOLs at the REIT level do not expire until 2029. Federal NOLs at the TRS level expire between 2030 and 2034.
Federal capital loss carryforwards of $220 million and $23 million at the REIT and TRS, respectively, will expire between 2015 and 2019. In order to utilize these carryforwards, the respective entities must recognize capital gains in excess of capital losses before the expiration dates. Utilization of capital loss carryforwards by the REIT reduces the REIT’s taxable income and distribution requirement. Capital loss carryforwards do not reduce the taxability of dividends to shareholders.
Tax Characteristics of Distributions to Shareholders
For the year ended December 31, 2014, we declared and distributed four regular quarterly dividends totaling $93 million ($1.12 per share). Under the federal income tax rules applicable to REITs, the taxable portion of any distribution to shareholders in excess of the minimum requirement is determined by (i) taxable income of the REIT, exclusive of the dividends paid deduction and NOLs; and, (ii) net capital gains recognized by the REIT, exclusive of capital loss carryforwards.
Our 2014 dividend distributions are expected to be characterized for income tax purposes as 90% ordinary income and 10% return of capital. Thus, we expect approximately $84 million of our 2014 dividend distributions to be characterized as ordinary income to shareholders, as this amount represents the taxable income and net capital gains we generated in 2014 prior to the application of a dividends paid deduction, NOLs, and capital loss carryforwards in accordance with federal income tax rules. Of the $84 million, $20 million is expected to be attributable to current year net capital gains. The remaining $9 million of dividend distributions are expected to be characterized as a return of capital to shareholders and are generally not taxable. A distribution of capital reduces the tax basis for common shares held by a shareholder at each quarterly distribution date (provided the distribution does not exceed a shareholder’s tax basis in our common shares). While the REIT earned net capital gains in 2014, none of the 2014 dividend distributions are expected to be characterized as long-term capital gains. Under the federal income tax rules applicable to REITs, capital loss carryforwards offset the 2014 capital gains when determining the characterization of ordinary versus long-term capital gain dividend distributions.
In November 2014, our board of directors announced its intention to pay a regular dividend of $0.28 per share each quarter in 2015.
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Differences between Estimated Total Taxable Income and GAAP Income
Differences between estimated taxable income and GAAP income are largely due to the following: (i) we cannot establish loss reserves for future anticipated events for tax but can for GAAP as realized credit losses are expensed when incurred for tax and these losses are anticipated through lower yields on assets or through loss provisions for GAAP; (ii) the timing, and possibly the amount, of some expenses (e.g., compensation expenses) are different for tax than for GAAP; (iii) since amortization and impairments differ for tax and GAAP, the tax and GAAP gains and losses on sales may differ, resulting in differences in realized gains on sale; (iv) at the REIT and certain TRS entities, unrealized gains and losses on market valuation adjustments of securities and derivatives are not recognized for tax until the instrument is sold or extinguished; (v) for tax, basis may not be assigned to mortgage servicing rights retained when whole loans are sold resulting in lower tax gain on sale, and, (vi) for tax, we do not consolidate noncontrolling interests or securitization entities as we do under GAAP. As a result of these differences in accounting, our estimated taxable income can vary significantly from our GAAP income during certain reporting periods.
The tax basis in assets and liabilities at the REIT was $2.8 billion and $1.7 billion, respectively, at December 31, 2014. The GAAP basis in assets and liabilities at the REIT was $4.2 billion and $3.0 billion, respectively, at December 31, 2014. The primary difference in both the tax and GAAP assets and liabilities is attributable to securitization entities that are consolidated for GAAP reporting purposes but not for tax purposes.
The tables below reconcile our estimated total taxable income to our GAAP income for the years ended December 31, 2014, 2013, and 2012.
Table 35 – Differences between Estimated Total Taxable Income and GAAP Net Income
| Year Ended December 31, 2014 | ||||||||||||
| (In Thousands, Except per Share Data) |
Tax (Est.) | GAAP | Differences | |||||||||
| Interest income |
$ | 206,147 | $ | 242,070 | $ | (35,923 | ) | |||||
| Interest expense |
(74,727 | ) | (87,463 | ) | 12,736 | |||||||
|
|
|
|
|
|
|
|||||||
| Net interest income |
131,420 | 154,607 | (23,187 | ) | ||||||||
| Provision for loan losses |
— | (961 | ) | 961 | ||||||||
| Realized credit losses |
(6,930 | ) | — | (6,930 | ) | |||||||
| Mortgage banking activities |
11,252 | 34,938 | (23,686 | ) | ||||||||
| MSR income (loss) |
15,763 | (4,261 | ) | 20,024 | ||||||||
| Other market valuation adjustments |
— | (10,146 | ) | 10,146 | ||||||||
| Operating expenses |
(97,583 | ) | (90,123 | ) | (7,460 | ) | ||||||
| Other income (expense) |
(8,219 | ) | 1,781 | (10,000 | ) | |||||||
| Realized gains, net |
— | 15,478 | (15,478 | ) | ||||||||
| Provision for income taxes |
(132 | ) | (744 | ) | 612 | |||||||
|
|
|
|
|
|
|
|||||||
| Net Income |
$ | 45,571 | $ | 100,569 | $ | (54,998 | ) | |||||
|
|
|
|
|
|
|
|||||||
| Income per share |
$ | 0.55 | $ | 1.15 | $ | (0.60 | ) | |||||
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| Year Ended December 31, 2013 | ||||||||||||
| (In Thousands, Except per Share Data) |
Tax | GAAP | Differences | |||||||||
| Interest income |
$ | 209,317 | $ | 226,156 | $ | (16,839 | ) | |||||
| Interest expense |
(55,099 | ) | (80,971 | ) | 25,872 | |||||||
|
|
|
|
|
|
|
|||||||
| Net interest income |
154,218 | 145,185 | 9,033 | |||||||||
| Provision for loan losses |
— | (4,737 | ) | 4,737 | ||||||||
| Realized credit losses |
(12,911 | ) | — | (12,911 | ) | |||||||
| Mortgage banking activities |
19,526 | 102,494 | (82,968 | ) | ||||||||
| MSR income |
8,218 | 20,309 | (12,091 | ) | ||||||||
| Other market valuation adjustments |
— | (5,709 | ) | 5,709 | ||||||||
| Operating expenses |
(79,361 | ) | (86,607 | ) | 7,246 | |||||||
| Other Expense |
— | (12,000 | ) | 12,000 | ||||||||
| Realized gains, net |
— | 25,259 | (25,259 | ) | ||||||||
| Provision for income taxes |
(283 | ) | (10,948 | ) | 10,665 | |||||||
|
|
|
|
|
|
|
|||||||
| Net Income |
$ | 89,407 | $ | 173,246 | $ | (83,839 | ) | |||||
|
|
|
|
|
|
|
|||||||
| Income per share |
$ | 1.09 | $ | 1.94 | $ | (0.85 | ) | |||||
| Year Ended December 31, 2012 | ||||||||||||
| (In Thousands, Except per Share Data) |
Tax | GAAP | Differences | |||||||||
| Interest income |
$ | 160,737 | $ | 231,384 | $ | (70,647 | ) | |||||
| Interest expense |
(26,187 | ) | (120,705 | ) | 94,518 | |||||||
|
|
|
|
|
|
|
|||||||
| Net interest income |
134,550 | 110,679 | 23,871 | |||||||||
| Provision for loan losses |
— | (3,648 | ) | 3,648 | ||||||||
| Realized credit losses |
(25,609 | ) | — | (25,609 | ) | |||||||
| Mortgage banking activities |
(127 | ) | 36,593 | (36,720 | ) | |||||||
| MSR income (loss) |
623 | (1,391 | ) | 2,014 | ||||||||
| Other market valuation adjustments |
— | 1,539 | (1,539 | ) | ||||||||
| Operating expenses |
(56,430 | ) | (65,633 | ) | 9,203 | |||||||
| Realized gains, net |
— | 54,921 | (54,921 | ) | ||||||||
| Provision for income taxes |
(93 | ) | (1,291 | ) | 1,198 | |||||||
|
|
|
|
|
|
|
|||||||
| Net Income |
$ | 52,914 | $ | 131,769 | $ | (78,855 | ) | |||||
|
|
|
|
|
|
|
|||||||
| Income per share |
$ | 0.66 | $ | 1.59 | $ | (0.93 | ) | |||||
Potential Taxable Income Volatility
We expect period-to-period estimated taxable income volatility for a variety of reasons, including those described below.
Credit Losses on Securities and Loans
To determine estimated taxable income, we are generally not permitted to anticipate, or reserve for, credit losses on investments which are generally purchased at a discount. For tax purposes, we accrue the entire purchase discount on a security into taxable income over the expected life of the security. Estimated taxable income is reduced when actual credit losses occur. For GAAP purposes, we establish a credit reserve and only accrete the portion of the purchase discount we expect to realize into income and write-down securities that become impaired. Our income recognition is therefore faster for tax as compared to GAAP, especially in the early years of owning a security (when there are generally few credit losses). At December 31, 2014, the cumulative difference between the GAAP and tax amortized cost basis of our residential securities (excluding our investments in our consolidated securitization entities and IO securities) was $27 million.
As we have no credit reserves or allowances for tax, any future credit losses on securities or loans will have a more significant impact on tax earnings than on GAAP earnings and may create significant taxable income volatility to the extent the level of credit losses fluctuates during reporting periods. We anticipate that credit losses will continue to be a meaningful, but declining, factor for determining taxable income. Credit losses are based on our tax basis, which differs materially from our basis for GAAP purposes. We
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anticipate an additional $34 million of credit losses for tax on securities, based on our projection of principal balance losses and assuming a similar tax basis as we have recently experienced, although the timing of actual losses is difficult to accurately project. At December 31, 2014, for GAAP we had a designated credit reserve of $70 million on our securities, and an allowance for loan losses of $29 million for our consolidated residential and commercial loans.
Recognition of Gains and Losses on Sale
Since the computation of amortization and impairments on assets may differ for tax and GAAP, the tax and GAAP basis on assets sold or called may differ, resulting in differences in gains and losses on sale or call. In addition, gains realized for tax may be offset by prior capital losses and, thus, not affect taxable income. At December 31, 2014, the REIT had an estimated $220 million in federal capital loss carryforwards that can be used to offset future capital gains over the next three years. Since our intention is to generally make long-term investments, it is difficult to anticipate when sales may occur and, thus, when or whether we might exhaust these capital loss carryforwards. At December 31, 2014, we had an estimated $23 million in federal capital loss carryforwards at the TRS level. We anticipate selling appreciated securities within the capital loss carryforward period, and consequently, it is likely that the TRS will benefit from the use of the capital loss carryforwards and no valuation allowance was recorded against the corresponding deferred tax asset. However, our estimate could change in future periods and to the extent we no longer expect to utilize the capital loss carryforwards, we could record additional tax expense for GAAP.
Prepayments on Securities
We have retained certain IO securities at the time they were issued from Sequoia securitizations we sponsored. Our tax basis in these securities was $77 million at December 31, 2014, which includes a tax basis of $68 million for IOs retained from securitizations completed in 2010 and later. The return on IOs is sensitive to prepayments and, to the extent prepayments vary period to period, income from these IOs will vary. Typically, fast prepayments reduce yields and slow prepayments increase yields. We are not permitted to recognize a negative yield under tax accounting rules, so during periods of fast prepayments our periodic premium expense for tax purposes can be relatively low and the tax cost basis for these securities may not be significantly reduced. In periods prior to 2008, we experienced fast prepayments on the loans underlying our IOs. More recently, prepayments on loans owned at Consolidated Sequoia Entities issued prior to 2010 have been slow, and our tax basis is now below the fair values for these IOs in the aggregate. If a Sequoia securitization is called, the remaining tax basis in the IO is expensed, creating an ordinary loss at the call date.
Prepayments also affect the taxable income recognition on other securities we own. We are required to use particular prepayment assumptions for the remaining lives of each security. As actual prepayment speeds vary, the yield we recognize for tax purposes will be adjusted accordingly. Thus, to the extent prepayments differ from our long-term assumptions or vary from period to period, the yield recognized will also vary and this difference could be material.
Compensation Expense
The total tax expense for equity award compensation is dependent upon varying factors such as the timing of payments of dividend equivalent rights, the distribution of deferred stock units and preferred stock units, and the cash deferrals to and withdrawals from our Executive Deferred Compensation Plan. For GAAP purposes, the total expense associated with an equity award is determined at the award date and is recognized over the vesting period. For tax, the total expense is recognized at the date of distribution or exercise, not the award date. In addition, some compensation may not be deductible for tax if it exceeds certain levels and is not performance-based. Thus, the total amount of compensation expense, as well as the timing, could be significantly different for tax than for GAAP.
As an example, for GAAP we expense the grant date fair value of performance stock units (“PSUs”) granted over the vesting term of those PSUs (regardless of the degree to which the performance conditions for vesting are ultimately satisfied, if at all), whereas for tax the value of the PSUs that actually vest in accordance with the performance conditions of those awards and are subsequently distributed to the award recipient is recorded as an expense on the date of distribution. For example, if no PSUs under a particular grant ultimately vest, due to the failure to satisfy the performance conditions, no tax expense will be recorded for those PSUs, even though we would have already recorded expense for GAAP equal to the grant date fair value of the PSU awards. Conversely, for example, if performance is such that a number of shares of common stock equal to 200% of the PSU award ultimately vest and are delivered to the award recipient, expense for tax will equal the common stock value on the date of distribution of 200% of the number of PSUs originally granted. This expense for tax could significantly exceed the recorded expense for GAAP.
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In addition, since the decision to distribute deferred stock units, performance stock units, or cash out of the Executive Deferred Compensation Plan is an employee’s, it can be difficult to project when the tax expense will occur.
Mortgage Servicing Rights
For GAAP purposes, we recognize MSRs through the direct acquisition of servicing rights from third parties or through the retention of MSRs associated with residential loans that we have acquired and subsequently sold to non-consolidated securitization entities or to third parties. For tax purposes, basis in our MSR assets is recognized through the direct acquisition of servicing rights from third parties, or to the extent that a retained MSR entitles us to receive a servicing fee in excess of so-called normal servicing, the right to receive reasonable compensation for services to be performed under the mortgage serving contract. Tax basis in our normal MSR assets is not recognized when MSRs are retained from sales of loans to non-consolidated securitization entities or to third parties thereby creating a favorable temporary GAAP to tax difference from sale of the loans. For the year ended December 31, 2014, we retained $49 million of MSRs from jumbo and conforming loan sales for which no tax basis was recognized. Additionally, in 2014, we purchased $48 million of MSRs associated with conforming loans where the initial tax basis was equal to the purchase price. No other tax basis in our MSR assets was recognized in 2014.
For GAAP purposes, mortgage servicing fee income, net of servicing expense, as well as changes in the estimated fair value of our MSRs, is recognized on our consolidated statements of income over the life of the MSR asset. For tax purposes, only mortgage servicing fee income, net of servicing expense is recognized as taxable income. Any MSR where basis is recognized for tax purposes through acquisition is amortized as a tax expense over a finite life.
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LIQUIDITY AND CAPITAL RESOURCES
Summary
Our principal sources of cash consist of borrowings under mortgage loan warehouse facilities, securities repurchase agreements, and our FHLB member subsidiary’s borrowing facility with the FHLBC, payments of principal and interest we receive on our securities portfolio and commercial investments portfolio and cash generated from our operating activities. Our most significant uses of cash are to purchase mortgage loans for our residential and commercial mortgage banking operations, to fund investments in residential and commercial loans, to repay principal and interest on our warehouse facilities, repurchase agreements, and long-term debt, to purchase investment securities, to make dividend payments on our capital stock, and to fund our operations.
At December 31, 2014, we held $270 million of cash and cash equivalents and we estimated our investment capacity (defined as the amount of capital we have readily available for long-term investments) at approximately $198 million. During 2014, we raised $205 million through an offering of exchangeable notes issued by one of our taxable subsidiaries and our FHLB member subsidiary borrowed $496 million of long-term debt from the FHLBC, which together increased our total capital to $2.4 billion at December 31, 2014. Total capital included $1.3 billion of equity capital and $1.1 billion of long term debt, comprised of $140 million of debt due in 2037, $288 million of convertible debt due in 2018, $205 million of exchangeable debt due in 2019, and $496 million of FHLB borrowings with an average maturity of 9.4 years.
While we believe our remaining investment capacity is sufficient to fund our near-term investment activities, we may need additional capital to make long-term investments over the coming quarters. To the extent we need additional incremental capital to fund our operations and investment activities, our approach to raising capital will continue to be based on what we believe to be in the best long-term interests of shareholders. Any future capital raising transaction could include the issuance of debt or equity securities under the shelf registration statement we currently have on file with the SEC or the issuance of similar or other types of securities in public or private offerings.
We are subject to risks relating to our liquidity and capital resources, including risks relating to incurring short-term debt under residential and commercial loan warehouse facilities, securities repurchase facilities, and other short- and long-term debt facilities and other risks relating to our use of derivatives. A further discussion of these risks is set forth below under the heading “Risks Relating to Debt Incurred Under Short- and Long-Term Borrowing Facilities” and in Part I, Item 1A – Risk Factors of this Annual Report on Form 10-K.
Cash Flows and Liquidity for the Year Ended December 31, 2014
Cash flows from our residential and commercial mortgage banking activities and our investments can be volatile from quarter to quarter depending on many factors, including the timing and amount of loan and securities acquisitions and sales and repayments, the profitability of mortgage banking activities, as well as changes in credit losses, prepayments, and interest rates. Therefore, cash flows generated in the current period are not necessarily reflective of the long-term cash flows we will receive from these investments or activities.
Cash Flows from Operating Activities
Cash flows from operating activities were negative $1.8 billion in 2014. This amount includes the net cash utilized during the period from the purchase and sale of residential and commercial mortgage loans associated with our mortgage banking activities. Purchases of loans are financed to a large extent with short-term debt, for which changes in cash are included as a component of financing activities. Additionally, net cash utilized from the purchase and sale of loans during 2014 partially results from a timing difference as we had $1.5 billion of residential and commercial loans held-for-sale at the end of 2014.
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Cash Flows from Investing Activities
Although we generally intend to hold our investment securities as long-term investments, we may sell certain of these securities in order to manage our interest rate risk and liquidity needs, to meet other operating objectives, and to adapt to market conditions. We cannot predict the timing and impact of future sales of investment securities, if any. Because many of our investment securities are financed through repurchase agreements, a significant portion of the proceeds from any