Redwood Trust Inc (RWT) 2013 Q3 法說會逐字稿

Good morning and welcome to the Redwood Trust, Inc. 2013 third quarter earnings conference call. (Operator Instructions) Management has requested that I remind you that certain information presented and certain statements made during management's presentation with respect to future financial or business performance, strategies, and expectations may constitute forward-looking statements. Forward-looking statements are based on current expectations, forecasts, and assumptions that involve risk and uncertainties that could cause actual results to differ materially.

Management encourages you to read the Company's most recent Annual Report form on Form 10-K filed with the SEC, which provides a description of some of the factors that could have a material impact on the Company's performance and could cause actual results to differ from those that that may be expressed in forward-looking statements. I also have been asked to note that the content of this conference call contain time-sensitive information that it is accurate only as of today, Thursday, November 7, 2013. The Company does not intend and undertakes no duty to update this information to reflect subsequent events or circumstances.

Finally, today's call is being recorded and access to the recording of the call will be available on the Company's website at www.redwoodtrust.com later today. For opening remarks and introductions, I would now like to turn the call over to Mr. Marty Hughes, Redwood's Chief Executive Officer. Please go ahead, Mr. Hughes.

Good morning, everyone. Thank you for participating in Redwood's third quarter 2013 earnings call. Joining me on the call today are Brett Nicholas, Redwood's President, and Chris Abate, Redwood's CFO; who will get into some of the details when they cover the residential and commercial business activities and financials. I will speak to the bigger picture issues.

Over the past two quarters, we successfully steered through a tumultuous period in the mortgage market. By the end of the third quarter, we worked through the vast majority of our lower coupon inventory. We are proud that through this difficult period we were able to increase book value per share net of dividend payments reflecting the strength of our portfolio management and mortgage pipeline hedging. Protecting book value is important to us and Chris will go through the numbers in a few minutes. Our goal in building our residential and commercial loan platforms was to have a proprietary source of fee income and to create attractive portfolio investments, which we believe is the key to grow and prosper in a world awash with excess liquidity.

We consciously designed our residential loan platform to have the flexibility and operating leverage to handle multiple sellers, loan products, and sources of distribution. To this end, we worked hard over the last year to add scalability by building out our Denver support operations and systems. We also put considerable effort in expanding our direct whole loan distribution capabilities, which complement our securitization distribution. So as we look ahead, we believe our residential business has significant growth opportunities. Yes, we do face near-term challenges; slowing refinance activity, aggressive price competition from banks for jumbo mortgages; and a slowdown in the securitization market; that will likely continue to impact our financial results for the remainder of 2013 and into early 2014.

In terms of slowing loan volume, the answer is to add more loan sellers and loan products beyond jumbos. The next step is to add conforming loans to our product menu, which we are now rolling out. We expect this program to gain real traction in early 2014. This will allow us to create our own investments in servicing and positions us to be involved with potential risk sharing opportunities at the originator level consistent with the concept envisioned by the FHFA. This market opportunity is many times the size of our traditional jumbo business. Another idea we are exploring is to acquire and distribute safe well underwritten non-QM loans. This is an underserved market, but we would note that there's quite a bit of wood to chop and to work through in getting our arms around regulatory and compliance risk.

Let's turn to the state of the securitization market. While the market has slowed, in our opinion it was primarily triggered by the recent and steep rise in mortgage rates, which resulted in a sizable amount of below market mortgage collateral that needed to be sold into a higher coupon environment. When combined with the market expectations for rates to further increase, RMBS investors pause while they try to figure out how to price for the expected longer investment duration. Assuming interest rates remain relatively stable, we expect investors in AAA rated RMBS to view securities backed by more recently originated higher coupon mortgages more favorably from a pricing standpoint. This should help to revive the RMBS issuance.

In the near term, we expect our loan sale distribution to be a combination of direct whole loan sales and securitizations. We expect to complete at least one securitization transaction in the fourth quarter of 2013. We believe that over time based on these distribution outlets and our ability to adjust loan pricing to our sellers, we can earn on average 25 basis points to 50 basis points in loan sale profit margins net of our hedges. We are particularly encouraged about the direction of the GSE reform legislation that favors private capital credit providers with loan platforms such as Redwood. Redwood has the platform and the people and we are well positioned to capitalize on opportunities resulting from the government's policies designed to attract private capital into the mortgage market.

Turning to our strategy with our commercial business. We have successfully shifted our focus to originating senior commercial loans for sale into CMBS transactions. Our commercial activities have been an important contributor to our earnings. Heading into 2014, we feel good about our strategic position. Now, I'd like to turn it over to Brett Nicholas, Redwood's President, to discuss our residential and commercial businesses.

Thank you, Marty. I'll spend a few minutes on our residential and commercial activities. We're very happy with how we managed our business during a very difficult operating environment, particularly as it relates to the mortgage capital markets and interest rate volatility. Our ability to manage risk, distribute our supportive private label securities, and leverage a robust whole loan distribution system allowed us to protect book value, generate earnings, and remain competitive throughout this time frame. In the third quarter we completed three securitizations totaling $1.2 billion and we completed $600 million of whole loan sales. In fact year-to-date through October, we have completed 31 separate whole loan sales transactions totaling $1.1 billion.

Given the backdrop of higher rates and strong competition for jumbo loans from large banks, we were able to identify just over $1 billion of loans for purchase in the third quarter. However, activity has picked up in October off the lows in the summer. Our best estimate for total purchases this year is between $7 billion and $7.5 billion, down from our previous estimate of $8 billion. Our residential platform continues to grow. Our focus is on broadening our product offerings and growing the number of originators to sell loans to us. We added 11 new loan sellers, increasing the total number of active sellers to 112 as of the end of September.

As mentioned, we added conforming loans to our product menu this quarter. We are excited to be a Fannie/Freddie seller servicer for a number of reasons. First, we were able to leverage our existing client base and provide them with liquidity for more products. We also will acquire investments and mortgage servicing rights through our loan acquisition process and at levels we find more attractive than the bulk MSR market. We believe these new products can grow mortgage banking fee income over time. And lastly, we believe direct seller service relationships with the GSEs will most likely position Redwood to be at the forefront of risk sharing and other GSE reform opportunities.

I'd like to comment on the current loan price competition we face for jumbo loans. During the third quarter and through today, some large banks were offering 30-year fixed rate jumbo mortgages to their retail customers more than 0.25 point below current GSE conforming rates. As a historical point of context, jumbo loans are generally offered 0.25 point higher than conforming rates. We do expect this pricing anomaly to last for the foreseeable future as higher guarantee fees being charged by the GSEs, excess liquidity in the banking system, together with the desire for loan and interest income growth trumps potential consequences from asset liability mismatch. While this certainly creates headwinds for jumbo volume, it is limited to money center retail loan channels.

In light of that specific competition, we remain very competitive among other non-bank aggregators and against the correspondent channels of banks for loans coming from our correspondent loan seller network. An area of great success has been our ability to build out a large network of direct whole loan relationships with banks nationwide. Our preference is to securitize all of our production since it gives us an opportunity to deploy capital into credit investments. However, our model has to also be focused on best execution and risk management. Our ability to distribute whole loans directly has allowed us to protect profit margins and maintain our competitive position.

Turning to our commercial real estate strategy. We have had a successful year originating senior commercial loans to generate fee income while continuing to originate mezzanine loans for our investment portfolio. While we will likely fall short of our full-year goal to originate $1 billion of senior loans, our loan sale margins have been higher than we expected. We expect our commercial origination activities to grow and create attractive fee income and portfolio opportunities for the Company over time.

Our investment portfolio grew in the third quarter. We invested $80 million in securities created from our Sequoia transactions during the quarter and another $143 million of senior and subordinate securities bought in the secondary markets. One important investment I'd like to emphasize is that our securitization platform has generated over $0.5 billion of attractive credit and other investments for our portfolio that would not have been available in the secondary markets if we did not have those platforms. Our investment goals remain the same, protect and grow book value through active interest rate, liquidity, and investment management.

With that, I will turn it over to Chris Abate, our CFO, to run through the numbers.

Thank you, Brett, and good morning, everyone. We managed well through another challenging quarter marked by additional volatility in interest rates and a sharp industrywide decline in finance volumes. Our third quarter 2013 reported earnings were $22 million or $0.25 per share as compared to $66 million or $0.71 per share for the second quarter of 2013. Our third quarter earnings were impacted as expected and as we discussed on last quarter's earnings call by negative mark-to-market valuation adjustments on the loans that we identified for purchase at June 30. If you recall, last quarter we had $1.4 billion of loans that we had identified for purchase, but that were not mark-to-market as of June 30, 2013.

As of August 1, 2013 just prior to the release of our second quarter numbers, we estimated the negative mark on our June 30 loan pipeline would be about $21 million. The negative mark came in closer to $15 million or $0.17 per share in the third quarter. As a reminder, we recognized hedging gains in the second quarter relating to those loans that have resulted in a small overall economic profit, which is not obvious because of the timing issues between quarters. Regardless, for GAAP reporting purposes, our residential mortgage banking activities generated a loss of $6 million in the third quarter as compared to a gain of $59 million in the second quarter.

Turning to our commercial mortgage banking results for the third quarter. We generated mortgage banking income of $3 million, which was down from $6 million in the second quarter. Decline in mortgage banking income was primarily related to lower origination volume, which amounted to $113 million in the third quarter as compared to $150 million in the second quarter. Industrywide origination activity on the commercial side much like on the residential side was impacted by interest rate volatility during the third quarter. Net interest income for the third quarter of 2013 was $36 million, which was about the same as the first and second quarters.

We are pleased with the consistency of net interest income generated by our investment portfolio as we continue to put capital to work by creating our own investments through our Sequoia platform acquiring third-party residential investments and originating commercial mezzanine loans. Capital deployed during the third quarter amounted to $146 million. Operating expenses were $22 million in the third quarter 2013, down $2 million from the second quarter which included $3 million of severance costs. We realized $10 million of gain from the sale of $182 million of primarily senior residential securities on repo in the third quarter, up from gains on sale of $1 million from the prior quarter.

Finally, we recognized a $5 million tax benefit relating to an existing capital loss carry-forward that we previously expected would expire unused. Our GAAP book value at September 30, 2013 was $14.65 per share, a slight $0.04 decrease from prior quarter. The reduction in book value per share reflects the adverse impact of $0.17 per share of negative market valuation adjustments related to the loans in our pipeline at June 30. Over the first nine months of 2013, our book value per share has increased from $13.95 to $14.65. We have declared and paid $0.84 per share of dividends to investors.

Turning to our cash position and our capital. At September 30, our unrestricted cash was $205 million and our current investment capacity, which we define as the approximate amount of capital we would have readily available for long-term investments, was estimated to be $150 million. Based on our near-term outlook, we currently believe that our available capital and liquidity will be sufficient to fund our business and our investment objectives for the remainder of 2013.

And with that, we are happy to take questions. I'll now ask the operator to begin the Q&A process.

Thank you. (Operator Instructions) Steve DeLaney, JMP Securities.

Marty, let me jump right in on this latest securitization that we saw filed on Monday 2013-12. So my question is why are you guys confident and your dealers confident that this transaction $325 million can get executed when just less than a month ago, Shell Point after trying to pull that deal and Citi, the chatter is they didn't sell all the AAAs out of their recent deal. Can you just give us some color on why you think you can get access to the sector and market? Thanks.

Again, I can't comment, Steve, specifically on anything related to the transaction itself as it is in the marketplace today. We do feel confident that with higher coupon mortgages that are backed by the deal that those higher coupon mortgages will be priced more favorably by investors.

So that's the real issues which you're offering is a differentiated product that the buyer's not going to be worried about the extension risk and he's going to feel more confident understanding the duration of what he's buying?

Correct.

Okay. A follow-up on that. This is 30-year fixed and we know what's going on with the banks with these 4% rates. I was curious if in your channel with your sellers, have you detected any increase in consumer appetite or (inaudible) ARMs and are the banks being just as aggressive on the ARM product as they are on the fixed rate product?

Hi, Steve. It's Brett. We have seen a shift to more intermediate and shorter ARMs. I think during the quarter 55% were 30-year fixed, down from 83% and 95% respectively. In many of those loans, we have direct whole loan buyers for them.

Yes, I figured that because you're going into the whole loan execution there, I mean just looking out a quarter or two, I guess it depends on where interest rates go in the 10-year and the 30-year paper. But is it too optimistic to think that you could aggregate enough hybrids to offer that out to the Street in the form of a securitization like you did back in 2010 and 2011?

Currently, the execution on whole loans is far superior to securitization economics for loans that are I would say inside of 10 years.

Okay, great. Well, thanks for that and I will drop back into the queue.

Daniel Furtado, Jefferies & Co.

This is [Mark Semlek] in for Dan Furtado. So it looks like shorter duration loans were nearly 50% of loan purchases this quarter versus less than 20% last quarter. I guess I have two questions on this. Can you just talk about your expectation to increase the percentage of shorter duration loan purchases further? And maybe two, just kind of talk around what impact you expect this to have on execution economics in the securitization market versus a deal with primarily 30-year fixed products. Thanks.

I'll take that again. It's Brett. As I previously said to Steve, the economics for securitizing short ARMs is just not economical vis-a-vis whole loan sales. So short ARMs we have specified whole loan buyers for that and we'll continue to operate that business with the profit margins that we've previously disclosed. Our goals are to grow volume whether that's 30-year, 15-year, or other ARM products for distribution both in securitized and in whole loan sales.

And I would add to that. Our acquisitions of loans will naturally follow what the market is doing and as rates move up, bars will tend to go shorter to keep the payment and rate down and that's what's happening in the shift. When rates moved up, there's been less 30-year fixed being created so naturally, our acquisitions will follow the market.

Understood. Thanks, guys.

Joel Houck, Wells Fargo.

I guess maybe to broaden out Steve's question a little bit, two parts. One, have you ever seen in your history banks pricing jumbo below conforming? And number two, I guess more importantly, what do you think it will take for that relationship to become dislodged? And if you could look in your crystal ball, maybe give us a sense for how you see this playing out. Does it rationalize in early 2014 or is this something you think you might have to deal with the balance of next year? Thank you.

Joel, in part if we were to parse through it, probably as Brett went through, you have probably a 50 basis point change in what the coupon would have been. Guarantee fees probably account for about 25% of that, guarantee fees having gone up on conforming. But no, I haven't in 20 years seen jumbo mortgages price below agency mortgages and when you see something you've never seen before, it does make you pause to figure out how long it could last. If it's driven by excess liquidity and reserves that the banks have, that's a very big number. So if that's what really the genesis is out to bring down that number to increase assets and net interest margin, I think it could persist for a while.

Okay. I appreciate the comments. Thanks, Marty.

Paul Miller, FBR.

Can you talk a little bit about the economics between whole loan sales versus securitizations? I think you would much rather do the securitizations. And then secondly, mainly the whole loan sales, is that like a broker business that you're just finding buyers and sellers and who are the main buyers of this product?

This is Chris, Paul, and I'll start with the economics. Our clear preference is securitization. From a gain on sale standpoint, the economics are similar although more recently, it's been advantageous to distribute to the whole loan channel. Long term we think that margins will be similar, our long-term estimate is 25 basis points to 50 basis points consistent with sort of the long-term historical average of the market. From an economic perspective though, we are able to create investments through our Sequoia platform. Taking a $500 million type of transaction; you're going to create $40 million of investments between the subordinate securities, interest-only securities and mortgage servicing rights on average. So we're able to create those investments and generate through a combination of funding the subordinate securities with equity and leveraging the mezzanine securities something in the neighborhood of a 10% to 14% return.

And so the whole loan sales, you just get straight 25 basis point, 50 basis point gain on sale, but you're not creating any securities for the REIT?

Paul, I was going to answer the other half of your question. This is Brett. We have similar to what we've done branding our Sequoia program is spend a great deal of time marketing our story to I would say mostly regional banks nationwide who also, similar to what Marty's comments on the large money center banks, they need to grow assets. They don't have aggregation vehicles. We're able to provide them high quality collateral, they can trust Redwood's process, and we can generate fees, and also be very competitive out there in the correspondent lending market. But I'd say it's generally regional banks nationwide.

Correct.

And when you talk about entering the GSE conforming market, my guess you're not going to really securitize them, right; you're just going to act as a whole loan sales correspondent with that type of product until there is more clarification on the risk-sharing aspects of it.

Correct. For now, we'll look a lot like our whole loan business where we are in a fee. However, in many cases we sell servicing with our whole loans, with our jumbo whole loans. In the case of Fannie/Freddie business, we will retain mortgage servicing rights.

Okay. So really getting into that side of business is to get more Fannie and Freddie to grow your servicing portfolio quota.

Yes, to grow that and also look for opportunities in and around potential risk sharing down the road in whatever form that takes place.

Okay. Hey guys, thank you very much.

Stephen Laws, Deutsche Bank.

Follow-up on the conforming side with the GSEs. Can you give us any color around sell margin there or volumes even though it's not going forward, maybe what traction you've seen quarter to date?

We really just entered the space. We started buying loans this quarter and at this point, we'll probably have a much better sense of margins and volume when we release fourth quarter results as far as an estimate for next year. But at this point, we've really just gotten started.

The history of margins on the GSE have been kind of all over the place. There's been times where essentially what your profit will be, will be your investment in the servicing and other times you could earn the servicing right and earn 50 basis points to 100 basis points in addition to that.

Okay, great. I appreciate the color there, Marty and Brett. One follow-up, more bigger picture GSE conforming loan limit, where do you guys think those settle out here in the near term? And what timing as we look at the calendar here do you think that they would start making the announcement about possibly lowering those conforming loan limits going forward? And then I guess from a higher level at the margin, how much of an impact or opportunity does that create or is it hard to quantify just given there's a significant size market versus the volume you're currently doing?

First I'll say, if they change their loan limits, we will be in both the GSE market and the jumbo market so to be participating both would be the first higher level thought. And we have no information on exactly what the FHFA is going to do. Our guess and it's strictly a guess; if something was to happen, it would happen in the beginning of May after the market had a chance to settle down and absorb the QM rules. And my guess is it would be a modest decrease probably going down to probably 400 on the conforming side and 600 on the agency jumbo side would be our best guess. In terms of additional volume, obviously on the jumbo side, difficult exactly within that band to project exactly what the increase would be.

Great. Well, I appreciate the just high level thoughts there and will continue to monitor that. Thanks for taking my question.

Bose George, KBW.

Actually when you think about the potential growth in the agency business, can that pay you back pretty well with your existing lenders so can you wrap volume up well doing it that way?

Hey, Bose. It's Brett. Absolutely, one of the big drivers is that we believe upwards of probably 90% of our existing correspondent lenders not only would they ask us to provide liquidity for them, but we could leverage that entire seller base.

Bose, just to add to that. Really what the model was designed to do would be have Redwood and its platform and everything that goes with that to sit between sellers. We want to add more sellers on one side, we want to add more loan products outside of jumbo, GSEs, and we had mentioned potentially non-QM down the road. And on the other side, it's expanding distribution; distribution through securitization which is our preferred on jumbos, distribution through whole loans, and then distribution to the GSEs. And within that process, we are in fees, we get credit investments and servicing.

A quick question on the commercial. You guys kind of capped out in terms of how much you want to allocate to that. Just can you talk about the growth opportunities in that market and how you're thinking about it? If you want to grow that, is that basically like separating it out the Company, is that kind of what you're thinking?

Well, in terms of the business model there, we've allocated $300 million and it's a gain on sale business so it's very ROE and fee driven focus not a capital-intensive business so we can generate. Our goals there to make as many loans as possible, sell it into CMBS and earn a fee. The mezzanine lending business is more capital-intensive and that's where at some point we may hit a cap on capital.

Okay, great. Thanks.

(Operator Instructions) Matthew Howlett, UBS.

My question first on the margin at the REIT. As it relates specifically to the prime subordinate yields when they went down about 100 basis points sequentially. What point do you think that will stop and start to go up? And then the second question as it relates to capital, I know there's no plans to raise your filler capital [in the] year. When you look at 2014, will you continue to look at your legacy portfolio and some of the higher mezz that you own from the new issue stuff to sell or run-off before you raise new capital?

This is Chris. The yields on subs we still find very attractive on the legacy subordinate positions, the legacy primes, they're close to 20%. But some of the newer issue on the Sequoia side, they are lower and really it's a function of just mark-to-market accounting. So as we're creating these securities, we need to value them, where we think we can sell them, and we get color from the market, spin a few deals in the market from a transaction perspective. So the real income stream is a combination of the run rate on yield along with the margin that we create from the deal, which goes up if the pricing on those bonds is higher.

We have created a lot of mezzanine securities that we've held. One of the reasons why we've held them is because we thought we would be required under the QM-QRM Rules to retain risk of 5%. Going forward, I think we have about $300 million of investments in Sequoia what we characterize as mezzanine positions, which are those positions say AA through BBB. And those we do have more or less unlevered and to the extent that we need capital, we would absolutely look to those positions to either potentially apply some type of non-recourse financing or sell.

Right. And you got a few of those rated recently, is that sort of in anticipation of selling or offloading those?

No, not in particular, I wouldn't say that. We can sell any of them at this point if we choose so it's not a function of the ratings.

And at this point, do we have any indication of the capital needs in the REIT and if we continue to hit your origination targets, retain the subs on your securitizations? I know you have $150 million of excess capital and you have a large legacy portfolio and these mezzos, is there any indication on what the capital needs of the Company will be next year?

Just sticking with what we disclosed, we think we have $150 million of investment capacity. As you mentioned, we have the ability to sell assets if we choose to raise capital. From an operation standpoint, as Brett mentioned, we're recycling capital in the operating platforms so they're not very capital intensive so we can continue to originate loans and distribute them. It will really be a function of the pace of securitization in 2014 as far as the rate of putting capital to work in new subordinate investments and at this point, we don't have an estimate that we're going to share.

Great, thanks. And just one last question, any change in writing issue levels on the new transaction? Thanks a lot.

I don't think we can comment on the new transaction other than what's been disclosed publicly.

Thanks, Chris.

And that does conclude today's question-and-answer session. I'd like to turn the call back over to speaker for any additional or closing remarks.

Thank you everybody for joining us this morning. Have a joyous day.

And that does conclude today's conference. Thank you for your participation.