Redwood Trust Inc (RWT) 2013 Q4 法說會逐字稿

Good afternoon, and welcome to the Redwood Trust, Inc. 2013 fourth-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, or expectations, may constitute forward-looking statements. Forward-looking statements are based on current expectations, forecasts, and assumptions that involve risks and uncertainties that could cause actual results to differ materially.

Management encourages you to read the Company's most recent annual report 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 may be expressed in the forward-looking statements.

I have also been asked to note that the content of this conference call contains time-sensitive information that is accurate only as of today, Monday, February 24, 2014. The Company does not intend to 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'd now turn call over to Marty Hughes, Redwood's Chief Executive Officer. Please go ahead, Mr. Hughes.

Good afternoon, everyone. Thank you for participating in Redwood's fourth-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 the financials.

This afternoon, I will limit my comments during my prepared remarks to the biggest issues related to Redwood's vision and strategy. First, we had a good fourth quarter and a very productive year at Redwood in 2013, and finished in a strong position. On the financial side, our book value per share, earnings per share, and dividends were all up considerably on a year-over-year basis, contributing to a 21.4% total return for shareholders for 2013.

Among our accomplishments in 2013, we entered into the conforming mortgage sector in the fourth quarter, executed on our strategy to invest in mortgage servicing rights, established a new residential mortgage processing center in Denver, and continue to build our jumbo and commercial loan conduits.

At Redwood, our vision and business strategy are driven by the market opportunities we see over the next several years, not over the next several quarters. That long-term prospectus gives us confidence that both our residential and commercial businesses, while still in the early stages of expansion, are very well-positioned to take advantage of the market opportunities we see evolving for Redwood.

Over the past four years, we have built residential and commercial loan acquisition platforms for one simple reason: to create a proprietary source of attractive investments and fee-generating opportunities. Trying to source investments slowly through a bidding competition process is an increasingly unproductive and maddening exercise in today's liquidity-flooded world as available risk-adjusted investment yields keep grinding lower and lower. Our loan acquisition platforms provide us with strong competitive advantages, including the ability to leverage or sell our relationships, infrastructure, and distribution capabilities.

The barriers to building an effective assembly line for creating investments are high. There's simply no fast or easy way to replicate the platforms we have built.

On the residential side, our foremost objectives are to invest in well-underwritten prime mortgage credit risk and servicing, and to generate fees from loan sales. While we believe we have significant long-term growth opportunities, we do face near-term challenges, as refinance activity dwindles, aggressive price competition from banks continues, and due to the slowdown in securitization activity.

Brett will go through each of these, and give you our thoughts for 2013, but the bottom line is we need to add more sellers and loan products beyond our initial foray into jumbo mortgages. To that end, we recently added conforming loans to our product menu, and are looking at potential to add well-underwritten non-QM loans to further expand our market opportunity.

Looking down the road a bit further, we believe the long process of GSE reform will eventually conclude, with the creation of an entity that functions much as the GSEs do today, providing some type of conforming mortgage financing to mainstream US borrowers, but with one big exception: The private sector will be center stage as the provider of first loss credit risk, ahead of a government guarantee.

This would represent a very large market opportunity for private credit risk investors, especially those with loan acquisition platforms such as Redwood. The foundation for this news structure is already being laid while the GSEs are in conservatorship, through structured risk sharing and contractual recourse arrangements.

Moving onto the commercial side, our commercial team did a terrific job in 2013. The near-term outlook for the commercial mortgage market, and our business continues to look attractive. With close to $250 billion worth of commercial real estate loans set to mature annually over the next four years, we expect to see substantial refinancing opportunities, which will benefit those with established commercial origination platforms such as Redwood.

Now, I would like to turn it over to Brett Nicholas, Redwood's President, to discuss our residential and commercial business.

Thank you, Marty. As Marty noted, we have confidence that as the mortgage markets continue to evolve, and in particular the residential market, it's likely there will be substantial need for private capital to take conforming mortgage credit risk, and as well as for private label securitization. As a mortgage credit investor, we believe Redwood is well-positioned to benefit over the long-term.

Turning to the current state of private label securitization. The market clearly experienced turmoil during 2013, as AAA spreads widened from early in the second quarter, through the end of the year.

Presently, AAA prices have not only stabilized, but have shown clear signs of improvement, and still offer compelling relative value versus other fixed income assets. However, based on significant volatility of AAA pricing over the past couple of years, it's difficult to project the near-term direction of the market with confidence.

Redwood completed one $325 million private label residential securitization during the fourth quarter of 2013, and we completed 12 securitizations totaling $5.6 billion for the year. We expect to complete our next securitization late in the first quarter, or early in the second quarter of 2014.

Our preferred distribution for jumbo loans is securitization, since we can retain attractive investments for our portfolio. Today, however, home loan sales offer better execution. This is a result of high post-crisis credit enhancement levels, combined with wider AAA prices.

Unless these dynamics change, we expect whole loan sales to make up the largest portion of Redwood's distribution of jumbo loan volume in 2014. Between our two distribution outlets, we remain confident that we can generate attractive loan sale profit margins, within our long-term target range of 25 to 50 basis points.

Our whole loan distribution and direct relationships are significant. Not only did we complete 40 transactions totaling $1.6 billion during 2013. But our ability to distribute whole loans into a strong portfolio bid has enabled us to remain active, provide competitive pricing to our sellers, maintain our competitive position, and protect profit margins.

In 2013, we acquired $6.9 billion of jumbo loans, a large increase from 2012 when we acquired $2.3 billion, but short of our upwardly revised goal of $8 billion. For 2014, we expect to increase the number of sellers we acquire loans from. While we expect that our 2014 jumbo acquisition volume will be lower than in 2013, we expect our decline to be less than the 32% decline projected for the industry as a whole.

Our approved correspondent customer network continues to grow. As of the fourth quarter, we had 118 active loan sellers, and we were very active adding sellers, with an emphasis around conforming loan acquisitions. The growth of our Denver operation has been very successful, and has given us the opportunity to really scale the business to be a much bigger player in the residential mortgage markets over the coming years.

For our residential conforming acquisition, our goal is to ramp up to a run rate of $1 billion per month by the end of 2014. While we do not expect that this ramp will be linear, however, given our internal processes for expanded product offerings to our sellers, as well as projected declining industry-wide origination volume.

Turning to our commercial business. Our commercial team had its best quarter, with $242 million in senior commercial loan originations, and a very successful year in 2013, originating $805 million of senior commercial loans.

Although we fell short of our goal of $1 billion of senior commercial originations, our loan sale profit margins significantly exceeded our expectations, as did the overall profitability of the business. We plan to expand our commercial platform in 2014 by adding experienced originators, paving the way for us to exceed our $1 billion annual commercial senior loan origination goal we had set for 2013, while also increasing our mezzanine loan origination activity.

Our investment portfolio grew in the fourth quarter, with $368 million of acquisitions. We invested $22 million in securities created from our Sequoia transaction during the quarter, and another $346 million of senior insubordinate securities bought in the secondary markets. One important investment highlight I'd like to emphasize again is that our securitization platform has generated over $0.5 billion of credit and other investments for our portfolio, that would not have been available in the secondary markets.

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 our Chris Abate, our CFO, to run through the numbers.

Thank you, Brett, and good afternoon, everyone. Redwood generated solid financial results in the fourth quarter of 2013, to cap what was a productive year of operations. Commercial group had its strongest quarter to date, as Brad mentioned, and the residential group still produced satisfactory results, despite lower acquisition activity.

Also of note, our investment portfolio continued to generate attractive returns, as our credit-sensitive securities and MSRs increased in value during the quarter. In the fourth quarter, Redwood earned $0.29 per share, an increase from $0.25 per share in the third quarter.

Both of these quarters included significant items. The fourth quarter included a pretax charge of $0.15 per share for litigation reserves. These reserves relate to previously disclosed litigation, pertaining to certain legacy Sequoia securitizations.

Also as a reminder, our third-quarter results included $0.17 per share of negative mark-to-market adjustments related to our residential loan pipeline at June 30th. We spoke about this particular adjustment and the associated timing difference on our third-quarter earnings call.

Our GAAP book value at December 31, 2013 was $15.10 per share, $0.45 per share increase from the prior quarter, reflecting our fourth-quarter net income as well as positive mark to market adjustments on many of our investments. For the full year, our book value increased by $1.15 per share, after paying $1.12 per share of dividends during the year.

Capital deployed during the fourth quarter amounted to $76 million, compared to $146 million in the third quarter. In the fourth quarter we acquired $373 million in mortgage securities, commercial loans, and MSRs, compared to $249 million in the third quarter. Many of these acquisitions were funded with a combination of short-term debt and capital.

Turning back to our fourth-quarter earnings. Net interest income was $38 million for the quarter, a $2 million increase from the third-quarter. This increase largely reflected continued growth in our investment portfolio, as well as a reduction in interest expense, as we relied less on short-term debt to fund residential and commercial loan activity in the fourth quarter.

Our provision for loan losses was $4 million in fourth quarter, up from $2 million in the third quarter. As is usually the case, most of this reserve relates to loans held at legacy Sequoia securitization entities that we are required to consolidate for financial reporting purposes.

We believe the increase can be related to efforts of servicers to resolve existing delinquencies at some of these legacy entities. Our more recent Sequoia securitizations, those issued from 2010 onward, continued to perform very well in the fourth quarter, with very low delinquencies.

Residential mortgage banking income was $10 million in the fourth quarter, compared to a loss of $13 million in the third quarter, after giving effect to the timing differences I noted earlier. Timing differences related to our residential pipeline have to do with timing of mark to market adjustments on loans versus hedging derivatives, for accounting purposes.

These adjustments currently relate to our jumbo residential purchases. We don't currently anticipate similar timing issues related to our conforming purchases in future quarters, given the liquidity in that market and the speed of transactions.

However, we continue to expect quarterly timing differences that will impact the loan sale profit margins we earn on our jumbo production. For the first quarter of 2014, we do not currently expect a significant adjustment related to our year-end residential loan pipeline of around $900 million.

Back to our fourth-quarter results. The Sequoia securitization we completed was for $325 million, and that was in addition to the $648 million of whole loan sales we completed during the quarter.

All of these transactions were profitable for us, net of our hedges, and we continue to see robust demand in the whole loan market. MSR income increased to $6 million in the fourth quarter from $3 million in the third quarter, mostly due to positive mark to market adjustments, as the overall market continues to assume slow prepayment rates and the recently originated loans backing new MSRs.

Turning to our commercial mortgage banking results. We generated mortgage banking income of $7 million for the fourth quarter, which was up from $3 million in the third quarter. The increase was driven by high origination volume, which amounted to $242 million in the fourth quarter, versus $121 million in the third quarter.

As we noted earlier, our commercial team had a strong quarter. Margins in this business continued to remain at elevated levels, allowing us to exceed our profit contribution targets for our commercial business in 2013, despite not hitting our origination goal of $1 billion for the year.

Operating expenses were $19 million in the fourth quarter, down $3 million from the third quarter, mostly due to a lower approval for variable compensation expense. We realized $2 million of net gains from the sale of $3 million of securities in the fourth quarter, which was down from $10 million in gains from the sale of $168 million of securities in the third quarter. Fourth-quarter 2013 income tax expense was $2 million versus the positive $5 million benefit in the third quarter.

In the third quarter, we released a reserve against our deferred tax asset. The $2 million fourth-quarter provision primarily related to taxable income generated by our mortgage banking activities, which are conducted at taxable REIT subsidiaries.

Turning to our cash position and our capital. As December 31, the unrestricted cash was $173 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 approximately $130 million. We currently expect that our available capital liquidity is sufficient to fund our business investment objectives for most, if not all, of 2014.

That concludes my prepared remarks and our fourth-quarter financial results. Before we move forward and open the call up to Q&A, I wanted to note that our year-end disclosures may look a little different this quarter to those that downloaded or read our review or upcoming 10-K filing.

Beginning with fourth quarter, we adopted segment accounting as a supplement to our usual top-down consolidated disclosures. Specifically, we have included segment contribution information for our three main operating areas. Those are, residential mortgage banking, residential investment which we have sometimes referred to as our investment portfolio, and commercial mortgage banking and investments.

As part of the transition to segment disclosures, we made some conforming changes to our consolidated income statement. Hopefully, you will find these supplementary disclosures useful this quarter, and in the future.

With that, let's open it up for questions. Operator, please go ahead with the Q&A.

(Operator Instructions)

We'll take our first question from Dan Furtado with Jefferies.

Two questions. The first is comments surrounding the GSE risk-sharing deals. What do you think has to be put in place for this to become a possibility, and what gives you confidence that something like this, in terms of pairing up with the GSE, is something that could potentially happen in the future?

I think what really needs to do is to work out the contractual arrangements, and the terms around those, which is not completely straightforward. It is different, obviously, than the stackers deal and some of the other structured deals, where it is simply people are looking to that deal and looking for a certain investment yield and return based on those.

This is more of a function on an operating an ongoing business in the amount and how that risk-sharing could get done. We would be hopeful that we could be doing risk-sharing by the end of 2014.

And the second collection from a big picture, how are you currently looking at the QM versus non-QM mortgage markets? How do you think that those markets will evolve?

Brett?

I will take this. Well, currently, about 80% of the volume that we securitized post-crisis was actually QM. About 20% of it would have been considered non-QM, mainly only due to interest-only features and debt-to-income features.

We will continue to -- we will be buying non-QM loans, high-quality non-QM loans for the purpose of securitization, and we will continue to monitor and grow our product offerings, as we come up with new securitization alternatives, other distribution channels for non-QM, including both whole loans and other financing vehicles.

Got you. Just generally, do you think the banks will be equally as aggressive in both the QM and non-QM markets, or do you think there will be some disparity in their level of competition?

We believe, generally speaking, that the banks will definitely stick much more to just generic QM loans, albeit that interest-only loans, to high net worth borrowers, I think they will continue to portfolio, and those would be considered non-QM.

Got you. Thank you for the time.

Thank you. We will take our next question from Steve DeLaney from JMP Securities.

I wanted to touch on your execution on the sale of the jumbo loans. So, it is clear that what you are seeing in the whole loan bid execution beats the RMBS 2.0 market.

So my first question is, Brett, you have reaffirmed in the review that you still think the 25 to 50 basis points is the right range. Would it be reasonable -- let me put it that way -- if we were to read into your comments that maybe the whole loan bid gets you closer to the upper end of that range, and the securitization execution gets you at the lower or even below 25?

Are the whole loan bids strong enough that you are near the top end of your range, I guess is my question?

Go ahead, Chris.

Yes, the answer is yes. For 2013 our long-term estimate of loan sale profit margins of 25 to 50 basis points, by and large, we exceeded that. Obviously, through the first half of the year, and even in the second half, thanks to hedging and whole loan execution.

If you look at -- I mentioned that the timing issues that make it difficult for us to specify what those are at any point in time, but if you look at our residential mortgage banking for 2013, we earned $78 million on just over $7 billion of production, so we were north of 100 basis points for the year. Since the end of the year, the securitization markets actually started to become more attractive.

Mortgage rates are down an eighth to a quarter, and spreads have tightened. So the whole loan execution for a while was significantly better than securitization, but that gap has tightened quite a bit here over the past few months.

Thanks, Chris. Talking about that decision that you make, obviously, best execution on the front end is a big factor. You've got the cost of the conduit, the Denver center, et cetera, that you got to cover in the current period.

On the other hand, every quarter we are seeing the benefits of your retained investments in sub-IOs, MSRs especially, the hedge value that Chris just alluded to. How do you weigh that decision, and will you continue to do some amount of securitization, just to continue to create those attractive long-term assets?

The short answer is yes. We weigh that -- we take that decision very seriously.

We not only -- we will always prefer securitization to selling whole loans for a number of reasons, most of which you just mentioned in terms of investment activity, but also to ensure the long-term liquidity of our program. Investors -- AAA investors want to see ongoing activity, that this is not a one-and-done program. So there are a lot of soft benefits to us, that we will remain a consistent securitizer of loans.

Thanks, Brett. And I guess the last spin on that, and then I will hop off and get back in the queue, does your accounting -- you are doing gain on sale, you switched about a year ago or so, a year and-a-half ago. Does your accounting regime allow you on a transaction by transaction basis to consider recording a deal as a financing rather than a sale?

I am asking that because your legacy Sequoia deals have obviously been paying down, and those are whole loans consolidated, which help you for the 55% rule for the 40 Act exemption. I mean, would it be possible that going forward you might even elect to do a financing treatment, just to give yourself cushion on the 40 Act? Thanks.

Yes. You are right. Our consolidated loans have gone down, as our legacy Sequoia deals have paid down.

We have been utilizing sale accounting for the better part of the last three years. We could move back to financing, with certain changes to the deal structure. At this point, we have concluded that the costs -- the benefits outweigh the costs of not changing.

But in the future, we could revisit that as part of our bigger view on the 40 Act compliance and retests. But currently, we continue to pass our compliance tests, and we don't have any near-term plans to change.

Steve, I would just add that doing sale accounting just makes for a much simpler presentation, better transparency, so the reader can actually see the securities that we actually own, when -- rather having to figure out what we own through the consolidation of assets and liabilities, and the net effect is our equity. I think it's just a much cleaner, simpler way of showing it.

Understood. Thanks for the comments, gentlemen.

Thank you. We will go next to Paul Miller with FBR.

This is actually Thomas on behalf of Paul. On the securitization side, we note that the market is tight, given the appetite for jumbos at the banks right now.

Has that loosened any? I'm just trying to size growth opportunities. I guess another way of asking that would be your securitization forecast for 2014. Would we expect that to start slowly in the first half of the year, and then ramp up in the back half?

Tom, it's Brett speaking. We did mention we will have a transaction out here shortly, late in the first quarter, early second quarter. It's really going to depend on where spreads are, versus our execution on whole loans, and balancing the two, particularly related to how we responded to Steve's question.

So, yes, if spreads remained firm and tighten, vis-a-vis whole loan securitization, you will see securitization activity ramp up. Meanwhile, we do see large money center banks through their retail lending platforms be very aggressive in the jumbo lending space. However, in terms of aggregators or non-banks, we remain very, very competitively positioned to acquire jumbo loans.

Okay, great. One quick follow-up. On the QM side, or I guess the non-QM side, when you talk about well underwritten product, is there a plan to re-underwrite that product yourselves, or can you talk a little bit about what that means?

Well, if we had -- the 20% of the loans that we purchased post-crisis, those would now be considered non-QM, but they would be considered, they would be low-LTV, they would either have an interest-only feature, so low-LTV would be somewhere in the neighborhood of 60% to 70%. They would have an interest-only feature, or they would have a debt-to-income ratio that exceeded the 43%, mainly because they have very, very high incomes.

So we will continue to buy those loans. There are other non-QM loans, such as limited doc and other features, that we will continue to monitor and grow those product offerings, as we feel more comfortable with the viability of securitization of those, or other funding strategies.

Okay, great. Thank you.

Thank you. We will take our next question from Joel Houck with Wells Fargo.

Wondering if on the conforming side, you talked about $1 billion by the end of 2012, or assuming that is mostly back-end loaded -- I'm sorry, 2014. Have you talked about or can you give us a sense of what the economics are going to look like on the conforming side of business?

Yes. I mean, really at this stage, we hope to generate MSR, primarily through the conforming side of the business. With MSR pricing being somewhere in the neighborhood of 1% of originations today, plus or minus, we would hope that we could put some money to work there.

At this point, we are not giving guidance on specific gain-on-sale margins, mostly because we just entered the business. I think we disclosed that we purchased $43 million of loans in the fourth quarter, and the pipeline is ramping, but we still need to continue to ramp. And hopefully later in the year, we've got a better handle on the potential profitability of that business.

Okay. Obviously, you kind of continued cautionary comments surrounding the jumbo market. What are you looking for, for early signs of improvement, or what should investors be looking for?

Joel, can you be more specific? What are you -- just in terms of volumes, or --?

Well, I guess more on the spread or the economics of the business. There is product out there, right, but I guess the issue right now is there is too much liquidity, and that hurts the overall margins on the business.

Are you looking for banks to be less aggressive? What are some of the early signs you look at, that would suggest that the economics are going to improve a couple quarters out in this business for you?

Well, a couple things. I'd say the biggest one is to keep your eye on AAA spreads, as it's -- 93% of the economics is important. We have gone through, with AAA spreads, a pretty wild ride over the last two years, from where they were very wide, and it didn't look like a securitization was viable as either a business, or just the math didn't work.

And then we all know what happened. It tightened incredibly, to where we got in early 2013, and spreads were almost inside agencies. And then we went back out from there.

It seems like it is tightening back, but it is hard to stand here with confidence and say after that ride, that AAA spreads are going to hang in there. Based on the relative value of the product, it looks good, compared to CMBS and others, but it is a relatively thin market.

We are going to do our best. Do a transaction here and hopefully multiple next year, but it's really going to be AAA spreads.

Another factor over time would be subordination levels, which historically were in the 3.5%, 4% range, and currently they are in the 7% range, to see if those tighten up. That would help the economics as well.

Yes, one would think that would be the next thing to occur, just given the overall appetite for yield in the space. Anyway, thanks for the comments.

Thank you. We will go next to Bose George with KBW.

First, how are commercial gain on sale margins doing so far in 2014?

They're still -- relative to historical measures, still elevated. Our gain on sales margin in commercial in the fourth quarter were less than the third quarter, but it was a very busy quarter from a production standpoint.

The first quarter, historically in commercial, is from a seasonality -- from a seasonal perspective, a challenging quarter. A lot of production occurs late in the fourth quarter. There's also a lot of new entrants.

Historically, Q1 has been slower quarter for our commercial business, and for most market participants. It's tough to say at this point, the long-term direction of margins, but they still do remain elevated from what we have seen historically.

Great. I'm not sure if you've mentioned this, but did you provide guidance for expected volume in commercial for 2014?

No, we said we hope to achieve $1 billion of originations or higher for the year in 2014, which was our original goal in 2013.

Okay, great. Thanks. I wanted to go back to an earlier question about risk-sharing. So the structures that you have been working -- contemplating with the GSEs, it would essentially allow you to strip off risk at the time alone is originated, so you'd be retaining risk to similar to retaining servicing. Is that the idea?

That is the idea. If it weren't for that, we would retain first loss risk into that pool.

Okay, great. Thanks a lot.

Thank you. We will go next to Matthew Howlett with UBS.

Congrats on the quarter. Looking at the investment portfolio, can you tell in the guidance, you have $130 million of excess cash, and you said really don't expect to raise money this year. Would you look to sell some of the lower yielding?

What do you have that is lower yielding? What would you look to sell?

Is it all contingent on how much new issue you can do in terms of vesting the subordinate? Have you figured that out, or can you guide to something in terms of what we can expect in terms of ready to invest this year?

Well, yes, we have a fair amount of excess capital, we believe, today. We have the $130 million of investment capacity.

But as you know, there are some positions in the portfolio, for instance, our Sequoia mezzanine positions, we had $335 million at year end. Those are 4% to 6% yielding assets.

They are very high-quality assets, though AA, AAA -- or A and BBB securities that we have retained from many of our recent transactions.

Those positions are something that we will look to potentially finance going forward, to free up capital. There is always portfolio optimization that we could do throughout the year.

We would look, Bose, if it came to it, to sell lower yielding assets, if at the end of the day, the opportunity was to build either the commercial or residential franchises. I think it's an easy trade.

So you'd look to sell the mezzanine, and you have a significant senior, third-party --

Yes, I apologize. Sorry.

You would look to sell those as well, the legacy stuff you have?

To us it is -- it would become the source of capital, internally generated. Before, we would raise capital internally, externally we would look to the balance sheet and to see what the best -- those being best risk returns, what we think the risk profile is. Again, if the opportunity was to turn that capital into investments that further and add to the franchise, we would do that.

Got you. Just to follow on. Redwood has been primarily buying the credit pieces, the B pieces, what are you doing from third-party securitization? I know you did a deal last quarter, in terms of the subs, of someone else's new issue.

Redwood has historically has been a partner with a lot of the big conduits out there, wall Street conduits, bank conduits. Do you have an idea of what you would do in terms of non-self origination in terms of taking down these guys, their B pieces, this year?

Matt, it is Brett. Trying to forecast anything in the secondary markets is very difficult. We are very opportunistic when we see value, or an opportunity to put capital to work.

But in terms of trying to forecast third-party subordinate transactions or other legacy assets, we are going to be opportunistic on that front. Which gets back to the thesis of the business, which is originate our own investments.

Along those lines, Matt, I think the best thing that could happen for both securitization generally, and for us to have an opportunity, if in fact, the banks, which are now putting everything in portfolio, they were the biggest securitizers in the past, actually looked to a securitization execution, would be the best thing for both the market and for people like Redwood, and looking for a chance to invest. It has just been -- there has just not been that many market transactions happening.

Exactly. And just last question on that front. With Mel Watt in there, and he's been in there for a month or two, any sense on what his big picture is? If conforming limits do come down in October, I think they are scheduled to, do feel he put the hold -- he put the increase on hold for now while he looks at it?

Is there any sense of what he is aiming to do as the FHFA Commissioner? Any idea of whether it's helpful or hurtful to your business with him in place?

Matt, I wish we knew, but we don't. It has really been all quiet on that side, other than what you've mentioned, which is, they nixed the GC increases.

Our hope would be that you continue -- both Fannie and Freddie continue to move ahead with risk-sharing transactions, which to us is the forerunner or precursor to the next model for GSE reform. It seems to have a lot of momentum in that direction. Our hope would be that those efforts are continued.

I would agree. Thanks.

Thanks. We will take our next question from Ryan Zacharia with JAM.

Thanks for taking the questions, I just have a couple. Between the MSRs and the IOs, you had $9 million of favorable valuation adjustment this quarter. So given the rate move that we have seen quarter to date, would we expect those to be flat or negative this quarter? If the quarter were to end today, let's say.

We haven't disclosed updated marks, but yes, the multiples and the prices of IO and MSR are tied to prepayments. They are tied to rates, and they are going to be volatile.

So if the quarter ended today and rates have gone down, you could see some movement. At this point, we have no intentions of selling any MSR, and we use IO both for investment purposes and to manage our pipeline.

Okay. And then when we think about what drove the $5 million of residential loan valuation adjustments in the quarter, is it loans actually purchased? Is it loans identified for purchase, or is it the loans actually sold?

It is loans purchased. So loans -- essentially what happens on the jumbo side is we purchase loans at the end of each quarter, or upon sale, they are re-marked.

Jumbo loans at this point that we identify for purchase but are not in our balance sheet are not reflected in our financials. That gets back to some of the timing issues that we have experienced over the past few quarters.

I can't say on the conforming side it is different. I think the accounting is a little bit more transparent from the standpoint that the commitments to purchase are contractual derivatives, and those are marked.

So the implication is that this quarter you saw basically 75 basis points of gain on sale margin, just taking the $5 million on the $650 million of loans that were purchased?

Yes, but remember, our entire pipeline is $900 million, or just over $900 million. A lot of our exposure is not reflected, or is in those loans that aren't on our balance sheet yet. That's really why we look at loan sale profit margins over a longer period of time on the jumbo side than a quarter-over-quarter basis.

So I guess I'm just trying to understand then. Is it loans purchased that drives the gain on sale to $5 million, or is it some other larger number?

It is loans purchased on the jumbo side. On the conforming side, it's the combination of purchased loans and derivative commitments to purchased loans.

Right. So the $650 million of loans that were acquired are what drove the $5 million of gains in the quarter?

On the jumbo side, in the fourth quarter, yes.

Okay. And then are you guys still pre-selling the AAAs on this latest deal?

We enter into various different underwriting transactions. There is no set way of entering into those relationships.

Is the deal that you are doing in the first quarter similar to the deal that you did in the fourth quarter, in terms of execution?

We cannot comment on any potential transaction other than to say that we are going to do one.

Okay. And just a final question. Would the conforming business be deemed a success if you just broke even, but were able to accumulate servicing at attractive levels?

We would find that to be a success. We will measure success when we are up to $1 billion a month, because of all the other ancillary benefits in the relationships with the GSEs, as well as acquiring mortgage servicing rights, and as well as making a profit above and beyond that. We have a lot of measures for success there.

Great. Thanks a lot.

Thank you. We will go next to Jim Fowler with Harvest Capital.

The last couple quarters there's been a nice steady decline in operating expense, as a percentage of interest income and average total assets. I was thinking that we might see an uptick in expenses, the direct fixed, given the Denver build out. Could you comment a bit on where you are capacity wise in Denver, and give the direction of fixed expenses that we might see, if that starts to become -- hit some of your origination targets?

Again, we haven't issued any formal guidance on operating expenses. I can say we started the year with 86 employees and we ended with 141, so we did -- 61 of those are new employees in Denver, which is a pretty significant buildout. At this point, we are continuing to add staff on both the residential and commercial fronts, so I think we are still in a growth mode.

That said, where we stand with the existing infrastructure, we've got a lot of room for capacity. Over time we do -- on the resi side, the goal is to really leverage that platform, and most of the existing staff that we have brought on.

On the commercial side, we are really interested in expanding the platform. We are seeing significant opportunities, and we need to do some additional hiring on the originator front, so I think operating expenses for the last few quarters have been somewhat stable. At this point, aside from the normal adds, they should continue to be stable for the immediate future.

I guess that's my point. They've been stable, while you've added a large component of people. What would be -- is there a capacity level, if you would be able to feel comfortable with right now discussing, relative to your current originations, given the footprint that you have in Denver? It has to be much larger than what you are currently doing, I would suspect, without increasing expenses a whole lot, I would guess?

Yes. We feel like we've got a lot of capacity. I can't put a specific number on at this point, especially since, again, a large portion of that staff is directly related to our conforming build-out, and we just don't know at this point what the ramp there is going to be, or what additional staff we may need, based on underwriting and production. At this point, it's a little early to tell.

Okay, great. Thank you very much.

What I would say, and it's Marty, really just to frame it a little bit, I think on the commercial side, I think we are talking four or five originators to help it on that side. And I would say on -- basically, where we are in Denver, based on the current volumes that we have in jumbo, and the buildup of the GSEs and the ramp that is right now, I think we're okay. There will be increases, but I don't see market increases.

And then what it really comes down it is if we are successful, and we are at $1 billion a month, let's just see how we have to tweak staff at that period of time. For the near-term, I think we are in general, pretty much okay.

Thanks, Marty. Appreciate it.

Thank you, and we have time for one final question. We will take that question from Steve DeLaney of JMP Securities.

Just two quick follow-up items. You talked about AAA spreads tightening a bit, since year-end. Can you give us some kind of range on where those stand, where you see that?

I know it's a fuzzy market relative to swaps. Are AAA investors still pricing jumbo paper to a five-year swap, or has it moved out with higher rates, like a seven-year life?

All right. This is Brett. To give some perspective, one, you have to look at the different coupons.

So a current coupon mortgage, more 4.5% gross WAC, versus something of sub-4%, obviously, it's a much different average life profile and price. As an overall benchmark, just some rough numbers.

The wides, they were trading or quoted at being 4 points back of benchmark TBAs, and we could be as tight as 2 to 2.5 points back of benchmark TBAs currently, so that's a considerable amount of tightening. Some of that also has to do with legacy -- not really legacy, but lower coupon collateral that was originating really back in the late second quarter versus higher current coupon today.

Right. And I think the deal you did in the fourth quarter was close to 4.70% in terms of the WAC, something in that ballpark.

(multiple speakers) that paper.

Appreciate the time. And the last month or so, we have seen two mortgage finance companies disclose that they have gained membership to the Federal Home Loan Bank system. Just curious if that is something that Redwood is looking at, and if there is any particular assets that, if you can achieve that membership, where would -- would the financing really fit within your portfolio? Thanks.

Go ahead.

This is Chris. I was going to just say quickly that, yes, we are aware of what's happening in the market. Again, as a non-bank aggregator, anytime you can achieve low-cost financing or term financing that is attractive, so we are focused on the potential opportunity to join the Federal Home Loan Banking system.

At this point, we are studying it. We don't know exactly where we would utilize that type of financing.

Currently, today, we rely on the warehouse financing for our loan pipeline, and some repo financing for our senior securities. Those are two potential areas that could be attractive for us with that type of opportunity.

Okay. Thanks, Chris.

At this time, I'd like to turn the call over to Mr. Mike McMahon for any additional or closing comments.

I'd like to thank everyone for participating on our earnings call this afternoon. If you have any follow-up questions, you can reach me shortly after the call. Thank you very much.

That does conclude today's call. Thank you for your participation.