Redwood Trust Inc (RWT) 2014 Q2 法說會逐字稿

Good afternoon and welcome to the Redwood Trust, Incorporated, 2014 second-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 material impact on the Company's performance and could cause actual results to differ from those that may be expressed in 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, Thursday, August 7, 2014. 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 a recording of the call will be available on the Company's website at www.RedwoodTrust.com later today.

For opening remarks and introductions I will now turn the 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 second-quarter 2014 earnings call. Joining me on the call are Brett Nicholas, Redwood's President, and Chris Abate, Redwood's CFO; and they will get into some of the details when they cover the residential and commercial business activities and the financials.

We continue to manage, invest, and position our residential and commercial businesses for long-term growth and to build sustainable franchise value. With these goals in mind, both businesses continued to make really solid measurable progress in the second quarter.

Our residential and commercial loan platforms are the vehicles that drive earnings and new investment creation. There are three levers to grow and expand these platforms.

We can do it by adding new products, adding new sellers, and by adding more distribution capability. As Brett will discuss shortly, we made significant progress on these fronts during the quarter, especially with our new business relationship with the Federal Home Loan Bank of Chicago.

Unfortunately, despite all the good news with the key growth metrics, our near-term quarterly earnings are lagging the progress we see in our operations. It is not a Company-wide issue. Our earnings from our commercial mortgage banking business and our investment portfolio continue to be in line with or ahead of our expectations.

The primary area of earnings pressure is coming from our residential mortgage banking activities. This is due to two factors.

First, our conforming loan product line is more commoditized when compared to the jumbo product line and, therefore, more subjected to the overall industrywide pressure on gain-on-sale margins resulting from lower refinancing activity. Our jumbo product line margins were in excess of our long-term target of 25 to 50 basis points before personnel and overhead costs.

Additionally, we are incurring upfront costs that are going through the P&L as we build our operations and processes to try and increase market share. We are building at the same time the overall market is contracting.

We still think it is better to build more towards the bottom of a market cycle and position us for upside when the cycle turns back. Ultimately, we believe the pressure on margins that is broadly impacting the residential mortgage industry will gradually correct, as market capacity and pricing move back in line with origination volumes.

Additionally, we believe we can improve our conforming loan sale margins by increasing loan purchase volumes and by better leveraging the cost of our operating infrastructure. Importantly, our conforming loan business also opens up opportunities to invest in homegrown servicing and potentially in credit risk transfers with the GSEs.

Our commercial business had a solid quarter in terms of business metrics and its contribution to earnings. We have an excellent commercial team. The business metrics, volume, margin, and pipeline were all up in the second quarter.

We like the prospects for our commercial business, both in terms of our competitive position and the strength and outlook for the commercial market fundamentals. We remain excited about Redwood's position in the mortgage market and the opportunities we see ahead to generate shareholder value.

Now I would like to turn the call over to Brett Nicholas, Redwood's President, to discuss the key highlights in our residential and commercial businesses.

Thank you, Marty. We made significant operational progress in the second quarter, specifically on the three levers Marty just mentioned. Let me run through some of the operating metrics.

Our residential loan acquisition volume was $1.8 billion in the second quarter. That is up 64% from the first quarter.

We originated $149 million of senior commercial loans in the second quarter. We issued a $347 million residential loan securitization that closed in April, and we also issued a second securitization late in the second quarter for $306 million that closed in early July.

Our residential securities portfolio increased by $102 million to $1.8 billion. I will comment briefly on each of these areas.

In the second quarter we acquired $923 million of jumbo loans; that is up 16% from the first quarter of 2014. We made very good progress growing our conforming product line in the second quarter, which was only the second full quarter in which we have been acquiring conforming loans.

We acquired $868 million in the second quarter, up from $299 million in the first quarter. That is a 190% increase for our conforming product line.

Our seller network continues to grow every quarter. At the end of the second quarter we had 140 sellers, up from 124 at the end of the prior quarter. Our team has done a very good job of identifying high-quality originators nationwide, engaging and getting them up and running, which is driving new business across all residential product lines.

In the second quarter, we completed six jumbo whole loan sales transactions for a total of $357 million. As with the past few quarters, whole loan sales continue to offer better execution, but securitization has become more competitive with whole loan execution as AAA spreads have tightened over the last quarter.

Given the tightening of AAA spreads, we are likely to increase our securitization activity in the second half of 2014, with our next securitization likely to close in September. As stated previously, our preferred distribution for jumbo loans remains securitization, since we can retain attractive investments for our portfolio and continue to build the Sequoia brand in the capital markets.

Our commercial business is performing well. We originated $149 million of senior loans, and we sold $181 million in the second quarter to CMBS transactions. At the end of June, our pipeline on loans in application was a record $347 million, which bodes well for the third quarter as well as for full-year origination goals in 2014 for our commercial team.

Our investment portfolio performed well during the quarter. We acquired $141 million in the second quarter, which included $116 million of senior securities and $26 million of subordinate securities, $20 million of which were retained from our Sequoia securitization which closed in the second quarter. These acquisitions were funded with $121 million of short-term debt and $21 million of capital.

Additionally, we acquired $12 million of mortgage servicing rights, which brings our total servicing investment to $71 million, which is associated with $7.1 billion of loans.

We have had very good momentum going into the third quarter in both our residential and commercial mortgage banking operations. In our residential business, loans identified for purchase at the end of June were $2 billion. That is up 140% from the end of the first quarter.

Our commercial business has also seen a pickup in origination activity. And as mentioned before, we entered the third quarter with a record $347 million pipeline.

In terms of the product and seller expansion that Marty spoke to earlier, we made excellent progress on new products. We have added a new non-QM product and successfully added some non-QM loans to our April securitizations. As mentioned before, conforming product line is really gaining some momentum, and we are making good progress on a direct risk transfer program with the GSEs.

In terms of new sellers, the second lever, we continue to add sellers in each quarter. But the big news here is our relationship with the Federal Home Loan Bank of Chicago to purchase high balance loans from member banks who participate in the Mortgage Partnership Finance program. Our relationship with the Federal Home Loan Bank of Chicago helps the bank expand its mission to provide liquidity for its members, and it opens the door for Redwood to potentially add a significant number of new sellers across the country.

We are currently working with the Federal Home Loan Bank of Chicago to identify early participants and working through operations. We expect to begin acquiring loans from this program in the fourth quarter.

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

Thank you, Brett, and good afternoon, everyone. Earnings per share were $0.18 for the second quarter of 2014, up from $0.14 in the first quarter. The increase in earnings is largely attributable to higher mortgage banking income, which increased by $6 million or $0.07 per share in the second quarter. Partially offsetting the improved mortgage banking results were an additional $2 million or $0.02 of operating expenses quarter-over-quarter that related to the buildout of our residential and commercial platforms.

Our quarterly results continue to experience timing differences related to our jumbo mortgage pipeline and hedging for those loans, making it difficult to fully ascertain our quarterly operating performance from our high-level GAAP results. In the second quarter, we incurred hedging expenses due to falling interest rates that were reflected in that period's earnings, but the anticipated increase in value of the $1.6 billion of jumbo loans we plan to purchase at June 30 was not reflected in earnings.

Instead, the valuation will be reflected in third-quarter earnings to the extent those loans are acquired throughout the quarter. Our best estimate of this amount would currently be positive $9 million, or $0.10 per share, of additional income that we would currently expect to come through our third-quarter 2014 reported earnings. Obviously as I have stated in the past, this is only an estimate and is subject to change based on a number of different factors.

Additionally, I would note that this type of timing difference is specific to our jumbo products and is self-correcting over time, as loans process through our conduit. However, to the extent we believe it is significant in this quarter or any given quarter, whether positive or negative, we may choose to discuss it on the quarterly call.

Additional irregularities that affected our second-quarter earnings include hedging expenses related to our investment portfolio. For example, we incurred negative marks of $10 million or $0.12 per share on some hedging derivatives in MSRs that were reflected in earnings, while the corresponding offset from higher marks on the hedge portfolio assets of $12 million or $0.14 per share was reflected in equity and not earnings. We continue to explore ways with our accountants to better align the economics of our business with our reported earnings going forward.

Getting back to our quarterly results, net interest income was $37 million in the second quarter, an increase of $1 million from the first quarter. Our investment portfolio continues to generate strong, stable income and cash flows that more than cover the cost to run our operations, service our debt, and pay our quarterly dividend.

Our GAAP book value per share was $15.03 at June 30, a decrease from $15.14 at March 31. The second quarter decline is net of $0.18 per share of net income and $0.15 per share of net unrealized gains on securities, and also reflects the second-quarter dividend paid to shareholders and an increase in shares outstanding related to our annual distribution of common stock underlying vested equity awards. These awards had previously been expensed through our income statement.

Turning to our cash position and our capital, at June 30 our unrestricted cash was $157 million; and our current investment capacity, which we define as the approximate amount of capital we have readily available for long-term investments, was approximately $62 million. While we have previously expected our available capital and liquidity to be sufficient to fund our business and investment objectives for most of 2014, as a result of improving market conditions our rate of capital deployment in the second half of 2014 may require us to source additional capital prior to the end of the year.

As we have stated in the past, we look first to our own balance sheet for attractive opportunities to raise capital through sales or financings of assets before we look externally. Should we decide we need to raise additional external capital to fund our business activities, we would consider the issuance of convertible debt securities under the shelf registration statement we currently have on file with the SEC, as well as the issuance of other debt securities or common equity in a public or private offering.

That concludes our prepared remarks for second-quarter results. Operator, we are ready to take questions.

(Operator Instructions) Steve Delaney, JMP Securities.

Good afternoon, gentlemen. Thanks for taking my question. Maybe I could start on the commercial real estate. It definitely sounds like some momentum there, and the margins were holding up.

I just wanted to ask, I guess, Chris, if you are the right person, just to make sure my math is -- I am doing the right math here. It looks like the commercial mortgage banking contribution, net of the hedge costs, was $5 million. I think based on prior conversations in calls that the appropriate denominator for that to try to calculate a margin on that business is actually the loans originated in the quarter.

I think everything that is originated for sale is marked to fair value. So that would be $149 million, and the simple math gets us to somewhere between a 3%, 3.5% margin. Is that the right way to think about the profit margin on that business?

That is one way to look at it. We certainly -- I think you've got it right in that we look at the loans originated, and the point at which they are distributed. And there is noise, as there was last quarter, Steve, with loans that were held over from the prior quarter.

I think that big-picture, though, 3% is not a realistic trend or a number to draw a line through.

Okay.

I think in this business there is a lot of competition, and through the end of the year I think margins have been healthy and will remain healthy, but something well over 100 basis points, but not 350 is (multiple speakers)

Okay, so when we look at the $300 million-and-some, $350 million in the third quarter, I think you are just cautioning that -- don't carry that second-quarter margin forward.

Yes, I mean, it's -- we had -- there were a few quarters last year where we were generating returns like that. But I think that looking at the pipeline, and thinking about the end of the year and the supply in the market, I would caution you to (multiple speakers) before booking that.

Okay, well, (multiple speakers) I appreciate your candor.

This is Marty. I would look closer to 2.

Okay. That's very helpful. Then I appreciate the challenge you guys have with the timing differences, and I know you are working to try to maybe get some documents changed so that will be resolved in 2015. But, Chris, I just wanted to clarify.

The $1.6 billion, that was the pipeline, or -- maybe the pipeline; I want to use the right term. Those where the loans identified for acquisition at June 30 in the jumbos, right?

That's correct. They weren't on the balance sheet.

Okay, okay. You are suggesting that those may have a -- since that wasn't recognized, that may have been a $9 million offset to hedge costs, or $0.10 a share. Now if we think about -- I try to net these timing differences, to basically start with a core number and then adjust the timing difference. But I think I probably need to net against the June 30 timing difference.

Don't I have to look back to where we were at March 31, and maybe I think that pipeline was like $670 million. So should I think about, as far as the net timing difference, the impact in 2Q? Should I look at the dollar difference in the jumbo pipeline and then try to apply some kind of unrecognized margin?

Yes, that's right. Last quarter we didn't spend as much time on this because the numbers weren't as significant. As you said, the pipeline was quite a bit less.

I think where we ended the last quarter, since our last call, we bought those loans and distributed them. There was probably less than $1 million of additional income on the loans.

So I think if you're looking at netting, I think that you are looking at the $9 million and some number that is less than $1 million from [2/31].

Okay, that's helpful to note. Thanks. Okay, well -- yes, that's enough on the nitty-gritty. Maybe, Marty, I would just like to get a big-picture thought and then I will drop off; I know there are others that probably want to ask questions.

Last year, thinking about Washington DC, last year we were all hoping while the market was there we might get a cut in limits; and GSE reform was going to be something that would benefit the business model for the private-label model. That didn't happen.

But now it seems there is a new move there, some focus. I guess Treasury at the end of June when they were celebrating 5 years of making homes affordable, there was a White Paper put out on reinvigorating the private-label market. And then just yesterday, SFIG put out this Green Paper.

I was just curious if you've got some thoughts, big-picture thoughts, you could share with us about what are these -- what really needs to be fixed in this market to improve the liquidity and the breadth of the market? Thanks.

By the way, for everyone on the call, we submitted a White Paper yesterday as well.

Okay.

My observations would be, one, for a Redwood-type deal, probably doing something to more safety, when we have done 10,000 loans and there is only two loans that have issues and one of which is current.

But I think one of the things that, with all the talk on RMBS 3.0, again, we took the position: Why don't we lead? How can we build to standards that is even higher? And really being built with an eye towards sometime the collateral will get worse, in which case you will need more protections, not necessarily on our deals but other deals.

And there is people out there that are actually boycotting at the moment, waiting until RMBS 3.0 comes in. And essentially it is two things.

It is essentially, one, much more scripted and prescriptiveness to the documents, standardization, taking out ambiguity so there is less discretion on the behalf of the servicers or trustees. And then the second thing is to have a traffic cop in the deals -- and these are our ideas -- to overlook the three areas which were most impacted, where investors are most impacted. And that would be to oversee servicing, oversee reps and warrants, and oversee cash flow mechanisms.

It is a lot to go on in the call, but really our paper is out there and I encourage you to take a look at it.

We'll take a look. Thank you. Thank you for the comments.

Vik Agrawal, Wells Fargo Securities.

Hey, thanks, guys, for taking my question. I am just curious. When you talk about or mention that you are looking at increased activity for the second half of the year, is that a sign that the market is starting to normalize on the jumbo side?

Vik, this is Brett Nicholas. No, it is a combination a few things.

One, we continue to grow our seller network and origination network. And then secondly, rates are down and spreads have tightened. So borrowers are -- there is much more competitive rates out there for borrowers to buy homes or refinance.

So that is really what is driving a lot of it. So some of it is on our behalf and the other is just absolute interest rates.

Okay. Then shifting gears, on your -- you mentioned that there were higher residential expansion costs. Can you give me a sense of how much that was in the quarter? And are you expecting more in the future?

We have a lot of just general overhead that we don't allocate specifically to segments each quarter. But we did say that they went up $2 million quarter-over-quarter.

And just to give you an idea, we have got a headcount of 172 at June 30; most of those hires have occurred on the residential mortgage banking side. So our goal is -- we are ramping up the conforming business, trying to achieve a level of volume that makes us efficient. And in order to accommodate that volume we still have some hiring to do.

We have some work on systems. But we expect it to be substantially completed by the end of the year.

Okay. Thank you. Appreciate the answers.

Paul Miller, FBR.

Afternoon, guys. This is actually Thomas LeTrent on behalf of Paul. Another question on the pipeline, if I can. The $9 million benefit is obviously based on some sort of rate assumption.

If rates continue to move down like we saw today -- I mean the 10-year was weak again today -- would it be fair to say that that benefit could be higher? Or would there are also cause some additional hedging costs that would flow through third quarter as well?

Yes, I mean we are -- there are some assumptions built into that number and why we are always hesitant to say too much, because -- obviously, one of them is fallout and how many of the loans in the pipeline, how much of the $1.6 billion of the jumbo pipeline, actually pulls through.

Rates is another one. Rates has a big influence on fallout.

So at this point, that $9 million estimate is a current estimate, so it is our estimate as of today. You are correct; the rates have fallen. So at this point we don't have a better guess or sense of where it is going to head, but rates do impact ultimately the pullthrough.

Okay. Then one more question. On the conforming loan piece, which obviously conforming loan acquisitions were very strong in the quarter, would you say you are on par with where you wanted to be at this point? Would you say you are ahead of schedule?

I know you are targeting $1 billion per month by the end of the year. But just trying to get a sense of where you feel like you are right now.

We think we are on schedule or even slightly ahead of schedule. I think we were pretty impressed with our second-quarter volumes.

As Chris mentioned, our focus is really around acquisition costs and efficiencies, so that expenses don't keep going up with volume, but that they go flat and the volume goes up.

Okay, great. Thank you.

(Operator Instructions) Bose George, KBW.

Hey, guys. Good afternoon. Can you just comment on the gain-on-sale margin on the conforming side?

And then just your longer-term outlook, you have given the 25 to 50 on the jumbo side. Just what do you think that will be on the conforming side?

You know, the 25 to 50 on the jumbo side, that has been our long-term assumption for those products. And I think we mentioned earlier that we are doing even a little bit better than that or in the higher end of that through the first 6 months of the year.

On the conforming side, it is a completely different situation. As Marty mentioned, it is a commoditized market and we are a new entrant in that space. Really, margins there are very close to breakeven at this point; and that is before expenses.

So through the end of the year, we expect things to improve somewhat. And the reason why is, number one, as Brett mentioned, there is going to be more efficiencies in the business. But also we are still in the middle of ramping our sellers.

We have got 140 active sellers on the jumbo side. There is a lot more that we need to add on the conforming side. And as we do that, from a pricing standpoint we expect to see margins move.

But I think at this point in the year, breakeven margins are where we are at.

Just in terms of the outlook for that, is there a way to think about where that will be as you get to the scale that you want to be, like in 2015?

Well, I mean what we are most focused on is covering our costs, and we need to achieve a level of efficiency. If that level is somewhere in the neighborhood 30 to 45 basis points for the industry, then that is where we need to be.

The way we look at that business is, not only are we operating and running mortgage banking activities, but we are creating investments both through adding mortgage servicing rights and, at some point in the future, potentially adding investments through risk-sharing transactions with the GSEs.

So we see a lot of upside in the business, but some of it is 2015.

It is Marty here, Bose. In part, we are trying to build market share in the conforming side. Everybody knows us on the jumbo side.

To ultimately be a real counterparty to these different sellers, we need to have multiple products and have the same level of service, whether it's jumbo, conforming, or non-QM. So there is market share building that we are doing right now to get in the door, show them what we can do. And then ultimately over time, begin to bring back up price and build in a little thicker margin. And obviously the (multiple speakers)

Okay, so let me just throw in one on the commercial side. Did you guys -- are you growing that in terms of originators, etc.? Or does your strength really reflect the strength in the market as a whole?

It has been through adding originators, and the market has also picked up as well. So it is a combination of both.

Okay. Good, excellent.

And also, Bose, we have been in the business now for 3 years on that side, so our names and brand recognition on the commercial side is growing. And that is really helping a lot.

Okay, great. Thanks.

At this time we have no further questions in the queue. I would like to turn things back over to management for any additional remarks.

Thank you, everyone. Obviously, The Redwood Review is out, to take a look at with everything, as well as our White Paper. Thank you very much. Bye.

That does conclude today's presentation. We thank you for your participation.