Redwood Trust Inc (RWT) 2014 Q3 法說會逐字稿

Good afternoon and welcome to the Redwood Trust, Incorporated, 2014 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, 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, November 6, 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 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 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 third-quarter 2014 earnings call. Joining me on the call are Brett Nicholas, Redwood's President, and Chris Abate, Redwood's CFO. There's a lot to like in the operating metrics and financial numbers for the third quarter and Brett and Chris will go through them.

To me, the most important takeaway is the progress, momentum, and our ability to further leverage our residential and commercial loan platforms. It's been a tough four-year slog to build and integrate all the components that comprise these platforms. But thankfully we are now at a maturity point where we can really leverage the platforms and become more efficient, especially on the residential [loan] side by further ramping up our jumbo and conforming loan products with existing sellers and, importantly, by expanding our loan seller base and adding additional loan products.

Both platforms share a common purpose in that they allow us to create proprietary investments, generate fees, and build franchise value. They also provide us with strong competitive advantages, as it requires multiple relationships and multiple disciplines to effectively and efficiently execute our strategy.

In terms of highlights, our residential conduit had record total loan acquisitions in the third quarter, up significantly from the prior quarter. Along with the Federal Home Loan Bank of Chicago, we started the test phase of the MPF Direct loan program with 10 banks, and we look forward to rolling out that program system-wide next quarter. We are utilizing our borrowing ability through our subsidiary's membership in the Federal Home Loan Bank of Chicago to finance certain loans at attractive spreads that we plan to hold on balance sheet.

And consistent with our belief that private capital will have an increasing and significant role in the residential mortgage market, we entered into a risk-sharing arrangement with Fannie Mae on conforming loans that we will acquire into our conduit and we will sell to Fannie Mae. Under this arrangement, Redwood will earn a return by taking up to the first 1% of credit losses on $1.1 billion of new conforming loans that we plan to sell to Fannie Mae during the fourth quarter.

This transaction is significant for us and is one of the reasons for our entry into the conforming product. If credit performance on the underlying loans is strong, which we believe it will be, this will enhance our overall profitability.

On the commercial side, our commercial business had a very good quarter, with record originations and a high contribution level to earnings. We have an excellent commercial team in place and are well positioned to finance the coming wave of commercial mortgage maturities we expect over the next few years.

Finally, in October we agreed to settle our most significant piece of litigation, which related to a 2006 vintage Sequoia securitization on a confidential and mutually satisfactory terms. The settlement amount was within the accounting reserves which we set aside last year.

Now with that I'd like to turn the call over to Brett Nicholas, Redwood's President.

Thank you, Marty.

As Marty noted, we continued to make significant operational progress in the third quarter. Let me run through some of the key operating metrics.

Our residential loan acquisition volume was $3.4 billion in the third quarter, up 89% from the second quarter. We issued two residential jumbo securitization, one in July, one in September, totaling $636 million. Our investment in mortgage servicing rights nearly doubled in the third quarter to $135 million. We executed our first loss risk-sharing transaction with Fannie Mae. We originated $340 million of senior commercial loans and $26 million of mezzanine loans in the third quarter. And, lastly, we sold $456 million of securities from our portfolio in order to free up capital for reinvestment. I will comment briefly on each of these areas.

In the third quarter we acquired $1.8 billion of jumbo loans. That's up 99% from the second quarter of 2014. We acquired $1.5 billion of conforming loans, up from $868 million in the second quarter and $299 million in the first quarter. Our conforming product line has grown significantly this year. We now have the platform and capacity to ramp up our conforming product line to hit our goal of $1 billion a month.

We are trending to fall short of that goal this year. Growth from our current level has slowed as we've adjusted our pricing to improve profitability. We are still working towards that goal, but will need to see profit margins and industry capacity adjust, which we don't expect until next year.

During the quarter we ramped up our investment in mortgage servicing rights by $62 million to $135 million.

Our seller network continues to grow every quarter. At the end of the third quarter we had 152 sellers, up from 140 at the end of the prior quarter. We expect the new pace of sellers to increase as we begin to roll out our MPF Direct program with the Federal Home Loan Bank of Chicago and continue to selectively add new mortgage originators.

In the third quarter we completed two jumbo securitizations totaling $636 million, and seven jumbo whole loan sales totaling $700 million. Our securitizations created $45 million of investments which were financed with a combination of short-term debt and capital. Although the difference has narrowed, our home loan sale execution for most jumbo loans continues to be more attractive than our securitization execution as a result of strong demand from banks.

That being said, our subsidiary's recently established Federal Home Loan Bank financing capabilities provide us with an alternative to selling or securitizing jumbo loans that we also plan to utilize. During the third quarter our Federal Home Loan Bank member subsidiary financed $236 million of jumbo loans with the Federal Home Loan Bank of Chicago.

Our commercial business had its biggest quarter to date. We originated $340 million of senior loans, up from $149 million last quarter. And we sold $291 million in the third quarter [to] CMBS transactions. We also originated $26 million of mezzanine commercial loans in the third quarter.

Our investment portfolio performed well during the quarter. We estimate the portfolio generated an annualized total rate of return of about 14% between appreciation and net interest income. Our portfolio also became a source of funds for us in the third quarter. We sold $456 million of securities, mainly senior and mezzanine securities. We generated about $49 million of capital that we plan to reinvest in core assets with higher returns.

Finally, we have 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 September were $1.6 billion, and our commercial business entered the [third] quarter with about $200 million under application.

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 $0.50 for the third quarter of 2014, up from $0.18 in the second quarter. The increase in earnings is largely attributable to higher mortgage banking and mortgage servicing income, which increased by $19 million, or $0.20 per share, in the third quarter.

We also benefited from higher net interest income, slightly lower operating expenses, a release of credit and litigation reserves, and higher securities gains. This was partially offset by a higher tax provision.

Our quarterly results continue to experience timing differences related to our jumbo mortgage pipeline and the hedging for those loans, making it difficult to fully ascertain our quarterly operating performance from a high level GAAP results. In the third quarter we incurred hedging expenses that were reflected in that period's earnings, but the anticipated increase in value of the $1.3 billion of jumbo loans we planned to purchase at September 30 was not reflected in earnings. Instead, the anticipated increase in value will be reflected in fourth-quarter earnings to the extent those loans are acquired throughout the quarter.

Factoring in this timing difference with the one we spoke about on our last quarterly call, which related to our June 30th pipeline, we estimate about $7 million of income was included in our third-quarter 2014 reported earnings as a result of net favorable timing differences.

I'd like to be clear that timing differences such as those I illustrated do not affect the amount of income we generate, only the specific reporting period in which it is recognized. The differences are therefore self-correcting over time as loans process through our conduit. To the extent we believe they are significant, whether positive or negative, we may choose to discuss them on the quarterly call. We are also working to amend our loan purchase agreement so that we can reduce or eliminate these types of timing differences in future periods.

Getting back to our third-quarter results, net interest income was $40 million in the third quarter, an increase of $3 million from the second quarter, driven by a higher level of residential and commercial loan inventory held for sale. Our investment portfolio continues to generate a high level of cash flow and more than covers the cost to run our operations, service our long-term debt, and pay our quarterly dividend.

Our GAAP book value per share was $15.21 at September 30, an increase from $15.03 at June 30. The third-quarter increase is net of $0.50 per share of net income. It also reflects the $0.28 per share third-quarter dividend we paid to shareholders.

Turning to our cash position and our capital, on September 30 our unrestricted cash was $150 million and our investment capacity, which we define as the approximate amount of capital we have readily available to make long-term investments, was $145 million.

As we mentioned last quarter, our increased rate of capital deployment in the second half of 2014 is requiring us to source additional capital to support our investment opportunities. As has been our normal course of action we look first to our own balance sheet, and in the third quarter we sold $456 million of lower yielding residential mezzanine and senior securities financed with short-term debt, which freed up $49 million of capital for reinvestment.

While we believe our remaining investment capacity is sufficient to fund our near-term investment activities, we will likely need additional capital to make sustained long-term investments over the coming quarters. As a result, we are considering raising capital from outside sources such as through a convertible debt offering or other medium- or long-term debt issuance.

That concludes my prepared remarks for our third-quarter financial results. Operator, we're ready for Q&A.

Thank you. (Operator Instructions) Bose George; KBW.

First, just on the jumbo volume, that was obviously very impressive. Just curious if there was any kind of bulk activity there and just how we should think about the volumes we could see over the coming quarters.

That was all flow business, no bulks.

So is that the level we should -- we could think about going forward as well?

No. The pipeline was $1.3 billion at the end of September. So each quarter is a little bit different. It was a big jump from the last quarter when we bought [$1.7] billion total. So at this point, October has been somewhat consistent, but it's hard to say heading into the end of the year.

Yes, we can't give you the guidance.

That's okay. Great. And then, switching to the Fannie Mae risk-sharing deal, just curious how the structure of that works. Like how much capital do you need up front and what kind of returns do you expect on that?

Well, Marty told you in his opening remarks that we expect if credit performs well that it should be accretive to earnings. Obviously the terms of the transaction are confidential and we cannot disclose anything.

Okay, fair enough. Actually -- and then one last one. To calculate your GAAP earnings do you just add back the interest expense on the convert?

Yes. You mean earnings per share?

Yes, just to get that EPS number.

Yes.

Okay, thanks.

Steve DeLaney; JMP Securities.

First, a housekeeping thing; I guess, Chris, this would be for you. Your commercial mortgage banking income of $6 million, I can't recall whether on commercial versus resi whether you recognize the value of the loans, or the revenue, based on loans actually sold or on total loans acquired. So I think we had, what, $340 million of originations. And I'm just trying to understand what the $6 million actually relates to in terms of UPD.

Yes. Steve, it relates to the $340 million. On the commercial side we recognize income when we originate the loans --

Got it.

-- on the senior side. So that's correct.

So that's the same as the jumbo, right? But not the conforming -- is that correct?

Yes. On the conforming we have the purchase commitment so there's the additional derivative which gets valued. But on the commercial side we're originating the loans and at the point of origination they go on our balance sheet and they're marked to market, so no timing differences there.

Okay. And Brett or Marty, whoever wants to tackle this one. So obviously the big driver in terms of the numbers and the big jump in earnings -- and, by the way, congratulations on a really exciting quarter in terms of the near-term financial but also the strategic opportunities that you've put in place here. Obviously, the residential contribution I think is the game changer, as I kind of see it, from 3Q to 2Q. And can you comment a little bit -- you kind of alluded to conforming got better, jumbo got better. Was there any one particular -- I mean, the volume actually was about equal between the two. Can you comment as far as the magnitude of the two as to where you really got the most benefit in the quarter?

Yes. This is Chris. The volume was pretty consistent. And I think at least during the quarter the rate environment wasn't quite as volatile and actually rates trended down. So that was somewhat helpful.

We also -- the timing difference last quarter, which I think we said was $9 million, that had an impact as far as the mortgage banking results quarter over quarter. So last quarter reported $1 million of income for resi. And that definitely had an impact on the jumbo side where we recognized some of the hedging costs in Q2, but we purchased the loans in Q3.

So it wasn't -- economically I don't think the quarters were that far off. It was more of a GAAP story.

Right, in terms of the timing. Yes. No, I was going to ask you to kind of clarify that, because -- and I know we're getting down in the weeds. And I think you're using a $9 million figure. At the end of the quarter at June we had given you -- we knew there was like $1.6 billion and we compared that to what we had at March. And in there we made a normalization credit of -- I think it was, like, $6 million. But your pencil's a lot sharper than ours.

I just want to make sure I understand what you're saying, because you've got a smaller pipeline of $1.3 million at September 30. Are you saying that -- just help me clarify and understand -- that the net benefit -- how would you describe the net benefit in third-quarter earnings from the timing differences, if you kind of throwed in the your carryover recognition of the June 30 balances, but then your third-quarter hedges. I'm trying to just understand the net.

Yes. No, and I apologize; it's not the easiest thing to decipher or communicate over the phone. But it's essentially -- we announced the $9 million on the last call. Towards the end of the quarter we think the timing difference heading into the fourth quarter was much smaller. Right now we've estimated it closer to $2 million.

$2 million.

So on sort of a net basis, consistent with my opening remarks, we think that there was about $7 million of income -- of timing difference in the third-quarter results that benefited .

Got it. Okay, that's clear for me now. Thanks very much.

Steve?

Yes, sir.

It's Brett. Thanks for the compliment, by the way. Related to your jumbo conforming question, I would just say that conforming was profitable, jumbo has been more profitable, and falling in line with some of the guidance we've been giving in the past from 0 to 50 basis points profit, which has basically been consistent with what we've been saying.

Yes. And I read your Letter to Shareholders and you said recently you actually -- coming in over the top end of that I think was the way you worded it in the letter.

Correct.

And I see you did two deals in the third quarter. We see obviously the pre-sale reports and see there's another deal maybe pricing in the next week or two -- or may have priced, but closing in mid-November. I'm not going to mention the specifics because I know you can't talk on deals in the market. But from what we're seeing in the report anyway, we're seeing a lower credit enhancement relative to the last two deals. And I guess -- I'll ask it very general, not so much about this transaction. Are you sensing that in the PLS market, are we near where we're going to get some help from the rating agencies on credit support? Do you feel like you're making any progress there? And I'll leave it at that. Thanks.

Generally speaking, I think our securitization platform is getting credit for four years of issuance and exemplary credit performance. And I'd also say that the general market, the securitization market, has been in as good a shape as it's been in the last year. There's numerous issuances, which we think is good for the market. More investors are coming into the market. But we take pride in our brand and certainly hope that all the hard work we put in four years ago pays off with better credit enhancement and better execution on the AAA side.

Yes. Well, thanks a lot. Thanks for your comments from each of you. Appreciate it.

Vik Agrawal; Wells Fargo Securities.

A good quarter. I was just curious on the FHLB opportunity. What do you see as the market opportunity there overall? Because the $236 million -- and I think, Marty, you said there was 10 banks? I missed the beginning part of your comments.

Okay, Vik. There's two different things going on. So one is 10 banks -- and there are 750 community banks in the MPF program. That is a program where we would buy jumbo loans from the community banks. But the first step to that is getting the pipes all clean, getting documents signed with the individual community banks. And that's what we're going through now. And as we said, we'll be able to more ramp that program once we get through the pilot phase.

The second part of the question in terms of the borrowing, that is the result of our subsidiary's membership with Chicago. And those are the borrowings that we had at Chicago.

Okay. And then, how long do you think it will take you to get through all the documentation phase?

We think we should be getting probably a lot more traction next quarter, in the first quarter of 2015.

Okay. And then I think in your Letter to Shareholders you talked about you're looking to add high quality loans that are non-QM. What type of loans are you looking at, or what type of products are you exploring?

Initially it would be those loans that are in the rebuttal area, so basically up to DTIs of 50%. I guess we also would do IOs with jumbo borrowers. Ultimately once we get secure financing either through borrowings or through securitization we would consider widening that box --

Okay.

-- potentially to self-employed borrowers. But we're not ready to go there today.

Okay. Appreciate the answers and nice quarter.

Paul Miller; FBR Capital Markets.

I know you don't want to talk too much about the securitization, but is this the first time that any other company's entered into risk-sharing securitization at the time of origination, I guess? I haven't heard of one before. I know they've sold risk-sharing pieces, but is this the first time somebody's getting an agreement with them like this?

No, we're not sure, Paul. I mean, it might be. Really have to talk to Fannie or Freddie.

Oh, they don't talk to anybody. The other question is, did you guys make the comment that -- do you expecting the MPF program -- you mentioned you expect that a conduit could produce about $1 billion on the conforming side per month. Are we at that run rate now? And is that mainly coming out of the MPF or is that just your conforming loan origination cranking up?

No, that's just coming directly out of our conduit. We're at around a $500 million run rate. And given the pricing compression there's just not a lot of profit margin. So we would prefer to stay at that level rather than ramp it up and lose money. So we probably it expect it there. I mean, we have the capacity to do significantly more.

And I would add MPF, just to clarify, is a high-balance program. So it's basically a jumbo program at this point, for us.

It's a jumbo program versus a conforming. And then, did you also mention -- correct me if I'm wrong -- that you backed off the pricing a little bit and so your pipeline dropped because maybe you were too aggressive on pricing in the quarter?

No. We're just saying that we're focused on making money.

Yes. Yes.

And when profit margins are getting squeezed we're going -- yes, you're right, we're going to back off. But we're still maintaining that momentum.

Okay.

And the early start and rollout, we wanted to get some critical mass going with sellers. We were pricing at more favorable levels just to build market share.

And then on the equity side, your primary form of equity of course is your balance sheet. But you said you're going to need some more and you want to try to get some kind of a debt financing. How much of a debt equity can carry you through the next year and the next two years?

You know, we're not -- we'll probably in the next quarter's Red Review announce some of our intentions for 2015. At this point, the way we look at capital, as I stated, is investment capacity. And we're closing in here on $100 million. We were at $145 million at September 30. So we need capital for a lot of reasons -- for risk purposes, for cash management. And so we're thinking about our near-term needs at this point. And I think in next quarter's call we'll probably talk a little bit more about our 2015 initiatives.

Okay. And thank you very much. Good quarter, by the way.

Brock Vandervliet; Nomura Securities.

I know Paul and Bose kind of took shots at this as well, but I thought I'd ask it in a different way. With the Fannie Mae structure -- is there anything you could say just conceptually about this transaction versus some of the other risk-sharing deals in the marketplace and how it may be similar or different?

Yes. The difference of this transaction versus the secondary market transactions, this is actually a point-of-sale transaction. So therefore the loans that we are acquiring and selling to Fannie Mae, we are taking first-loss risk on. That is significantly different than Connecticut Avenue and other secondary marketing transactions where it's really a reference pool of loans that Fannie Mae owns where they're showing credit risk into the market or a reinsurance program where it's a book of business that Fannie and Freddie have that an insurance company comes in and guarantees a portion of.

From our minds, just in terms of alignment of interests and improving the pool, to the extent you're doing a structured transaction you can get risk sharing with somebody opening up their checkbook, with this -- in an arrangement like this where we are taking directly first-loss risk on loans that we acquired, it should enhance and make better, I would think, the alignment of interests and make the pool characteristics and credit performance better. Otherwise we're crazy for doing it. And we don't think we're crazy.

Got it. Yes, I agree. It sounds very exciting. Now, is this just conforming or jumbo as well?

Just conforming.

Just conforming. Okay. And just a separate question -- you mentioned potentially looking at IOs for jumbo borrowers. That structure I haven't seen since, well, since pre-crisis mainly. Are there other participants offering structures like that right now?

We're talking about IO loans to jumbo borrowers. They are pretty common right now.

They are. Okay.

Yes, in the private wealth channels.

In the private wealth channels where they're not -- to the extent that you were using them for borrowers at lower income levels and were stretching for purchases. Yes, there's very few of those loans going on right now.

Got it. Okay. Thank you.

(Operator Instructions) Matthew Howlett; UBS.

The jumbo execution is impressive. I think clearly you obviously are seeing that whole loan sales are higher than the securitization gain on sale. And then obviously we'd love for you to break that out in terms of what you're getting on each. But even if you don't, I think you put out a white paper on sort of what needs to change. But any guesstimate on where securitizations next year could go. I guess the Treasury Department is looking to help the market. Do you envision doing 100% securitizations next year? Is that sort of the exit that you still would like to do?

Obviously, Matt, our preferred execution is to do securitization. In that, as a result of that transaction, we also get investments in credit (inaudible) that you couldn't otherwise get in the marketplace. But right now the market, the math and the execution and economics on a whole loan sale are still through securitization. And obviously one of the issues is that the securitization market is pretty nascent. So it's there and spreads have come in tight. They widen out.

So it's really hard at this point to say exactly how many we would do next year other than we will try, if the math is close, to do securitization. But as long as there is a much better bid on the whole loan side, we cannot, for shareholders' sake, ignore the economics there.

Any sense of what -- all the sort of talk from Treasury Department to get things going, I mean, do AAAs, do they just sort of need to come in to where they were pre credit crisis to TDAs, I mean they were like a point back or to credit asset levels where you just have to bring down stuff? What is it that needs to happen to make this just a viable, consistent exit for jumbo loans?

So, for everybody on the call, I would -- we wrote a whole white paper on this that we issued, which you can get on our website. It's obviously a complicated topic. But I would say it's three things.

I would say investors in general are looking for improvement in structures, transparency, and taking some of the ambiguity out of the agreements. We're actually working on that and we have ideas in there.

Secondly, it's just the market is suffering from illiquidity and nobody likes an illiquid market. Buyers don't like it, sellers don't like it -- wide bid/ask spreads, volatility. That one may just take time to where you can get more volume in there. It's been encouraging to see early in the fourth quarter the number of deals are getting done. So we're hope that that adds to the liquidity. That would bring more investors in. Because there's some investors that simply are on the sidelines because the investment opportunity is too low and because of volatility and spreads.

And I'd say the last one -- there's some major banks out there that were significant issuers in the past, who are sitting on literally $1 trillion of excess reserves at the Federal Reserve, so they really have no economic incentive to sell loans off their balance sheet to get cash back and then to get 25 basis points from the Fed.

The benchmark security that the Treasury has talked about, could that be the solution? Could that be it?

I think it's a start in the right direction. But really, remember, this is just a benchmark hypothetical solution that's out there. Again, I would encourage you to read our white paper. I think SFIG has a white paper out there.

And really, what people need to do is begin for the best practices is actually incorporate it in their deals. And that's one of the things we're going to try and do as we can in 2015, is just -- the best way to get a standard going is to put it in deals and hopefully you get to a point where you can attract more investors.

Well, certainly encourages, you guys make money on those when really it seems like no one else can. So I guess that separates you from the rest.

And just a last question. Chris, just -- and maybe this one's for you -- the mezz holdings look like they were flattish. I notice you guys had put out a bid list on about $53 million -- at least Bloomberg reported that -- of mezzanine. One, did those get off? Two -- I mean, they still -- their yields are 5%. Can we expect those all to go before you tap the convertible or senior debt market? And can we just presume that, given their low yields, or are you just trying to hold onto them because the pricing just isn't there?

We did sell some mezzanine securities. Most of the security sales we've completed this year have been legacy senior securities that we also financed. We have retained the vast majority of the AAs and As that we've created through our Sequoia platform over the last few years. We still hold most of them.

To the extent we can finance them attractively, we'll continue to hold them. But the yields are, as you said, mid-single digits. And to the extent that we can recycle capital and redeploy it either into the credit bonds in Sequoia or through some other mechanism, through risk sharing or something else, we're always going to think about that tradeoff. But I don't think it's imminent that we're going to liquidate our mezzanine portfolio.

Okay, great. Well, could you tell me whether you sold -- on your latest Sequoia are you selling the AAs and single As now? Has that market opened?

Matt, we really can't comment what we're doing with the current deal.

Got you. Thanks, guys. Thank you, Marty.

This does conclude today's question-and-answer session. At this time I would like to turn the conference back to our speakers for any additional or closing remarks.

All right. We'd just like to thank everybody for participating, and have a great afternoon. Take care.

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