Redwood Trust Inc (RWT) 2016 Q2 法說會逐字稿

Good afternoon and welcome to the Redwood Trust Inc. 2016 second-quarter earnings conference call.

(Operator Instructions)

I would now like to turn the conference over to Kristin Brown, Vice President of Investor Relations. Please go ahead.

Thank you, Dustin. Good afternoon and thank you for joining us to review Redwood Trust second-quarter 2016 earnings report.

Before we begin, I wanted to remind you that certain statements made during Management's presentation with respect to future financial or business performance 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. We encourage you to read the Company's Annual Report on Form 10-K, 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 forward-looking statements.

On this call, we will also refer to both GAAP and non-GAAP financial measures. The non-GAAP financial measures provided should not be utilized in isolation or considered as a substitute for measures of financial performance prepared in accordance with GAAP. They are included to aid investors in further understanding the Company's performance and to provide insight into one of the ways that Management analyzes Redwood's performance. A reconciliation between GAAP and non-GAAP financial measures is provided in both our second-quarter earnings press release and the Redwood Review, which is available on our website redwoodtrust.com.

Also note that the content of this conference call contains time-sensitive information that is accurate only as of today Monday, August 8, 2016. 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 will be available on the Company's website later today. For opening remarks and introductions I will now turn the call over to Marty Hughes, Redwood's Chief Executive Officer.

Good afternoon, everyone. Thank you for participating in Redwood's second-quarter 2016 earnings call. Joining me on the call is Chris Abate, Redwood's President and CFO. Following my remarks on the quarter's highlights and our current investment initiatives, Chris will discuss the quarter's investment, our quarterly investments, residential mortgage banking activities and our financial results for the second quarter.

For the second quarter of 2016 our GAAP earnings improved to $0.48 a share from $0.15 per share in the first quarter. Our non-GAAP core earnings increased by $0.03 to $0.47 a share and our GAAP book value increased to $14.20 per share at June 30 from $14.17 a share at March 31. We made significant progress on both our operational and financial objectives during the second quarter, following the successful repositioning of our conforming residential and commercial mortgage banking businesses in the first quarter.

Taking advantage of our leaner and more nimble platform, we moved forward on a few long-term strategic initiatives that we expect will enhance our growth in opportunities and earnings power going forward. We also engaged an external broker to sell our commercial mezzanine loan portfolio, which we no longer consider core -- a core investment following the wind down of our commercial mortgage banking operations in the first quarter. We have received strong interest from a wide range of institutional investors and anticipate closing the sale of this portfolio in the third quarter.

At June 30, our available capital for investments was approximately $140 million. After the sale of our commercial loan portfolio and other recent investment activities, we expect this amount to increase by an additional $240 million to $260 million bringing our total capital available for investment to around $400 million. One of our most important goals is to redeploy this capital efficiently and at the highest possible returns.

The core of our business lies in investing in prime residential credit risk. And in addition to our Sequoia program and other existing initiatives, we have been working on new innovative ways of making residential credit investments with two primary areas of focus. The first is credit risk sharing, or CRT, with the GSEs, which have emerged as the de facto means for the GSEs [to] transfer credit risk to the private sector. Our CRT initiatives currently include both acquiring subordinate investments from the GSE sponsored securitizations and working directly with the GSEs on alternative proprietary solutions where Redwood can assume first loss risk on loan pools either sold to our securitized by the GSEs.

We completed three of these transactions through our conforming residential conduit activities prior to 2016, and we are currently pursuing ways to complete similar transactions through portfolio initiatives that do not require the operational cost necessary to aggregate loans. While such proprietary initiatives are still in development, we are encouraged by the potential of future capital deployment and are optimistic that we can work through the fine details to complete a new transaction in 2016.

Our second area of focus is portfolio risk sharing, or PRT, with large banks. One of the effects of quantitative easing is that large banks now have significant excess reserves, some of which are being used to substantially increase their portfolio holdings of jumbo and conforming mortgages. PRTs, which were introduced in late in the first quarter, remain in the early stages of development and facilitate credit risk transfers by large banks to investors such as Redwood without actually transferring the loans they own off their books. In essence banks become the effective owners of AAA-rated RMBS, potentially allowing them to hold significantly less regulatory capital against the loans and improve their returns on equity.

For Redwood, PRT allows us to access credit exposure on jumbo and conforming loans held by banks, one of the largest sources of residential mortgage credit risk available in the market today, without a significant expansion of our operations. Importantly, since PRT investments are treated like traditional RMBS for federal income taxes, we can further leverage the advantages of our REIT tax structure.

We have also recently invested opportunistically in commercial securities, primarily in multi-family issued by Freddie Mac. These securities leverage our core capital market structuring expertise, and the credit analysis is similar to RMBS. These securities have typically been rated BBB by the credit rating agencies with 7 to 8 points of structural credit enhancement.

We also have approximately $90 million in remaining authorization to repurchase shares and will do so to the extent that returns are attractive relative to other available opportunities. Over time we believe these initiatives will provide us with ample investment opportunities to deploy our available capital.

Given that credit spreads are currently near historical [tights], we also intend to be patient with respect to deploying our available capital. There are -- there remain many unresolved geopolitical and economic issues to work through and fewer liquidity buffers available in the financial system to absorb supply and demand imbalances and keep volatility low. Consequently we intend to keep a cautious eye on the overall macro environment and keep our liquidity position strong.

In conclusion, our full attention is now on growing earnings by seizing on attractive new investment opportunities and maximizing the value of our jumbo loan franchise. We are upbeat about the remainder of 2016 and more importantly about the long-term growth projects for Redwood. As we stated in our fourth-quarter Redwood Review, our expectation is to generate GAAP earnings between $1.20 and $1.50 per share for the full year of 2016. After incorporating our second-quarter results into our current outlook, we continue to expect GAAP earnings for the full-year 2016 to fall within this range.

Now I would like to turn the call over to Chris Abate, Redwood's President and CFO.

Thank you, Marty, and good afternoon to everyone on the call. I would like to begin with some comments on our recent investment activity.

We deployed $77 million of capital into new investments during the second quarter with an emphasis on residential CRT securities and agency commercial multi-family securities. Through June 30, we have deployed $223 million, including $63 million into residential CRT, $39 million into commercial securities, $19 million in the new Sequoia and other RMBS, as well as $20 million into MSRs. We also deployed $82 million of capital into loans financed through the FHLB of Chicago earlier in the year, fully utilizing our $2 billion of financing capacity in the second quarter. Finally our convertible debt and share repurchases totaled $26 million year to date.

We sold $109 million of residential securities during the second quarter and $261 million through June 30, freeing up approximately $131 million of capital for reinvestment and generating $19 million of realized gains. While we have been a net seller of RMBS during the first half of the year, our sales activity has primarily focused on selling lower yielding legacy securities that have fully appreciated. Going forward we anticipate redeploying this capital into CRT, PRT and subordinate RMBS and commercial securities.

We are pleased with the performance of our investment portfolio during the second quarter. Net interest income continued to grow, and the underlying credit performance of our residential investments remains excellent. Our investment portfolio represented $1.5 billion, or about 90% of our $1.7 billion of total capital at June 30. The remaining 10% was allocated to our residential mortgage banking business, which has continued to perform profitably since we repositioned our platform in early 2016. Gross margins from our jumbo mortgage banking activities were 68 basis points for the second quarter, within our long-term expectation of 50 to 75 basis points.

As we noted last quarter, we recently introduced our new expanded prime jumbo loan program, Redwood Choice, to capture a larger cross-section of the prime jumbo universe and better leverage our core competencies in taking concentrated mortgage credit risk. Although we are still a few quarters away from understanding its volume potential, the rollout so far has been very well received by our sellers. In time, we believe that securitizing Choice loans or financing them through our FHLB subsidiary can provide us with the high-quality long-term credit investments we desire at attractive risk adjusted returns.

Our traditional jumbo program, rebranded as Redwood Select, continues to provide a stable source of loans for our residential conduit. In addition to our recurring whole-loan sales, we completed our first Sequoia securitization of 2016 in late June, securitizing $354 million of Select loans. Our June Sequoia transaction generated a significant amount of follow-on interest from institutional buyers. As a result, we closed a second similarly sized transaction in late July at pricing that was meaningfully better than the June transaction.

While loan sales generally remain more profitable relative to securitization, the economics between the two have narrowed considerably in recent months as spread tightening on securities during the quarter led to improved securitization margins. This has been due, in part, to tightening industry benchmarks as well as limited supplies in newly issued RMBS. While we find the current RMBS issuance market much more favorable than we did earlier in the year, additional transactions in 2016 will remain dependent upon prevailing securitization market conditions.

Now turning to our financial results for the quarter. Our GAAP earnings improved to $0.48 per share from $0.15 per share for the first quarter benefiting from higher net-interest income and reduced negative market valuation adjustments on our residential investments and related hedges. Earnings also benefited from the release of commercial loan loss reserves associated with the anticipated commercial mezzanine loan portfolio sale in the third quarter. This was in addition to four commercial mezzanine loans prepaying during the second quarter.

Second-quarter earnings also benefited from lower operating expenses, which decreased to $20 million from $30 million in the first quarter. This was primarily due to the $11 million of restructuring charges and $2 million of employee transition expenses included in the first quarter, partially offset by $3 million in higher variable compensation expense due to higher earnings in the second quarter. We expect operating expenses to decline further in the second half of 2016 fully reflecting the benefit of the restructuring we completed in the first quarter.

Our core earnings for the second quarter were $0.47 per share, an increase of $0.03 per share from the first quarter. Core earnings benefited from higher net interest income, due in part to higher average balances of loans held by our FHLB member subsidiary and $5 million of prepayment penalty interest received from the four commercial mezzanine loans that prepaid during the quarter.

Our GAAP book value was $14.20 per share at June 30 as compared with $14.17 per share at March 31. The increase in book value was driven by our second-quarter earnings exceeding our dividend payment, was partially offset by declines from annual equity award distributions and negative mark to market adjustments on interest-rate derivatives hedging our long-term debt.

Turning to the balance sheet, our debt-to-equity leverage ratio was 3.4 times at June 30. We exclude $860 million of legacy Sequoia consolidated ABS debt from our leverage calculation as it is non-recourse to Redwood. Leverage included $2 billion of borrowings by our FHLB member subsidiary with a weighted average maturity of approximately nine years and a weighted average cost of 57 basis points per annum. We had short-term repurchase debt, or repo debt, of $353 million at June 30 funding residential securities down from $694 million at December 31.

That concludes my prepared remarks. Operator, why don't we start with the Q&A?

(Operator Instructions)

Bose George, KBW.

Good afternoon. The first question I have is, you noted the spread tightening between sale and securitization. Given that trend, is it fair to think that sales should be higher in the third quarter, just with a better execution on your July deal?

Hey, Bose. Maybe a better expectation is -- maybe we might do a few more securitizations if the current spread remains tight, so I think one of us mentioned it was 25 to 50 basis points difference between home loan execution and securitization. I don't know that the absolute margins will be significantly higher, but we could see -- just given increased demand for RMBS, we could execute a few more deals.

Actually, if current market conditions exist, I think the difference between a book sale execution and a Sequoia execution right now is only 1/8 of 1 point. So that is the tightest it has probably been in a year and a half.

Okay. Great. Actually, just on the volume side, any thoughts on where the trend -- should we just think about the broader market on refi's and use that as an indication, or do you think there is room for you guys to take some share?

I think we are relatively optimistic. We have had pretty stable jumbo volume the last few quarters. It was stable again in the second quarter. Locks have been up. Locks have been trending higher more recently.

I think that is largely due to purchase activity, but we could see -- if the is a mean reversal in the primary, secondary spreads -- from a mortgage perspective, we could see an uptick in refi's in third quarter. We have not started to see that, though, as of yet.

Okay. Great. Actually, just one more. In terms of your -- the gains you guys generate on asset sales. I'm trying to think a good way to think about that because -- are those gains that you might have realized or might have shown if you had not sold the assets? Or should we think of it as, your assets are marked fairly conservatively, so when you go to sell these assets that is when you kind of realize those gains at that point?

A lot of those gains are from available for sale securities that we haven't marked-to-mark in the income statement yet., so most of our loan portfolio now goes right to the P&L each quarter as does our servicing book. A lot of our securities, the mark-to-market still go to equity until we sell them.

As always has been the case -- really that decision to sell is a function of risk management. Many of the legacy securities, especially the senior securities we have owned, have fully appreciated at or in cases above par, so it gives us an opportunity to take some risk off the table and redeploy it.

Okay. Great. Thanks.

Vivek Agrawal, Wells Fargo Securities.

Thanks for taking my question. On the PRT transactions, I want to get your outlook for that market? Also, did you participate in the transaction in mid July?

Yes, we did participate in the latest transaction, both at the non-rated tranche and the tranche above it. What we could say -- it's really early to see how it develops. But what has us very positive is -- and I mentioned this on last quarter's call -- is I think the elegance of these structures, they fix so many points of friction. They reduce the capital charge from 4.5% to 2%.

The banks continue to consolidate the loans for accounting purposes, so they are carrying the cost and they reduce volatility based on spread widening to the extent that the underlying loans are conforming loans. We believe that it is effectively lowering the guarantee fee from 50-ish basis points down to 30-ish. Also, with servicing they are not doing advances. Again, I think it is a very elegant transaction, and we think it is applicable both for large banks and for regional banks as well.

Okay. Thanks. Then on the $240 million to $260 million of proceeds that you expect from the sale of the commercial business, how quickly do you expect to be deploying that? Is it going to be similar to the pace that you did this quarter?

That is probably not a bad expectation. I think one thing we want to do is to just remark on the spread tightening that we have seen, and I think patience is a good word for how we are going to approach capital deployment. Things are very tight in the market today. And from a macroeconomic perspective, it does not appear as though much has been solved from where we were six months ago, which I am sure everyone is familiar with on the call.

So I think it is important that we are patient and opportunistic. That said, we are working on a lot of different things. To the extent we complete a few more Sequoia transactions, you might be able to see elevated capital deployment.

Risk sharing, I think, especially on the PRT side, there is an opportunity to put significant amounts of capital to work. But these are still in the earlier stages, and like Chris said, this is probably not a bad time to have some dry powder, to be patient. Also having the upside to the extent that some of these transactions that we are working on actually come to fruition.

Okay. Then with a competitor exiting the market a couple weeks ago, how do you think that has changed the market, or has it changed pricing more favorably or not?

No. It really has not. Just our comments there is we have, first the utmost respect for Two Harbors and their management team. I would say on the -- probably on the more negative side, I would say having less -- another issuer drop out and having less liquidity in RMBS is not a particularly good fact.

On the flip side, we would say having -- on the margin, less competition is a good thing. And the last thing that we note, we had two good quarters on jumbo and the mortgage banking results. And we have a slightly different model than them, so we have the Federal Home Loan Bank, which they also had.

We had securitization. But more importantly, which was our bulk whole-loan distribution, which is very strong, that allows us to pivot between the different options. And when securitization was a tight option, we went to bulk whole loan sales, which are very strong.

Okay. Chris, just one quick numbers question for you, if I may. Do you have your TBA and swap balance at the end of Q2, by chance?

I don't have it in front of me, but I will get back to as soon as I can.

Okay. Thanks, Chris.

(Operator Instructions)

Brock Vandervliet, Nomura Securities. Again your line is open. Please go ahead with your question.

Hello?

Yes, we can now.

Brock, we cannot hear you.

Again your line is open. We could hear you for a second, and then it was silent again.

Hearing no response from that line we will go ahead and take that question out.

(Operator Instructions)

John Helfst, Voya Financial.

Hey, guys, good quarter. Can you, or have you, broken out current or estimated ROE/ROAs for the PRT, maybe relative to what you are selling this year [emez]? Is this accretive to the bottom line, do you think, or near-term/long-term any upside? Thanks.

We think the PRT investments are absolutely accretive. We are looking at low to mid double-digit returns. They are good REIT assets, so they are REMIC structures, which is obviously important. And we have liked the credit profile of both transactions to this point, so we are very optimistic about the structure and return profile.

Okay. Thanks.

Bose George, KBW.

Hey, guys. Just a couple follow-ups. The CRT structure you said you are working on now with the GSEs, would that be a good REIT asset or would it have the same issues like the [stackers and cast sets]?

It has similar issues. We are working on that, Bose. So as you correctly note, some of the GSE specific CRT transactions, the first loss is treated somewhat like a derivative. There is interpretations today -- there is a more likely than not that it would be a good REIT asset.

That said, if it is going to be a primary area of focus for us, we're going to want more than that, and we will likely pursue an IRS ruling. That said, that is not prohibiting us from participating today. It would be a more of a long-term -- if this is in fact an area where we could deploy a lot of capital.

Okay. Great. Actually, just one more. I don't know if you said this early, but the GSE multi-family investment, did you -- do you have a feel for how big that could be for you guys?

We did something in the neighborhood of $27 million to $30 million recently. The interesting thing there is, one, it really leverages our structuring and knowledge of the RMBS structures, so it is multi-family -- it is a single property type. Unlike CMBS, where there is multiple property types, there is also usually a top-10 loan list that has very large balances. So here the profile is much more similar to RMBS.

The other interesting thing is there has been a fairly consistent and programmatic issuance, so there has been a consistent deal flow, star opportunities to deploy capital. We have also liked the return profile of the BBB equivalent investments, which do have -- I think Marty mentioned, 7 to 8 points of credit support.

Okay. But just in terms of how much the -- or the size of potential investments in that asset class going forward?

We don't have a specific amount at this point, Bose, but we would certainly allocate more capital to that over the coming quarters.

Obviously, it will just depend where our credit spreads are.

Okay. Thanks.

Brock Vandervliet, Nomura Securities.

Great. We will try this again. My headset is recharging. Anyway, just a couple of modeling questions. I think you'd mentioned, Chris, the repo balance dropped sharply. I think that was one of the goals. Do you see any follow-through in that, or is that decline pretty much done this quarter?

Hey, Brock. I think it's more or less leveled off, so it was $353 million at the end of the quarter. We wanted to get it down towards $300 million, so we are pretty close. At this point I do not foresee it moving significantly in either direction unless something changes in the markets. Repo is still available, at least from the onshore banks, so we feel comfortable with what we have today.

Okay. And there had been some swap repositioning also. Could you comment on that?

I believe Vic asked. We had $2.5 billion of TBA notional at the end of the quarter and $1.6 billion of swaps. Really, our swaps and TBA position is a function of hedging and risk management. We are hedging our pipelines. We are also hedging our servicing book. So I would not read too much into any strategic changes. I think really, we're trying to be rate neutral, more or less, and we're always going to be doing some rebalancing.

Okay. Just big picture, you touched on it a couple times. But as you look back over the last year and a half -- and you mentioned it already on the call in the differential between sale and securitization has never been as tight at is in right now. What -- if you listed off three or four drivers of that, what would they -- could you just review them?

I would say just the bigger drivers is just a -- in the market, is just a risk-on mentality. Everything has come in from where it was almost -- you had a little blow out towards the end of June, but since the end of June it is just continuing to grind further.

I just think it is just people looking for yield. And it really comes down to -- other than liquidity, as you said, there isn't much RMBS out there. The actual credit performance has been outstanding.

Brock, I would add -- as Marty alluded to earlier, we are in a position where we do not need to securitize, just given our whole loan distribution. So I think investors realize that if spreads are widening, we do not need to be in the market. So things have really settled in here and the executions have been strong.

Deals that have been in the market since ours appear to be tightening further, which gives us some confidence that perhaps we could issue a few more transactions if things stay the same. I think a lot of it is just market technicals.

Got it. Okay. Thank you.

Thank you. There are no further questions at this time. This concludes our conference. On behalf of management, we very much appreciate you taking the time to participate in our earnings call.