Redwood Trust Inc (RWT) 2018 Q3 法說會逐字稿

Good afternoon, and welcome to the Redwood Trust, Inc. Third Quarter 2018 Earnings Conference Call. (Operator Instructions)

Before we begin, at management's request, 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.

Management encourages 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, management may 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're 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 Redwood's third quarter earnings press release and our Redwood Review available on the company's website, redwoodtrust.com.

Also note that the content of this conference call contains time-sensitive information that is accurate only as of today, Wednesday, November 7, 2018. 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.

I will now turn the call over to Chris Abate, Redwood's Chief Executive Officer, for opening remarks and introductions.

Good afternoon, everyone. Thank you for participating in Redwood's Third Quarter 2018 earnings call.

Joining me on the call today is Dash Robinson, Redwood's President; and Collin Cochrane, our CFO. The third quarter was our first full quarter as a newly seated management team. As many of you may recall, we laid out our high-level vision for Redwood's future growth in late 2017 when the management transition was first announced.

The key aspect of our plan was to recognize and respond to the secular shifts occurring in the housing market. These shifts are putting constraints on the traditional owner occupied segment of the market and are contributing to an evolving trend towards rentership. To address these shifts, we spent the first half of the year diligently building out our processes to support the growth of our operating platform in the new segments of the market. This entailed cultivating new relationships to increase our access to unique investment opportunities as well as expanding on our investment sourcing capabilities to allow us to serve both the owner occupied and nonowner occupied segments of the market.

All of this was done with the expectation that we would continue to expand our traditional jumbo conduit activities, including the launch of new products and funding solutions for our network of sellers. Having laid the foundation for a long-term strategic plan, we entered the third quarter focused on execution. In the face of challenging marketing conditions, our focus paid off.

During the third quarter, we deployed $281 million of capital into new investments, the most in company's 24-year history. Importantly, over 2/3 of the capital deployed was in the new initiatives in housing credit and business-purpose lending. Our jumbo residential business achieved its own milestones during the third quarter, as we completed our 50th Sequoia securitization post-crisis, followed quickly by 2 additional securitizations. All told, we generated earnings of $0.42 per share in the third quarter, which comfortably exceeded our recently increased quarterly dividend. We also grew book value for the 10th consecutive quarter.

The momentum we built allowed us to quickly put the proceeds from our July equity offering to work, and our pipeline of opportunities continues to bear fruit as we broaden our reach throughout the industry. Our approach to raising capital remains consistent. We will look both internally and externally at various forms and structures based on what we believe is in the long-term interest of our shareholders. Our demonstrated ability to deploy capital at an accelerated pace speaks to our asset-sourcing capabilities and our prospects to grow profitably in a manner that greatly benefits our shareholders.

I'd also like to highlight that our recent successes were achieved despite rising interest rates in a difficult origination environment. We've highlighted in the past that our business has the potential to thrive in most interest rate scenarios, whether up or down. While the challenges the rising rates present to our industry have our foremost attention, they've not, in our opinion, significantly change the credit quality of the housing sector.

We continue to source loans from high-quality borrowers in both the owner occupied and investor segments of the market, and we continue to see many potential borrowers as underserved.

In addition to our traditional Sequoia investments, our recent activity included a mix of multifamily securities, business-purpose mortgage loans and securities collateralized by reperforming mortgage loans.

As many industry participants became more aggressive in pricing loans to preserve volumes in the third quarter, we remain focused on profitability. This yielded strong mortgage banking margins in the third quarter, but we will have to navigate these challenging market conditions going forward. We currently expect our full year jumbo loan purchases to be near the lower end of our original $7 billion to $8 billion for 2018. Even at the lower end of our range, 2018 volume continues to trend towards record post-crisis volume for Redwood and year-over-year growth of around 20%.

Additionally, we expect full year returns from our mortgage banking platform to be towards the higher end of our originally forecasted range. Finally, with the midterm elections taking place yesterday, we'll devote part of our focus on Washington and the new opportunities that may arise in the coming year. With the Democrats taking control of the house, all signs point towards housing finance changes occurring primarily through regulatory reforms as the prospect of legislation diminishes.

Most expect a new Head of the FHFA early next year as well as new CEOs at both Fannie Mae and Freddie Mac. These changes in appointments could have significant downstream effects, with the potential for private sector participation to increase significantly. In fact, we've already begun to see a shift in the FHFA's direction of the GSEs, as they recently announced the discontinuation of pilot programs in single-family rental sector. We've also seen more credit risk getting sold through GSE-sponsored securities backed by conforming loans. This dovetailed with the first GSE-sponsored REMIC securitization for recently originated conforming loans in the third quarter. It goes without saying that we view these developments as positives for companies like Redwood and would look to be part of any private capital solutions that may arise through agency-based GSE reform.

With that, I'll turn the call over now to Dash Robinson, Redwood's President.

Thank you, Chris, and good afternoon, everyone. I'd like to start off by touching on a very productive quarter for our investment portfolio. As Chris mentioned, we deployed a record amount of capital in the third quarter. The strong results were anchored by several investments that highlight our focus on opportunities across the broader housing sector that leverage our core competencies in housing credit.

The quarter's activity centered on organically created investments sourced from our Sequoia platform and strategic partnerships we continue to develop and grow.

As we discussed on our second quarter earnings Call, in August, we made important investments in the multifamily and the fix-and-flip sectors. We deployed $55 million in a pool of seasoned subordinate multifamily bonds sponsored by Freddie Mac, further expanding our efforts in this space. We also committed $50 million to invest in a pool of fix-and-flip loans originated in asset managed by our partners at 5 Arches. These loans carry a weighted average coupon of approximately 9.1%, with a weighted average loan to value ratio at origination of 76% and a weighted average after repaid loan to value at origination of 57%.

Weighted average borrower FICO at origination was approximately 718. The investment is revolving in nature, meaning that principal payments are replenished with new production going forward. We currently use a modest amount of bank financing on this investment and are carefully following recent developments in the capital markets for fix-and-flip loans, including the emergence of securitization as we assess financing alternatives going forward.

Additionally, during the quarter, we made a deposit of $58 million to secure an investment in subordinate securities backed by reperforming loans currently owned by Freddie Mac. The weighted average seasoning of the pool is approximately 12 years, with the current weighted average loan to value of 76%. We anticipate incremental capital deployment of approximately $75 million in the fourth quarter to complete the investment.

Our remaining capital deployment included $30 million into bonds issued from our Sequoia program and $92 million into third-party RMBS issuances. Additionally, we remained active in optimizing our capital allocations in the third quarter, continuing to rotate our lower yielding and less strategic assets. Specifically, we freed up approximately $106 million of capital for redeployment during the third quarter, capturing $15 million of previously unrealized gains.

Our mortgage banking platform also delivered a strong quarter, navigating a market that as Chris mentioned is still adjusting capacity in response to interest rates and overall demand. During the third quarter, we generated margins that exceeded our long-term expectations of 75 to 100 basis points and were above realized margins in the second quarter. A key driver of these results was continued strength in the securitization market and a robust quarter for whole loan sales. The securitization market improved relative to second quarter, and we successfully completed 3 Sequoia securitizations on loans totaling over $1.1 billion. This included 2 Choice deals, the programs fifth and sixth overall, and as Chris mentioned, issuance of our 50th Sequoia securitization since the crisis. A benchmark we are proud of that reflects the importance of maintaining a reliable cadence for coming to market.

Total Sequoia issuance since the crisis across both the Select and Choice channels has totaled over $20 billion. Complementing these activities, we sold approximately $800 million of whole loans during the third quarter, our highest level in almost 2 years. As we have described before, even when securitization markets are favorable, as they have generally been the last couple of years, we work to keep our whole loan sales channels open and active. This paid dividends during the third quarter as we expanded our group of whole loan buyers and continue to deepen the existing partnerships. Overall purchase volumes were not immune to broader market trends, and third quarter loan purchases totaled $1.8 billion, down 8% from the prior quarter, but up over 20% from the third quarter of 2017.

We continue to observe the benefits of channel diversification through efforts such as Redwood Choice. In an increasingly purchase money market our sellers value the diversity of our products and reliability of our process. Redwood Choice volume increased modestly in the third quarter accounting for approximately 35% of our total third quarter lock volume and up 33% in the second quarter.

The overall growth trends in Choice remain compelling. Through the first 9 months of 2018, we have purchased $1.8 billion of Choice loans, up over twofold from the same period last year. The nature of our pipeline in the third quarter continued to reflect the overall market trend and heavier purchase money volume. 75% of our volume represented purchase money transactions versus 73% in the second quarter and 64% for full year 2017.

Overall, through the end of the third quarter, our total year-to-date purchase volume in mortgage banking was $5.6 billion.

I'll conclude with an update on our partnership with 5 Arches. We funded our first single-family rental loans in the third quarter and have a growing pipeline we expect to purchase in the coming months. Overall, we continue to observe a deep addressable market in the single-family rental sector, with recent events, most notably the FHFA decision that Chris alluded to, potentially expanding our opportunity set. While it is uncertain if and when the FHFA will reconsider a role for the GSEs in this asset class, we view this development positively as it relates to Redwood's strategic positioning in single-family rental.

Overall, our partnership with 5 Arches positions us well to be a solutions provider to several areas within business-purpose real estate lending. And we believe the integration of these new loan types with our platform will drive additional scale and continue to enhance our value to the marketplace.

Now to recap our financial results, I'm going to turn it over to Collin Cochrane, Redwood's Chief Financial Officer.

Thanks, Dash, and good afternoon, everyone. To summarize our financial results for the third quarter, our GAAP earnings were $0.42 per share compared with $0.38 in the second quarter. And core earnings were $0.39 per share compared with $0.41 in the second quarter.

Our third quarter results reflect the benefit from increased capital deployment, improved asset pricing and solid mortgage banking results. Additionally, we experienced an increasing gains realized from securities sales relative to the second quarter as we continue to focus on portfolio optimization. Our GAAP book value increased $0.19 to $16.42 per share at September 30, and when combined with our quarterly dividend of $0.30 per share, generated a total company return of 3% for the quarter and 9.3% year-to-date through September.

As we've noted previously, our investment in hedging strategy makes our portfolio less sensitive to changes in interest rates, and our overall book value is minimally impacted by rising rates during the quarter.

On a hedge adjusted basis, we saw an overall benefit from fair value changes during the third quarter, driven mostly by improvements in CRT and multifamily spreads. Additionally, our hedges effectively serve to insulate our net interest margins from rising rates on our variable rate debt. Although GAAP net interest income was flat quarter-over-quarter, when including the impact from hedges, we saw an increase due to the benefit from capital deployment and continued portfolio optimization.

To help analyze this impact, in the third quarter, we introduced a new non-GAAP measure, economic net interest income, which we define as GAAP net interest income plus the net interest paid or received on hedges as well as the change in basis for fair value investments. More detail on this metric is included in the appendix section of the Redwood Review.

In addition to the new metric in this quarter's review, we've expanded our disclosures for core earnings by showing a full core income statement to better present the impact of the adjustments we make for core earnings. One final change on financials we'd like to highlight this quarter is the consolidation of 2 Freddie Mac K-Series securitizations that resulted from our recent investment in the b-pieces of these deals. While our economic investment in these securitizations is $67 million, GAAP requires us to consolidate about $950 million of multifamily loans and $875 million of ABS debt on to our financial statements.

I'll also point out that an additional impact from the consolidation of these 2 deals as well as a recent Choice securitizations was the cause of a notable increase in our gross interest income and interest expense. The net interest income from these consolidated deals represents the interest income on the securities we actually own. Additional information on these investments and their impacts to our financial statements is included in the review.

Shifting to the taxable side for a moment. Our total taxable income was $0.48 per share for the third quarter, a small decrease from the second quarter, mainly reflecting dilution from a recent equity raise. Focusing specifically on retaxable income, while we saw a small dip in the third quarter due to some nonrecurrent expenses, year-to-date, retaxable income of $1.06 per share has exceeded our dividends of $0.88 per share. And as a result, we expect to utilize a portion of our $55 million NOL at the REIT in 2018.

Turning to the balance sheet and our capital position. We ended the quarter with about $150 million of capital available for investment. In addition to this available capital, we believe we have $100 million to $150 million of capital that is in a good position to be optimized. While I expect this capital to be sufficient to meet our near-term needs, to the extent we seek additional capital to fund our operations and investment activities, our approach to raising capital continue to be based on what we believe to be in the best interest of our shareholders.

Regarding leverage, our recourse debt to equity leverage ratio was 3.1x at the end of the third quarter. Although our strong capital deployment during the quarter left us with less available capital than the prior quarter-end, we saw leverage decline, primarily due to a lower balance of loans held for sale at quarter-end relative to the prior quarter. We do expect leverage to increase modestly in the next few months as we fully deploy our excess capital towards new investments.

I'll close with the 2018 financial outlook. In summary, our year-to-date results have already exceeded our expected annual dividend payments of $1.18 per share, and we remain on track to meet the full year operational targets we provided in our fourth quarter 2017 Redwood Review. We expect to provide an updated outlook for 2019 when we issue our fourth quarter Redwood Review.

And with that, I'll conclude our prepared remarks. Operator, why don't we start the Q&A?

(Operator Instructions) And we'll go first to Bose George with KBW.

This is Tommy on for Bose. Just want to ask a question on -- about your excess capital. How much exactly do you guys have available for deployment right now? And could you just sort of discuss where you see the best opportunities in the market today?

We have about $150 million of available capital, and that is the capital that we have available for deployment at September 30. And in terms of opportunities, I think it's the same fundamental opportunities we've been talking about and that we mentioned here in the third quarter. And additionally, we mentioned one new investment that we put a $57 million deposit on that we do expect to fund an additional $75 million on in the fourth quarter.

Yes, Tommy, it's Dash. Just to piggyback those comments, I think it's consistent with where we've been discussing the last several quarters in terms of parts of the market where our capital can be of most used and most accretive for shareholders, so things like business-purpose lending, like single-family rental and fix-and-flip, obviously, continue to deploy capital into the Choice securities and Select securities that we create off of Sequoia. Those are all things that we've been doing. Collin alluded to the incremental investment of reperforming loans. I think thematically, again, it's areas where we see more opportunity that are less sufficiently financed and that we can leverage our existing infrastructure and credit acumen. I think we've begun to execute there. I think the third quarter was some really, really some strong momentum. And where we spent our time in the third quarter, I think, is generally indicative of where we see the most compelling opportunities at the moment.

That's great. And going in a different direction, now that we've had some spread widening since quarter-end as well as some volatility, can you give any sort of indication as to what's happened to book value quarter-to-date since 9/30? And then, I guess, to kind of piggybacking off that, has that spread widening since quarter-end created any better opportunities in any particular markets that you can think of?

It's Chris. Book might be down 1%. I don't think it's down materially since September 30. And we saw mortgages had a great day today, so we've still got some time before the end of the year. As far as opportunities go, we're still very engaged with specific counterparties that we alluded to in the script, trying to follow on from what we did in the third quarter. So again, the business-purpose lending and certainly, Sequoia, we're still active. And to the extent we can we can find some bonds cheaper or opportunities to put more capital to work, that's what we're going to do.

(Operator Instructions) We'll go to Steve Delaney with JMP Securities.

So not surprising, given where rates have moved, but we're hearing among the origination community, the folks that we cover there, that it's really tough out there. And I know you work with banks. You also work with private mortgage bankers. Dash, I guess, I'm just curious if you're seeing any fallout from some of your previous customers, anybody shutting down or scaling back? And maybe could you give us a headcount and just an updated count on how many active sellers, how many correspondents you have today?

Sure, Steve. So obviously, as you know, we track both qualitatively and quantitatively the -- where our sellers are, how their financials are evolving. And you're right, we hear a common theme from folks that we talk to that this has been a tough point in the market. Obviously, it's open for debate how long we'll be here, but it is striking the -- that there is a relatively low percentage certainly versus the past few years of the percentage of mortgage loans that are currently refinanceable. We are starting to see evidence, and everyone sort of goes at their own tempo, that capacity is being rightsized for where the opportunities are in the market. You can see the financials come through, through the end of the third quarter. The cost and expense ratios are gradually coming more on to line. Obviously, that's a broad statement. Like I said, everyone is different, everyone moves at their own pace. But we are definitely seeing progress towards adjusting, and obviously, we've all seen this before. And so that progress isn't necessarily surprising. I do think -- like I said that this sort of environment reinforces the value of our platform. And if you're a mortgage banker or a bank that is dealing with operating costs and overhead, it's that much more valuable to deal with a counterparty like Redwood because of our product diversity, because of our ability to close quickly. Us being able to close loans in half the time or less than some of our peers is usually viable to folks particularly at this point in time, as it allows them to recycle their equity more quickly and continue to invest in their business and just manage where we are in the cycle. So while it's been hard for everyone, I think these are the times where our relative value is probably higher, frankly, than at other points in the cycle.

I think you make a great -- go ahead, I'm sorry.

Sorry, Steve, I was just going to say our headcount for sellers is still around 188, so that hasn't really changed materially.

Okay, great. And listen, I don't know when you guys posted this year when you went through the management change and you went through sort of the -- added the new products, sort of expanding the product mix, if you will. But it strikes me, if I didn't know better, I would have thought you had a crystal ball and somebody told you that the 10 year was going up 40, 50 basis points, because it strikes me that your new products, especially the business-purpose mortgages, and to a degree, Choice as well, although I've realized Choice was a concept that -- it goes back a year or more. But it strikes me that those product versus Select, those borrowers may be less rate sensitive than a Select borrower probably looking to refi or whatever. And I'm just curious if you see it that way that the diversity not only gives you more product, but does it possibly make you less rate sensitive, if you will, in terms of the impact on originations?

Steve, I'll take that one. It's Chris. We spend a lot of time formulating this evolution of our strategy. And we felt really good that at our core, we're a specialty finance firm and there's going to be areas of the market that we can offer solutions that really get back to the competencies of the firm, which is credit and structuring. And a big goal was to be able to implement a strategy that could withstand the turns in the mortgage business and maybe leverage those competencies. And so when we think about the business-purpose lending and fix-and-flip in particular, where the terms of those mortgages are a lot shorter, and then certainly, some of the expanded credit products like Choice, all of these types of solutions really get to some of the underserved parts of the market. And so while Select is always going to be a key aspect of what we do, I think the goal is to really, as you said, diversify the asset base. And I think that will result in a more durable earnings stream over time.

Yes. We do -- I mean, do you see those borrowers as slightly less rate sensitive than you would, say, the profile of your Select borrower? Or is -- am I stretching on that?

No, I think that's fair. These are folks that their credit aspect and the solutions that we can provide on a case-by-case basis are what's meaningful. I think Select is more or less a purchase market today, and I think refis are at precrisis lows. That's a market we're always going to focus on, but really the opportunities in multifamily and single-family rental and where folks move to when affordability to purchase a home becomes difficult, that's what's really exciting about the evolution of the platform to us. And if we can continue to penetrate and grow those markets, I think shareholders would be happy.

And Steve, it's Dash. Just one thing I would add on the business purpose side is those borrowers, whether it's a single-family rental product or fix-and-flip product, clearly, rate matters. But when you think about what those business are or what those products do, they finance people's business plans, it's someone redeveloping a home, it's someone trying to finance a portfolio of stabilized properties to rent out on a longer-term basis. And those borrowers respond much more favorably to speed and reliability of service. The proceeds are needed by a certain point of time. And many of those are repeat customers, obviously, folks that are investing in real estate for rent or more transitionally, a lot of times, use the proceeds just to grow their business and reequitize or equitize new projects and creating up the demand for more debt. And we've seen that in 5 Arches pipeline. A really high percentage of their customers are repeat business, which is a great risk mitigant tool, but also really creates a positive snowball effect for growth in the business. So I think, business purpose in particular is really much more service oriented than it is cost of funds.

Got it. Makes sense. And just to close out to one quick one for Collin. Collin, operating expenses up $2 million to $21 million. Anything we should highlight in there or just volume related?

Yes, I think we did see a little pickup in expenses related to some of this new business activity, getting some of these new businesses up and running. We saw a little bump in that this quarter. So I don't think we'd expect to see that continue to carry forward. And also, the variable comp was up a little bit just in line with the higher overall earnings for the quarter. So I think those 2 things are really what moved the needle around.

(Operator Instructions) We'll go next to Stephen Laws with Raymond James.

Appreciate you taking the time for my questions, and then congratulations on a consistent book value growth. I know that's certainly something that differentiates you from many other mortgage investors out there. Can you -- you've touched on a good bit with previous answer from Steve. But looks like the proprietary deal flow is really driving capital deployment. The third-party investment activity over the last number of quarters has been remarkably consistent. Is that a level of the third-party activity you think will continue? Is that something you think will decline just given where we are in the cycle for housing? Or how do you think about third-party investment activity as we look into next year?

I think the goal has been to pick up the pace for starter. So we are operating with, I think, greater urgency overall as a firm. But really, I think the deployment is going to be dependent upon the cultivation of some of these relationships as we mentioned in our opening remarks. So it's got a lot of traction with a few different counterparties, and we think deals begot deals. So overall, certainly the goal -- the stated goal as part of the vision is to really start to scale the platform. And we've had a bump in overhead, our operating expenses I should say. I think over time, that pace of deployment should serve us well. So overall, I think the pace should be something that we focus on going forward. And as far as 2019 goes, we typically offer a much more specific guidance with our fourth quarter review.

Sure. And on the -- just a follow-up on the business-purpose loans. Are you guys tied exclusively to only buying those production from 5 Arches? Can you buy from other originators there? And if so, are you doing that? Or is 5 Arches going to meet the volume of -- to support the growth that the you want in an asset class?

Stephen, it's Dash. So the way it's currently structured, so we are not exclusive to them. We can purchase those sorts of mortgage loans from whomever we choose. And frankly, the news out of the FHFA in August that Chris and I touched on could create an opportunity to do that. They are exclusive to us in a way that our arrangement works with them. Obviously as you're aware, we have an option to purchase the remainder of their platform through the end of April of next year. But in this period and through that end date, we have exclusivity to purchase their single-family rental loans, and obviously, we've made an initial investment in some of their fix-and-flip production, but we are not bound to them exclusively.

Appreciate the color there. I knew they were exclusive to you. I didn't know if that went both ways. So appreciate the color there. And then for clarification, I wanted to make sure I was driving that a lot of numbers as far as capital deployment. But in summary, you guys had $150 million at quarter-end with the $75 million obligation for funding in Q4 and then you had an additional $100 million to $150 million of capital invested in securities that could be freed up for reallocation if you choose to that, is that a fair summary?

Yes, you got all the numbers right there.

And ladies and gentlemen, that will conclude today's conference. We thank you for your participation. You may now disconnect.