Redwood Trust, Inc. (RWT) Q4 2015 Earnings Report, Transcript and Summary

Good afternoon, and welcome to the Redwood Trust Inc. 2015 Fourth Quarter Earnings Conference. During management's presentation, your line will be in a listen-only mode [Operator instructions]. I would now like to turn the conference over to Kristin Brown, Vice President of Investor Relations. Please go ahead, ma'am.

Thank you, Kelian. Good afternoon, and thank you for joining us to review Redwood Trust's fourth quarter 2015 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 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. 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. Also note that the content of this conference call contains time-sensitive information that is accurate only as of today, Thursday, February 25, 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 access to this recording will be available on the Company's website at redwoodtrust.com later today. For opening remarks and introductions, I will now turn the call over to Redwood's Chief Executive Officer, Marty Hughes.

Good afternoon, everyone. Thank you for participating in Redwood's fourth quarter 2015 earnings call. Joining me on the call are Brett Nicholas, Redwood's President; and Chris Abate, Redwood's CFO. After my remarks, Brett will go through our thoughts on the recent repositioning of our conforming residential and commercial mortgage banking operations, as well as our strategy going forward. Then, Chris will discuss the quarter's financial results and our earnings outlook for 2016. We earned $0.46 per share in the fourth quarter compared to $0.22 per share in the third quarter of 2015. Book value was $14.67 per share, almost flat from the prior quarter. For the full year 2015, we earned $1.18 per share and our GAAP ROE was 8.2% as compared to 2014 earnings of $1.15 and a GAAP ROE of 8%. In characterizing the year's performance, we would say it's gratifying that our investment portfolio generated sufficient income to cover our annual dividend of $1.12 per share paid to shareholders, especially in light of the challenges we faced. However, the performance of our residential and commercial mortgage banking businesses was disappointed and resulted in our repositioning these operations, which we announced earlier this year, and which Brett Nicholas will discuss further in a moment. Now, in light of the extreme capital markets volatility that has occurred over the past few quarters, we'd like to address Redwood's capital position, liquidity and investment opportunity. These topics are multi-faceted, dynamic, and interconnected, and therefore we must be considered collectively as we position our business for the future. Assessing our current capital needs requires us to continually make "if that, then this" determinations as circumstances in our business change and new opportunities arise. So, as you might suspect, we can't say at this time with exact precision how much of our available capital, which we currently estimate to be around $200 million, we will allocate towards any particular deployment alternative, but we can offer you insight in how we think about and evaluate our options. In the near-term, we believe that the severe volatility and credit spread widening recently observed in the debt markets is signaling an element of potential dislocations that we have not felt since the financial crisis. We're not exactly sure what the specific dislocation events will be, or even if they will occur. But, our near-term posture is to operate defensively and cautiously. This requires us to maintain or enhance spread with already strong liquidity in coordination with other uses of capital. We consider several factors when determining how much of this capital is allocated between share repurchases, maintaining our strong liquidity, and new investments. First of all, as internal managers, we have demonstrated our alignment of interest with shareholders with our intention to repurchase common stock at attractive levels. We fully utilized the $100 million stock authorization that was approved by Redwood's Board of Directors back in the third quarter of 2015, and yesterday the Board authored a new $100 million stock repurchase program. We can assure you that the relative attractiveness of buying back shares remains the yardstick against which competing investment opportunities and capital decisions will be measured. Secondly, we are keenly aware of the maturity of our $493 million of outstanding convertible debt. $288 million is due in 2018, with remainder due in late 2019. While we may be able to attractively refinance this debt as it matures, we are also preparing to repay and could sell unencumbered portfolio assets as one source of funds as we approach these maturity dates. In addition, we may also have opportunities to repurchase a portion of this debt at attractive levels prior to its maturity. A final consideration pertaining to our capital deployment is to keep some capital or dry powder for attractive investment opportunities that may arise and that we are beginning to see as a result of market dislocations. This is a strategy that proved very successful for us in the post-crisis RMBS market. We also continued to evaluate our existing portfolio to ensure that our deployed capital is generating attractive, risk-adjusted returns relative to other investment opportunities. In closing, we can say we are committed to the guiding principle of balancing the attractiveness of near-term opportunities with what we believe to be in the best long-term interest of shareholders. As a further step towards greater transparency on this topic, we have created a new section in the Redwood Review that provides important data and analysis regarding our capital, liquidity and investments. While we have been reluctant to provide any specific earnings guidance in the past, especially during periods of market volatility, we believe that today's extraordinary market conditions justify a one-time financial projection to underscore our views on Redwood's near-term liquidity and financial outlook. For the full year of 2016, we currently expect GAAP earnings to fall within a range of $1.20 to $1.50 per share and Chris will provide further details and assumptions on our 2016 outlook in a moment. Now, I'd like to turn the call over to Brett Nicholas, Redwood's President.

Thank you, Marty. As we have shifted part of our strategic direction, we believe it is important to lay out for you what business assumptions changed that led us to reposition our conforming residential and commercial businesses, as well as the financial impact of these changes. In our conforming residential loan operation, we discontinued our aggregation and loan sale activity because we no longer believe that our conduit can generate sufficient conforming loan sale margin primarily due to the unrelenting competitor pricing pressure for conforming loans. Going forward, our GSE seller servicer licenses will allow us to remain an investor in conforming mortgage servicing rights through co-issue channels at a lower cost than through the traditional conduit channel. Our commercial business was established six years ago when there was a shortage of lending capacity and a gap between what a senior lender would provide and the available equity. We used our balance sheet to bridge this gap, originating over $460 of mezzanine loans, of which $300 million remain in our portfolio as of December 31st, 2015, and all of which are performing. We evolved our strategy to originate senior loans for distribution into CMBS transactions as we saw the opportunity to profitably deploy our capital in a market with increasing origination volume. While highly profitable through 2013 and 2014, excess lending capacity, pressure on CMBS spreads and increased market volatility over the past 15 months has significantly eroded the profit opportunity. We concluded these factors are unlikely to change in the foreseeable future, and as a result, decided to exit the CMBS origination business. We have sold all but $4 million of our senior loans into the most recent transaction, albeit at a small loss, and the sale of this remaining balance is in process. Collectively, repositioning these businesses will result in $6 million to $7 million of severance and other nonrecurring charges that we expect to expense primarily in the first quarter of 2016. On a recurring basis, we expect to eliminate the earnings drag from the approximately $13 million pretax loss we incurred on these activities during 2015, and have freed up $150 million of capital for redeployment. We believe that the changes we have made to our residential and commercial operations have put us in a position to meaningfully improve on our 2015 financial results. More importantly, we believe these changes will enable us to operate leaner and with a renewed investment focus, going forward. Although our tactics have changed, our business strategy continues to be grounded in creating or acquiring attractive investments in residential and commercial mortgage credit. And our investment portfolio continued to produce strong results in the fourth quarter. Our investment portfolio represented 83% of our total capital at December 31, 2015, and provided the majority of our income during 2015. Overall, this portfolio generated over $200 million of cash flow during 2015, which more than covered quarterly dividend payments on our common stock, interest on corporate debt, and corporate operating expenses. For 2016, we plan to deploy approximately 95% of our capital in investment activities while moving forward with three key areas of focus. First, we expect our $1.5 billion investment portfolio to generate attractive and reliable income in 2016 and beyond. A significant portion of this portfolio is funded with federal home loan bank debt financing with terms that we believe can no longer be found in the marketplace. We expect our investment portfolio to generate cash flows in 2016 that should significantly exceed our operating expenses, debt service requirements, and the $1.12 per share annual dividend. Second, our core jumbo mortgage banking franchise is well positioned and remains consistently profitable despite evolving market conditions. This business represents an engine for future investments and contributes direct fee income and sourcing capabilities from 309 correspondent lenders nationwide, which include 106 MPF direct sellers. Many of these correspondent relationships have been in place for years, and represent an important cornerstone for our franchise that we believe cannot be easily replicated. While we expect our conduit activities to focus primarily on whole loan acquisition and sales in 2016, our flagship Sequoia securitization platform remains an active option and is positioned to effectively create investments as opportunities arise. Our federal home loan bank-funded Captive Insurance subsidiary continues to source loans through our jumbo mortgage banking conduit as the existing portfolio pays down. Third and finally, we expect that the extended dislocation in mortgage capital markets may result in significant opportunities to invest capital in high yielding assets. These may include traditional RMBS, CMBS, and credit risk sharing transactions. We have taken the necessary steps to strengthen our liquidity, and will be offensively minded to the extent difficult markets force good assets to trade at distressed prices. I will now turn the call over to Chris Abate, Redwood's CFO, to discuss the quarter's financial results and our outlook for 2016.

Thank you, Brett, and good afternoon, everyone. Our fourth quarter earnings were $0.46 per share as compared to $0.22 per share for the second quarter. The increase was driven by higher net interest income from our investment portfolio, higher jumbo mortgage banking margins, and higher realized gains from sales of residential securities. Our book value is $14.67 per share at December 31, down only slightly from $14.69 per share at September 30. Higher earnings and the impact of $53 million of share repurchases were offset by our fourth quarter dividend distribution and a decrease in unrealized gains from securities that were sold during the fourth quarter. As a result of strong portfolio growth over the past few quarters, our estimated fourth quarter REIT taxable income was $0.37 per share, more than exceeding our fourth quarter dividend. Our total REIT taxable income for 2015 was estimated to be $1.05 per share, the highest we have reported in nine years. Turning to our recent investment activity, we deployed $116 million of capital into new investments during the fourth quarter, bringing total capital deployed into new investments to $417 million for the year. We continue to make significant progress replacing lower yielding portfolio assets with higher yielding, longer duration investments. During the fourth quarter, we sold $130 million of residential securities while redeploying a portion of the net proceeds into loans financed with the Federal Home Loan Bank of Chicago. This represented $51 million of capital invested during the quarter. Other notable investment activity during the quarter included $21 million of MSR investments and $4 million of commercial CMBS investments. Additionally, as I noted earlier, we repurchased $53 million of our common stock. The stock was purchased at a weighted average price of $13.35 per share. In total, since the third quarter of 2015, we have repurchased 7.2 million shares and fully utilized the associated $100 million share repurchase authorization from our Board of Directors. Turning to the income statement, net interest income was $44 million for the fourth quarter, an increase of $4 million from the third quarter. The improvement primarily reflects a $431 million increase of loans held for investment at our FHLB member subsidiary, in addition to $2 million of yield maintenance fees received from the early payoff of two commercial mezzanine loans during the fourth quarter. Income from residential mortgage banking activities increased slightly from the third quarter primarily due to higher jumbo loan sale margins. For the full year 2015, jumbo gross margins were 59 basis points, above the high end of our long-term target rate of 25 to 50 basis points. As whole loan sales have recently provided a better execution for us than securitization, we have been targeting a higher percentage of these sales, which we anticipate will benefit jumbo margins in the near-term. Gross conforming margins were 24 basis points for the full year of 2015. Commercial mortgage banking activities recorded a $1 million loss for the fourth quarter, which compared to income of $1 million for the third quarter. In this quarter's Redwood Review, as Marty mentioned, we've added an overview of Redwood's capital position, as well as an analysis of capital allocated to Redwood's investment portfolio and mortgage banking operations. We also provide additional information on Redwood's liquidity in our earnings outlook for 2016. To summarize our capital position, we use a combination of corporate long-term debt and equity to fund our businesses. Our total capital position was $1.8 billion at December 31, 2015, of which $1.5 billion, or 83%, was allocated to our investments, with the remaining $0.3 billion, or 17%, allocated towards our mortgage banking activities. Following our discontinuation of residential conforming and commercial mortgage banking activities, we expect that approximately 95% of our total capital will be allocated to investments, with the remainder allocated to mortgage banking. Included in our capital allocation is available capital, which represents a combination of capital available for investment and risk capital we hold for liquidity management purposes. After taking into account the discontinuation of conforming and commercial mortgage banking activities and investments to date in the first quarter of 2016, we estimate that our capital available for investments to be in excess of $200 million at February 19, up from $172 million at December 31, 2015. We believe that our available capital is sufficient to fund our businesses and capital needs for the foreseeable future. Our debt to equity leverage ratio, which includes our $632 million of corporate debt and $3.3 billion of the $3.4 billion of total collateralized debt, was 3.4 times our equity at December 31. We exclude $116 million of commercial collateralized debt from our leverage calculation, as it is non-recourse to Redwood. At December 31, 2015, our leverage also included $1.1 billion of short-term debt associated with our residential mortgage banking operations, which consists of loan warehouse and securities repurchase facilities that we use to finance our inventory of residential loans and Sequoia AAA securities that we intend to sell to third parties in the near-term. As of February 19, 2016, the repurchase debt associated with the Sequoia AAA securities had declined to $47 million as a result of the sale of $149 million of these securities to third parties. At year-end, the securities we financed through repurchase facilities had no material credit issues, and in addition to the haircuts, we continue to hold a designated amount of supplemental risk capital available for potential margin calls or future obligations related to these facilities. At December 31, 2015, the weighted average GAAP fair value of our finance securities was 96% of their aggregate principal balance. All finance securities received external market price indications as of December 31, and were in aggregate valued for GAAP reporting purposes within 1% of the external market price indications. Between year-end and February 19, 2016, our financing terms remained consistent for these securities, and our utilization of repo financing declined to $578 million. We intend to further reduce this financing to below $300 million in the next few months through the sale of securities and by using excess cash reserves rather than repurchase facilities to fund investments. At December 31, 2015, our leverage also included $1.5 billion of borrowings from our FHLB member subsidiary. As of February 19, this subsidiary had increased its borrowings to $2 billion through the FHLB, and we expect loans held for investment by this subsidiary to increase from $1.8 billion at year-end to $2.3 billion by the end of the first quarter of 2016. The weighted average maturity of these borrowings is approximately 9.5 years, with a weighted average cost at February 19 of 0.59%. Under the final rule published by the Federal Housing Finance Agency in January 2016, our Captive Insurance subsidiary will remain an FHLB member through the five-year transition period for Captive insurers. Our FHLB member subsidiary's existing $2 billion of advances, which mature beyond this transition period, are permitted to remain outstanding until their stated maturity. As residential loans pledge this collateral for these advances pay down, we are permitted to pledge additional loans, or other eligible assets, to collateralize these advances. Turning to our financial outlook for 2016, we expect to generate GAAP earnings between $1.20 and $1.50 per share for the full year of 2016. This reflects solid growth we anticipate in portfolio net interest income, improved residential mortgage banking income as we focus on our more profitable home loan distributions, and a $30 million annual reduction in our operating expense run rate as a result of the previously announced repositioning of our mortgage banking businesses. Also included in this range is $6 million to $7 million or $0.06 to $0.08 per share of one-time charges related to this repositioning. We expect most of this expense to be incurred in the first quarter. To follow that point, it is important to note that, despite underlying credit fundamentals that remain strong, the first quarter has proved challenging for all risk investors. Nearly all asset classes have seen large price declines to start the year with the exception of government bonds and gold. Interest rates touched multi-year lows in February, and repurchase or repo debt has generally gotten more restrictive. Combination of these factors will likely cause our first quarter results to remain volatile relative to our normalized expectations for the remainder of the year as our GAAP results will be impacted by mark-to-market adjustments related to spread widening on our loans and our securities portfolio. That concludes my prepared remarks. Operator, we're ready to start with the Q&A.

[Operator Instructions] We’ll move first today to Bose George with KBW.

Hey, guys, good afternoon. The first question - thanks for the guidance for next year. Just when I try and bridge where your run rate versus where it will be next year, are the main things to think about the $13 million earnings drag that goes away, and then the investment income on the $150 million that you're freeing up, or is there anything else, as well, that we should think about?

Hey, Bose, yes. Yeah, with the press releases we issued over the past month and a half or so, I think that guidance still holds. We expect to relieve the earnings drag from those businesses. In addition, we will have all else equal, $30 million reduction in operating expenses, which is a component of that. One piece that's not as obvious is, by freeing up $150 million of capital that was essentially not making money, we'll be able to redeploy that through stock repurchases or through opportunistic investments and generate what we expect to be a much better return.

Okay, that makes sense. And then, actually for this quarter's earnings, apart from the realized gains, is there anything we can consider an unusual item, or is it kind of a reasonable run rate for where earnings should be?

I think other than expenses were elevated as we started to incur severance and nonrecurring costs associated with the discontinuations. That was a component. Otherwise, I think it was a relatively straightforward quarter. We had the full impact of our FHLB investments, which I mentioned earlier. Jumbo mortgage banking margins had increased from the prior quarter. I think we have 71 basis points of gross margin in the fourth quarter. We announced 59 basis points for the full year. I think what that reflects is a transition to hold on sales as opposed to securitization. So, in the first quarter, we expect jumbo margins to be in excess of the 59 basis points that we reported for 2015.

Okay, thanks, and then just one more. Actually, the share count, the diluted share count, can you remind me just what drives the increase, or what drove the increase this quarter?

Really it has to do with the GAAP rules around EPS, and it's really stemming from our convertibles. So, based on profit levels, the impact of the convertible debt either goes in the numerator or the denominator. This quarter it went into the denominator as if we had to convert the debt. That's the GAAP assumption. We're not currently assuming that for forecasting purposes, it's just the way EPS calculation works.

Okay, so we should think about the share count, whatever in the mid-80s kind of when you think it for next year?

Yeah. I think it was around $84 million to start the year, or maybe at June 30th it was around $84 million and I think today it is closer to $77 million, $78 million.

Okay, great. Thanks.

We’ll hear next from Steve Delaney with JMP Securities.

Hi, good afternoon, everyone, and congrats on a solid close to what I know was a tough year for you. Chris just a housekeeping thing first, just to be following-up so we can get sort of what we feel is a good representation of core EPS for the fourth quarter compared to the $0.46 GAAP, the January 20th press release suggested severance of about $2 million split 50-50 between 4Q and 1Q. So, if we were to use $1 million for one-time severance in 4Q, would that be an appropriate adjustment in your view?

Yes.

Okay, alright, great. And then bigger picture stuff, one for Brett, if I may, obviously so you guys have made some tough decisions and you're going to focus on sort of your long-term core prime jumbo business, I me wondered, Brett, if you'd mind commenting sort of on the competitive landscape there for acquiring loans. We just looking today at Wells' website, and it just seems they're still pricing like, jumbos three eights through their conforming rate. And if you could just comment on your confidence level of continuing to be able - that's your biggest bucket in your investment portfolio now, so love to hear how we're going to continue to see a good flow there, both to replenish FHLBC, but also to generate some gains. Thanks.

Thanks, Steve. For quite a few years now, we've been competing for jumbo loans from the large money center banks who continue to have very aggressive appetites for their portfolio. We have been successful with our correspondent network still acquiring loans. I think our service levels are one of the reasons why. Secondly is, we have a large group of whole loan buyers who have the same appetite for jumbo collateral as the big banks. So, their price we could pass through to our loan sellers which keeps them competitive with obviously the big money center banks. And I think that's really what drives it on those relationships at our service levels.

That makes a lot of sense. I'd always thought of just sort of the securitization execution, et cetera, but your guys are - your correspondents are kind of hoarding the jumbos just like Wells and JPMorgan and everybody else is, aren't they?

Well, I'd say our whole loan buyers are.

Your whole loan buyers, I meant, yes.

There are other large banks that do not have large origination capacity, and they look at us as being a source of portfolio growth for them.

Okay, great. And so Chris, when you gave your guidance, should we still think about the historic 25 to 50 basis points as sort of being part of the framework for your 2016 guidance?

Yes, Steve. I think that's still a good long-term metric. I made the note that early in 2016 and coming out of the fourth quarter, margins remained elevated. Volumes were down in the fourth quarter as a result of other factors, but the margins looked good. And thus far in 2016, they look good. We had a warm January. From a purchase loan perspective that was good and mortgage rates are down. So, we feel pretty good about the jumbo business right now.

Okay, thanks, guys. And Marty just one to finish up, one for you if I may and I know how much time you've spent in Washington in recent years, and I'm sure the FHFA's decision was disappointing to you. I'm just curious if you've got any thoughts on how this plays out over the next couple years and how you would peg the odds of somehow or another Redwood and maybe other mortgage REITs regaining membership into the FLUB system.

Again, yes, we were a little disappointed with the ruling, although we were one of a handful of people that actually are in for the five-year period, nine and a half years of term financing. In my opinion, Steve, this was really gnarly political, and I think the FHFA making this decision was just something that they wanted to get behind them. I don't think this is something that would get opened up again anytime soon, in our opinion.

Okay, so you don't think any efforts through Congress are going to really be that beneficial?

I personally don't think so. I mean, Congress has in the grand scheme of things, you think through tax reform, the multitude of very, very important issues, I just don't think that stepping in the breach and helping out the Captive issue is way up there on anybody's top of their list.

I hear you. Well, good judgment on your part to get in early and to lock it up for nine and a half years. Thanks for the comments, guys.

[Operator instructions] We’ll move next to Vic Agrawal with Wells Fargo Securities.

Hi, guys, thanks for taking my question. I think, Chris, you said that you haven't seen any material credit issues in the portfolio. But, as we continue to see credit spreads move wider, especially on the CRT bonds, and I know your portfolio's been pristine for a number of years, are you seeing any signs of early delinquencies, so at all?

Not at this time, Vic. On the residential side, we continue to just have very, very positive credit performance. I think we're more concerned about repo in the capital markets, but we don't expect anything to be driven by fundamentals on the resi credit front.

Okay. And then, on your cost of funds, obviously that improves in the quarter. Do you expect the current level to be sort of a good run rate, or do you expect any further improvement?

I think the guidance that we provided here is a good proxy for the run rate for the foreseeable future.

Okay. Thanks, Chris.

Yeah.

And from Chimney Rock Investments we’ll hear from Beau Lescott.

Hi, thanks for taking the call. Two quick questions, one, can you provide any color on share repurchases that happened after the quarter-end and what share count you're using for your 2016 guidance? And then, the second question is, with respect to your repo financing, you outline a plan to reduce that as soon as possible, I think you put it. Can you talk about how you plan to accomplish that, whether you plan to sell the underlying securities or replace that financing with something else?

Sure. Sure, Beau. Since the end of the year, we used another $11 million or so of the remaining authorization to buy back stock. I think we bought it back at an average of $13.42. That was done earlier in the quarter, and that effectively used up the full $100 million authorization. So, that was what we have left that we used in 2016. As far as reducing the repo, I did mention our current plan is to reduce repo down to or below $300 million. That's a pretty significant drop from where we're at today. I think that'll be a combination of sales and just using cash to buy securities off of repo, if you will. It's going to be opportunistic, so we're not operating with great urgency, but we do expect this to occur over the next few months.

This is the first signal that I've seen so far, and I think it's the right thing to do to act prudently, but would you characterize this as preventative rather than reactive?

Well, any time there's market volatility, especially in pricing, the first thing that we think about is repo. It's usually the first sign of distress. And while we still feel good about the bonds we have on repo, I think we're a little bit more cautious today. Obviously there's fewer counterparties, there's been a few large European banks that have been pulling back. I think a lot of that capacity can be absorbed by onshore banks, but still, to us it's a sign and a measure of liquidity. So, we may be more cautious than others at this point, but that's our posture.

I appreciated it.

And at this time, there are no further questions. I'll turn it back to you all for closing remarks.

Thank you for joining us today, and we look forward to talking to you again next quarter.