Redwood Trust, Inc. (RWT) Q4 2017 Earnings Report, Transcript and Summary

Good afternoon, and welcome to the Redwood Trust, Inc. Fourth Quarter 2017 Earnings Conference Call. [Operator Instructions] I’d now like to turn the conference over to Ms. Kristin Brown, Vice President of Investor Relations. Please go ahead, ma’am.

Thank you, Tom. Good afternoon, and thank you for joining us to review Redwood Trust’s fourth quarter 2017 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 may 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-Q, 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 our fourth quarter earnings press release and the Redwood Review, which will be 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, Thursday, February, 22, 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 Marty Hughes, Redwood’s Chief Executive Officer for opening remarks and introduction.

Good afternoon, everyone. Thank you for participating in Redwood’s Fourth Quarter 2017 Earnings Call. Joining me on the call are Chris Abate, Redwood’s President; Dash Robinson, Redwood’s Executive Vice President; and Collin Cochrane, our CFO. This quarter I’m going to intentionally keep my – put my comments brief, so you can hear more from these gentlemen, they will go through the numbers, the progress in our businesses and our strategic initiatives. After in almost two year quiet and seemingly uninterrupted March higher in the financial markets, we all know too well that a lot has recently changed. Equities have been under pressure and higher volatility is currently more of the daily norm. It’s important for our shareholders but the only thing we can do is focus on what we can control by profitably building our core credit investing businesses and our operating businesses. Chris and Dash will have a lot to say on these topics in their presentations. Long-term rates have trended higher but the 30-year mortgage rates still remain very attractive for homebuyers by historical standards and the fundamentals around housing remained strong. We all have a new tax plan, which we believe on balance is a net positive for Redwood. We touch on this in the shareholder letter and we can address any additional questions you may have during Q&A. There is a lot of recent talk on reducing the grip of mortgage regulation and giving lenders more clarity and transparency on the – where the lines are in interpreting the mortgage rule. We believe this would also be a positive for Redwood and bring more liquidity in the mortgage market for borrowers. Another positive development is the continuing traction in the market for non-agency securitization. There are now more issuers including banks and insurance companies and new investors who have entered the market what has brought more liquidity and tightened credit spreads. Issuance volume was $6 billion in 2016, $15 billion in 2017 and has been almost $4 billion into the first two months this year. We would note that RMBS credit spreads have recently remained tight, despite the volatility and pressure in the equity markets. Redwood has been about 40% of the RMBS issuance volume this year, distribution through RMBS is important to Redwood as both the source of earnings and to organically create investments. At our core, we remain patient long-term credit investors who measure outcomes in years, not quarters. Our strengths continue the way where they always have been. In sourcing and analyzing credit risk, prudent management of capital, and our ability to execute in the marketplace. With that, I will turn it over to Chris Abate to recap 2017 highlights.

Thank you, Marty. And good afternoon, everyone. As the company, we made strong tactical and financial progress in 2017. And we are off to a positive start in 2018. I’ll offer you just a few of the highlights. First, we ended up completing nine securitizations in 2017, including our first two Redwood Choice securitizations. This compares to three total Select transactions completed in 2016. Perhaps, more notably, with the first two months of 2018, we’ve now completed or priced five new Sequoia securitizations. This includes four new Select transactions and one new Choice transaction. In total, our Choice loan volume increased over 350% in 2017 to $1.3 billion. With respect to capital deployment, we deployed $511 million of capital in 2017 versus $419 million in 2016. We were also active in optimizing our investment portfolio, particularly, as spreads tightened in the second half of 2017. We sold $281 million of mostly lower yielding securities and the remainder of our noncore conforming MSR portfolio, capturing gains and freeing up $167 million of capital for redeployment. We also invested in Redwood stock in the later months of the year at attractive levels below book, buying back $9 million of Redwood common shares during the fourth quarter of 2017. And through today, an additional $16 million of shares thus far in 2018. We continue to find the trading price of Redwood stock very attractive. And today, with our board secured an increase in our share repurchase authorization to $100 million. From a longer-term strategic perspective, we expanded our market footprint to reflect the secular changes, we see happening in housing that play off our core strengths. This included investing $237 million in multifamily securities, representing $85 million of capital in 2017 as well as our initial investments in single-family rental securities during the fourth quarter. We expect single- family rental products to be a significant focus area of ours in the coming quarters. In only 2018, we also finalized an investment framework to start investing in energy improvement loans secured by commercial properties, also known as commercial PACE loans. We expect to begin investing soon. Finally, we ended the year with a fully seated executive team with the addition of Dash and Collin. In terms of our 2017 financial results, our GAAP book value increased $0.87 per share to $15.83 at the end of 2017 from $14.96 at the end of 2016. This is our biggest annual increase in book value since 203. Our GAAP earnings per share were $1.16, an increase from $1.54 in 2016, and our ROE improved slightly from 11.9% in 2017 from 11.8% in 2016. So in summary, we feel good about our progress in 2017, particularly, in terms of our success in deploying capital, despite a tight spread environment. We are also encouraged by the momentum of our Choice program in our Sequoia activity as well as the strong underlying credit performance of our investment portfolio. We feel we’ve positioned our operating platform to scale profitably going forward. We can augment that growth to some of our new strategic initiatives in 2018. Finally, before I turn it over to Dash, I’d like to personally invite all of our investors to our inaugural Investor Day, which will be on March 6, in New York City. As you may have noticed, our recent slide decks in our outreach meetings, there’s a lot of very exciting things going on at Redwood. On the dedicated Investor Day, we’ll provide a great form for you to learn more about the company and our plans going forward. Judgments will include Redwood executives as well as senior managers within our mortgage banking, securitization and investment platforms. We’ll also have a few guest speakers as well. Please reach out to Kristin Brown for registration details. I’ll now turn the call over to Dash Robinson, Redwood’s Executive Vice President.

Thanks, Chris, and good afternoon, everyone. I’d like to start off by touching on our mortgage banking activity. After three straight quarters of out size returns, the mortgage banking team experienced more normalized earnings in the fourth quarter. With margins that were below our long-term expectation of 75 to 100 basis points as loan prices softened heading into year end. However, as they often do, market conditions rebounded in January and we took full advantage, funding two select transactions in January and pricing three more transactions in February including two Select and one Choice. In the face of the recent uptick in volatility that Marty alluded to, these transactions are all priced profitability and at better executions relative to year-end. Together, these five deals included just over $2 billion worth of loans. Mortgage banking was active in the fourth quarter as well, completing two Sequoia transactions, including one Choice and one Select and selling at $474 million of whole loans to portfolio buyers. The Choice issuance was our second overall and, importantly, closely followed our inaugural Choice issuance in September. This transaction created $47 million of credit securities that we retained, utilizing approximately $15 million of capital, around three times that of a traditional Sequoia transaction. Given the current pace of Choice purchases, we expect to issue larger transactions going forward. Total purchase volume was $2 billion in the fourth quarter of 2017, our highest quarterly jumbo purchase volume since the crisis and a 33% increase over the third quarter. Choice purchase volume increased over 50% from the third quarter to over $500 million or 32% of total fourth quarter lock volume. Our full year total purchase volume was $5.7 billion, at the higher end of the $5 billion to $6 billion guidance we set out to our investors in February of last year and an increases of over 20% from our 2016 volume. Choice represented almost 30% of our full year lock volume and was a key driver of our year-over-year growth. Also during the fourth quarter, we increased capital allocated to our mortgage banking operations to $200 million from $170 million to accommodate an anticipated increase in loan purchase volume in 2018. Looking forward, our focus continues to be on growing our Choice volume while maintaining our competitive position in Select through speed, reliability and deepening relationships with our sellers. Turning to the investment portfolio, we deployed $118 million of capital toward new investments in the fourth quarter. And as Chris noted, $511 million for the full year with 15% of new investments organically created through our mortgage banking activities. We continue to optimize our portfolio by selling lower-yielding Agency CRT in mezzanine securities and redeploying that capital into high-yielding alternatives. Also during the quarter, we allocated additional capital to our Federal Home Loan Bank facility due to an increase in the collateral requirement associated with that borrowing. Our fourth quarter capital deployment also included $9 million of common share repurchases at an average price of $15.05 per share. And year-to-date, we have deployed an additional $16 million towards share repurchases at an average price of $14.91 per share. As Chris mentioned, the Board has also approved renewing our share repurchase authorization back up to the original $100 million approved in 2016. Now to recap our financial results, I’ll turn it over to Collin Cochrane, our CFO.

Thanks, Dash. And good afternoon, everyone. To summarize our financial results for the fourth quarter, our GAAP earnings were $0.35 per share compared with $0.41 in the third quarter, and core earnings were $0.35 per share consistent with the third quarter. Our fourth quarter GAAP results reflect lower mortgage banking income which, as Dash mentioned, was driven in part by the impact to margins from a temporary pullback in loan pricing at year- end. This decrease was partially offset by a tax benefit related to the recently passed tax reform. Our GAAP book value increased to $15.83 per share at December 31 from $15.67 per share at September 30, with the increase primarily driven by our quarterly earnings exceeding our dividend and fair value increases on a fair – available- for-sale securities as we saw continued spread tightening in this portfolio. Subsequent to year-end, we have seen spreads move around a bit. But currently, they are slightly tighter or flat to year-end through most of our investment portfolio. However, the benefit we’ve seen from any spread tightening as mostly been offset by increased hedging cost due to the recent interest rate volatility. As a credit investor, our investments are generally more sensitive to changes in credit spreads and changes in interest rates. Though we do have some interest rate exposure, particularly, on our FHLB portfolio. We do seek to fully hedge our interest rate exposure through a combination of swaps, TBAs and other instruments. Turning to the balance sheet, our recourse debt-to-equity leverage ratio was 3.7 times at the end of the fourth quarter compared to 3.2x at the end of the third quarter. The increase was primarily related to the higher- than-usual balance of loans held-for-sale and finance with warehouse debt at the end of the fourth quarter. As we mentioned, a significant amount of these loans were already sold this quarter which will bring this ratio back down. In regard to our upcoming convertible debt maturity, we had $280 million of available capital at year-end and have generated additional capital during the first quarter through continued portfolio optimization. Consequently, we have sufficient capital to repay this maturity in April. As a reminder, we will no longer be subject to the dilutive GAAP EPS impact of these notes subsequent to their repayment, which should benefit our EPS going forward. I’ll close with our outlook for 2018. Our priorities for the remainder of 2018 are to generate GAAP earnings that exceed our recent historical annual dividends of $1.12 per share, grow our residential loan purchase volume and maintain our strong capital deployment trends. For our mortgage banking business, we are targeting loan purchase volumes of $7 billion to $8 billion for 2018 versus $5.7 billion in 2017. And gross margins within our long-term expectations of 75 to 100 basis points. As part of our growth initiatives, we expect to double our Redwood Choice purchase volume in 2018. , : Finally, we anticipate baseline corporate operating expenses of $40 million to $45 million with variable compensation commensurate with company performance. And with that, I’ll conclude our prepared remarks. Operator, why don’t we start the Q&A?

Thank you. [Operator Instructions] Our first question comes from Bose George with KBW.

Hey guys, good afternoon. The first question is just the – can you discuss the competitive landscape for Redwood Choice? What are the trends there? And then, you noted that you wanted to double the volume there in 2018. And what does that imply for Redwood Choice as part of your total production by the end of 2018?

Bose, it’s Chris. I would say the competitive landscape is fairly consistent with the prior quarter. As you’ve seen, we’ve successfully continued to grow volume through Choice on quarter-over-quarter basis, notwithstanding annual basis. I think that the – doubling the volume in 2018, we hope to do better than that. But with the visibility we have today, there is some softness in areas of the origination landscape. I will say, though, that Choice plays well in a market that’s – that continues to drift towards purchase activity. Originators that are trying to supplement a lack of refis are looking to Choice as a way to do that. So we’re encouraged, even with some softening in the market that we’ll be able to achieve our 2018 goals. As far as the percentage of Choice, we expect that to continue to trend up. If I had to put a number on it, I’d say maybe one-third of our total volume we like to see as Choice so we’re better. We’ll have a better update on that as we get through a few quarters.

Okay. Great, that helps. And then actually in terms of the expectation for mortgage banking income, this quarter, you noted it was a little light. Last quarter it was – above the 75 to 100 range. In the 75 to 100 range, what’s your reasonable expectation for reasonable expectation for that line item? Is it something like $10 million of earnings? Or is there a way to kind of frame that?

I’d say north of that. Just to confirm, the fourth quarter, things get soften, specifically towards the end of the year when we’re required to mark our book. And now the fourth quarter, I think we had total pipeline in excess of $2.5 billion, so as we were heavy on loans, and the incremental softening impacted that line item. Since then, as I mentioned, we’ve now priced or completed five securitizations. As Dash mentioned, we’ve taken a lot of risk off the table. And spreads did tighten a quite a bit in the first two months of the year. So in the first quarter, we expect to see a benefit from that but certainly in the range of $10 million to $20 million. We have to sharpen our pencils on what the rest of the year might look like.

Okay, that’s helpful. And then actually, just the last one on book value. Just based on your comments about spread tightening, a little offset with the hedging, is it – in terms of book value since quarter ended, is it relatively stable?

Very much so. Yes.

Okay, great. Thank you.

We’ll take our next question from Steve Delaney with JMP Securities.

Thanks for taking the question. One of the things I noticed this quarter – by the way, a lot going on, it’s been a very interesting call. The jump in REIT taxable income, it had averaged about $0.25 year-to-date. Now here in fourth quarter, we see it popped up to $0.42. I was wondering, Collin, if you could shed any light on that for us?

Yes, in the fourth quarter we made a dividend from our TRS up to the REIT. And that’s something we’ll do occasionally. We sold our MSR conforming portfolio during the year, which freed up some capital down at the TRS. And we had the opportunity because we had some room at the REIT to move that capital back up. So that’s what you’re seeing there, in the fourth quarter, is the jump. And that correlate to that characterization of our dividend where we noted a portion of that’s going to be characterized as a qualified dividend.

Okay, that’s helpful. Thank you. And that kind of rolls into the fact that the current $0.28 dividend, and we discussed that in light of the new information about the buyback, you’ve had that dividend for five years, I think now, just looking back to my model. And I’m just curious, as your taxable income grows, your REIT income and it came to be at the REIT or, as you say, you can push it up and distribute it as qualified. I’m just curious what the Board is looking to see in order to consider increasing the dividend in the future? We almost expect it because you’ve done – gone through your restructuring, you were getting momentum from, obviously, RMBS 2.0 and Choice, in particular. So frankly, we went ahead and threw in a $0.02 bump in the dividend, being a little optimistic, I guess. But just curios kind of how that dialogue goes between the Board and management and what would it take for the board to consider raising the dividend?

Steve, it’s Chris. First – the Board did announce its intention in December for the full year. So that’s certainly public at $0.28. What I would say is there’s a few moving parts. Number one, we’re still sitting on a $57 million NOL at the REIT. So from an increasing perspective, we – at some point we’d like to benefit from that. We started to – late last year, I think it was $59million at the end of September, so we’ve been bleeding that down slowly. I think more importantly, though, the way, I think the Board thinks about it is in terms of cash flow and portfolio income. So as you know, our mortgage banking revenue is basically taxable. So we’re able to retain those tax earnings. So I think the primary focus is on growing the investment portfolio and generating a significant level of cash flow that would justify a higher dividend. That’s something we’ll continue to monitor over time.

Okay, all right, that’s helpful. And the buyback, we always applaud buybacks in the REIT world or at least the mortgage REIT worldview. You generally see them when we’re maybe more down like around 85% to 80% of book. I think that says two things to me, one, what you guys internally see in the real value of the stock going forward, which is encouraging; and the other thing is, should we look at that as a function of kind of managing your capital, if you will, so in order to fine-tune your return on common equity profile? Just trying to understand, I think your $15.05 was like 95% of quarter-end book value?

Yes. Certainly, we look at the buybacks through the lens of alternative uses for capital. So we did $25 million or so. And that – we sort of look at that as an investment like we look at the rest of the capital we deployed during the fourth quarter. It’s just – we think about it in terms of our historical trading range, where we would expect to see the stock vis-a-vis the business plan. I do think that there’s been a lot of correlation in the markets over the past few months, certainly, as interest rates are sold off. And one thing we continue to try and do is differentiate how our business is impacted. Just given the operating nature and given, on a relative basis, much lower leverage, we’re much less sensitive to a selloff in rates than you might think from a traditional mortgage REIT perspective. So we certainly see value in where the stock is trading today, and we’re going to continue plowing ahead with our initiatives and, hopefully, that gets reflected.

Yes, I hear you. And I hope my question didn’t imply that I thought your stock would ever get to 85% of book. But I hear you. And I think – okay. Just one – that’s all very good guys, one final question. You had talked about your single-family rental loan program kicking up maybe in the second quarter. But it sounded like you – in your comments, you did make an investment. Can you describe what you did? It’s sounded like that might have been a securitized product?

Steve, it’s Dash, thanks for the question. That’s right, we continue internally working on organically creating single-family rental base investments for ourselves. And that continues to be a core initiative. The investment we did make was a third-party securitization, about $3 million of capital, largely investment-grade bonds, $13 million of total assets. So that was a third-party issuance where we have deployed capital thus far.

Okay, great. But you’re in the IG range, but I assume probably not AAA just given the low yields there.

Right. Yes, it’s more of the lower investment grade tranches. But obviously, going forward, in the broader – rental strategy, it would be the credit pieces we would look to be retaining.

Yes, exactly. That’s a nice lead-in. So when you are lending, I assume you’re looking to aggregate and then securitize and look at that product as just an alternative to what you do in the prime space. Is that the way we should think about it?

As a complement to the prime space, yes, exactly.

Okay. Well. Thank you all for your comments.

[Operator Instructions] And 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. This does conclude today’s conference. You may now disconnect.