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Section 1: 10-Q (10-Q)

Document

UNITED STATES OF AMERICA
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 
FORM 10-Q
 

x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended: June 30, 2018

OR

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period from _______________ to _______________.
Commission File Number 1-13759
 
REDWOOD TRUST, INC.
(Exact Name of Registrant as Specified in Its Charter)
Maryland
 
68-0329422
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)

One Belvedere Place, Suite 300
Mill Valley, California
 
94941
(Address of Principal Executive Offices)
 
(Zip Code)

(415) 389-7373
(Registrant’s Telephone Number, Including Area Code)
Not Applicable
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer
x
 
Accelerated filer
o
Non-accelerated filer
o
(Do not check if a smaller reporting company)
Smaller reporting company
o
 
 
 
Emerging growth company
o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.
Common Stock, $0.01 par value per share
 
82,929,990 shares outstanding as of August 6, 2018





REDWOOD TRUST, INC.
2018 FORM 10-Q REPORT
TABLE OF CONTENTS
 
 
 
 
Page
PART I —
FINANCIAL INFORMATION
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
Item 3.
 
Item 4.
 
 
 
 
 
PART II —
OTHER INFORMATION
 
 
Item 1.
 
Item 1A.
 
Item 2.
 
Item 3.
 
Item 4.
 
Item 5.
 
Item 6.
 
 



i



PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In Thousands, except Share Data)
(Unaudited)
 
June 30, 2018
 
December 31, 2017
ASSETS (1)
 
 
 
 
Residential loans, held-for-sale, at fair value
 
$
1,104,660

 
$
1,427,945

Residential loans, held-for-investment, at fair value
 
4,386,510

 
3,687,265

Real estate securities, at fair value
 
1,453,936

 
1,476,510

Cash and cash equivalents
 
184,779

 
144,663

Restricted cash
 
15,285

 
2,144

Accrued interest receivable
 
29,066

 
27,013

Derivative assets
 
65,645

 
15,718

Other assets
 
272,670

 
258,564

Total Assets
 
$
7,512,551

 
$
7,039,822

 
 
 
 
 
LIABILITIES AND EQUITY (1)
 
 
 
 
Liabilities
 
 
 
 
Short-term debt (2)
 
$
1,426,288

 
$
1,938,682

Accrued interest payable
 
21,925

 
18,435

Derivative liabilities
 
55,929

 
63,081

Accrued expenses and other liabilities
 
79,571

 
67,729

Asset-backed securities issued, at fair value
 
1,929,662

 
1,164,585

Long-term debt, net
 
2,770,221

 
2,575,023

Total liabilities
 
6,283,596

 
5,827,535

Equity
 
 
 
 
Common stock, par value $0.01 per share, 180,000,000 shares authorized; 75,742,719 and 76,599,972 issued and outstanding
 
757

 
766

Additional paid-in capital
 
1,665,749

 
1,673,845

Accumulated other comprehensive income
 
75,620

 
85,248

Cumulative earnings
 
1,369,933

 
1,290,341

Cumulative distributions to stockholders
 
(1,883,104
)
 
(1,837,913
)
Total equity
 
1,228,955

 
1,212,287

Total Liabilities and Equity
 
$
7,512,551

 
$
7,039,822

——————
(1)
Our consolidated balance sheets include assets of consolidated variable interest entities (“VIEs”) that can only be used to settle obligations of these VIEs and liabilities of consolidated VIEs for which creditors do not have recourse to Redwood Trust, Inc. or its affiliates. At June 30, 2018 and December 31, 2017, assets of consolidated VIEs totaled $2,082,771 and $1,259,774, respectively. At June 30, 2018 and December 31, 2017, liabilities of consolidated VIEs totaled $1,935,299 and $1,167,157, respectively. See Note 4 for further discussion.
(2)
At December 31, 2017, balance includes $250 million of convertible notes, which were reclassified from Long-term debt, net to Short-term debt as the notes matured in April 2018. See Note 10 for further discussion.

The accompanying notes are an integral part of these consolidated financial statements.

2


REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands, except Share Data)
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(Unaudited)
 
2018
 
2017
 
2018
 
2017
Interest Income
 
 
 
 
 
 
 
 
Residential loans
 
$
55,514

 
$
36,635

 
$
105,745

 
$
70,997

Real estate securities
 
26,296

 
21,826

 
51,991

 
41,643

Other interest income
 
1,166

 
763

 
1,859

 
1,212

Total interest income
 
82,976

 
59,224

 
159,595

 
113,852

Interest Expense
 
 
 
 
 
 
 
 
Short-term debt
 
(13,175
)
 
(9,350
)
 
(26,610
)
 
(13,803
)
Asset-backed securities issued
 
(16,349
)
 
(3,705
)
 
(27,750
)
 
(7,235
)
Long-term debt
 
(18,689
)
 
(11,179
)
 
(35,367
)
 
(24,227
)
Total interest expense
 
(48,213
)
 
(24,234
)
 
(89,727
)
 
(45,265
)
Net Interest Income
 
34,763

 
34,990

 
69,868

 
68,587

Non-interest Income
 
 
 
 
 
 
 
 
Mortgage banking activities, net
 
10,596

 
12,046

 
37,172

 
29,650

Investment fair value changes, net
 
889

 
8,115

 
2,498

 
9,666

Other income, net
 
3,322

 
3,764

 
5,440

 
6,661

Realized gains, net
 
4,714

 
1,372

 
14,077

 
7,075

Total non-interest income, net
 
19,521

 
25,297

 
59,187

 
53,052

Operating expenses
 
(19,009
)
 
(18,641
)
 
(42,039
)
 
(36,867
)
Net Income before Provision for Income Taxes
 
35,275

 
41,646

 
87,016

 
84,772

Provision for income taxes
 
(2,528
)
 
(5,322
)
 
(7,424
)
 
(11,479
)
Net Income
 
$
32,747

 
$
36,324

 
$
79,592

 
$
73,293

 
 
 
 
 
 
 
 
 
Basic earnings per common share
 
$
0.42

 
$
0.46

 
$
1.02

 
$
0.93

Diluted earnings per common share
 
$
0.38

 
$
0.43

 
$
0.88

 
$
0.85

Regular dividends declared per common share
 
$
0.30

 
$
0.28

 
$
0.58

 
$
0.56

Basic weighted average shares outstanding
 
75,380,715

 
76,819,703

 
75,388,638

 
76,779,178

Diluted weighted average shares outstanding
 
100,431,993

 
97,494,144

 
104,291,180

 
97,718,550


The accompanying notes are an integral part of these consolidated financial statements.



3


REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(In Thousands)
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(Unaudited)
 
2018
 
2017
 
2018
 
2017
Net Income
 
$
32,747

 
$
36,324

 
$
79,592

 
$
73,293

Other comprehensive (loss) income:
 
 
 
 
 
 
 
 
Net unrealized (loss) gain on available-for-sale securities (1)
 
(3,104
)
 
1,811

 
(7,341
)
 
4,741

Reclassification of unrealized gain on available-for-sale securities to net income
 
(4,748
)
 
(2,322
)
 
(14,135
)
 
(6,250
)
Net unrealized gain (loss) on interest rate agreements
 
3,417

 
(2,429
)
 
11,848

 
(696
)
Reclassification of unrealized loss on interest rate agreements to net income
 

 
14

 

 
28

Total other comprehensive (loss) income
 
(4,435
)
 
(2,926
)
 
(9,628
)
 
(2,177
)
Total Comprehensive Income
 
$
28,312

 
$
33,398

 
$
69,964

 
$
71,116

——————
(1)
Amounts are presented net of tax benefit (provision) of $0.2 million and $0.1 million for the three and six months ended June 30, 2018, respectively, and $0.1 million and $(0.1) million for the three and six months ended June 30, 2017, respectively.

The accompanying notes are an integral part of these consolidated financial statements.



4



REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY

For the Six Months Ended June 30, 2018
(In Thousands, except Share Data)
 
Common Stock
 
Additional
Paid-In
Capital
 
Accumulated
Other
Comprehensive
Income
 
Cumulative
 Earnings
 
Cumulative
Distributions
to Stockholders
 
Total
(Unaudited)
 
Shares
 
Amount
 
 
 
 
 
December 31, 2017
 
76,599,972

 
$
766

 
$
1,673,845

 
$
85,248

 
$
1,290,341

 
$
(1,837,913
)
 
$
1,212,287

Net income
 

 

 

 

 
79,592

 

 
79,592

Other comprehensive loss
 

 

 

 
(9,628
)
 

 

 
(9,628
)
Employee stock purchase and incentive plans
 
183,576

 
1

 
(195
)
 

 

 

 
(194
)
Non-cash equity award compensation
 

 

 
7,633

 

 

 

 
7,633

Share repurchases
 
(1,040,829
)
 
(10
)
 
(15,534
)
 

 

 

 
(15,544
)
Common dividends declared
 

 

 

 

 

 
(45,191
)
 
(45,191
)
June 30, 2018
 
75,742,719

 
$
757

 
$
1,665,749

 
$
75,620

 
$
1,369,933

 
$
(1,883,104
)
 
$
1,228,955


For the Six Months Ended June 30, 2017
(In Thousands, except Share Data)
 
Common Stock
 
Additional
Paid-In
Capital
 
Accumulated
Other
Comprehensive
Income
 
Cumulative
 Earnings
 
Cumulative
Distributions
to Stockholders
 
Total
(Unaudited)
 
Shares
 
Amount
 
 
 
 
 
December 31, 2016
 
76,834,663

 
$
768

 
$
1,676,486

 
$
71,853

 
$
1,149,935

 
$
(1,749,614
)
 
$
1,149,428

Net income
 

 

 

 

 
73,293

 

 
73,293

Other comprehensive loss
 

 

 

 
(2,177
)
 

 

 
(2,177
)
Employee stock purchase and incentive plans
 
282,212

 
3

 
(2,388
)
 

 

 

 
(2,385
)
Non-cash equity award compensation
 

 

 
5,377

 

 

 

 
5,377

Common dividends declared
 

 

 

 

 

 
(44,112
)
 
(44,112
)
June 30, 2017
 
77,116,875

 
$
771

 
$
1,679,475

 
$
69,676

 
$
1,223,228

 
$
(1,793,726
)
 
$
1,179,424



The accompanying notes are an integral part of these consolidated financial statements.


5


REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)
(Unaudited)
 
Six Months Ended June 30,
 
2018
 
2017
Cash Flows From Operating Activities:
 
 
 
 
Net income
 
$
79,592

 
$
73,293

Adjustments to reconcile net income to net cash used in operating activities:
 
 
 
 
Amortization of premiums, discounts, and securities issuance costs, net
 
(7,963
)
 
(9,638
)
Depreciation and amortization of non-financial assets
 
582

 
605

Purchases of held-for-sale loans
 
(3,772,494
)
 
(2,309,856
)
Proceeds from sales of held-for-sale loans
 
2,966,508

 
2,031,326

Principal payments on held-for-sale loans
 
30,656

 
22,093

Net settlements of derivatives
 
40,426

 
776

Non-cash equity award compensation expense
 
7,633

 
5,377

Market valuation adjustments
 
(34,136
)
 
(30,743
)
Realized gains, net
 
(14,077
)
 
(7,075
)
Net change in:
 
 
 
 
Accrued interest receivable and other assets
 
32,478

 
(26,226
)
Accrued interest payable and accrued expenses and other liabilities
 
(3,582
)
 
(16,840
)
Net cash used in operating activities
 
(674,377
)
 
(266,908
)
Cash Flows From Investing Activities:
 
 
 
 
Principal payments on loans held-for-investment
 
335,720

 
258,267

Purchases of real estate securities
 
(319,975
)
 
(236,036
)
Proceeds from sales of real estate securities
 
352,563

 
99,121

Principal payments on real estate securities
 
33,974

 
34,752

Sales (purchases) of mortgage servicing rights, net
 
6,064

 
42,861

(Funding) payments of participation in loan warehouse facility, net
 
(34,333
)
 

Other investing activities, net
 
(9,999
)
 

Net cash provided by investing activities
 
364,014

 
198,965

Cash Flows From Financing Activities:
 
 
 
 
Proceeds from borrowings on short-term debt
 
3,219,350

 
2,070,873

Repayments on short-term debt
 
(3,731,917
)
 
(1,855,233
)
Proceeds from issuance of asset-backed securities
 
925,845

 

Repayments on asset-backed securities issued
 
(181,781
)
 
(103,371
)
Proceeds from issuance of long-term debt
 
199,000

 

Deferred long-term debt issuance costs paid
 
(4,940
)
 

Net settlements of derivatives
 
(237
)
 
(72
)
Net proceeds from issuance of common stock
 
177

 
145

Net payments on repurchase of common stock
 
(16,315
)
 

Taxes paid on equity award distributions
 
(371
)
 
(2,530
)
Dividends paid
 
(45,191
)
 
(44,112
)
Net cash provided by financing activities
 
363,620

 
65,700

Net increase (decrease) in cash, cash equivalents and restricted cash
 
53,257

 
(2,243
)
Cash, cash equivalents and restricted cash at beginning of period (1)
 
146,807

 
221,467

Cash, cash equivalents, and restricted cash at end of period (1)
 
$
200,064

 
$
219,224

Supplemental Cash Flow Information:
 
 
 
 
Cash paid during the period for:
 
 
 
 
 Interest
 
$
83,781

 
$
44,274

 Taxes
 
3,722

 
1,040

Supplemental Noncash Information:
 
 
 
 
Real estate securities retained from loan securitizations
 
$
43,513

 
$
38,051

Retention of mortgage servicing rights from loan securitizations and sales
 

 
7,387

Transfers from loans held-for-sale to loans held-for-investment
 
1,069,326

 
247,377

Transfers from loans held-for-investment to loans held-for-sale
 

 
459

Transfers from residential loans to real estate owned
 
1,835

 
2,044

Transfers from long-term debt to short-term debt
 

 
285,900

——————
(1)
Cash, cash equivalents, and restricted cash at June 30, 2018 includes cash and cash equivalents of $185 million and restricted cash of $15 million, and at December 31, 2017 includes cash and cash equivalents of $145 million and restricted cash of $2 million.
The accompanying notes are an integral part of these consolidated financial statements.

6


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2018
(Unaudited)




Note 1. Organization
Redwood Trust, Inc., together with its subsidiaries, is a specialty finance company focused on making credit-sensitive investments in residential mortgages and related assets and engaging in mortgage banking activities. Our goal is to provide attractive returns to shareholders through a stable and growing stream of earnings and dividends, as well as through capital appreciation. We operate our business in two segments: Investment Portfolio and Residential Mortgage Banking.
Our primary sources of income are net interest income from our investment portfolios and non-interest income from our mortgage banking activities. Net interest income consists of the interest income we earn on investments less the interest expense we incur on borrowed funds and other liabilities. Income from mortgage banking activities is generated through the acquisition of loans and their subsequent sale or securitization.
Redwood Trust, Inc. has elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Internal Revenue Code”), beginning with its taxable year ended December 31, 1994. We generally refer, collectively, to Redwood Trust, Inc. and those of its subsidiaries that are not subject to subsidiary-level corporate income tax as “the REIT” or “our REIT.” We generally refer to subsidiaries of Redwood Trust, Inc. that are subject to subsidiary-level corporate income tax as “our operating subsidiaries” or “our taxable REIT subsidiaries” or “TRS.”
Redwood was incorporated in the State of Maryland on April 11, 1994, and commenced operations on August 19, 1994. References herein to “Redwood,” the “company,” “we,” “us,” and “our” include Redwood Trust, Inc. and its consolidated subsidiaries, unless the context otherwise requires.
Note 2. Basis of Presentation
The consolidated financial statements presented herein are at June 30, 2018 and December 31, 2017, and for the three and six months ended June 30, 2018 and 2017. These interim unaudited consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and note disclosures normally included in our annual financial statements prepared in accordance with U.S. generally accepted accounting principles ("GAAP") — as prescribed by the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) — have been condensed or omitted in these interim financial statements according to these SEC rules and regulations. Management believes that the disclosures included in these interim financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the company's Annual Report on Form 10-K for the year ended December 31, 2017. In the opinion of management, all normal and recurring adjustments to present fairly the financial condition of the company at June 30, 2018 and results of operations for all periods presented have been made. The results of operations for the three and six months ended June 30, 2018 should not be construed as indicative of the results to be expected for the full year.
Principles of Consolidation
In accordance with GAAP, we determine whether we must consolidate transferred financial assets and variable interest entities (“VIEs”) for financial reporting purposes. We currently consolidate the assets and liabilities of certain Sequoia securitization entities issued prior to 2012 where we maintain an ongoing involvement ("Legacy Sequoia"), as well as entities formed in connection with the securitization of Redwood Choice expanded-prime loans beginning in the third quarter of 2017 ("Sequoia Choice"). Each securitization entity is independent of Redwood and of each other and the assets and liabilities are not owned by and are not legal obligations of Redwood Trust, Inc. Our exposure to these entities is primarily through the financial interests we have retained, although we are exposed to certain financial risks associated with our role as a sponsor, servicing administrator, or depositor of these entities or as a result of our having sold assets directly or indirectly to these entities.
For financial reporting purposes, the underlying loans owned at the consolidated Sequoia entities are shown under Residential loans, held-for-investment, at fair value on our consolidated balance sheets. The asset-backed securities (“ABS”) issued to third parties by these entities are shown under ABS issued. In our consolidated statements of income, we recorded interest income on the loans owned at these entities and interest expense on the ABS issued by these entities as well as other income and expenses associated with these entities' activities. See Note 11 for further discussion on ABS issued.
See Note 4 for further discussion on principles of consolidation.

7


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2018
(Unaudited)
Note 2. Basis of Presentation - (continued)

Use of Estimates
The preparation of financial statements requires us to make a number of significant estimates. These include estimates of fair value of certain assets and liabilities, amounts and timing of credit losses, prepayment rates, and other estimates that affect the reported amounts of certain assets and liabilities as of the date of the consolidated financial statements and the reported amounts of certain revenues and expenses during the reported periods. It is likely that changes in these estimates (e.g., valuation changes due to supply and demand, credit performance, prepayments, interest rates, or other reasons) will occur in the near term. Our estimates are inherently subjective in nature and actual results could differ from our estimates and the differences could be material.
Note 3. Summary of Significant Accounting Policies

Significant Accounting Policies
Included in Note 3 to the Consolidated Financial Statements of our 2017 Annual Report on Form 10-K is a summary of our significant accounting policies. Provided below is a summary of additional accounting policies that are significant to the company’s consolidated financial position and results of operations for the three and six months ended June 30, 2018.
Recent Accounting Pronouncements
Newly Adopted Accounting Standards Updates ("ASUs")
In May 2017, the FASB issued ASU 2017-09, "Compensation - Stock Compensation (Topic 718)." This new guidance provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in Topic 718. This new guidance is effective for fiscal years beginning after December 15, 2017, and should be applied prospectively to an award modified on or after the adoption date. We adopted this guidance, as required, in the first quarter of 2018, which did not have a material impact on our consolidated financial statements.
In November 2016, the FASB issued ASU 2016-18, "Statement of Cash Flows (Topic 230): Restricted Cash." This new guidance amends previous guidance on how to classify and present changes in restricted cash on the statement of cash flows. This new guidance is effective for fiscal years beginning after December 15, 2017. We adopted this guidance, as required, in the first quarter of 2018, which did not have a material impact on our results of operations but impacted the presentation of the statements of cash flows and related footnote disclosures.
In October 2016, the FASB issued ASU 2016-16, "Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory." This new guidance allows an entity to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. It also eliminates the exceptions for an intra-entity transfer of assets other than inventory. This new guidance is effective for fiscal years beginning after December 15, 2017. We adopted this guidance, as required, in the first quarter of 2018, which did not have a material impact on our consolidated financial statements.
In August 2016, the FASB issued ASU 2016-15, "Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments." This new guidance provides guidance on how to present and classify certain cash receipts and cash payments in the statement of cash flows. This new guidance is effective for fiscal years beginning after December 15, 2017. We adopted this guidance, as required, in the first quarter of 2018, which did not have a material impact on our consolidated financial statements.
In January 2016, the FASB issued ASU 2016-01, "Recognition and Measurement of Financial Assets and Financial Liabilities." This new guidance amends accounting related to the classification and measurement of investments in equity securities and the presentation of certain fair value changes for financial liabilities measured at fair value. This new guidance also amends certain disclosure requirements associated with the fair value of financial instruments and it is effective for fiscal years beginning after December 15, 2017. In February 2018, the FASB issued ASU 2018-03, "Technical Corrections and Improvements to Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities," which clarified certain aspects of the guidance issued in ASU 2016-01. We adopted this guidance, as required, in the first quarter of 2018. This did not have a material impact on our consolidated financial statements as our investments in debt securities and loans were not subject to the amendments in this ASU. In accordance with this guidance, we amended certain fair value disclosures related to financial instruments that are carried at amortized cost on the consolidated balance sheets.

8


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2018
(Unaudited)

Note 3. Summary of Significant Accounting Policies - (continued)

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers.” The update modifies the guidance companies use to recognize revenue from contracts with customers for transfers of goods or services and transfers of nonfinancial assets, unless those contracts are within the scope of other standards. The guidance also requires new qualitative and quantitative disclosures, including information about contract balances and performance obligations. In July 2015, the FASB approved a one-year deferral of the effective date. Accordingly, the update is effective for us in the first quarter of 2018 with retrospective application to prior periods presented or as a cumulative effect adjustment in the period of adoption. In March 2016, the FASB issued ASU 2016-08, "Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net)." This new guidance provides additional implementation guidance on how an entity should identify the unit of accounting for the principal versus agent evaluations. In May 2016, the FASB issued ASU 2016-12, "Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients," and in December 2016, the FASB issued ASU 2016-20, "Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers." These new ASUs provide more specific guidance on certain aspects of Topic 606. In September 2017, the FASB issued ASU 2017-13, "Revenue Recognition (Topic 605), Revenue from Contracts with Customers (Topic 606), Leases (Topic 840), and Leases (Topic 842): Amendments to SEC Paragraphs Pursuant to the Staff Announcement at the July 20, 2017 EITF Meeting and Rescission of Prior SEC Staff Announcements and Observer Comments (SEC Update)." This new ASU allows certain public business entities to use the nonpublic business entity effective dates for adoption of the new revenue standard. In November 2017, the FASB issued ASU 2017-14, "Income Statement - Reporting Comprehensive Income (Topic 220), Revenue Recognition (Topic 605), and Revenue from Contracts with Customers (Topic 606): Amendments to SEC Paragraphs Pursuant to Staff Accounting Bulletin No. 116 and SEC Release No. 33-10403." This new ASU amends various paragraphs that contain SEC guidance. We adopted this guidance, as required, in the first quarter of 2018. This did not have a material impact on our consolidated financial statements as nearly all of our income is generated from financial instruments, which are explicitly scoped out of these standards. 
Other Recent Accounting Pronouncements
In February 2018, the FASB issued ASU 2018-02, "Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income." This new guidance allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act of 2017 (the "Tax Act"). This new guidance is effective for fiscal years beginning after December 15, 2018. Early adoption is permitted. We plan to adopt this new guidance by the required date and do not anticipate that this update will have a material impact on our consolidated financial statements.
In August 2017, the FASB issued ASU 2017-12, "Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities." This new guidance amends previous guidance to better align an entity's risk management activities and financial reporting for hedging relationships through changes to both the designation and measurement guidance for qualifying hedging relationships and the presentation of hedge results. This new guidance is effective for fiscal years beginning after December 15, 2018. Early adoption is permitted. We plan to adopt this new guidance by the required date and do not anticipate that this update will have a material impact on our consolidated financial statements.
In July 2017, the FASB issued ASU 2017-11, "Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815): (Part I) Accounting for Certain Financial Instruments with Down Round Features, (Part II) Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception." This new guidance changes the classification analysis of certain equity-linked financial instruments (or embedded conversion options) with down round features. This new guidance is effective for fiscal years beginning after December 15, 2018. Early adoption is permitted. We plan to adopt this new guidance by the required date and do not anticipate that this update will have a material impact on our consolidated financial statements.
In March 2017, the FASB issued ASU 2017-08, "Receivables - Nonrefundable Fees and Other Costs (Subtopic 310-20)." This new guidance shortens the amortization period for certain callable debt securities purchased at a premium by requiring the premium to be amortized to the earliest call date. This new guidance is effective for fiscal years beginning after December 15, 2018. Early adoption is permitted. We plan to adopt this new guidance by the required date and do not anticipate that this update will have a material impact on our consolidated financial statements.

9


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2018
(Unaudited)

Note 3. Summary of Significant Accounting Policies - (continued)

In June 2016, the FASB issued ASU 2016-13, "Financial Instruments - Credit Losses." This new guidance provides a new impairment model that is based on expected losses rather than incurred losses to determine the allowance for credit losses. This new guidance is effective for fiscal years beginning after December 15, 2019. Early adoption is permitted for fiscal years beginning December 15, 2018. We currently have only a small balance of loans receivable that are not carried at fair value and would be subject to this new guidance for allowance for credit losses. Separately, we account for our available-for-sale securities under the other-than-temporary impairment ("OTTI") model for debt securities. This new guidance requires that credit impairments on our available-for-sale securities be recorded in earnings using an allowance for credit losses, with the allowance limited to the amount by which the security's fair value is less than its amortized cost basis. Subsequent reversals in credit loss estimates are recognized in income. We plan to adopt this new guidance by the required date and continue to evaluate the impact that this update will have on our consolidated financial statements.
In February 2016, the FASB issued ASU 2016-02, "Leases." This new guidance requires lessees to recognize most leases on their balance sheet as a right-of-use asset and a lease liability. This new guidance retains a dual lease accounting model, which requires leases to be classified as either operating or capital leases for lessees, for purposes of income statement recognition. This new guidance is effective for fiscal years beginning after December 15, 2018. Early adoption is permitted. In July 2018, the FASB issued ASU 2018-10, "Codification Improvements to Topic 842, Leases," which provides more specific guidance on certain aspects of Topic 842. Additionally, in July 2018, the FASB issued ASU 2018-11, "Leases (Topic 842): Targeted Improvements." This new ASU introduces an additional transition method which allows entities to apply the new standard at the adoption date and recognize a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. As discussed in Note 13, our only material leases are those related to our leased office space, for which future payments under these leases totaled $17 million at June 30, 2018. Upon adoption of this standard in the first quarter of 2019, we will record a right-of-use asset and lease liability equal to the present value of these future lease payments discounted at our incremental borrowing rate. Based on our initial evaluation of this new guidance, and taking into consideration our current in-place leases, we do not expect that its adoption will have a material impact on our consolidated financial statements. We will continue evaluating this new standard and caution that any changes in our business or additional leases we may enter into could change our initial assessment.


10


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2018
(Unaudited)

Note 3. Summary of Significant Accounting Policies - (continued)

Balance Sheet Netting
Certain of our derivatives and short-term debt are subject to master netting arrangements or similar agreements. Under GAAP, in certain circumstances we may elect to present certain financial assets, liabilities and related collateral subject to master netting arrangements in a net position on our consolidated balance sheets. However, we do not report any of these financial assets or liabilities on a net basis, and instead present them on a gross basis on our consolidated balance sheets.
The table below presents financial assets and liabilities that are subject to master netting arrangements or similar agreements categorized by financial instrument, together with corresponding financial instruments and corresponding collateral received or pledged at June 30, 2018 and December 31, 2017.
Table 3.1 – Offsetting of Financial Assets, Liabilities, and Collateral
 
 
Gross Amounts of Recognized Assets (Liabilities)
 
Gross Amounts Offset in Consolidated Balance Sheet
 
Net Amounts of Assets (Liabilities) Presented in Consolidated Balance Sheet
 
Gross Amounts Not Offset in Consolidated
Balance Sheet
(1)
 
Net Amount
June 30, 2018
(In Thousands)
 
 
 
 
Financial Instruments
 
Cash Collateral (Received) Pledged
 
Assets (2)
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate agreements
 
$
59,468

 
$

 
$
59,468

 
$
(12,372
)
 
$
(6,803
)
 
$
40,293

TBAs
 
3,186

 

 
3,186

 
(2,568
)
 
(481
)
 
137

Total Assets
 
$
62,654

 
$

 
$
62,654

 
$
(14,940
)
 
$
(7,284
)
 
$
40,430

 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities (2)
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate agreements
 
$
(44,730
)
 
$

 
$
(44,730
)
 
$
12,372

 
$
32,358

 
$

TBAs
 
(6,372
)
 

 
(6,372
)
 
2,568

 
3,804

 

Futures
 
(126
)
 

 
(126
)
 

 
126

 

Loan warehouse debt
 
(719,394
)
 

 
(719,394
)
 
719,394

 

 

Security repurchase agreements
 
(706,894
)
 

 
(706,894
)
 
706,894

 

 

Total Liabilities
 
$
(1,477,516
)
 
$

 
$
(1,477,516
)
 
$
1,441,228

 
$
36,288

 
$


11


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2018
(Unaudited)

Note 3. Summary of Significant Accounting Policies - (continued)

 
 
Gross Amounts of Recognized Assets (Liabilities)
 
Gross Amounts Offset in Consolidated Balance Sheet
 
Net Amounts of Assets (Liabilities) Presented in Consolidated Balance Sheet
 
Gross Amounts Not Offset in Consolidated
Balance Sheet
(1)
 
Net Amount
December 31, 2017
(In Thousands)
 
 
 
 
Financial Instruments
 
Cash Collateral (Received) Pledged
 
Assets (2)
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate agreements
 
$
10,164

 
$

 
$
10,164

 
$
(6,196
)
 
$
(42
)
 
$
3,926

TBAs
 
133

 

 
133

 
(133
)
 

 

Futures
 
1

 

 
1

 

 

 
1

Total Assets
 
$
10,298

 
$

 
$
10,298

 
$
(6,329
)
 
$
(42
)
 
$
3,927

 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities (2)
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate agreements
 
$
(55,567
)
 
$

 
$
(55,567
)
 
$
6,196

 
$
49,371

 
$

TBAs
 
(3,808
)
 

 
(3,808
)
 
133

 
1,376

 
(2,299
)
Loan warehouse debt
 
(1,039,666
)
 

 
(1,039,666
)
 
1,039,666

 

 

Security repurchase agreements
 
(648,746
)
 

 
(648,746
)
 
648,746

 

 

Total Liabilities
 
$
(1,747,787
)
 
$

 
$
(1,747,787
)
 
$
1,694,741

 
$
50,747

 
$
(2,299
)
(1)
Amounts presented in these columns are limited in total to the net amount of assets or liabilities presented in the prior column by instrument. In certain cases, there is excess cash collateral or financial assets we have pledged to a counterparty (which may, in certain circumstances, be a clearinghouse) that exceed the financial liabilities subject to a master netting arrangement or similar agreement. Additionally, in certain cases, counterparties may have pledged excess cash collateral to us that exceeds our corresponding financial assets. In each case, any of these excess amounts are excluded from the table although they are separately reported in our consolidated balance sheets as assets or liabilities, respectively.
(2)
Interest rate agreements, TBAs, and futures are components of derivatives instruments on our consolidated balance sheets. Loan warehouse debt, which is secured by residential mortgage loans, and security repurchase agreements are components of Short-term debt on our consolidated balance sheets.
For each category of financial instrument set forth in the table above, the assets and liabilities resulting from individual transactions within that category between us and a counterparty are subject to a master netting arrangement or similar agreement with that counterparty that provides for individual transactions to be aggregated and treated as a single transaction. For certain categories of these instruments, some of our transactions are cleared and settled through one or more clearinghouses that are substituted as our counterparty. References herein to master netting arrangements or similar agreements include the arrangements and agreements governing the clearing and settlement of these transactions through the clearinghouses. In the event of the termination and close-out of any of those transactions, the corresponding master netting agreement or similar agreement provides for settlement on a net basis. Any such settlement would include the proceeds of the liquidation of any corresponding collateral, subject to certain limitations on termination, settlement, and liquidation of collateral that may apply in the event of the bankruptcy or insolvency of a party. Such limitations should not inhibit the eventual practical realization of the principal benefits of those transactions or the corresponding master netting arrangement or similar agreement and any corresponding collateral.






12


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2018
(Unaudited)



Note 4. Principles of Consolidation
GAAP requires us to consider whether securitizations we sponsor and other transfers of financial assets should be treated as sales or financings, as well as whether any VIEs that we hold variable interests in – for example, certain legal entities often used in securitization and other structured finance transactions – should be included in our consolidated financial statements. The GAAP principles we apply require us to reassess our requirement to consolidate VIEs each quarter and therefore our determination may change based upon new facts and circumstances pertaining to each VIE. This could result in a material impact to our consolidated financial statements during subsequent reporting periods.
Analysis of Consolidated VIEs
At June 30, 2018, we consolidated certain of our Legacy Sequoia and Sequoia Choice securitization entities that we determined were VIEs and for which we determined we were the primary beneficiary. Each of these entities is independent of Redwood and of each other and the assets and liabilities of these entities are not owned by and are not legal obligations of ours. Our exposure to these entities is primarily through the financial interests we have retained, although we are exposed to certain financial risks associated with our role as a sponsor, servicing administrator, or depositor of these entities or as a result of our having sold assets directly or indirectly to these entities. At June 30, 2018, the estimated fair value of our investments in the consolidated Legacy Sequoia and Sequoia Choice entities was $13 million and $135 million, respectively. The following table presents a summary of the assets and liabilities of these VIEs.
Table 4.1 – Assets and Liabilities of Consolidated VIEs
June 30, 2018
 
Legacy
Sequoia
 
Sequoia
Choice
 
Total
Consolidated
VIEs
(Dollars in Thousands)
 
 
 
Residential loans, held-for-investment
 
$
592,029

 
$
1,481,145

 
$
2,073,174

Restricted cash
 
147

 
10

 
157

Accrued interest receivable
 
835

 
5,956

 
6,791

REO
 
2,649

 

 
2,649

Total Assets
 
$
595,660

 
$
1,487,111

 
$
2,082,771

Accrued interest payable
 
$
589

 
$
5,038

 
$
5,627

Accrued expenses and other liabilities
 

 
10

 
10

Asset-backed securities issued
 
582,235

 
1,347,427

 
1,929,662

Total Liabilities
 
$
582,824

 
$
1,352,475

 
$
1,935,299

 
 
 
 
 
 
 
Number of VIEs
 
20

 
4

 
24


13


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2018
(Unaudited)

Note 4. Principles of Consolidation - (continued)


December 31, 2017
 
Legacy
Sequoia
 
Sequoia
Choice
 
Total
Consolidated
VIEs
(Dollars in Thousands)
 
 
 
Residential loans, held-for-investment
 
$
632,817

 
$
620,062

 
$
1,252,879

Restricted cash
 
147

 
4

 
151

Accrued interest receivable
 
867

 
2,524

 
3,391

REO
 
3,353

 

 
3,353

Total Assets
 
$
637,184

 
$
622,590

 
$
1,259,774

Accrued interest payable
 
$
537

 
$
2,031

 
$
2,568

Accrued expenses and other liabilities
 

 
4

 
4

Asset-backed securities issued
 
622,445

 
542,140

 
1,164,585

Total Liabilities
 
$
622,982

 
$
544,175

 
$
1,167,157

 
 
 
 
 
 
 
Number of VIEs
 
20

 
2

 
22

We consolidate the assets and liabilities of certain Sequoia securitization entities, as we did not meet the GAAP sale criteria at the time we transferred financial assets to these entities. Our involvement in consolidated Sequoia entities continues in the following ways: (i) we continue to hold subordinate investments in each entity, and for certain entities, more senior investments; (ii) we maintain certain discretionary rights associated with our sponsorship of, or our subordinate investments in, each entity; and (iii) we continue to hold a right to call the assets of certain entities (once they have been paid down below a specified threshold) at a price equal to, or in excess of, the current outstanding principal amount of the entity’s asset-backed securities issued. These factors have resulted in our continuing to consolidate the assets and liabilities of these Sequoia entities in accordance with GAAP.
Analysis of Unconsolidated VIEs with Continuing Involvement
Since 2012, we have transferred residential loans to 42 Sequoia securitization entities sponsored by us and accounted for these transfers as sales for financial reporting purposes, in accordance with ASC 860. We also determined we were not the primary beneficiary of these VIEs as we lacked the power to direct the activities that will have the most significant economic impact on the entities. For certain of these transfers to securitization entities, for the transferred loans where we held the servicing rights prior to the transfer and continued to hold the servicing rights following the transfer, we recorded MSRs on our consolidated balance sheets, and classified those MSRs as Level 3 assets. We also retained senior and subordinate securities in these securitizations that we classified as Level 3 assets. Our continuing involvement in these securitizations is limited to customary servicing obligations associated with retaining servicing rights (which we retain a third-party sub-servicer to perform) and the receipt of interest income associated with the securities we retained.
The following table presents information related to securitization transactions that occurred during the three and six months ended June 30, 2018 and 2017.
Table 4.2 – Securitization Activity Related to Unconsolidated VIEs Sponsored by Redwood
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2018
 
2017
 
2018
 
2017
Principal balance of loans transferred
 
$
1,127,665

 
$
348,599

 
$
2,408,133

 
$
1,384,123

Trading securities retained, at fair value
 
33,757

 
10,287

 
46,248

 
30,990

AFS securities retained, at fair value
 
2,047

 
1,905

 
5,952

 
7,060

MSRs recognized
 

 

 

 
7,123


14


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2018
(Unaudited)

Note 4. Principles of Consolidation - (continued)


The following table summarizes the cash flows during the three and six months ended June 30, 2018 and 2017 between us and the unconsolidated VIEs sponsored by us and accounted for as sales since 2012.
Table 4.3 – Cash Flows Related to Unconsolidated VIEs Sponsored by Redwood
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2018
 
2017
 
2018
 
2017
Proceeds from new transfers
 
$
1,104,094

 
$
351,485

 
$
2,393,781

 
$
1,373,509

MSR fees received
 
3,397

 
3,698

 
6,811

 
7,173

Funding of compensating interest, net
 
(31
)
 
(41
)
 
(56
)
 
(79
)
Cash flows received on retained securities
 
7,410

 
6,588

 
14,453

 
12,961

The following table presents the key weighted-average assumptions used to measure MSRs and securities retained at the date of securitization for securitizations completed during the three and six months ended June 30, 2018 and 2017.
Table 4.4 – Assumptions Related to Assets Retained from Unconsolidated VIEs Sponsored by Redwood

 
 
Three Months Ended June 30, 2018
 
Three Months Ended June 30, 2017
At Date of Securitization
 
MSRs
 
Senior IO Securities
 
Subordinate Securities
 
MSRs
 
Senior IO Securities
 
Subordinate Securities
Prepayment rates
 
N/A
 
10
%
 
10
%
 
N/A
 
10
%
 
10
%
Discount rates
 
N/A
 
14
%
 
5
%
 
N/A
 
14
%
 
5
%
Credit loss assumptions
 
N/A
 
0.20
%
 
0.20
%
 
N/A
 
0.25
%
 
0.25
%
 
 
Six Months Ended June 30, 2018
 
Six Months Ended June 30, 2017
At Date of Securitization
 
MSRs
 
Senior IO Securities
 
Subordinate Securities
 
MSRs
 
Senior IO Securities
 
Subordinate Securities
Prepayment rates
 
N/A
 
9
%
 
10
%
 
9
%
 
10
%
 
10
%
Discount rates
 
N/A
 
14
%
 
5
%
 
11
%
 
12
%
 
5
%
Credit loss assumptions
 
N/A
 
0.20
%
 
0.20
%
 
N/A

 
0.25
%
 
0.25
%

15


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2018
(Unaudited)

Note 4. Principles of Consolidation - (continued)


The following table presents additional information at June 30, 2018 and December 31, 2017, related to unconsolidated VIEs sponsored by Redwood and accounted for as sales since 2012.
Table 4.5 – Unconsolidated VIEs Sponsored by Redwood
(In Thousands)
 
June 30, 2018
 
December 31, 2017
On-balance sheet assets, at fair value:
 
 
 
 
Interest-only, senior and subordinate securities, classified as trading
 
$
127,861

 
$
101,426

Subordinate securities, classified as AFS
 
164,498

 
219,255

Mortgage servicing rights
 
63,176

 
60,980

Maximum loss exposure (1)
 
$
355,535

 
$
381,661

Assets transferred:
 
 
 
 
Principal balance of loans outstanding
 
$
10,277,901

 
$
8,364,148

Principal balance of loans 30+ days delinquent
 
30,571

 
27,926

(1)
Maximum loss exposure from our involvement with unconsolidated VIEs pertains to the carrying value of our securities and MSRs retained from these VIEs and represents estimated losses that would be incurred under severe, hypothetical circumstances, such as if the value of our interests and any associated collateral declines to zero. This does not include, for example, any potential exposure to representation and warranty claims associated with our initial transfer of loans into a securitization.
The following table presents key economic assumptions for assets retained from unconsolidated VIEs and the sensitivity of their fair values to immediate adverse changes in those assumptions at June 30, 2018 and December 31, 2017.
Table 4.6 – Key Assumptions and Sensitivity Analysis for Assets Retained from Unconsolidated VIEs Sponsored by Redwood
June 30, 2018
 
MSRs
 
Senior
Securities (1)
 
Subordinate Securities
(Dollars in Thousands)
 
 
 
Fair value at June 30, 2018
 
$
63,176

 
$
59,628

 
$
232,731

Expected life (in years) (2)
 
9

 
7

 
15

Prepayment speed assumption (annual CPR) (2)
 
7
%
 
10
%
 
10
%
Decrease in fair value from:
 
 
 
 
 
 
10% adverse change
 
$
1,742

 
$
2,142

 
$
603

25% adverse change
 
4,221

 
5,100

 
1,487

Discount rate assumption (2)
 
11
%
 
11
%
 
6
%
Decrease in fair value from:
 
 
 
 
 
 
100 basis point increase
 
$
2,571

 
$
2,204

 
$
22,194

200 basis point increase
 
4,972

 
4,249

 
41,045

Credit loss assumption (2)
 
N/A

 
0.20
%
 
0.20
%
Decrease in fair value from:
 
 
 
 
 
 
10% higher losses
 
N/A

 
$

 
$
1,384

25% higher losses
 
N/A

 

 
3,444


16


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2018
(Unaudited)

Note 4. Principles of Consolidation - (continued)


December 31, 2017
 
MSRs
 
Senior
Securities (1)
 
Subordinate Securities
(Dollars in Thousands)
 
 
 
Fair value at December 31, 2017
 
$
60,980

 
$
33,773

 
$
286,908

Expected life (in years) (2)
 
8

 
6

 
13

Prepayment speed assumption (annual CPR) (2)
 
9
%
 
10
%
 
11
%
Decrease in fair value from:
 
 
 
 
 
 
10% adverse change
 
$
2,022

 
$
1,371

 
$
611

25% adverse change
 
4,839

 
3,289

 
1,506

Discount rate assumption (2)
 
11
%
 
11
%
 
5
%
Decrease in fair value from:
 
 
 
 
 
 
100 basis point increase
 
$
2,386

 
$
1,158

 
$
25,827

200 basis point increase
 
4,597

 
2,265

 
47,885

Credit loss assumption (2)
 
N/A

 
0.25
%
 
0.25
%
Decrease in fair value from:
 
 
 
 
 
 
10% higher losses
 
N/A

 
$

 
$
1,551

25% higher losses
 
N/A

 

 
3,873


(1)
Senior securities included $60 million and $34 million of interest-only securities at June 30, 2018 and December 31, 2017, respectively.
(2)
Expected life, prepayment speed assumption, discount rate assumption, and credit loss assumption presented in the tables above represent weighted averages.
Analysis of Third-Party VIEs
Third-party VIEs are securitization entities in which we maintain an economic interest, but do not sponsor. Our economic interest may include several securities from the same third-party VIE, and in those cases, the analysis is performed in consideration of all of our interests. The following table presents a summary of our interests in third-party VIEs at June 30, 2018, grouped by security type.
Table 4.7 – Third-Party Sponsored VIE Summary
(Dollars in Thousands)
 
June 30, 2018
 
December 31, 2017
Mortgage-Backed Securities
 
 
 
 
Senior
 
$
226,191

 
$
177,191

Mezzanine
 
536,700

 
38,875

Subordinate
 
398,686

 
939,763

Total Investments in Third-Party Sponsored VIEs
 
$
1,161,577

 
$
1,155,829

We determined that we are not the primary beneficiary of any third-party VIEs, as we do not have the required power to direct the activities that most significantly impact the economic performance of these entities. Specifically, we do not service or manage these entities or otherwise solely hold decision making powers that are significant. As a result of this assessment, we do not consolidate any of the underlying assets and liabilities of these third-party VIEs – we only account for our specific interests in them.
Our assessments of whether we are required to consolidate a VIE may change in subsequent reporting periods based upon changing facts and circumstances pertaining to each VIE. Any related accounting changes could result in a material impact to our financial statements.

17


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2018
(Unaudited)



Note 5. Fair Value of Financial Instruments
For financial reporting purposes, we follow a fair value hierarchy established under GAAP that is used to determine the fair value of financial instruments. This hierarchy prioritizes relevant market inputs in order to determine an “exit price” at the measurement date, or the price at which an asset could be sold or a liability could be transferred in an orderly process that is not a forced liquidation or distressed sale. Level 1 inputs are observable inputs that reflect quoted prices for identical assets or liabilities in active markets. Level 2 inputs are observable inputs other than quoted prices for an asset or liability that are obtained through corroboration with observable market data. Level 3 inputs are unobservable inputs (e.g., our own data or assumptions) that are used when there is little, if any, relevant market activity for the asset or liability required to be measured at fair value.
In certain cases, inputs used to measure fair value fall into different levels of the fair value hierarchy. In such cases, the level at which the fair value measurement falls is determined based on the lowest level input that is significant to the fair value measurement. Our assessment of the significance of a particular input requires judgment and considers factors specific to the asset or liability being measured.


18


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2018
(Unaudited)

Note 5. Fair Value of Financial Instruments - (continued)


The following table presents the carrying values and estimated fair values of assets and liabilities that are required to be recorded or disclosed at fair value at June 30, 2018 and December 31, 2017.

Table 5.1 – Carrying Values and Fair Values of Assets and Liabilities
 
 
June 30, 2018
 
December 31, 2017
 
 
Carrying
Value
 
Fair
Value
 
Carrying
Value
 
Fair
Value
(In Thousands)
 
 
 
 
Assets
 
 
 
 
 
 
 
 
Residential loans, held-for-sale
 
 
 
 
 
 
 
 
At fair value
 
$
1,104,545

 
$
1,104,545

 
$
1,427,052

 
$
1,427,052

At lower of cost or fair value
 
115

 
135

 
893

 
993

Residential loans, held-for-investment
 
 
 
 
 
 
 
 
At fair value
 
4,386,510

 
4,386,510

 
3,687,265

 
3,687,265

Trading securities
 
1,054,295

 
1,054,295

 
968,844

 
968,844

Available-for-sale securities
 
399,641

 
399,641

 
507,666

 
507,666

Cash and cash equivalents
 
184,779

 
184,779

 
144,663

 
144,663

Restricted cash
 
15,285

 
15,285

 
2,144

 
2,144

Accrued interest receivable
 
29,066

 
29,066

 
27,013

 
27,013

Derivative assets
 
65,645

 
65,645

 
15,718

 
15,718

MSRs (1)
 
64,674

 
64,674

 
63,598

 
63,598

REO (1)
 
2,649

 
3,534

 
3,354

 
3,806

Margin receivable (1)
 
49,538

 
49,538

 
85,044

 
85,044

FHLBC stock (1)
 
43,393

 
43,393

 
43,393

 
43,393

Guarantee asset (1)
 
2,936

 
2,936

 
2,869

 
2,869

Pledged collateral (1)
 
42,201

 
42,201

 
42,615

 
42,615

Participation in loan warehouse facility (1)
 
41,658

 
41,658

 

 

Liabilities
 
 
 
 
 
 
 
 
Short-term debt facilities
 
$
1,426,288

 
$
1,426,288

 
$
1,688,412

 
$
1,688,412

Accrued interest payable
 
21,925

 
21,925

 
18,435

 
18,435

Margin payable (2)
 
7,282

 
7,282

 
390

 
390

Guarantee obligation (2)
 
18,124

 
17,903

 
19,487

 
18,878

Derivative liabilities
 
55,929

 
55,929

 
63,081

 
63,081

ABS issued at fair value, net
 
1,929,662

 
1,929,662

 
1,164,585

 
1,164,585

FHLBC long-term borrowings
 
1,999,999

 
1,999,999

 
1,999,999

 
1,999,999

Convertible notes, net
 
631,663

 
639,204

 
686,759

 
692,369

Trust preferred securities and subordinated notes, net
 
138,559

 
107,415

 
138,535

 
103,230

(1)
These assets are included in Other assets on our consolidated balance sheets.
(2)
These liabilities are included in Accrued expenses and other liabilities on our consolidated balance sheets.
During the three and six months ended June 30, 2018, we elected the fair value option for $60 million and $72 million of residential senior securities, $161 million and $289 million of subordinate securities, and $1.93 billion and $3.73 billion of residential loans (principal balance), respectively. We anticipate electing the fair value option for all future purchases of residential loans that we intend to sell to third parties or transfer to securitizations, as well as for MSRs retained from sales of residential loans, and for certain securities we purchase, including IO securities and fixed-rate securities rated investment grade or higher.

19


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2018
(Unaudited)

Note 5. Fair Value of Financial Instruments - (continued)


The following table presents the assets and liabilities that are reported at fair value on our consolidated balance sheets on a recurring basis at June 30, 2018 and December 31, 2017, as well as the fair value hierarchy of the valuation inputs used to measure fair value.
Table 5.2 – Assets and Liabilities Measured at Fair Value on a Recurring Basis
June 30, 2018
 
Carrying
Value
 
Fair Value Measurements Using
(In Thousands)
 
 
Level 1
 
Level 2
 
Level 3
Assets
 
 
 
 
 
 
 
 
Residential loans
 
$
5,491,055

 
$

 
$

 
$
5,491,055

Trading securities
 
1,054,295

 

 

 
1,054,295

Available-for-sale securities
 
399,641

 

 

 
399,641

Derivative assets
 
65,645

 
3,186

 
59,468

 
2,991

MSRs
 
64,674

 

 

 
64,674

Pledged collateral
 
42,201

 
42,201

 

 

FHLBC stock
 
43,393

 

 
43,393

 

Guarantee asset
 
2,936

 

 

 
2,936

 
 
 
 
 
 
 
 
 
Liabilities
 


 
 
 
 
 
 
Derivative liabilities
 
$
55,929

 
$
6,498

 
$
44,730

 
$
4,701

ABS issued
 
1,929,662

 

 

 
1,929,662


December 31, 2017
 
Carrying
Value
 
Fair Value Measurements Using
(In Thousands)
 
 
Level 1
 
Level 2
 
Level 3
Assets
 
 
 
 
 
 
 
 
Residential loans
 
$
5,114,317

 
$

 
$

 
$
5,114,317

Trading securities
 
968,844

 

 

 
968,844

Available-for-sale securities
 
507,666

 

 

 
507,666

Derivative assets
 
15,718

 
134

 
10,164

 
5,420

MSRs
 
63,598

 

 

 
63,598

Pledged collateral
 
42,615

 
42,615

 

 

FHLBC stock
 
43,393

 

 
43,393

 

Guarantee asset
 
2,869

 

 

 
2,869

 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
Derivative liabilities
 
$
63,081

 
$
3,808

 
$
55,567

 
$
3,706

ABS issued
 
1,164,585

 

 

 
1,164,585


20


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2018
(Unaudited)

Note 5. Fair Value of Financial Instruments - (continued)


The following table presents additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the six months ended June 30, 2018.
Table 5.3 – Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis
 
 
Assets
 
 
 
Liabilities
 
 
Residential Loans
 
Trading Securities
 
AFS
Securities
 
MSRs
 
Guarantee Asset
 
Derivatives(1)
 
ABS
Issued
(In Thousands)
 
 
 
 
 
 
 
Beginning balance -
   December 31, 2017
 
$
5,114,317

 
$
968,844

 
$
507,666

 
$
63,598

 
$
2,869

 
$
1,714

 
$
1,164,585