Toggle SGML Header (+)


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: September 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 every Interactive Data File required to be submitted 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 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
 
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
 
82,965,298 shares outstanding as of November 5, 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)
 
September 30, 2018
 
December 31, 2017
ASSETS (1)
 
 
 
 
Residential loans, held-for-sale, at fair value
 
$
866,444

 
$
1,427,945

Residential loans, held-for-investment, at fair value
 
5,055,815

 
3,687,265

Business purpose loans, at fair value
 
115,620

 

Multifamily loans, held-for-investment, at fair value
 
942,165

 

Real estate securities, at fair value
 
1,470,084

 
1,476,510

Cash and cash equivalents
 
173,516

 
144,663

Restricted cash
 
27,253

 
2,144

Accrued interest receivable
 
35,644

 
27,013

Derivative assets
 
87,219

 
15,718

Other assets
 
365,875

 
258,564

Total Assets
 
$
9,139,635

 
$
7,039,822

 
 
 
 
 
LIABILITIES AND EQUITY (1)
 
 
 
 
Liabilities
 
 
 
 
Short-term debt (2)
 
$
1,424,275

 
$
1,938,682

Accrued interest payable
 
31,076

 
18,435

Derivative liabilities
 
42,724

 
63,081

Accrued expenses and other liabilities
 
102,278

 
67,729

Asset-backed securities issued, at fair value
 
3,406,985

 
1,164,585

Long-term debt, net
 
2,770,970

 
2,575,023

Total liabilities
 
7,778,308

 
5,827,535

Equity
 
 
 
 
Common stock, par value $0.01 per share, 180,000,000 shares authorized; 82,930,281 and 76,599,972 issued and outstanding
 
829

 
766

Additional paid-in capital
 
1,785,957

 
1,673,845

Accumulated other comprehensive income
 
72,327

 
85,248

Cumulative earnings
 
1,410,854

 
1,290,341

Cumulative distributions to stockholders
 
(1,908,640
)
 
(1,837,913
)
Total equity
 
1,361,327

 
1,212,287

Total Liabilities and Equity
 
$
9,139,635

 
$
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 September 30, 2018 and December 31, 2017, assets of consolidated VIEs totaled $3,693,140 and $1,259,774, respectively. At September 30, 2018 and December 31, 2017, liabilities of consolidated VIEs totaled $3,417,835 and $1,167,157, respectively. See Note 4 for further discussion.
(2)
At December 31, 2017, balance includes $250 million of convertible notes, which matured in April 2018. See Note 12 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 September 30,
 
Nine Months Ended September 30,
(Unaudited)
 
2018
 
2017
 
2018
 
2017
Interest Income
 
 
 
 
 
 
 
 
Residential loans
 
$
63,265

 
$
38,541

 
$
169,010

 
$
109,538

Business purpose loans
 
1,445

 

 
1,445

 

Multifamily loans
 
5,578

 

 
5,578

 

Real estate securities
 
27,063

 
23,425

 
79,054

 
65,068

Other interest income
 
2,046

 
771

 
3,905

 
1,983

Total interest income
 
99,397

 
62,737

 
258,992

 
176,589

Interest Expense
 
 
 
 
 
 
 
 
Short-term debt
 
(14,146
)
 
(10,182
)
 
(40,756
)
 
(23,985
)
Asset-backed securities issued
 
(27,421
)
 
(3,956
)
 
(55,171
)
 
(11,191
)
Long-term debt
 
(22,784
)
 
(13,305
)
 
(58,151
)
 
(37,532
)
Total interest expense
 
(64,351
)
 
(27,443
)
 
(154,078
)
 
(72,708
)
Net Interest Income
 
35,046

 
35,294

 
104,914

 
103,881

Non-interest Income
 
 
 
 
 
 
 
 
Mortgage banking activities, net
 
11,224

 
21,200

 
48,396

 
50,850

Investment fair value changes, net
 
10,332

 
324

 
12,830

 
9,990

Other income, net
 
3,453

 
2,812

 
8,893

 
9,473

Realized gains, net
 
7,275

 
1,734

 
21,352

 
8,809

Total non-interest income, net
 
32,284

 
26,070

 
91,471

 
79,122

Operating expenses
 
(21,490
)
 
(19,922
)
 
(63,529
)
 
(56,789
)
Net Income before Provision for Income Taxes
 
45,840

 
41,442

 
132,856

 
126,214

Provision for income taxes
 
(4,919
)
 
(5,262
)
 
(12,343
)
 
(16,741
)
Net Income
 
$
40,921

 
$
36,180

 
$
120,513

 
$
109,473

 
 
 
 
 
 
 
 
 
Basic earnings per common share
 
$
0.49

 
$
0.46

 
$
1.51

 
$
1.39

Diluted earnings per common share
 
$
0.42

 
$
0.41

 
$
1.30

 
$
1.26

Regular dividends declared per common share
 
$
0.30

 
$
0.28

 
$
0.88

 
$
0.84

Basic weighted average shares outstanding
 
80,796,856

 
76,850,830

 
77,211,188

 
76,803,324

Diluted weighted average shares outstanding
 
114,682,688

 
102,703,108

 
107,792,029

 
99,397,866


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 September 30,
 
Nine Months Ended September 30,
(Unaudited)
 
2018
 
2017
 
2018
 
2017
Net Income
 
$
40,921

 
$
36,180

 
$
120,513

 
$
109,473

Other comprehensive (loss) income:
 
 
 
 
 
 
 
 
Net unrealized (loss) gain on available-for-sale securities
 
(2,408
)
 
13,158

 
(9,749
)
 
17,899

Reclassification of unrealized gain on available-for-sale securities to net income
 
(5,686
)
 
(853
)
 
(19,821
)
 
(7,103
)
Net unrealized gain (loss) on interest rate agreements
 
4,801

 
321

 
16,649

 
(375
)
Reclassification of unrealized loss on interest rate agreements to net income
 

 
14

 

 
42

Total other comprehensive (loss) income
 
(3,293
)
 
12,640

 
(12,921
)
 
10,463

Total Comprehensive Income
 
$
37,628

 
$
48,820

 
$
107,592

 
$
119,936



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 Nine Months Ended September 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
 

 

 

 

 
120,513

 

 
120,513

Other comprehensive loss
 

 

 

 
(12,921
)
 

 

 
(12,921
)
Issuance of common stock
 
7,187,500

 
72

 
116,964

 

 

 

 
117,036

Employee stock purchase and incentive plans
 
183,638

 
1

 
(101
)
 

 

 

 
(100
)
Non-cash equity award compensation
 

 

 
10,783

 

 

 

 
10,783

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

 

 

 
(15,544
)
Common dividends declared
 

 

 

 

 

 
(70,727
)
 
(70,727
)
September 30, 2018
 
82,930,281

 
$
829

 
$
1,785,957

 
$
72,327

 
$
1,410,854

 
$
(1,908,640
)
 
$
1,361,327


For the Nine Months Ended September 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
 

 

 

 

 
109,473

 

 
109,473

Other comprehensive income
 

 

 

 
10,463

 

 

 
10,463

Employee stock purchase and incentive plans
 
288,024

 
3

 
(2,315
)
 

 

 

 
(2,312
)
Non-cash equity award compensation
 

 

 
7,797

 

 

 

 
7,797

Common dividends declared
 

 

 

 

 

 
(66,209
)
 
(66,209
)
September 30, 2017
 
77,122,687

 
$
771

 
$
1,681,968

 
$
82,316

 
$
1,259,408

 
$
(1,815,823
)
 
$
1,208,640



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)
 
Nine Months Ended September 30,
 
2018
 
2017
Cash Flows From Operating Activities:
 
 
 
 
Net income
 
$
120,513

 
$
109,473

Adjustments to reconcile net income to net cash used in operating activities:
 
 
 
 
Amortization of premiums, discounts, and securities issuance costs, net
 
(11,091
)
 
(14,246
)
Depreciation and amortization of non-financial assets
 
922

 
909

Purchases of held-for-sale loans
 
(5,596,326
)
 
(3,760,110
)
Proceeds from sales of held-for-sale loans
 
4,097,211

 
3,079,877

Principal payments on held-for-sale loans
 
51,853

 
38,500

Net settlements of derivatives
 
36,721

 
(10,570
)
Non-cash equity award compensation expense
 
10,783

 
7,797

Market valuation adjustments
 
(53,666
)
 
(50,352
)
Realized gains, net
 
(21,352
)
 
(8,809
)
Net change in:
 
 
 
 
Accrued interest receivable and other assets
 
(32,722
)
 
(19,868
)
Accrued interest payable and accrued expenses and other liabilities
 
34,137

 
(1,677
)
Net cash used in operating activities
 
(1,363,017
)
 
(629,076
)
Cash Flows From Investing Activities:
 
 
 
 
Purchases of loans held-for-investment
 
(111,231
)
 

Principal payments on loans held-for-investment
 
550,973

 
370,595

Purchases of real estate securities
 
(482,150
)
 
(396,721
)
Purchases of multifamily securities held in consolidated securitization trusts
 
(54,957
)
 

Proceeds from sales of real estate securities
 
432,199

 
142,931

Principal payments on real estate securities
 
61,278

 
55,544

Sales (purchases) of mortgage servicing rights, net
 
6,344

 
50,705

Net investment in participation in loan warehouse facility
 
(37,814
)
 

Other investing activities, net
 
(10,075
)
 

Net cash provided by investing activities
 
354,567

 
223,054

Cash Flows From Financing Activities:
 
 
 
 
Proceeds from borrowings on short-term debt
 
4,760,083

 
3,126,949

Repayments on short-term debt
 
(5,274,664
)
 
(2,968,050
)
Proceeds from issuance of asset-backed securities
 
1,658,848

 
286,898

Repayments on asset-backed securities issued
 
(305,528
)
 
(146,357
)
Proceeds from issuance of long-term debt
 
199,000

 
245,000

Deferred long-term debt issuance costs paid
 
(4,977
)
 
(7,380
)
Net settlements of derivatives
 
(244
)
 
(115
)
Net proceeds from issuance of common stock
 
117,311

 
224

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

Taxes paid on equity award distributions
 
(375
)
 
(2,536
)
Dividends paid
 
(70,727
)
 
(66,209
)
Net cash provided by financing activities
 
1,062,412

 
468,424

Net increase in cash, cash equivalents and restricted cash
 
53,962

 
62,402

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)
 
$
200,769

 
$
283,869

Supplemental Cash Flow Information:
 
 
 
 
Cash paid during the period for:
 
 
 
 
 Interest
 
$
139,003

 
$
67,339

 Taxes
 
6,372

 
1,476

Supplemental Noncash Information:
 
 
 
 
Real estate securities retained from loan securitizations
 
$
46,872

 
$
67,083

Retention of mortgage servicing rights from loan securitizations and sales
 

 
7,387

Consolidation of multifamily loans held in securitization trusts
 
946,650

 

Consolidation of multifamily ABS
 
880,602

 

Transfers from loans held-for-sale to loans held-for-investment
 
1,981,170

 
643,876

Transfers from loans held-for-investment to loans held-for-sale
 
15,717

 
98,853

Transfers from residential loans to real estate owned
 
2,139

 
3,177

(1)
Cash, cash equivalents, and restricted cash at September 30, 2018 includes cash and cash equivalents of $174 million and restricted cash of $27 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
September 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 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 September 30, 2018 and December 31, 2017, and for the three and nine months ended September 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 September 30, 2018 and results of operations for all periods presented have been made. The results of operations for the three and nine months ended September 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"). In addition, we consolidated the assets and liabilities of certain third-party Freddie Mac K-Series securitization trusts beginning in the third quarter of 2018. 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.

7


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

For financial reporting purposes, the underlying loans owned at the consolidated Sequoia entities are shown under Residential loans, held-for-investment, at fair value, and the underlying loans owned at the consolidated Freddie Mac K-Series are shown under Multifamily 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 13 for further discussion on ABS issued.
See Note 4 for further discussion on principles of consolidation.
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 nine months ended September 30, 2018.
Business Purpose Loans at Fair Value
Business purpose loans include loans to investors in single-family rental properties ("Single-family rental loans") and loans to investors rehabilitating and reselling residential properties ("Fix-and-flip loans"). Our single-family rental loans are held-for-sale at fair value, as we have purchased these loans with the intent to sell to third parties or transfer to securitization entities. Fix-and-flip loans are primarily interest-only fixed-rate loans with a term of less than two years which are carried as held-for-investment at fair value.
Coupon interest for these loans is recognized as revenue when earned and deemed collectible or, for single-family rental loans, until a loan becomes more than 90 days past due, at which point the loan is placed on nonaccrual status. When a seriously delinquent loan previously placed on nonaccrual status has cured, meaning all delinquent principal and interest have been remitted by the borrower, the loan is placed back on accrual status. Changes in fair value are recurring and reported through our consolidated statements of income in Mortgage banking activities, net and Investment fair value changes, net for single-family rental loans and fix-and-flip loans, respectively.
Multifamily Loans, Held-for-Investment at Fair Value
Multifamily loans are multifamily mortgage loans held in Freddie Mac-sponsored K-series securitization trusts that we consolidate. In accordance with accounting guidance for collateralized financing entities ("CFEs"), we use the fair value of the ABS issued by the Freddie Mac K-Series entities (which we determined to be more observable) to determine the fair value of the loans held at these entities. Coupon interest for these loans is recognized as revenue when earned and deemed collectible or, until a loan becomes more than 90 days past due, at which point the loan is placed on nonaccrual status. When a seriously delinquent loan previously placed on nonaccrual status has cured, meaning all delinquent principal and interest have been remitted by the borrower, the loan is placed back on accrual status. Changes in fair value for the assets and liabilities of these trusts are recurring and are reported through our consolidated statements of income in Investment fair value changes, net.

8


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

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

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.

9


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 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 August 2018, the FASB issued ASU 2018-13, "Fair Value Measurement (Topic 820): Disclosure Framework - Changes to the Disclosure Requirements for Fair Value Measurement." This new guidance amends previous guidance by removing and modifying certain existing fair value disclosure requirements, while adding other new disclosure requirements. This new guidance is effective for fiscal years beginning after December 15, 2019. Early adoption is permitted and entities may elect to early adopt the removal or modification of disclosures immediately and delay adoption of the new disclosure requirements until their effective date. 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 2018, the FASB issued ASU 2018-09, "Codification Improvements." This new guidance is intended to clarify, correct, and make minor improvements to the FASB Accounting Standards Codification. The transition and effective dates are based on the facts and circumstances of each amendment, with some amendments becoming effective upon issuance of this ASU and others becoming effective for annual periods beginning after December 15, 2018. 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 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.

10


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

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

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.
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 after 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 15, our only material leases are those related to our leased office space, for which future payments under these leases totaled $16 million at September 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.


11


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 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 September 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
September 30, 2018
(In Thousands)
 
 
 
 
Financial Instruments
 
Cash Collateral (Received) Pledged
 
Assets (2)
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate agreements
 
$
78,006

 
$

 
$
78,006

 
$
(10,429
)
 
$
(28,159
)
 
$
39,418

TBAs
 
6,987

 

 
6,987

 
(919
)
 
(5,234
)
 
834

Futures
 
44

 

 
44

 

 

 
44

Total Assets
 
$
85,037

 
$

 
$
85,037

 
$
(11,348
)
 
$
(33,393
)
 
$
40,296

 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities (2)
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate agreements
 
$
(38,581
)
 
$

 
$
(38,581
)
 
$
10,429

 
$
28,152

 
$

TBAs
 
(1,744
)
 

 
(1,744
)
 
919

 
762

 
(63
)
Loan warehouse debt
 
(578,157
)
 

 
(578,157
)
 
578,157

 

 

Security repurchase agreements
 
(780,818
)
 

 
(780,818
)
 
780,818

 

 

Total Liabilities
 
$
(1,399,300
)
 
$

 
$
(1,399,300
)
 
$
1,370,323

 
$
28,914

 
$
(63
)

12


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 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.






13


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 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 September 30, 2018, we consolidated our Legacy Sequoia and Sequoia Choice securitization entities that we determined were VIEs and for which we determined we were the primary beneficiary. Additionally, in the third quarter of 2018 we consolidated certain third-party Freddie Mac K-Series 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 for the consolidated Sequoia entities 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 September 30, 2018, the estimated fair value of our investments in the consolidated Legacy Sequoia, Sequoia Choice, and Freddie Mac K-Series entities was $12 million, $196 million, and $67 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
September 30, 2018
 
Legacy
Sequoia
 
Sequoia
Choice
 
Freddie Mac
K-Series
 
Total
Consolidated
VIEs
(Dollars in Thousands)
 
 
 
 
Residential loans, held-for-investment
 
$
553,958

 
$
2,181,195

 
$

 
$
2,735,153

Multifamily loans, held-for-investment
 

 

 
942,165

 
942,165

Restricted cash
 
147

 
11

 

 
158

Accrued interest receivable
 
860

 
9,046

 
2,843

 
12,749

REO
 
2,915

 

 

 
2,915

Total Assets
 
$
557,880

 
$
2,190,252

 
$
945,008

 
$
3,693,140

Accrued interest payable
 
$
590

 
$
7,643

 
$
2,606

 
$
10,839

Accrued expenses and other liabilities
 

 
11

 

 
11

Asset-backed securities issued
 
544,923

 
1,986,456

 
875,606

 
3,406,985

Total Liabilities
 
$
545,513

 
$
1,994,110

 
$
878,212

 
$
3,417,835

 
 
 
 
 
 
 
 
 
Number of VIEs
 
20

 
6

 
2

 
28


14


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

Note 4. Principles of Consolidation - (continued)


December 31, 2017
 
Legacy
Sequoia
 
Sequoia
Choice
 
Freddie Mac
K-Series
 
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.
Beginning in the third quarter of 2018, we consolidated the assets and liabilities of two Freddie Mac K-Series securitization trusts as we invested in multifamily subordinate securities issued by these trusts and maintain certain discretionary rights associated with the ownership of these investments. We determined that our involvement with these VIEs reflected a controlling financial interest, and that we have both the power to direct the activities that most significantly impact the economic performance of the VIEs and the right to receive benefits of and the obligation to absorb losses from the VIE that could potentially be significant to the VIEs.
Analysis of Unconsolidated VIEs with Continuing Involvement
Since 2012, we have transferred residential loans to 43 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 mortgage servicing rights ("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.

15


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

Note 4. Principles of Consolidation - (continued)


The following table presents information related to securitization transactions that occurred during the three and nine months ended September 30, 2018 and 2017.
Table 4.2 – Securitization Activity Related to Unconsolidated VIEs Sponsored by Redwood
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
(In Thousands)
 
2018
 
2017
 
2018
 
2017
Principal balance of loans transferred
 
$
327,511

 
$
839,264

 
$
2,735,644

 
$
2,223,387

Trading securities retained, at fair value
 
2,583

 
24,617

 
48,831

 
55,607

AFS securities retained, at fair value
 
776

 
4,416

 
6,728

 
11,476

MSRs recognized
 

 

 

 
7,123

The following table summarizes the cash flows during the three and nine months ended September 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 September 30,
 
Nine Months Ended September 30,
(In Thousands)
 
2018
 
2017
 
2018
 
2017
Proceeds from new transfers
 
$
329,231

 
$
839,642

 
$
2,723,012

 
$
2,213,151

MSR fees received
 
3,405

 
3,631

 
10,216

 
10,804

Funding of compensating interest, net
 
(46
)
 
(35
)
 
(102
)
 
(114
)
Cash flows received on retained securities
 
7,267

 
6,882

 
21,720

 
19,843

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 nine months ended September 30, 2018 and 2017.
Table 4.4 – Assumptions Related to Assets Retained from Unconsolidated VIEs Sponsored by Redwood

 
 
Three Months Ended September 30, 2018
 
Three Months Ended September 30, 2017
At Date of Securitization
 
MSRs
 
Senior IO Securities
 
Subordinate Securities
 
MSRs
 
Senior IO Securities
 
Subordinate Securities
Prepayment rates
 
N/A
 
9
%
 
9
%
 
N/A
 
11
%
 
10
%
Discount rates
 
N/A
 
14
%
 
7
%
 
N/A
 
14
%
 
5
%
Credit loss assumptions
 
N/A
 
0.20
%
 
0.20
%
 
N/A
 
0.25
%
 
0.25
%
 
 
Nine Months Ended September 30, 2018
 
Nine Months Ended September 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
%
 
13
%
 
5
%
Credit loss assumptions
 
N/A
 
0.20
%
 
0.20
%
 
N/A

 
0.25
%
 
0.25
%

16


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

Note 4. Principles of Consolidation - (continued)


The following table presents additional information at September 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)
 
September 30, 2018
 
December 31, 2017
On-balance sheet assets, at fair value:
 
 
 
 
Interest-only, senior and subordinate securities, classified as trading
 
$
130,598

 
$
101,426

Subordinate securities, classified as AFS
 
163,870

 
219,255

Mortgage servicing rights
 
62,325

 
60,980

Maximum loss exposure (1)
 
$
356,793

 
$
381,661

Assets transferred:
 
 
 
 
Principal balance of loans outstanding
 
$
10,349,405

 
$
8,364,148

Principal balance of loans 30+ days delinquent
 
19,625

 
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 September 30, 2018 and December 31, 2017.
Table 4.6 – Key Assumptions and Sensitivity Analysis for Assets Retained from Unconsolidated VIEs Sponsored by Redwood
September 30, 2018
 
MSRs
 
Senior
Securities (1)
 
Subordinate Securities
(Dollars in Thousands)
 
 
 
Fair value at September 30, 2018
 
$
62,325

 
$
62,996

 
$
231,472

Expected life (in years) (2)
 
9

 
8

 
15

Prepayment speed assumption (annual CPR) (2)
 
7
%
 
9
%
 
9
%
Decrease in fair value from:
 
 
 
 
 
 
10% adverse change
 
$
1,631

 
$
2,156

 
$
547

25% adverse change
 
3,974

 
5,145

 
1,361

Discount rate assumption (2)
 
11
%
 
11
%
 
6
%
Decrease in fair value from:
 
 
 
 
 
 
100 basis point increase
 
$
2,469

 
$
2,383

 
$
22,243

200 basis point increase
 
4,812

 
4,592

 
41,116

Credit loss assumption (2)
 
N/A

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

 
$

 
$
559

25% higher losses
 
N/A

 

 
4,220


17


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 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 $63 million and $34 million of interest-only securities at September 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 Unconsolidated 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 September 30, 2018, grouped by security type.
Table 4.7 – Third-Party Sponsored VIE Summary
(Dollars in Thousands)
 
September 30, 2018
 
December 31, 2017
Mortgage-Backed Securities
 
 
 
 
Senior
 
$
214,655

 
$
216,066

Mezzanine
 
538,847

 
508,010

Subordinate
 
422,114

 
431,753

Total Investments in Third-Party Sponsored VIEs
 
$
1,175,616

 
$
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.

18


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 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.


19


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 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 September 30, 2018 and December 31, 2017.

Table 5.1 – Carrying Values and Fair Values of Assets and Liabilities
 
 
September 30, 2018
 
December 31, 2017
 
 
Carrying
Value
 
Fair
Value
 
Carrying
Value
 
Fair
Value
(In Thousands)
 
 
 
 
Assets
 
 
 
 
 
 
 
 
Residential loans, held-for-sale
 
 
 
 
 
 
 
 
At fair value
 
$
866,331

 
$
866,331

 
$
1,427,052

 
$
1,427,052

At lower of cost or fair value
 
113

 
133

 
893

 
993

Residential loans, held-for-investment
 
 
 
 
 
 
 
 
At fair value
 
5,055,815

 
5,055,815

 
3,687,265

 
3,687,265

Business purpose loans
 
115,620

 
115,620

 

 

Multifamily loans
 
942,165

 
942,165

 

 

Trading securities
 
1,108,243

 
1,108,243

 
968,844

 
968,844

Available-for-sale securities
 
361,841

 
361,841

 
507,666

 
507,666

Cash and cash equivalents
 
173,516

 
173,516

 
144,663

 
144,663

Restricted cash
 
27,253

 
27,253

 
2,144

 
2,144

Accrued interest receivable
 
35,644

 
35,644

 
27,013

 
27,013

Derivative assets
 
87,219

 
87,219

 
15,718

 
15,718

MSRs (1)
 
63,785

 
63,785

 
63,598

 
63,598

REO (1)
 
2,915

 
3,490

 
3,354

 
3,806

Margin receivable (1)
 
48,655

 
48,655

 
85,044

 
85,044

FHLBC stock (1)
 
43,393

 
43,393

 
43,393

 
43,393

Guarantee asset (1)
 
2,885

 
2,885

 
2,869

 
2,869

Pledged collateral (1)
 
42,127

 
42,127

 
42,615

 
42,615

Participation in loan warehouse facility (1)
 
39,219

 
39,219

 

 

Liabilities
 
 
 
 
 
 
 
 
Short-term debt
 
$
1,424,275

 
$
1,424,275

 
$
1,688,412

 
$
1,688,412

Accrued interest payable
 
31,076

 
31,076

 
18,435

 
18,435

Margin payable (2)
 
33,950

 
33,950

 
390

 
390

Guarantee obligation (2)
 
17,423

 
17,409

 
19,487

 
18,878

Derivative liabilities
 
42,724

 
42,724

 
63,081

 
63,081

ABS issued at fair value, net
 
3,406,985

 
3,406,985

 
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
 
632,401

 
639,684

 
686,759

 
692,369

Trust preferred securities and subordinated notes, net
 
138,570

 
108,113

 
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 nine months ended September 30, 2018, we elected the fair value option for $32 million and $105 million of residential senior securities, $128 million and $417 million of subordinate securities, and $1.79 billion and $5.52 billion of residential loans (principal balance), respectively. Additionally, during the three months ended September 30, 2018, we elected the fair value option for $126 million of business purpose loans (principal balance) and $963 million of multifamily loans (principal balance). 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 business purpose loans and for certain securities we purchase, including IO securities and fixed-rate securities rated investment grade or higher.

20


REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 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 September 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
September 30, 2018
 
Carrying
Value
 
Fair Value Measurements Using
(In Thousands)
 
 
Level 1
 
Level 2
 
Level 3
Assets
 
 
 
 
 
 
 
 
Residential loans
 
$
5,922,146

 
$

 
$

 
$
5,922,146

Business purpose loans
 
115,620

 

 

 
115,620

Multifamily loans
 
942,165

 

 

 
942,165

Trading securities
 
1,108,243

 

 

 
1,108,243

Available-for-sale securities
 
361,841

 

 

 
361,841

Derivative assets
 
87,219

 
7,031

 
78,006

 
2,182

MSRs
 
63,785

 

 

 
63,785

Pledged collateral
 
42,127

 
42,127

 

 

FHLBC stock
 
43,393

 

 
43,393

 

Guarantee asset
 
2,885

 

 

 
2,885

 
 
 
 
 
 
 
 
 
Liabilities
 


 
 
 
 
 
 
Derivative liabilities
 
$
42,724

 
$
1,744

 
$
38,581

 
$
2,399

ABS issued
 
3,406,985

 

 

 
3,406,985