Redwood Trust Inc (NYSE:RWT)
Q2 2016 Results Earnings Conference Call
August 08, 2016, 05:00 PM ET
Kristin Brown - VP, IR
Marty Hughes - CEO
Christopher Abate - President and CFO
Bose George - KBW
Nick Agrawal - Well Fargo Securities
John Helfst - Voya Financial
Brock Vandervliet - Nomura Securities
Good afternoon, and welcome to the Redwood Trust Inc. 2016 Second Quarter Earnings Conference call. During management's presentation, your line will be in listen-only mode. [Operator Instructions]
I would now like to turn the conference over to Kristin Brown, Vice President of Investor Relations. Please go ahead.
Thank you, Justin. Good afternoon, and thank you for joining us to review Redwood Trust's second quarter 2016 earnings report.
Before we begin, I wanted to remind you that certain statements made during management's presentation with respect to future financial or business performance may constitute forward-looking statements.
Forward-looking statements are based on current expectations, forecasts, and assumptions that involve risks and uncertainties that could cause actual results to differ materially. We encourage you to read the Company's Annual Report on Form 10-K, which provides a description of some of the factors that could have a material impact on the Company's performance, and could cause actual results to differ from those that may be expressed in forward-looking statements.
On this call we will also refer to both GAAP and non-GAAP financial measures. The non-GAAP financial measures provided should not be utilized in isolation or considered as a substitute for measures of financial performance prepared in accordance with GAAP. They are included to aid investors in further understanding the Company's performance and to provide insight into one of the ways that management analysis Redwood's performance. A reconciliation between GAAP and non-GAAP financial measures is provided in both our second quarter earnings press release and Redwood review which is available on our website redwoodtrust.com.
Also note that the content of this conference call contains time-sensitive information that is accurate only as of today, Monday, August 8, 2016. The Company does not intend, and undertakes no duty to update this information to reflect subsequent events or circumstances. Finally, today's call is being recorded, and will be available on the Company's website later today.
For opening remarks and introductions, I will now turn the call over to Marty Hughes, Redwood' Chief Executive Officer.
Good afternoon, everyone. Thank you for participating in Redwood's second quarter 2016 earnings call. Joining me on the call is Chris Abate, Redwood's President and CFO. Following my remarks on the quarter's highlights and our current investment and initiatives, Chris will discuss the quarter's investment - our quarterly investments, residential mortgage banking activities, and our financial results for the second quarter.
For the second quarter of 2016, our GAAP earnings improved to $0.48 per share from $0.15 per share in the first quarter. Our non-GAAP core earnings increased by $0.03 to $0.47 per share and our GAAP book value increased to $14.20 per share at June 30, from $14.17 a share at March 31.
We made significant progress on both our operational and financial objectives during the second quarter following is a successful repositioning of our conforming residential and commercial mortgage banking businesses in the first quarter. Taking advantage of our linear and more nimble platform, we move forward on a few long term strategic initiatives that we expect will enhance our growth and opportunities and earnings power going forward.
We also engage in external broker to sell our commercial mezzanine loan portfolio which we no longer consider core at core investments following the wind-down of our commercial mortgage banking operations in the first quarter.
We have received strong interest from a wide range of institutional investors and anticipate closing to sell this portfolio in the third quarter. At June 30, our available capital for investments was approximately $140 million. After the sale of our commercial loan portfolio and other recent investment activities, we expect this amount to increase by an additional $240 million to $260 million, bringing our total capital available for investment to around $400 million.
One of our most important calls is to redeploy this capital efficiently and at the highest possible returns. The core of our business lies in investing in prime residential credit risk and in addition to our Sequoia program and other existing initiatives, we have been working on new innovative ways of making residential credit investments with two primary areas of focus. The first is credit risk-sharing or CRT with the GSEs, which have emerged as the de facto means for the GSEs transfer credit risk to the private sector.
Our CRT initiatives currently include both acquiring subordinate investments from the GSE-sponsored securitizations and working directly with the GSEs on alternative, proprietary solutions where Redwood can assume first-loss risk on loan pools either sold to or securitized by the GSEs.
We completed three of these transactions through our conforming residential conduit activities prior to 2016, and we are currently pursuing ways to complete similar transaction through portfolio initiatives that do not require the operational costs necessary to aggregate loans.
While such proprietary initiatives are still in development, we are encouraged by the potential of future capital deployment and are optimistic that we can work through the fine details to complete a new transaction in 2016.
Our second area of focus is portfolio risk-sharing or PRT with large banks. One of the effects that quantitative easing is that large banks now had significant excess reserves, some of which are being used to substantially increase their portfolio holdings of jumbo and conforming mortgages.
PRTs which were introduced late in the first quarter remain in the early stages of development and facilitate our credit-risk transfers by large banks to investors such as Redwood, without actually transferring the loans they own off their books. In essence, banks become the effective owners of AAA-rated RMBS, potentially allowing them to hold significantly less regulatory capital gains of loans and improve their returns on equity.
For Redwood, PRT allows us to access credit exposure on jumbo conforming loans held by banks, one of the largest sources of residential mortgage credit risk available in the market today without a significant expansion of our operation. Importantly, since PRT investments are treated like traditional RMBS for federal income taxes we can further leverage the advantages of our REIT tax structure.
We have also recently invested opportunistically in commercial security primarily in multifamily issued by Freddie Mac. These securities leverage our core capital market structuring expertise and the credit analysis is similar to RMBS. These securities have typically been rated BBB by the credit rating agencies with 7 to 8 points of structural credit enhancement.
We also have approximately $90 million in remaining authorization to repurchase shares and will do so to the extent that returns are attractive relative to other available opportunity. Over time, we believe these initiatives will provide us with ample investment opportunities to deploy our available capital.
Given that credit spreads are currently near historical tight, we also intend to be patient with respect to deploying our available capital. There remain many unresolved geo political and economic issues to work through and few liquidity buffers available in the financial system to absorb supply and demand imbalances and keep volatility low. Consequently we intend to keep a cautious side in the overall macro environment and keep our liquidity position strong.
In conclusion, our full attention is now on growing earnings by seizing on attractive new investment opportunities and maximizing the value of our jumbo loan franchise. We're upbeat about the remainder of 2016 and more importantly about the long term growth prospects for Redwood.
As we stated in our fourth quarter Redwood review, our expectations to generate GAAP earnings between $1.20 and $1.50 per share for the full year of 2016. After incorporating our second quarter results into our current outlook we continue to expect GAAP per earnings for the full year 2016 to fall within this range.
Now I’d like to turn the call over to Chris Abate, Redwood's President and CFO.
Well thank you Marty, and good afternoon to everyone on the call.
I’d like to begin with some comments on our recent investment activity. We deployed $77 million as capital in the new investments during the second quarter with an emphasis on residential CRT securities and agency commercial multifamily securities. Though June 30, we’ve deployed $223 million including $63 million in the residential CRT, $39 million into commercial securities, $19 million in to new Sequoia and other RMB as well as $20 million into NSRs. We also deployed $82 million of capital into loans financed through the FHLB of Chicago earlier in the year fully utilizing our $2 billion of financing capacity in the second quarter. Finally our convertible debt and share repurchases totaled $26 million year-to-date.
We sold $109 million of residential securities during the second quarter and $261 million through June 30, bringing up approximately $131 million of capital for reinvestment and generating $19 million of realized gains. While we’ve been a net seller of RMBS during the first half of the year our sales activity has primarily focused on selling lower yielding legacy securities that have full appreciated. Going forward we anticipate redeploying this capital into CRT, PRT and supporting RMB assets and commercial securities.
We are pleased with the performance of our investment portfolio during the second quarter. Net interest income continues to grow and the underlying credit performance of our residential investments remains excellent. Our investment portfolio represented $1.5 billion or 90% of our $1.7 billion of total capital at June 30. The remaining 10% was allocated to our residential mortgage banking business which has continued to perform profitably since we repositioned our platform in early 2016.
Gross margins from our jumbo mortgage banking activities were 68 basis points for the second quarter within our long-term expectation of 50 to 75 basis points. As we noted last quarter we recently introduced our new expanded prime jumbo loan program Redwood Choice to capture a larger cross section of the prime jumbo universe and better leverage our core competencies and taking concentrated mortgage credit risk.
Although we’re still a few quarters away from understanding its volume potential the rollout so far has very well received by our sellers. In time we believe that securitizing choice loans or financing them through our FHLB subsidiary can provide us with a high quality long-term credit investments we desire at attractive risk adjusted returns.
Our traditional jumbo program rebranded as Redwood Select continues to provide a stable source of loans for residential conduit. In addition to our recurring whole loan sales we completed our first Sequoia securitization of 2016 in late June securitizing $254 million of select loans. Our June Sequoia transaction generated a significant amount of follow on interest from institutional buyers and as a result we closed a second similarly sized transaction in late July at pricing that was meaningfully better than the June transaction.
While loan sales generally remain more profitable relative to securitization the economics between the two have narrowed considerably in recent months as spread tightening on securities during the quarter led to improved securitization margins. This has been due in part to tightening industry benchmarks as well as limited supplies and newly issued RMBS. While we find the current RMBS issuance market much more favorable than we did earlier in the year additional transactions in 2016 will remain dependent on prevailing securitization market conditions.
Now turning to our financial results for the quarter, our GAAP earnings improved $0.48 per share from $0.15 per share for the first quarter benefiting from higher net interest income and reduced negative market valuation adjustments on our residential investments and related hedges. Earnings also benefited from the release of commercial loan loss reserves associated with the anticipated commercial mezzanine loan portfolio sale in the third quarter. This was in addition to four commercial mezzanine loans prepaying during the second quarter.
Second quarter earnings also benefited from lower operating expenses which decreased to $20 million from $30 million in the first quarter. This was primarily due to the $11 million of restructuring changes and $2 million of employee transition expenses included in the first quarter partially offset by $3 million higher variable compensation expense due to higher earnings in the second quarter. We expect operating expenses to decline further in the second half of 2016 fully reflecting the benefit of the restructuring we completed in the first quarter
Our core earnings for the second quarter were $0.47 per share, an increase of $0.03 per share from the first quarter. Core earnings benefited from higher net interest income due in part to higher average balances of loans held by our FHLB member subsidiary and $5 million of prepayment penalty interest received from the four commercial mezzanine loans prepaid during the quarter.
Our GAAP book value was $14.20 per share at June 30, as compared with $14.17 per share at March 31. The increase in book value was driven by our second quarter earnings exceeding our dividend payment was partially offset by declines from annual equity award distributions and negative market-to-market adjustments and interest rate derivatives hedging our long-term debt.
Turing to the balance sheet, our debt-to-equity leverage ratio was 3.4 times at June 30. We exclude $860 million of legacy Sequoia consolidated ABS debt from our leverage calculation as it is non-recourse to Redwood. Leverage included $2 billion of borrowings by our FHLB member subsidiary with a weighted average majority\ of approximately nine year and a weighted average cost of 57 basis points per annum. We had short term repurchased debt or repo debt of $353 million at June 30 funding residential securities down from $694 million at December 31.
And that concludes my prepared remarks. Operator, why don’t we start with the Q&A.
[Operator Instructions] And our first question will come from Bose George with KBW.
Hi, guys good afternoon. The first question I have is just, you noted the spread tightening between sale and securitization. Given that trend is it fair to think that gain on sales should be higher in the third quarter with a better execution on your July deal?
Hi Bose, well maybe a better expectation is maybe we might do a few more securitizations if the current spread remains tight so I think one of us mentioned it was 25 to 50 basis points difference between whole loan execution and securitization. So I don’t know that the absolute margins will be significantly higher but we could see just given increased demand for RMBS we could execute a few more deals.
And actually if current market conditions exist I think the difference between a bulk sale execution and a Sequoia execution right now is only an eight of a point. So that’s the tightest it’s probably been in a year and a half.
Okay, great thanks. And then actually just on the volume side any thoughts on where that trend, should we just think about the broader market on refis and kind of view that as an indication or do you think there is room for your guys to take some share?
I think we’re relatively optimistic. We’ve had pretty stable jumbo volume in the last few quarters and it was stable again in the second quarter. Locks have been up. Locks have been trending higher more recently. I think that it’s largely due to purchase activity but we could see if there is a mean reversal in the primary secondary spread from a mortgage perspective we could see an uptick in refis in the third quarter. We haven’t started to see that go as of yet.
Okay, great. Actually just one more. In terms of you’re the gains you guys generate on asset sales I am trying to think of a good way to think about that because are those gains that you might have realized it or might have shown if you hadn’t sold the assets or should we think of it as your assets are marked fairly conservatively so when they go to sell these assets that’s when you kind of realize those gains at that point?
A lot of those gains are available for sale at securities that we haven’t mark-to-market in the income statement yet. So most of our loan portfolio now goes right to the P&L each quarter as does our servicing book. A lot of our securities the mark-to-market still go to equity until we sell them and as has always been the case really that decision to sell is a function of risk management. Many of the legacy securities especially the senior securities we’ve brought into have fully appreciated at or in cases above par so it gives us an opportunity to take some risk off the table and redeploy it.
Okay great. Thanks.
And our next question comes from Nick Agrawal with Well Fargo Securities.
Hi thanks, and thanks for taking my questions. On the PRT transaction I wanted to get your outlook for that market and also did you participate in the transaction in the individual line.
Yes, we did participate in a latest transaction both at the non-rated tranche and the tranche above it. What could say, it’s really early to see how it develops but what has us very positive is and I mentioned this on last quarter’s call is I think the elegance of these structures they fix on many points of friction, they reduce the capital charge from 4.5 to 2.
The banks continue to consolidate the loans for accounting purposes so they are carrying them across and they reduce volatility based on spread widening to the extent that the underlying loans or conforming loans we believe that it’s effectively lowering the guarantee fee from 50ish basis points down to 30ish and also with servicing they’re not doing advances. So again I think it’s a very elegant transaction and we think it’s applicable both for large banks and for regional banks as well.
Okay thanks. And then on the $240 million to $260 million of proceeds that you expect from the sale of the commercial business how quickly do you expect to be deploying that, I mean is it going to be similar to the pace you did this quarter?
That’s probably not a bad expectation. I think one thing we want to do is just remark on the spread tightening that we’ve seen and I think patience is a good word for how we’re going to approach capital deployment. Things are very tight in the market today and from a macro economic perspective it doesn’t appear as though much has been solved from where we were six months ago which I am sure everyone is familiar with on the call.
So I think it’s important that we were patient and opportunistic. That said we’re working on a lot of different things and to the extent we complete a few more Sequoia transactions you might be able to see elevated capital deployment.
Risk sharing I think especially on the PRT side gives an opportunity to put significant amounts of capital work but these are still in the earlier stages and like Chris said this is probably not a bad time to have some dry powder to be patient and also having the upside to the extent that some these transactions that we’re working actually come to fruition.
Okay. And then with the competitor existing the market couple of weeks ago, how do you think that’s changed the market or how has changed the pricing more favorably or not?
No, it really hasn’t. Just our comments there is we have the first the utmost respect for Two Harbors and their management team. I would say on the probably on the more negative side I would say having less another issuer drop out and having less liquidity in RMBS is not a particularly good fact.
On the flip side we would say having on the margin less competition is a good thing and the last thing that we note, we had two good quarters on jumbo and the mortgage banking results and we have a slightly different model than them. So we have the federal home loan home back which they also had, we had securitization.
More importantly which was our book whole loan distribution which is very strong that allow us to pivot between the different options and when securitization was the tight option we went to book whole loan sales which were very strong.
Okay. Chris just one quick numbers questions for you if I may. Do you have your TBA and swap balance at the end of the Q2 by chance.
I don’t have it in front of me, but I’ll get back to you as soon as I can.
Okay, thanks Chris.
[Operator Instructions] Our next question comes from Brock Vandervliet with Nomura securities. Again your line is open. Please go ahead with your questions.
Again your line is open, we could hear you for a second, and then it's silent again. Again your line is Brock please go ahead with your questions.
And hearing no response to that line we’ll go ahead and take that question out. [Operator Instructions] Our next question comes from John Helfst with Voya Financial.
Hi guys good quarter. Can you or have you broken out current or estimated ROE, ROAs for the PRT maybe relative to what you are selling the CRE mez, is this accretive to the bottom line you think or near term, long term, any offset. Thanks.
We think the PRT investments are absolutely accretive. We're looking at low to mid double-digit returns and they are good REIT assets so they’re REMIC structures which is obviously important and we’ve liked the credit profile of both transactions to this point. So we're very optimistic about the structure and the return profile.
Our next question comes from Bose George with KBW.
Hi, guys just a couple of follow-ups. The CRT structure you said you’re working on now with the GSE would that be a good REIT asset or would it have the same issues like the stackers and casters.
It has similar issues we’re working on that Bose so as you correctly note some of the GSE specific CRT transactions the first loss is treated somewhat like a derivative and there is interpretations today, there is a more likely than not that it would be a good REIT asset. That said it’s going to be a primary area of focus for us, we’re going to want more than that and we’ll likely pursue an IRS ruling. That said that’s not permitting us from participating today, it would be more of a long term if this in fact an area where we could deploy a lot of capital.
Okay, great. And actually just more, I don’t know if you said this earlier but the GSE being multifamily investment did you give a feel for how big that could be for you guys?
So, we did something in the neighborhood of $27 million to $30 million recently and the interesting thing there is one it really leverages our structuring and knowledge of the RMBS structures so it’s multifamily, it’s a single property type unlike CMBS where there is multiple property types there is also usually a top 10 list that has very large balances. So here the profile is much more similar to RMBS.
The other interesting thing is there has been a fairly consistent and programmatic issuance so there has been a consistent deal flow start opportunities to deploy capital and we’ve also liked the return profile of the BBB equivalent investments which do have I think Marty mentioned 78 points of credit support.
Okay. But just in terms of how much or the size of potential investments in that asset class going forward.
We don’t have specific amount at this point Bose but we would certainly allocate more capital to that over the coming quarters.
And then obviously it will just depend on where the credit spreads are.
Okay, fair enough. Great, thanks.
And moving on to Brock Vandervliet with Nomura Securities.
Great, we'll try this again, my headset is recharging. Anyway, just a couple of modeling questions. I think you mentioned Chris the repo balance dropped sharply I think that was one of the goals. Do you see any fall through in that or is that decline pretty much done this quarter?
Hi, Brock. I think it’s more or less level to ops so it was 353 at the end of the quarter we wanted to get it down towards 300 so we’re pretty close. At this point I don’t perceive it moving significantly in either direction unless something changes in the markets. Repo is still available at least from the onshore banks so we feel comfortable with what we have today.
Okay. And there had been some swap repositioning also could you comment on that.
I believe Vic asked - we had $2.5 billion of TBA notional at the end of the quarter and $1.6 billion swaps, really our swaps in TBA position is a function of hedging and risk management. We're hedging our pipelines, we’re also hedging our servicing book, so I wouldn't read too much into any strategic changes. I think really we're trying to be rate neutral more or less and we’re always going to be doing some rebalancing.
Okay. And just a big picture, you’ve touched on it a couple of times but as you look back over the last year and a half and you mentioned it already on the call and the differential between sale and securitization has never been as tight as it is right now. What if you listed off three or four drivers of that what would they -- can you just review them.
I would say just the bigger drivers is just a - in the market is just a risk on mentality, I mean everything has come in where it was almost you had a little blow out towards the end of June but since the end of June it’s just continuing to grind further and I just think it's just people looking for yield and it really comes down to I mean other than liquidity issues there isn’t much RMBS out there the actual credit performance has been outstanding.
Yes, Brock, and I would add as Marty alluded to earlier, we're in a position where we don’t need to securitize just given our whole loan distribution. So I think investors realize that if spreads are widening we don’t need to be in the market so things have really settled in here and the executions have been strong.
Deals that had been in the market since ours - appear to be tightening further which gives us some confidence that perhaps we could issue a few more transactions if things stay the same. But I think a lot of it is just market technicals.
Got it. Okay, thank you.
And thank you. There are no further questions at this time. This concludes our conference. On behalf of management, we very much appreciate you taking the time to participate in our earnings call.
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