Redwood Trust Inc. (NYSE:RWT) Q4 2018 Earnings Conference Call November 7, 2018 5:00 PM ET
Chris Abate - Chief Executive Officer
Dash Robinson - President
Collin Cochrane - Chief Financial Officer
Tommy McJoynt-Griffith - KBW
Steve DeLaney - JMP Securities
Stephen Laws - Raymond James
Good afternoon, and welcome to the Redwood Trust Inc., Third Quarter 2018 Earnings Conference Call. During management’s presentation your line will be in a listen-only mode. At the conclusion of management’s remarks, there will be question-and-answer session. I will provide you with instructions to enter the Q&A queue after management’s comments.
Before we begin, at management’s request, 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 upon current expectations, forecasts and assumptions that involve risks and uncertainties that could cause actual results to differ materially. Management encourages 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, management may also refer to both GAAP and non-GAAP financial measures. The non-GAAP financial measures provided should not be utilized in isolation or considered as a substitute for measures of financial performance prepared in accordance with GAAP. They are included to aid investors in further understanding the company's performance and to provide insight into one of the ways that management analyzes Redwood's performance.
A reconciliation between GAAP and non-GAAP financial measures is provided in both Redwood’s third quarter earnings press release and Redwood Review available on the company’s website www.Redwoodtrust.com.
Also note that the content of this conference call contains time-sensitive information that is accurate only as of today, Wednesday, November 7, 2018. The company does not intend and undertakes no duty to update this information to reflect subsequent events or circumstances.
Finally, today's call is being recorded and will be available on the company's website later today.
I will now turn the call over to Chris Abate, Redwood's Chief Executive Officer for opening remarks and introductions.
Good afternoon, everyone. Thank you for participating in Redwood's third quarter 2018 earnings call. Joining me on the call today is Dash Robinson, Redwood's President and Collin Cochrane our CFO.
The third quarter was our first full quarter as a newly seated management team. As many of you may recall, we laid out our high level vision for Redwood’s future growth in late 2017 when the management transition was first announced.
The key aspect of our plan was to recognize and respond to the secular shifts occurring in the housing market. These shifts are putting constraints on the traditional owner occupied segment of the market, and are contributing to an evolving trend towards rentership. To address these shifts we spent the first half of the year diligently building out our processes to support the growth of our operating platform in the new segments of the market.
This entailed cultivating new relationships to increase our access to unique investment opportunities, as well as expanding on our investment sourcing capabilities to allow us to serve both the owner occupied and non-owner occupied segments of the market. All of this was done with the expectation that we would continue to expand our traditional jumbo conduit activities, including the launch of new products and funding solutions for a network of sellers.
Having laid the foundation for a long term strategic plan, we ended the third quarter focused on execution. In the face of challenging market conditions, our focus paid off. During the third quarter we deployed $281 million into new investments, the most in the company's 24 year history. Importantly, over two-thirds of the capital deployed was in the new initiatives in housing credit and business purpose lending.
Our jumbo residential business achieved its own milestones during the quarter as we completed our 50th Sequoia securitization post crisis, followed quickly by two additional securitizations. All told, we generated earnings of $0.42 per share in the third quarter, which comfortably exceeded our recently increased quarterly dividend. We also grew book value for the 10th consecutive quarter.
The momentum we built allowed us to quickly put the proceeds from our July equity offering to work and our pipeline of opportunities continues to bear fruit as we broaden our reach throughout the industry.
Our approach to raising capital remains consistent. We will look both internally and externally in various forms and structures based on what we believe is in the long term interest of our shareholders. Our demonstrated ability to deploy capital at an accelerated pace speak to our asset sourcing capabilities and our prospects to grow profitably in a manner that greatly benefits our shareholders.
I'd also like to highlight that our recent successes were achieved despite rising interest rates in a difficult origination environment. We’ve highlighted in the past that our business has the potential to thrive in most interest rates scenarios, whether up or down. While the challenges the rising rates presents to our industry have our foremost attention, they have not in our opinion significantly changed the credit quality of the housing sector.
We continue to source loans from high quality borrowers in both the owner occupied and investor segments of the market, and we continue to see many potential borrowers as underserved.
In addition to our traditional Sequoia investments, our recent activity included a mix of multifamily securities, business purpose mortgage loans and securities collateralized by reperforming mortgage loans.
As many industry participants became more aggressive in pricing loans to preserve volumes in the third quarter, we remain focused on profitability. This yielded strong mortgage banking margins in the third quarter, but we will have to navigate these challenging market conditions going forward. We currently expect our full year jumbo loan purchases to be near the lower end of our original $7 billion to $8 billion range for 2018.
Even at the lower end of a range 2018 volume continues the trend towards record post crisis volume for Redwood and year-over-year growth of around 20%. Additionally we expect full year returns from our mortgage banking platform to be towards the higher end of our originally forecasted range.
Finally, with the midterm elections taking place yesterday, we’ll devote part of our focus on Washington and the new opportunities that may arise in the coming year. With the Democrats retaking control of the house, all signs point towards housing finance changes occurring primarily through regulatory forms as the prospect of legislation diminishes.
Most expect a new head of the FHFA early next year, as well as new CEOs at both Fannie Mae and Freddie Mac. These changes and appointments could have significant downstream effects with the potential for private sector participation to increase significantly.
In fact, we’ve already begun to see a shift in the FHFAs direction of the GSE as they recently announced the discontinuation of pilot programs in the single family rental sector. We've also seen more credit risk getting sold through GSE sponsored securities backed by conforming loans. This dovetailed with the first GSE sponsored securitization for recently originated conforming loans in the third quarter.
It goes without saying that we view these developments as positives for companies like Redwood and would look to be part of any private capital solutions that may arise through agency based GSE reform.
With that, I'll turn the call over now to Dash Robinson, Redwood’s President.
Thank you, Chris, and good afternoon everyone. I'd like to start off by touching on a very productive quarter for our investment portfolio. As Chris mentioned, we deployed a record amount of capital in the third quarter. The strong results were anchored by several investments that highlight our focus on opportunities across the broader housing sector that leverage our core competencies and housing credit. The quarter’s activity centered on organically created investments sourced from our Sequoia platform and strategic partnerships we continue to develop and grow.
As we discussed on our second quarter earnings call, in August we made important investments in the multifamily and fixed and flip sectors. We deployed $55 million in a pool of seasoned subordinate multifamily bonds sponsored by Freddie Mac, further expanding our efforts in this space.
We also committed $50 million to invest in a pool of fix and flip loans originated and asset managed by our partners at 5 Arches. These loans carry a weighted average coupon of approximately 9.1% with a weighted average loan to value ratio at origination of 76% and a weighted average after repaired loan to value at origination of 57%. Weighted average borrowed FICO at origination was approximately 780.
The investment is revolving in nature, meaning that principal payments are replenished with the new production going forward. We currently use a modest amount of bank financing on this investment and are carefully following the recent developments in the capital markets for fixed and flip loans, including the emergence of securitization as we assess financing alternatives going forward.
Additionally, during the quarter we made a deposit of $58 million to secure an investment and subordinate securities backed by reperforming loans currently owned by Freddie Mac. The weighted average seasoning of the pool is approximately 12 years with a current weighted average loan to value of 76%. We anticipate incremental capital deployment of approximately $75 million in the fourth quarter to complete the investment.
Our remaining capital deployment included $30 million into bonds issued from our Sequoia program and $92 million into third party RMBS issuances. Additionally we remained active in optimizing our capital allocations in the third quarter, continuing to rotate out of lower yielding and less strategic assets. Specifically, we freed up approximately $106 million of capital for redeployment during the third quarter, capturing $15 million of previously unrealized gains.
Our mortgage banking platform also delivered a strong quarter, navigating a market that as Chris mentioned is still adjusting capacity in a response to interest rates and overall demand. During the third quarter, we generated margin that exceeded our long term expectations of 75 to a 100 basis points and we are above realized margins in the second quarter. A key driver of these results was continued strength in the securitization market and a robust quarter for whole loan sales.
The securitization market improved relative to the second quarter and we successfully completed three Sequoia securitizations on loans totaling over $1.1 billion. This included two Choice deals, for programs fifth and sixth overall and as Chris mentioned, issuance of our 50th Sequoia securitization since the crisis, a benchmark we are proud of that reflects the importance of maintaining a reliable cadence for coming to market. Total Sequoia issuance since the crisis across both the select and Choice channels has totaled over $20 billion.
Complementing these activities we sold approximately $800 million of home loans during the third quarter, our highest level in almost two years. As we have described before, even when securitization markets are favorable, as they have generally been the last couple of years, we work to keep our whole loan sales channels open and active. This paid dividends during the third quarter as we expanded our group of whole loan buyers and continue to deepen the existing partnerships.
Overall purchase volumes were not immune to broader market trends and third quarter loan purchases totaled $1.8 billion, down 8% from the prior quarter, but up over 20% from the third quarter of 2017.
We continue to observe the benefits of channel diversification through efforts such as Redwood Choice, at an increasingly purchase money market our sellers value the diversity of our products and reliability of our process.
Redwood Choice line increased modestly in the third quarter, accounting for approximately 35% of our total third quarter lock volume and up 33% in the second quarter. The overall growth trends in Choice remain compelling. Through the first nine months of 2018 we have purchased $1.8 billion of Choice loans, up over twofold from the same period last year.
The nature of our pipeline in the third quarter continued to reflect the overall market trend of heavier purchase money volume. 75% of our volume represented purchase money transactions versus 73% in the second quarter and 64% for full year 2017. Overall through the end of the third quarter, our total year-to-date purchase volume and mortgage banking was $5.6 billion.
I’ll conclude with an update on our partnership with 5 Arches. We funded our first single family rental loans in the third quarter and have a growing pipeline we expect to purchase in the coming months. Overall, we continue to observe a deep addressable market in the single family rental sector, with recent events, most notably the FHFA decision that Chris alluded to potentially expanding our opportunities there.
Well it is uncertain if and when the FHFA will reconsider a role for the GSEs in this asset class. We view this development positively as it relates to Redwood’s strategic positioning in single family rental.
Overall our partnership with 5 Arches positions us well to be a solutions provider to several areas within business purpose real estate lending and we believe the integration of these new loan types with our platform will drive additional scale and continue to enhance our value to the marketplace.
Now to recap our financial results, I'm going to turn over to Collin Cochrane, Redwood’s Chief Financial Officer.
Thank Dash and good afternoon everyone. To summarize our financial results for the third quarter, our GAAP earnings were $0.42 per share compared with $0.38 in the second quarter and core earnings were $0.39 per share compared with $0.41 in the second quarter.
Our third quarter results reflect the benefit from increases capital deployment, improved asset pricing and solid mortgage banking results. Additionally, we experienced an increase in gains realized from security sales relative to the second quarter as we continue to focus on portfolio optimization.
Our GAAP book value increased $0.19 to $16.42 per share at September 30, and when combined with our quarterly dividend of $0.30 per share, it generated a total economic return of 3% for the quarter and 9.3% year-to-date through September.
As we've noted previously, our investment in hedging strategy makes our portfolio less sensitive to changes in interest rates and our overall book value was minimally impacted by rising rates during the quarter.
On a hedge adjusted basis, we saw an overall benefit from fair value changes during the third quarter, driven mostly by modest improvements in CRT and multifamily spreads. Additionally our hedges effectively served to insulate our net interest margins from rising rates on our variable rate debt. Although GAAP net interest income was flat quarter-over-quarter, when including the impact from hedges we saw an increase due the benefit from capital deployment and continued portfolio optimization.
To help analyzes this impact, in the third quarter we introduced a new non-GAAP measure economic net interest income, which we define as GAAP net interest income, plus the net interest paid or received on hedges, as well as the change in basis for fair value investments. More detail on this metric is included in the appendix section of the Redwood Review.
In addition to the new metric in this quarter's review we've expanded our disclosures for core earnings by showing a full core income statement to better present the impact of adjustments we make for core earnings.
One final change to our financials we’d like to highlight this order is the consolidation of two Freddie Mac case series securitization that resulted from a recent investment in the big pieces of these deals. While our economic investment in the securitization is $67 million GAAP requires us to consolidate about $950 million of multifamily loans and $875 million of ABS debt on to our financial statements.
I’ll also point out that an additional impact on the consolidation of these two deals, as well as our recent choice securitization was to cause a notable increase in our gross interest income and interest expense.
The net interest income from these consolidated deals represents the interest income on the securities we actually own. Additional information on these investments and their impact to our financial statements is included in the review.
Shifting to the taxable side for a moment, our total taxable income was $0.48 per share for the third quarter, a small decrease from the second quarter, mainly reflecting dilution from our recent equity raise.
Focusing specifically on retaxable income, while we saw a small dip in the third quarter due to some non-recurring expenses, year-to-date retaxable income of $1.06 per share has exceeded our dividends of $0.88 per share, and as a result we expect to utilize a portion of our $55 million NOL at the REIT in 2018.
Turning to the balance sheet and our capital position, we ended the quarter with about $150 million of capital available for investment. In addition to this available capital, we believe we have $100 million to $150 million of capital that is in a good position be optimized or expect this capital will be sufficient to meet our near term needs. To the extent we seek additional capital to fund our operations and investment activities, our approach to raising capital continued to be based on what we believe to be in the best interest of our shareholders.
Regarding leverage, our recourse debt to equity leverage ratio was 3.1x at the end of the third quarter. Although our strong capital deployment during the quarter left us with less available capital than the prior quarter end, we saw leverage decline primarily due to a lower balance of loans held for sale at quarter end relative to the prior quarter. We do expect leverage to increased modestly in the next few months as we fully deploy our access capital towards new investment.
I’ll close with our 2018 financial outlook. In summary, our year-to-date results have already exceeded our expected annual dividend payments of $1.18 per share and we remain on track to meet the full year operational targets we provided in our fourth quarter 2017 Redwood Review. We expect to provide an updated outlook for 2019 when we issue our fourth quarter Redwood Review.
And with that, I'll conclude our prepared remarks. Operator, why don’t we start the Q&A?
Thank you. [Operator Instructions] And we’ll go first to Bose George with KBW.
Hey guys, this is Tommy on for Bose. Just wanted to ask a question about you excess capital. How much exactly do you guys have available for deployment right now and could you just sort of discuss where you see the best opportunities in the market today?
We have about $150 million of available capital and that is the capital that we have available for deployment at September 30. And in terms of opportunities, I think it's the you know same fundamental opportunities we've been talking about and that we mentioned here in the third quarter and additionally we mentioned one new investment that we put a $57 million deposit on that we do expect to fund an additional $75 million on in the fourth quarter.
Hey Tommy, it’s Dash. Just to piggy back those comments, I think it’s consistent with where we’ve been discussing the last several quarters in terms of the parts of the market where our capital can be of most used than most accretive for shareholders. So things like business purpose lending, like single family rental and fix and flip, obviously continue to deploy capital into the Choice securities and select securities the we create off of Sequoia, you know those are all things that we've been doing.
Collin alluded to the incremental investment of reperforming loans. I think semantically again its areas where we see more opportunity that are less efficiently financed and that we can leverage our existing infrastructure and credit acumen. I think we’ve began to execute there. I think the third quarter was some really, really strong momentum and where we spent our time in the third quarter I think is generally indicative of where we see the most compelling opportunities at the moment.
That’s great. And going in a different direction, now that we’ve had some spread lines since quarter-end, as well as some volatility, do you have any sort of indication as to what’s happened to book value quarter-to-date since 930 and then I guess to kind of piggy backing off that, has that spread widening since quarter end created any better opportunities in any particular markets that you can think of?
Hey, it’s Chris. You know book might be down 1%, I don't think it's down materially since September 30 you know, and we saw mortgages have a great day today. So we still got some time before the end of the year.
As far as opportunities go, you know we are still very engaged with specific counter parties that we alluded to in the script trying to follow on from what we did in the third quarter. So you know again the business purpose lending and certainly Sequoia, we are still active and to the extent that we can find you know some bonds cheaper or opportunities you know to put more capital to work, that's what we are going to do.
[Operator Instructions] We’ll go next to Steve DeLaney with JMP Securities.
Hey, thanks guys, and congratulations on the record capital deployment in the quarter. So not surprising given where rates have moved, but we are hearing among the origination community, the folks that we cover there, that its really tough out there and I know you worked with banks, you also work with private mortgage bankers. Dash, I guess I'm just curious if you're seeing any fallout from some of your previous customers, anybody shutting down or scaling back and maybe if you could give us a head count or just an updated count on how many active sellers, how many correspondence you have today? Thanks.
Sure Steve. So obviously as you know we track both qualitatively and quantitatively, you know where our sellers are, how their financials are evolving, and you are right, we hear a common theme from folks who we talk to that this has been a tough point in the market. Obviously it’s open for debate. How long it will be here, but it is striking that there is a relatively low percentage and certainly versus the past few years of the percentage of mortgage loans that are currently refinanceable.
We are starting to see evidence and everyone sort of goes at their own tempo, that capacity is being right sized for where the opportunities are in the market. You can see as the financials come through, through the end of the third quarter that cost and expense ratios are gradually coming more into line. Obviously that’s a broad statement. Like I said, everyone’s different, everyone moves at their own pace. But we are definitely seeing progress toward adjusting and obviously we've all seen this before and so that progress isn’t necessarily surprising.
You know I do think like I said that this sort of environment reinforces the value of our platform and if you're a mortgage banker or a bank that is dealing with operating costs and overhead, it's that much more valuable to deal with a counterparty like Redwood because of our product diversity, because of our ability to close quickly. You know us being able to close loans in half the time or less than some of our peers is usually valuable to folks, particularly at this point in time, because it allows them to recycle their equity more quickly and continue to invest in their business and just manage where we are in the cycle.
So while it’s been hard for everyone, I think these are the times where our relative value is probably higher frankly than at another point in the cycle.
I think you make a great. Go ahead I’m sorry.
Well, sorry Steve. I was just going to say our headcount for sellers is still around 188, so that hasn’t really changed materially.
Okay, great, thank you for that. And listen, I don't know when you guys posted this year when you went through the management change and you went through sort of the – added the new products sort of expanding the product mix if you will, but it strikes me, you know if I didn't know better I would have thought you had a crystal ball and somebody told you that the tenure was you know was going up 40, 50 basis points, because it strikes me that your new products, especially the business purpose mortgages and you know to a degree choices as well, although I realize choice was a concept that goes back a year or more.
But it strikes me that those products verses select, those borrowers may be less rate sensitive than a select borrower you know probably looking to refi or whatever and I'm just curious if you see it that way. That the diversity not only gives you more product but does it possibly make you less rate sensitive if you will in terms of the impact on originations?
Hey Steve, I’ll take that one. It’s Chris. Yeah, I mean we spent a lot of time in formulating you know this evolution of our strategy and we felt really good that you know at our core we are a specialty finance firm and there's going to be areas in the market that we can offer solutions, that really get back to the competencies of the firm, which is credit and structuring.
And you know our big goal was you know to be able to implement a strategy that could withstand the turns in the mortgage business and really leverage you know those competencies. So when you think about the business purpose lending and fix and flip in particular where the terms of those mortgages are a lot shorter and then certainly you know some of the expanded credit products like Choice, all of these types of you know solutions really get to some of the underserved parts of the market. And so well, Select is always going to be a key aspect of what we do I think, the goal is to really as you said diversify the asset base and I think that will result in a more durable earning stream over time.
Yes, I mean do you see those borrowers as slightly less rate sensitive than you would say your profile of your Select borrower, or is that – am I stretching on them.
No, I think that's fair. These are folks that credit aspects and the solutions that we can provide on a case by case basis are what’s meaningful. I think Select, Select is more or less a purchase market today and you know I think refis are at pre-crises lows. So that’s a market where we are always going to focus on, but really the opportunities in multifamily and single family rental and where folks move to when affordability to purchase a home becomes difficult, that's what's really exciting about the evolution of platform to us and if we can continue to penetrate and grow those markets, I think you know shareholders will be happy.
Steve, its Dash, there’s one thing I would add. On the business focus side, you know those borrowers, whether it's a single family rental product or fix and flip product, clearly rate matters, but when you think about what those businesses are or what those products do, they finance people's business plans if someone is redeveloping a home, if someone is trying to finance a portfolio, stabilize properties to rent out on a longer term basis and those borrowers respond much more favorably to speed and reliability and service.
You know the proceeds are needed by certain point in time and many of those are repeat customers. Obviously folks that are investing in real estate or for rent or more transitionally a lot of times that use the proceeds to grow their business and reequitize or equitize new projects and creating demand for more debt and we’ve that in 5 Arches pipeline, a really high percentage of their customers are repeat business which is a great rest mitigate tool, but also really it’s a positive snowball effect for growth in the business. So I think business purpose in particular is really much more service oriented than it is cost of funds.
Got it. Makes sense, and just to close out one quick one for Collin, Collin operating expenses up $2 million to 21. Anything we should highlight in there or just volume related.
Yeah, I think we did see a little tick-up in expenses related to some of this new business activity, getting some of these new businesses up and running. We saw a little bump in that this quarter, so I don't think we’d expect to see that continue to carry forward and also the variable comp was up a little bit, just in line with the higher overall earnings for the quarter. So I think those two things are really what moved the needle this year around.
I appreciate the comments. Good quarter guys.
[Operator Instructions]. We’ll go next to Stephen Laws with Raymond James.
Hi, good afternoon. Thanks for taking the time for my questions and congratulations on a consistent book value growth. I know that’s certainly something that differentiates you from many other mortgage investors out there.
You touched on a good bit with the previous answer from Steve, but you know it looks like the proprietary deal flow is really driving capital deployment. The third party investment activity over the last number quarters has been remarkably consistent. Is that a level of third party activity you think will continue, is that something you think will decline just given where we are in the cycle for housing or how do you think about third party investment activity as we look into next year.
Hi Steven. I think the goal is has been to pick up the pace for starters, so we are operating with I think greater urgency overall as a firm. But really I think the deployment is going to be dependent upon the cultivation of some of these relationships as we mentioned in our opening remarks. So we got a lot of traction with a few different counter parties and we think deals beget deals, so overall you know certainly the goal, you know the stated goal as part of the vision is to really start to scale platform and we’ve had a bump in overhead or operating expenses I should say. I think over time you know that pace of deployment should service well.
So overall I think you know the pace should be something that we focus on going forward, and as far as 2019 goes, we typically offer much more specific guidance with our fourth quarter review.
Sure and just following-up on the business purpose loans you know are you guys tied exclusively to only buying those production from 5 Arches. Can you buy from other originators there and if so are you doing that or is 5 Arches going to meet the volume to support the growth that you want in that asset class.
Hey Steven, its Dash. So the way it’s currently structured, so we are not exclusive to that. We can purchase those sort of mortgage loans from whomever we chose and frankly the news out of the FHFA in August that Chris and I touched on could create an opportunity to do that. They are exclusive to us, the way our arrangement works with them. Obviously as you are aware we have an option to purchase the remainder of their platform through the end of April of next year, but in this period and through that end date we have exclusively to purchase their single family rental loans and obviously we've made an initial investment in some of their fix and flip production. But we are not bound to them exclusively.
I appreciate the color there. I knew they were exclusive to you, I didn’t know if that went both ways, so I appreciate the color there. And then for clarification I wanted to make sure. I was going down a lot of numbers as far as capital deployment, but in summary you guys had a $150 million at quarter end with a $75 million obligation for funding in Q4 and then you had an additional $100 million to $150 million of capital invested in securities that could be freed up for reallocation if you choose to do that. Is that a fare summary?
Yeah, you got all the numbers right.
Okay, just wanted to double check. Great! Good speaking with you guys again and congratulations on a nice quarter.
Thanks a lot.
And ladies and gentlemen that will conclude today’s conference. We thank you for your participation. You may now disconnect.