Redwood Trust (RWT) Q1 2019 Earnings Call Transcript

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Redwood Trust (RWT 1.50%)
Q1 2019 Earnings Call
May. 08, 2019, 5:00 p.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good afternoon, and welcome to the Redwood Trust, Incorporated first-quarter 2019 financial results conference call. [Operator instructions] Today's conference is being recorded. I'll now turn the call over to Lisa Hartman, Redwood senior vice president and head of investor relations, for opening remarks and introductions. Please go ahead.

Lisa Hartman -- Senior Vice President and Head of Investor Relations

Thank you, James. Hello, everyone. Thank you for participating in Redwood's first-quarter 2019 financial results call. Joining me on the call today are Chris Abate, Redwood's chief executive officer; Dash Robinson, Redwood's president; and Collin Cochrane, Redwood's chief financial officer.

Before we begin, I want 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 management analyze 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 available on our website. Also note that the content of this conference call contains time-sensitive information that is accurate only as of today, May 8, 2019.

The company does not intend and undertakes no obligation 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.

Chris Abate -- Chief Executive Officer

Thanks, Lisa, and good afternoon, everyone. Our first-quarter results reflected both strong operational performance and improved market conditions. Mortgage industry began 2019 focused on the prior year's volatility and concerns over rate hikes and low refinance activity. As quickly as the reckoning was to begin, revised signaling from the federal benchmarks and mortgage rates precipitously lower.

The much anticipated corporate earnings season yielded strong results, and the IPO market became quite active. Closer to home, lower mortgage rates coincided with the spring selling season to provide a much needed boost to the housing market. All told, we view the current market sentiment as markedly improved versus where we started the year. That said, we are managing the business with cautious optimism acknowledging that rates can move quickly, and that there is continued volatility in the broader markets in response to news from the Fed and current trade talks.

While we closely monitor the macro environment, the first quarter was an especially busy one for us as we continue to execute on our strategic initiatives. Our GAAP book value increased to $16 per share in the first quarter, primarily driven by strong GAAP earnings that exceeded our dividend. Our Non-GAAP core earnings of $0.36 per share were down slightly versus the fourth quarter as variable compensation normalized, and we work to deploy the proceeds of our first-quarter equity offering. So like GAAP, our quarter earnings also comfortably exceeded our quarterly dividend.

At our second annual Investor Day held in March, I laid out a bold vision for the company, the essence of which is the following. Residential loans change hands away from government supported entities, we participate profitably in some form or fashion. This vision has informed our strategic initiatives, the key ingredients of which include the following: one, expanding our reach across all major thruways of housing finance, offering a range of loan solutions not only to consumers, but also to a growing segment of investors who renovate and/or rent single family, or multifamily dwellings. Two, scaling our platform to grow profitably including buying and selling loans faster through operational efficiencies and technology, and by turning our capital over more quickly to boost returns.

Three, turbo-charging our investing activity and taking an engineered approach to capital allocation and leverage, while staying extremely disciplined to the risk management framework that has sustained us over multiple cycles in the past 25 years. And four, leveraging our growing voice in Washington advocating for regulatory base and administrative reforms that will promote a major leveling of the playing field between the private and public housing finance sectors. Importantly, we did not consider this final point as a prerequisite to achieving our vision, but we have new found optimism that it can significantly accelerate our path to getting there. Over the past year, we've made progress in all of these fronts.

Foundational work started with building or enhancing key strategic relationships both in the public and private sectors, and we guide our capital toward its highest and best use. These efforts have helped us to significantly grow and extend our portfolio with long-term durable streams of cash flows. And we continue to leverage our team's ability to source and structure opportunities that our competitors cannot easily replicate. During the first quarter, we deployed 163 million of capital and made meaningful progress toward the optimization of our portfolio through different financing structures.

There's still plenty of room to do more as Dash and Collin will address in their remarks. We also close the acquisition of 5 Arches in March, and work is now under way to fully integrate the platform. Our measured incremental approach to this transaction allow us to add a highly accretive and scalable platform to our portfolio, while also helping to ensure that the acquisition is the long-term success for stakeholders of both the Redwood and 5 Arches. Combination of our respective businesses is truly strategic.

Rather than just acquiring a pool of assets, we've significantly accelerated our penetration into the business purpose, real estate lending space, and are now in a much better position to further scale our platform in pursuit of our vision. Turning to our traditional mortgage banking business, we generated strong margins at a time when volumes remained very challenging for the industry. Our Redwood Choice program continues to be a meaningful contributor to earnings as gross margins on these loans were significantly higher than the returns we saw from traditional jumbo loans. We're also identifying new sources of demand for residential credit that will further bolster our condos liquidity.

Our ability to increase capital efficiency as we grow our asset base is starting to untap some of the significant earnings potential that remains embedded in the business. The quality of our choice program and our leadership position in non-QM loan acquisitions and distributions has helped us to emerge as the powerful voice in Washington on behave of private capital. Last month, Mark Calabria was confirmed as the new director of the Federal Housing Finance Agency, and the Trump administration directed both treasury and HUD to develop and submit housing finance reform plans as soon as practicable. We believe we are ideally positioned to take advantage of any reforms that promote a leveling of the playing field between the public and private sectors.

We continue to highlight the strength and durability of Redwood's platform to policy makers as an example of private sector leadership that can offer real solutions to the issues confronting regulators today including the so-called QM patch. With over 50 securitizations completed since the financial crisis, by far the most of any private sector issuer, we've demonstrated the strong demand from PLS investors and emphasized the need for policies that will make room for private capital and not crowd us out. We note that for the first time in many years, the private sector is speaking for an increasing share of loans that are eligible for sales to the GSEs, and we believe they can speak for more without a meaningful impact in rate to the borrower. Before I turn it over to Dash and Collin, I'd sum things up by saying that we exited the first quarter more optimistic about 2019 than we began it.

Our second-quarter loan purchase activity is on pace to significantly exceed the first quarter's, and we expect the pace of capital deployment to increase over the course of 2019. The biggest driver for returns in our portfolio is credit performance, which remains very strong. As we continue to allocate capital in areas with highest returns and gain access to proprietary investments, we will remain focused on creating durable long-term cash flows and optimizing our balance sheet to support a sustainable higher dividend. With that, I'll now turn the call over to Dash Robinson, Redwood's president.

Dash Robinson -- President

Thank you, Chris, and good afternoon, everyone. We continue to make meaningful progress executing on our strategic initiatives aimed at expanding our platform to serve growing areas of the housing market. We remain focused on efficiently allocating our capital into underserved areas of housing finance that we believe will deliver strong risk-adjusted returns for our shareholders. To this end, the first quarter of 2019 was highlighted by the closing of the acquisition of 5 Arches, a key milestone for Redwood.

As Chris noted, 5 Arches is a leading originator of what we call business purpose real estate loans. Namely loans made to investors and single family and small-ticket multifamily real estate. As a complement to our core residential mortgage banking activities, we view the competencies of the 5 Arches platform as particularly relevant in a housing market that continues to be categorized by uncertain trends in the homeownership rate, and an acute supply demand imbalance at more affordable price points. While the integration is still under way, we are already seeing the 5 Arches platform contribute positively to our overall mortgage banking results and accretive credit investments for our portfolio.

Of note, we expect to continue purchasing 100% of the platform single-family rental production, and have begun allocating more capital to short-term real estate bridge loans that 5 Arches originate. Turning to our residential mortgage banking business, first-quarter results reflected the benefits of improved market conditions, but also the impacts of seasonality, and higher mortgage rates at several points during the quarter. Residential mortgage banking volumes for the first quarter totaled $1 billion, and during the quarter, we executed one select and one choice securitization. Notwithstanding the volume decrease, mortgage banking revenues for the first quarter were up versus the fourth quarter with strong gross margins in excess of the long-term target range of 75 to 100 basis points to which we continue to manage the business.

This outperformance was driven in part by Redwood Choice, our expanded prime offering, which represented 44% of the first-quarter lock volume. Execution of our choice securitization was particularly strong reflective of growing investor appetite for well-underwritten loans that fall outside of traditional bank prime jumbo guidelines. Notably, since the beginning of 2018, close to 40% of our choice production are non-qualified mortgages, many to borrowers with debt to income ratios above the level prescribed by the ability to repay loans. Acceptance from private label securitization investors for these loans continues to broaden, underscoring Chris's earlier remarks about the ability of the private market to continue speaking for more and more of the GSE's current footprint without a substantial impact on rates available to borrowers.

Complementing strength in the securitization markets has continued robust demand from our whole-loan buyers. Whole-loan sales representative 41% of our total distribution in the first quarter. We continue executing on our plan to reallocate residential mortgage banking capital to other areas of our business, and the increase in volumes we have seen thus far in the second quarter demonstrates our ability to support higher levels of mortgage banking activity without the need for additional capital. Turning to our portfolio, we deployed $163 million of capital in the first quarter, with a recurring theme of investments weighted toward unique opportunities that others cannot easily access.

Highlights of our first-quarter investments include a 78 million-dollar commitment to a fund setup to purchase short-term floating rate light renovation multifamily loans from Freddie Mac. We funded approximately $22 million of this commitment in the first quarter. Over time, there will be the opportunity to convert the fund investment into subordinate securities issued from one or more Freddie Mac sponsored securitization. Portfolio also invested $11 million in capital across our two Sequoia.

Additionally, during the quarter, we purchased $7 million of third party residential securities, $13 million of agency CRT securities, and $14 million of agency multifamily securities. The second quarter is off to a strong start from a deployment perspective, highlighted by a $70 million investment in an additional Freddie Mac multifamily BPs. More broadly, we continue to make progress on several new investment opportunities that should begin to bear fruit in the second quarter and later this year. We also continue to opportunistically rebalance the portfolio by rotating out of lower-yielding assets, and during the first quarter, captured $11 million of realized GAAP gains and freed up $33 million of capital for redeployment.

Portfolio sales were focused in seasoned agency CRT and legacy RMBS securities. The impact of which, Collin will describe in further detail. Realized gains also included the economic impact of calling a Sequoia securitization that was issued in 2012. Overall,, we remain pleased with the pace and substance of our capital deployment.

Portfolio construction remains top of mind, not only through a continued focus on strong credit performance, but also the appropriate mix of current cash-on-cash returns and embedded long-term upside through investments we made at a discount to par value. Now to recap our financial results, I'm going to turn it over to Collin.

Collin Cochrane -- Chief Financial Officer

Thanks, Dash, and good afternoon, everyone. To summarize our financial results for the first quarter, our GAAP earnings were $0.49 per share, compared with negative $0.02 in the fourth quarter, and core earnings were $0.36 per share, compared with $0.41 in the fourth quarter. The increase in GAAP earnings in the first quarter was primarily driven by a recovery in the value of our portfolio investments, driven by spread tightening and improved market conditions. Core earnings was supported by solid mortgage banking results and measured progress in economic net interest income growth, but declined quarter over quarter, primarily due to higher variable compensation expense commensurate with higher quarterly GAAP earnings.

Of note this quarter for investment portfolio we saw a decline in GAAP net interest income and an increase in non-GAAP economic net interest income. This dynamic was accentuated this quarter as we experienced continued pay downs in sales available for sale securities, for which returns are reflected in net interest income being replaced with trading securities for which returns are reflected in net interest income and investment per value changes. To address this dynamic, we adjusted our calculation of core earnings and economic net interest income this quarter to more accurately capture the effective yield of some of our newer investments, including multifamily securities, certain reperforming securities, and our servicing advance investments. Going forward, we expect to see this dynamic continue, and we remain focused on growing economic net interest income. Moving on, our GAAP book value increased approximately 0.7% during the first quarter to $16 per share, which along with our dividend contributed to a 2.6% economic return for the quarter.

The increase in book value was primarily driven by positive market valuation adjustments on our portfolio of investments, which recovered a significant portion of the losses we experienced in the fourth quarter, offset by a decrease in the value of the long-term debt hedges, stock-based compensation distributions, and dilution from a January stocks issuances. As previously mentioned, we completed the acquisition of 5 Arches in March, and our results for the first quarter include the impact of purchase accounting, and one month of operating activity from the platform. The total impact to our first-quarter results from the acquisition was approximately $0.02 per share to GAAP earnings, and included $2.4 million of remeasurement gain, $600,000 of intangible amortization, and $1.5 million tax benefits. Each of which were excluded from our core earnings.

The operating activity from 5 Arches is included in our mortgage banking segment as a component of business purpose mortgage banking. Additional information on the acquisition is included in the Redwood review and will also be provided in our 10-Q. Turning to the balance sheet and our capital position, after raising approximately 180 million of equity capital in January, reducing the capital allocated to our residential mortgage banking business, and after taking investment activity into account, we estimate that at the end of March, we had approximately 100 billion of capital available for investment. Of note, we also had an additional 75 million in capital that was committed to investments over the last two quarters that remains to be invested and is not yet contributing to earnings.

We expect the bulk of this capital to be invested over the next few months. Looking forward, as we think about how to fund the growth of our asset base, our near-term focus is on fully deploying our available capital and generating capital through security sales, and new financing structures that will optimize our balance sheet. Further, while the capital markets are open to us to refinance our upcoming convert maturity, we're evaluating all our options and are focused on how we can fund our business most efficiently, including through the utilization of over 700 million of unencumbered securities we currently hold. On a related note regarding leverage, our recourse debt-to-equity leverage ratio was 2.9 times at the end of the first quarter.

The decline from the fourth quarter was driven by our issuance of common stock, as well as a lower balance of loans held for sale that were financed. We expect leverage to increase in the future as we continue to deploy capital and optimize our balance sheet. And over the longer term, we expect to operate with a recourse leverage ratio closer to our historical average of around 3.5 times. I'll close with our 2019 financial outlook, which overall we have not changed from what we published last quarter.

With the acquisition of 5 Arches, we do expect the composition of our income statements to change somewhat, with increases to run rates of our revenue line items and expense line items. Overall, however, the allocation of capital to the 5 Arches platform is relatively small, and our outlook in the beginning of the year accounted for the likelihood of this transaction. For the remainder of the year based on current forecasts, we expect to see increases to operating expenses of $4 million to $5 million per quarter, and the overall return expectations for the capital we've allocated to this platform are included in our Redwood review. And with that, I will conclude our prepared remarks.

Operator, please open the call for Q&A.

Questions & Answers:

Operator

Thank you. [Operator instructions] And we'll take our first question today from Doug Harter with Credit Suisse.

Unknown speaker

Hey, guys, this is actually Josh on for Doug. Thanks for taking the questions. Real quick on the 100 million of investable capital at the end of March and then also the 75 million that's been committed but not deployed, can you, guys, give us any idea of the pace of that deployment? Or maybe how the pipeline is looking quarter to date? Thanks.

Chris Abate -- Chief Executive Officer

Yes. What we said is we expect that the pace of deployment will pick up as we head into the second and third quarters. The first quarter, just from a seasonal perspective, is traditionally not a heavy quarter for us. That said, we think we have a fair amount of investable capital.

And I think a big aspect of our strategy will be in further optimizing our balance sheet. As Dash noted, there's quite a few levers that we can pull to the extent the pace of deployments picks up sooner than we would expect. So I think overall, we don't have a roadmap for the calendar. But we do feel like we've got the capital today to meet our near-term objectives.

Unknown speaker

Great. And then, looking at how the markets have performed year to date, how are you seeing the execution? Or how are you thinking about the trade-off between whole-loan sales versus securitizations? Thanks.

Dash Robinson -- President

Hey, it's Dash. I would say if you think about last year, for the preponderance of 2018, the execution via securitization was notably stronger than whole-loan sales. We discussed this a little bit last quarter as well. I think our view at this point is that those executions are relatively in parity with each other at this point.

That's driven in part by continued robust demand from bank balance sheet that we are delivering product into. Securitization markets have clearly found their footing year to date and have continued to strengthen here in the second quarter. But we continue to see strong opportunities to whole loans, and driven in part by our continued deepening of our whole loan buyers, and their continued confidence in our process. We are always going to focus on the best execution for any given loan or pool of loans.

But as we've said before, keeping the spigot open for whole-loan buyers is critically important and has served us very well in the past. And so we will continue to balance those considerations going forward.

Unknown speaker

Great, thanks, guys.

Operator

Next we'll hear from Bose George with KBW.

Bose George -- KBW -- Analyst

Yes. Good afternoon. Can you talk about how gain on sale margins are trending in the second quarter? And also just in the first quarter, was the gain on sale margin on the select product pretty stable and the improvement was on the choice side?

Chris Abate -- Chief Executive Officer

Yes, I think that's right. The select margins were stable. And the choice margins, like we said, those were strong, driven largely by the securitization execution that we had. But also we did in our production have an increasing amount of choice hybrids which we're able to sell on whole-loan form, as well, which represented good margins for us, too.

So it was really a mix of those things.

Dash Robinson -- President

Yes, I think one thing I'd add, Bose, is where we executed our last securitization where the market was at that time, AAAs were somewhere in the neighborhood of one and three quarters back of TBAs. I think the markets tightened, more or less, around a half a point since then. So, I think just observed market levels are quite a bit tighter, which all else equal be positive for margins.

Bose George -- KBW -- Analyst

OK, great. That's helpful. And then just in terms of the different opportunities out there that you're seeing, where do you feel sort of the best incremental returns are?

Chris Abate -- Chief Executive Officer

I think the view is, we continue to see probably the best risk adjusted returns in a few different areas, and obviously the market, in general, has tightened since the beginning of the year. So, first of all, in the multifamily space, we continue to deploy more capital, as I mentioned in my prepared remarks, into the Freddie Mac programs. We purchased other BPs earlier this quarter with a pretty substantial capital allocation of $70 million. We continue to really like the risk return in the Freddie Mac multifamily space in no small part by the continued strength of credit quality and the underwriting discipline that we can leverage by participating in Freddie's programs.

That's definitely a big one. The risk return on choice continues to be very, very strong. We talked about the margins there, and net of those margins we continue to retain the copies in the portfolio where we're very pleased with the return. And then thirdly, I would say, on the business purpose lending side with 5 Arches, we intent to allocate incremental capital above the $50 million we currently have allocated.

So their bridge products and are continuing to build our pipeline of single-family rental loans. On a stand-alone unlevered basis just from a whole loan perspective, we really like the returns in that space. And as I mentioned before on prior calls, the financing markets continue to mature, and at least at this point, continue to come our way in terms of opportunity to create better levered returns there. So I would say those are the areas where we are probably most focused at this point.

Bose George -- KBW -- Analyst

OK, great. Thanks. And actually just one more, in terms of book value since quarter end, any meaningful changes there?

Collin Cochrane -- Chief Financial Officer

At this point I don't expect book value to be down. It's a little early to give any guidance, but certainly spreads have generally tightened. And we've seen good liquidity in the markets we're focused in. So I think the trajectory, all else equal, I think is positive.

Bose George -- KBW -- Analyst

OK, great. Thanks.

Operator

We will now hear from Steve Delaney with JMP Securities.

Steve Delaney -- JMP Securities -- Analyst

Hey, guys I'm in the airport so I'm going to ask my question and drop off on mute, so you won't pick up all this background noise. Chris, I'm curious have you had the chance yet to meet Mark Calabria? And if so, anything that he may have said or you have read or heard where you might have any ideas about narrowing program to the agencies maybe besides maximum loan sizes, etc. Anything that you sense is possible to create more white space for the private sector in the residential mortgage market. Thanks, appreciate it.

Chris Abate -- Chief Executive Officer

Thanks for the question, Steve. I have had the opportunity to sit down one on one with Director Calabria, and I would say it's too early to get into any type of specifics on initiatives that might occur via regulatory changes. But I can't say and I think you can sight some of the interviews he has given that he is very focused on giving Congress an opportunity to act. But in the absence of action there are changes that can be made to level the playing field between the public and private sectors.

I do sense a market difference in approach, since the regime change, and there are opportunities such as the QM patch which is set to expire to really allow private capital to step in and be part of that solution. Certainly a number of focus areas that we think we can engage in Washington. And at this point, I think we're letting the new leaders sort of get comfortable in the positions. And over the next few months, hopefully, we can be of help.

Steve Delaney -- JMP Securities -- Analyst

Thanks, Chris. That's helpful.

Operator

Next we will hear from George Bahamondes with Deutsche Bank.

George Bahamondes -- Deutsche Bank -- Analyst

Hey, guys. Good afternoon. Just a point of clarity here. So you referenced the $100 million of available capital that the 75 million of committed capital is separate from that, so the 100 million is dry powder uncommitted or is it 75 million of committed capital accounted for in that $100 million that you referenced?

Collin Cochrane -- Chief Financial Officer

Yes, those are two separate amounts, George. We have the 100 million that is dry powder that we have available. And then the 75 million, we've already counted that and that's been committed. It just hasn't quite funded yet.

So as I mentioned in my remarks, we expect that to go out here in the next few months.

George Bahamondes -- Deutsche Bank -- Analyst

OK, great. And I know you referenced mortgage rates being down, and they've been down for a few weeks. Are you seeing maybe acceleration in an acquisition or refi volumes that are maybe materially different from maybe what you were seeing earlier this year, or is it not something that -- has a change not really been material from what you've been seeing as you been speak to folks you have relationships with.

Chris Abate -- Chief Executive Officer

Yes, we have noticed the change in refinance activity. It's not a major change it might be 70-30 purchased to 60-40 for us. We can check on that, I think the overarching point is we have observed the change -- not earth shattering. That said, we're pretty optimistic about where we see volumes in the near-term.

We've seen a steady trend month over month of increased volumes across the board. And so we're fairly optimistic that the lower rates are resulting in increased activity. And when you couple that with the traditional spring selling season, I think that's been a reversal from what we observed heading into the end of the year.

George Bahamondes -- Deutsche Bank -- Analyst

Got it, that's helpful. That's all for me today. Thank you.

Chris Abate -- Chief Executive Officer

Thank you.

Lisa Hartman -- Senior Vice President and Head of Investor Relations

All right. Operator, you can close the call.

Operator

[Operator signoff]

Duration: 32 minutes

Call participants:

Lisa Hartman -- Senior Vice President and Head of Investor Relations

Chris Abate -- Chief Executive Officer

Dash Robinson -- President

Collin Cochrane -- Chief Financial Officer

Unknown speaker

Bose George -- KBW -- Analyst

Steve Delaney -- JMP Securities -- Analyst

George Bahamondes -- Deutsche Bank -- Analyst

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