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REDWOOD TRUST INC - Quarter Report: 2019 June (Form 10-Q)

UNITED STATES OF AMERICA
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 

☒
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended: June 30, 2019

OR
☐
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
☐
Non-accelerated filer
o
 
Smaller reporting company
☐
 
 
 
Emerging growth company
☐
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 ☐ No x
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Trading symbol(s)
Name of each exchange on which registered
Common stock, par value $0.01 per share
RWT
New York Stock Exchange
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
 
97,715,021

shares outstanding as of August 5, 2019



REDWOOD TRUST, INC.
2019 FORM 10-Q REPORT
TABLE OF CONTENTS
 
 
 
 
Page
PART I —
FINANCIAL INFORMATION
 
 
Item 1.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
Item 3.
 
Item 4.
 
 
 
 
 
PART II —
OTHER INFORMATION
 
 
Item 1.
 
Item 1A.
 
Item 2.
 
Item 3.
 
Item 4.
 
Item 5.
 
Item 6.
 
 

i


PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In Thousands, except Share Data)
(Unaudited)
 
June 30, 2019
 
December 31, 2018
ASSETS (1)
 
 
 
 
Residential loans, held-for-sale, at fair value
 
$
1,056,287

 
$
1,048,801

Residential loans, held-for-investment, at fair value
 
6,227,078

 
6,205,941

Business purpose residential loans, at fair value
 
250,854

 
141,258

Multifamily loans, held-for-investment, at fair value
 
3,749,657

 
2,144,598

Real estate securities, at fair value
 
1,477,486

 
1,452,494

Other investments
 
372,130

 
438,518

Cash and cash equivalents
 
218,145

 
175,764

Restricted cash
 
33,953

 
29,313

Goodwill and intangible assets
 
50,999

 
—

Accrued interest receivable
 
54,265

 
47,105

Derivative assets
 
26,609

 
35,789

Other assets
 
334,123

 
217,825

Total Assets
 
$
13,851,586

 
$
11,937,406

 
 
 
 
 
LIABILITIES AND EQUITY (1)
 
 
 
 
Liabilities
 
 
 
 
Short-term debt, net (2)
 
$
2,462,885

 
$
2,400,279

Accrued interest payable
 
47,092

 
42,528

Derivative liabilities
 
173,847

 
84,855

Accrued expenses and other liabilities
 
117,428

 
78,719

Asset-backed securities issued, at fair value
 
6,913,129

 
5,410,073

Long-term debt, net
 
2,573,173

 
2,572,158

Total liabilities
 
12,287,554

 
10,588,612

Commitments and Contingencies (see Note 16)
 


 


Equity
 
 
 
 
Common stock, par value $0.01 per share, 270,000,000 and 180,000,000 shares authorized; 97,715,021 and 84,884,344 issued and outstanding
 
977

 
849

Additional paid-in capital
 
2,013,044

 
1,811,422

Accumulated other comprehensive income
 
48,923

 
61,297

Cumulative earnings
 
1,495,671

 
1,409,941

Cumulative distributions to stockholders
 
(1,994,583
)
 
(1,934,715
)
Total equity
 
1,564,032

 
1,348,794

Total Liabilities and Equity
 
$
13,851,586

 
$
11,937,406

——————
(1)
Our consolidated balance sheets include assets of consolidated variable interest entities (“VIEs”) that can only be used to settle obligations of these VIEs and liabilities of consolidated VIEs for which creditors do not have recourse to Redwood Trust, Inc. or its affiliates. At June 30, 2019 and December 31, 2018, assets of consolidated VIEs totaled $7,937,685 and $6,331,191, respectively. At June 30, 2019 and December 31, 2018, liabilities of consolidated VIEs totaled $7,189,086 and $5,709,807, respectively. See Note 4 for further discussion.
(2)
Includes $201 million of convertible notes, which were reclassified from Long-term debt, net to Short-term debt as the maturity of the notes was less than one year as of November 15, 2018. See Note 13 for further discussion.


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

2

REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands, except Share Data)
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(Unaudited)
 
2019
 
2018
 
2019
 
2018
Interest Income
 
 
 
 
 
 
 
 
Residential loans
 
$
77,288

 
$
55,514

 
$
153,238

 
$
105,745

Business purpose residential loans
 
3,996

 
—

 
6,785

 
—

Multifamily loans
 
35,917

 
—

 
57,305

 
—

Real estate securities
 
25,017

 
26,296

 
49,467

 
51,991

Other interest income
 
6,324

 
1,166

 
12,788

 
1,859

Total interest income
 
148,542

 
82,976

 
279,583

 
159,595

Interest Expense
 
 
 
 
 
 
 
 
Short-term debt
 
(24,275
)
 
(13,175
)
 
(46,493
)
 
(26,610
)
Asset-backed securities issued
 
(70,113
)
 
(16,349
)
 
(125,408
)
 
(27,750
)
Long-term debt
 
(21,832
)
 
(18,689
)
 
(43,595
)
 
(35,367
)
Total interest expense
 
(116,220
)
 
(48,213
)
 
(215,496
)
 
(89,727
)
Net Interest Income
 
32,322

 
34,763

 
64,087

 
69,868

Non-interest Income
 
 
 
 
 
 
 
 
Mortgage banking activities, net
 
19,160

 
10,596

 
31,469

 
37,172

Investment fair value changes, net
 
3,138

 
889

 
23,297

 
2,498

Other income, net
 
2,407

 
3,322

 
5,994

 
5,440

Realized gains, net
 
2,827

 
4,714

 
13,513

 
14,077

Total non-interest income, net
 
27,532

 
19,521

 
74,273

 
59,187

Operating expenses
 
(26,255
)
 
(19,009
)
 
(49,414
)
 
(42,039
)
Net Income before Provision for Income Taxes
 
33,599

 
35,275

 
88,946

 
87,016

Provision for income taxes
 
(2,333
)
 
(2,528
)
 
(3,216
)
 
(7,424
)
Net Income
 
$
31,266

 
$
32,747

 
$
85,730

 
$
79,592

 
 
 
 
 
 
 
 
 
Basic earnings per common share
 
$
0.31

 
$
0.42

 
$
0.88

 
$
1.02

Diluted earnings per common share
 
$
0.30

 
$
0.38

 
$
0.78

 
$
0.88

Basic weighted average shares outstanding
 
96,983,764

 
75,380,715

 
94,846,431

 
75,388,638

Diluted weighted average shares outstanding
 
130,696,954

 
100,431,993

 
128,499,431

 
104,291,180



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



3

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

(In Thousands)
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(Unaudited)
 
2019
 
2018
 
2019
 
2018
Net Income
 
$
31,266

 
$
32,747

 
$
85,730

 
$
79,592

Other comprehensive loss:
 
 
 
 
 
 
 
 
Net unrealized gain (loss) on available-for-sale securities
 
8,562

 
(3,104
)
 
15,280

 
(7,341
)
Reclassification of unrealized gain on available-for-sale securities to net income
 
(2,822
)
 
(4,748
)
 
(12,315
)
 
(14,135
)
Net unrealized (loss) gain on interest rate agreements
 
(9,501
)
 
3,417

 
(15,339
)
 
11,848

Total other comprehensive loss
 
(3,761
)
 
(4,435
)
 
(12,374
)
 
(9,628
)
Total Comprehensive Income
 
$
27,505

 
$
28,312

 
$
73,356

 
$
69,964




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 Three Months Ended June 30, 2019
(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
 
 
 
 
 
March 31, 2019
 
96,866,464

 
$
969

 
$
1,996,358

 
$
52,684

 
$
1,464,405

 
$
(1,964,489
)
 
$
1,549,927

Net income
 
—

 
—

 
—

 
—

 
31,266

 
—

 
31,266

Other comprehensive loss
 
—

 
—

 
—

 
(3,761
)
 
—

 
—

 
(3,761
)
Issuance of common stock
 
791,191

 
8

 
12,503

 
—

 
—

 
—

 
12,511

Direct stock purchase and dividend reinvestment plan
 
—

 
—

 
—

 
—

 
—

 
—

 
—

Employee stock purchase and incentive plans
 
57,366

 
—

 
18

 
—

 
—

 
—

 
18

Non-cash equity award compensation
 
—

 
—

 
4,165

 
—

 
—

 
—

 
4,165

Common dividends declared ($0.30 per share)
 
—

 
—

 
—

 
—

 
—

 
(30,094
)
 
(30,094
)
June 30, 2019
 
97,715,021

 
$
977

 
$
2,013,044

 
$
48,923

 
$
1,495,671

 
$
(1,994,583
)
 
$
1,564,032

For the Six Months Ended June 30, 2019
(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, 2018
 
84,884,344

 
$
849

 
$
1,811,422

 
$
61,297

 
$
1,409,941

 
$
(1,934,715
)
 
$
1,348,794

Net income
 
—

 
—

 
—

 
—

 
85,730

 
—

 
85,730

Other comprehensive loss
 
—

 
—

 
—

 
(12,374
)
 
—

 
—

 
(12,374
)
Issuance of common stock
 
12,291,191

 
123

 
189,985

 
—

 
—

 
—

 
190,108

Direct stock purchase and dividend reinvestment plan
 
399,838

 
4

 
6,303

 
—

 
—

 
—

 
6,307

Employee stock purchase and incentive plans
 
139,648

 
1

 
(1,921
)
 
—

 
—

 
—

 
(1,920
)
Non-cash equity award compensation
 
—

 
—

 
7,255

 
—

 
—

 
—

 
7,255

Common dividends declared ($0.60 per share)
 
—

 
—

 
—

 
—

 
—

 
(59,868
)
 
(59,868
)
June 30, 2019
 
97,715,021

 
$
977

 
$
2,013,044

 
$
48,923

 
$
1,495,671

 
$
(1,994,583
)
 
$
1,564,032

For the Three Months Ended June 30, 2018
(In Thousands, except Share Data)
 
Common Stock
 
Additional
Paid-In
Capital
 
Accumulated
Other
Comprehensive
Income
 
Cumulative
Earnings
 
Cumulative
Distributions
to Stockholders
 
Total
(Unaudited)
 
Shares
 
Amount
 
 
 
 
 
March 31, 2018
 
75,703,107

 
$
757

 
$
1,661,701

 
$
80,055

 
$
1,337,186

 
$
(1,859,716
)
 
$
1,219,983

Net income
 
—

 
—

 
—

 
—

 
32,747

 
—

 
32,747

Other comprehensive loss
 
—

 
—

 
—

 
(4,435
)
 
—

 
—

 
(4,435
)
Employee stock purchase and incentive plans
 
39,612

 
—

 
89

 
—

 
—

 
—

 
89

Non-cash equity award compensation
 
—

 
—

 
3,959

 
—

 
—

 
—

 
3,959

Common dividends declared ($0.30 per share)
 
—

 
—

 
—

 
—

 
—

 
(23,388
)
 
(23,388
)
June 30, 2018
 
75,742,719

 
$
757

 
$
1,665,749

 
$
75,620

 
$
1,369,933

 
$
(1,883,104
)
 
$
1,228,955


5

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

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

 
$
766

 
$
1,673,845

 
$
85,248

 
$
1,290,341

 
$
(1,837,913
)
 
$
1,212,287

Net income
 
—

 
—

 
—

 
—

 
79,592

 
—

 
79,592

Other comprehensive loss
 
—

 
—

 
—

 
(9,628
)
 
—

 
—

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

 
1

 
(195
)
 
—

 
—

 
—

 
(194
)
Non-cash equity award compensation
 
—

 
—

 
7,633

 
—

 
—

 
—

 
7,633

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

 
—

 
—

 
(15,544
)
Common dividends declared ($0.58 per share)
 
—

 
—

 
—

 
—

 
—

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

 
$
757

 
$
1,665,749

 
$
75,620

 
$
1,369,933

 
$
(1,883,104
)
 
$
1,228,955




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


6


REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)
(Unaudited)
 
Six Months Ended June 30,
 
2019
 
2018
Cash Flows From Operating Activities:
 
 
 
 
Net income
 
$
85,730

 
$
79,592

Adjustments to reconcile net income to net cash used in operating activities:
 
 
 
 
Amortization of premiums, discounts, and securities issuance costs, net
 
144

 
(7,963
)
Depreciation and amortization of non-financial assets
 
696

 
582

Originations of held-for-sale loans
 
(84,924
)
 
—

Purchases of held-for-sale loans
 
(2,534,886
)
 
(3,772,494
)
Proceeds from sales of held-for-sale loans
 
2,123,794

 
2,966,508

Principal payments on held-for-sale loans
 
49,894

 
30,656

Net settlements of derivatives
 
(25,751
)
 
40,426

Non-cash equity award compensation expense
 
7,255

 
7,633

Market valuation adjustments
 
(48,172
)
 
(34,136
)
Realized gains, net
 
(13,513
)
 
(14,077
)
Net change in:
 
 
 
 
Accrued interest receivable and other assets
 
(108,985
)
 
32,478

Accrued interest payable and accrued expenses and other liabilities
 
(9,744
)
 
(3,582
)
Net cash used in operating activities
 
(558,462
)
 
(674,377
)
Cash Flows From Investing Activities:
 
 
 
 
Originations of loans held-for-investment
 
(84,638
)
 
—

Purchases of loans held-for-investment
 
(49,489
)
 
—

Proceeds from sales of loans held-for-investment
 
2,780

 
—

Principal payments on loans held-for-investment
 
619,085

 
335,720

Purchases of real estate securities
 
(242,970
)
 
(319,975
)
Purchases of multifamily securities held in consolidated securitization trusts
 
(68,601
)
 
—

Proceeds from sales of real estate securities
 
241,217

 
352,563

Principal payments on real estate securities
 
39,041

 
33,974

Purchases of servicer advance investments
 
(68,976
)
 
—

Principal repayments from servicer advance investments
 
111,662

 
—

Acquisition of 5 Arches, net of cash acquired
 
(3,714
)
 
—

Net investment in participation in loan warehouse facility
 
38,209

 
(34,333
)
Net investment in multifamily loan fund
 
(28,673
)
 
—

Other investing activities, net
 
(7,616
)
 
(3,935
)
Net cash provided by investing activities
 
497,317

 
364,014

Cash Flows From Financing Activities:
 
 
 
 
Proceeds from borrowings on short-term debt
 
2,731,731

 
3,219,350

Repayments on short-term debt
 
(2,675,308
)
 
(3,731,917
)
Proceeds from issuance of asset-backed securities
 
330,534

 
925,845

Repayments on asset-backed securities issued
 
(416,789
)
 
(181,781
)
Proceeds from issuance of long-term debt
 
—

 
199,000

Deferred long-term debt issuance costs paid
 
—

 
(4,940
)
Net proceeds from issuance of common stock
 
198,333

 
177

Net payments on repurchase of common stock
 
—

 
(16,315
)
Dividends paid
 
(59,868
)
 
(45,191
)
Other financing activities, net
 
(467
)
 
(608
)
Net cash provided by financing activities
 
108,166

 
363,620

Net increase in cash, cash equivalents and restricted cash
 
47,021

 
53,257

Cash, cash equivalents and restricted cash at beginning of period (1)
 
205,077

 
146,807

Cash, cash equivalents and restricted cash at end of period (1)
 
$
252,098

 
$
200,064


7


REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)

(In Thousands)
(Unaudited)
 
Six Months Ended June 30,
 
2019
 
2018
Supplemental Cash Flow Information:
 
 
 
 
Cash paid during the period for:
 
 
 
 
 Interest
 
$
203,086

 
$
83,781

 Taxes
 
4,158

 
3,722

Supplemental Noncash Information:
 
 
 
 
Real estate securities retained from loan securitizations
 
$
5,462

 
$
43,513

Retention of mortgage servicing rights from loan securitizations and sales
 
868

 
—

Consolidation of multifamily loans held in securitization trusts
 
1,481,554

 
—

Consolidation of multifamily ABS
 
1,408,002

 
—

Transfers from loans held-for-sale to loans held-for-investment
 
518,521

 
1,069,326

Transfers from loans held-for-investment to loans held-for-sale
 
22,808

 
—

Transfers from residential loans to real estate owned
 
5,098

 
1,835

Right-of-use asset obtained in exchange for operating lease liability
 
13,016

 
—

(1)
Cash, cash equivalents, and restricted cash at June 30, 2019 includes cash and cash equivalents of $218 million and restricted cash of $34 million, and at December 31, 2018 includes cash and cash equivalents of $176 million and restricted cash of $29 million.

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

8

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)




Note 1. Organization
Redwood Trust, Inc., together with its subsidiaries, is a specialty finance company focused on making credit-sensitive investments in single-family residential and multifamily 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 portfolio 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 residential loans and their subsequent sale or securitization, as well as through the origination of business purpose residential loans.
Redwood Trust, Inc. has elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Internal Revenue Code”), beginning with its taxable year ended December 31, 1994. We generally refer, collectively, to Redwood Trust, Inc. and those of its subsidiaries that are not subject to subsidiary-level corporate income tax as “the REIT” or “our REIT.” We generally refer to subsidiaries of Redwood Trust, Inc. that are subject to subsidiary-level corporate income tax as “our operating subsidiaries” or “our taxable REIT subsidiaries” or “TRS.”
Redwood was incorporated in the State of Maryland on April 11, 1994, and commenced operations on August 19, 1994. References herein to “Redwood,” the “company,” “we,” “us,” and “our” include Redwood Trust, Inc. and its consolidated subsidiaries, unless the context otherwise requires.
Note 2. Basis of Presentation
The consolidated financial statements presented herein are at June 30, 2019 and December 31, 2018, and for the three and six months ended June 30, 2019 and 2018. 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, 2018. In the opinion of management, all normal and recurring adjustments to present fairly the financial condition of the company at June 30, 2019 and results of operations for all periods presented have been made. The results of operations for the three and six months ended June 30, 2019 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 Freddie Mac K-Series securitizations beginning in the third quarter of 2018, and the assets and liabilities of one Freddie Mac SLST securitization beginning in the fourth 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 purchased or 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.

9

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)
Note 2. Basis of Presentation - (continued)

For financial reporting purposes, the underlying loans owned at the consolidated Sequoia and Freddie Mac SLST entities are shown under Residential loans, held-for-investment, at fair value, and the underlying loans 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 14 for further discussion on ABS issued.
Beginning in the fourth quarter of 2018, we consolidated two partnerships ("Servicing Investment" entities) through which we have invested in servicing-related assets. We maintain an 80% ownership interest in each entity and have determined that we are the primary beneficiary of these partnerships.
Beginning in the first quarter of 2019, we consolidated 5 Arches, LLC ("5 Arches"), an originator of business purpose residential loans, pursuant to the exercise of our purchase option and the acquisition of the remaining equity in the company.
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.
Acquisition of 5 Arches, LLC
On March 1, 2019, we completed the acquisition of the remaining 80% interest in 5 Arches, an originator of business purpose residential loans. In May 2018, Redwood acquired a 20% minority interest in 5 Arches for $10 million in cash, with a one-year option to purchase all remaining equity in the company. At closing, we paid approximately $13 million of cash and the remainder of the consideration, which could total up to an additional $27 million, will be paid in a mix of cash and Redwood common stock and is contingent on the achievement of certain specified loan origination thresholds over the next two years.

10

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)
Note 2. Basis of Presentation - (continued)

We accounted for the acquisition of 5 Arches under the acquisition method of accounting pursuant to ASC 805. We performed the preliminary purchase price allocation and recorded underlying assets acquired and liabilities assumed based on their estimated fair values using the information available as of the acquisition date, with the excess of the purchase price allocated to goodwill. Through June 30, 2019, there have been no changes to our preliminary purchase price allocation, which is summarized in the following table.
Table 2.1 – 5 Arches Purchase Price Allocation
(In Thousands)
 
March 1, 2019
Purchase price:
 
 
Cash
 
$
12,575

Contingent consideration, at fair value
 
24,621

Purchase option, at fair value
 
5,082

Equity method investment, at fair value
 
8,052

Total consideration
 
$
50,330

 
 
 
Allocated to:
 
 
Tangible net assets acquired (1)
 
$
1,004

Goodwill
 
28,728

Intangible assets
 
24,800

Deferred tax liability
 
(4,202
)
Total net assets acquired
 
$
50,330

(1)
5 Arches net assets acquired consisted of assets of $19 million and liabilities of $18 million as of March 1, 2019.
Because we owned a 20% noncontrolling interest in 5 Arches immediately before obtaining full control, we remeasured our initial minority investment and purchase option at their acquisition-date fair values using the income approach, which resulted in a gain of $2 million that was recorded in Other income, net on our consolidated statements of income during the three months ended March 31, 2019.
As part of this acquisition, we identified and recorded finite-lived intangible assets totaling $25 million. The amortization period for each of these assets and the activity for the period from March 1, 2019 to June 30, 2019 is summarized in the table below.
Table 2.2 – Intangible Assets – Activity
(Dollars in Thousands)
 
Carrying Value at December 31, 2018
 
Additions
 
Amortization Expense
 
Carrying Value at June 30, 2019
 
Weighted Average Amortization Period (in years)
Finite-lived intangible assets:
 
 
 
 
 
 
 
 
 
 
Broker network
 
$
—

 
$
18,100

 
$
(1,207
)
 
$
16,893

 
5
Non-compete agreements
 
—

 
2,900

 
(322
)
 
2,578

 
3
Management fee on existing assets under management
 
—

 
2,600

 
(867
)
 
1,733

 
1
Tradename
 
—

 
1,200

 
(133
)
 
1,067

 
3
Total
 
$
—

 
$
24,800

 
$
(2,529
)
 
$
22,271

 
4


11

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)
Note 2. Basis of Presentation - (continued)

All of our intangible assets are amortized on a straight-line basis. Estimated amortization expense for the remainder of 2019 and the following years is summarized in the table below.
Table 2.3 – Intangible Asset Amortization Expense by Year
(In Thousands)
 
June 30, 2019
2019 (6 months)
 
$
3,794

2020
 
5,420

2021
 
4,987

2022
 
3,848

2023 and thereafter
 
4,222

Total Future Intangible Asset Amortization
 
$
22,271


We recorded goodwill of $29 million as a result of the total consideration exceeding the fair value of the net assets acquired. The goodwill was attributed to the expected business synergies and expansion into business purpose loan markets, as well as access to the knowledgeable and experienced workforce continuing to provide services to the business. We expect $3 million of our goodwill balance to be deductible for tax purposes. The following table presents the goodwill activity for the six months ended June 30, 2019.
Table 2.4 – Goodwill – Activity
(In Thousands)
 
Six Months Ended
June 30, 2019
Beginning balance
 
$
—

Goodwill recognized from 5 Arches acquisition
 
28,728

Impairment
 
—

Ending Balance
 
$
28,728


The liability resulting from the contingent consideration arrangement was recorded at its acquisition-date fair value of $25 million as part of total consideration for the acquisition of 5 Arches. At June 30, 2019, our estimated fair value of this contingent liability was $25 million and was recorded as a component of Accrued expenses and other liabilities on our consolidated balance sheets. See Note 16 for additional information on our contingent consideration liability.
The following unaudited pro forma financial information presents Net interest income, Non-interest income, and Net income of Redwood and 5 Arches combined, as if the acquisition occurred as of January 1, 2018. These pro forma amounts have been adjusted to include the amortization of intangible assets for both periods, and to exclude the income statement impacts related to our equity method investment in 5 Arches. The unaudited pro forma financial information is not intended to represent or be indicative of the consolidated financial results of operations that would have been reported if the acquisition had been completed as of January 1, 2018 and should not be taken as indicative of our future consolidated results of operations. During the period from March 1, 2019 to June 30, 2019, 5 Arches had mortgage banking income of $6 million and a net loss of $2 million. Included in the net loss for this period was intangible asset amortization expense of $3 million.
Table 2.5 – Unaudited Pro Forma Financial Information
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2019
 
2018
 
2019
 
2018
Supplementary pro forma information:
 
 
 
 
 
 
 
 
Net interest income
 
$
32,322

 
$
35,099

 
$
64,588

 
$
70,430

Non-interest income
 
27,532

 
21,321

 
71,282

 
62,404

Net income
 
31,266

 
32,310

 
81,499

 
78,436



12

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)



Note 3. Summary of Significant Accounting Policies

Significant Accounting Policies
Included in Note 3 to the Consolidated Financial Statements of our Annual Report on Form 10-K for the year ended December 31, 2018 is a summary of our significant accounting policies. Provided below is a summary of additional accounting policies that are significant to the company’s consolidated financial position and results of operations for the three and six months ended June 30, 2019.
Business Combinations
We use the acquisition method of accounting for business combinations, under which the purchase price is allocated to the fair values of the assets acquired and liabilities assumed at the acquisition date. The excess of the purchase price over the amount allocated to the assets acquired and liabilities assumed is recorded as goodwill. Adjustments to the values of the assets acquired and liabilities assumed that could be made during the measurement period, which could be up to one year after the acquisition date, are recorded in the period in which the adjustment is identified, with a corresponding offset to goodwill. Any adjustments made after the measurement period are recorded in the consolidated statements of income. Acquisition-related costs are expensed as incurred.
Goodwill and Intangible Assets
Significant judgment is required to estimate the fair value of intangible assets and in assigning their estimated useful lives. Accordingly, we typically seek the assistance of independent third-party valuation specialists for significant intangible assets. The fair value estimates are based on available historical information and on future expectations and assumptions we deem reasonable. We generally use an income-based valuation method to estimate the fair value of intangible assets, which discounts expected future cash flows to present value using estimates and assumptions we deem reasonable.
Determining the estimated useful lives of intangible assets also requires judgment. Our assessment as to which intangible assets are deemed to have finite or indefinite lives is based on several factors including economic barriers of entry for the acquired business, retention trends, and our operating plans, among other factors.
Finite-lived intangible assets are amortized over their estimated useful lives on a straight-line basis and reviewed for impairment if indicators are present. Additionally, useful lives are evaluated each reporting period to determine if revisions to the remaining periods of amortization are warranted. Goodwill is tested for impairment annually or more frequently if indicators of impairment exist. We have elected to make the first day of our fiscal fourth quarter the annual impairment assessment date for goodwill. We first assess qualitative factors to determine whether it is more likely than not that the fair value is less than the carrying value. If, based on that assessment, we believe it is more likely than not that the fair value is less than the carrying value, then a two-step quantitative goodwill impairment test is performed.
Loan Originations
Our wholly-owned subsidiary, 5 Arches, originates business purpose residential loans, including single-family rental and residential bridge loans. Single-family rental loans are mortgage loans secured by 1-4 unit residential real estate with a mortgage loan borrower that owns the real estate as an investment property and rents the property to residential tenants. Residential bridge loans are mortgage loans generally secured by unoccupied residential real estate that the borrower owns as an investment and that is being renovated, rehabilitated or constructed. Single-family rental loans are classified as held-for-sale at fair value, as we have originated these loans with the intent to sell to third parties or transfer to securitization entities. Residential bridge loans are classified as held-for-investment at fair value, if we intend to hold these loans to maturity, or held-for-sale at fair value, if we intend to sell the loans to a third party.
Contingent Consideration
In relation to our acquisition of 5 Arches, we recorded contingent consideration liabilities that represent the estimated fair value (at the date of acquisition) of our obligation to make certain earn-out payments that are contingent on 5 Arches loan origination volumes exceeding certain specified thresholds. These liabilities are carried at fair value and periodic changes in their estimated fair value are recorded through Other income, net on our consolidated statements of income. The estimate of the fair value of contingent consideration requires significant judgment regarding assumptions about future operating results, discount rates, and probabilities of projected operating result scenarios.

13

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

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

Leases
Upon adoption of ASU 2016-02, "Leases," in the first quarter of 2019, we recorded a lease liability and right-of-use asset on our consolidated balance sheets. The lease liability is equal to the present value of our remaining lease payments discounted at our incremental borrowing rate and the right-of-use asset is equal to the lease liability adjusted for our deferred rent liability at the adoption of this accounting standard. As lease payments are made, the lease liability is reduced to the present value of the remaining lease payments and the right-of-use asset is reduced by the difference between the lease expense (straight-lined over the lease term) and the theoretical interest expense amount (calculated using the incremental borrowing rate). See Note 16 for further discussion on leases.
Recent Accounting Pronouncements
Newly Adopted Accounting Standards Updates ("ASUs")
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 ("AOCI") 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. However, we did not elect to reclassify any income tax effects of the Tax Act from AOCI to retained earnings as we did not have any tax effects related to the Tax Act remaining in AOCI at December 31, 2018. Our policy is to release any stranded income tax effects from AOCI to income tax expense on an investment-by-investment basis.
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. Additionally, in October 2018, the FASB issued ASU 2018-16, "Derivatives and Hedging (Topic 815): Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes," which permits the use of the OIS rate based on SOFR as a U.S. benchmark interest rate for hedge accounting purposes under Topic 815. The amendments in this update are required to be adopted concurrently with the amendments in ASU 2017-12. We adopted this guidance, as required, in the first quarter of 2019, which did not have a material impact on our consolidated financial statements.
In July 2017, the FASB issued ASU 2017-11, "Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815): (Part I) Accounting for Certain Financial Instruments with Down Round Features, (Part II) Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception." This new guidance changes the classification analysis of certain equity-linked financial instruments (or embedded conversion options) with down round features. This new guidance is effective for fiscal years beginning after December 15, 2018. We adopted this guidance, as required, in the first quarter of 2019, which did not 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. We adopted this guidance, as required, in the first quarter of 2019, which did not have a material impact on our consolidated financial statements.


14

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

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

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. 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. In March 2019, the FASB issued ASU 2019-01, "Leases (Topic 842): Codification Improvements," which is intended to clarify Codification guidance. We adopted this guidance, as required, in the first quarter of 2019, which did not have a material impact on our consolidated financial statements. We elected the package of practical expedients under the transition guidance within this standard, which allowed us to carry forward the classifications of each of our existing leases as operating leases. In connection with the adoption of this guidance, at June 30, 2019, our lease liability was $13 million, which represented the present value of our remaining lease payments discounted at our incremental borrowing rate and was recorded in Accrued expenses and other liabilities on our consolidated balance sheets. At June 30, 2019, our right-of-use asset was $12 million, which was equal to the lease liability adjusted for our deferred rent liability at adoption and was recorded in Other assets on our consolidated balance sheets. We will continue to record lease expense on a straight-line basis and have included required lease disclosures within Note 16.
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 January 2017, the FASB issued ASU 2017-04, "Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment." This new guidance simplifies the subsequent measurement of goodwill by eliminating Step 2 from the goodwill impairment test. This new guidance is effective for fiscal years beginning after December 15, 2019. Early adoption is permitted for interim and annual goodwill impairment tests performed on testing dates after January 1, 2017. 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.

15

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

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

In June 2016, the FASB issued ASU 2016-13, "Financial Instruments - Credit Losses." This new guidance provides a new impairment model that is based on expected losses rather than incurred losses to determine the allowance for credit losses. This new guidance is effective for fiscal years beginning after December 15, 2019. Early adoption is permitted for fiscal years beginning after December 15, 2018. In November 2018, the FASB issued ASU 2018-19, "Codification Improvements to Topic 326, Financial Instruments - Credit Losses," which clarifies the scope of the amendments in ASU 2016-13. In April 2019, the FASB issued ASU 2019-04, "Codification Improvements to Topic 326, Financial Instruments - Credit Losses, Topic 815, Derivatives and Hedging, and Topic 825, Financial Instruments," which is intended to clarify this guidance. Additionally, in May 2019, the FASB issued ASU 2019-05, "Financial Instruments - Credit Losses (Topic 326): Targeted Transition Relief," which provides an option to irrevocably elect the fair value option for certain financial assets previously measured at amortized cost. 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 do not anticipate that these updates will have a material impact on our consolidated financial statements as nearly all of our financial instruments are carried at fair value and changes in fair values of these instruments are recorded on our consolidated statements of income in the period in which the valuation change occurs. We will continue evaluating these new standards and caution that any changes in our business or additional amendments to these standards could change our initial assessment.
Balance Sheet Netting
Certain of our derivatives and short-term debt are subject to master netting arrangements or similar agreements. Under GAAP, in certain circumstances we may elect to present certain financial assets, liabilities and related collateral subject to master netting arrangements in a net position on our consolidated balance sheets. However, we do not report any of these financial assets or liabilities on a net basis, and instead present them on a gross basis on our consolidated balance sheets.
The table below presents financial assets and liabilities that are subject to master netting arrangements or similar agreements categorized by financial instrument, together with corresponding financial instruments and corresponding collateral received or pledged at June 30, 2019 and December 31, 2018.
Table 3.1 – Offsetting of Financial Assets, Liabilities, and Collateral
 
 
Gross Amounts of Recognized Assets (Liabilities)
 
Gross Amounts Offset in Consolidated Balance Sheet
 
Net Amounts of Assets (Liabilities) Presented in Consolidated Balance Sheet
 
Gross Amounts Not Offset in Consolidated
Balance Sheet (1)
 
Net Amount
June 30, 2019
(In Thousands)
 
 
 
 
Financial Instruments
 
Cash Collateral (Received) Pledged
 
Assets (2)
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate agreements
 
$
19,258

 
$
—

 
$
19,258

 
$
(17,869
)
 
$
—

 
$
1,389

TBAs
 
1,784

 
—

 
1,784

 
(1,784
)
 
—

 
—

Total Assets
 
$
21,042

 
$
—

 
$
21,042

 
$
(19,653
)
 
$
—

 
$
1,389

 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities (2)
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate agreements
 
$
(168,436
)
 
$
—

 
$
(168,436
)
 
$
17,869

 
$
150,567

 
$
—

TBAs
 
(4,639
)
 
—

 
(4,639
)
 
1,784

 
1,600

 
(1,255
)
Loan warehouse debt
 
(638,055
)
 
—

 
(638,055
)
 
638,055

 
—

 
—

Security repurchase agreements
 
(1,213,920
)
 
—

 
(1,213,920
)
 
1,213,920

 
—

 
—

Total Liabilities
 
$
(2,025,050
)
 
$
—

 
$
(2,025,050
)
 
$
1,871,628

 
$
152,167

 
$
(1,255
)

16

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(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, 2018
(In Thousands)
 
 
 
 
Financial Instruments
 
Cash Collateral (Received) Pledged
 
Assets (2)
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate agreements
 
$
28,211

 
$
—

 
$
28,211

 
$
(28,211
)
 
$
—

 
$
—

TBAs
 
4,665

 
—

 
4,665

 
(3,391
)
 
(835
)
 
439

Total Assets
 
$
32,876

 
$
—

 
$
32,876

 
$
(31,602
)
 
$
(835
)
 
$
439

 
 
 
 
 
 
 
 
 
 
 
 
 
Liabilities (2)
 
 
 
 
 
 
 
 
 
 
 
 
Interest rate agreements
 
$
(70,908
)
 
$
—

 
$
(70,908
)
 
$
28,211

 
$
42,697

 
$
—

TBAs
 
(13,215
)
 
—

 
(13,215
)
 
3,391

 
5,620

 
(4,204
)
Loan warehouse debt
 
(860,650
)
 
—

 
(860,650
)
 
860,650

 
—

 
—

Security repurchase agreements
 
(988,890
)
 
—

 
(988,890
)
 
988,890

 
—

 
—

Total Liabilities
 
$
(1,933,663
)
 
$
—

 
$
(1,933,663
)
 
$
1,881,142

 
$
48,317

 
$
(4,204
)
(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 and TBAs 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.
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.

17

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 4. Principles of Consolidation - (continued)


Analysis of Consolidated VIEs
At June 30, 2019, 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, beginning in the second half of 2018, we consolidated certain Freddie Mac K-Series securitization entities and the Freddie Mac SLST securitization entity 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 June 30, 2019, the estimated fair value of our investments in the consolidated Legacy Sequoia, Sequoia Choice, Freddie Mac SLST and Freddie Mac K-Series entities was $11 million, $220 million, $244 million, and $207 million, respectively.
Beginning in the fourth quarter of 2018, we consolidated two Servicing Investment entities formed to invest in servicing-related assets that we determined were VIEs and for which we determined we were the primary beneficiary. At June 30, 2019, we held an 80% ownership interest in, and were responsible for the management of, each entity. See Note 10 for a further description of these entities and the investments they hold and Note 12 for additional information on the minority partner’s interest. Additionally, beginning in the fourth quarter of 2018, we consolidated an entity that was formed to finance servicer advances that we determined was a VIE and for which we, through our control of one of the aforementioned partnerships, were the primary beneficiary. The servicer advance financing consists of non-recourse short-term securitization debt, secured by servicer advances. We consolidate the securitization entity, but the securitization entity is independent of Redwood and the assets and liabilities are not owned by and are not legal obligations of Redwood. See Note 13 for additional information on the servicer advance financing. At June 30, 2019, the estimated fair value of our investment in the Servicing Investment entities was $67 million.
The following table presents a summary of the assets and liabilities of these VIEs.
Table 4.1 – Assets and Liabilities of Consolidated VIEs
June 30, 2019
 
Legacy
Sequoia
 
Sequoia
Choice
 
Freddie Mac SLST
 
Freddie Mac
K-Series
 
Servicing Investment
 
Total
Consolidated
VIEs
(Dollars in Thousands)
 
 
 
 
 
 
Residential loans, held-for-investment
 
$
457,750

 
$
2,147,356

 
$
1,235,089

 
$
—

 
$
—

 
$
3,840,195

Multifamily loans, held-for-investment
 
—

 
—

 
—

 
3,749,657

 
—

 
3,749,657

Other investments
 
—

 
—

 
—

 
—

 
274,617

 
274,617

Cash and cash equivalents
 
—

 
—

 
—

 
—

 
19,393

 
19,393

Restricted cash
 
144

 
14

 
—

 
—

 
23,650

 
23,808

Accrued interest receivable
 
771

 
8,946

 
3,786

 
11,317

 
3,747

 
28,567

REO
 
1,448

 
—

 
—

 
—

 
—

 
1,448

Total Assets
 
$
460,113

 
$
2,156,316

 
$
1,238,875

 
$
3,760,974

 
$
321,407

 
$
7,937,685

Short-term debt
 
$
—

 
$
—

 
$
—

 
$
—

 
$
236,231

 
$
236,231

Accrued interest payable
 
519

 
7,322

 
2,774

 
10,822

 
321

 
21,758

Accrued expenses and other liabilities
 
—

 
14

 
—

 
—

 
17,954

 
17,968

Asset-backed securities issued
 
448,862

 
1,929,444

 
991,766

 
3,543,057

 
—

 
6,913,129

Total Liabilities
 
$
449,381

 
$
1,936,780

 
$
994,540

 
$
3,553,879

 
$
254,506

 
$
7,189,086

 
 
 
 
 
 
 
 
 
 
 
 
 
Number of VIEs
 
20

 
7

 
1

 
4

 
3

 
35


18

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 4. Principles of Consolidation - (continued)


December 31, 2018
 
Legacy
Sequoia
 
Sequoia
Choice
 
Freddie Mac SLST
 
Freddie Mac
K-Series
 
Servicing Investment
 
Total
Consolidated
VIEs
(Dollars in Thousands)
 
 
 
 
 
 
Residential loans, held-for-investment
 
$
519,958

 
$
2,079,382

 
$
1,222,669

 
$
—

 
$
—

 
$
3,822,009

Multifamily loans, held-for-investment
 
—

 
—

 
—

 
2,144,598

 
—

 
2,144,598

Other investments
 
—

 
—

 
—

 
—

 
312,688

 
312,688

Restricted cash
 
146

 
1,022

 
—

 
—

 
25,363

 
26,531

Accrued interest receivable
 
822

 
8,988

 
3,926

 
6,595

 
1,091

 
21,422

REO
 
3,943

 
—

 
—

 
—

 
—

 
3,943

Total Assets
 
$
524,869

 
$
2,089,392

 
$
1,226,595

 
$
2,151,193

 
$
339,142

 
$
6,331,191

Short-term debt
 
$
—

 
$
—

 
$
—

 
$
—

 
$
262,740

 
$
262,740

Accrued interest payable
 
571

 
7,180

 
2,907

 
6,239

 
483

 
17,380

Accrued expenses and other liabilities
 
—

 
1,022

 
—

 
—

 
18,592

 
19,614

Asset-backed securities issued
 
512,240

 
1,885,010

 
993,748

 
2,019,075

 
—

 
5,410,073

Total Liabilities
 
$
512,811

 
$
1,893,212

 
$
996,655

 
$
2,025,314

 
$
281,815

 
$
5,709,807

 
 
 
 
 
 
 
 
 
 
 
 
 
Number of VIEs
 
20

 
6

 
1

 
3

 
3

 
33

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.
We consolidate the assets and liabilities of certain Freddie Mac K-Series securitization trusts and a Freddie Mac SLST securitization trust resulting from our investment in subordinate securities issued by these trusts. Additionally, we consolidate the assets and liabilities of Servicing Investment entities from our investment in servicer advance investments and excess MSRs. In each case, we maintain certain discretionary rights associated with the ownership of these investments that we determined reflected a controlling financial interest, as 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 VIEs that could potentially be significant to the VIEs.
Analysis of Unconsolidated VIEs with Continuing Involvement
Since 2012, we have transferred residential loans to 44 Sequoia securitization entities sponsored by us that are still outstanding as of June 30, 2019, 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.
During the first quarter of 2019, the master servicer for one of our unconsolidated Sequoia entities exercised their right to call the securitization and paid off the underlying securities. We realized a $4 million gain related to the called securities, which was recognized through Realized gains, net on our consolidated statements of income. In connection with this called securitization, Redwood acquired $39 million of residential real estate loans that were held in both our held-for-sale and held-for-investment portfolios at Redwood at June 30, 2019.

19

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 4. Principles of Consolidation - (continued)


The following table presents information related to securitization transactions that occurred during the three and six months ended June 30, 2019 and 2018.
Table 4.2 – Securitization Activity Related to Unconsolidated VIEs Sponsored by Redwood
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2019
 
2018
 
2019
 
2018
Principal balance of loans transferred
 
$
400,836

 
$
1,127,665

 
$
749,093

 
$
2,408,133

Trading securities retained, at fair value
 
1,792

 
33,757

 
3,508

 
46,248

AFS securities retained, at fair value
 
1,069

 
2,047

 
1,954

 
5,952


The following table summarizes the cash flows during the three and six months ended June 30, 2019 and 2018 between us and the unconsolidated VIEs sponsored by us and accounted for as sales since 2012.
Table 4.3 – Cash Flows Related to Unconsolidated VIEs Sponsored by Redwood
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2019
 
2018
 
2019
 
2018
Proceeds from new transfers
 
$
410,281

 
$
1,104,094

 
$
762,652

 
$
2,393,781

MSR fees received
 
3,105

 
3,397

 
6,165

 
6,811

Funding of compensating interest, net
 
(47
)
 
(31
)
 
(137
)
 
(56
)
Cash flows received on retained securities
 
6,743

 
7,410

 
14,289

 
14,453


The following table presents the key weighted-average assumptions used to measure MSRs and securities retained at the date of securitization for securitizations completed during the three and six months ended June 30, 2019 and 2018.
Table 4.4 – Assumptions Related to Assets Retained from Unconsolidated VIEs Sponsored by Redwood

 
 
Three Months Ended June 30, 2019
 
Three Months Ended June 30, 2018
At Date of Securitization
 
Senior IO Securities
 
Subordinate Securities
 
Senior IO Securities
 
Subordinate Securities
Prepayment rates
 
16
%
 
15
%
 
10
%
 
10
%
Discount rates
 
14
%
 
7
%
 
14
%
 
5
%
Credit loss assumptions
 
0.20
%
 
0.20
%
 
0.20
%
 
0.20
%

 
 
Six Months Ended June 30, 2019
 
Six Months Ended June 30, 2018
At Date of Securitization
 
Senior IO Securities
 
Subordinate Securities
 
Senior IO Securities
 
Subordinate Securities
Prepayment rates
 
16
%
 
15
%
 
9
%
 
10
%
Discount rates
 
14
%
 
7
%
 
14
%
 
5
%
Credit loss assumptions
 
0.20
%
 
0.20
%
 
0.20
%
 
0.20
%


20

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 4. Principles of Consolidation - (continued)


The following table presents additional information at June 30, 2019 and December 31, 2018, related to unconsolidated VIEs sponsored by Redwood and accounted for as sales since 2012.
Table 4.5 – Unconsolidated VIEs Sponsored by Redwood
(In Thousands)
 
June 30, 2019
 
December 31, 2018
On-balance sheet assets, at fair value:
 
 
 
 
Interest-only, senior and subordinate securities, classified as trading
 
$
121,825

 
$
129,111

Subordinate securities, classified as AFS
 
136,310

 
162,314

Mortgage servicing rights
 
45,010

 
58,572

Maximum loss exposure (1)
 
$
303,145

 
$
349,997

Assets transferred:
 
 
 
 
Principal balance of loans outstanding
 
$
10,586,480

 
$
10,580,216

Principal balance of loans 30+ days delinquent
 
24,749

 
21,805

(1)
Maximum loss exposure from our involvement with unconsolidated VIEs pertains to the carrying value of our securities and MSRs retained from these VIEs and represents estimated losses that would be incurred under severe, hypothetical circumstances, such as if the value of our interests and any associated collateral declines to zero. This does not include, for example, any potential exposure to representation and warranty claims associated with our initial transfer of loans into a securitization.
The following table presents key economic assumptions for assets retained from unconsolidated VIEs and the sensitivity of their fair values to immediate adverse changes in those assumptions at June 30, 2019 and December 31, 2018.
Table 4.6 – Key Assumptions and Sensitivity Analysis for Assets Retained from Unconsolidated VIEs Sponsored by Redwood
June 30, 2019
 
MSRs
 
Senior
Securities (1)
 
Subordinate Securities
(Dollars in Thousands)
 
 
 
Fair value at June 30, 2019
 
$
45,010

 
$
49,014

 
$
209,121

Expected life (in years) (2)
 
6

 
6

 
14

Prepayment speed assumption (annual CPR) (2)
 
11
%
 
12
%
 
13
%
Decrease in fair value from:
 
 
 
 
 
 
10% adverse change
 
$
1,898

 
$
1,905

 
$
158

25% adverse change
 
4,513

 
4,857

 
1,124

Discount rate assumption (2)
 
11
%
 
13
%
 
5
%
Decrease in fair value from:
 
 
 
 
 
 
100 basis point increase
 
$
1,624

 
$
1,310

 
$
20,756

200 basis point increase
 
3,135

 
2,758

 
38,452

Credit loss assumption (2)
 
N/A

 
0.21
%
 
0.21
%
Decrease in fair value from:
 
 
 
 
 
 
10% higher losses
 
N/A

 
$
—

 
$
1,645

25% higher losses
 
N/A

 
—

 
4,112


21

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 4. Principles of Consolidation - (continued)


December 31, 2018
 
MSRs
 
Senior
Securities (1)
 
Subordinate Securities
(Dollars in Thousands)
 
 
 
Fair value at December 31, 2018
 
$
58,572

 
$
61,178

 
$
230,247

Expected life (in years) (2)
 
8

 
7

 
15

Prepayment speed assumption (annual CPR) (2)
 
7
%
 
10
%
 
9
%
Decrease in fair value from:
 
 
 
 
 
 
10% adverse change
 
$
1,668

 
$
2,151

 
$
201

25% adverse change
 
4,027

 
5,127

 
1,372

Discount rate assumption (2)
 
11
%
 
12
%
 
6
%
Decrease in fair value from:
 
 
 
 
 
 
100 basis point increase
 
$
2,323

 
$
2,190

 
$
21,982

200 basis point increase
 
4,493

 
4,226

 
40,641

Credit loss assumption (2)
 
N/A

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

 
$
—

 
$
1,387

25% higher losses
 
N/A

 
—

 
3,471


(1)
Senior securities included $49 million and $61 million of interest-only securities at June 30, 2019 and December 31, 2018, 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 and other investments from the same third-party VIE, and in those cases, the analysis is performed in consideration of all of our interests. The following table presents a summary of our interests in third-party VIEs at June 30, 2019 and December 31, 2018, grouped by asset type.
Table 4.7 – Third-Party Sponsored VIE Summary
(In Thousands)
 
June 30, 2019
 
December 31, 2018
Mortgage-Backed Securities
 
 
 
 
Senior
 
$
166,184

 
$
185,107

Mezzanine
 
679,908

 
547,249

Subordinate
 
373,260

 
428,713

Total Mortgage-Backed Securities
 
1,219,352

 
1,161,069

Excess MSR
 
18,224

 
15,092

Total Investments in Third-Party Sponsored VIEs
 
$
1,237,576

 
$
1,176,161


We determined that we are not the primary beneficiary of these 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.

22

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(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.


23

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

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


The following table presents the carrying values and estimated fair values of assets and liabilities that are required to be recorded or disclosed at fair value at June 30, 2019 and December 31, 2018.

Table 5.1 – Carrying Values and Fair Values of Assets and Liabilities
 
 
June 30, 2019
 
December 31, 2018
 
 
Carrying
Value
 
Fair
Value
 
Carrying
Value
 
Fair
Value
(In Thousands)
 
 
 
 
Assets
 
 
 
 
 
 
 
 
Residential loans, held-for-sale
 
 
 
 
 
 
 
 
At fair value
 
$
1,056,178

 
$
1,056,178

 
$
1,048,690

 
$
1,048,690

At lower of cost or fair value
 
109

 
128

 
111

 
131

Residential loans, held-for-investment
 
6,227,078

 
6,227,078

 
6,205,941

 
6,205,941

Business purpose residential loans
 
250,854

 
250,854

 
141,258

 
141,258

Multifamily loans
 
3,749,657

 
3,749,657

 
2,144,598

 
2,144,598

Trading securities
 
1,205,389

 
1,205,389

 
1,118,612

 
1,118,612

Available-for-sale securities
 
272,097

 
272,097

 
333,882

 
333,882

Servicer advance investments (1)
 
259,222

 
259,222

 
300,468

 
300,468

MSRs (1)
 
47,396

 
47,396

 
60,281

 
60,281

Participation in loan warehouse facility (1)
 
—

 
—

 
39,703

 
39,703

Excess MSRs (1)
 
33,620

 
33,620

 
27,312

 
27,312

Cash and cash equivalents
 
218,145

 
218,145

 
175,764

 
175,764

Restricted cash
 
33,953

 
33,953

 
29,313

 
29,313

Accrued interest receivable
 
54,265

 
54,265

 
47,105

 
47,105

Derivative assets
 
26,609

 
26,609

 
35,789

 
35,789

REO (2)
 
6,305

 
6,509

 
3,943

 
4,396

Margin receivable (2)
 
211,199

 
211,199

 
100,773

 
100,773

FHLBC stock (2)
 
43,393

 
43,393

 
43,393

 
43,393

Guarantee asset (2)
 
1,999

 
1,999

 
2,618

 
2,618

Pledged collateral (2)
 
42,913

 
42,913

 
42,433

 
42,433

Liabilities
 
 
 
 
 
 
 
 
Short-term debt facilities
 
$
2,026,418

 
$
2,026,418

 
$
1,937,920

 
$
1,937,920

Short-term debt - servicer advance financing
 
236,231

 
236,231

 
262,740

 
262,740

Accrued interest payable
 
47,092

 
47,092

 
42,528

 
42,528

Margin payable (3)
 
—

 
—

 
835

 
835

Guarantee obligation (3)
 
15,744

 
15,456

 
16,711

 
16,774

Contingent consideration (3)
 
24,932

 
24,932

 
—

 
—

Derivative liabilities
 
173,847

 
173,847

 
84,855

 
84,855

ABS issued at fair value
 
6,913,129

 
6,913,129

 
5,410,073

 
5,410,073

FHLBC long-term borrowings
 
1,999,999

 
1,999,999

 
1,999,999

 
1,999,999

Convertible notes, net
 
634,805

 
639,849

 
633,196

 
618,271

Trust preferred securities and subordinated notes, net
 
138,605

 
97,650

 
138,582

 
102,533

(1)
These investments are included in Other investments on our consolidated balance sheets.
(2)
These assets are included in Other assets on our consolidated balance sheets.
(3)
These liabilities are included in Accrued expenses and other liabilities on our consolidated balance sheets.

24

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

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


During the three and six months ended June 30, 2019, we elected the fair value option for $2 million and $34 million of residential senior securities, respectively, $86 million and $206 million of subordinate securities, respectively, $1.53 billion and $2.53 billion of residential loans (principal balance), respectively, $112 million and $177 million of business purpose residential loans (principal balance), respectively, zero and $69 million of servicer advance investments, respectively, and $5 million and $7 million of excess MSRs, respectively. We anticipate electing the fair value option for all future purchases of residential and business purpose residential loans that we intend to sell to third parties or transfer to securitizations, as well as for certain securities we purchase, including IO securities and fixed-rate securities rated investment grade or higher.
The following table presents the assets and liabilities that are reported at fair value on our consolidated balance sheets on a recurring basis at June 30, 2019 and December 31, 2018, as well as the fair value hierarchy of the valuation inputs used to measure fair value.
Table 5.2 – Assets and Liabilities Measured at Fair Value on a Recurring Basis
June 30, 2019
 
Carrying
Value
 
Fair Value Measurements Using
(In Thousands)
 
 
Level 1
 
Level 2
 
Level 3
Assets
 
 
 
 
 
 
 
 
Residential loans
 
$
7,283,256

 
$
—

 
$
—

 
$
7,283,256

Business purpose residential loans
 
250,854

 
—

 
—

 
250,854

Multifamily loans
 
3,749,657

 
—

 
—

 
3,749,657

Trading securities
 
1,205,389

 
—

 
—

 
1,205,389

Available-for-sale securities
 
272,097

 
—

 
—

 
272,097

Servicer advance investments
 
259,222

 
—

 
—

 
259,222

MSRs
 
47,396

 
—

 
—

 
47,396

Excess MSRs
 
33,620

 
—

 
—

 
33,620

Derivative assets
 
26,609

 
1,784

 
19,258

 
5,567

Pledged collateral
 
42,913

 
42,913

 
—

 
—

FHLBC stock
 
43,393

 
—

 
43,393

 
—

Guarantee asset
 
1,999

 
—

 
—

 
1,999

 
 
 
 
 
 
 
 
 
Liabilities
 


 
 
 
 
 
 
Contingent consideration
 
$
24,932

 
$
—

 
$
—

 
$
24,932

Derivative liabilities
 
173,847

 
4,639

 
168,436

 
772

ABS issued
 
6,913,129

 
—

 
—

 
6,913,129




25

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

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


December 31, 2018
 
Carrying
Value
 
Fair Value Measurements Using
(In Thousands)
 
 
Level 1
 
Level 2
 
Level 3
Assets
 
 
 
 
 
 
 
 
Residential loans
 
$
7,254,631

 
$
—

 
$
—

 
$
7,254,631

Business purpose residential loans
 
141,258

 
—

 
—

 
141,258

Multifamily loans
 
2,144,598

 
—

 
—

 
2,144,598

Trading securities
 
1,118,612

 
—

 
—

 
1,118,612

Available-for-sale securities
 
333,882

 
—

 
—

 
333,882

Servicer advance investments
 
300,468

 
—

 
—

 
300,468

MSRs
 
60,281

 
—

 
—

 
60,281

Excess MSRs
 
27,312

 
—

 
—

 
27,312

Derivative assets
 
35,789

 
4,665

 
28,211

 
2,913

Pledged collateral
 
42,433

 
42,433

 
—

 
—

FHLBC stock
 
43,393

 
—

 
43,393

 
—

Guarantee asset
 
2,618

 
—

 
—

 
2,618

 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
Derivative liabilities
 
$
84,855

 
$
13,215

 
$
70,908

 
$
732

ABS issued
 
5,410,073

 
—

 
—

 
5,410,073


The following table presents additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the six months ended June 30, 2019.
Table 5.3 – Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis
 
 
Assets
 
 
Residential Loans
 
Business Purpose
Residential Loans
 
Multifamily Loans
 
Trading Securities
 
AFS
Securities
 
Servicer Advance Investments
 
MSRs
 
Excess MSRs
 
Guarantee Asset
(In Thousands)
 
 
 
 
 
 
 
 
 
Beginning balance -
   December 31, 2018
 
$
7,254,631

 
$
141,258

 
$
2,144,598

 
$
1,118,612

 
$
333,882

 
$
300,468

 
$
60,281

 
$
27,312

 
$
2,618

Acquisitions
 
2,583,951

 
29,093

 
1,481,554

 
240,478

 
8,954

 
68,976

 
868

 
6,810

 
—

Originations
 
—

 
169,562

 
—

 
—

 
—

 
—

 
—

 
—

 
—

Sales
 
(2,088,273
)
 
(43,548
)
 
—

 
(174,216
)
 
(67,001
)
 
—

 
—

 
—

 
—

Principal paydowns
 
(614,975
)
 
(43,931
)
 
(7,516
)
 
(14,836
)
 
(24,207
)
 
(111,662
)
 
—

 
—

 
—

Gains (losses) in net income, net
 
147,969

 
3,416

 
131,021

 
40,302

 
17,503

 
1,440

 
(13,753
)
 
(502
)
 
(619
)
Unrealized losses in OCI, net
 
—

 
—

 
—

 
—

 
2,966

 
—

 
—

 
—

 
—

Other settlements, net (1)
 
(47
)
 
(4,996
)
 
—

 
(4,951
)
 
—

 
—

 
—

 
—

 
—

Ending Balance -
   June 30, 2019
 
$
7,283,256

 
$
250,854

 
$
3,749,657

 
$
1,205,389

 
$
272,097

 
$
259,222

 
$
47,396

 
$
33,620

 
$
1,999


26

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

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


Table 5.3 – Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis (continued)
 
 
 
 
Liabilities
 
 
Derivatives (2)
 
Contingent Consideration
 
ABS
Issued
(In Thousands)
 
 
 
Beginning balance - December 31, 2018
 
$
2,181

 
$
—

 
$
5,410,073

Acquisitions
 
—

 
24,621

 
1,738,537

Principal paydowns
 
—

 
—

 
(416,791
)
Gains (losses) in net income, net
 
28,908

 
311

 
181,310

Other settlements, net (1)
 
(26,294
)
 
—

 
—

Ending Balance - June 30, 2019
 
$
4,795

 
$
24,932

 
$
6,913,129

(1)
Other settlements, net for residential and business purpose residential loans represents the transfer of loans to REO, and for derivatives, the settlement of forward sale commitments and the transfer of the fair value of loan purchase commitments at the time loans are acquired to the basis of residential loans. Other settlements, net for trading securities relates to the consolidation of a Freddie Mac K-Series entity during the second quarter of 2019.
(2)
For the purpose of this presentation, derivative assets and liabilities, which consist of loan purchase and forward sale commitments, are presented on a net basis.


27

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

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


The following table presents the portion of gains or losses included in our consolidated statements of income that were attributable to Level 3 assets and liabilities recorded at fair value on a recurring basis and held at June 30, 2019 and 2018. Gains or losses incurred on assets or liabilities sold, matured, called, or fully written down during the three and six months ended June 30, 2019 and 2018 are not included in this presentation.
Table 5.4 – Portion of Net Gains (Losses) Attributable to Level 3 Assets and Liabilities Still Held at June 30, 2019 and 2018 Included in Net Income
 
 
Included in Net Income
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2019
 
2018
 
2019
 
2018
Assets
 
 
 
 
 
 
 
 
Residential loans at Redwood
 
$
48,575

 
$
(12,981
)
 
$
80,615

 
$
(51,029
)
Residential loans at consolidated Sequoia entities
 
6,772

 
367

 
21,243

 
20,914

Residential loans at consolidated Freddie Mac SLST entity
 
31,477

 
—

 
55,005

 
—

Business purpose residential loans
 
3,038

 
—

 
4,032

 
—

Multifamily loans at consolidated Freddie Mac K-Series entities
 
96,649

 
—

 
131,020

 
—

Trading securities
 
17,771

 
(1,989
)
 
38,658

 
(6,011
)
Available-for-sale securities
 
—

 
(56
)
 
—

 
(56
)
Servicer advance investments
 
432

 
—

 
1,440

 
—

MSRs
 
(7,334
)
 
689

 
(11,518
)
 
4,610

Excess MSRs
 
(66
)
 
—

 
(502
)
 
—

Loan purchase commitments
 
5,534

 
2,835

 
5,567

 
2,901

Other assets - Guarantee asset
 
(277
)
 
(120
)
 
(196
)
 
66

 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
Loan purchase commitments
 
$
(756
)
 
$
(4,646
)
 
$
(772
)
 
$
(4,687
)
ABS issued
 
(121,127
)
 
(279
)
 
(181,310
)
 
(21,014
)

The following table presents information on assets recorded at fair value on a non-recurring basis at June 30, 2019. This table does not include the carrying value and gains or losses associated with the asset types below that were not recorded at fair value on our consolidated balance sheets at June 30, 2019.
Table 5.5 – Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis at June 30, 2019
 
 
 
 
 
 
 
 
 
 
Gain (Loss) for
June 30, 2019
 
Carrying
Value
 
Fair Value Measurements Using
 
Three Months Ended
 
Six Months Ended
(In Thousands)
 
 
Level 1
 
Level 2
 
Level 3
 
June 30, 2019
 
June 30, 2019
Assets
 
 
 
 
 
 
 
 
 
 
 
 
REO
 
$
5,732

 
$
—

 
$
—

 
$
5,732

 
$
(150
)
 
$
(422
)


28

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

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


The following table presents the net market valuation gains and losses recorded in each line item of our consolidated statements of income for the three and six months ended June 30, 2019 and 2018.
Table 5.6 – Market Valuation Gains and Losses, Net
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2019
 
2018
 
2019
 
2018
Mortgage Banking Activities, Net
 
 
 
 
 
 
 
 
Residential loans held-for-sale, at fair value
 
$
3,379

 
$
6,122

 
$
6,912

 
$
10,896

Residential loan purchase and forward sale commitments
 
16,888

 
(2,758
)
 
28,199

 
(9,726
)
Single-family rental loans held-for-sale, at fair value
 
1,313

 
—

 
2,917

 
—

Single-family rental loan purchase commitments
 
569

 
—

 
709

 
—

Residential bridge loans
 
1,012

 
—

 
1,098

 
—

Risk management derivatives, net
 
(7,431
)
 
6,150

 
(12,415
)
 
34,582

Total mortgage banking activities, net (1)
 
$
15,730

 
$
9,514

 
$
27,420

 
$
35,752

Investment Fair Value Changes, Net
 
 
 
 
 
 
 
 
Residential loans held-for-investment, at Redwood
 
$
35,548

 
$
(15,010
)
 
$
63,656

 
$
(53,995
)
Residential bridge loans held-for-investment
 
(318
)
 
—

 
(621
)
 
—

Trading securities
 
18,442

 
(930
)
 
40,302

 
(3,885
)
Servicer advance investments
 
432

 
—

 
1,440

 
—

Excess MSRs
 
(65
)
 
—

 
(502
)
 
—

REO
 
(139
)
 
—

 
(139
)
 
—

Net investments in Legacy Sequoia entities (2)
 
(123
)
 
(720
)
 
(497
)
 
(728
)
Net investments in Sequoia Choice entities (2)
 
2,879

 
1,072

 
6,144

 
986

Net investment in Freddie Mac SLST entity (2)
 
8,037

 
—

 
14,402

 
—

Net investments in Freddie Mac K-Series entities (2)
 
3,246

 
—

 
6,365

 
—

Risk-sharing investments
 
(61
)
 
(209
)
 
(138
)
 
(348
)
Risk management derivatives, net
 
(64,740
)
 
16,742

 
(107,115
)
 
60,524

Impairments on AFS securities
 
—

 
(56
)
 
—

 
(56
)
Total investment fair value changes, net
 
$
3,138

 
$
889

 
$
23,297

 
$
2,498

Other Income (Expense), Net
 
 
 
 
 
 
 
 
MSRs
 
$
(8,653
)
 
$
(745
)
 
$
(13,753
)
 
$
2,147

Risk management derivatives, net
 
6,517

 
(1,122
)
 
8,768

 
(6,261
)
Gain on re-measurement of 5 Arches investment
 
—

 
—

 
2,440

 
—

Total other expense, net (3)
 
$
(2,136
)
 
$
(1,867
)
 
$
(2,545
)
 
$
(4,114
)
Total Market Valuation Gains, Net
 
$
16,732

 
$
8,536

 
$
48,172

 
$
34,136

(1)
Mortgage banking activities, net presented above does not include fee income or provisions for repurchases that are components of Mortgage banking activities, net presented on our consolidated statements of income, as these amounts do not represent market valuation changes.
(2)
Includes changes in fair value of the residential loans held-for-investment, REO and the ABS issued at the entities, which netted together represent the change in value of our investments at the consolidated VIEs.
(3)
Other income (expense), net presented above does not include net MSR fee income or provisions for repurchases for MSRs, as these amounts do not represent market valuation adjustments.
At June 30, 2019, our valuation policy and processes had not changed from those described in our Annual Report on Form 10-K for the year ended December 31, 2018. The following table provides quantitative information about the significant unobservable inputs used in the valuation of our Level 3 assets and liabilities measured at fair value.

29

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

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


Table 5.7 – Fair Value Methodology for Level 3 Financial Instruments
June 30, 2019
 
Fair
Value
 
 
 
Input Values
(Dollars in Thousands, except Input Values)
 
 
Unobservable Input
 
Range
 
 
Weighted
Average
Assets
 
 
 
 
 
 
 
 
 
 
 
 
Residential loans, at fair value:
 
 
 
 
 
 
 
 
 
 
 
 
Jumbo fixed-rate loans
 
$
2,724,429

 
Prepayment rate (annual CPR)
 
20

-
20

%
 
20

%
 
 
 
 
Whole loan spread to TBA price
 
$
1.55

-
$
1.55

 
 
$
1.55

 
 
 
 
 
Whole loan spread to swap rate
 
80

-
365

bps
 
179

bps
 
 
 
 
 
 
 
 
 
 
 
 
 
Jumbo hybrid loans
 
344,151

 
Prepayment rate (annual CPR)
 
15

-
15

%
 
15

%
 
 
 
 
Whole loan spread to swap rate
 
65

-
360

bps
 
141

bps
 
 
 
 
 
 
 
 
 
 
 
 
 
Jumbo loans committed to sell
 
374,481

 
Whole loan committed sales price
 
$
101.84

-
$
103.08

 
 
$
102.12

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans held by Legacy Sequoia (1)
 
457,750

 
Liability price
 
 
 
N/A

 
 
N/A

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans held by Sequoia Choice (1)
 
2,147,356

 
Liability price
 
 
 
N/A

 
 
N/A

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Loans held by Freddie Mac SLST (1)
 
1,235,089

 
Liability price
 
 
 
N/A

 
 
N/A

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Business purpose residential loans:
 
 
 
 
 
 
 
 
 
 
 
 
Single-family rental loans
 
91,501

 
IO discount rate
 
12

-
12

%
 
12

%
 
 
 
 
Prepayment rate (annual CPR)
 
2

-
10

%
 
5

%
 
 
 
 
Senior credit spread
 
95

-
95

bps
 
95

bps
 
 
 
 
Subordinate credit spread
 
140

-
1,200

bps
 
306

bps
 
 
 
 
Senior credit support
 
35

-
35

%
 
35

%
 
 
 
 
 
 
 
 
 
 
 
 
 
Residential bridge loans
 
159,353

 
Discount rate
 
7

-
8

%
 
7

%
 
 
 
 
 
 
 
 
 
 
 
 
 
Multifamily loans held by Freddie Mac K-Series (1)
 
3,749,657

 
Liability price
 
 
 
N/A

 
 
N/A

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Trading and AFS securities
 
1,477,486

 
Discount rate
 
3

-
14

%
 
5

 %
 
 
 
 
Prepayment rate (annual CPR)
 
—

-
60

%
 
10

 %
 
 
 
 
Default rate
 
—

-
20

%
 
2

 %
 
 
 
 
Loss severity
 
—

-
40

%
 
21

 %
 
 
 
 
 
 
 
 
 
 
 
 
 
Servicer advance investments
 
259,222

 
Discount rate
 
4

-
4

%
 
4

%
 
 
 
 
Prepayment rate (annual CPR)
 
8

-
15

%
 
14

%
 
 
 
 
Expected remaining life (2)
 
2

-
2

years
 
2

years
 
 
 
 
Mortgage servicing income
 
6

-
14

bps
 
10

bps
 
 
 
 
 
 
 
 
 
 
 
 
 
MSRs
 
47,396

 
Discount rate
 
11

-
17

%
 
11

 %
 
 
 
 
Prepayment rate (annual CPR)
 
5

-
45

%
 
12

 %
 
 
 
 
Per loan annual cost to service
 
$
82

-
$
82

 
 
$
82

 
 
 
 
 
 
 
 
 
 
 
 
 
 
Excess MSRs
 
33,620

 
Discount rate
 
11

-
16

%
 
14

%
 
 
 
 
Prepayment rate (annual CPR)
 
8

-
14

%
 
11

%
 
 
 
 
Excess mortgage servicing income
 
8

-
17

bps
 
12

bps
 
 
 
 
 
 
 
 
 
 
 
 
 
Guarantee asset
 
1,999

 
Discount rate
 
11

-
11

%
 
11

%
 
 
 
 
Prepayment rate (annual CPR)
 
15

-
15

%
 
15

%
 
 
 
 
 
 
 
 
 
 
 
 
 
REO
 
5,732

 
Loss severity
 
3

-
52

%
 
7

%
 
 
 
 
 
 
 
 
 
 
 
 
 
Loan purchase commitments, net
 
4,707

 
MSR multiple
 
0.7

-
4.6

x
 
2.2

x
 
 
 
 
Pull-through rate
 
7

-
100

%
 
70

%
 
 
 
 
Whole loan spread to TBA price
 
$
0.61

-
$
1.55

 
 
$
1.54

 
 
 
 
 
Whole loan spread to swap rate - fixed rate
 
115

-
365

bps
 
228

bps
 
 
 
 
Prepayment rate (annual CPR)
 
15

-
20

%
 
18

%
 
 
 
 
Whole loan spread to swap rate - hybrid
 
90

-
345

bps
 
129

bps
 
 
 
 
 
 
 
 
 
 
 
 
 

30

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

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


Table 5.7 – Fair Value Methodology for Level 3 Financial Instruments (continued)
June 30, 2019
 
Fair
Value
 
 
 
Input Values
(Dollars in Thousands, except Input Values)
 
 
Unobservable Input
 
Range
 
 
Weighted
Average
Liabilities
 
 
 
 
 
 
 
 
 
 
 
 
ABS issued (1):
 
 
 
 
 
 
 
 
 
 
 
 
At consolidated Sequoia entities
 
2,378,306

 
Discount rate
 
3

-
15

%
 
4

 %
 
 
 
 
Prepayment rate (annual CPR)
 
8

-
49

%
 
19

 %
 
 
 
 
Default rate
 
—

-
9

%
 
2

 %
 
 
 
 
Loss severity
 
20

-
22

%
 
21

 %
 
 
 
 
 
 
 
 
 
 
 
 
 
At consolidated Freddie Mac SLST entity
 
991,766

 
Discount rate
 
3

-
8

%
 
3

%
 
 
 
 
Prepayment rate (annual CPR)
 
6

-
6

%
 
6

%
 
 
 
 
Default rate
 
2

-
2

%
 
2

%
 
 
 
 
Loss severity
 
30

-
30

%
 
30

%
 
 
 
 
 
 
 
 
 
 
 
 
 
At consolidated Freddie Mac K-Series entities
 
3,543,057

 
Discount rate
 
2

-
9

%
 
3

 %
 
 
 
 
Prepayment rate (annual CPR)
 
—

-
—

%
 
—

 %
 
 
 
 
Default rate
 
1

-
1

%
 
1

 %
 
 
 
 
Loss severity
 
20

-
20

%
 
20

 %
 
 
 
 
 
 
 
 
 
 
 
 
 
Contingent consideration
 
24,932

 
Discount rate
 
23

-
23

%
 
23

%
 
 
 
 
Probability of outcomes (3)
 
—

-
100

%
 
90

%
(1)
The fair value of the loans held by consolidated entities was based on the fair value of the ABS issued by these entities, including securities we own, which we determined were more readily observable, in accordance with accounting guidance for collateralized financing entities.
(2)
Represents the estimated average duration of outstanding servicer advances at a given point in time (not taking into account new advances made with respect to the pool).
(3)
Represents the probability of a full payout of contingent purchase consideration.
Determination of Fair Value
A description of the instruments measured at fair value as well as the general classification of such instruments pursuant to the Level 1, Level 2, and Level 3 valuation hierarchy is listed herein. We generally use both market comparable information and discounted cash flow modeling techniques to determine the fair value of our Level 3 assets and liabilities. Use of these techniques requires determination of relevant inputs and assumptions, some of which represent significant unobservable inputs as indicated in the preceding table. Accordingly, a significant increase or decrease in any of these inputs – such as anticipated credit losses, prepayment rates, interest rates, or other valuation assumptions – in isolation would likely result in a significantly lower or higher fair value measurement.
Residential loans at Redwood
Estimated fair values for residential loans are determined using models that incorporate various observable inputs, including pricing information from whole loan sales and securitizations. Certain significant inputs in these models are considered unobservable and are therefore Level 3 in nature. Pricing inputs obtained from market whole loan transaction activity include indicative spreads to indexed to be announced ("TBA") prices and indexed swap rates for fixed-rate loans and indexed swap rates for hybrid loans (Level 3). Pricing inputs obtained from market securitization activity include indicative spreads to indexed TBA prices for senior residential mortgage-backed securities ("RMBS") and indexed swap rates for subordinate RMBS, and credit support levels (Level 3). Other unobservable inputs also include assumed future prepayment rates. Observable inputs include benchmark interest rates, swap rates, and TBA prices. These assets would generally decrease in value based upon an increase in the credit spread, prepayment speed, or credit support assumptions.

31

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

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


Residential and multifamily loans at consolidated entities
We have elected to account for our consolidated securitization entities as CFEs in accordance with GAAP. A CFE is a variable interest entity that holds financial assets and issues beneficial interests in those assets, and these beneficial interests have contractual recourse only to the related assets of the CFE. Accounting guidance for CFEs allow companies to elect to measure both the financial assets and financial liabilities of a CFE using the more observable of the fair value of the financial assets or fair value of the financial liabilities. Pursuant to this guidance, we use the fair value of the ABS issued by the CFEs (which we determined to be more observable) to determine the fair value of the loans held at these entities, whereby the net assets we consolidate in our financial statements related to these entities represent the estimated fair value of our retained interests in the CFEs. 
Business purpose residential loans
Business purpose residential loans include single-family rental loans and residential bridge loans that are generally illiquid in nature and trade infrequently. Significant inputs in the valuation analysis are predominantly Level 3 in nature, due to the lack of readily available market quotes and related inputs.
Prices for our single-family rental loans are determined using market comparable information. Significant inputs obtained from market activity include indicative spreads to indexed swap rates for senior and subordinate mortgage-backed securities ("MBS"), IO MBS discount rates, senior credit support levels, and assumed future prepayment rates (Level 3). These assets would generally decrease in value based upon an increase in the credit spread or prepayment speed assumptions.
Prices for our residential bridge loans are determined using discounted cash flow modeling, which incorporates a primary significant unobservable input of discount rate. These assets would generally decrease in value based upon an increase in the discount rate.
Real estate securities
Real estate securities include residential, multifamily, and other mortgage-backed securities that are generally illiquid in nature and trade infrequently. Significant inputs in the valuation analysis are predominantly Level 3 in nature, due to the lack of readily available market quotes and related inputs. For real estate securities, we utilize both market comparable pricing and discounted cash flow analysis valuation techniques. Relevant market indicators that are factored into the analysis include bid/ask spreads, the amount and timing of credit losses, interest rates, and collateral prepayment rates. Estimated fair values are based on applying the market indicators to generate discounted cash flows (Level 3). These cash flow models use significant unobservable inputs such as a discount rate, prepayment rate, default rate and loss severity. The estimated fair value of our securities would generally decrease based upon an increase in discount rate, default rates, loss severities, or a decrease in prepayment rates.
As part of our securities valuation process, we request and consider indications of value from third-party securities dealers. For purposes of pricing our securities at June 30, 2019, we received dealer price indications on 88% of our securities, representing 96% of our carrying value. In the aggregate, our internal valuations of the securities for which we received dealer price indications were within 1% of the aggregate average dealer valuations. Once we receive the price indications from dealers, they are compared to other relevant market inputs, such as actual or comparable trades, and the results of our discounted cash flow analysis. In circumstances where relevant market inputs cannot be obtained, increased reliance on discounted cash flow analysis and management judgment are required to estimate fair value.
Derivative assets and liabilities
Our derivative instruments include swaps, swaptions, TBAs, loan purchase commitments ("LPCs"), and forward sale commitments ("FSCs"). Fair values of derivative instruments are determined using quoted prices from active markets, when available, or from valuation models and are supported by valuations provided by dealers active in derivative markets. Fair values of TBAs and financial futures are generally obtained using quoted prices from active markets (Level 1). Our derivative valuation models for swaps and swaptions require a variety of inputs, including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates, and correlations of certain inputs. Model inputs can generally be verified and model selection does not involve significant management judgment (Level 2).
LPC and FSC fair values for residential jumbo and single-family rental loans are estimated based on the estimated fair values of the underlying loans (as described in "Residential loans at Redwood" and "Business purpose residential loans" above). In addition, fair values for LPCs are estimated based on the probability that the mortgage loan will be purchased (the "Pull-through rate") (Level 3).

32

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

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


For other derivatives, valuations are based on various factors such as liquidity, bid/ask spreads, and credit considerations for which we rely on available market inputs. In the absence of such inputs, management’s best estimate is used (Level 3).
Servicer advance investments
Estimated fair values for servicer advance investments are determined through internal pricing models that estimate future cash flows and utilize certain significant inputs that are considered unobservable and are therefore Level 3 in nature. Our estimations of cash flows include the combined cash flows of all of the components that comprise the servicer advance investments: existing advances, the requirement to purchase future advances, the recovery of advances, and the right to a portion of the associated mortgage servicing fee ("mortgage servicing income"). The valuation technique is based on discounted cash flows. Significant inputs used in the valuations included prepayment rate (of the loans underlying the investments), mortgage servicing income, servicer advance WAL (the weighted-average expected remaining life of servicer advances), and discount rate. These assets would generally decrease in value based upon an increase in prepayment rates, an increase in servicer advance WAL, or an increase in discount rate, or a decrease in mortgage servicing income.
MSRs
MSRs include the rights to service jumbo and conforming residential mortgage loans. Significant inputs in the valuation analysis are predominantly Level 3, due to the nature of these instruments and the lack of readily available market quotes. Changes in the fair value of MSRs occur primarily due to the collection/realization of expected cash flows, as well as changes in valuation inputs and assumptions. Estimated fair values are based on applying the inputs to generate the net present value of estimated future MSR income (Level 3). These discounted cash flow models utilize certain significant unobservable inputs including market discount rates, assumed future prepayment rates of serviced loans, and the market cost of servicing. An increase in these unobservable inputs would generally reduce the estimated fair value of the MSRs.
As part of our MSR valuation process, we received a valuation estimate from a third-party valuations firm. In the aggregate, our internal valuation of the MSRs were within 2% of the third-party valuation.
Excess MSRs
Estimated fair values for excess MSRs are determined through internal pricing models that estimate future cash flows and utilize certain significant inputs that are considered unobservable and are therefore Level 3 in nature. The valuation technique is based on discounted cash flows. Significant inputs used in the valuations included prepayment rate (of the loans underlying the investments), the amount of excess servicing income expected to be received ("excess mortgage servicing income"), and discount rate. These assets would generally decrease in value based upon an increase in prepayment rates or discount rate, or a decrease in excess mortgage servicing income.
FHLBC stock
Our Federal Home Loan Bank ("FHLB") member subsidiary is required to purchase Federal Home Loan Bank of Chicago ("FHLBC") stock under a borrowing agreement between our FHLB-member subsidiary and the FHLBC. Under this agreement, the stock is redeemable at face value, which represents the carrying value and fair value of the stock (Level 2).
Guarantee asset
The guarantee asset represents the estimated fair value of cash flows we are contractually entitled to receive related to a risk-sharing arrangement with Fannie Mae. Significant inputs in the valuation analysis are Level 3, due to the nature of this asset and the lack of market quotes. The fair value of the guarantee asset is determined using a discounted cash flow model, for which significant unobservable inputs include assumed future prepayment rates and market discount rate (Level 3). An increase in prepayment rates or discount rate would generally reduce the estimated fair value of the guarantee asset.
Pledged collateral
Pledged collateral consists of cash and U.S. Treasury securities held by a custodian in association with certain agreements we have entered into. Treasury securities are carried at their fair value, which is determined using quoted prices in active markets (Level 1).

33

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

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


Cash and cash equivalents
Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less. Fair values equal carrying values (Level 1).
Restricted cash
Restricted cash primarily includes interest-earning cash balances related to risk-sharing transactions with the Agencies, cash held in association with borrowings from the FHLBC, cash held at Servicing Investment entities, and cash held at consolidated Sequoia entities for the purpose of distribution to investors and reinvestment. Due to the short-term nature of the restrictions, fair values approximate carrying values (Level 1).
Accrued interest receivable and payable
Accrued interest receivable and payable includes interest due on our assets and payable on our liabilities. Due to the short-term nature of when these interest payments will be received or paid, fair values approximate carrying values (Level 1).
Real estate owned
Real estate owned ("REO") includes properties owned in satisfaction of foreclosed loans. Fair values are determined using available market quotes, appraisals, broker price opinions, comparable properties, or other indications of value (Level 3).
Margin receivable
Margin receivable reflects cash collateral we have posted with our various derivative and debt counterparties as required to satisfy margin requirements. Fair values approximate carrying values (Level 2).
Contingent consideration
Contingent consideration is related to our acquisition of 5 Arches and is estimated and recorded at fair value as part of purchase consideration. Each reporting period we estimate the change in fair value of the contingent consideration, and such change is recognized in our consolidated statements of income, unless it is determined to be a measurement period adjustment. The estimate of the fair value of contingent consideration requires significant judgment and assumptions to be made about future operating results, discount rates, and probabilities of projected operating result scenarios (Level 3).
Short-term debt
Short-term debt includes our credit facilities for residential and business purpose residential loans and real estate securities as well as non-recourse short-term borrowings used to finance servicer advance investments. As these borrowings are secured and subject to margin calls and as the rates on these borrowings reset frequently to market rates, we believe that carrying values approximate fair values (Level 2).
ABS issued
ABS issued includes asset-backed securities issued through the Legacy Sequoia and Sequoia Choice securitization entities, as well as securities issued by certain third-party Freddie Mac SLST and K-series securitization entities which we consolidate. These instruments are generally illiquid in nature and trade infrequently. Significant inputs in the valuation analysis are predominantly Level 3, due to the nature of these instruments and the lack of readily available market quotes. For ABS issued, we utilize both market comparable pricing and discounted cash flow analysis valuation techniques. Relevant market indicators factored into the analysis include bid/ask spreads, the amount and timing of collateral credit losses, interest rates, and collateral prepayment rates. Estimated fair values are based on applying the market indicators to generate discounted cash flows (Level 3). These cash flow models use significant unobservable inputs such as a discount rates, prepayment rate, default rate, loss severity and credit support. A decrease in credit losses or discount rate, or an increase in prepayment rates, would generally cause the fair value of the ABS issued to decrease (i.e., become a larger liability).

34

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

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


FHLBC borrowings
FHLBC borrowings include amounts borrowed from the FHLBC that are secured, generally by residential mortgage loans. As these borrowings are secured and subject to margin calls and as the rates on these borrowings reset frequently to market rates, we believe that carrying values approximate fair values (Level 2).
Financial Instruments Carried at Amortized Cost
Participation in loan warehouse facility
Our participation in a loan warehouse facility was carried at amortized cost (Level 2).
Guarantee obligations
In association with our risk-sharing transactions with the Agencies, we have made certain guarantees which are carried on our balance sheet at amortized cost (Level 3).
Convertible notes
Convertible notes include unsecured convertible and exchangeable senior notes that are carried at their unpaid principal balance net of any unamortized deferred issuance costs. The fair value of the convertible notes is determined using quoted prices in generally active markets (Level 2).
Trust preferred securities and subordinated notes
Trust preferred securities and subordinated notes are carried at their unpaid principal balance net of any unamortized deferred issuance costs (Level 3).
Note 6. Residential Loans
We acquire residential loans from third-party originators and may sell or securitize these loans or hold them for investment. The following table summarizes the classifications and carrying values of the residential loans owned at Redwood and at consolidated Sequoia entities at June 30, 2019 and December 31, 2018.
Table 6.1 – Classifications and Carrying Values of Residential Loans
June 30, 2019
 
 
 
Legacy
 
Sequoia
 
Freddie Mac
 
 
(In Thousands)
 
Redwood
 
Sequoia
 
Choice
 
SLST
 
Total
Held-for-sale
 
 
 
 
 
 
 
 
 
 
At fair value
 
$
1,056,178

 
$
—

 
$
—

 
$
—

 
$
1,056,178

At lower of cost or fair value
 
109

 
—

 
—

 
—

 
109

Total held-for-sale
 
1,056,287

 
—


—

 
—

 
1,056,287

Held-for-investment at fair value
 
2,386,883

 
457,750

 
2,147,356

 
1,235,089

 
6,227,078

Total Residential Loans
 
$
3,443,170

 
$
457,750


$
2,147,356

 
$
1,235,089

 
$
7,283,365


35

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 6. Residential Loans - (continued)

December 31, 2018
 
 
 
Legacy
 
Sequoia
 
Freddie Mac
 
 
(In Thousands)
 
Redwood
 
Sequoia
 
Choice
 
SLST
 
Total
Held-for-sale
 
 
 
 
 
 
 
 
 
 
At fair value
 
$
1,048,690

 
$
—

 
$
—

 
$
—

 
$
1,048,690

At lower of cost or fair value
 
111

 
—

 
—

 
—

 
111

Total held-for-sale
 
1,048,801

 
—

 
—

 
—

 
1,048,801

Held-for-investment at fair value
 
2,383,932

 
519,958

 
2,079,382

 
1,222,669

 
6,205,941

Total Residential Loans
 
$
3,432,733

 
$
519,958

 
$
2,079,382

 
$
1,222,669

 
$
7,254,742

At June 30, 2019, we owned mortgage servicing rights associated with $2.65 billion (principal balance) of consolidated residential loans purchased from third-party originators. The value of these MSRs is included in the carrying value of the associated loans on our consolidated balance sheets. We contract with licensed sub-servicers that perform servicing functions for these loans.
Residential Loans Held-for-Sale
At Fair Value
At June 30, 2019, we owned 1,417 loans held-for-sale at fair value with an aggregate unpaid principal balance of $1.03 billion and a fair value of $1.06 billion, compared to 1,484 loans with an aggregate unpaid principal balance of $1.03 billion and a fair value of $1.05 billion at December 31, 2018. At both June 30, 2019 and December 31, 2018, one of these loans with a fair value of $0.6 million was greater than 90 days delinquent and none of these loans were in foreclosure.
During the three and six months ended June 30, 2019, we purchased $1.53 billion and $2.49 billion (principal balance) of loans, respectively, for which we elected the fair value option, and we sold $1.23 billion and $2.39 billion (principal balance) of loans, respectively, for which we recorded net market valuation gains of $3 million and $7 million, respectively, through Mortgage banking activities, net on our consolidated statements of income. At June 30, 2019, loans held-for-sale with a market value of $712 million were pledged as collateral under short-term borrowing agreements.
During the three and six months ended June 30, 2018, we purchased $1.93 billion and $3.73 billion (principal balance) of loans, respectively, for which we elected the fair value option, and we sold $1.92 billion and $3.93 billion (principal balance) of loans, respectively, for which we recorded net market valuation gains of $6 million and $11 million, respectively, through Mortgage banking activities, net on our consolidated statements of income.
At Lower of Cost or Fair Value
At both June 30, 2019 and December 31, 2018, we held two residential loans at the lower of cost or fair value with $0.1 million in outstanding principal balance and carrying values of $0.1 million. At both June 30, 2019 and December 31, 2018, none of these loans were greater than 90 days delinquent or in foreclosure.
Residential Loans Held-for-Investment at Fair Value
At Redwood
At June 30, 2019, we owned 3,262 held-for-investment loans at Redwood with an aggregate unpaid principal balance of $2.32 billion and a fair value of $2.39 billion, compared to 3,296 loans with an aggregate unpaid principal balance of $2.39 billion and a fair value of $2.38 billion at December 31, 2018. At June 30, 2019, two of these loans with an aggregate fair value of $1 million were greater than 90 days delinquent and none of these loans were in foreclosure. At December 31, 2018, two of these loans with an aggregate fair value of $1 million were greater than 90 days delinquent and none of these loans were in foreclosure.

36

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 6. Residential Loans - (continued)

During the three and six months ended June 30, 2019, we purchased zero and $39 million (principal balance) of loans, respectively, for which we elected the fair value option, and did not sell any loans. During the three and six months ended June 30, 2019, we transferred loans with a fair value of $30 million and $69 million, respectively, from held-for-sale to held-for-investment. During the three and six months ended June 30, 2019, we transferred loans with a fair value of zero and $23 million, respectively, from held-for-investment to held-for-sale. During the three and six months ended June 30, 2019, we recorded net market valuation gains of $36 million and $64 million, respectively, on residential loans held-for-investment at fair value through Investment fair value changes, net on our consolidated statements of income. At June 30, 2019, loans with a fair value of $2.39 billion were pledged as collateral under a borrowing agreement with the FHLBC.
During the three and six months ended June 30, 2018, we transferred loans with a fair value of $32 million and $88 million, respectively, from held-for-sale to held-for-investment. During both the three and six months ended June 30, 2018, we did not transfer any loans from held-for-investment to held-for-sale. During the three and six months ended June 30, 2018, we recorded net market valuation losses of $15 million and $54 million, respectively, on residential loans held-for-investment at fair value through Investment fair value changes, net on our consolidated statements of income.
The outstanding loans held-for-investment at Redwood at June 30, 2019 were prime-quality, first lien loans, of which 90% were originated between 2013 and 2019, and 1% were originated in 2012 and prior years. The weighted average Fair Isaac Corporation ("FICO") score of borrowers backing these loans was 768 (at origination) and the weighted average loan-to-value ("LTV") ratio of these loans was 66% (at origination). At June 30, 2019, these loans were comprised of 88% fixed-rate loans with a weighted average coupon of 4.16%, and the remainder were hybrid or ARM loans with a weighted average coupon of 4.20%.
At Consolidated Legacy Sequoia Entities
At June 30, 2019, we consolidated 2,400 held-for-investment loans at consolidated Legacy Sequoia entities, with an aggregate unpaid principal balance of $475 million and a fair value of $458 million, as compared to 2,641 loans at December 31, 2018, with an aggregate unpaid principal balance of $545 million and a fair value of $520 million. At origination, the weighted average FICO score of borrowers backing these loans was 727, the weighted average LTV ratio of these loans was 66%, and the loans were nearly all first lien and prime-quality.
At June 30, 2019 and December 31, 2018, the aggregate unpaid principal balance of loans at consolidated Legacy Sequoia entities delinquent greater than 90 days was $13 million and $14 million, respectively, of which the aggregate unpaid principal balance of loans in foreclosure was $5 million and $5 million, respectively. During the three and six months ended June 30, 2019, we recorded net market valuation gains of $1 million and $5 million, respectively, on these loans through Investment fair value changes, net on our consolidated statements of income. During the three and six months ended June 30, 2018, we recorded net market valuation gains of $4 million and $33 million, respectively, on these loans through Investment fair value changes, net on our consolidated statements of income. Pursuant to the collateralized financing entity guidelines, the market valuation changes of these loans are based on the estimated fair value of the associated ABS issued. The net impact to our income statement associated with our retained economic investment in the Legacy Sequoia securitization entities is presented in Note 5.
At Consolidated Sequoia Choice Entities
At June 30, 2019, we consolidated 2,912 held-for-investment loans at the consolidated Sequoia Choice entities, with an aggregate unpaid principal balance of $2.08 billion and a fair value of $2.15 billion, as compared to 2,800 loans at December 31, 2018 with an aggregate unpaid principal balance of $2.04 billion and a fair value of $2.08 billion. At origination, the weighted average FICO score of borrowers backing these loans was 745, the weighted average LTV ratio of these loans was 75%, and the loans were all first lien and prime-quality. At June 30, 2019, six of these loans with an aggregate unpaid principal balance of $3 million were greater than 90 days delinquent and none of these loans were in foreclosure. At December 31, 2018, three of these loans with an aggregate unpaid principal balance of $2 million were greater than 90 days delinquent and none of these loans were in foreclosure.

37

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 6. Residential Loans - (continued)

During the three and six months ended June 30, 2019, we transferred loans with a fair value of zero and $350 million, respectively, from held-for-sale to held-for-investment associated with Choice securitizations. During the three and six months ended June 30, 2019, we recorded net market valuation gains of $6 million and $16 million, respectively, on these loans through Investment fair value changes, net on our consolidated statements of income. Pursuant to the collateralized financing entity guidelines, the market valuation changes of these loans are based on the estimated fair value of the ABS issued associated with Choice securitizations. The net impact to our income statement associated with our retained economic investment in the Sequoia Choice securitization entities is presented in Note 5.
At Consolidated Freddie Mac SLST Entity
During the fourth quarter of 2018, we invested in subordinate securities issued by a Freddie Mac SLST securitization trust and were required to consolidate the underlying seasoned re-performing and non-performing residential loans owned at this entity for financial reporting purposes in accordance with GAAP. At securitization, which occurred during the fourth quarter of 2018, each of these mortgage loans was a fully amortizing, fixed- or step-rate, first-lien loan that had been modified. At June 30, 2019, we consolidated 7,744 held-for-investment loans at the consolidated Freddie Mac SLST entity, with an aggregate unpaid principal balance of $1.27 billion and a fair value of $1.24 billion, compared to 7,900 loans at December 31, 2018 with an aggregate unpaid principal balance of $1.31 billion and a fair value of $1.22 billion. At securitization, the weighted average FICO score of borrowers backing these loans was 597 and the weighted average LTV ratio of these loans was 69%. At June 30, 2019, 301 of these loans with an aggregate unpaid principal balance of $78 million were greater than 90 days delinquent, and 101 of these loans with an aggregate unpaid principal balance of $15 million were in foreclosure. At December 31, 2018, 306 of these loans with an aggregate unpaid principal balance of $51 million were greater than 90 days delinquent and none of these loans were in foreclosure.
During the three and six months ended June 30, 2019, we recorded net market valuation gains of $31 million and $55 million, respectively, on these loans through Investment fair value changes, net on our consolidated statements of income. Pursuant to the collateralized financing entity guidelines, the market valuation changes of these loans are based on the estimated fair value of the ABS issued associated with the Freddie Mac SLST securitization. The net impact to our income statement associated with our economic investment in the Freddie Mac SLST securitization entity is presented in Note 5.
Note 7. Business Purpose Residential Loans
We originate business purpose residential loans, including single-family rental loans and residential bridge loans. This origination activity commenced in connection with our acquisition of 5 Arches on March 1, 2019.
Business Purpose Residential Loan Originations
During the three months ended June 30, 2019, we funded $134 million of business purpose residential loans, of which $23 million of residential bridge loans were sold to a third party. During the period from March 1, 2019 to June 30, 2019, we funded $170 million of business purpose residential loans, of which $44 million of residential bridge loans were sold to a third party. The remaining business purpose residential loans were transferred to our investment portfolio (residential bridge loans), or retained in our mortgage banking business (single-family rental loans). Prior to the transfer of residential bridge loans to our investment portfolio, we recorded net market valuation gains of $1 million on these loans through Mortgage banking activities, net on our consolidated statements of income for both the three months ended June 30, 2019 and for the period from March 1, 2019 to June 30, 2019. Market valuation adjustments on our single-family rental loans are also recorded in Mortgage banking activities, net on our consolidated statements of income. Additionally, during both the three months ended June 30, 2019 and during the period from March 1, 2019 to June 30, 2019, we recorded loan origination fee income of $3 million through Mortgage banking activities, net on our consolidated statements of income.

38

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)


The following table summarizes the classifications and carrying values of the business purpose residential loans owned at Redwood at June 30, 2019 and December 31, 2018.
Table 7.1 – Classifications and Carrying Values of Business Purpose Residential Loans
(In Thousands)
 
June 30, 2019
 
December 31, 2018
Single-family rental loans, held-for-sale at fair value
 
$
91,501

 
$
28,460

Residential bridge loans, held-for-investment at fair value
 
159,353

 
112,798

Total Business Purpose Residential Loans
 
$
250,854

 
$
141,258


Single-Family Rental Loans Held-for-Sale at Fair Value
At June 30, 2019, we owned 43 single-family rental loans with an aggregate unpaid principal balance of $87 million and a fair value of $92 million, compared to 11 loans at December 31, 2018 with an aggregate unpaid principal balance of $28 million and a fair value of $28 million. At both June 30, 2019 and December 31, 2018, none of these loans were greater than 90 days delinquent or in foreclosure.
During the three months ended June 30, 2019 and for the period from March 1, 2019 to June 30, 2019, $33 million and $41 million of newly originated single-family rental loans, respectively, were retained in our mortgage banking business, and we did not sell any loans during either of these periods. Prior to our acquisition of 5 Arches on March 1, 2019, we purchased $19 million of single-family rental loans from 5 Arches. During the three and six months ended June 30, 2019, we recorded net market valuation gains of $1 million and $2 million, respectively, on single-family rental loans held-for-sale at fair value through Mortgage banking activities, net on our consolidated statements of income. At June 30, 2019, loans held-for-sale with a market value of $71 million were pledged as collateral under short-term borrowing agreements.
The outstanding single-family rental loans held-for-sale at June 30, 2019 were first lien, fixed-rate loans with maturities of five, seven, or ten years. At June 30, 2019, the weighted average coupon of our single-family rental loans was 5.54% and the weighted average loan term was six years. At origination, the weighted average LTV ratio of these loans was 66% and the weighted average debt service coverage ratio ("DSCR") was 1.33 times.
Residential Bridge Loans Held-for-Investment at Fair Value
At June 30, 2019, we owned 274 residential bridge loans held-for-investment with an aggregate unpaid principal balance of $158 million and a fair value of $159 million, compared to 157 loans at December 31, 2018 with an aggregate unpaid principal balance of $112 million and a fair value of $113 million.
As part of our credit risk management practices, our residential bridge loans are subject to individual risk assessment using an internal borrower and collateral quality evaluation framework. At June 30, 2019, 11 loans with an aggregate fair value of $12 million were greater than 90 days delinquent, and nine of these loans with an aggregate fair value of $7 million were in foreclosure. At December 31, 2018, seven loans with an aggregate fair value of $12 million were greater than 90 days delinquent and four of these loans with an aggregate fair value of $11 million were in foreclosure. During the six months ended June 30, 2019, we transferred one loan with a fair value of $5 million to REO, which is included in Other assets on our consolidated balance sheets. We recognized losses of $0.1 million and $0.4 million related to this loan for the three and six months ended June 30, 2019, respectively, which was included in Investment fair value changes, net on our consolidated statements of income.
During the three months ended June 30, 2019 and for the period from March 1, 2019 to June 30, 2019, $79 million and $86 million of newly originated residential bridge loans, respectively, were transferred to our investment portfolio. Prior to our acquisition of 5 Arches on March 1, 2019, we purchased $10 million of residential bridge loans from 5 Arches. During the three and six months ended June 30, 2019, we recorded net market valuation losses of $0.3 million and $0.6 million, respectively, on residential bridge loans held-for-investment at fair value through Investment fair value changes, net on our consolidated statements of income. At June 30, 2019, loans with a market value of $144 million were pledged as collateral under short-term borrowing agreements.

39

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)


The outstanding residential bridge loans held-for-investment at June 30, 2019 were first lien, fixed-rate, interest-only loans with a weighted average coupon of 9.08% and original maturities of six to 24 months. At origination, the weighted average FICO score of borrowers backing these loans was 690 and the weighted average LTV ratio of these loans was 74%.
At June 30, 2019, we had a $33 million commitment to fund residential bridge loans. See Note 16 for additional information on this commitment.
Note 8. Multifamily Loans
Beginning in the second half of 2018, we invested in multifamily subordinate securities issued by certain Freddie Mac K-Series securitization trusts and were required to consolidate the underlying multifamily loans owned at these entities for financial reporting purposes in accordance with GAAP. At June 30, 2019, we consolidated 250 held-for-investment multifamily loans, with an aggregate unpaid principal balance of $3.55 billion and a fair value of $3.75 billion, compared to 162 loans at December 31, 2018 with an aggregate unpaid principal balance of $2.13 billion and a fair value of $2.14 billion. The outstanding multifamily loans held-for-investment at the Freddie Mac K-Series entities at June 30, 2019 were first lien, fixed-rate loans that were originated between 2015 and 2017 and had original loan terms of seven to ten years and an original weighted average LTV ratio of 69%. At June 30, 2019, the weighted average coupon of these multifamily loans was 4.19% and the weighted average remaining loan term was six years. At both June 30, 2019 and December 31, 2018, none of these loans were greater than 90 days delinquent or in foreclosure.
During the three and six months ended June 30, 2019, we recorded net market valuation gains of $97 million and $131 million, respectively, on these loans through Investment fair value changes, net on our consolidated statements of income. Pursuant to the collateralized financing entity guidelines, the market valuation changes of these loans are based on the estimated fair value of the ABS issued associated with the securitizations. The net impact to our income statement associated with our economic investment in the securities of the Freddie Mac K-Series securitization entities is presented in Note 5.
Note 9. Real Estate Securities
We invest in real estate securities that we acquire from third parties or create and retain from our Sequoia securitizations. The following table presents the fair values of our real estate securities by type at June 30, 2019 and December 31, 2018.
Table 9.1 – Fair Values of Real Estate Securities by Type
(In Thousands)
 
June 30, 2019
 
December 31, 2018
Trading
 
$
1,205,389

 
$
1,118,612

Available-for-sale
 
272,097

 
333,882

Total Real Estate Securities
 
$
1,477,486

 
$
1,452,494


Our real estate securities include mortgage-backed securities, which are presented in accordance with their general position within a securitization structure based on their rights to cash flows. Senior securities are those interests in a securitization that generally have the first right to cash flows and are last in line to absorb losses. Mezzanine securities are interests that are generally subordinate to senior securities in their rights to receive cash flows, and have subordinate securities below them that are first to absorb losses. Most of our mezzanine classified securities were initially rated AA through BBB- and issued in 2012 or later. Subordinate securities are all interests below mezzanine. Nearly all of our residential securities are supported by collateral that was designated as prime at the time of issuance.

40

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 9. Real Estate Securities - (continued)


Trading Securities
The following table presents the fair value of trading securities by position and collateral type at June 30, 2019 and December 31, 2018.
Table 9.2 – Trading Securities by Position
(In Thousands)
 
June 30, 2019
 
December 31, 2018
Senior
 
$
170,731

 
$
158,670

Mezzanine
 
748,282

 
610,819

Subordinate
 
286,376

 
349,123

Total Trading Securities
 
$
1,205,389

 
$
1,118,612

We elected the fair value option for certain securities and classify them as trading securities. Our trading securities include both residential and multifamily mortgage-backed securities. At June 30, 2019, trading securities with a carrying value of $874 million as well as $148 million, $203 million, and $207 million of securities we owned that were issued by consolidated Sequoia Choice, Freddie Mac SLST, and Freddie Mac K-Series securitizations, respectively, were pledged as collateral under short-term borrowing agreements. See Note 13 for additional information on short-term debt.
At June 30, 2019 and December 31, 2018, our senior trading securities included $66 million and $82 million of interest-only securities, respectively, for which there is no principal balance, and the remaining unpaid principal balance of our senior trading securities was $102 million and $78 million, respectively. Our interest-only securities included $35 million and $43 million of A-IO-S securities at June 30, 2019 and December 31, 2018, respectively, which are securities we retained from certain of our Sequoia securitizations that represent certificated servicing strips.
At June 30, 2019 and December 31, 2018, our mezzanine and subordinate trading securities had an unpaid principal balance of $1.19 billion and $1.12 billion, respectively. At June 30, 2019 and December 31, 2018, the fair value of our mezzanine and subordinate securities was $1.03 billion and $960 million, respectively, and included $201 million and $277 million, respectively, of Agency residential mortgage credit risk transfer (or "CRT") securities, $73 million and $68 million, respectively, of Sequoia securities, $233 million and $186 million, respectively, of other third-party residential securities, and $528 million and $429 million, respectively, of third-party commercial/multifamily securities.
During the three and six months ended June 30, 2019, we acquired $115 million and $269 million (principal balance), respectively, of securities for which we elected the fair value option and classified as trading, and sold $132 million and $161 million, respectively, of such securities. During the three and six months ended June 30, 2018, we acquired $233 million and $378 million (principal balance), respectively, of securities for which we elected the fair value option and classified as trading, and sold $62 million and $244 million, respectively, of such securities.
During the three and six months ended June 30, 2019, we recorded net market valuation gains of $18 million and $40 million, respectively, on trading securities, included in Investment fair value changes, net on our consolidated statements of income. During the three and six months ended June 30, 2018, we recorded net market valuation losses of $1 million and $4 million, respectively, on trading securities, included in Investment fair value changes, net on our consolidated statements of income.

41

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 9. Real Estate Securities - (continued)


AFS Securities
The following table presents the fair value of our available-for-sale securities by position and collateral type at June 30, 2019 and December 31, 2018.
Table 9.3 – Available-for-Sale Securities by Position
(In Thousands)
 
June 30, 2019
 
December 31, 2018
Senior
 
$
44,467

 
$
87,615

Mezzanine
 
8,976

 
36,407

Subordinate
 
218,654

 
209,860

Total AFS Securities
 
$
272,097

 
$
333,882


At June 30, 2019 and December 31, 2018, all of our available-for-sale securities were comprised of residential mortgage-backed securities. At June 30, 2019, AFS securities with a carrying value of $70 million were pledged as collateral under short-term borrowing agreements. See Note 13 for additional information on short-term debt.
During the three and six months ended June 30, 2019, we purchased $4 million and $9 million of AFS securities, respectively, and sold $25 million and $67 million of AFS securities, respectively, which resulted in net realized gains of $3 million and $9 million, respectively. During the three and six months ended June 30, 2018, we purchased $2 million and $6 million of AFS securities, respectively, and sold $41 million and $92 million of AFS securities, respectively, which resulted in net realized gains of $5 million and $14 million, respectively.
We often purchase AFS securities at a discount to their outstanding principal balances. To the extent we purchase an AFS security that has a likelihood of incurring a loss, we do not amortize into income the portion of the purchase discount that we do not expect to collect due to the inherent credit risk of the security. We may also expense a portion of our investment in the security to the extent we believe that principal losses will exceed the purchase discount. We designate any amount of unpaid principal balance that we do not expect to receive and thus do not expect to earn or recover as a credit reserve on the security. Any remaining net unamortized discounts or premiums on the security are amortized into income over time using the effective yield method.
At June 30, 2019, there were no AFS securities with contractual maturities less than five years, $3 million with contractual maturities greater than five years but less than 10 years, and the remainder of our AFS securities had contractual maturities greater than 10 years.
The following table presents the components of carrying value (which equals fair value) of AFS securities at June 30, 2019 and December 31, 2018.
Table 9.4 – Carrying Value of AFS Securities
June 30, 2019
 
 
 
 
 
 
(In Thousands)
 
Senior
 
Mezzanine
 
Subordinate
 
Total
Principal balance
 
$
45,147

 
$
8,778

 
$
291,997

 
$
345,922

Credit reserve
 
(1,323
)
 
—

 
(33,526
)
 
(34,849
)
Unamortized discount, net
 
(15,009
)
 
(576
)
 
(121,697
)
 
(137,282
)
Amortized cost
 
28,815


8,202

 
136,774

 
173,791

Gross unrealized gains
 
15,664

 
774

 
81,880

 
98,318

Gross unrealized losses
 
(12
)
 
—

 
—

 
(12
)
Carrying Value
 
$
44,467


$
8,976

 
$
218,654

 
$
272,097


42

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 9. Real Estate Securities - (continued)


December 31, 2018
 
 
 
 
 
 
(In Thousands)
 
Senior
 
Mezzanine
 
Subordinate
 
Total
Principal balance
 
$
91,736

 
$
36,852

 
$
302,524

 
$
431,112

Credit reserve
 
(7,790
)
 
—

 
(33,580
)
 
(41,370
)
Unamortized discount, net
 
(18,460
)
 
(3,697
)
 
(129,043
)
 
(151,200
)
Amortized cost
 
65,486


33,155

 
139,901

 
238,542

Gross unrealized gains
 
22,178

 
3,252

 
70,458

 
95,888

Gross unrealized losses
 
(49
)
 
—

 
(499
)
 
(548
)
Carrying Value
 
$
87,615


$
36,407

 
$
209,860

 
$
333,882


The following table presents the changes for the three and six months ended June 30, 2019, in unamortized discount and designated credit reserves on residential AFS securities.
Table 9.5 – Changes in Unamortized Discount and Designated Credit Reserves on AFS Securities
 
 
Three Months Ended June 30, 2019
 
Six Months Ended June 30, 2019
 
 
Credit
Reserve
 
Unamortized
Discount, Net
 
Credit
Reserve
 
Unamortized
Discount, Net
(In Thousands)
 
 
 
 
Beginning balance
 
$
34,834

 
$
142,013

 
$
41,370

 
$
151,200

Amortization of net discount
 
—

 
(2,059
)
 
—

 
(3,989
)
Realized credit losses
 
(1,014
)
 
—

 
(1,180
)
 
—

Acquisitions
 
787

 
350

 
1,464

 
704

Sales, calls, other
 
(5
)
 
(2,775
)
 
(6,397
)
 
(11,041
)
(Release of) transfers to credit reserves, net
 
247

 
(247
)
 
(408
)
 
408

Ending Balance
 
$
34,849

 
$
137,282

 
$
34,849

 
$
137,282


AFS Securities with Unrealized Losses
The following table presents the components comprising the total carrying value of residential AFS securities that were in a gross unrealized loss position at June 30, 2019 and December 31, 2018.
Table 9.6 – Components of Fair Value of Residential AFS Securities by Holding Periods
 
 
Less Than 12 Consecutive Months
 
12 Consecutive Months or Longer
 
 
Amortized
Cost
 
Unrealized
Losses
 
Fair
Value
 
Amortized
Cost
 
Unrealized
Losses
 
Fair
Value
(In Thousands)
 
 
 
 
 
 
June 30, 2019
 
$
—

 
$
—

 
$
—

 
$
6,445

 
$
(12
)
 
$
6,433

December 31, 2018
 
12,923

 
(499
)
 
12,424

 
7,464

 
(49
)
 
7,415


At June 30, 2019, after giving effect to purchases, sales, and extinguishment due to credit losses, our consolidated balance sheet included 114 AFS securities, of which one was in an unrealized loss position and one was in a continuous unrealized loss position for 12 consecutive months or longer. At December 31, 2018, our consolidated balance sheet included 128 AFS securities, of which seven were in an unrealized loss position and three were in a continuous unrealized loss position for 12 consecutive months or longer.

43

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 9. Real Estate Securities - (continued)


Evaluating AFS Securities for Other-than-Temporary Impairments
Gross unrealized losses on our AFS securities were less than $0.1 million at June 30, 2019. We evaluate all securities in an unrealized loss position to determine if the impairment is temporary or other-than-temporary (resulting in an OTTI). At June 30, 2019, we did not intend to sell any of our AFS securities that were in an unrealized loss position, and it is more likely than not that we will not be required to sell these securities before recovery of their amortized cost basis, which may be at their maturity. We review our AFS securities that are in an unrealized loss position to identify those securities with losses that are other-than-temporary based on an assessment of changes in expected cash flows for such securities, which considers recent security performance and expected future performance of the underlying collateral.
For both the three and six months ended June 30, 2019, there were no other-than-temporary impairments related to our AFS securities. AFS securities for which OTTI is recognized have experienced, or are expected to experience, credit-related adverse cash flow changes. In determining our estimate of cash flows for AFS securities we may consider factors such as structural credit enhancement, past and expected future performance of underlying mortgage loans, including timing of expected future cash flows, which are informed by prepayment rates, default rates, loss severities, delinquency rates, percentage of non-performing loans, FICO scores at loan origination, year of origination, loan-to-value ratios, and geographic concentrations, as well as general market assessments. Changes in our evaluation of these factors impacted the cash flows expected to be collected at the OTTI assessment date and were used to determine if there were credit-related adverse cash flows and if so, the amount of credit related losses. Significant judgment is used in both our analysis of the expected cash flows for our AFS securities and any determination of the credit loss component of OTTI.
The table below summarizes the significant valuation assumptions we used for our AFS securities in unrealized loss positions at June 30, 2019.
Table 9.7 – Significant Valuation Assumptions
June 30, 2019
 
Range for Securities
Prepayment rates
 
15%
-
15%
Projected losses
 
1%
-
1%

The following table details the activity related to the credit loss component of OTTI (i.e., OTTI recognized through earnings) for AFS securities held at June 30, 2019 and 2018, for which a portion of an OTTI was recognized in other comprehensive income.
Table 9.8 – Activity of the Credit Component of Other-than-Temporary Impairments
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2019
 
2018
 
2019
 
2018
Balance at beginning of period
 
$
18,652

 
$
20,924

 
$
18,652

 
$
21,037

Additions
 
 
 
 
 
 
 
 
Initial credit impairments
 
—

 
43

 
—

 
43

Reductions
 
 
 
 
 
 
 
 
Securities sold, or expected to sell
 
(14
)
 
—

 
(14
)
 
(99
)
Securities with no outstanding principal at period end
 
(58
)
 
—

 
(58
)
 
(14
)
Balance at End of Period
 
$
18,580

 
$
20,967

 
$
18,580

 
$
20,967



44

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 9. Real Estate Securities - (continued)


Gains and losses from the sale of AFS securities are recorded as Realized gains, net, in our consolidated statements of income. The following table presents the gross realized gains and losses on sales and calls of AFS securities for the three and six months ended June 30, 2019 and 2018.
Table 9.9 – Gross Realized Gains and Losses on AFS Securities
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2019
 
2018
 
2019
 
2018
Gross realized gains - sales
 
$
2,827

 
$
4,674

 
$
9,487

 
$
14,037

Gross realized gains - calls
 
—

 
43

 
4,026

 
43

Gross realized losses - sales
 
—

 
(3
)
 
—

 
(3
)
Total Realized Gains on Sales and Calls of AFS Securities, net
 
$
2,827

 
$
4,714

 
$
13,513

 
$
14,077


Note 10. Other Investments
Other investments at June 30, 2019 and December 31, 2018 are summarized in the following table.
Table 10.1 – Components of Other Investments
(In Thousands)
 
June 30, 2019
 
December 31, 2018
Servicer advance investments
 
$
259,222

 
$
300,468

Mortgage servicing rights
 
47,396

 
60,281

Excess MSRs
 
33,620

 
27,312

Investment in multifamily loan fund
 
28,678

 
—

Other notes receivable
 
3,214

 
—

Participation in loan warehouse facility
 
—

 
39,703

Investment in 5 Arches
 
—

 
10,754

Total Other Investments
 
$
372,130

 
$
438,518


Servicer advance investments
In 2018, we and a third-party co-investor, through two partnerships (“SA Buyers”) consolidated by us, purchased the outstanding servicer advances and excess MSRs related to a portfolio of legacy residential mortgage-backed securitizations serviced by the co-investor (See Note 4 for additional information regarding the transaction). At June 30, 2019, we had funded $66 million of capital to the SA Buyers and funded the remaining $6 million of capital in July 2019 (see Note 16 for additional detail).
Our servicer advance investments (owned by the consolidated SA Buyers) are comprised of outstanding servicer advance receivables, the requirement to purchase all future servicer advances made with respect to a specified pool of residential mortgage loans, and a portion of the mortgage servicing fees from the underlying loan pool. A portion of the remaining mortgage servicing fees from the underlying loan pool are paid directly to the third-party servicer for the performance of servicing duties and a portion is paid to excess MSRs that we own as a separate investment. We hold our servicer advance investments at our taxable REIT subsidiary.
Servicer advances are non-interest bearing and are a customary feature of residential mortgage securitization transactions. Servicer advances are generally reimbursable cash payments made by a servicer when the borrower fails to make scheduled payments due on a residential mortgage loan or to support the value of the collateral property. Servicer advances typically fall into three categories:
•
Principal and Interest Advances: cash payments made by the servicer to cover scheduled principal and interest payments on a residential mortgage loan that have not been paid on a timely basis by the borrower.

45

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)


•
Escrow Advances (Taxes and Insurance Advances): Cash payments made by the servicer to third parties on behalf of the borrower for real estate taxes and insurance premiums on the property that have not been paid on a timely basis by the borrower.
•
Corporate Advances: Cash payments made by the servicer to third parties for the reimbursable costs and expenses incurred in connection with the foreclosure, preservation and sale of the mortgaged property, including attorneys’ and other professional fees.
Servicer advances are generally permitted to be repaid from amounts received with respect to the related residential mortgage loan, including payments from the borrower or amounts received from the liquidation of the property securing the loan. Residential mortgage servicing agreements generally require a servicer to make advances in respect of serviced residential mortgage loans unless the servicer determines in good faith that the advance would not be ultimately recoverable from the proceeds of the related residential mortgage loan or the mortgaged property.
At June 30, 2019, our servicer advance investments had a carrying value of $259 million and were associated with a portfolio of residential mortgage loans with an unpaid principal balance of $8.34 billion. The outstanding servicer advance receivables associated with this investment were $237 million at June 30, 2019, which were financed with short-term non-recourse securitization debt (see Note 13 for additional detail on this debt). The servicer advance receivables were comprised of the following types of advances at June 30, 2019 and December 31, 2018:
Table 10.2 – Components of Servicer Advance Receivables
(In Thousands)
 
June 30, 2019
 
December 31, 2018
Principal and interest advances
 
$
91,707

 
$
144,336

Escrow advances (taxes and insurance advances)
 
95,071

 
94,828

Corporate advances
 
49,854

 
47,614

Total Servicer Advance Receivables
 
$
236,632

 
$
286,778


We account for our servicer advance investments at fair value and during the three and six months ended June 30, 2019, we recorded $3 million and $5 million of interest income associated with these investments, respectively, and recorded net market valuation gains of $0.4 million and $1 million, respectively, through Investment fair value changes, net in our consolidated statements of income.
Mortgage Servicing Rights
We invest in mortgage servicing rights associated with residential mortgage loans and contract with licensed sub-servicers to perform all servicing functions for these loans. The majority of our investments in MSRs were made through the retention of servicing rights associated with the residential jumbo mortgage loans that we acquired and subsequently transferred to third parties. We hold our MSR investments at our taxable REIT subsidiary.
At June 30, 2019 and December 31, 2018, our MSRs had a fair value of $47 million and $60 million, respectively, and were associated with loans with an aggregate principal balance of $4.83 billion and $4.93 billion, respectively.

46

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)


The following table presents activity for MSRs for the three and six months ended June 30, 2019 and 2018.
Table 10.3 – Activity for MSRs
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2019
 
2018
 
2019
 
2018
Balance at beginning of period
 
$
55,284

 
$
66,496

 
$
60,281

 
$
63,598

Additions
 
764

 
—

 
868

 
—

Sales
 
—

 
(1,077
)
 
—

 
(1,077
)
Changes in fair value due to:
 
 
 
 
 
 
 
 
Changes in assumptions (1)
 
(6,555
)
 
943

 
(10,141
)
 
5,289

Other changes (2)
 
(2,097
)
 
(1,688
)
 
(3,612
)
 
(3,136
)
Balance at End of Period
 
$
47,396

 
$
64,674

 
$
47,396

 
$
64,674

(1)
Primarily reflects changes in prepayment assumptions due to changes in market interest rates.
(2)
Represents changes due to the realization of expected cash flows.
The following table presents the components of our MSR income for the three and six months ended June 30, 2019 and 2018.
Table 10.4 – Components of MSR Income, net
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2019
 
2018
 
2019
 
2018
Servicing income
 
$
3,850

 
$
3,802

 
$
7,460

 
$
7,597

Cost of sub-servicer
 
(268
)
 
(338
)
 
(771
)
 
(930
)
Net servicing fee income
 
3,582

 
3,464

 
6,689

 
6,667

Market valuation changes of MSRs
 
(8,652
)
 
(745
)
 
(13,753
)
 
2,147

Market valuation changes of associated derivatives
 
6,517

 
(1,122
)
 
8,768

 
(6,261
)
MSR reversal of provision for repurchases
 
207

 
277

 
207

 
277

MSR Income, Net (1)
 
$
1,654

 
$
1,874

 
$
1,911

 
$
2,830

(1)
MSR income, net is included in Other income, net on our consolidated statements of income.
Excess MSRs
In association with our servicer advance investments described above, in the fourth quarter of 2018, we (through our consolidated SA Buyers) also invested in excess MSRs associated with the same portfolio of legacy residential mortgage-backed securitizations. Additionally, beginning in 2018, we invested in excess MSRs associated with specified pools of multifamily loans. We account for our excess MSRs at fair value and during the three and six months ended June 30, 2019, we recognized $2 million and $4 million of interest income, respectively, through Other interest income, and recorded net market valuation losses of $0.1 million and $0.5 million, respectively, through Investment fair value changes, net on our consolidated statements of income.

47

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)


Investment in Multifamily Loan Fund
In January 2019, we invested in a limited partnership created to acquire floating rate, light-renovation multifamily loans from Freddie Mac. We committed to fund an aggregate of $78 million to the partnership, and have funded approximately $29 million at June 30, 2019. Freddie Mac is providing a debt facility to finance loans purchased by the partnership. After the partnership's acquisitions have reached a specific threshold, the partnership and Freddie Mac may agree to include the related loans in a Freddie Mac-sponsored securitization and the limited partners may acquire the subordinate securities issued in any such securitization.
We account for our ownership interest in this partnership using the equity method of accounting as we are able to exert significant influence over but do not control the activities of the investee. At June 30, 2019, the carrying amount of our investment in the partnership was $29 million. We have elected to record our share of earnings or losses from this investment on a one-quarter lag. During the three months ended June 30, 2019, we recorded $0.1 million of losses associated with this investment in Other income, net on our consolidated statements of income.
Participation in Loan Warehouse Facility
In the second quarter of 2018, we invested in a subordinated participation in a revolving mortgage loan warehouse credit facility of one of our loan sellers. We accounted for this subordinated participation interest as a loan receivable at amortized cost, and all associated interest income was recorded as a component of Other interest income in our consolidated statements of income. During the first quarter of 2019, our agreement associated with this investment was terminated and the balance outstanding under this agreement was repaid.
Investment in 5 Arches
In May 2018, we acquired a 20% minority interest in 5 Arches for $10 million, which included a one-year option to purchase all remaining equity in the company for a combination of cash and stock totaling $40 million. In March 2019, we closed on our option to acquire the remaining 80% interest in 5 Arches. See Note 2 for discussion of this acquisition.
During 2018 and through February 28, 2019, we accounted for our minority ownership interest in 5 Arches using the equity method of accounting as we were able to exert significant influence over but did not control the activities of the investee. During the period from January 1, 2019 to February 28, 2019, we recorded $0.3 million of gross income associated with this investment and, including amortization of certain intangible assets, recorded $0.1 million of net earnings in Other income, net on our consolidated statements of income.

48

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 11. Derivative Financial Instruments
The following table presents the fair value and notional amount of our derivative financial instruments at June 30, 2019 and December 31, 2018.
Table 11.1 – Fair Value and Notional Amount of Derivative Financial Instruments
 
 
June 30, 2019
 
December 31, 2018
 
 
Fair
Value
 
Notional
Amount
 
Fair
Value
 
Notional
Amount
(In Thousands)
 
 
 
 
Assets - Risk Management Derivatives
 
 
 
 
 
 
 
 
Interest rate swaps
 
$
18,576

 
$
1,053,000

 
$
28,211

 
$
2,106,500

TBAs
 
1,784

 
950,000

 
4,665

 
520,000

Swaptions
 
682

 
200,000

 
—

 
—

Assets - Other Derivatives
 
 
 
 
 
 
 
 
Loan purchase commitments
 
5,567

 
775,831

 
2,913

 
331,161

Total Assets
 
$
26,609

 
$
2,978,831

 
$
35,789

 
$
2,957,661

 
 
 
 
 
 
 
 
 
Liabilities - Cash Flow Hedges
 
 
 
 
 
 
 
 
Interest rate swaps
 
$
(49,827
)
 
$
139,500

 
$
(34,492
)
 
$
139,500

Liabilities - Risk Management Derivatives
 
 
 
 
 
 
 
 
Interest rate swaps
 
(118,609
)
 
3,084,300

 
(36,416
)
 
1,742,000

TBAs
 
(4,639
)
 
1,150,000

 
(13,215
)
 
935,000

Liabilities - Other Derivatives
 
 
 
 
 
 
 
 
Loan purchase commitments
 
(772
)
 
245,111

 
(732
)
 
137,224

Total Liabilities
 
$
(173,847
)
 
$
4,618,911

 
$
(84,855
)
 
$
2,953,724

Total Derivative Financial Instruments, Net
 
$
(147,238
)
 
$
7,597,742

 
$
(49,066
)
 
$
5,911,385


Risk Management Derivatives
To manage, to varying degrees, risks associated with certain assets and liabilities on our consolidated balance sheets, we may enter into derivative contracts. At June 30, 2019, we were party to swaps and swaptions with an aggregate notional amount of $4.34 billion and TBA agreements sold with an aggregate notional amount of $2.10 billion. At December 31, 2018, we were party to swaps with an aggregate notional amount of $3.85 billion and TBA agreements sold with an aggregate notional amount of $1.46 billion.
During the three and six months ended June 30, 2019, risk management derivatives had net market valuation losses of $66 million and $111 million, respectively. During the three and six months ended June 30, 2018, risk management derivatives had net market valuation gains of $22 million and $89 million, respectively. These market valuation gains and losses are recorded in Mortgage banking activities, net, Investment fair value changes, net, and Other income, net on our consolidated statements of income.

49

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)
Note 11. Derivative Financial Instruments - (continued)


Loan Purchase and Forward Sale Commitments
LPCs and FSCs that qualify as derivatives are recorded at their estimated fair values. For the three and six months ended June 30, 2019, LPCs and FSCs had net market valuation gains of $17 million and $29 million, respectively, that were recorded in Mortgage banking activities, net on our consolidated statements of income. For the three and six months ended June 30, 2018, LPCs and FSCs had net market valuation losses of $3 million and $10 million, respectively, that were recorded in Mortgage banking activities, net on our consolidated statements of income.
Derivatives Designated as Cash Flow Hedges
To manage the variability in interest expense related to portions of our long-term debt and certain adjustable-rate securitization entity liabilities that are included in our consolidated balance sheets for financial reporting purposes, we designated certain interest rate swaps as cash flow hedges with an aggregate notional balance of $140 million.
For the three and six months ended June 30, 2019, changes in the values of designated cash flow hedges were negative $10 million and negative $15 million, respectively, and were recorded in Accumulated other comprehensive income, a component of equity. For the three and six months ended June 30, 2018, changes in the values of designated cash flow hedges were positive $3 million and positive $12 million, respectively, and were recorded in Accumulated other comprehensive income, a component of equity. For interest rate agreements currently or previously designated as cash flow hedges, our total unrealized loss reported in Accumulated other comprehensive income was $49 million and $34 million at June 30, 2019 and December 31, 2018, respectively.
The following table illustrates the impact on interest expense of our interest rate agreements accounted for as cash flow hedges for the three and six months ended June 30, 2019 and 2018.
Table 11.2 – Impact on Interest Expense of Interest Rate Agreements Accounted for as Cash Flow Hedges
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2019
 
2018
 
2019
 
2018
Net interest expense on cash flows hedges
 
$
(640
)
 
$
(804
)
 
$
(1,277
)
 
$
(1,802
)
Total Interest Expense
 
$
(640
)
 
$
(804
)
 
$
(1,277
)
 
$
(1,802
)

Derivative Counterparty Credit Risk
As discussed in our Annual Report on Form 10-K for the year ended December 31, 2018, we consider counterparty risk as part of our fair value assessments of all derivative financial instruments at each quarter-end. At June 30, 2019, we assessed this risk as remote and did not record a specific valuation adjustment.
At June 30, 2019, we had outstanding derivative agreements with three counterparties (other than clearinghouses) and were in compliance with ISDA agreements governing our open derivative positions.

50

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 12. Other Assets and Liabilities
Other assets at June 30, 2019 and December 31, 2018, are summarized in the following table.
Table 12.1 – Components of Other Assets
(In Thousands)
 
June 30, 2019
 
December 31, 2018
Margin receivable
 
$
211,199

 
$
100,773

FHLBC stock
 
43,393

 
43,393

Pledged collateral
 
42,913

 
42,433

Right-of-use asset
 
11,573

 
—

REO
 
6,305

 
3,943

Fixed assets and leasehold improvements (1)
 
5,093

 
5,106

Investment receivable
 
1,697

 
6,959

Other
 
11,950

 
15,218

Total Other Assets
 
$
334,123

 
$
217,825

(1)
Fixed assets and leasehold improvements had a basis of $11 million and accumulated depreciation of $6 million at June 30, 2019.
Accrued expenses and other liabilities at June 30, 2019 and December 31, 2018 are summarized in the following table.
Table 12.2 – Components of Accrued Expenses and Other Liabilities
(In Thousands)
 
June 30, 2019
 
December 31, 2018
Contingent consideration
 
$
24,932

 
$
—

Payable to minority partner
 
16,937

 
14,331

Guarantee obligations
 
15,744

 
16,711

Accrued compensation
 
13,671

 
19,769

Lease liability
 
13,082

 
—

Deferred tax liabilities
 
11,986

 
9,022

Residential bridge loan holdbacks
 
6,016

 
—

Residential loan and MSR repurchase reserve
 
3,769

 
4,189

Accrued operating expenses
 
3,149

 
3,122

Legal reserve
 
2,000

 
2,000

Accrued income taxes payable
 
764

 
423

Margin payable
 
—

 
835

Other
 
5,378

 
8,317

Total Accrued Expenses and Other Liabilities
 
$
117,428

 
$
78,719


Margin Receivable and Payable
Margin receivable and payable resulted from margin calls between us and our counterparties under derivatives, master repurchase agreements, and warehouse facilities, whereby we or the counterparty posted collateral.
FHLBC Stock
In accordance with our FHLB-member subsidiary's borrowing agreement with the FHLBC, our subsidiary is required to purchase and hold stock in the FHLBC. See Note 3 and Note 15 for additional information on this borrowing agreement.

51

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)
Note 12. Other Assets and Liabilities - (continued)


Pledged Collateral and Guarantee Obligations
The pledged collateral and guarantee obligations presented in the tables above are related to our risk-sharing arrangements with Fannie Mae and Freddie Mac. In accordance with these arrangements, we are required to pledge collateral to secure our guarantee obligations. See Note 3 and Note 16 for additional information on our risk-sharing arrangements.
Contingent Consideration
The contingent consideration presented in the table above is related to our acquisition of 5 Arches in the first quarter of 2019. See Note 16 for additional information on our contingent consideration liabilities.
Lease Liability and Right-of-Use Asset
The lease liability and right-of-use asset presented in the tables above resulted from our adoption of ASU 2016-02, "Leases," in the first quarter of 2019. The lease liability is equal to the present value of our remaining lease payments discounted at our incremental borrowing rate and the right-of-use asset is equal to the lease liability adjusted for our deferred rent liability. These balances are reduced as lease payments are made. See Note 16 for additional information on leases.
Residential Bridge Loan Holdbacks
Residential bridge loan holdbacks represent loan amounts payable to residential bridge loan borrowers subject to the completion of various phases of property rehabilitation.
Investment Receivable
At June 30, 2019, investment receivable primarily consisted of unsettled trade receivables related to real estate securities sales. In accordance with our policy to record purchases and sales of securities on the trade date, if the trade and settlement of a purchase or sale crosses over a quarterly reporting period, we will record an investment receivable for sales and an unsettled trades liability for purchases.
REO
The carrying value of REO at June 30, 2019 was $6 million, which included $1 million of REO from our Legacy Sequoia entities and $5 million from our residential bridge loan portfolio. During the six months ended June 30, 2019, transfers into REO included $0.1 million from Legacy Sequoia entities and a $5 million residential bridge loan. During the six months ended June 30, 2019, there were Legacy Sequoia REO liquidations of $3 million, resulting in $0.5 million of unrealized gains which were recorded in Investment fair value changes, net, on our consolidated statements of income. At June 30, 2019, there were seven REO properties at our Legacy Sequoia entities and one residential bridge loan REO property recorded on our consolidated balance sheets. At December 31, 2018, there were 13 REO properties recorded, all of which were owned at consolidated Legacy Sequoia entities.
Legal and Repurchase Reserves
See Note 16 for additional information on the legal and residential repurchase reserves.
Payable to Minority Partner
In 2018, Redwood and a third-party co-investor, through two partnership entities consolidated by Redwood, purchased servicer advances and excess MSRs related to a portfolio of residential mortgage loans serviced by the co-investor (see Note 4 and Note 10 for additional information on the partnership entities and associated investments). We account for the co-investor’s interests in the entities as liabilities and at June 30, 2019, the carrying value of their interests was $17 million, representing their current economic interest in the entities. Earnings from the partnership entities are allocated to the co-investors on a proportional basis and during the three and six months ended June 30, 2019, we allocated $0.2 million and $0.5 million of gains to the co-investors, respectively, which were recorded in Other income, net on our consolidated statements of income.

52

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)


Note 13. Short-Term Debt
We enter into repurchase agreements, bank warehouse agreements, and other forms of collateralized (and generally uncommitted) short-term borrowings with several banks and major investment banking firms. At June 30, 2019, we had outstanding agreements with several counterparties and we were in compliance with all of the related covenants. For additional information about these financial covenants and our short-term debt, see Part I, Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations of this Quarterly Report on Form 10-Q and Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2018.
The table below summarizes our short-term debt, including the facilities that are available to us, the outstanding balances, the weighted average interest rate, and the maturity information at June 30, 2019 and December 31, 2018.
Table 13.1 – Short-Term Debt
 
 
June 30, 2019
(Dollars in Thousands)
 
Number of Facilities
 
Outstanding Balance
 
Limit
 
Weighted Average Interest Rate
 
Maturity
 
Weighted Average Days Until Maturity
Facilities
 
 
 
 
 
 
 
 
 
 
 
 
Residential loan warehouse (1)
 
4

 
$
638,055

 
$
1,425,000

 
3.90
%
 
8/2019-3/2020
 
166
Real estate securities repo (1)
 
10

 
1,213,920

 
—

 
3.48
%
 
7/2019-8/2019
 
27
Single-family rental loan warehouse (2)
 
2

 
53,998

 
400,000

 
4.67
%
 
6/2020-6/2021
 
426
Residential bridge loan warehouse (2)
 
4

 
120,445

 
330,000

 
4.93
%
 
11/2019-5/2022
 
821
Business purpose loan working capital (2)
 
1

 
—

 
15,000

 
5.00
%
 
12/2020
 
N/A
Total Short-Term Debt Facilities
 
21

 
2,026,418

 
 
 
 
 
 
 
 
Servicer advance financing
 
1

 
236,231

 
350,000

 
4.23
%
 
11/2019
 
152
Convertible notes, net
 
N/A

 
200,236

 
—

 
5.63
%
 
11/2019
 
138
Total Short-Term Debt
 

 
$
2,462,885

 
 
 
 
 
 
 
 

53

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)
Note 13. Short-Term Debt - (continued)


 
 
December 31, 2018
(Dollars in Thousands)
 
Number of Facilities
 
Outstanding Balance
 
Limit
 
Weighted Average Interest Rate
 
Maturity
 
Weighted Average Days Until Maturity
Facilities
 
 
 
 
 
 
 
 
 
 
 
 
Residential loan warehouse (1)
 
4

 
$
860,650

 
$
1,425,000

 
4.10
%
 
2/2019-12/2019
 
178
Real estate securities repo (1)
 
9

 
988,890

 
—

 
3.47
%
 
1/2019-3/2019
 
26
Single-family rental loan warehouse (2)
 
2

 
22,053

 
400,000

 
4.77
%
 
6/2020-6/2021
 
560
Residential bridge loan warehouse (2)
 
2

 
66,327

 
80,000

 
5.20
%
 
11/2019-4/2021
 
629
Total Short-Term Debt Facilities
 
17

 
1,937,920

 
 
 
 
 
 
 
 
Servicer advance financing
 
1

 
262,740

 
350,000

 
4.32
%
 
11/2019
 
333
Convertible notes, net
 
N/A

 
199,619

 

 
5.63
%
 
11/2019
 
319
Total Short-Term Debt
 
 
 
$
2,400,279

 
 
 
 
 
 
 
 

(1)
Borrowings under our facilities are generally charged interest based on a specified margin over the one-month LIBOR interest rate. At June 30, 2019, all of these borrowings were under uncommitted facilities and were due within 364 days (or less) of the borrowing date.
(2)
Due to the revolving nature of the borrowings under these facilities, we have classified these facilities as short-term debt at June 30, 2019. Borrowings under these facilities will be repaid as the underlying loans mature or are sold to third parties or transferred to securitizations.
At June 30, 2019 and December 31, 2018, the fair value of held-for-sale residential loans pledged as collateral under our short-term debt facilities was $712 million and $935 million, respectively. At June 30, 2019, the fair value of real estate securities pledged as collateral under our short-term debt facilities was $945 million, and also included $148 million of securities retained from our consolidated Sequoia Choice securitizations as well as $203 million and $207 million of securities we owned that were issued by consolidated Freddie Mac SLST and Freddie Mac K-series securitizations, respectively. At December 31, 2018, the fair value of real estate securities pledged as collateral under our short-term debt facilities was $844 million, and also included $130 million of securities retained from our consolidated Sequoia Choice securitizations as well as $229 million and $18 million of securities we owned that were issued by consolidated Freddie Mac SLST and Freddie Mac K-series securitizations, respectively. The fair value of single-family rental and residential bridge loans pledged as collateral under our warehouse facilities was $71 million and $144 million, respectively, at June 30, 2019 and $28 million and $98 million, respectively, at December 31, 2018.
For the three and six months ended June 30, 2019, the average balances of our short-term debt facilities were $1.86 billion and $1.73 billion, respectively. At June 30, 2019 and December 31, 2018, accrued interest payable on our short-term debt facilities was $5 million and $4 million, respectively.
Servicer advance financing consists of non-recourse short-term securitization debt used to finance servicer advance investments. We consolidate the securitization entity that issued the debt, but the entity is independent of Redwood and the assets and liabilities are not owned by and are not legal obligations of Redwood. At June 30, 2019, the fair value of servicer advances, cash and restricted cash collateralizing the securitization financing was $265 million. At June 30, 2019, the accrued interest payable balance on this financing was $0.3 million and the unamortized capitalized commitment costs were $1 million.
During the fourth quarter of 2018, $201 million principal amount of 5.625% exchangeable senior notes and $1 million of unamortized deferred issuance costs were reclassified from long-term debt to short-term debt as the maturity of the notes was less than one year as of November 2018. At June 30, 2019, the accrued interest payable balance on this debt was $1 million. See Note 15 for additional information on our convertible notes.
We also maintain a $10 million committed line of credit with a financial institution that is secured by certain mortgage-backed securities with a fair market value of $4 million at June 30, 2019. At both June 30, 2019 and December 31, 2018, we had no outstanding borrowings on this facility.

54

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)
Note 13. Short-Term Debt - (continued)


Remaining Maturities of Short-Term Debt
The following table presents the remaining maturities of our secured short-term debt by the type of collateral securing the debt as well as our convertible notes at June 30, 2019.
Table 13.2 – Short-Term Debt by Collateral Type and Remaining Maturities
 
 
June 30, 2019
(In Thousands)
 
Within 30 days
 
31 to 90 days
 
Over 90 days
 
Total
Collateral Type
 
 
 
 
 
 
 
 
Held-for-sale residential loans
 
$
—

 
$
189,798

 
$
448,257

 
$
638,055

Real estate securities
 
871,520

 
342,400

 
—

 
1,213,920

Single-family rental loans
 
—

 
—

 
53,998

 
53,998

Residential bridge loans
 
—

 
—

 
120,445

 
120,445

Total Secured Short-Term Debt
 
871,520

 
532,198

 
622,700

 
2,026,418

Servicer advance financing
 
—

 
—

 
236,231

 
236,231

Convertible notes, net
 
—

 
—

 
200,236

 
200,236

Total Short-Term Debt
 
$
871,520

 
$
532,198

 
$
1,059,167

 
$
2,462,885


Note 14. Asset-Backed Securities Issued
Through our Sequoia securitization program, we sponsor securitization transactions in which securities backed by residential mortgage loans (ABS) are issued by Sequoia entities. We consolidated the Legacy Sequoia and Sequoia Choice securitization entities, and beginning in 2018, certain third-party Freddie Mac K-Series and SLST securitization entities, that we determined were VIEs and for which we determined we were the primary beneficiary. Each consolidated 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. 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.
We account for the ABS issued under our consolidated entities at fair value, with periodic changes in fair value recorded in Investment fair value changes, net on our consolidated statements of income. Pursuant to the CFE guidelines, the market valuation changes on our loans are based on the estimated fair value of the associated ABS issued. The net impact to our income statement associated with our retained economic investment in each of these securitization entities is presented in Note 5.
The ABS issued by these entities consist of various classes of securities that pay interest on a monthly basis. All ABS issued by the Sequoia Choice and Freddie Mac K-Series, and Freddie Mac SLST entities pay fixed rates of interest and substantially all ABS issued by the Legacy Sequoia entities pay variable rates of interest, which are indexed to one-, three-, or six-month LIBOR. ABS issued also includes some interest-only classes with coupons set at a fixed spread to a benchmark rate, or set at a spread to the interest rates earned on the assets less the interest rates paid on the liabilities of a securitization entity.

55

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 14. Asset-Backed Securities Issued - (continued)

The carrying values of ABS issued by Sequoia securitization entities we sponsored at June 30, 2019 and December 31, 2018, along with other selected information, are summarized in the following table.

Table 14.1 – Asset-Backed Securities Issued
June 30, 2019
 
Legacy
Sequoia
 
Sequoia
Choice
 
Freddie Mac SLST
 
Freddie Mac
K-Series
 
Total
(Dollars in Thousands)
 
 
 
 
 
Certificates with principal balance
 
$
468,193

 
$
1,862,408

 
$
951,074

 
$
3,244,398

 
$
6,526,073

Interest-only certificates
 
1,637

 
17,713

 
—

 
207,278

 
226,628

Market valuation adjustments
 
(20,968
)
 
49,323

 
40,692

 
91,381

 
160,428

ABS Issued, Net
 
$
448,862

 
$
1,929,444

 
$
991,766

 
$
3,543,057

 
$
6,913,129

Range of weighted average interest rates, by series
 
2.55% to 3.68%

 
4.42% to 5.08%

 
3.50
%
 
3.39% to 4.20%

 
 
Stated maturities
 
2024 - 2036

 
2047 - 2049

 
2028

 
2025 - 2049

 
 
Number of series
 
20

 
7

 
1

 
4

 
 

December 31, 2018
 
Legacy
Sequoia
 
Sequoia
Choice
 
Freddie Mac SLST
 
Freddie Mac
K-Series
 
Total
(Dollars in Thousands)
 
 
 
 
 
Certificates with principal balance
 
$
540,456

 
$
1,838,758

 
$
993,659

 
$
1,936,691

 
$
5,309,564

Interest-only certificates
 
1,537

 
25,662

 
—

 
131,600

 
158,799

Market valuation adjustments
 
(29,753
)
 
20,590

 
89

 
(49,216
)
 
(58,290
)
ABS Issued, Net
 
$
512,240

 
$
1,885,010

 
$
993,748

 
$
2,019,075

 
$
5,410,073

Range of weighted average interest rates, by series
 
1.36% to 3.60%

 
4.46% to 4.97%

 
3.51
%
 
3.39% to 4.08%

 
 
Stated maturities
 
2024 - 2036

 
2047 - 2048

 
2028

 
2025 - 2049

 
 
Number of series
 
20

 
6

 
1

 
3

 
 

The actual maturity of each class of ABS issued is primarily determined by the rate of principal prepayments on the assets of the issuing entity. Each series is also subject to redemption prior to the stated maturity according to the terms of the respective governing documents of each ABS issuing entity. As a result, the actual maturity of ABS issued may occur earlier than its stated maturity. At June 30, 2019, all of the ABS issued and outstanding had contractual maturities beyond five years. The following table summarizes the accrued interest payable on ABS issued at June 30, 2019 and December 31, 2018. Interest due on consolidated ABS issued is payable monthly.
Table 14.2 – Accrued Interest Payable on Asset-Backed Securities Issued
(In Thousands)
 
June 30, 2019
 
December 31, 2018
Legacy Sequoia
 
$
519

 
$
571

Sequoia Choice
 
7,322

 
7,180

Freddie Mac SLST
 
2,774

 
2,907

Freddie Mac K-Series
 
10,822

 
6,239

Total Accrued Interest Payable on ABS Issued
 
$
21,437

 
$
16,897



56

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 14. Asset-Backed Securities Issued - (continued)

The following table summarizes the carrying value components of the collateral for ABS issued and outstanding at June 30, 2019 and December 31, 2018.
Table 14.3 – Collateral for Asset-Backed Securities Issued
June 30, 2019
 
Legacy
Sequoia
 
Sequoia
Choice
 
Freddie Mac SLST
 
Freddie Mac
K-Series
 
Total
(In Thousands)
 
 
 
 
 
Residential loans
 
$
457,750

 
$
2,147,356

 
$
1,235,089

 
$
—

 
$
3,840,195

Multifamily loans
 
—

 
—

 
—

 
3,749,657

 
3,749,657

Restricted cash
 
144

 
14

 
—

 
—

 
158

Accrued interest receivable
 
771

 
8,946

 
3,786

 
11,317

 
24,820

REO
 
1,448

 
—

 
—

 
—

 
1,448

Total Collateral for ABS Issued
 
$
460,113

 
$
2,156,316

 
$
1,238,875

 
$
3,760,974

 
$
7,616,278

December 31, 2018
 
Legacy
Sequoia
 
Sequoia
Choice
 
Freddie Mac SLST
 
Freddie Mac
K-Series
 
Total
(In Thousands)
 
 
 
 
 
Residential loans
 
$
519,958

 
$
2,079,382

 
$
1,222,669

 
$
—

 
$
3,822,009

Multifamily loans
 
—

 
—

 
—

 
2,144,598

 
2,144,598

Restricted cash
 
146

 
1,022

 
—

 
—

 
1,168

Accrued interest receivable
 
822

 
8,988

 
3,926

 
6,595

 
20,331

REO
 
3,943

 
—

 
—

 
—

 
3,943

Total Collateral for ABS Issued
 
$
524,869

 
$
2,089,392

 
$
1,226,595

 
$
2,151,193

 
$
5,992,049


Note 15. Long-Term Debt

FHLBC Borrowings

In July 2014, our FHLB-member subsidiary entered into a borrowing agreement with the Federal Home Loan Bank of Chicago. At June 30, 2019, under this agreement, our subsidiary could incur borrowings up to $2.00 billion, also referred to as “advances,” from the FHLBC secured by eligible collateral, including residential mortgage loans. During the three and six months ended June 30, 2019, our FHLB-member subsidiary made no additional borrowings under this agreement. Under a final rule published by the Federal Housing Finance Agency in January 2016, our FHLB-member subsidiary will remain an FHLB member through the five-year transition period for captive insurance companies. Our FHLB-member subsidiary's existing $2.00 billion of FHLB debt, which matures beyond this transition period, is permitted to remain outstanding until its stated maturity. As residential loans pledged as collateral for this debt pay down, we are permitted to pledge additional loans or other eligible assets to collateralize this debt; however, we do not expect to be able to increase our subsidiary's FHLB debt above the existing $2.00 billion maximum.
At June 30, 2019, $2.00 billion of advances were outstanding under this agreement, which were classified as long-term debt, with a weighted average interest rate of 2.57% and a weighted average maturity of approximately six years. At December 31, 2018, $2.00 billion of advances were outstanding under this agreement, which were classified as long-term debt, with a weighted average interest rate of 2.52% and a weighted average maturity of seven years. Advances under this agreement incur interest charges based on a specified margin over the FHLBC’s 13-week discount note rate, which resets every 13 weeks. At June 30, 2019, total advances under this agreement were secured by residential mortgage loans with a fair value of $2.39 billion. This agreement also requires our subsidiary to purchase and hold stock in the FHLBC in an amount equal to a specified percentage of outstanding advances. At June 30, 2019, our subsidiary held $43 million of FHLBC stock that is included in Other assets in our consolidated balance sheets.

57

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)
Note 15. Long-Term Debt - (continued)


The following table presents maturities of our FHLBC borrowings by year at June 30, 2019.
Table 15.1 – Maturities of FHLBC Borrowings by Year
(In Thousands)
 
June 30, 2019
2024
 
$
470,171

2025
 
887,639

2026
 
642,189

Total FHLBC Borrowings
 
$
1,999,999


For additional information about our FHLBC borrowings, see Part I, Item 2 of Quarterly Report on Form 10-Q under the heading “Risks Relating to Debt Incurred under Short- and Long-Term Borrowing Facilities.”
Convertible Notes
In June 2018, we issued $200 million principal amount of 5.625% convertible senior notes due 2024 at an issuance price of 99.5%. These convertible notes require semi-annual interest payments at a fixed coupon rate of 5.625% until maturity or conversion, which will be no later than July 15, 2024. After deducting the issuance discount, the underwriting discount and offering costs, we received $194 million of net proceeds. Including amortization of deferred debt issuance costs and the debt discount, the weighted average interest expense yield on these convertible notes is approximately 6.2% per annum. These notes are convertible at the option of the holder at a conversion rate of 54.7645 common shares per $1,000 principal amount of convertible senior notes (equivalent to a conversion price of $18.26 per common share). Upon conversion of these notes by a holder, the holder will receive shares of our common stock. At June 30, 2019, the outstanding principal amount of these notes was $200 million and the accrued interest payable on this debt was $5 million. At June 30, 2019, the unamortized deferred issuance costs and debt discount were $4 million and $1 million, respectively.
In August 2017, we issued $245 million principal amount of 4.75% convertible senior notes due 2023. These convertible notes require semi-annual interest payments at a fixed coupon rate of 4.75% until maturity or conversion, which will be no later than August 15, 2023. After deducting the underwriting discount and offering costs, we received $238 million of net proceeds. Including amortization of deferred debt issuance costs, the weighted average interest expense yield on these convertible notes is approximately 5.3% per annum. At June 30, 2019, these notes were convertible at the option of the holder at a conversion rate of 53.9060 common shares per $1,000 principal amount of convertible senior notes (equivalent to a conversion price of $18.55 per common share). Upon conversion of these notes by a holder, the holder will receive shares of our common stock. At June 30, 2019, the outstanding principal amount of these notes was $245 million. At June 30, 2019, the accrued interest payable balance on this debt was $4 million and the unamortized deferred issuance costs were $5 million.
In November 2014, RWT Holdings, Inc., a wholly-owned subsidiary of Redwood Trust, Inc., issued $205 million principal amount of 5.625% exchangeable senior notes due 2019. These exchangeable notes require semi-annual interest payments at a fixed coupon rate of 5.625% until maturity or exchange, which will be no later than November 15, 2019. After deducting the underwriting discount and offering costs, we received $198 million of net proceeds. Including amortization of deferred debt issuance costs, the weighted average interest expense yield on these exchangeable notes is approximately 6.3% per annum. At June 30, 2019, these notes were exchangeable at the option of the holder at an exchange rate of 46.2370 common shares per $1,000 principal amount of exchangeable senior notes (equivalent to an exchange price of $21.63 per common share). Upon exchange of these notes by a holder, the holder will receive shares of our common stock. During 2016, we repurchased $4 million par value of these notes at a discount and recorded a gain on extinguishment of debt of $0.3 million in Realized gains, net on our consolidated statements of income. Additionally, during the fourth quarter of 2018, $201 million principal amount of these notes and $1 million of unamortized deferred issuance costs were reclassified from long-term debt to short-term debt as the maturity of the notes was less than one year as of November 2018. At June 30, 2019, the outstanding principal amount of these notes was $201 million. At June 30, 2019, the accrued interest payable balance on this debt was $1 million and the unamortized deferred issuance costs were $1 million.

58

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)
Note 15. Long-Term Debt - (continued)


Trust Preferred Securities and Subordinated Notes
At June 30, 2019, we had trust preferred securities and subordinated notes outstanding of $100 million and $40 million, respectively. This debt requires quarterly interest payments at a floating rate equal to three-month LIBOR plus 2.25% until the notes are redeemed. The $100 million trust preferred securities will be redeemed no later than January 30, 2037, and the $40 million subordinated notes will be redeemed no later than July 30, 2037. Prior to 2014, we entered into interest rate swaps with aggregate notional values totaling $140 million to hedge the variability in this long-term debt interest expense. Including hedging costs and amortization of deferred debt issuance costs, the weighted average interest expense yield on our trust preferred securities and subordinated notes is approximately 6.9% per annum. At both June 30, 2019 and December 31, 2018, the accrued interest payable balance on our trust preferred securities and subordinated notes was $1 million.
Under the terms of this debt, we covenant, among other things, to use our best efforts to continue to qualify as a REIT. If an event of default were to occur in respect of this debt, we would generally be restricted under its terms (subject to certain exceptions) from making dividend distributions to stockholders, from repurchasing common stock or repurchasing or redeeming any other then-outstanding equity securities, and from making any other payments in respect of any equity interests in us or in respect of any then-outstanding debt that is pari passu or subordinate to this debt.
Note 16. Commitments and Contingencies
Lease Commitments
At June 30, 2019, we were obligated under five non-cancelable operating leases with expiration dates through 2028 for $16 million of cumulative lease payments. Our principal executive and administrative office is located in Mill Valley, California and we have several additional offices, as disclosed in Part I, Item 2 of our Annual Report on Form 10-K for the year ended December 31, 2018. Additionally, with our acquisition of 5 Arches in the first quarter of 2019, we added an office located in Irvine, California. Our operating lease expense was $1 million for both six-month periods ended June 30, 2019 and 2018.
The following table presents our future lease commitments and a reconciliation to our lease liability at June 30, 2019.
Table 16.1 – Future Lease Commitments by Year
(In Thousands)
 
June 30, 2019
2019 (6 months)
 
$
1,376

2020
 
2,721

2021
 
1,864

2022
 
1,468

2023 and thereafter
 
8,749

Total Lease Commitments
 
16,178

Less: Imputed interest
 
(3,096
)
Lease Liability
 
$
13,082


During the three months ended March 31, 2019, we adopted ASU 2016-02, "Leases," which required us to recognize a lease liability that was equal to the present value of our remaining lease payments of $16 million discounted at various incremental borrowing rates, and a right-of-use asset, which was equal to our lease liability adjusted for our deferred rent liability. We elected to apply the new guidance using the optional transition method, which permits lessees to measure the lease liability and right-of-use asset at January 1, 2019, without adjusting the comparative periods presented. We elected the package of practical expedients under the transition guidance within this standard, which allowed us to carry forward the classifications of each of our four existing leases as operating leases and to continue to expense lease payments on a straight-line basis. As one of our operating leases qualifies for the short-term lease exception under this guidance, we will continue to account for this lease under legacy GAAP and did not include this lease in our calculation of the lease liability and right-of-use asset. At June 30, 2019, our lease liability was $13 million, which was a component of Accrued expenses and other liabilities, and our right-of-use asset was $12 million, which was a component of Other assets.

59

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)
Note 16. Commitments and Contingencies - (continued)


We determined that the four remaining leases did not contain an implicit interest rate and used a discount rate equal to our incremental borrowing rate on a collateralized basis to determine the present value of our total lease payments. As such, we determined the applicable discount rate for each of our leases using a swap rate plus an applicable spread for borrowing arrangements secured by our real estate loans and securities for a length of time equal to the remaining lease term on the date of adoption. At June 30, 2019, the weighted-average remaining lease term and weighted-average discount rate for our leases was 8 years and 5.3%, respectively.
Commitment to Fund Residential Bridge Loans
As of June 30, 2019, we had commitments to fund $33 million of residential bridge loans. These commitments are generally subject to loan agreements with covenants regarding the financial performance of the customer and other terms regarding advances that must be met before we fund the commitment. We may also advance funds related to loans sold under a separate loan sale agreement that are generally repaid immediately by the loan purchaser and do not generally expose us to loss (outstanding commitments related to these loans that we may temporarily fund totaled approximately $80 million at June 30, 2019).
Commitment to Fund Partnerships
In the fourth quarter of 2018, we invested in two partnerships created to acquire and manage certain mortgage servicing related assets (see Note 10 for additional detail). At June 30, 2019, we had an outstanding commitment to fund an additional $6 million to these partnerships to acquire additional outstanding servicer advances and excess MSRs. We funded this remaining commitment in July 2019. In connection with this investment, we are also required to fund future net servicer advances related to the underlying mortgage loans. The actual amount of net servicer advances we may fund in the future is subject to significant uncertainty and will be based on the credit and prepayment performance of the underlying loans.
In the first quarter of 2019, we invested in a partnership created to acquire floating rate, light-renovation multifamily loans from Freddie Mac (see Note 10 for additional detail). At June 30, 2019, we had an outstanding commitment to fund an additional $49 million to the partnership. Additionally, in connection with this transaction, we have made a guarantee to Freddie Mac in the event of losses incurred on the loans that exceed the equity available in the partnership to absorb such losses. At June 30, 2019, the carrying value of this guarantee was $0.1 million. We believe the likelihood of performance under the guarantee is remote. Our maximum loss exposure from this guarantee arrangement is $135 million.
5 Arches Contingent Consideration
As part of the consideration for our acquisition of 5 Arches, we are committed to make earn-out payments up to $27 million, payable in a mix of cash and Redwood common stock, which will be calculated following each of the first two anniversaries of the option closing date based on loan origination volumes exceeding certain specified thresholds. These contingent earn-out payments are classified as a contingent consideration liability and carried at fair value. At June 30, 2019, our estimated fair value of this contingent liability was $25 million.
Commitment to Participate in Loan Warehouse Facility
In the second quarter of 2018, we invested in a participation in the mortgage loan warehouse credit facility of one of our loan sellers. This investment included a commitment to participate in (and an obligation to fund) a designated amount of the loan seller's borrowings under this warehouse credit facility. Our commitment to participate in this facility was terminated in the first quarter of 2019. See Note 10 for additional detail on our participation in a loan warehouse facility.

60

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)
Note 16. Commitments and Contingencies - (continued)


Loss Contingencies — Risk-Sharing
During 2015 and 2016, we sold conforming loans to the Agencies with an original unpaid principal balance of $3.19 billion, subject to our risk-sharing arrangements with the Agencies. At June 30, 2019, the maximum potential amount of future payments we could be required to make under these arrangements was $44 million and this amount was fully collateralized by assets we transferred to pledged accounts and is presented as pledged collateral in Other assets on our consolidated balance sheets. We have no recourse to any third parties that would allow us to recover any amounts related to our obligations under the arrangements. At June 30, 2019, we had not incurred any losses under these arrangements. For the three and six months ended June 30, 2019, other income related to these arrangements was $1 million for each of these periods, and net market valuation losses related to these investments were $0.1 million for each of these periods. For the three and six months ended June 30, 2018, other income related to these arrangements was $1 million and $2 million, respectively, and net market valuation losses related to these investments were $0.2 million and $0.3 million, respectively.
All of the loans in the reference pools subject to these risk-sharing arrangements were originated in 2014 and 2015, and at June 30, 2019, the loans had an unpaid principal balance of $1.74 billion and a weighted average FICO score of 759 (at origination) and LTV ratio of 76% (at origination). At June 30, 2019, $6 million of the loans were 90 days or more delinquent, of which $2 million were in foreclosure. At June 30, 2019, the carrying value of our guarantee obligation was $16 million and included $5 million designated as a non-amortizing credit reserve, which we believe is sufficient to cover current expected losses under these obligations.
Our consolidated balance sheets include assets of special purpose entities ("SPEs") associated with these risk-sharing arrangements (i.e., the "pledged collateral" referred to above) that can only be used to settle obligations of these SPEs for which the creditors of these SPEs (the Agencies) do not have recourse to Redwood Trust, Inc. or its affiliates. At June 30, 2019 and December 31, 2018, assets of such SPEs totaled $48 million and $47 million, respectively, and liabilities of such SPEs totaled $16 million and $17 million, respectively.
Loss Contingencies — Residential Repurchase Reserve
We maintain a repurchase reserve for potential obligations arising from representation and warranty violations related to residential loans we have sold to securitization trusts or third parties and for conforming residential loans associated with MSRs that we have purchased from third parties. We do not originate residential loans and we believe the initial risk of loss due to loan repurchases (i.e., due to a breach of representations and warranties) would generally be a contingency to the companies from whom we acquired the loans. However, in some cases, for example, where loans were acquired from companies that have since become insolvent, repurchase claims may result in our being liable for a repurchase obligation.
At both June 30, 2019 and December 31, 2018, our repurchase reserve associated with our residential loans and MSRs was $4 million and was recorded in Accrued expenses and other liabilities on our consolidated balance sheets. We received seven repurchase requests during the six months ended June 30, 2019, and did not repurchase any loans during this period. During the six months ended June 30, 2019 and 2018, we recorded reversals of repurchase provisions of $0.4 million and $0.5 million, respectively, that were recorded in Mortgage banking activities, net and Other income, net on our consolidated statements of income.
Loss Contingencies — Litigation
On or about December 23, 2009, the Federal Home Loan Bank of Seattle (the “FHLB-Seattle”) filed a complaint in the Superior Court for the State of Washington (case number 09-2-46348-4 SEA) against Redwood Trust, Inc., our subsidiary, Sequoia Residential Funding, Inc. (“SRF”), Morgan Stanley & Co., and Morgan Stanley Capital I, Inc. (collectively, the “FHLB-Seattle Defendants”), which alleged that the FHLB-Seattle Defendants made false or misleading statements in offering materials for a mortgage pass-through certificate (the “Seattle Certificate”) issued in the Sequoia Mortgage Trust 2005-4 securitization transaction (the “2005-4 RMBS”) and purchased by the FHLB-Seattle. The Seattle Certificate was issued with an original principal amount of approximately $133 million, and, at June 30, 2019, approximately $127 million of principal and $12 million of interest payments had been made in respect of the Seattle Certificate. The matter was subsequently resolved and the claims were dismissed by the FHLB Seattle as to all the FHLB Seattle Defendants. At the time the Seattle Certificate was issued, Redwood agreed to indemnify the underwriters of the 2005-4 RMBS, which underwriters were named as defendants in the action, for certain losses and expenses they might incur as a result of claims made against them relating to this RMBS, including, without limitation, certain legal expenses. Regardless of the resolution of this litigation, we could incur a loss as a result of these indemnities.

61

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)
Note 16. Commitments and Contingencies - (continued)


On or about July 15, 2010, The Charles Schwab Corporation (“Schwab”) filed a complaint in the Superior Court for the State of California in San Francisco (case number CGC-10-501610) against SRF and 26 other defendants (collectively, the “Schwab Defendants”), which alleged that the Schwab Defendants made false or misleading statements in offering materials for various residential mortgage-backed securities sold or issued by the Schwab Defendants. Schwab alleged only a claim for negligent misrepresentation under California state law against SRF and sought unspecified damages and attorneys’ fees and costs from SRF. Schwab claimed that SRF made false or misleading statements in offering materials for a mortgage pass-through certificate (the “Schwab Certificate”) issued in the 2005-4 RMBS and purchased by Schwab. The Schwab Certificate was issued with an original principal amount of approximately $15 million, and, at June 30, 2019, approximately $14 million of principal and $1 million of interest payments had been made in respect of the Schwab Certificate. On November 14, 2014, Schwab voluntarily dismissed with prejudice its negligent misrepresentation claim, which resulted in the dismissal with prejudice of SRF from the action. Subsequently, the matter was resolved and Schwab dismissed its claims against the lead underwriter of the 2005-4 RMBS. At the time the Schwab Certificate was issued, Redwood agreed to indemnify the underwriters of the 2005-4 RMBS, which underwriters were also named as defendants in the action, for certain losses and expenses they might incur as a result of claims made against them relating to this RMBS, including, without limitation, certain legal expenses. Regardless of the resolution of this litigation, Redwood could incur a loss as a result of these indemnities.
Through certain of our wholly-owned subsidiaries, we have in the past engaged in, and expect to continue to engage in, activities relating to the acquisition and securitization of residential mortgage loans. In addition, certain of our wholly-owned subsidiaries have in the past engaged in activities relating to the acquisition and securitization of debt obligations and other assets through the issuance of collateralized debt obligations (commonly referred to as CDO transactions). Because of this involvement in the securitization and CDO businesses, we could become the subject of litigation relating to these businesses, including additional litigation of the type described above, and we could also become the subject of governmental investigations, enforcement actions, or lawsuits, and governmental authorities could allege that we violated applicable law or regulation in the conduct of our business. As an example, in July 2016 we became aware of a complaint filed by the State of California on April 1, 2016 against Morgan Stanley & Co. and certain of its affiliates alleging, among other things, that there were misleading statements contained in offering materials for 28 different mortgage pass-through certificates purchased by various California investors, including various California public pension systems, from Morgan Stanley and alleging that Morgan Stanley made false or fraudulent claims in connection with the sale of those certificates. Of the 28 mortgage pass-through certificates that were the subject of the complaint, two were Sequoia mortgage pass-through certificates issued in 2004 and two were Sequoia mortgage pass-through certificates issued in 2007. With respect to each of those certificates, our wholly-owned subsidiary, RWT Holdings, Inc., was the sponsor and our wholly-owned subsidiary, Sequoia Residential Funding, Inc., was the depositor. The plaintiffs subsequently withdrew from the litigation their claims based on eight of the 28 mortgage pass-through certificates, including one of the Sequoia mortgage pass-through certificates issued in 2004. We believe this matter was subsequently resolved and the plaintiffs withdrew their remaining claims. At the time these Sequoia mortgage pass-through certificates were issued, Sequoia Residential Funding, Inc. and Redwood Trust agreed to indemnify the underwriters of these certificates for certain losses and expenses they might incur as a result of claims made against them relating to these certificates, including, without limitation, certain legal expenses. Regardless of the resolution of this litigation, we could incur a loss as a result of these indemnities.
In accordance with GAAP, we review the need for any loss contingency reserves and establish reserves when, in the opinion of management, it is probable that a matter would result in a liability and the amount of loss, if any, can be reasonably estimated. Additionally, we record receivables for insurance recoveries relating to litigation-related losses and expenses if and when such amounts are covered by insurance and recovery of such losses or expenses are due. At June 30, 2019, the aggregate amount of loss contingency reserves established in respect of the FHLB-Seattle and Schwab litigation matters described above was $2 million. We review our litigation matters each quarter to assess these loss contingency reserves and make adjustments in these reserves, upwards or downwards, as appropriate, in accordance with GAAP based on our review.
In the ordinary course of any litigation matter, including certain of the above-referenced matters, we have engaged and may continue to engage in formal or informal settlement communications with the plaintiffs or co-defendants. Settlement communications we have engaged in relating to certain of the above-referenced litigation matters are one of the factors that have resulted in our determination to establish the loss contingency reserves described above. We cannot be certain that any of these matters will be resolved through a settlement prior to trial and we cannot be certain that the resolution of these matters, whether through trial or settlement, will not have a material adverse effect on our financial condition or results of operations in any future period.

62

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)
Note 16. Commitments and Contingencies - (continued)


Future developments (including resolution of substantive pre-trial motions relating to these matters, receipt of additional information and documents relating to these matters (such as through pre-trial discovery), new or additional settlement communications with plaintiffs relating to these matters, or resolutions of similar claims against other defendants in these matters) could result in our concluding in the future to establish additional loss contingency reserves or to disclose an estimate of reasonably possible losses in excess of our established reserves with respect to these matters. Our actual losses with respect to the above-referenced litigation matters may be materially higher than the aggregate amount of loss contingency reserves we have established in respect of these litigation matters, including in the event that any of these matters proceeds to trial and the plaintiff prevails. Other factors that could result in our concluding to establish additional loss contingency reserves or estimate additional reasonably possible losses, or could result in our actual losses with respect to the above-referenced litigation matters being materially higher than the aggregate amount of loss contingency reserves we have established in respect of these litigation matters include that: there are significant factual and legal issues to be resolved; information obtained or rulings made during the lawsuits could affect the methodology for calculation of the available remedies; and we may have additional obligations pursuant to indemnity agreements, representations and warranties, and other contractual provisions with other parties relating to these litigation matters that could increase our potential losses.
Note 17. Equity
The following table provides a summary of changes to accumulated other comprehensive income by component for the three and six months ended June 30, 2019 and 2018.
Table 17.1 – Changes in Accumulated Other Comprehensive Income by Component
 
 
Three Months Ended June 30, 2019
 
Three Months Ended June 30, 2018
(In Thousands)
 
Net Unrealized Gains on Available-for-Sale Securities
 
Net Unrealized Losses on Interest Rate Agreements Accounted for as Cash Flow Hedges
 
Net Unrealized Gains on Available-for-Sale Securities
 
Net Unrealized Losses on Interest Rate Agreements Accounted for as Cash Flow Hedges
Balance at beginning of period
 
$
92,567

 
$
(39,883
)
 
$
114,577

 
$
(34,522
)
Other comprehensive income (loss)
before reclassifications (1)
 
8,562

 
(9,501
)
 
(3,104
)
 
3,417

Amounts reclassified from other
accumulated comprehensive income
 
(2,822
)
 
—

 
(4,748
)
 
—

Net current-period other comprehensive income (loss)
 
5,740

 
(9,501
)
 
(7,852
)
 
3,417

Balance at End of Period
 
$
98,307

 
$
(49,384
)
 
$
106,725

 
$
(31,105
)

63

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)
Note 17. Equity - (continued)


 
 
Six Months Ended June 30, 2019
 
Six Months Ended June 30, 2018
(In Thousands)
 
Net Unrealized Gains on Available-for-Sale Securities
 
Net Unrealized Losses on Interest Rate Agreements Accounted for as Cash Flow Hedges
 
Net Unrealized Gains on Available-for-Sale Securities
 
Net Unrealized Losses on Interest Rate Agreements Accounted for as Cash Flow Hedges
Balance at beginning of period
 
$
95,342

 
$
(34,045
)
 
$
128,201

 
$
(42,953
)
Other comprehensive income (loss)
before reclassifications (1)
 
15,280

 
(15,339
)
 
(7,341
)
 
11,848

Amounts reclassified from other
accumulated comprehensive income
 
(12,315
)
 
—

 
(14,135
)
 
—

Net current-period other comprehensive income (loss)
 
2,965

 
(15,339
)
 
(21,476
)
 
11,848

Balance at End of Period
 
$
98,307

 
$
(49,384
)
 
$
106,725

 
$
(31,105
)
(1)
Amounts presented for net unrealized gains on available-for-sale securities are net of tax benefit (provision) of $0.2 million and $0.1 million for the three and six months ended June 30, 2018, respectively.
The following table provides a summary of reclassifications out of accumulated other comprehensive income for the three and six months ended June 30, 2019 and 2018.
Table 17.2 – Reclassifications Out of Accumulated Other Comprehensive Income
 
 
 
 
 
 
 
 
 
 
 
Amount Reclassified From Accumulated Other Comprehensive Income
 
 
Affected Line Item in the
 
Three Months Ended June 30,
(In Thousands)
 
Income Statement
 
2019
 
2018
Net Realized (Gain) Loss on AFS Securities
 
 
 
 
 
 
Other than temporary impairment (1)
 
Investment fair value changes, net
 
$
—

 
$
56

Gain on sale of AFS securities
 
Realized gains, net
 
(2,822
)
 
(4,804
)
 
 
 
 
$
(2,822
)
 
$
(4,748
)

 
 
 
 
Amount Reclassified From Accumulated Other Comprehensive Income
 
 
Affected Line Item in the
 
Six Months Ended June 30,
(In Thousands)
 
Income Statement
 
2019
 
2018
Net Realized (Gain) Loss on AFS Securities
 
 
 
 
 
 
Other than temporary impairment (1)
 
Investment fair value changes, net
 
$
—

 
$
56

Gain on sale of AFS securities
 
Realized gains, net
 
(12,315
)
 
(14,191
)
 
 
 
 
$
(12,315
)
 
$
(14,135
)
(1)
For both the three and six months ended June 30, 2019, there were no other-than-temporary impairments. For both the three and six months ended June 30, 2018, other-than-temporary impairments were $0.3 million, of which $0.1 million were recognized through our consolidated statements of income and $0.2 million were recognized in Accumulated other comprehensive income, a component of our consolidated balance sheet.

64

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)
Note 17. Equity - (continued)


Issuance of Common Stock
In the fourth quarter of 2018, we established a program to sell up to an aggregate of $150 million of common stock from time to time in at-the-market ("ATM") offerings. During the fourth quarter of 2018, we issued 1,550,819 common shares for net proceeds of approximately $25 million through ATM offerings. During both the three and six months ended June 30, 2019, we issued 791,191 common shares for net proceeds of approximately $13 million through ATM offerings. At June 30, 2019, approximately $112 million remained outstanding for future offerings under this program.
On January 29, 2019, we sold 11,500,000 shares of common stock in an underwritten public offering, resulting in net proceeds of approximately $177 million.
Direct Stock Purchase and Dividend Reinvestment Plan
During the six months ended June 30, 2019, we issued 399,838 shares of common stock through our Direct Stock Purchase and Dividend Reinvestment Plan, resulting in net proceeds of approximately $6 million.
Earnings per Common Share
The following table provides the basic and diluted earnings per common share computations for the three and six months ended June 30, 2019 and 2018.
Table 17.3 – Basic and Diluted Earnings per Common Share
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands, except Share Data)
 
2019
 
2018
 
2019
 
2018
Basic Earnings per Common Share:
 
 
 
 
 
 
 
 
Net income attributable to Redwood
 
$
31,266

 
$
32,747

 
$
85,730

 
$
79,592

Less: Dividends and undistributed earnings allocated to participating securities
 
(877
)
 
(1,074
)
 
(2,417
)
 
(2,535
)
Net income allocated to common shareholders
 
$
30,389

 
$
31,673

 
$
83,313

 
$
77,057

Basic weighted average common shares outstanding
 
96,983,764

 
75,380,715

 
94,846,431

 
75,388,638

Basic Earnings per Common Share
 
$
0.31

 
$
0.42

 
$
0.88

 
$
1.02

Diluted Earnings per Common Share:
 
 
 
 
 
 
 
 
Net income attributable to Redwood
 
$
31,266

 
$
32,747

 
$
85,730

 
$
79,592

Less: Dividends and undistributed earnings allocated to participating securities
 
(1,053
)
 
(1,156
)
 
(2,595
)
 
(2,584
)
Add back: Interest expense on convertible notes for the period, net of tax
 
8,698

 
6,335

 
17,385

 
14,976

Net income allocated to common shareholders
 
$
38,911

 
$
37,926

 
$
100,520

 
$
91,984

Weighted average common shares outstanding
 
96,983,764

 
75,380,715

 
94,846,431

 
75,388,638

Net effect of dilutive equity awards
 
270,550

 
277,788

 
210,360

 
156,307

Net effect of assumed convertible notes conversion to common shares
 
33,442,640

 
24,773,490

 
33,442,640

 
28,746,235

Diluted weighted average common shares outstanding
 
130,696,954

 
100,431,993

 
128,499,431

 
104,291,180

Diluted Earnings per Common Share
 
$
0.30

 
$
0.38

 
$
0.78

 
$
0.88


We included participating securities, which are certain equity awards that have non-forfeitable dividend participation rights, in the calculations of basic and diluted earnings per common share as we determined that the two-class method was more dilutive than the alternative treasury stock method for these shares. Dividends and undistributed earnings allocated to participating securities under the basic and diluted earnings per share calculations require specific shares to be included that may differ in certain circumstances.

65

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)
Note 17. Equity - (continued)


During the three and six months ended June 30, 2019 and 2018, certain of our convertible notes were determined to be dilutive and were included in the calculation of diluted EPS under the "if-converted" method. Under this method, the periodic interest expense (net of applicable taxes) for dilutive notes is added back to the numerator and the weighted average number of shares that the notes are entitled to (if converted, regardless of whether they are in or out of the money) are included in the denominator.
For the three and six months ended June 30, 2019, the number of outstanding equity awards that were antidilutive totaled 8,996 and 8,186, respectively. For the three and six months ended June 30, 2018, the number of outstanding equity awards that were antidilutive totaled 7,091 and 6,965, respectively.
Stock Repurchases
In February 2018, our Board of Directors approved an authorization for the repurchase of our common stock, increasing the total amount authorized for repurchases of common stock to $100 million, and also authorized the repurchase of outstanding debt securities, including convertible and exchangeable debt. This authorization increased the previous share repurchase authorization approved in February 2016 and has no expiration date. This repurchase authorization does not obligate us to acquire any specific number of shares or securities. Under this authorization, shares or securities may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. At June 30, 2019, $100 million of the current authorization remained available for the repurchase of shares of our common stock.
Note 18. Equity Compensation Plans
At June 30, 2019 and December 31, 2018, 4,202,935 and 4,616,776 shares of common stock, respectively, were available for grant under our Incentive Plan. The unamortized compensation cost of awards issued under the Incentive Plan and purchases under the Employee Stock Purchase Plan totaled $27 million at June 30, 2019, as shown in the following table.
Table 18.1 – Activities of Equity Compensation Costs by Award Type
 
 
Six Months Ended June 30, 2019
(In Thousands)
 
Restricted Stock Awards
 
Restricted Stock Units
 
Deferred Stock Units
 
Performance Stock Units
 
Employee Stock Purchase Plan
 
Total
Unrecognized compensation cost at beginning of period
 
$
3,498

 
$
74

 
$
14,489

 
$
7,061

 
$
—

 
$
25,122

Equity grants
 
—

 
3,483

 
4,831

 
—

 
160

 
8,474

Equity grant forfeitures
 
—

 
—

 
—

 
—

 
—

 
—

Equity compensation expense
 
(766
)
 
(277
)
 
(4,184
)
 
(1,670
)
 
(80
)
 
(6,977
)
Unrecognized Compensation Cost at End of Period
 
$
2,732

 
$
3,280

 
$
15,136

 
$
5,391

 
$
80

 
$
26,619


At June 30, 2019, the weighted average amortization period remaining for all of our equity awards was two years.
Restricted Stock Awards ("RSAs")
At June 30, 2019 and December 31, 2018, there were 218,022 and 334,606 shares, respectively, of RSAs outstanding. Restrictions on these shares lapse through 2022. During the six months ended June 30, 2019, there were no RSAs granted, restrictions on 116,584 RSAs lapsed and those shares were distributed, and no RSAs forfeited.
Restricted Stock Units ("RSUs")
At June 30, 2019 and December 31, 2018, there were 229,943 and 4,876 shares, respectively, of RSUs outstanding. Restrictions on these shares lapse through 2023. During the six months ended June 30, 2019, there were 225,067 RSUs granted, no RSUs distributed, and no RSUs forfeited.

66

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)
Note 18. Equity Compensation Plans - (continued)


Deferred Stock Units (“DSUs”)
At June 30, 2019 and December 31, 2018, there were 2,405,497 and 2,336,720 DSUs, respectively, outstanding of which 1,249,606 and 1,181,622, respectively, had vested. During the six months ended June 30, 2019, there were 329,228 DSUs granted, 260,451 DSUs distributed, and no DSUs forfeited. Unvested DSUs at June 30, 2019 vest through 2023.
Performance Stock Units (“PSUs”)
At both June 30, 2019 and December 31, 2018, the target number of PSUs that were unvested was 725,616. Vesting for all PSUs will generally occur at the end of three years from their grant date based on various TSR performance calculations, as discussed in our Annual Report on Form 10-K for the year ended December 31, 2018.
Employee Stock Purchase Plan ("ESPP")
The ESPP allows a maximum of 600,000 shares of common stock to be purchased in aggregate for all employees. As of June 30, 2019 and December 31, 2018, 406,941 and 390,569 shares had been purchased, respectively, and there remained a negligible amount of uninvested employee contributions in the ESPP at June 30, 2019.
Note 19. Mortgage Banking Activities, Net
The following table presents the components of Mortgage banking activities, net, recorded in our consolidated statements of income for the three and six months ended June 30, 2019 and 2018.
Table 19.1 – Mortgage Banking Activities
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2019
 
2018
 
2019
 
2018
Residential Mortgage Banking Activities, Net
 
 
 
 
 
 
 
 
Changes in fair value of:
 
 
 
 
 
 
 
 
Residential loans, at fair value (1)
 
$
20,267

 
$
3,364

 
$
35,111

 
$
1,170

Risk management derivatives (2)
 
(5,760
)
 
6,150

 
(9,898
)
 
34,582

Other income, net (3)
 
852

 
1,082

 
973

 
1,420

Total residential mortgage banking activities, net
 
15,359

 
10,596

 
26,186

 
37,172

 
 
 
 
 
 
 
 
 
Business Purpose Mortgage Banking Activities, Net:
 
 
 
 
 
 
 
 
Changes in fair value of:
 
 
 
 
 
 
 
 
Single-family rental loans, at fair value (1)
 
1,882

 
—

 
3,626

 
—

Risk management derivatives (2)
 
(1,671
)
 
—

 
(2,517
)
 
—

Residential bridge loans, at fair value
 
1,012

 
—

 
1,098

 
—

Other income, net (4)
 
2,578

 
—

 
3,076

 
—

Total business purpose mortgage banking activities, net
 
3,801

 
—

 
5,283

 
—

Mortgage Banking Activities, Net
 
$
19,160

 
$
10,596

 
$
31,469

 
$
37,172

(1)
Includes changes in fair value for associated loan purchase and forward sale commitments.
(2)
Represents market valuation changes of derivatives that were used to manage risks associated with our accumulation of loans.
(3)
Amounts in this line item include other fee income from loan acquisitions and the provision for repurchases expense, presented net.
(4)
Amounts in this line item include other fee income from loan originations.

67

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)


Note 20. Investment Fair Value Changes, Net
The following table presents the components of Investment fair value changes, net, recorded in our consolidated statements of income for the three and six months ended June 30, 2019 and 2018.
Table 20.1 – Investment Fair Value Changes
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2019
 
2018
 
2019
 
2018
Investment Fair Value Changes, Net
 
 
 
 
 
 
 
 
Changes in fair value of:
 
 
 
 
 
 
 
 
Residential loans held-for-investment, at Redwood
 
$
35,548

 
$
(15,010
)
 
$
63,656

 
$
(53,995
)
Residential bridge loans held-for-investment
 
(318
)
 
—

 
(621
)
 
—

Trading securities
 
18,442

 
(930
)
 
40,302

 
(3,885
)
Servicer advance investments
 
432

 
—

 
1,440

 
—

Excess MSRs
 
(65
)
 
—

 
(502
)
 
—

REO
 
(139
)
 
—

 
(139
)
 
—

Net investments in Legacy Sequoia entities (1)
 
(123
)
 
(720
)
 
(497
)
 
(728
)
Net investments in Sequoia Choice entities (1)
 
2,879

 
1,072

 
6,144

 
986

Net investment in Freddie Mac SLST entity (1)
 
8,037

 
—

 
14,402

 
—

Net investments in Freddie Mac K-Series entities (1)
 
3,246

 
—

 
6,365

 
—

Risk-sharing investments
 
(61
)
 
(209
)
 
(138
)
 
(348
)
Risk management derivatives, net
 
(64,740
)
 
16,742

 
(107,115
)
 
60,524

Impairments on AFS securities
 
—

 
(56
)
 
—

 
(56
)
Investment Fair Value Changes, Net
 
$
3,138

 
$
889

 
$
23,297

 
$
2,498


(1)
Includes changes in fair value of the loans held-for-investment, REO and the ABS issued at the entities, which netted together represent the change in value of our investments at the consolidated VIEs.

68

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)


Note 21. Other Income, Net
The following table presents the components of Other income, net, recorded in our consolidated statements of income for the three and six months ended June 30, 2019 and 2018.
Table 21.1 – Other Income
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2019
 
2018
 
2019
 
2018
MSR income, net
 
$
1,654

 
$
1,874

 
$
1,911

 
$
2,830

Risk share income
 
800

 
1,020

 
1,446

 
1,799

FHLBC capital stock dividend
 
535

 
428

 
1,082

 
811

Equity investment losses
 
(96
)
 
—

 
(5
)
 
—

5 Arches management fee income
 
1,488

 
—

 
1,954

 
—

Amortization of intangible assets
 
(1,900
)
 
—

 
(2,532
)
 
—

Gain on re-measurement of investment in 5 Arches
 
—

 
—

 
2,441

 
—

Other
 
(74
)
 
—

 
(303
)
 
—

Other Income, Net
 
$
2,407

 
$
3,322

 
$
5,994

 
$
5,440


Note 22. Operating Expenses
Components of our operating expenses for the three and six months ended June 30, 2019 and 2018 are presented in the following table.
Table 22.1 – Components of Operating Expenses
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2019
 
2018
 
2019
 
2018
Fixed compensation expense
 
$
9,252

 
$
5,775

 
$
17,457

 
$
12,214

Variable compensation expense
 
4,021

 
1,825

 
8,423

 
8,732

Equity compensation expense
 
4,024

 
3,835

 
6,977

 
6,532

Total compensation expense
 
17,297

 
11,435

 
32,857

 
27,478

Systems and consulting
 
2,536

 
1,774

 
4,364

 
3,640

Loan acquisition costs (1)
 
1,516

 
2,155

 
2,993

 
3,973

Office costs
 
1,585

 
1,084

 
2,889

 
2,224

Accounting and legal
 
960

 
1,074

 
2,085

 
1,908

Corporate costs
 
545

 
496

 
1,219

 
1,000

Other operating expenses
 
1,816

 
991

 
3,007

 
1,816

Total Operating Expenses
 
$
26,255

 
$
19,009

 
$
49,414

 
$
42,039

(1)
Loan acquisition costs primarily includes underwriting and due diligence costs related to the acquisition of residential loans held-for-sale at fair value.

69

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)


Note 23. Taxes
For the six months ended June 30, 2019 and 2018, we recognized a provision for income taxes of $3 million and $7 million, respectively. The following is a reconciliation of the statutory federal and state tax rates to our effective tax rate at June 30, 2019 and 2018.
Table 23.1 – Reconciliation of Statutory Tax Rate to Effective Tax Rate
 
 
June 30, 2019
 
June 30, 2018
Federal statutory rate
 
21.0
 %
 
21.0
 %
State statutory rate, net of Federal tax effect
 
8.6
 %
 
8.6
 %
Differences in taxable (loss) income from GAAP income
 
(4.7
)%
 
(2.9
)%
Change in valuation allowance
 
(3.6
)%
 
(3.3
)%
Dividends paid deduction
 
(17.7
)%
 
(14.9
)%
Effective Tax Rate
 
3.6
 %
 
8.5
 %

We assessed our tax positions for all open tax years (i.e., Federal, 2015 to 2019, and State, 2014 to 2019) at June 30, 2019 and December 31, 2018, and concluded that we had no uncertain tax positions that resulted in material unrecognized tax benefits.
Note 24. Segment Information
Redwood operates in two segments: Investment Portfolio and Mortgage Banking. Our segments are based on our organizational and management structure, which aligns with how our results are monitored and performance is assessed. For a full description of our segments, see Part I, Item 1—Business in our Annual Report on Form 10-K for the year ended December 31, 2018.
Our Mortgage Banking segment includes activity from both our residential and business purpose mortgage banking operations. Our business purpose mortgage banking operations includes activity from our wholly-owned subsidiary 5 Arches and our single-family rental loans that we are aggregating for subsequent sale or securitization. In connection with our acquisition of 5 Arches on March 1, 2019, the goodwill, intangible assets, and contingent consideration we recorded on our consolidated balance sheets were included in our Mortgage Banking segment. The gain on re-measurement of our initial minority investment and purchase option in 5 Arches during the three months ended March 31, 2019 was included in Corporate/Other.
Segment contribution represents the measure of profit that management uses to assess the performance of our business segments and make resource allocation and operating decisions. Certain corporate expenses not directly assigned or allocated to one of our two segments, as well as activity from certain consolidated Sequoia entities, are included in the Corporate/Other column as reconciling items to our consolidated financial statements. These unallocated corporate expenses primarily include interest expense associated with certain long-term debt, indirect operating expenses, and other expense.

70

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 24. Segment Information - (continued)


The following tables present financial information by segment for the three and six months ended June 30, 2019 and 2018.
Table 24.1 – Business Segment Financial Information
 
 
Three Months Ended June 30, 2019
(In Thousands)
 
Investment Portfolio
 
Mortgage Banking
 
 Corporate/
Other
 
 Total
Interest income
 
$
132,048

 
$
11,352

 
$
5,142

 
$
148,542

Interest expense
 
(93,912
)
 
(6,595
)
 
(15,713
)
 
(116,220
)
Net interest income (loss)
 
38,136


4,757


(10,571
)
 
32,322

Non-interest income
 
 
 
 
 
 
 
 
Mortgage banking activities, net
 
—

 
19,160

 
—

 
19,160

Investment fair value changes, net
 
3,297

 
—

 
(159
)
 
3,138

Other income (expense), net
 
2,874

 
(156
)
 
(311
)
 
2,407

Realized gains, net
 
2,827

 
—

 
—

 
2,827

Total non-interest income, net
 
8,998


19,004


(470
)
 
27,532

Direct operating expenses
 
(2,258
)
 
(11,571
)
 
(12,426
)
 
(26,255
)
Provision for income taxes
 
(896
)
 
(1,437
)
 
—

 
(2,333
)
Segment Contribution
 
$
43,980


$
10,753


$
(23,467
)
 
 
Net Income
 
 
 
 
 
 
 
$
31,266

Non-cash amortization income (expense), net
 
$
2,622

 
$
(2,014
)
 
$
(1,125
)
 
$
(517
)
 
 
Three Months Ended June 30, 2018
(In Thousands)
 
Investment Portfolio
 
Mortgage Banking
 
 Corporate/
Other
 
 Total
Interest income
 
$
64,569

 
$
13,084

 
$
5,323

 
$
82,976

Interest expense
 
(27,004
)
 
(7,629
)
 
(13,580
)
 
(48,213
)
Net interest income (loss)
 
37,565

 
5,455

 
(8,257
)
 
34,763

Non-interest income
 
 
 
 
 
 
 
 
Mortgage banking activities, net
 
—

 
10,596

 
—

 
10,596

Investment fair value changes, net
 
1,600

 
—

 
(711
)
 
889

Other income, net
 
3,322

 
—

 
—

 
3,322

Realized gains, net
 
4,714

 
—

 
—

 
4,714

Total non-interest income, net
 
9,636

 
10,596

 
(711
)
 
19,521

Direct operating expenses
 
(1,858
)
 
(5,739
)
 
(11,412
)
 
(19,009
)
Provision for income taxes
 
(1,130
)
 
(1,398
)
 
—

 
(2,528
)
Segment Contribution
 
$
44,213

 
$
8,914

 
$
(20,380
)
 
 
Net Income
 
 
 
 
 
 
 
$
32,747

Non-cash amortization income (expense), net
 
$
4,654

 
$
(22
)
 
$
(891
)
 
$
3,741


71

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 24. Segment Information - (continued)


 
 
Six Months Ended June 30, 2019
(In Thousands)
 
Investment Portfolio
 
Mortgage Banking
 
 Corporate/
Other
 
 Total
Interest income
 
$
247,500

 
$
21,729

 
$
10,354

 
$
279,583

Interest expense
 
(171,799
)
 
(12,159
)
 
(31,538
)
 
(215,496
)
Net interest income (loss)
 
75,701

 
9,570

 
(21,184
)
 
64,087

Non-interest income
 
 
 
 
 
 
 
 
Mortgage banking activities, net
 
—

 
31,469

 
—

 
31,469

Investment fair value changes, net
 
23,853

 
—

 
(556
)
 
23,297

Other income, net
 
4,095

 
(323
)
 
2,222

 
5,994

Realized gains, net
 
13,513

 
—

 
—

 
13,513

Total non-interest income, net
 
41,461

 
31,146

 
1,666

 
74,273

Direct operating expenses
 
(4,919
)
 
(19,675
)
 
(24,820
)
 
(49,414
)
Provision for income taxes
 
(1,238
)
 
(1,978
)
 
—

 
(3,216
)
Segment Contribution
 
$
111,005

 
$
19,063

 
$
(44,338
)
 
 
Net Income
 
 
 
 
 
 
 
$
85,730

Non-cash amortization income (expense), net
 
$
4,990

 
$
(2,737
)
 
$
(2,425
)
 
$
(172
)

 
 
Six Months Ended June 30, 2018
(In Thousands)
 
Investment Portfolio
 
Mortgage Banking
 
 Corporate/
Other
 
 Total
Interest income
 
$
123,326

 
$
25,981

 
$
10,288

 
$
159,595

Interest expense
 
(46,867
)
 
(13,766
)
 
(29,094
)
 
(89,727
)
Net interest income (loss)
 
76,459

 
12,215

 
(18,806
)
 
69,868

Non-interest income
 
 
 
 
 
 
 
 
Mortgage banking activities, net
 
—

 
37,172

 
—

 
37,172

Investment fair value changes, net
 
3,190

 
—

 
(692
)
 
2,498

Other income, net
 
5,440

 
—

 
—

 
5,440

Realized gains, net
 
14,077

 
—

 
—

 
14,077

Total non-interest income, net
 
22,707

 
37,172

 
(692
)
 
59,187

Direct operating expenses
 
(3,865
)
 
(14,371
)
 
(23,803
)
 
(42,039
)
Provision for income taxes
 
(2,018
)
 
(5,406
)
 
—

 
(7,424
)
Segment Contribution
 
$
93,283

 
$
29,610

 
$
(43,301
)
 
 
Net Income
 
 
 
 
 
 
 
$
79,592

Non-cash amortization income (expense), net
 
$
9,271

 
$
(44
)
 
$
(1,845
)
 
$
7,382



72

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 24. Segment Information - (continued)


The following table presents the components of Corporate/Other for the three and six months ended June 30, 2019 and 2018.
Table 24.2 – Components of Corporate/Other
 
 
Three Months Ended June 30,
 
 
2019
 
2018
(In Thousands)
 
Legacy Consolidated VIEs (1)
 
Other
 
Total
 
Legacy Consolidated VIEs (1)
 
Other
 
 Total
Interest income
 
$
4,776

 
$
366

 
$
5,142

 
$
5,017

 
$
306

 
$
5,323

Interest expense
 
(3,981
)
 
(11,732
)
 
(15,713
)
 
(4,215
)
 
(9,365
)
 
(13,580
)
Net interest income (loss)
 
795

 
(11,366
)
 
(10,571
)
 
802

 
(9,059
)
 
(8,257
)
Non-interest income
 
 
 
 
 
 
 
 
 
 
 
 
Investment fair value changes, net
 
(123
)
 
(36
)
 
(159
)
 
(720
)
 
9

 
(711
)
Other income
 
—

 
(311
)
 
(311
)
 
—

 
—

 
—

Total non-interest income, net
 
(123
)
 
(347
)
 
(470
)
 
(720
)
 
9

 
(711
)
Direct operating expenses
 
—

 
(12,426
)
 
(12,426
)
 
—

 
(11,412
)
 
(11,412
)
Total
 
$
672

 
$
(24,139
)
 
$
(23,467
)
 
$
82

 
$
(20,462
)
 
$
(20,380
)
 
 
Six Months Ended June 30,
 
 
2019
 
2018
(In Thousands)
 
Legacy Consolidated
VIEs (1)
 
Other
 
Total
 
Legacy Consolidated
VIEs (1)
 
Other
 
 Total
Interest income
 
$
9,629

 
$
725

 
$
10,354

 
$
9,829

 
$
459

 
$
10,288

Interest expense
 
(8,096
)
 
(23,442
)
 
(31,538
)
 
(8,067
)
 
(21,027
)
 
(29,094
)
Net interest income (loss)
 
1,533

 
(22,717
)
 
(21,184
)
 
1,762

 
(20,568
)
 
(18,806
)
Non-interest income
 
 
 
 
 
 
 
 
 
 
 
 
Investment fair value changes, net
 
(497
)
 
(59
)
 
(556
)
 
(728
)
 
36

 
(692
)
Other income
 
—

 
2,222

 
2,222

 
—

 
—

 
—

Total non-interest income, net
 
(497
)
 
2,163

 
1,666

 
(728
)
 
36

 
(692
)
Direct operating expenses
 
—

 
(24,820
)
 
(24,820
)
 
—

 
(23,803
)
 
(23,803
)
Total
 
$
1,036

 
$
(45,374
)
 
$
(44,338
)
 
$
1,034

 
$
(44,335
)
 
$
(43,301
)
(1)
Legacy consolidated VIEs represent Legacy Sequoia entities that are consolidated for GAAP financial reporting purposes. See Note 4 for further discussion on VIEs.


73

REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2019
(Unaudited)

Note 24. Segment Information - (continued)


The following table presents supplemental information by segment at June 30, 2019 and December 31, 2018.
Table 24.3 – Supplemental Segment Information
(In Thousands)
 
Investment Portfolio
 
Mortgage Banking
 
Corporate/
Other
 
Total
June 30, 2019
 
 
 
 
 
 
 
 
Residential loans
 
$
5,777,759

 
$
1,047,856

 
$
457,750

 
$
7,283,365

Business purpose residential loans
 
159,353

 
91,501

 
—

 
250,854

Multifamily loans
 
3,749,657

 
—

 
—

 
3,749,657

Real estate securities
 
1,477,486

 
—

 
—

 
1,477,486

Other investments
 
369,900

 
2,230

 
—

 
372,130

Goodwill and intangible assets
 
—

 
50,999

 
—

 
50,999

Total assets
 
11,790,419

 
1,225,117

 
836,050

 
13,851,586

 
 
 
 
 
 
 
 
 
December 31, 2018
 
 
 
 
 
 
 
 
Residential loans
 
$
5,685,983

 
$
1,048,801

 
$
519,958

 
$
7,254,742

Business purpose residential loans
 
112,798

 
28,460

 
—

 
141,258

Multifamily loans
 
2,144,598

 
—

 
—

 
2,144,598

Real estate securities
 
1,452,494

 
—

 
—

 
1,452,494

Other investments
 
427,764

 
—

 
10,754

 
438,518

Total assets
 
10,093,993

 
1,103,090

 
740,323

 
11,937,406


Note 25. Subsequent Events
In July 2019, we entered into an agreement with Freddie Mac to purchase mortgage-backed securities to be issued in a securitization transaction sponsored by Freddie Mac. Pursuant to the terms of this agreement, we plan to acquire subordinate securities backed by a pool of seasoned re-performing and, to a lesser extent, non-performing residential first lien mortgage loans. We deposited $60 million with Freddie Mac towards the purchase price of these securities and expect to fund the remainder of the purchase price of these securities, approximately $150 million, upon the closing of this transaction in the third quarter of 2019, which we expect will be partially financed by a third-party financial institution under a securities repurchase facility. We anticipate consolidating the assets and liabilities of the securitization trust resulting from this transaction as we expect to maintain certain discretionary rights associated with the ownership of this investment.



74

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
INTRODUCTION
Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to provide a reader of our financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in six main sections:
•
Overview
•
Results of Operations
•
Liquidity and Capital Resources
•
Off-Balance Sheet Arrangements and Contractual Obligations
•
Critical Accounting Policies and Estimates
•
New Accounting Standards
Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Part I, Item 1 of this Quarterly Report on Form 10-Q and in Part II, Item 8, Financial Statements and Supplementary Data in our most recent Annual Report on Form 10-K, as well as the sections entitled “Risk Factors” in Part I, Item 1A of our most recent Annual Report on Form 10-K and Part II, Item 1A of this Quarterly Report on Form 10-Q, as well as other cautionary statements and risks described elsewhere in this report and our most recent Annual Report on Form 10-K. The discussion in this MD&A contains forward-looking statements that involve substantial risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, such as those discussed in the Cautionary Statement below.
References herein to “Redwood,” the “company,” “we,” “us,” and “our” include Redwood Trust, Inc. and its consolidated subsidiaries, unless the context otherwise requires. Financial information concerning our business is set forth in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and our consolidated financial statements and notes thereto, which are included in Part I, Item 1 of this Quarterly Report on Form 10-Q.
Our website can be found at www.redwoodtrust.com. We make available, free of charge through the investor information section of our website, access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the U.S. Securities Exchange Act of 1934, as well as proxy statements, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the U.S. Securities and Exchange Commission (“SEC”). We also make available, free of charge, access to our charters for our Audit Committee, Compensation Committee, and Governance and Nominating Committee, our Corporate Governance Standards, and our Code of Ethics governing our directors, officers, and employees. Within the time period required by the SEC and the New York Stock Exchange, we will post on our website any amendment to the Code of Ethics and any waiver applicable to any executive officer or director of Redwood. In addition, our website includes information concerning purchases and sales of our equity securities by our executive officers and directors, and may include disclosure relating to certain non-GAAP financial measures (as defined in the SEC’s Regulation G) that we may make public orally, telephonically, by webcast, by broadcast, or by similar means from time to time. The information on our website is not part of this Quarterly Report on Form 10-Q.
Our Investor Relations Department can be contacted at One Belvedere Place, Suite 300, Mill Valley, CA 94941, Attn: Investor Relations, telephone (866) 269-4976.


75

Our Business
Redwood Trust, Inc., together with its subsidiaries, is a specialty finance company focused on making credit-sensitive investments in single-family residential and multifamily 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 segments are based on our organizational and management structure, which aligns with how our results are monitored and performance is assessed. For a full description of our segments, see Item 1—Business in our Annual Report on Form 10-K for the year ended December 31, 2018.
Our primary sources of income are net interest income from our investment portfolio 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.” Our mortgage banking activities and investments in MSRs are generally carried out through our taxable REIT subsidiaries, while our portfolio of mortgage- and other real estate-related investments is primarily held at our REIT. We generally intend to retain profits generated and taxed at our taxable REIT subsidiaries, and to distribute as dividends at least 90% of the taxable income we generate at our REIT.
Redwood Trust, Inc. was incorporated in the State of Maryland on April 11, 1994, and commenced operations on August 19, 1994. Our executive offices are located at One Belvedere Place, Suite 300, Mill Valley, California 94941.
Cautionary Statement
This Quarterly Report on Form 10-Q and the documents incorporated by reference herein contain forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve numerous risks and uncertainties. Our actual results may differ from our beliefs, expectations, estimates, and projections and, consequently, you should not rely on these forward-looking statements as predictions of future events. Forward-looking statements are not historical in nature and can be identified by words such as “anticipate,” “estimate,” “will,” “should,” “expect,” “believe,” “intend,” “seek,” “plan” and similar expressions or their negative forms, or by references to strategy, plans, or intentions. These forward-looking statements are subject to risks and uncertainties, including, among other things, those described in our Annual Report on Form 10-K for the fiscal year ended December 31, 2017 and this Quarterly Report on Form 10-Q, in each case under the caption “Risk Factors.” Other risks, uncertainties, and factors that could cause actual results to differ materially from those projected may be described from time to time in reports we file with the SEC, including reports on Forms 10-Q and 8-K. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.
Statements regarding the following subjects, among others, are forward-looking by their nature: (i) statements we make regarding Redwood’s business strategy and strategic focus, including statements relating to our overall market position, strategy and long-term prospects (including trends driving the flow of capital in the housing finance market, our strategic initiatives designed to capitalize on those trends, our ability to attract capital to finance those initiatives, our approach to raising capital, and the prospects for federal housing finance reform); (ii) statements related to our financial outlook and expectations for 2019, including with respect to our investment portfolio and mortgage banking activities; (iii) statements related to our investment portfolio, including our long-term goals to deploy capital and build our investment portfolio, our expectations to increase capital allocated to multifamily securities, re-performing loan securities, and business purpose residential loans, and our expectations to fund the remainder of our commitment to a light-renovation multifamily loan fund over the next few quarters; (iv) statements related to our business purpose mortgage banking platform, including our focus on originations that deliver superior risk-adjusted returns, including single-family rental loans and further development of small-balance multifamily and other loans related to rental dwellings, the market opportunity that we continue to see as plentiful, and our expectations to continue ramping this platform throughout 2019; (v) statements relating to the potential for regulatory reform, including the expiration of the “QM Patch” and shifting GSE market share to the private sector, and positioning Redwood to capitalize on resulting opportunities; (vi) statements relating to acquiring residential mortgage loans in the future that we have identified for purchase or plan to purchase, including the amount of such loans that we identified for purchase during the second quarter of 2019 and at June 30, 2019, and expected fallout and the corresponding volume of residential mortgage loans expected to be available for purchase; (vii) statements regarding business purpose loan originations, loans funded, and associated funding commitments; (viii) statements relating to our estimate of our available capital (including that we estimate our available capital at June 30, 2019 was approximately $200 million, and that, while we believe our available capital, together with additional liquidity we believe we can source through continued portfolio optimization (including collateralized borrowings or assets sales), is sufficient to fund our operations and currently contemplated investment activities and to repay existing debt, we may raise equity or debt capital from time to time to acquire assets and make long-term investments to

76

expand our investment portfolio or enhance our mortgage banking operating platforms, including funding large purchases of portfolios of residential, multifamily, or business purpose residential loans or securities, or other portfolio investments, or for other purposes, such as for acquisitions to expand our mortgage banking platform or to repay our $201 million of exchangeable debt maturing in November 2019); (ix) statements we make regarding future dividends, including with respect to our regular quarterly dividends in 2019; and (x) statements regarding our expectations and estimates relating to the characterization for income tax purposes of our dividend distributions, our expectations and estimates relating to tax accounting, tax liabilities and tax savings, and GAAP tax provisions, and our estimates of REIT taxable income and TRS taxable income.
Important factors, among others, that may affect our actual results include:
•
the pace at which we redeploy our available capital into new investments and initiatives;
•
our ability to scale our platform and systems, particularly with respect to our new initiatives;
•
interest rate volatility, changes in credit spreads, and changes in liquidity in the market for real estate securities and loans;
•
changes in the demand from investors for residential mortgages and investments, and our ability to distribute residential mortgages through our whole-loan distribution channel;
•
our ability to finance our investments in securities and our acquisition of residential mortgages with short-term debt;
•
changes in the values of assets we own;
•
general economic trends, the performance of the housing, real estate, mortgage, credit, and broader financial markets, and their effects on the prices of earning assets and the credit status of borrowers;
•
federal and state legislative and regulatory developments, and the actions of governmental authorities, including the new U.S. presidential administration, and in particular those affecting the mortgage industry or our business (including, but not limited to, the Federal Housing Finance Agency’s rules relating to FHLB membership requirements and the implications for our captive insurance subsidiary’s membership in the FHLB);
•
strategic business and capital deployment decisions we make;
•
developments related to the fixed income and mortgage finance markets and the Federal Reserve’s statements regarding its future open market activity and monetary policy;
•
our exposure to credit risk and the timing of credit losses within our portfolio;
•
the concentration of the credit risks we are exposed to, including due to the structure of assets we hold and the geographical concentration of real estate underlying assets we own;
•
our exposure to adjustable-rate mortgage loans;
•
the efficacy and expense of our efforts to manage or hedge credit risk, interest rate risk, and other financial and operational risks;
•
changes in credit ratings on assets we own and changes in the rating agencies’ credit rating methodologies;
•
changes in interest rates; changes in mortgage prepayment rates;
•
changes in liquidity in the market for real estate securities and loans;
•
our ability to finance the acquisition of real estate-related assets with short-term debt;
•
the ability of counterparties to satisfy their obligations to us;
•
our involvement in securitization transactions, the profitability of those transactions, and the risks we are exposed to in engaging in securitization transactions;
•
exposure to claims and litigation, including litigation arising from our involvement in securitization transactions;
•
ongoing litigation against various trustees of RMBS transactions;
•
whether we have sufficient liquid assets to meet short-term needs;
•
our ability to successfully compete and retain or attract key personnel;
•
our ability to adapt our business model and strategies to changing circumstances;
•
changes in our investment, financing, and hedging strategies and new risks we may be exposed to if we expand our business activities;
•
our exposure to a disruption or breach of the security of our technology infrastructure and systems;
•
exposure to environmental liabilities;
•
our failure to comply with applicable laws and regulations;
•
our failure to maintain appropriate internal controls over financial reporting and disclosure controls and procedures;
•
the impact on our reputation that could result from our actions or omissions or from those of others; changes in accounting principles and tax rules;
•
our ability to maintain our status as a REIT for tax purposes;
•
limitations imposed on our business due to our REIT status and our status as exempt from registration under the Investment Company Act of 1940;
•
decisions about raising, managing, and distributing capital; and
•
other factors not presently identified.
This Quarterly Report on Form 10-Q may contain statistics and other data that in some cases have been obtained from or compiled from information made available by servicers and other third-party service providers.

77

OVERVIEW
Business Update
Market volatility during the second quarter of 2019 kept us focused on managing our interest rate exposure while executing against our broader initiatives. The steep decline in rates, coupled with a continuing demand for yield, had varying impacts on our second quarter results. Most notably, lower rates benefited our mortgage banking operations, but resulted in higher hedging costs for certain segments of our investment portfolio. These dynamics are a good reminder of why we seek to maintain a balanced business model. Our second quarter GAAP book value remained stable at $16.01 per share as of June 30, 2019, with second quarter GAAP net income covering our second quarter dividend.
Strong mortgage banking results were a key driver of earnings for the second quarter. Our residential mortgage banking business benefited from the decline in interest rates, resulting in a 59% increase in loan purchase volume over the first quarter of 2019. Gross margins in the second quarter exceeded our long-term target range for both securitization and whole loan sale executions, and overall returns for this business benefited from operational and capital efficiencies we have achieved thus far in 2019. The mix of Select and Choice loan purchase commitments was consistent with the first quarter, and second quarter Choice loan purchase commitments were the second highest since the Choice program's inception in 2016. For the remainder of 2019, we expect gross margins to normalize and volume growth to stabilize.
While strong demand for yield and tighter credit spreads benefited our mortgage banking margins, they made portfolio capital deployment challenging. While our long-term goal is to deploy capital and build our investment portfolio, the second quarter represented one of the best quarters in recent memory to realize gains through portfolio sales and free up capital for future deployment. We deployed $136 million of capital into new investments during the second quarter, while generating $243 million of capital through financing structures that optimize our balance sheet and sales of lower-yielding assets. Taking a long-term approach allowed us to realize gains on the sale of securities, and we have already seen better opportunities to deploy capital in the third quarter of 2019, with over $100 million deployed in July 2019 alone. At June 30, 2019, we estimate that our available capital was approximately $200 million.
From an underwriting and credit perspective, we remain pleased with the performance of our portfolio. Though housing price appreciation is slowing from the unsustainable levels of recent years, the labor market is at full employment, homebuilding continues to lag demand, and the excesses of the last cycle - including poorly underwritten mortgage credit - are not driving today’s market. Not coincidentally, the areas of recent underperformance in our portfolio have been investments most exposed to interest rates and prepayments rather than credit risk. This included jumbo residential loans that we finance with borrowings from the FHLBC, and the residential mortgage servicing rights (MSRs) that we hold outright or in securitized form.
Another key area of focus during the second quarter was the ongoing integration of the 5 Arches business. The second quarter marked our first full quarter of 5 Arches operating results, and we are pleased with our progress as we deepened our market footprint in the business purpose lending space and produced attractive loans for our portfolio. We are focused on originations that deliver superior risk-adjusted returns, including single-family rental loans and further development of small-balance multifamily and other loans related to rental dwellings. This production mix reflects a market opportunity we continue to see as plentiful, driven by the overall fundamental supply/demand imbalance in housing, most notably at affordable price points for both renters and prospective owners. Importantly, we expect to continue ramping the origination volume of this platform throughout 2019.
Over the last several months, we have dedicated a considerable amount of time working with policymakers in Washington, D.C. to demonstrate the private sector's ability to partner with Fannie Mae and Freddie Mac (the “GSEs”) in providing financing solutions for a broad array of borrowers, including through non-qualified mortgage (non-QM) loans. In support of this work, in May 2019 we published an extensive presentation on our perspectives on private capital and the “QM Patch," the qualified mortgage regulatory exemption currently applicable to the GSEs. In the presentation we advanced a robust, data-based argument that, if this exemption were allowed to expire at a proper cadence, additional “crowding in” of private capital could occur in a safe and sound manner for all stakeholders, including borrowers and taxpayers alike.
Our presentation focused on potential solutions pertaining to the QM Patch, highlighting our view that Redwood is ideally positioned and qualified to participate with the public sector in establishing a framework for non-QM mortgage origination and financing on a level playing field. Redwood has been a leader in the private sector resurgence in housing finance since issuing the first post-crisis securitization in 2010. The private sector has been financing an increasing share of certain market segments that have been long dominated by the GSEs and we believe the private sector can speak for more without a meaningful impact on rates available to borrowers. We presented this analysis to key policymakers in Washington, D.C. and were encouraged by the feedback.

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We were further encouraged when the Consumer Finance Protection Bureau ("CFPB") recently released a notice of proposed rulemaking seeking information relating to the expiration of the QM Patch. In related remarks, the CFPB stated that it “currently plans to allow the GSE Patch to expire in January 2021 or after a short extension, if necessary, to facilitate a smooth and orderly transition away from the GSE Patch.” The CFPB Director’s reference to “a more transparent, level playing field that ultimately benefits consumers” speaks directly to the core of our May 2019 publication.
More broadly, the Director of the Federal Housing Finance Agency (“FHFA”) has been regularly stating his determination to shift GSE market share to the private sector, a dramatic departure from the policies of his predecessor. The Director, as regulator and conservator of the GSEs, has a number of tools at his disposal to make that happen without Congressional action. These include altering GSE underwriting guidelines, discontinuing GSE eligibility for certain loan products (such as high balance loans and/or second home financings), requiring the GSEs to sell more first-loss risk as part of their risk-transfer programs, or even raising GSE guaranty fees to create a more level playing field with the private sector. In addition, the Director has suggested changes to the GSEs’ capital and regulatory regimes that would make holding risk more expensive, an incentive for additional credit risk transfer and a catalyst to further level the playing field with the private sector.
Taken together, these themes represent a clear direction of Federal housing finance policy that is fully aligned with Redwood’s business model and core strengths. As such, we maintain an active presence in Washington, D.C., meeting with key policymakers to provide input and demonstrate that private capital is ready and able to take on a larger share of the mortgage market. We have noted many times that the range of potential housing reform outcomes for the market - and Redwood - is broad, but there remains opportunity for revolutionary change for our firm. This is still the case, but the quality of discourse over the past several months leaves room for more optimism than we have had in quite some time.
We continue to make good progress executing on our strategic initiatives, and the current environment has provided us with an opportunity to demonstrate the strength and agility of our diversified business model. We are entering the second half of the year with a healthy balance sheet, disciplined cost management and a portfolio built on strong credit performance.

79

Financial and Operational Overview - Second Quarter of 2019
Highlights
The following table presents key earnings metrics for the three and six months ended June 30, 2019.
Table 1 – Key Earnings and Return Metrics
 
 
Three Months Ended
 
Six Months Ended
(In Thousands, except per Share Data)
 
June 30, 2019
 
June 30, 2019
Net income
 
$
31,266

 
$
85,730

Net income per diluted common share
 
$
0.30

 
$
0.78

Annualized GAAP return on equity
 
8
%
 
11
%
Book value per share
 
$
16.01

 
$
16.01

Economic return on book value (1)
 
1.9
%
 
4.5
%
REIT taxable income per share
 
$
0.25

 
$
0.55

Dividends per share
 
$
0.30

 
$
0.60

(1)
Economic return on book value is based on the periodic change in GAAP book value per common share plus dividends declared per common share during the period.
•
GAAP earnings per share declined in the second quarter, as we experienced a reduced benefit to investment fair value changes from spread tightening and lower realized gains from sales of available-for-sale securities, relative to the first quarter. Additionally, the sharp decline in rates during the second quarter impacted certain segments of our portfolio more sensitive to interest rates and prepayments, resulting in negative investment fair value changes from increased hedging costs and change in basis expense from loans and securities with premiums. These decreases were offset by higher mortgage banking income at our residential mortgage banking business, as loan purchase volume increased during the quarter and margins remained strong.
•
We deployed $136 million of capital in the second quarter, including $28 million into proprietary investments and $108 million into third-party investments.
•
Our 5 Arches business originated $175 million of business purpose mortgage loans in the first full quarter of integrated results, including $134 million in funded loans and $41 million in associated funding commitments.
•
Residential jumbo loan purchase commitments were $1.70 billion, and we purchased $1.56 billion of residential jumbo loans during the second quarter of 2019.
•
During the second quarter, we completed a $411 million securitization of Select residential jumbo loans and sold $842 million of residential jumbo loans to third parties.









80

Book Value per Share
At June 30, 2019, our book value was $1.56 billion, or $16.01 per share, an increase from $16.00 per share at March 31, 2019. The following table sets forth the changes in our book value per share for the three and six months ended June 30, 2019.
Table 2 – Changes in Book Value per Share
 
 
Three Months Ended
 
Six Months Ended
(In Dollars, per share basis)
 
June 30, 2019
 
June 30, 2019
Beginning book value per share
 
$
16.00

 
$
15.89

Net income
 
0.30

 
0.78

Changes in unrealized gains on securities, net, from:
 
 
 
 
Realized gains recognized in net income
 
(0.02
)
 
(0.10
)
Amortization income recognized in net income
 
(0.02
)
 
(0.03
)
Mark-to-market adjustments, net
 
0.11

 
0.21

Total change in unrealized gains on securities, net
 
0.07

 
0.08

Dividends
 
(0.30
)
 
(0.60
)
Issuance of common stock
 
—

 
(0.05
)
Equity compensation, net
 
0.02

 
0.01

Changes in unrealized losses on derivatives hedging long-term debt
 
(0.10
)
 
(0.17
)
Other, net
 
0.02

 
0.07

Ending Book Value per Share
 
$
16.01

 
$
16.01

Our GAAP book value per share increased $0.01 per share to $16.01 per share during the second quarter of 2019. This increase was primarily driven by positive market valuation adjustments on our portfolio investments, partially offset by a decrease in the value of derivatives hedging our long-term debt.
Unrealized gains on our available-for-sale securities resulted in a $0.11 per share increase in mark-to-market adjustments, offset by $0.02 per share of previously unrealized net gains that were realized as income from the sale of securities, as well as $0.02 per share of discount accretion income recognized in earnings from the appreciation in the amortized cost basis of our available-for-sale securities.
Lower benchmark interest rates during the second quarter of 2019 resulted in a $0.10 per share decrease to book value due to an increase in unrealized losses on the derivatives hedging a portion of our long-term debt. At June 30, 2019, the cumulative unrealized loss on these derivatives, which is included in our GAAP book value per share, was $0.51 per share.

81

Capital Allocation Summary
This section provides an overview of our capital position and how it was allocated at June 30, 2019. A detailed discussion of our liquidity and capital resources is provided in the Liquidity and Capital Resources section of this MD&A that follows.
We use a combination of equity and corporate debt (which we collectively refer to as “capital”) to fund our business. Our total capital was $2.34 billion at June 30, 2019, and included $1.56 billion of equity capital and $0.77 billion of unsecured corporate debt, including $201 million of exchangeable debt due in 2019, $245 million of convertible debt due in 2023, $200 million of convertible debt due in 2024, and $140 million of trust-preferred securities due in 2037.
We also utilize various forms of collateralized short-term and long-term debt to finance certain investments and to warehouse some of our inventory of residential loans held-for-sale. We do not consider this collateralized debt as "capital" and, therefore, it is presented separately from allocated capital in the table below. The following table presents how our capital was allocated between business segments and investment types at June 30, 2019.
Table 3 – Capital Allocation Summary
At June 30, 2019
 
 
 
 
 
 
 
 
(Dollars in Thousands)
 
Fair Value
 
Collateralized Debt
 
Allocated Capital
 
% of Total Capital
Investment portfolio
 
 
 
 
 
 
 
 
Residential loans (1)
 
$
2,485,759

 
$
(1,999,999
)
 
$
485,760

 
21
 %
 
 
 
 
 
 
 
 
 
Securities portfolio
 
 
 
 
 
 
 
 
Sequoia residential securities (2)
 
476,047

 
(192,819
)
 
283,228

 
12
 %
Agency CRT securities
 
208,603

 
(26,370
)
 
182,233

 
8
 %
Multifamily securities (3)
 
734,522

 
(574,544
)
 
159,978

 
7
 %
Re-performing residential loan securities (4)
 
406,867

 
(201,978
)
 
204,889

 
9
 %
Third-party residential securities
 
319,282

 
(218,209
)
 
101,073

 
4
 %
Total securities portfolio
 
2,145,321

 
(1,213,920
)
 
931,401

 
40
 %
 
 
 
 
 
 
 
 
 
Business purpose residential loans
 
159,353

 
(120,919
)
 
38,434

 
2
 %
Other investments
 
190,368

 
—

 
190,368

 
8
 %
Other assets/(other liabilities)
 
(20,251
)
 
—

 
(20,251
)
 
(1
)%
Cash and liquidity capital
 
 
 
 
 
517,070

 
N/A

Total investment portfolio
 
$
4,960,550

 
$
(3,334,838
)
 
2,142,782

 
92
 %
Residential
 
 
 
 
 
130,000

 
6
 %
Business purpose
 
 
 
 
 
64,660

 
3
 %
Total mortgage banking
 
 
 
 
 
194,660

 
8
 %
Total
 
 
 
 
 
$
2,337,442

 
100
 %
(1)
Includes $43 million of FHLB stock, $49 million of cash and cash equivalents, and $7 million of restricted cash.
(2)
Sequoia residential securities presented above includes $218 million of securities retained from our consolidated Sequoia Choice securitizations. For GAAP purposes we consolidated $2.15 billion of residential loans and $1.93 billion of non-recourse ABS debt associated with these retained securities.
(3)
Multifamily securities presented above includes $207 million of subordinate investments in the Freddie Mac K-Series securitizations. For GAAP purposes we consolidated $3.75 billion of multifamily loans and $3.54 billion of non-recourse ABS debt associated with these securities.
(4)
Re-performing residential loan securities presented above represent third-party securities collateralized by seasoned re-performing, and to a lesser extent, non-performing residential loans and includes $243 million of subordinate and mezzanine investments in the Freddie Mac SLST securitization. For GAAP purposes we consolidated $1.24 billion of residential loans and $992 million of non-recourse ABS debt associated with these securities.

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During the second quarter, our portfolio optimization activities resulted in a decrease in capital allocated to Agency CRT securities and other third-party residential securities from sales, as well as to multifamily securities resulting from incremental financing on these assets. Additionally, we increased capital allocations to re-performing residential loan securities. In the near-term, we expect to further increase capital allocated to multifamily securities, re-performing loan securities, and business purpose residential loans.
As of June 30, 2019, our cash and liquidity capital included $200 million of capital available for investment.

83

RESULTS OF OPERATIONS
Within this Results of Operations section, we provide commentary that compares results year-over-year for 2019 and 2018. Most tables include a "change" column that shows the amount by which the results from 2019 are greater or less than the results from the respective period in 2018. Unless otherwise specified, references in this section to increases or decreases during the "three-month periods" refer to the change in results for the second quarter of 2019, compared to the second quarter of 2018, and increases or decreases in the "six-month periods" refer to the change in results for the first six months of 2019, compared to the first six months of 2018.
The following table presents the components of our net income for the three and six months ended June 30, 2019 and 2018.
Table 4 – Net Income
 
 
Three Months Ended June 30,
 
 
 
 
Six Months Ended June 30,
 
 
(In Thousands, except per Share Data)
 
2019
 
2018
 
Change
 
 
2019
 
2018
 
Change
Net Interest Income
 
$
32,322

 
$
34,763

 
$
(2,441
)
 
 
$
64,087

 
$
69,868

 
$
(5,781
)
Non-interest Income
 
 
 
 
 


 
 
 
 
 
 


Mortgage banking activities, net
 
19,160

 
10,596

 
8,564

 
 
31,469

 
37,172

 
(5,703
)
Investment fair value changes, net
 
3,138

 
889

 
2,249

 
 
23,297

 
2,498

 
20,799

Other income, net
 
2,407

 
3,322

 
(915
)
 
 
5,994

 
5,440

 
554

Realized gains, net
 
2,827

 
4,714

 
(1,887
)
 
 
13,513

 
14,077

 
(564
)
Total non-interest income, net
 
27,532

 
19,521

 
8,011

 
 
74,273

 
59,187

 
15,086

Operating expenses
 
(26,255
)
 
(19,009
)
 
(7,246
)
 
 
(49,414
)
 
(42,039
)
 
(7,375
)
Net income before income taxes
 
33,599

 
35,275

 
(1,676
)
 
 
88,946

 
87,016

 
1,930

Provision for income taxes
 
(2,333
)
 
(2,528
)
 
195

 
 
(3,216
)
 
(7,424
)
 
4,208

Net Income
 
$
31,266

 
$
32,747

 
$
(1,481
)
 
 
$
85,730

 
$
79,592

 
$
6,138

Diluted earnings per common share
 
$
0.30

 
$
0.38

 
$
(0.08
)
 
 
$
0.78

 
$
0.88

 
$
(0.10
)
Net Interest Income
The decrease in net interest income during the three- and six-month periods was primarily due to higher convertible debt expense in 2019, relative to 2018, due to the issuance and repayment of convertible debt during the second quarter of 2018. The decrease during the six-month periods was also driven by lower average balances of residential loans held-for-sale and higher interest rates on our variable rate financing. These decreases were partially offset by increased interest income from additional portfolio investments that we made during the past year that in part utilized capital we raised in July of 2018 and January of 2019.
We utilize hedges to manage interest rate risk in our investment portfolio and the net interest paid or received from these instruments is a component of our Investment fair value changes line item, which is discussed below. Net hedge interest expense associated with portfolio hedges decreased for the three- and six-month periods and on a combined basis, net interest income plus net interest income (expense) on hedges increased by $2 million and $6 million for the three- and six-month periods, respectively.
Additional detail on changes in net interest income is provided in the “Net Interest Income” section that follows.
Mortgage Banking Activities, Net
The increase in income from mortgage banking activities during the three-month periods was predominantly due to higher gross margins in 2019, relative to 2018, as well as a full quarter of activity from our business purpose mortgage banking operations from our purchase of 5 Arches in March 2019. The decrease in income from mortgage banking activities during the six-month periods was primarily due to lower loan purchase volume in 2019. A more detailed analysis of the changes in this line item is included in the “Results of Operations by Segment” section that follows.

84

Investment Fair Value Changes, Net
Investment fair value changes, net, is primarily comprised of the change in fair values of our portfolio investments accounted for under the fair value option and interest rate hedges associated with these investments. During the three and six months ended June 30, 2019, the positive investment fair value changes were primarily driven by tightening credit spreads in several parts of our portfolio, helping us to recover a significant amount of the fair value decline these investments experienced in the fourth quarter of 2018 from spread widening. Additional detail on our investment fair value changes is included in the Investment Portfolio portion of the “Results of Operations by Segment” section that follows.
Other Income, Net
The decrease in other income for the three-month periods was primarily due to amortization expense from intangible assets we recorded in connection with the acquisition of 5 Arches in the first quarter of 2019. The increase in other income for the six-month periods was primarily due to a $2 million gain associated with the re-measurement of our initial minority investment and purchase option in 5 Arches and asset management fee income earned by 5 Arches.
Realized Gains, Net
During the three and six months ended June 30, 2019, we realized gains of $3 million and $14 million, respectively, primarily from the sale of $25 million and $67 million of AFS securities, respectively, and the call of a seasoned Sequoia securitization in the first quarter. During the three and six months ended June 30, 2018, we realized gains of $5 million and $14 million, respectively, primarily from the sale of $41 million and $92 million of AFS securities, respectively.
Operating Expenses
The increase in operating expenses for the three- and six-month periods primarily resulted from additional expenses from the consolidated 5 Arches operations.
Provision for Income Taxes
Our provision for income taxes is almost entirely related to activity at our taxable REIT subsidiaries, which primarily includes our mortgage banking activities and MSR investments, as well as certain other investment and hedging activities. For the three- and six-month periods, the decrease in provision for income taxes was driven primarily by lower GAAP income earned at our TRS. Additionally, the six-month period included a tax benefit resulting from the purchase of 5 Arches. For additional detail on income taxes, see the “Taxable Income and Tax Provision” section that follows.



85

Net Interest Income
The following table presents the components of net interest income for the three and six months ended June 30, 2019 and 2018.
Table 5 – Net Interest Income
 
 
Three Months Ended June 30,
 
 
2019
 
2018
(Dollars in Thousands)
 
Interest Income/ (Expense)
 
 Average
   Balance (1)
 
Yield
 
Interest Income/ (Expense)
 
 Average
   Balance (1)
 
Yield
Interest Income
 
 
 
 
 
 
 
 
 
 
 
 
Residential loans, held-for-sale
 
$
10,015

 
$
898,054

 
4.5
 %
 
$
12,840

 
$
1,127,654

 
4.6
 %
Residential loans - HFI at Redwood (2)
 
24,090

 
2,399,670

 
4.0
 %
 
23,524

 
2,344,947

 
4.0
 %
Residential loans - HFI at Legacy Sequoia (2)
 
4,773

 
468,062

 
4.1
 %
 
5,015

 
599,203

 
3.3
 %
Residential loans - HFI at Sequoia Choice (2)
 
26,814

 
2,218,425

 
4.8
 %
 
14,135

 
1,192,756

 
4.7
 %
Residential loans - HFI at Freddie Mac SLST (2)
 
11,596

 
1,221,346

 
3.8
 %
 
—

 
—

 
—
 %
Business purpose residential loans
 
3,996

 
207,280

 
7.7
 %
 
—

 
—

 
—
 %
Multifamily loans - HFI at Freddie Mac K-Series
 
35,917

 
3,644,683

 
3.9
 %
 
—

 
—

 
—
 %
Trading securities
 
19,548

 
1,235,965

 
6.3
 %
 
17,368

 
956,365

 
7.3
 %
Available-for-sale securities
 
5,469

 
181,253

 
12.1
 %
 
8,928

 
313,530

 
11.4
 %
Other interest income
 
6,324

 
555,514

 
4.6
 %
 
1,166

 
183,095

 
2.5
 %
Total interest income
 
148,542

 
13,030,252

 
4.6
 %
 
82,976

 
6,717,550

 
4.9
 %
Interest Expense
 
 
 
 
 
 
 
 
 
 
 
 
Short-term debt facilities
 
(17,740
)
 
1,856,466

 
(3.8
)%
 
(12,666
)
 
1,478,332

 
(3.4
)%
Short-term debt - servicer advance financing
 
(3,401
)
 
238,669

 
(5.7
)%
 
—

 
—

 
—
 %
Short-term debt - convertible notes, net
 
(3,134
)
 
200,132

 
(6.3
)%
 
(509
)
 
38,530

 
(5.3
)%
ABS issued - Legacy Sequoia (2)
 
(3,981
)
 
459,305

 
(3.5
)%
 
(4,215
)
 
589,261

 
(2.9
)%
ABS issued - Sequoia Choice (2)
 
(23,134
)
 
2,002,552

 
(4.6
)%
 
(12,134
)
 
1,086,602

 
(4.5
)%
ABS issued - Freddie Mac SLST (2)
 
(8,557
)
 
984,150

 
(3.5
)%
 
—

 
—

 
—
 %
ABS issued - Freddie Mac K-Series
 
(34,441
)
 
3,442,411

 
(4.0
)%
 
—

 
—

 
—
 %
Long-term debt - FHLBC
 
(13,235
)
 
1,999,999

 
(2.6
)%
 
(9,833
)
 
1,999,999

 
(2.0
)%
Long-term debt - other
 
(8,597
)
 
573,003

 
(6.0
)%
 
(8,856
)
 
588,765

 
(6.0
)%
Total interest expense
 
(116,220
)
 
11,756,687

 
(4.0
)%
 
(48,213
)
 
5,781,489

 
(3.3
)%
Net Interest Income
 
$
32,322

 
 
 
 
 
$
34,763

 
 
 
 

86

 
 
Six Months Ended June 30,
 
 
2019
 
2018
(Dollars in Thousands)
 
Interest Income/ (Expense)
 
 Average
   Balance (1)
 
Yield
 
Interest Income/ (Expense)
 
 Average
   Balance (1)
 
Yield
Interest Income
 
 
 
 
 
 
 
 
 
 
 
 
Residential loans, held-for-sale
 
$
19,473

 
$
842,673

 
4.6
 %
 
$
25,532

 
$
1,164,138

 
4.4
 %
Residential loans - HFI at Redwood (2)
 
48,281

 
2,390,215

 
4.0
 %
 
47,317

 
2,370,132

 
4.0
 %
Residential loans - HFI at Legacy Sequoia (2)
 
9,623

 
481,633

 
4.0
 %
 
9,826

 
607,803

 
3.2
 %
Residential loans - HFI at Sequoia Choice (2)
 
52,470

 
2,180,091

 
4.8
 %
 
23,070

 
971,545

 
4.7
 %
Residential loans - HFI at Freddie Mac SLST (2)
 
23,391

 
1,218,153

 
3.8
 %
 
—

 
—

 
—
 %
Business purpose residential loans
 
6,785

 
180,042

 
7.5
 %
 
—

 
—

 
—
 %
Multifamily loans - HFI at Freddie Mac K-Series
 
57,305

 
2,897,936

 
4.0
 %
 
—

 
—

 
—
 %
Trading securities
 
38,261

 
1,198,531

 
6.4
 %
 
33,533

 
937,386

 
7.2
 %
Available-for-sale securities
 
11,206

 
197,684

 
11.3
 %
 
18,458

 
338,261

 
10.9
 %
Other interest income
 
12,788

 
567,669

 
4.5
 %
 
1,859

 
211,112

 
1.8
 %
Total interest income
 
279,583

 
12,154,627

 
4.6
 %
 
159,595

 
6,600,377

 
4.8
 %
Interest Expense
 
 
 
 
 
 
 
 
 
 
 
 
Short-term debt facilities
 
(33,214
)
 
1,732,720

 
(3.8
)%
 
(23,092
)
 
1,424,185

 
(3.2
)%
Short-term debt - servicer advance financing
 
(7,014
)
 
252,550

 
(5.6
)%
 
—

 
—

 
—
 %
Short-term debt - convertible notes, net
 
(6,265
)
 
199,978

 
(6.3
)%
 
(3,518
)
 
143,853

 
(4.9
)%
ABS issued - Legacy Sequoia (2)
 
(8,097
)
 
473,458

 
(3.4
)%
 
(8,067
)
 
597,859

 
(2.7
)%
ABS issued - Sequoia Choice (2)
 
(45,247
)
 
1,984,241

 
(4.6
)%
 
(19,683
)
 
880,387

 
(4.5
)%
ABS issued - Freddie Mac SLST (2)
 
(17,304
)
 
984,455

 
(3.5
)%
 
—

 
—

 
—
 %
ABS issued - Freddie Mac K-Series
 
(54,760
)
 
2,733,499

 
(4.0
)%
 
—

 
—

 
—
 %
Long-term debt - FHLBC
 
(26,418
)
 
1,999,999

 
(2.6
)%
 
(17,860
)
 
1,999,999

 
(1.8
)%
Long-term debt - other
 
(17,177
)
 
572,750

 
(6.0
)%
 
(17,507
)
 
582,120

 
(6.0
)%
Total interest expense
 
(215,496
)
 
10,933,650

 
(3.9
)%
 
(89,727
)
 
5,628,403

 
(3.2
)%
Net Interest Income
 
$
64,087

 
 
 
 
 
$
69,868

 
 
 
 
(1)
Average balances for residential loans held-for-sale, residential loans held-for-investment, business purpose residential loans, multifamily loans held-for-investment, and trading securities are calculated based upon carrying values, which represent estimated fair values. Average balances for available-for-sale securities and debt are calculated based upon amortized historical cost, except for ABS issued, which is based upon fair value.
(2)
Interest income from residential loans held-for-investment ("HFI") at Redwood exclude loans HFI at consolidated Sequoia or Freddie Mac SLST entities. Interest income from residential loans - HFI at Legacy Sequoia and the interest expense from ABS issued - Legacy Sequoia represent activity from our consolidated Legacy Sequoia entities. Interest income from residential loans - HFI at Sequoia Choice and the interest expense from ABS issued - Sequoia Choice represent activity from our consolidated Sequoia Choice entities. Interest income from residential loans - HFI at Freddie Mac SLST and the interest expense from ABS issued - Freddie Mac SLST represent activity from our consolidated Freddie Mac SLST entity.

The following table presents net interest income by segment for the three and six months ended June 30, 2019 and 2018.
Table 6 – Net Interest Income by Segment
 
 
Three Months Ended June 30,
 
 
 
 
Six Months Ended June 30,
 
 
(In Thousands)
 
2019
 
2018
 
Change
 
 
2019
 
2018
 
Change
Net Interest Income by Segment
 
 
 
 
 
 
 
 
 
 
 
 
 
Investment Portfolio
 
$
38,136

 
$
37,565

 
$
571

 
 
$
75,701

 
$
76,459

 
$
(758
)
Mortgage Banking
 
4,757

 
5,455

 
(698
)
 
 
9,570

 
12,215

 
(2,645
)
Corporate/Other
 
(10,571
)
 
(8,257
)
 
(2,314
)
 
 
(21,184
)
 
(18,806
)
 
(2,378
)
Net Interest Income
 
$
32,322

 
$
34,763

 
$
(2,441
)
 
 
$
64,087

 
$
69,868

 
$
(5,781
)

87

Additional details regarding the activities impacting net interest income at each segment are included in the “Results of Operations by Segment” section that follows.
The Corporate/Other line item in the table above primarily includes interest expense related to long-term debt not directly allocated to our segments and net interest income from consolidated Legacy Sequoia entities. Details regarding consolidated Legacy Sequoia entities are included in the "Results of Consolidated Legacy Sequoia Entities" section that follows. The increase in net expense from Corporate/Other for the three- and six-month periods was primarily due to higher convertible debt expense in 2019, relative to 2018, due to the issuance of $200 million of convertible notes in June 2018 and the repayment of $250 million of convertible notes in April 2018.
The following table presents the net interest rate spread between the yield on unsecuritized loans and securities and the debt yield of the short-term debt used in part to finance each investment type at June 30, 2019.
Table 7 – Interest Expense — Specific Borrowing Costs
June 30, 2019
 
Residential Loans Held-for-Sale
 
Single-Family Rental Loans
 
Residential Bridge Loans
 
Residential
Securities
Asset yield
 
4.69
%
 
5.54
%
 
9.10
%
 
4.20
%
Short-term debt yield
 
3.90
%
 
4.67
%
 
4.93
%
 
3.48
%
Net Spread
 
0.79
%
 
0.87
%
 
4.17
%
 
0.72
%
For additional discussion on short-term debt, including information regarding margin requirements and financial covenants, see “Risks Relating to Debt Incurred under Short-Term and Long-Term Borrowing Facilities" in the Liquidity and Capital Resources section of this MD&A.

88


Results of Operations by Segment
We report on our business using two distinct segments: Investment Portfolio and Mortgage Banking. Our segments are based on our organizational and management structure, which aligns with how our results are monitored and performance is assessed. For additional information on our segments, refer to Note 24 of our Notes to Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q. The following table presents the segment contribution from our two segments, reconciled to our consolidated net income, for the three and six months ended June 30, 2019 and 2018.
Table 8 – Segment Results Summary
 
 
Three Months Ended June 30,
 
 
 
 
Six Months Ended June 30,
 
 
(In Thousands)
 
2019
 
2018
 
Change
 
 
2019
 
2018
 
Change
Segment Contribution from:
 
 
 
 
 
 
 
 
 
 
 
 
 
Investment Portfolio
 
$
43,980

 
$
44,213

 
$
(233
)
 
 
$
111,005

 
$
93,283

 
$
17,722

Mortgage Banking
 
10,753

 
8,914

 
1,839

 
 
19,063

 
29,610

 
(10,547
)
Corporate/Other
 
(23,467
)
 
(20,380
)
 
(3,087
)
 
 
(44,338
)
 
(43,301
)
 
(1,037
)
Net Income
 
$
31,266

 
$
32,747

 
$
(1,481
)
 
 
$
85,730

 
$
79,592

 
$
6,138

The following sections provide a detailed discussion of the results of operations at each of our two business segments for the three and six months ended June 30, 2019 and 2018.
The increase in net expense from Corporate/Other for the three- and six-month periods was primarily due to higher convertible debt expense in 2019, relative to 2018, as discussed in the previous section. For the six-month periods, this increase was partially offset by a $2 million gain associated with the re-measurement of our initial minority investment and purchase option in 5 Arches.
Investment Portfolio Segment

Our Investment Portfolio segment is where we hold our housing-focused credit-sensitive investments in residential mortgage loans, mortgage-backed securities, and related assets. Our portfolio is primarily comprised of prime jumbo residential mortgage loans financed through the FHLBC, mortgage-backed securities collateralized by both residential and multifamily mortgages, and business purpose residential loans, which are mortgage loans to investors in residential properties.
The following table presents the components of segment contribution for the Investment Portfolio segment for the three and six months ended June 30, 2019 and 2018.
Table 9 – Investment Portfolio Segment Contribution
 
 
Three Months Ended June 30,
 
 
 
 
Six Months Ended June 30,
 
 
(In Thousands)
 
2019
 
2018
 
Change
 
 
2019
 
2018
 
Change
Interest income
 
$
132,048

 
$
64,569

 
$
67,479

 
 
$
247,500

 
$
123,326

 
$
124,174

Interest expense
 
(93,912
)
 
(27,004
)
 
(66,908
)
 
 
(171,799
)
 
(46,867
)
 
(124,932
)
Net interest income
 
38,136

 
37,565

 
571

 
 
75,701

 
76,459

 
(758
)
Non-interest income
 
 
 
 
 
 
 
 
 
 
 
 
 
Investment fair value changes, net
 
3,297

 
1,600

 
1,697

 
 
23,853

 
3,190

 
20,663

Other income, net
 
2,874

 
3,322

 
(448
)
 
 
4,095

 
5,440

 
(1,345
)
Realized gains, net
 
2,827

 
4,714

 
(1,887
)
 
 
13,513

 
14,077

 
(564
)
Total non-interest income, net
 
8,998

 
9,636

 
(638
)
 
 
41,461

 
22,707

 
18,754

Direct operating expenses
 
(2,258
)
 
(1,858
)
 
(400
)
 
 
(4,919
)
 
(3,865
)
 
(1,054
)
Segment contribution before income taxes
 
44,876

 
45,343

 
(467
)
 
 
112,243

 
95,301

 
16,942

Provision for income taxes
 
(896
)
 
(1,130
)
 
234

 
 
(1,238
)
 
(2,018
)
 
780

Total Segment Contribution
 
$
43,980

 
$
44,213

 
$
(233
)
 
 
$
111,005

 
$
93,283

 
$
17,722


89

The following table presents our primary portfolios of investment assets in our Investment Portfolio segment at June 30, 2019 and December 31, 2018.
Table 10 – Investment Portfolio
(In Thousands)
 
June 30, 2019
 
December 31, 2018
 
Change
Residential loans held-for-investment at Redwood
 
$
2,386,883

 
$
2,383,932

 
$
2,951

Residential bridge loans held-for-investment
 
159,353

 
112,798

 
46,555

Residential securities
 
949,564

 
1,023,415

 
(73,851
)
Multifamily securities
 
527,922

 
429,079

 
98,843

Securities retained from consolidated Sequoia Choice entities (1)
 
217,912

 
194,372

 
23,540

Securities issued by consolidated Freddie Mac SLST entity (2)
 
243,323

 
228,921

 
14,402

Securities issued by consolidated Freddie Mac K-Series entities (3)
 
206,600

 
125,523

 
81,077

Other investments
 
369,900

 
427,764

 
(57,864
)
Other assets
 
256,264

 
270,356

 
(14,092
)
Economic Assets at Investment Portfolio
 
$
5,317,721

 
$
5,196,160

 
$
121,561

(1)
Our investment in the consolidated Sequoia Choice entities at June 30, 2019 and December 31, 2018 represents $2.15 billion and $2.08 billion of loans, respectively, offset by $1.93 billion and $1.89 billion of ABS issued, respectively.
(2)
Our investment in the consolidated Freddie Mac SLST entity at June 30, 2019 and December 31, 2018 represents $1.24 billion and $1.22 billion of loans, respectively, offset by $0.99 billion of ABS issued for both periods.
(3)
Our investment in the consolidated Freddie Mac K-Series entities at June 30, 2019 and December 31, 2018 represents $3.75 billion and $2.14 billion of loans, respectively, offset by $3.54 billion and $2.02 billion of ABS issued, respectively.
Overview
During the first six months of 2019, we deployed $299 million of capital towards new residential and multifamily investments. We continued our focus on optimizing our investment portfolio by selling assets that had appreciated in value with lower current yields, and redeployed capital into higher-yielding opportunities. Additionally, during the second quarter of 2019, we added new leverage to our portfolio of multifamily credit investments and incremental leverage to our business purpose loan investments, which generated approximately $164 million of capital for redeployment and meaningfully improved return profiles on these investments. For the remainder of 2019, we expect portfolio optimization activity to moderate, which could result in lower gains relative to the first half of 2019. Credit fundamentals in our investment portfolio remain strong, reflecting continued strength in the general economy and in housing.

90

Net Interest Income
Net interest income from our Investment Portfolio primarily includes interest income from our securities and residential loans held-for-investment, as well as the associated interest expense from short-term debt, FHLBC borrowings, and ABS issued. The following table presents the components of net interest income for our Investment Portfolio segment by investment type for the three and six months ended June 30, 2019 and 2018.
Table 11 - Net Interest Income ("NII") from Investment Portfolio
 
 
Three Months Ended June 30,
 
 
 
 
Six Months Ended June 30,
 
 
(In Thousands)
 
2019
 
2018
 
Change
 
 
2019
 
2018
 
Change
Net interest income from:
 
 
 
 
 
 
 
 
 
 
 
 
 
Residential securities
 
$
13,796

 
$
19,398

 
$
(5,602
)
 
 
$
27,458

 
$
38,917

 
$
(11,459
)
Multifamily securities
 
1,271

 
1,861

 
(590
)
 
 
2,973

 
3,750

 
(777
)
HFI residential loans at Redwood
 
10,855

 
13,685

 
(2,830
)
 
 
21,863

 
29,457

 
(7,594
)
HFI residential loans at Sequoia Choice
 
3,680

 
2,001

 
1,679

 
 
7,223

 
3,387

 
3,836

HFI residential bridge loans
 
1,819

 
—

 
1,819

 
 
3,194

 
—

 
3,194

HFI residential loans at Freddie Mac SLST
 
3,039

 
—

 
3,039

 
 
6,087

 
—

 
6,087

HFI multifamily loans at Freddie Mac K-Series
 
1,476

 
—

 
1,476

 
 
2,545

 
—

 
2,545

Other interest income
 
2,200

 
620

 
1,580

 
 
4,358

 
948

 
3,410

NII from Investment Portfolio
 
$
38,136

 
$
37,565

 
$
571

 
 
$
75,701

 
$
76,459

 
$
(758
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Supplemental information:
 
 
 
 
 
 
 
 
 
 
 
 
 
Hedge interest income (expense), net
 
$
1,420

 
$
25

 
$
1,395

 
 
$
4,138

 
$
(2,859
)
 
$
6,997


The increase in net interest income from our Investment Portfolio segment for the three-month periods was primarily due to increased interest income from additional portfolio investments that we made during the past year. The decrease in interest income for the six-month periods was primarily due to higher interest expense on our variable-rate borrowings resulting from rising benchmark interest rates over the past year.

The table above also presents supplemental information about interest income (expense) from hedges that we use to manage interest rate risk in our investment portfolio, which are a component of Investment fair value changes, net on our consolidated statements of income. On a combined basis, net interest income in our investment portfolio segment plus interest income (expense) from hedges used to manage interest rate risk in our investment portfolio increased by $2 million and $6 million in the three- and six-month periods, respectively.
Investment fair value changes, net
Market valuation changes included in Investment fair value changes, net, result from changes in the fair value of investments and their associated hedges, generally due to changes in market interest rates, changes in credit spreads, and reductions in the basis of investments due to changes in principal balances. See Note 20 of our Notes to Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional detail regarding the components of Investment fair value changes, net presented on our consolidated statements of income.

91

The following table presents the components of investment fair value changes for our Investment Portfolio segment, which is comprised of market valuation gains and losses by investment type, inclusive of fair value changes of associated risk management derivatives, for the three and six months ended June 30, 2019 and 2018.
Table 12 - Investment Portfolio Fair Value Changes, Net by Investment Type
 
 
Three Months Ended June 30,
 
 
 
 
Six Months Ended June 30,
 
 
(In Thousands)
 
2019
 
2018
 
Change
 
 
2019
 
2018
 
Change
Market valuation changes:
 
 
 
 
 
 
 
 
 
 
 
 
 
Residential loans held-for-investment at Redwood
 
$
(8,228
)
 
$
(1,837
)
 
$
(6,391
)
 
 
$
(10,044
)
 
$
(2,288
)
 
$
(7,756
)
Residential bridge loans held-for-investment
 
(318
)
 
—

 
(318
)
 
 
(621
)
 
—

 
(621
)
Net investments in Sequoia Choice entities (1)
 
2,879

 
1,072

 
1,807

 
 
6,144

 
986

 
5,158

Net investment in Freddie Mac SLST entity (1)
 
8,037

 
—

 
8,037

 
 
14,402

 
—

 
14,402

Net investments in Freddie Mac K-Series entities (1)
 
3,246

 
—

 
3,246

 
 
6,365

 
—

 
6,365

Residential trading securities
 
(4,675
)
 
(56
)
 
(4,619
)
 
 
(4,167
)
 
1,146

 
(5,313
)
Multifamily trading securities
 
769

 
2,661

 
(1,892
)
 
 
6,975

 
6,609

 
366

Servicer advance investments
 
432

 
—

 
432

 
 
1,440

 
—

 
1,440

Excess MSRs
 
(65
)
 
—

 
(65
)
 
 
(502
)
 
—

 
(502
)
REO
 
(139
)
 
—

 
(139
)
 
 
(139
)
 
—

 
(139
)
Hedge interest income (expense), net
 
1,420

 
25

 
1,395

 
 
4,138

 
(2,859
)
 
6,997

Other valuation changes
 
(61
)
 
(265
)
 
204

 
 
(138
)
 
(404
)
 
266

Investment Fair Value Changes, Net
 
$
3,297

 
$
1,600

 
$
1,697

 
 
$
23,853

 
$
3,190

 
$
20,663

(1)
Includes changes in fair value of the loans held-for-investment and the ABS issued at the entities, which netted together represent the change in value of our investments (senior and subordinate securities) at the consolidated VIEs.
During the three and six months ended June 30, 2019, the positive investment fair value changes were primarily driven by tightening credit spreads in several parts of our portfolio, helping us to recover a significant amount of the fair value decline these investments experienced in the fourth quarter of 2018 from spread widening. For our residential loans held-for-investment at Redwood and certain securities with premiums, including IO securities, our basis in these investments declined due to reductions in principal or notional underlying principal balances, which resulted in negative fair value changes.
Other Income, net
The following table presents the components of Other income, net for our investment portfolio for the three and six months ended June 30, 2019 and 2018.
Table 13 – Other Income, Net from Investment Portfolio
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2019
 
2018
 
2019
 
2018
MSR income, net
 
$
1,654

 
$
1,874

 
$
1,911

 
$
2,830

Risk share income
 
800

 
1,020

 
1,446

 
1,799

FHLBC capital stock dividend
 
535

 
428

 
1,082

 
811

Equity investment losses
 
(96
)
 
—

 
(96
)
 
—

Other
 
(19
)
 
—

 
(248
)
 
—

Other Income, Net from Investment Portfolio
 
$
2,874

 
$
3,322

 
$
4,095

 
$
5,440


92

Realized Gains, net
During the three and six months ended June 30, 2019, we realized gains of $3 million and $14 million, respectively, primarily from the sale of $25 million and $67 million of AFS securities, respectively, and the call of a seasoned Sequoia securitization during the first quarter. During the three and six months ended June 30, 2018, we realized gains of $5 million and $14 million, respectively, primarily from the sale of $41 million and $92 million of AFS securities, respectively.
Direct Operating Expenses and Provision for Income Taxes
The increase in operating expenses at our Investment Portfolio segment for the three- and six-month periods was primarily related to additional personnel added in 2018 to support our new business initiatives.
The provision for income taxes at our Investment Portfolio segment primarily results from GAAP income earned at our TRS from MSRs and certain securities. For the three- and six-month periods, the decrease in the tax provision primarily resulted from decreased GAAP income at our TRS in this segment.
Residential Loans Held-for-Investment at Redwood Portfolio
The following table provides the activity of residential loans held-for-investment at Redwood during the three and six months ended June 30, 2019.
Table 14 – Residential Loans Held-for-Investment at Redwood - Activity
 
 
Three Months Ended
 
Six Months Ended
(In Thousands)
 
June 30, 2019
 
June 30, 2019
Fair value at beginning of period
 
$
2,404,870

 
$
2,383,932

Acquisitions
 
—

 
39,269

Sales
 
(2,780
)
 
(2,780
)
Transfers between portfolios (1)
 
43,250

 
60,394

Principal repayments
 
(94,005
)
 
(157,588
)
Changes in fair value, net
 
35,548

 
63,656

Fair Value at End of Period
 
$
2,386,883

 
$
2,386,883

(1)
Represents the net transfers of loans into our Investment Portfolio segment from our Mortgage Banking segment and their reclassification from held-for-sale to held-for-investment.
The increase in fair value of our loans during the three- and six-month periods was primarily due to a decline in benchmark interest rates. As our loans held-for-investment are generally fixed-rate and sensitive to changes in interest rates, we utilize various interest rate derivatives to hedge our interest rate risk for these investments. As a result of declining interest rates during the three and six months ended June 30, 2019, interest rate derivatives associated with these investments decreased in value by $42 million and $69 million, respectively.
At June 30, 2019, $2.39 billion of loans were held by our FHLB-member subsidiary and financed with $2.00 billion of borrowings from the FHLBC. In connection with these borrowings, our FHLB-member subsidiary is required to hold $43 million of FHLB stock.
At June 30, 2019, the weighted average maturity of these FHLB borrowings was approximately six years and they had a weighted average cost of 2.57% per annum. While the interest costs on these borrowings is variable and resets every 13 weeks, we utilize various interest rate derivative instruments to hedge our interest rate risk in this portfolio.
Under a final rule published by the Federal Housing Finance Agency in January 2016, our FHLB-member subsidiary will remain an FHLB member through the five-year transition period for captive insurance companies. Our FHLB-member subsidiary's existing $2.00 billion of FHLB debt, which matures beyond this transition period, is permitted to remain outstanding until its stated maturity. As residential loans pledged as collateral for this debt pay down, we are permitted to pledge additional loans or other eligible assets to collateralize this debt; however, we do not expect to be able to increase our subsidiary's FHLB debt above the existing $2.00 billion.

93

The following table presents the unpaid principal balances for residential real estate loans held-for-investment at fair value by product type at June 30, 2019.
Table 15 – Characteristics of Residential Real Estate Loans Held-for-Investment at Redwood
June 30, 2019
 
 
 
 
(Dollars in Thousands)
 
Principal Balance
 
Weighted Average Coupon
Fixed - 30 year
 
$
1,991,446

 
4.17
%
Fixed - 15, 20, & 25 year
 
58,146

 
3.69
%
Hybrid
 
273,404

 
4.20
%
Total Outstanding Principal
 
$
2,322,996

 
 
The outstanding loans held-for-investment at Redwood at June 30, 2019 were prime-quality, first lien loans, of which 90% were originated between 2013 and 2019 and 1% were originated in 2012 and prior years. The weighted average FICO score of borrowers backing these loans was 768 (at origination) and the weighted average loan-to-value ("LTV") ratio was 66% (at origination). At June 30, 2019, two of these loans with an aggregate fair value of $1 million were greater than 90 days delinquent and none of these loans were in foreclosure.
Residential Bridge Loans Held-for-Investment at Redwood Portfolio
The following table provides the activity of residential bridge loans held-for-investment at Redwood during the three and six months ended June 30, 2019.
Table 16 – Residential Bridge Loans Held-for-Investment at Redwood - Activity
 
 
Three Months Ended
 
Six Months Ended
(In Thousands)
 
June 30, 2019
 
June 30, 2019
Fair value at beginning of period
 
$
103,915

 
$
112,798

Originations
 
100,597

 
128,187

Acquisitions
 
—

 
10,295

Sales
 
(22,959
)
 
(43,549
)
Transfers to REO
 
—

 
(4,995
)
Principal repayments
 
(22,894
)
 
(43,860
)
Changes in fair value, net
 
694

 
477

Fair Value at End of Period
 
$
159,353

 
$
159,353

Our $159 million of residential bridge loans held-for-investment at June 30, 2019 were primarily acquired in 2018 and comprised of first-lien, fixed-rate, interest-only loans with a weighted average coupon of 9.08% and original maturities of six to 24 months. At origination, the weighted average FICO score of borrowers backing these loans was 690 and the weighted average LTV ratio of these loans was 74%. At June 30, 2019, of the 274 loans in this portfolio, 11 loans with an aggregate fair value of $12 million were greater than 90 days delinquent and nine of these loans with an aggregate fair value of $7 million were in foreclosure.
At June 30, 2019, we had $120 million of warehouse debt outstanding to fund our residential bridge loans held-for-investment. The weighted average cost of the borrowings outstanding under these facilities during the second quarter of 2019 was 5.4% per annum. Our residential bridge loan warehouse capacity totaled $330 million across four separate counterparties.

94

Real Estate Securities Portfolio
The following table sets forth our real estate securities activity by collateral type in our Investment Portfolio segment for the three and six months ended June 30, 2019.
Table 17 – Real Estate Securities Activity by Collateral Type
Three Months Ended June 30, 2019
 
Residential
 
Multifamily
 
Total
(In Thousands)
 
Senior
 
Mezzanine
 
Subordinate
 
Mezzanine
 
Beginning fair value
 
$
230,638

 
$
249,742

 
$
550,526

 
$
512,246

 
$
1,543,152

Transfers
 
—

 
—

 
—

 
(4,951
)
 
(4,951
)
Acquisitions
 
 
 
 
 
 
 
 
 
 
Sequoia securities
 
1,792

 
—

 
1,069

 
—

 
2,861

Third-party securities
 
—

 
29,023

 
31,437

 
28,639

 
89,099

Sales
 
 
 
 
 
 
 
 
 
 
Sequoia securities
 
—

 
(22,117
)
 
—

 
—

 
(22,117
)
Third-party securities
 
—

 
(33,100
)
 
(92,700
)
 
(19,282
)
 
(145,082
)
Gains on sales and calls, net
 
—

 
2,791

 
36

 
—

 
2,827

Effect of principal payments (1)
 
(8,098
)
 
(1,415
)
 
(1,843
)
 
(2,597
)
 
(13,953
)
Change in fair value, net
 
(9,134
)
 
4,412

 
16,505

 
13,867

 
25,650

Ending Fair Value (2)
 
$
215,198

 
$
229,336

 
$
505,030

 
$
527,922

 
$
1,477,486

Six Months Ended June 30, 2019
 
Residential
 
Multifamily
 
Total
(In Thousands)
 
Senior
 
Mezzanine
 
Subordinate
 
Mezzanine
 
Beginning fair value
 
$
246,285

 
$
218,147

 
$
558,983

 
$
429,079

 
$
1,452,494

Transfers
 
—

 
—

 
—

 
(4,951
)
 
(4,951
)
Acquisitions
 
 
 
 
 
 
 
 
 
 
Sequoia securities
 
3,508

 
—

 
1,954

 
—

 
5,462

Third-party securities
 
30,691

 
60,817

 
44,437

 
108,025

 
243,970

Sales
 
 
 
 
 
 
 
 
 
 
Sequoia securities
 
—

 
(22,117
)
 
(4,727
)
 
—

 
(26,844
)
Third-party securities
 
(38,780
)
 
(33,100
)
 
(115,279
)
 
(27,214
)
 
(214,373
)
Gains on sales and calls, net
 
5,749

 
3,059

 
4,705

 
—

 
13,513

Effect of principal payments (1)
 
(12,844
)
 
(8,393
)
 
(10,946
)
 
(5,152
)
 
(37,335
)
Change in fair value, net
 
(19,411
)
 
10,923

 
25,903

 
28,135

 
45,550

Ending Fair Value (2)
 
$
215,198

 
$
229,336

 
$
505,030

 
$
527,922

 
$
1,477,486

(1)
The effect of principal payments reflects the change in fair value due to principal payments, which is calculated as the cash principal received on a given security during the period multiplied by the prior quarter ending price or acquisition price for that security.
(2)
At June 30, 2019, excludes $218 million of securities retained from our consolidated Sequoia Choice securitizations as well as $243 million and $207 million of securities we owned that were issued by consolidated Freddie Mac SLST and Freddie Mac K-Series securitizations, respectively. For additional details on our Choice, Freddie Mac SLST, and multifamily loans, see the subsections titled "Residential Loans Held-for-Investment at Sequoia Choice Portfolio," "Residential Loans Held-for-Investment at Freddie Mac SLST Portfolio," and "Multifamily Loans Held-for-Investment at Freddie Mac K-Series Portfolio" that follow.
During the three and six months ended June 30, 2019, we sold $167 million and $241 million, respectively, of mostly lower-yielding securities as part of our ongoing portfolio optimization activities.
At June 30, 2019, our securities consisted of fixed-rate assets (81%), adjustable-rate assets (14%), hybrid assets that reset within the next year (4%), and hybrid assets that reset between 12 and 36 months (1%). For the portions of our securities portfolio that are sensitive to changes in interest rates, we seek to minimize this interest rate risk by using various derivative instruments.

95

We directly finance our holdings of real estate securities with a combination of capital and collateralized debt in the form of repurchase (or “repo”) financing. The following table presents the fair value of our residential securities that were financed with repurchase debt at June 30, 2019.
Table 18 – Real Estate Securities Financed with Repurchase Debt
June 30, 2019
 
Real Estate Securities (1)
 
Repurchase Debt
 
Allocated Capital
 
Weighted Average
Price(2)
 
Financing Haircut(3)
(Dollars in Thousands, except Weighted Average Price)
 
 
 
 
 
Residential Securities
 
 
 
 
 
 
 
 
 
 
Senior
 
$
149,239

 
$
(135,721
)
 
$
13,518

 
$
102

 
9
%
Mezzanine (4)
 
569,109

 
(463,120
)
 
105,989

 
97

 
19
%
Subordinate
 
49,620

 
(40,535
)
 
9,085

 
97

 
18
%
Total Residential Securities
 
767,968

 
(639,376
)
 
128,592

 
98

 
17
%
Multifamily Securities (5)
 
734,522

 
(574,544
)
 
159,978

 
88

 
22
%
Total
 
$
1,502,490

 
$
(1,213,920
)
 
$
288,570

 
 
 

(1)
Amounts represent carrying value of securities, which are held at GAAP fair value.
(2)
GAAP fair value per $100 of principal.
(3)
Allocated capital divided by GAAP fair value.
(4)
Includes $148 million and $203 million of securities retained from our consolidated Sequoia Choice and Freddie Mac SLST securitizations, respectively, which we consolidate in accordance with GAAP.
(5)
Includes $207 million of securities we owned that were issued by Freddie Mac K-Series securitizations, which we consolidate in accordance with GAAP.
At June 30, 2019, we had short-term debt incurred through repurchase facilities of $1.21 billion, which was secured by $1.50 billion of real estate securities. The remaining $643 million of our securities, including certain securities we own that were issued by consolidated Sequoia Choice and Freddie Mac K-Series securitization entities, were financed with capital. Our repo borrowings were made under facilities with 10 different counterparties, and the weighted average cost of funds for these facilities during the second quarter of 2019 was approximately 3.55% per annum.
At June 30, 2019, the credit performance on the securities we financed through repurchase facilities generally continued to perform in line with, or better than our expectations. In addition to the allocated capital listed in the table above that directly supports our repurchase facilities (the "financing haircut”), we continue to hold a designated amount of supplemental risk capital available for potential margin calls or future obligations relating to these facilities.
The majority of the $149 million of senior securities noted in the table above are supported by residential loans originated in 2018 and 2019. The $569 million of mezzanine securities financed through repurchase facilities at June 30, 2019 primarily carry investment grade credit ratings and are supported by residential loans originated between 2013 and 2019. The majority of the loans underlying these securities have experienced minimal delinquencies to date. The $735 million of multifamily securities financed through repurchase facilities at June 30, 2019 primarily carry investment grade credit ratings with 7%-8% of structural credit enhancement.
The following table presents our real estate securities at June 30, 2019 and December 31, 2018, categorized by portfolio vintage (the years the securities were issued), and by priority of cash flows (senior, mezzanine, and subordinate). We have additionally separated securities issued through our Sequoia platform or by third parties, including the Agencies.
Table 19 – Real Estate Securities by Vintage and Type
June 30, 2019
 
Sequoia 2012-2019
 
Third Party 2013-2019
 
Agency CRT 2015-2019
 
Third Party <=2008
 
Total Residential Securities
 
Multifamily 2016-2019
 
Total Real Estate Securities
(In Thousands)
 
 
 
 
 
Senior (1)
 
$
49,015

 
$
121,711

 
$
—

 
$
44,472

 
$
215,198

 
$
—

 
$
215,198

Mezzanine (2)
 
77,351

 
151,985

 
—

 
—

 
229,336

 
527,922

 
757,258

Subordinate (1)
 
131,770

 
150,671

 
208,603

 
13,986

 
505,030

 
—

 
505,030

Total Securities (3)
 
$
258,136

 
$
424,367

 
$
208,603

 
$
58,458

 
$
949,564

 
$
527,922

 
$
1,477,486


96

December 31, 2018
 
Sequoia 2012-2018
 
Third Party 2013-2018
 
Agency CRT 2013-2018
 
Third Party <=2008
 
Total Residential Securities
 
Multifamily 2015-2018
 
Total Real Estate Securities
(In Thousands)
 
 
 
 
 
Senior (1)
 
$
61,179

 
$
96,069

 
$
—

 
$
89,037

 
$
246,285

 
$
—

 
$
246,285

Mezzanine (2)
 
99,977

 
118,170

 
—

 
—

 
218,147

 
429,079

 
647,226

Subordinate (1)
 
130,271

 
135,826

 
276,894

 
15,992

 
558,983

 
—

 
558,983

Total Securities (3)
 
$
291,427

 
$
350,065

 
$
276,894

 
$
105,029

 
$
1,023,415


$
429,079

 
$
1,452,494

(1)
At June 30, 2019 and December 31, 2018, senior Sequoia and third-party securities included $66 million and $82 million of IO securities, respectively. At both June 30, 2019 and December 31, 2018, subordinate third-party securities included $12 million of IO securities. Our interest-only securities included $35 million and $43 million of A-IO-S securities at June 30, 2019 and December 31, 2018, respectively, that we retained from certain of our Sequoia securitizations. These securities represent certificated servicing strips and therefore may be negatively impacted by the operating and funding costs related to servicing the associated securitized mortgage loans.
(2)
Mezzanine includes securities initially rated AA through BBB- and issued in 2012 or later.
(3)
At June 30, 2019, excluded $218 million, $243 million, and $207 million of securities we owned that were issued by consolidated Sequoia Choice, Freddie Mac SLST, and Freddie Mac K-Series securitizations, respectively. At December 31, 2018, excluded $194 million, $229 million, and $126 million of securities we owned that were issued by consolidated Sequoia Choice, Freddie Mac SLST, and Freddie Mac K-Series securitizations, respectively. For GAAP purposes we consolidated $7.13 billion of residential loans and $6.46 billion of non-recourse ABS debt associated with these retained securities.
The following tables present the components of the interest income we earned on AFS securities for the three and six months ended June 30, 2019 and 2018.
Table 20 – Interest Income — AFS Securities
Three Months Ended June 30, 2019
 
 
 
 
 
 
 
 
 
Yield as a Result of
 
 
Interest Income
 
Discount (Premium) Amortization
 
Total Interest Income
 
Average Amortized Cost
 
Interest Income
 
Discount (Premium) Amortization
 
Total Interest Income
(Dollars in Thousands)
 
 
 
 
 
 
 
Residential
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior
 
$
554

 
$
768

 
$
1,322

 
$
30,462

 
7.27
%
 
10.09
%
 
17.36
%
Mezzanine
 
146

 
49

 
195

 
13,750

 
4.25
%
 
1.42
%
 
5.67
%
Subordinate
 
2,710

 
1,242

 
3,952

 
137,041

 
7.91
%
 
3.63
%
 
11.54
%
Total AFS Securities
 
$
3,410

 
$
2,059

 
$
5,469

 
$
181,253

 
7.53
%
 
4.54
%
 
12.07
%
Three Months Ended June 30, 2018
 
 
 
 
 
 
 
 
 
Yield as a Result of
 
 
Interest Income
 
Discount (Premium) Amortization
 
Total Interest Income
 
Average Amortized Cost
 
Interest Income
 
Discount (Premium) Amortization
 
Total Interest Income
(Dollars in Thousands)
 
 
 
 
 
 
 
Residential
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior
 
$
1,741

 
$
2,185

 
$
3,926

 
$
116,862

 
5.96
%
 
7.48
%
 
13.44
%
Mezzanine
 
532

 
226

 
758

 
49,951

 
4.26
%
 
1.81
%
 
6.07
%
Subordinate
 
2,807

 
1,437

 
4,244

 
146,717

 
7.65
%
 
3.92
%
 
11.57
%
Total AFS Securities
 
$
5,080

 
$
3,848

 
$
8,928

 
$
313,530

 
6.48
%
 
4.91
%
 
11.39
%
Six Months Ended June 30, 2019
 
 
 
 
 
 
 
 
 
Yield as a Result of
 
 
Interest Income
 
Discount (Premium) Amortization
 
Total Interest Income
 
Average Amortized Cost
 
Interest Income
 
Discount (Premium) Amortization
 
Total Interest Income
(Dollars in Thousands)
 
 
 
 
 
 
 
Residential
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior
 
$
1,376

   
$
1,758

   
$
3,134

 
$
38,267

   
7.19
%
 
9.19
%
 
16.38
%
Mezzanine
 
450

   
199

 
649

 
22,323

 
4.03
%
 
1.78
%
 
5.81
%
Subordinate
 
5,391

   
2,032

 
7,423

 
137,094

 
7.87
%
 
2.96
%
 
10.83
%
Total AFS Securities
 
$
7,217

 
$
3,989

 
$
11,206

 
$
197,684

 
7.30
%
 
4.04
%
 
11.34
%

97

Six Months Ended June 30, 2018
 
 
 
 
 
 
 
 
 
Yield as a Result of
 
 
Interest Income
 
Discount (Premium) Amortization
 
Total Interest Income
 
Average Amortized Cost
 
Interest Income
 
Discount (Premium) Amortization
 
Total Interest Income
(Dollars in Thousands)
 
 
 
 
 
 
 
Residential
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Senior
 
$
3,567

   
$
4,671

   
$
8,238

 
$
123,924

   
5.76
%
 
7.54
%
 
13.30
%
Mezzanine
 
1,298

 
542

 
1,840

 
61,467

 
4.22
%
 
1.76
%
 
5.98
%
Subordinate
 
5,685

 
2,695

 
8,380

 
152,870

 
7.44
%
 
3.53
%
 
10.97
%
Total AFS Securities
 
$
10,550

 
$
7,908

 
$
18,458

 
$
338,261

 
6.24
%
 
4.68
%
 
10.92
%
Residential Loans Held-for-Investment at Sequoia Choice Portfolio

As of June 30, 2019, we had issued seven securitizations primarily comprised of expanded-prime Choice loans that we consolidate for financial reporting purposes in accordance with GAAP. These entities are independent of Redwood and the assets and liabilities of these entities are not, respectively, owned by us or legal obligations of ours. We record the assets and liabilities of the consolidated Sequoia Choice entities at fair value, based on the estimated fair value of the debt securities (ABS) issued from the securitizations, in accordance with GAAP provisions for collateralized financing entities. At June 30, 2019, our economic investment in the consolidated Sequoia Choice entities had an estimated fair value of $220 million. The securities retained from our consolidated Sequoia Choice entities included senior and subordinate securities of $13 million and $205 million, respectively, at June 30, 2019.
The following tables present the statements of income for the three and six months ended June 30, 2019 and 2018 and the balance sheets of the consolidated Sequoia Choice entities at June 30, 2019 and December 31, 2018. All amounts in the statements of income and balance sheets presented below are included in our consolidated financial statements and are included in our Investment Portfolio segment.
Table 21 – Consolidated Sequoia Choice Entities Statements of Income
 
 
Three Months Ended June 30,
 
 
 
 
Six Months Ended June 30,
 
 
(In Thousands)
 
2019
 
2018
 
Change
 
 
2019
 
2018
 
Change
Interest income
 
$
26,828

 
$
14,135

 
$
12,693

 
 
$
52,490

 
$
23,070

 
$
29,420

Interest expense
 
(23,134
)
 
(12,134
)
 
(11,000
)
 
 
(45,247
)
 
(19,683
)
 
(25,564
)
Net interest income
 
3,694

 
2,001

 
1,693

 
 
7,243

 
3,387

 
3,856

Investment fair value changes, net
 
2,879

 
1,073

 
1,806

 
 
6,144

 
987

 
5,157

Net Income from Consolidated Sequoia Choice Entities
 
$
6,573

 
$
3,074

 
$
3,499

 
 
$
13,387

 
$
4,374

 
$
9,013

Table 22 – Consolidated Sequoia Choice Entities Balance Sheets
(In Thousands)
 
June 30, 2019
 
December 31, 2018
Residential loans, held-for-investment, at fair value
 
$
2,147,356

 
$
2,079,382

Other assets
 
8,960

 
10,010

Total Assets
 
$
2,156,316


$
2,089,392

Other liabilities
 
$
7,336

 
$
8,202

Asset-backed securities issued, at fair value
 
1,929,444

 
1,885,010

Total liabilities
 
1,936,780


1,893,212

Equity (fair value of Redwood's retained investments in entities)
 
219,536

 
196,180

Total Liabilities and Equity
 
$
2,156,316


$
2,089,392


98

The following table presents residential loan activity at the consolidated Sequoia Choice entities for the three and six months ended June 30, 2019.
Table 23 – Residential Loans Held-for-Investment at Sequoia Choice - Activity
 
 
Three Months Ended
 
Six Months Ended
(In Thousands)
 
June 30, 2019
 
June 30, 2019
Balance at beginning of period 
 
$
2,333,248

 
$
2,079,382

New securitization issuance
 
—

 
349,583

Principal repayments
 
(191,796
)
 
(297,478
)
Changes in fair value, net
 
5,904

 
15,869

Balance at End of Period
 
$
2,147,356


$
2,147,356

The outstanding loans held-for-investment at our Sequoia Choice entities at June 30, 2019 were primarily comprised of prime-quality, first-lien, 30-year, fixed-rate loans originated in 2017 or 2018. The gross weighted average coupon of these loans was 4.76%, the weighted average FICO score of borrowers backing these loans was 745 (at origination) and the weighted average original LTV ratio was 75% (at origination). At June 30, 2019, six of these loans with an aggregate unpaid principal balance of $3 million were greater than 90 days delinquent and none of these loans were in foreclosure. At December 31, 2018, three of these loans with an aggregate unpaid principal balance of $2 million were greater than 90 days delinquent and none of these loans were in foreclosure.
Residential Loans Held-for-Investment at Freddie Mac SLST Portfolio

During the fourth quarter of 2018, we invested in certain subordinate securities backed by a pool of seasoned re-performing and non-performing residential mortgage loans that were issued by a Freddie Mac SLST securitization entity and we were required to consolidate this entity for financial reporting purposes in accordance with GAAP. This entity is independent of Redwood and the assets and liabilities of this entity are not, respectively, owned by us or legal obligations of ours. We record the assets and liabilities of the consolidated Freddie Mac SLST entity at fair value, based on the estimated fair value of the debt securities (ABS) issued from the securitization, in accordance with GAAP provisions for collateralized financing entities. At June 30, 2019, our economic investment in the consolidated Freddie Mac SLST entity had an estimated fair value of $244 million, and was comprised of subordinate securities.
The following tables present the statements of income for the three and six months ended June 30, 2019 and 2018 and the balance sheets of the consolidated Freddie Mac SLST entity at June 30, 2019 and December 31, 2018. All amounts in the statements of income and balance sheets presented below are included in our consolidated financial statements and are included in our Investment Portfolio segment.
Table 24 – Consolidated Freddie Mac SLST Entity Statements of Income
 
 
Three Months Ended June 30,
 
 
 
 
Six Months Ended June 30,
 
 
(In Thousands)
 
2019
 
2018
 
Change
 
 
2019
 
2018
 
Change
Interest income
 
$
11,597

 
$
—

 
$
11,597

 
 
$
23,391

 
$
—

 
$
23,391

Interest expense
 
(8,557
)
 
—

 
(8,557
)
 
 
(17,304
)
 
—

 
(17,304
)
Net interest income
 
3,040

 
—

 
3,040

 
 
6,087

 
—

 
6,087

Investment fair value changes, net
 
8,037

 
—

 
8,037

 
 
14,402

 
—

 
14,402

Net Income from Consolidated Freddie Mac SLST Entity
 
$
11,077

 
$
—

 
$
11,077

 
 
$
20,489

 
$
—

 
$
20,489


99

Table 25 – Consolidated Freddie Mac SLST Entity Balance Sheets
(In Thousands)
 
June 30, 2019
 
December 31, 2018
Residential loans, held-for-investment, at fair value
 
$
1,235,089

     
$
1,222,669

Other assets
 
3,786

 
3,926

Total Assets
 
$
1,238,875

 
$
1,226,595

Other liabilities
 
$
2,774

 
$
2,907

Asset-backed securities issued, at fair value
 
991,766

 
993,748

Total liabilities
 
994,540

 
996,655

Equity (fair value of Redwood's investments in entity)
 
244,335

 
229,940

Total Liabilities and Equity
 
$
1,238,875

 
$
1,226,595

The following table presents residential loan activity at the consolidated Freddie Mac SLST entity for the three and six months ended June 30, 2019.
Table 26 – Residential Loans Held-for-Investment at Freddie Mac SLST - Activity
 
 
Three Months Ended
 
Six Months Ended
(In Thousands)
 
June 30, 2019
 
June 30, 2019
Balance at beginning of period 
 
$
1,228,317

 
$
1,222,669

Principal repayments
 
(24,706
)
 
(42,585
)
Changes in fair value, net
 
31,478

 
55,005

Balance at End of Period
 
$
1,235,089

 
$
1,235,089

The outstanding re-performing and non-performing residential loans held-for-investment at the Freddie Mac SLST entity at June 30, 2019 were first-lien, fixed- or step-rate loans that have been modified. At securitization, in December 2018, the weighted average FICO score of borrowers backing these loans was 597 and the weighted average LTV ratio of these loans was 69%. At June 30, 2019, 301 of these loans with an aggregate unpaid principal balance of $78 million were greater than 90 days delinquent and 101 of these loans with an aggregate unpaid principal balance of $15 million were in foreclosure. At December 31, 2018, 306 of these loans with an aggregate unpaid principal balance of $51 million were greater than 90 days delinquent and none of these loans were in foreclosure. Due to the credit profile of re-performing and non-performing loans, our investment in the subordinate securities issued by the Freddie Mac SLST entity was made based on an expectation of defaults and credit losses that will occur on the underlying pool of residential mortgage loans, which was reflected in our purchase price yield. At June 30, 2019, delinquencies and credit losses in the portfolio remain in line with our expectations.
Multifamily Loans Held-for-Investment at Freddie Mac K-Series Portfolio

Beginning in the second half of 2018, we invested in certain subordinate securities issued by Freddie Mac K-Series securitization entities and were required to consolidate these entities for financial reporting purposes in accordance with GAAP. Each of these entities is independent of Redwood and of each other and the assets and liabilities of these entities are not, respectively, owned by us or legal obligations of ours. We record the assets and liabilities of the consolidated Freddie Mac K-Series entities at fair value, based on the estimated fair value of the debt securities (ABS) issued from the securitizations, in accordance with GAAP provisions for collateralized financing entities. At June 30, 2019, our economic investment in the consolidated Freddie Mac K-Series entities had an estimated fair value of $207 million, and was comprised of subordinate securities.

100

The following tables present the statements of income for the three and six months ended June 30, 2019 and 2018 and the balance sheets of the consolidated Freddie Mac K-Series entities at June 30, 2019 and December 31, 2018. All amounts in the statements of income and balance sheets presented below are included in our consolidated financial statements and are included in our Investment Portfolio segment.
Table 27 – Consolidated Freddie Mac K-Series Entities Statements of Income
 
 
Three Months Ended June 30,
 
 
 
 
Six Months Ended June 30,
 
 
(In Thousands)
 
2019
 
2018
 
Change
 
 
2019
 
2018
 
Change
Interest income
 
$
35,917

 
$
—

 
$
35,917

 
 
$
57,305

 
$
—

 
$
57,305

Interest expense
 
(34,441
)
 
—

 
(34,441
)
 
 
(54,760
)
 
—

 
(54,760
)
Net interest income
 
1,476

 
—

 
1,476

 
 
2,545

 
—

 
2,545

Investment fair value changes, net
 
3,246

 
—

 
3,246

 
 
6,365

 
—

 
6,365

Net Income from Consolidated Freddie Mac K-Series Entities
 
$
4,722

 
$
—

 
$
4,722

 
 
$
8,910

 
$
—

 
$
8,910

Table 28 – Consolidated Freddie Mac K-Series Entities Balance Sheets
(In Thousands)
 
June 30, 2019
 
December 31, 2018
Multifamily loans, held-for-investment, at fair value
 
$
3,749,657

     
$
2,144,598

Other assets
 
11,317

 
6,595

Total Assets
 
$
3,760,974

 
$
2,151,193

Other liabilities
 
$
10,822

 
$
6,239

Asset-backed securities issued, at fair value
 
3,543,057

 
2,019,075

Total liabilities
 
3,553,879

 
2,025,314

Equity (fair value of Redwood's retained investments in entities)
 
207,095

 
125,879

Total Liabilities and Equity
 
$
3,760,974

 
$
2,151,193

The following table presents multifamily loan activity at the consolidated Freddie Mac K-Series entities for the three and six months ended June 30, 2019.
Table 29 – Multifamily Loans Held-for-Investment at Freddie Mac K-Series - Activity
 
 
Three Months Ended
 
Six Months Ended
(In Thousands)
 
June 30, 2019
 
June 30, 2019
Balance at beginning of period 
 
$
2,175,899

 
$
2,144,598

Consolidation of multifamily loans held in securitization trusts
 
1,481,554

 
1,481,554

Principal repayments
 
(4,445
)
 
(7,516
)
Changes in fair value, net
 
96,649

 
131,021

Balance at End of Period
 
$
3,749,657

 
$
3,749,657

The outstanding multifamily loans held-for-investment at the Freddie Mac K-Series entities at June 30, 2019 were first lien, fixed-rate loans that were primarily originated between 2015 and 2017 and had original loan terms of seven to ten years and an original weighted average LTV ratio of 69%. At June 30, 2019, the weighted average coupon of these loans was 4.19% and the weighted average loan term was six years. At both June 30, 2019 and December 31, 2018, none of these loans were greater than 90 days delinquent or in foreclosure.

101

Mortgage Servicing Rights Portfolio
Our MSRs are held and managed at our taxable REIT subsidiary and typically are acquired together with loans from originators and then separately recognized under GAAP when the MSR is retained and the associated loan is sold to a third party or transferred to a Sequoia residential securitization sponsored by us that meets the GAAP criteria for sale. Although we own the rights to service loans, we contract with sub-servicers to perform these activities. Our receipt of MSR income is not subject to any covenants other than customary performance obligations associated with servicing residential loans. If a sub-servicer we contract with was to fail to perform these obligations, our servicing rights could be terminated and we would evaluate our MSR asset for impairment at that time.
The following table provides the activity for MSRs for the three and six months ended June 30, 2019.
Table 30 – MSR Activity
(In Thousands)
 
Three Months Ended June 30, 2019
 
Six Months Ended June 30, 2019
Balance at beginning of period
 
$
55,284

 
$
60,281

Additions
 
 
 
 
MSRs retained from third-party loan sales
 
764

 
868

Market valuation adjustments
 
(8,652
)
 
(13,753
)
Balance at End of Period
 
$
47,396

 
$
47,396

The following table presents characteristics of our MSR investments and their associated loans at June 30, 2019.
Table 31 – Characteristics of MSR Investments Portfolio
(Dollars in Thousands)
 
June 30, 2019
Unpaid principal balance
 
$
4,827,661

Fair value of MSRs
 
$
47,396

MSR values as percent of unpaid principal balance
 
0.98
%
Gross cash yield (1)
 
0.29
%
Number of loans
 
7,488

Average loan size
 
$
645

Average coupon
 
3.98
%
Average loan age (months)
 
58

Average original loan-to-value
 
67
%
Average original FICO score
 
770

60+ day delinquencies
 
0.14
%
(1)
Gross cash yield is calculated by dividing the annualized quarterly gross servicing fees we received for the three months ended June 30, 2019, by the weighted average notional balance of loans associated with MSRs we owned during that period.
At June 30, 2019, nearly all of our MSRs were comprised of base MSRs and within this portfolio we did not own any portion of a servicing right related to any loan where we did not own the entire servicing right. At both June 30, 2019 and December 31, 2018, we had $1 million of servicer advances outstanding related to our MSRs, which are presented in Other assets on our consolidated balance sheets.

102

Servicing Investments
In 2018, we invested in servicer advances and excess MSRs associated with legacy RMBS (See Note 10 of our Notes to Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional detail). At June 30, 2019, our servicer advance investments and excess MSRs associated with this investment had a carrying value of $259 million and $15 million, respectively. The following table presents characteristics of the residential mortgage loans underlying these investments at June 30, 2019.
Table 32 – Characteristics of Servicing Investments
(Dollars in Thousands)
 
June 30, 2019
Unpaid principal balance
 
$
8,336,516

Number of loans
 
41,787

Average loan size
 
$
200

Average coupon
 
5.21
%
Average loan age (months)
 
166

Average original loan-to-value
 
74
%
Average original FICO score
 
698

60+ day delinquencies (1)
 
9.45
%
(1)
Includes unpaid principal balance of $498 million, or 6% of total portfolio, of loans in foreclosure or transferred to REO.
Mortgage Banking Segment
Our Mortgage Banking segment includes activity from both our residential and business purpose mortgage banking operations. Our business purpose mortgage banking operations includes activity from our wholly-owned subsidiary 5 Arches and our single-family rental loans that we are currently aggregating for subsequent sale or securitization. The following table presents the components of segment contribution for the Mortgage Banking segment for the three and six months ended June 30, 2019 and 2018.
Table 33 – Mortgage Banking Segment Contribution
 
 
Three Months Ended June 30,
 
 
 
 
Six Months Ended June 30,
 
 
(In Thousands)
 
2019
 
2018
 
Change
 
 
2019
 
2018
 
Change
Interest income
 
$
11,352

 
$
13,084

 
$
(1,732
)
 
 
$
21,729

 
$
25,981

 
$
(4,252
)
Interest expense
 
(6,595
)
 
(7,629
)
 
1,034

 
 
(12,159
)
 
(13,766
)
 
1,607

Net interest income
 
4,757

 
5,455

 
(698
)
 
 
9,570

 
12,215

 
(2,645
)
Mortgage banking activities, net (1)
 
19,160

 
10,596

 
8,564

 
 
31,469

 
37,172

 
(5,703
)
Other income (expense), net (2)
 
(156
)
 
—

 
(156
)
 
 
(323
)
 
—

 
(323
)
Direct operating expenses (3)
 
(11,571
)
 
(5,739
)
 
(5,832
)
 
 
(19,675
)
 
(14,371
)
 
(5,304
)
Segment contribution before income taxes
 
12,190

 
10,312

 
1,878

 
 
21,041

 
35,016

 
(13,975
)
Provision for income taxes
 
(1,437
)
 
(1,398
)
 
(39
)
 
 
(1,978
)
 
(5,406
)
 
3,428

Segment Contribution
 
$
10,753

 
$
8,914

 
$
1,839

 
 
$
19,063

 
$
29,610

 
$
(10,547
)
(1)
Mortgage banking activities, net includes $15 million and $4 million from our residential mortgage banking and business purpose mortgage banking operations, respectively, for the three months ended June 30, 2019. Mortgage banking activities, net includes $26 million and $5 million from our residential mortgage banking and business purpose mortgage banking operations, respectively, for the six months ended June 30, 2019.
(2)
Other income (expense), net for our business purpose mortgage banking operations includes intangible asset amortization expense of $2 million and $3 million for the three and six months ended June 30, 2019, respectively, related to our acquisition of 5 Arches.
(3)
Direct operating expenses includes $6 million from both our residential mortgage banking and business purpose mortgage banking operations for the three months ended June 30, 2019. Direct operating expenses includes $12 million and $8 million from our residential mortgage banking and business purpose mortgage banking operations, respectively, for the six months ended June 30, 2019.

103

The following tables provide the activity of unsecuritized residential loans during the three and six months ended June 30, 2019 and 2018.
Table 34 – Residential Loans Held-for-Sale — Activity
 
 
Three Months Ended June 30,
 
 
2019
 
2018
(In Thousands)
 
Select
 
Choice
 
Total
 
Select
 
Choice
 
Total
Balance at beginning of period 
 
$
484,189

     
$
335,032

 
$
819,221

 
$
766,105

     
$
364,080

 
$
1,130,185

Acquisitions
 
1,073,674

     
488,078

 
1,561,752

 
1,343,224

     
608,342

 
1,951,566

Sales
 
(1,013,707
)
     
(238,709
)
 
(1,252,416
)
 
(1,399,862
)
     
(8,496
)
 
(1,408,358
)
Transfers between portfolios (1)
 
(13,718
)
     
(29,532
)
 
(43,250
)
 
(22,542
)
     
(539,168
)
 
(561,710
)
Principal repayments
 
(18,695
)
     
(13,706
)
 
(32,401
)
 
(7,374
)
     
(7,238
)
 
(14,612
)
Changes in fair value, net
 
3,042

     
339

 
3,381

 
1,265

     
6,324

 
7,589

Balance at End of Period
 
$
514,785

 
$
541,502

 
$
1,056,287

 
$
680,816

 
$
423,844

 
$
1,104,660

 
 
Six Months Ended June 30,
 
 
2019
 
2018
(In Thousands)
 
Select
 
Choice
 
Total
 
Select
 
Choice
 
Total
Balance at beginning of period 
 
$
716,193

     
$
332,608

 
$
1,048,801

 
$
1,101,356

     
$
326,589

 
$
1,427,945

Acquisitions
 
1,623,222

     
921,459

 
2,544,681

 
2,611,154

     
1,155,706

 
3,766,860

Sales
 
(1,810,937
)
     
(274,557
)
 
(2,085,494
)
 
(2,990,603
)
     
(12,286
)
 
(3,002,889
)
Transfers between portfolios (1)
 
8,365

     
(418,287
)
 
(409,922
)
 
(22,542
)
     
(1,046,784
)
 
(1,069,326
)
Principal repayments
 
(26,828
)
     
(22,998
)
 
(49,826
)
 
(20,608
)
     
(11,021
)
 
(31,629
)
Changes in fair value, net
 
4,770

     
3,277

 
8,047

 
2,059

     
11,640

 
13,699

Balance at End of Period
 
$
514,785

 
$
541,502

 
$
1,056,287

 
$
680,816

 
$
423,844

 
$
1,104,660

(1)
Represents the net transfers of loans out of our Mortgage Banking segment into our Investment Portfolio segment and their reclassification from held-for-sale to held-for-investment.
Overview
Strong margins, supported by improved securitization and whole loan execution during the second quarter of 2019, more than offset a reduction in volume to help segment contribution from our mortgage banking business to improve during the three-month periods. Our segment results for the six-month periods declined, as we experienced significantly higher volumes and margins during the first quarter of 2018. For the second quarter of 2019, our business purpose mortgage banking operations generated a segment contribution close to break-even, as our volumes were somewhat impacted by the continued integration of 5 Arches.
During the first half of 2019, we purchased $2.54 billion of predominately prime residential jumbo loans, securitized $764 million of jumbo Select loans that were accounted for as sales, and sold $1.32 billion of jumbo loans to third parties. Additionally, we transferred $350 million of jumbo Choice loans that did not qualify for sales accounting treatment under GAAP to Sequoia securitization entities and we had net transfers of $60 million of loans to our Investment Portfolio segment that were financed with borrowings from the FHLBC. Our pipeline of residential loans identified for purchase at June 30, 2019 included $1.02 billion of jumbo loans.
Prior to our acquisition of 5 Arches on March 1, 2019, we purchased $19 million of single-family rental loans from 5 Arches. During the period from March 1, 2019 to June 30, 2019, we funded $41 million of single-family rental loans, all of which were retained in our mortgage banking segment. Since our acquisition of 5 Arches, we have funded $128 million of residential bridge loans, of which $44 million were sold to a third party and the remaining loans were transferred to our investment portfolio.

104

We utilize a combination of capital and our loan warehouse facilities to manage our inventory of loans held-for-sale. At June 30, 2019, we had $638 million of warehouse debt outstanding to fund our residential loans held-for-sale. The weighted average cost of the borrowings outstanding under these facilities during the second quarter of 2019 was 3.95% per annum. Jumbo loan warehouse capacity at June 30, 2019 totaled $1.43 billion across four separate counterparties, which should continue to provide sufficient liquidity to fund our mortgage banking operations in the near-term.
At June 30, 2019, we had $54 million of warehouse debt outstanding to fund our single-family rental loans held-for-sale. The weighted average cost of the borrowings outstanding under these facilities during the second quarter of 2019 was 5.51% per annum. Our single-family rental loan warehouse capacity totaled $400 million across two separate counterparties.
At June 30, 2019, residential mortgage banking had 481 loan sellers, down from 501 at the end of 2018. This included 186 jumbo sellers and 295 sellers from various FHLB districts participating in the FHLB's MPF Direct program.
Net Interest Income
Net interest income from mortgage banking is primarily comprised of interest income earned on loans from the time we purchase the loans to when we sell or securitize them, offset by interest expense incurred on short-term warehouse debt used in part to finance the loans while we hold them on our balance sheet.
The decrease in net interest income during the three- and six-month periods was primarily due to a decrease in interest income driven by a lower average balance of residential loans held-for-sale and higher interest expense due to higher interest rates on our variable rate financing.
The amount of net interest income we earn on loans held-for-sale is dependent on many variables, including the amount of loans and the time they are outstanding on our consolidated balance sheet and their interest rates, as well as the amount of leverage we employ through the use of short-term debt to finance the loans and the interest rates on that debt. These factors will impact net interest income in future periods.
Mortgage Banking Activities, Net
Mortgage banking activities, net, includes the changes in market value of both the loans we hold for sale and commitments for loans we intend to purchase (collectively, our loan pipeline), as well as the effect of derivative instruments we utilize to manage risks associated with our loan pipeline. Our loan sale profit margins are measured over the period from when we commit to purchase a loan and subsequently sell or securitize the loan or transfer it into our investment portfolio. Accordingly, these profit margins may encompass positive or negative market valuation adjustments on loans, hedging gains or losses associated with our loan pipeline, and any other related transaction expenses, and may be realized over the course of one or more quarters for financial reporting purposes. In addition, beginning in the first quarter of 2019, mortgage banking activities includes fees from the origination of loans from our business purpose mortgage banking operations.

105

The following table presents the components of mortgage banking activities, net. Amounts presented include both the changes in market values for loans that were sold and associated derivative positions that were settled during the periods presented, as well as changes in market values of loans, derivatives and hedges outstanding at the end of each period.
Table 35 – Components of Mortgage Banking Activities, Net
 
 
Three Months Ended June 30,
 
 
 
 
Six Months Ended June 30,
 
 
(In Thousands)
 
2019
 
2018
 
Change
 
 
2019
 
2018
 
Change
Residential Mortgage Banking Activities, Net
 
 
 
 
 
 
 
 
 
 
 
 
 
Changes in fair value of:
 
 
 
 
 
 
 
 
 
 
 
 
 
Residential loans, at fair value (1)
 
$
20,267

 
$
3,364

 
$
16,903

 
 
$
35,111

 
$
1,170

 
$
33,941

Risk management derivatives (2)
 
(5,760
)
 
6,150

 
(11,910
)
 
 
(9,898
)
 
34,582

 
(44,480
)
Other income, net (3)
 
852

 
1,082

 
(230
)
 
 
973

 
1,420

 
(447
)
Total residential mortgage banking activities, net
 
15,359

 
10,596

 
4,763

 
 
26,186

 
37,172

 
(10,986
)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Business Purpose Mortgage Banking Activities, Net
 
 
 
 
 
 
 
 
 
 
 
 
 
Changes in fair value of:
 
 
 
 
 
 
 
 
 
 
 
 
 
Single-family rental loans, at fair value (1)
 
1,882

 
—

 
1,882

 
 
3,626

 
—

 
3,626

Risk management derivatives (2)
 
(1,671
)
 
—

 
(1,671
)
 
 
(2,517
)
 
—

 
(2,517
)
Residential bridge loans, at fair value
 
1,012

 
—

 
1,012

 
 
1,098

 
—

 
1,098

Other income, net (3)
 
2,578

 
—

 
2,578

 
 
3,076

 
—

 
3,076

Total business purpose mortgage banking activities, net
 
3,801

 
—

 
3,801

 
 
5,283

 
—

 
5,283

Mortgage Banking Activities, Net
 
$
19,160


$
10,596

 
$
8,564

 
 
$
31,469

 
$
37,172

 
$
(5,703
)
(1)
Includes changes in fair value for loan purchase commitments.
(2)
Represents market valuation changes of derivatives that are used to manage risks associated with our accumulation of loans.
(3)
Includes other fee income from loan originations and acquisitions as well as the provision for repurchase expense, presented net.
The increase in mortgage banking activities, net for the three-month periods was mostly the result of higher gross margins and income from our business purpose mortgage banking operations. The decrease in mortgage banking activities, net for the six-month periods was primarily due to a decrease in residential loan purchase volume.
Residential loan purchase commitments ("LPCs"), adjusted for fallout expectations, were $1.69 billion and $2.89 billion for the three and six months ended June 30, 2019, respectively. Our gross margins for our residential loans in the second quarter of 2019, which we define as net interest income plus income from mortgage banking activities, divided by LPCs, were above our long-term expectations, driven primarily by improved securitization execution in the second quarter of 2019.
At June 30, 2019 and December 31, 2018, we had repurchase reserves of $3 million and $4 million outstanding, respectively, related to residential loans sold through this segment. For each of the six months ended June 30, 2019 and 2018, we recorded reversals of repurchase provisions of $0.2 million that were included in income from mortgage banking activities, net, in this segment. We review our loan repurchase reserves each quarter and adjust them as necessary based on current information available at each reporting date.

106

Residential Loans Held-for-Sale
The following table details outstanding principal balances for residential loans held-for-sale by product type at June 30, 2019.
Table 36 – Characteristics of Residential Loans Held-for-Sale
June 30, 2019
 
Principal Value
 
Weighted Average Coupon
(Dollars in Thousands)
 
 
First Lien Prime
 
 
 
 
 Fixed - 30 year
 
$
716,630

 
4.80
%
 Fixed - 10, 15, & 20 year
 
65,580

 
3.90
%
 Hybrid
 
245,750

 
4.15
%
 ARM
 
145

 
4.45
%
Total Outstanding Principal
 
$
1,028,105

 


Single-Family Rental Loans Held-for-Sale
The $92 million of outstanding single-family rental loans held-for-sale at June 30, 2019 were first-lien, fixed-rate loans with maturities of five, seven, or ten years. At June 30, 2019, the weighted average coupon of our single-family rental loans was 5.54% and the weighted average loan term was six years. At origination, the weighted average LTV ratio of these loans was 66% and the weighted average debt service coverage ratio ("DSCR") was 1.33 times.

Operating Expenses and Taxes
Operating expenses for this segment primarily include costs associated with the origination, purchase and sale of residential and business purpose loans, including expenses from the 5 Arches platform we acquired in March 2019. For the three- and six-month periods, the increase in operating expenses was primarily due to additional expenses from the consolidated 5 Arches operations.
All mortgage banking activities are performed at our taxable REIT subsidiary and the provision for income taxes is generally correlated to the amount of this segment's contribution before income taxes in relation to the TRS's overall GAAP income and associated tax provision. The decrease in provision for income taxes resulted primarily from the reduction in GAAP income earned in this segment.

107

Results of Consolidated Legacy Sequoia Entities

We sponsored Sequoia securitization entities prior to 2012 that are reported on our consolidated balance sheets for financial reporting purposes in accordance with GAAP. Each of these entities is independent of Redwood and of each other and the assets and liabilities of these entities are not, respectively, owned by us or legal obligations of ours. We record the assets and liabilities of the consolidated Legacy Sequoia entities at fair value, based on the estimated fair value of the debt securities (ABS) issued from the securitizations, in accordance with GAAP provisions for collateralized financing entities. At June 30, 2019, the estimated fair value of our investments in the consolidated Legacy Sequoia entities was $11 million.

The following tables present the statements of income for the three and six months ended June 30, 2019 and 2018 and the balance sheets of the consolidated Legacy Sequoia entities at June 30, 2019 and December 31, 2018. All amounts in the statements of income and balance sheets presented below are included in our consolidated financial statements.
Table 37 – Consolidated Legacy Sequoia Entities Statements of Income
 
 
Three Months Ended June 30,
 
 
 
 
Six Months Ended June 30,
 
 
(In Thousands)
 
2019
 
2018
 
Change

 
2019
 
2018
 
Change
Interest income
 
$
4,776

 
$
5,017

 
$
(241
)
 
 
$
9,629

 
$
9,829

 
$
(200
)
Interest expense
 
(3,981
)
 
(4,215
)
 
234

 
 
(8,096
)
 
(8,067
)
 
(29
)
Net interest income
 
795

 
802

 
(7
)
 
 
1,533

 
1,762

 
(229
)
Investment fair value changes, net
 
(123
)
 
(720
)
 
597

 
 
(497
)
 
(728
)
 
231

Net Income from Consolidated Legacy Sequoia Entities
 
$
672

 
$
82

 
$
590

 
 
$
1,036

 
$
1,034

 
$
2

Table 38 – Consolidated Legacy Sequoia Entities Balance Sheets
(In Thousands)
 
June 30, 2019
 
December 31, 2018
Residential loans, held-for-investment, at fair value
 
$
457,750

 
$
519,958

Other assets
 
2,363

 
4,911

Total Assets
 
$
460,113

 
$
524,869

Other liabilities
 
$
519

 
$
571

Asset-backed securities issued, at fair value
 
448,862

 
512,240

Total liabilities
 
449,381

 
512,811

Equity (fair value of Redwood's retained investments in entities)
 
10,732

 
12,058

Total Liabilities and Equity
 
$
460,113

 
$
524,869


Net Interest Income at Consolidated Legacy Sequoia Entities     
The decrease in net interest income for the three- and six-month periods was primarily attributable to the continued paydown of loans at the consolidated entities.
Investment Fair Value Changes, net at Consolidated Legacy Sequoia Entities

Investment fair value changes, net at consolidated Legacy Sequoia entities includes the change in fair value of the residential loans held-for-investment, REO, and the ABS issued at the entities, which netted together represent the change in value of our retained investments in the consolidated Legacy Sequoia entities. The negative investment fair value changes in each of the periods presented was primarily related to the decline in fair value changes on retained IO securities, as the basis of these assets continue to diminish.

108

Residential Loans at Consolidated Legacy Sequoia Entities
The following table provides details of residential loan activity at consolidated Legacy Sequoia entities for the three and six months ended June 30, 2019 and 2018.
Table 39 – Residential Loans at Consolidated Legacy Sequoia Entities — Activity
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands)
 
2019
 
2018
 
2019
 
2018
Balance at beginning of period 
 
$
488,645

 
$
626,151

 
$
519,958

 
$
632,817

Principal repayments
 
(31,699
)
 
(37,869
)
 
(67,479
)
 
(72,091
)
Transfers to REO
 
(63
)
 
(567
)
 
(102
)
 
(1,835
)
Changes in fair value, net
 
867

 
4,314

 
5,373

 
33,138

Balance at End of Period
 
$
457,750

 
$
592,029

 
$
457,750

 
$
592,029

First lien adjustable rate mortgage ("ARM") and hybrid loans comprise all of the loans in the consolidated Legacy Sequoia entities and were primarily originated in 2006 or prior. For outstanding loans at consolidated Legacy Sequoia entities at June 30, 2019, the weighted average FICO score of borrowers backing these loans was 727 (at origination) and the weighted average original LTV ratio was 66% (at origination). At June 30, 2019 and December 31, 2018, the aggregate unpaid principal balance of loans at consolidated Legacy Sequoia entities delinquent greater than 90 days was $13 million and $14 million, respectively, of which the aggregate unpaid principal balance of loans in foreclosure was $5 million and $5 million, respectively.
Taxable Income and Tax Provision
Taxable Income
The following table summarizes our taxable income and distributions to shareholders for the three and six months ended June 30, 2019 and 2018.
Table 40 – Taxable Income
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
(In Thousands, except per Share Data)
 
2019 est. (1)
 
2018 est. (1)
 
2019 est. (1)
 
2018 est. (1)
REIT taxable income
 
$
24,561

 
$
26,794

 
$
53,322

 
$
60,268

Taxable REIT subsidiary income
 
16,347

 
11,883

 
23,044

 
35,964

Total Taxable Income
 
$
40,908

 
$
38,677

 
$
76,366

 
$
96,232

 
 
 
 
 
 
 
 
 
REIT taxable income per share
 
$
0.25

 
$
0.35

 
$
0.55

 
$
0.79

Total taxable income per share
 
$
0.42

 
$
0.51

 
$
0.79

 
$
1.27

 
 
 
 
 
 
 
 
 
Distributions to shareholders
 
$
29,306

 
$
22,721

 
$
58,304

 
$
43,916

Distributions to shareholders per share
 
$
0.30

 
$
0.30

 
$
0.60

 
$
0.58

(1)
Our tax results for the three and six months ended June 30, 2019 and 2018 are estimates until we file tax returns for these years.

Under normal circumstances, our minimum REIT dividend requirement would be 90% of our annual REIT taxable income. However, we currently maintain a $39 million federal net operating loss carry forward (NOL) at the REIT that affords us the option of retaining REIT taxable income up to the NOL amount, tax free, rather than distributing it as dividends. Federal income tax rules require the dividends paid deduction to be applied to reduce REIT taxable income before the applicability of NOLs is considered. It is possible our estimated REIT taxable income will exceed our dividend distributions in 2019; therefore, we may utilize a portion of our NOL in 2019 and any remaining amount will carry forward into 2020.


109

We also currently expect all or nearly all of the distributions to shareholders in 2019 will be taxable as dividend income and a smaller portion, if any, will be a return of capital, which is generally non-taxable. Additionally, a portion of our 2019 dividend distributions are expected to be characterized as long-term capital gains for federal income tax purposes.
Tax Provision under GAAP

For the three and six months ended June 30, 2019, we recorded tax provisions of $2 million and $3 million, respectively. For the three and six months ended June 30, 2018, we recorded tax provisions of $3 million and $7 million, respectively. Our tax provision is primarily derived from the activities at our TRS as we do not book a material tax provision associated with income generated at our REIT. The reduction in tax provision year-over-year was primarily the result of the lower GAAP income earned at our TRS as well as the recognition of discrete tax benefits in the first quarter ancillary to the 5 Arches acquisition, which impacted our tax provision by less than $2 million. Our TRS effective tax rate in 2019 is expected to be approximately equal to the federal corporate tax rate, excluding the one-time discrete tax benefits. The income or loss generated at our TRS will not directly affect the tax characterization of our 2019 dividends.

Realization of our deferred tax assets ("DTAs") is dependent on many factors, including generating sufficient taxable income prior to the expiration of NOL carryforwards and generating sufficient capital gains in future periods prior to the expiration of capital loss carryforwards. We determine the extent to which realization of our DTAs is not assured and establish a valuation allowance accordingly. At December 31, 2018, we reported net federal ordinary and capital deferred tax liabilities ("DTLs"), and, as such, had no associated valuation allowance. As a result of GAAP income at our TRS, we forecast that we will report net federal ordinary and capital DTLs at December 31, 2019 and consequently no valuation allowance is expected to be recorded against any federal DTA. Consistent with prior periods, we continued to maintain a valuation allowance against our net state DTAs. Our estimate of net deferred tax assets could change in future periods to the extent that actual or revised estimates of future taxable income during the carryforward periods change from current expectations.
Differences between Estimated Total Taxable Income and GAAP Income
Differences between estimated taxable income and GAAP income are largely due to the following: (i) we cannot establish loss reserves for future anticipated events for tax but we can for GAAP, as realized credit losses are expensed when incurred for tax and these losses are anticipated through lower yields on assets or through loss provisions for GAAP; (ii) the timing, and possibly the amount, of some expenses (e.g., certain compensation expenses) are different for tax than for GAAP; (iii) since amortization and impairments differ for tax and GAAP, the tax and GAAP gains and losses on sales may differ, resulting in differences in realized gains on sale; (iv) at the REIT and certain TRS entities, unrealized gains and losses on market valuation adjustments of securities and derivatives are not recognized for tax until the instrument is sold or extinguished; (v) for tax, basis may not be assigned to mortgage servicing rights retained when whole loans are sold resulting in lower tax gain on sale; (vi) for tax, we do not consolidate securitization entities as we do under GAAP; and, (vii) dividend distributions to our REIT from our TRS are included in REIT taxable income, but not GAAP income. As a result of these differences in accounting, our estimated taxable income can vary significantly from our GAAP income during certain reporting periods.

110

The table below reconciles our estimated total taxable income to our GAAP income for the six months ended June 30, 2019.
Table 41 – Differences between Estimated Total Taxable Income and GAAP Net Income
 
 
Six Months Ended June 30, 2019
(In Thousands, except per Share Data)
 
REIT (Est.)
 
TRS (Est.)
 
 
Total Tax (Est.)
 
GAAP
 
Differences
Interest income
 
$
125,902

 
$
25,305

 
 
$
151,207

 
$
279,583

 
$
(128,376
)
Interest expense
 
(63,439
)
 
(26,732
)
 
 
(90,171
)
 
(215,496
)
 
125,325

Net interest income
 
62,463

 
(1,427
)
 
 
61,036

 
64,087

 
(3,051
)
Realized credit losses
 
(580
)
 
—

 
 
(580
)
 
—

 
(580
)
Mortgage banking activities, net
 
—

 
29,976

 
 
29,976

 
31,469

 
(1,493
)
Investment fair value changes, net
 
793

 
157

 
 
950

 
23,297

 
(22,347
)
Operating expenses
 
(22,219
)
 
(24,808
)
 
 
(47,027
)
 
(49,414
)
 
2,387

Other income, net
 
786

 
8,958

 
 
9,744

 
5,994

 
3,750

Realized gains, net
 
12,229

 
10,305

 
 
22,534

 
13,513

 
9,021

Provision for income taxes
 
(150
)
 
(117
)
 
 
(267
)
 
(3,216
)
 
2,949

Net Income
 
$
53,322

 
$
23,044

 
 
$
76,366

 
$
85,730

 
$
(9,364
)
 
 
 
 
 
 
 
 
 
 
 
 
Income per basic common share
 
$
0.55

 
$
0.24

 
 
$
0.79

 
$
0.88

 
$
(0.09
)
Potential Taxable Income Volatility
We expect period-to-period volatility in our estimated taxable income. A description of the factors that can cause this volatility is described in the Taxable Income portion of the Results of Operations section in the MD&A included in Part II, Item 7, of our Annual Report on Form 10-K.

111

LIQUIDITY AND CAPITAL RESOURCES
Summary
In addition to the proceeds from equity and debt capital-raising transactions, our principal sources of cash consist of borrowings under mortgage loan warehouse facilities, securities repurchase agreements, payments of principal and interest we receive from our investment portfolios, and cash generated from our operating activities. Our most significant uses of cash are to purchase mortgage loans for our mortgage banking operations, to fund investments in residential loans, to purchase investment securities and make other investments, to repay principal and interest on our warehouse facilities, repurchase agreements, and long-term debt, to make dividend payments on our capital stock, and to fund our operations.
At June 30, 2019, our total capital was $2.34 billion and included $1.56 billion of equity capital and $0.77 billion of convertible notes and long-term debt on our consolidated balance sheet, including $201 million of exchangeable debt due in 2019, $245 million of convertible debt due in 2023, $200 million of convertible debt due in 2024, and $140 million of trust-preferred securities due in 2037.
As of June 30, 2019, our cash and liquidity capital included $200 million of available capital. While we believe our available capital, together with additional liquidity we believe we can source through continued portfolio optimization (including collateralized borrowings or assets sales), is sufficient to fund our operations and currently contemplated investment activities and to repay existing debt, we may raise equity or debt capital from time to time to acquire assets and make long-term investments to expand our investment portfolio or enhance our mortgage banking operating platforms, including funding large purchases of portfolios of residential, multifamily, or business purpose residential loans or securities, or other portfolio investments, or for other purposes, such as for acquisitions to expand our mortgage banking platform or to repay our $201 million of exchangeable debt maturing in November 2019. To the extent we seek to raise additional capital, our approach will continue to be based on what we believe to be in the best interest of our shareholders.
We are subject to risks relating to our liquidity and capital resources, including risks relating to incurring debt under residential loan warehouse facilities, securities repurchase facilities, and other short- and long-term debt facilities and other risks relating to our use of derivatives. A further discussion of these risks is set forth below under the heading “Risks Relating to Debt Incurred under Short-and Long-Term Borrowing Facilities."
Cash Flows and Liquidity for the Six Months Ended June 30, 2019
Cash flows from our mortgage banking activities and our investments can be volatile from quarter to quarter depending on many factors, including the timing and amount of loan and securities acquisitions and sales and repayments, the profitability of mortgage banking activities, as well as changes in interest rates, prepayments, and credit losses. Therefore, cash flows generated in the current period are not necessarily reflective of the long-term cash flows we will receive from these investments or activities.
Cash Flows from Operating Activities
Cash flows from operating activities were negative $558 million during the six months ended June 30, 2019. This amount includes the net cash utilized during the period from the purchase and sale of residential mortgage loans associated with our mortgage banking activities. Purchases of loans are financed to a large extent with short-term debt, for which changes in cash are included as a component of financing activities. Excluding cash flows from the purchase, origination, sale, and principal payments of loans classified as held-for-sale, cash flows from operating activities were negative $112 million and positive $101 million during the first six months of 2019 and 2018, respectively. For the six months ended June 30, 2019, cash flows from operating activities included net cash outflows of $136 million related to the funding of derivative margin obligations and the settlement of derivatives. These cash outflows were the result of declining benchmark interest rates during the first half of 2019.  
Cash Flows from Investing Activities
During the six months ended June 30, 2019, our net cash provided by investing activities was $497 million and primarily resulted from proceeds from principal payments on loans held-for-investment and sales of real estate securities. Although we generally intend to hold our investment securities as long-term investments, we may sell certain of these securities in order to manage our interest rate risk and liquidity needs, to meet other operating objectives, and to adapt to market conditions. We cannot predict the timing and impact of future sales of investment securities, if any.

112

Because many of our investment securities are financed through repurchase agreements, a significant portion of the proceeds from any sales or principal payments of our investment securities could be used to repay balances under these financing sources. Similarly, all or a significant portion of cash flows from principal payments of loans at consolidated Sequoia and Freddie Mac SLST and K-Series entities would generally be used to repay ABS issued by those entities.
During the three months ended June 30, 2019, we deployed capital into several new investments, including $75 million into Freddie Mac K-Series multifamily securities and $25 million into business purpose loans originated by 5 Arches.
As presented in the "Supplemental Noncash Information" subsection of our consolidated statements of cash flows, during the six months ended June 30, 2019, we transferred residential loans between held-for-sale and held-for-investment classification, retained securities from Sequoia securitizations we sponsored, and consolidated certain multifamily and re-performing residential securitization trusts which represent significant non-cash transactions that were not included in cash flows from investing activities.
Cash Flows from Financing Activities

During the six months ended June 30, 2019, our net cash provided by financing activities was $109 million. This primarily resulted from proceeds of $331 million from the issuance of asset-backed securities from our Sequoia Choice securitizations, proceeds of $198 million from the issuance of common stock, and $56 million of net borrowings of short-term debt. These cash inflows were partially offset by $417 million of repayments of ABS issued.
During the six months ended June 30, 2019, we paid $60 million of cash dividends on our common stock, representing cumulative dividends of $0.60 per share. In August 2019, the Board of Directors declared a regular dividend of $0.30 per share for the third quarter of 2019, which is payable on September 30, 2019 to shareholders of record on September 16, 2019.
In accordance with the terms of our outstanding deferred stock units, which are stock-based compensation awards, each time we declare and pay a dividend on our common stock, we are required to make a dividend equivalent payment in that same per share amount on each outstanding deferred stock unit.
Repurchase Authorization
In February 2018, our Board of Directors approved an authorization for the repurchase of our common stock, increasing the total amount authorized for repurchases of common stock to $100 million, and also authorized the repurchase of outstanding debt securities, including convertible and exchangeable debt. This authorization increased the previous share repurchase authorization approved in February 2016 and has no expiration date. This repurchase authorization does not obligate us to acquire any specific number of shares or securities. Under this authorization, shares or securities may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. At June 30, 2019, $100 million of the current authorization remained available for the repurchase of shares of our common stock. Like other investments we may make, any repurchases of our common stock or debt securities under this authorization would reduce our available capital described above.
Short-Term Debt
In the ordinary course of our business, we use recourse debt through several different types of borrowing facilities and use cash borrowings under these facilities to, among other things, fund the acquisition of residential loans (including those we acquire and originate in anticipation of securitization), finance investments in securities and other investments, and otherwise fund our business and operations.
At June 30, 2019, we had four short-term residential loan warehouse facilities with a total outstanding debt balance of $638 million (secured by residential loans with an aggregate fair value of $712 million) and a total uncommitted borrowing limit of $1.43 billion. In addition, at June 30, 2019, we had an aggregate outstanding short-term debt balance of $1.21 billion under 10 securities repurchase facilities, which were secured by securities with a fair market value of $945 million. In addition, at June 30, 2019, the fair value of our real estate securities pledged as collateral included $148 million of securities retained from our consolidated Sequoia Choice securitizations, as well as $203 million and $207 million of securities we owned that were issued by consolidated Freddie Mac SLST and Freddie Mac K-series securitizations, respectively. We also had a secured line of credit with no outstanding debt balance and a total borrowing limit of $10 million (secured by securities with a fair market value of $4 million) at June 30, 2019.

113


To finance our business purpose residential loan investments, at June 30, 2019, we had two single-family rental loan warehouse facilities with a total outstanding debt balance of $54 million (secured by single-family rental loans with an aggregate fair value of $71 million) and a total uncommitted borrowing limit of $400 million. In addition, at June 30, 2019, we had four residential bridge loan warehouse facilities with a total outstanding debt balance of $120 million (secured by residential bridge loans with an aggregate fair value of $144 million) and a total uncommitted borrowing limit of $330 million. We also had a business purpose loan working capital line with no outstanding balance and a total uncommitted borrowing limit of $15 million.
Servicer advance financing consists of non-recourse short-term securitization debt used to finance servicer advance investments we made in the fourth quarter of 2018. At June 30, 2019, the fair value of servicer advances, cash and restricted cash pledged as collateral was $265 million. At June 30, 2019, the accrued interest payable balance on this debt was $0.3 million and the unamortized capitalized commitment costs were $1 million.
During the fourth quarter of 2018, $201 million principal amount of 5.625% exchangeable senior notes and $1 million of unamortized deferred issuance costs were reclassified from long-term debt to short-term debt as the maturity of the notes was less than one year as of November 2018. At June 30, 2019, the accrued interest payable balance on this debt was $1 million. See Note 15 for additional information on our convertible notes.
At June 30, 2019, we had $2.46 billion of short-term debt outstanding. During the first six months of 2019, the highest balance of our short-term debt outstanding was $2.49 billion.
Long-Term Debt
FHLBC Borrowings
In July 2014, our FHLB-member subsidiary entered into a borrowing agreement with the Federal Home Loan Bank of Chicago. At June 30, 2019, under this agreement, our subsidiary could incur borrowings up to $2.00 billion, also referred to as “advances,” from the FHLBC secured by eligible collateral, including, but not limited to residential mortgage loans. During the six months ended June 30, 2019, our FHLB-member subsidiary made no additional borrowings under this agreement. Under a final rule published by the Federal Housing Finance Agency in January 2016, our FHLB-member subsidiary will remain an FHLB member through a five-year transition period for captive insurance companies. Our FHLB-member subsidiary's existing $2.00 billion of FHLB debt, which matures beyond this transition period, is permitted to remain outstanding until stated maturity. As residential loans pledged as collateral for this debt pay down, we are permitted to pledge additional loans or other eligible assets to collateralize this debt; however, we do not expect to be able to increase our subsidiary's FHLB debt above the existing $2.00 billion maximum.
At June 30, 2019, $2.00 billion of advances were outstanding under this agreement, which were classified as long-term debt, with a weighted average interest rate of 2.57% per annum and a weighted average maturity of six years. At June 30, 2019, accrued interest payable on these borrowings was $9 million. Advances under this agreement are charged interest based on a specified margin over the FHLBC’s 13-week discount note rate, which resets every 13 weeks. Our total advances under this agreement were secured by residential mortgage loans with a fair value of $2.39 billion at June 30, 2019. This agreement also requires our subsidiary to purchase and hold stock in the FHLBC in an amount equal to a specified percentage of outstanding advances. At June 30, 2019, our subsidiary held $43 million of FHLBC stock that is included in Other assets on our consolidated balance sheets.
Convertible Notes
In June 2018, we issued $200 million principal amount of 5.625% convertible senior notes due 2024 at an issuance price of 99.5%. After deducting the issuance discount, the underwriting discount and offering costs, we received approximately $194 million of net proceeds. Including amortization of deferred debt issuance costs and the debt discount, the weighted average interest expense yield on these convertible notes is approximately 6.2% per annum. At June 30, 2019, the outstanding principal amount of these notes was $200 million and the accrued interest payable balance on this debt was $5 million.
In August 2017, we issued $245 million principal amount of 4.75% convertible senior notes due 2023. After deducting the underwriting discount and offering costs, we received approximately $238 million of net proceeds. Including amortization of deferred debt issuance costs, the weighted average interest expense yield on these convertible notes is approximately 5.3% per annum. At June 30, 2019, the outstanding principal amount of these notes was $245 million and the accrued interest payable balance on this debt was $4 million.

114

In November 2014, one of our taxable subsidiaries issued $205 million principal amount of 5.625% exchangeable senior notes due 2019. After deducting the underwriting discount and offering costs, we received approximately $198 million of net proceeds. Including amortization of deferred debt issuance costs, the weighted average interest expense yield on these exchangeable notes is approximately 6.3% per annum. During the first quarter of 2016, we repurchased $4 million par value of these notes at a discount and recorded a gain on extinguishment of debt of $0.3 million in Realized gains, net on our consolidated statements of income. During the fourth quarter of 2018, $201 million principal amount of 5.625% exchangeable senior notes and $1 million of unamortized deferred issuance costs were reclassified from long-term debt to short-term debt as the maturity of the notes was less than one year as of November 2018. At June 30, 2019, the outstanding principal amount of these notes was $201 million and the accrued interest payable balance on this debt was $1 million.
 
Trust Preferred Securities and Subordinated Notes
At June 30, 2019, we had trust preferred securities and subordinated notes outstanding of $100 million and $40 million, respectively, issued by us in 2006 and 2007. This debt requires quarterly interest payments at a floating rate equal to three-month LIBOR plus 2.25% and must be redeemed no later than 2037. Prior to 2014, we entered into interest rate swaps with aggregate notional values totaling $140 million to hedge the variability in this long-term debt interest expense. Including hedging costs and amortization of deferred debt issuance costs, the weighted average interest expense yield on our trust preferred securities and subordinated notes is approximately 6.9% per annum. These swaps are accounted for as cash flow hedges with all interest recorded as a component of net interest income and other valuation changes recorded as a component of equity.
 Asset-Backed Securities
At June 30, 2019, there were $475 million (principal balance) of loans owned at consolidated Legacy Sequoia securitization entities, which were funded with $468 million (principal balance) of ABS issued at these entities. At June 30, 2019, there were $2.08 billion (principal balance) of loans owned at consolidated Sequoia Choice securitization entities, which were funded with $1.86 billion (principal balance) of ABS issued at these entities. At June 30, 2019, there were $1.27 billion (principal balance) of loans owned at the consolidated Freddie Mac SLST securitization entity, which were funded with $951 million (principal balance) of ABS issued at this entity. At June 30, 2019, there were $3.55 billion (principal balance) of loans owned at the consolidated Freddie Mac K-Series securitization entities, which were funded with $3.24 billion (principal balance) of ABS issued at these entities. The loans and ABS issued from these entities are reported at estimated fair value. See the subsections titled "Results of Consolidated Legacy Sequoia Entities," "Residential Loans Held-for-Investment at Sequoia Choice Portfolio," "Residential Loans Held-for-Investment at Freddie Mac SLST Portfolio," and "Multifamily Loans Held-for-Investment at Freddie Mac K-Series Portfolio" in the Results of Operations section of this MD&A for additional details on these entities.
Other Commitments and Contingencies
For additional information on commitments and contingencies that could impact our liquidity and capital resources, see Note 16 of our Notes to Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q.


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Risks Relating to Debt Incurred Under Short- and Long-Term Borrowing Facilities
As described above under the heading “Results of Operations,” in the ordinary course of our business, we use debt financing obtained through several different types of borrowing facilities to, among other things, finance the acquisition of mortgage loans (including those we acquire in anticipation of sale or securitization), and finance investments in securities and other investments. We may also use short- and long-term borrowings to fund other aspects of our business and operations, including the repurchase of shares of our common stock. Debt incurred under these facilities is generally either the direct obligation of Redwood Trust, Inc., or the direct obligation of subsidiaries of Redwood Trust, Inc. and guaranteed by Redwood Trust, Inc. Risks relating to debt incurred under these facilities are described in Part I, Item 2 of our Annual Report on Form 10-K for the year ended December 31, 2018, under the caption “Risks Relating to Debt Incurred under Short- and Long-Term Borrowing Facilities.”

Our sources of debt financing include short-term secured borrowings under mortgage loan warehouse facilities, short-term securities repurchase facilities, a $10 million committed line of short-term secured credit from a bank, and secured borrowings by our wholly-owned subsidiary, RWT Financial, LLC, under its borrowing facility with the FHLBC.

Aggregate borrowing limits are stated under certain of these facilities, and certain other facilities have no stated borrowing limit, but each of the facilities (with the exception of the $10 million committed line of short-term secured credit and two business purpose residential loan warehouse facilities secured by residential bridge loans) is uncommitted, which means that any request we make to borrow funds under these uncommitted facilities may be declined for any reason, even if at the time of the borrowing request we have then-outstanding borrowings that are less than the borrowing limits under these facilities. In general, financing under these facilities is obtained by transferring or pledging mortgage loans or securities to the counterparty in exchange for cash proceeds (in an amount less than 100% of the principal amount of the transferred or pledged assets). While transferred or pledged assets are financed under a facility, to the extent the market value of the assets declines, we are generally required to either immediately reacquire the assets or meet a margin requirement to transfer or pledge additional assets or cash in an amount at least equal to the decline in value. Margin call provisions under these facilities are further described in Part I, Item 2 of our Annual Report on Form 10-K for the year ended December 31, 2018 under the caption “Risks Relating to Debt Incurred under Short- and Long-Term Borrowing Facilities - Margin Call Provisions Associated with Short-Term Debt and Other Debt Financing.” Financial covenants included in these facilities are further described Part I, Item 2 of our Annual Report on Form 10-K for the year ended December 31, 2018 under the caption “Risks Relating to Debt Incurred under Short- and Long-Term Borrowing Facilities - Financial Covenants Associated with Short-Term Debt and Other Debt Financing.”

Because these borrowing facilities are uncommitted (except two business purpose residential loan warehouse facilities secured by residential bridge loans), at any given time we may not be able to obtain additional financing under them when we need it, exposing us to, among other things, liquidity risks of the types described in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2018 under the heading “Risk Factors,” and in Part II, Item 7A of our Annual Report on Form 10-K for the year ended December 31, 2018 under the heading “Market Risks.” In addition, with respect to mortgage loans that at any given time are already being financed through these warehouse facilities, we are exposed to market, credit, liquidity, and other risks of the types described in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2018 under the heading “Risk Factors,” and in Part II, Item 7A of our Annual Report on Form 10-K for the year ended December 31, 2018 under the heading “Market Risks,” if and when those loans or securities become ineligible to be financed, decline in value, or have been financed for the maximum term permitted under the applicable facility. Additionally, our access to financing under the borrowing facility with the FHLBC is subject to the risks described under the heading “Risk Factors - Federal regulations may limit, eliminate, or reduce the attractiveness of our subsidiary’s ability to use borrowings from the Federal Home Loan Bank of Chicago to finance the mortgage loans and securities it holds and acquires, which could negatively impact our business and operating results” in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2018.

At June 30, 2019, and through the date of this Quarterly Report on Form 10-Q, we were in compliance with the financial covenants associated with our short-term debt and other debt financing facilities. In particular, with respect to: (i) financial covenants that require us to maintain a minimum dollar amount of stockholders’ equity or tangible net worth, at June 30, 2019 our level of stockholders’ equity and tangible net worth resulted in our being in compliance with these covenants by more than $200 million; and (ii) financial covenants that require us to maintain recourse indebtedness below a specified ratio, at June 30, 2019 our level of recourse indebtedness resulted in our being in compliance with these covenants at a level such that we could incur at least $600 million in additional recourse indebtedness.

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OFF-BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS
In the normal course of business, we enter into transactions that may require future cash payments. As required by GAAP, some of these obligations are recorded on the balance sheet, while others are off-balance sheet or recorded on the balance sheet in amounts different from the full contract or notional amount of the transaction.
For additional information on our contractual obligations, see the Off-Balance Sheet Arrangements and Contractual Obligations section in the MD&A included in Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2018.
For additional information on our commitments and contingencies as of June 30, 2019, see Note 16 of our Notes to Consolidated Financial Statements in Part I, Item 1 of this Quarterly Report on Form 10-Q.


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CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reported periods. Actual results could differ from those estimates. A discussion of critical accounting policies and the possible effects of changes in estimates on our consolidated financial statements is included in Note 3 — Summary of Significant Accounting Policies included in Part I, Item 1 of this Quarterly Report on Form 10-Q and in Part I, Item 8 of our Annual Report on Form 10-K for the year ended December 31, 2018. Management discusses the ongoing development and selection of these critical accounting policies with the audit committee of the board of directors.
We expect quarter-to-quarter GAAP earnings volatility from our business activities. This volatility can occur for a variety of reasons, including the timing and amount of purchases, sales, calls, and repayment of consolidated assets, changes in the fair values of consolidated assets and liabilities, increases or decreases in earnings from mortgage banking activities, and certain non-recurring events. In addition, the amount or timing of our reported earnings may be impacted by technical accounting issues and estimates. Our critical accounting policies and the possible effects of changes in estimates on our consolidated financial statements are included in the "Critical Accounting Policies and Estimates" section of Part II, Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2018.
Market Risks
We seek to manage risks inherent in our business — including but not limited to credit risk, interest rate risk, prepayment risk, liquidity risk, and fair value risk — in a prudent manner designed to enhance our earnings and dividends and preserve our capital. In general, we seek to assume risks that can be quantified from historical experience, to actively manage such risks, and to maintain capital levels consistent with these risks. Information concerning the risks we are managing, how these risks are changing over time, and potential GAAP earnings and taxable income volatility we may experience as a result of these risks is discussed in Part II, Item 7A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2018.
Other Risks
In addition to the market and other risks described above, our business and results of operations are subject to a variety of types of risks and uncertainties, including, among other things, those described under the caption “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2018 and in this Quarterly Report on Form 10-Q.
NEW ACCOUNTING STANDARDS
A discussion of new accounting standards and the possible effects of these standards on our consolidated financial statements is included in Note 3 — Summary of Significant Accounting Policies included in Part I, Item 1 of this Quarterly Report on Form 10-Q.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Information concerning market risk is incorporated herein by reference to Part II, Item 7A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2018, as supplemented by the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Market Risks” within Item 2 above. Other than the developments described thereunder, including changes in the fair values of our assets, there have been no other material changes in our quantitative or qualitative exposure to market risk since December 31, 2018.

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Item 4. Controls and Procedures
We have adopted and maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed on our reports under the Securities Exchange Act of 1934, as amended (the Exchange Act), is recorded, processed, summarized, and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms and that the information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by Rule 13a-15(b) of the Exchange Act, we have carried out an evaluation, under the supervision and with the participation of management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the quarter covered by this report. Based on the foregoing, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective at a reasonable assurance level.
There have been no changes in our internal control over financial reporting during the second quarter of 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
On or about December 23, 2009, the Federal Home Loan Bank of Seattle (the “FHLB-Seattle”) filed a complaint in the Superior Court for the State of Washington (case number 09-2-46348-4 SEA) against Redwood Trust, Inc., our subsidiary, Sequoia Residential Funding, Inc. (“SRF”), Morgan Stanley & Co., and Morgan Stanley Capital I, Inc. (collectively, the “FHLB-Seattle Defendants”), which alleged that the FHLB-Seattle Defendants made false or misleading statements in offering materials for a mortgage pass-through certificate (the “Seattle Certificate”) issued in the Sequoia Mortgage Trust 2005-4 securitization transaction (the “2005-4 RMBS”) and purchased by the FHLB-Seattle. The Seattle Certificate was issued with an original principal amount of approximately $133 million, and, at June 30, 2019, approximately $127 million of principal and $12 million of interest payments had been made in respect of the Seattle Certificate. As of June 30, 2019, the Seattle Certificate had a remaining outstanding principal amount of approximately $6 million. The matter was subsequently resolved and the claims were dismissed by the FHLB Seattle as to all the FHLB Seattle Defendants. At the time the Seattle Certificate was issued, Redwood agreed to indemnify the underwriters of the 2005-4 RMBS, which underwriters were named as defendants in the action, for certain losses and expenses they might incur as a result of claims made against them relating to this RMBS, including, without limitation, certain legal expenses. Regardless of the resolution of this litigation, we could incur a loss as a result of these indemnities.
On or about July 15, 2010, The Charles Schwab Corporation (“Schwab”) filed a complaint in the Superior Court for the State of California in San Francisco (case number CGC-10-501610) against SRF and 26 other defendants (collectively, the “Schwab Defendants”), which alleged that the Schwab Defendants made false or misleading statements in offering materials for various residential mortgage-backed securities sold or issued by the Schwab Defendants. Schwab alleged only a claim for negligent misrepresentation under California state law against SRF and sought unspecified damages and attorneys’ fees and costs from SRF. Schwab claimed that SRF made false or misleading statements in offering materials for a mortgage pass-through certificate (the “Schwab Certificate”) issued in the 2005-4 RMBS and purchased by Schwab. The Schwab Certificate was issued with an original principal amount of approximately $15 million, and, at June 30, 2019, approximately $14 million of principal and $1 million of interest payments had been made in respect of the Schwab Certificate. As of June 30, 2019, the Schwab Certificate had a remaining outstanding principal amount of approximately $1 million. On November 14, 2014, Schwab voluntarily dismissed with prejudice its negligent misrepresentation claim, which resulted in the dismissal with prejudice of SRF from the action. Subsequently, the matter was resolved and Schwab dismissed its claims against the lead underwriter of the 2005-4 RMBS. At the time the Schwab Certificate was issued, Redwood agreed to indemnify the underwriters of the 2005-4 RMBS, which underwriters were also named as defendants in the action, for certain losses and expenses they might incur as a result of claims made against them relating to this RMBS, including, without limitation, certain legal expenses. Regardless of the resolution of this litigation, Redwood could incur a loss as a result of these indemnities.
Through certain of our wholly-owned subsidiaries, we have in the past engaged in, and expect to continue to engage in, activities relating to the acquisition and securitization of residential mortgage loans. In addition, certain of our wholly-owned subsidiaries have in the past engaged in activities relating to the acquisition and securitization of debt obligations and other assets through the issuance of collateralized debt obligations (commonly referred to as CDO transactions). Because of this involvement in the securitization and CDO businesses, we could become the subject of litigation relating to these businesses, including additional litigation of the type described above, and we could also become the subject of governmental investigations, enforcement actions, or lawsuits, and governmental authorities could allege that we violated applicable law or regulation in the conduct of our business. As an example, in July 2016 we became aware of a complaint filed by the State of California on April 1, 2016 against Morgan Stanley & Co. and certain of its affiliates alleging, among other things, that there were misleading statements contained in offering materials for 28 different mortgage pass-through certificates purchased by various California investors, including various California public pension systems, from Morgan Stanley and alleging that Morgan Stanley made false or fraudulent claims in connection with the sale of those certificates. Of the 28 mortgage pass-through certificates that were the subject of the complaint, two were Sequoia mortgage pass-through certificates issued in 2004 and two were Sequoia mortgage pass-through certificates issued in 2007. With respect to each of those certificates, our wholly-owned subsidiary, RWT Holdings, Inc., was the sponsor and our wholly-owned subsidiary, Sequoia Residential Funding, Inc., was the depositor. The plaintiffs subsequently withdrew from the litigation their claims based on eight of the 28 mortgage pass-through certificates, including one of the Sequoia mortgage pass-through certificates issued in 2004. We believe this matter was subsequently resolved and the plaintiffs withdrew their remaining claims. At the time these Sequoia mortgage pass-through certificates were issued, Sequoia Residential Funding, Inc. and Redwood Trust agreed to indemnify the underwriters of these certificates for certain losses and expenses they might incur as a result of claims made against them relating to these certificates, including, without limitation, certain legal expenses. Regardless of the resolution of this litigation, we could incur a loss as a result of these indemnities.

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In accordance with GAAP, we review the need for any loss contingency reserves and establish reserves when, in the opinion of management, it is probable that a matter would result in a liability and the amount of loss, if any, can be reasonably estimated. Additionally, we record receivables for insurance recoveries relating to litigation-related losses and expenses if and when such amounts are covered by insurance and recovery of such losses or expenses are due. At June 30, 2019, the aggregate amount of loss contingency reserves established in respect of the FHLB-Seattle and Schwab litigation matters described above was $2 million. We review our litigation matters each quarter to assess these loss contingency reserves and make adjustments in these reserves, upwards or downwards, as appropriate, in accordance with GAAP based on our review.
In the ordinary course of any litigation matter, including certain of the above-referenced matters, we have engaged and may continue to engage in formal or informal settlement communications with the plaintiffs or co-defendants. Settlement communications we have engaged in relating to certain of the above-referenced litigation matters are one of the factors that have resulted in our determination to establish the loss contingency reserves described above. We cannot be certain that any of these matters will be resolved through a settlement prior to trial and we cannot be certain that the resolution of these matters, whether through trial or settlement, will not have a material adverse effect on our financial condition or results of operations in any future period.
Future developments (including resolution of substantive pre-trial motions relating to these matters, receipt of additional information and documents relating to these matters (such as through pre-trial discovery), new or additional settlement communications with plaintiffs relating to these matters, or resolutions of similar claims against other defendants in these matters) could result in our concluding in the future to establish additional loss contingency reserves or to disclose an estimate of reasonably possible losses in excess of our established reserves with respect to these matters. Our actual losses with respect to the above-referenced litigation matters may be materially higher than the aggregate amount of loss contingency reserves we have established in respect of these litigation matters, including in the event that any of these matters proceeds to trial and the plaintiff prevails. Other factors that could result in our concluding to establish additional loss contingency reserves or estimate additional reasonably possible losses, or could result in our actual losses with respect to the above-referenced litigation matters being materially higher than the aggregate amount of loss contingency reserves we have established in respect of these litigation matters include that: there are significant factual and legal issues to be resolved; information obtained or rulings made during the lawsuits could affect the methodology for calculation of the available remedies; and we may have additional obligations pursuant to indemnity agreements, representations and warranties, and other contractual provisions with other parties relating to these litigation matters that could increase our potential losses.
Item 1A. Risk Factors
Our risk factors are discussed under Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2018 and under Part II, Item 1A of our Quarterly Report on Form 10-Q for the quarter ended March 31, 2019.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
During the three months ended June 30, 2019, we did not sell any equity securities that were not registered under the Securities Act of 1933, as amended.

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In February 2018, our Board of Directors approved an authorization for the repurchase of our common stock, increasing the total amount authorized for repurchases of common stock to $100 million, and also authorized the repurchase of outstanding debt securities, including convertible and exchangeable debt. This authorization increased the previous share repurchase authorization approved in February 2016 and has no expiration date. This repurchase authorization does not obligate us to acquire any specific number of shares or securities. Under this authorization, shares or securities may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. At June 30, 2019, $100 million of this current authorization remained available for the repurchase of shares of our common stock.
The following table contains information on the shares of our common stock that we purchased or otherwise acquired during the three months ended June 30, 2019.
 
 
Total Number of Shares Purchased or Acquired
 
Average
Price per
Share Paid
 
Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs
 
Maximum Number (or approximate dollar value) of Shares that May Yet be Purchased under the Plans or Programs
(In Thousands, except per Share Data)
 
 
 
 
April 1, 2019 - April 30, 2019
 
—

 
$
—

 
—

     
$
—

May 1, 2019 - May 31, 2019
 
—

 
$
—

 
—

 
$
—

June 1, 2019 - June 30, 2019
 
—

 
$
—

 
—

 
$
100,000

Total
 
—

 
$
—

 
—

 
$
100,000

Item 3. Defaults Upon Senior Securities
None.
Item 4. Not Applicable
Item 5. Other Information
On August 6, 2019, Redwood amended its employment agreements with Christopher J. Abate (Redwood’s CEO), Dashiell I. Robinson (Redwood’s President), and Andrew P. Stone (Redwood’s Executive Vice President, General Counsel, and Secretary). These agreements were amended to, among other things, update the provisions of the agreements related to severance payments and severance-related benefits continuation terms. The three amended employment agreements are filed as Exhibits 10.1, 10.2, and 10.3 to this Quarterly Report on Form 10-Q (collectively, the “Amended Employment Agreements”) and the description of the Amended Employment Agreements set forth in this Part II, Item 5 is qualified in its entirety by reference to the full text of the Amended Employment Agreements.


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Item 6. Exhibits
Exhibit
Number
 
Exhibit
3.1
 
3.1.1
 
3.1.2
 
3.1.3
 
3.1.4
 
3.1.5
 
3.1.6
 
3.1.7
 
3.1.8
 
3.1.9
 
3.1.10
 
3.1.11
 
3.2.1
 
3.2.2
 
3.2.3
 
10.1*
 
10.2*
 
10.3*
 
31.1
 
31.2
 
32.1
 
32.2
 
101
 
Pursuant to Rule 405 of Regulation S-T, the following financial information from the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2019, is filed in inline XBRL-formatted interactive data files:
 
(i) Consolidated Balance Sheets at June 30, 2019 and December 31, 2018;
(ii) Consolidated Statements of Income for the three and six months ended June 30, 2019 and 2018;
(iii) Statements of Consolidated Comprehensive Income for the three and six months ended June 30, 2019 and 2018;
(iv) Consolidated Statements of Changes in Stockholders' Equity for the three and six months ended June 30, 2019 and 2018;
(v) Consolidated Statements of Cash Flows for the six months ended June 30, 2019 and 2018; and
(vi) Notes to Consolidated Financial Statements.
104
 
Cover Page Interactive Data File (formatted as inline XBRL and contained in Exhibit 101)
* Indicates exhibits that include management contracts or compensatory plan or arrangements.

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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
REDWOOD TRUST, INC.
 
 
 
 
Date:
August 8, 2019
By:
/s/ Christopher J. Abate
 
 
 
Christopher J. Abate
 
 
 
Chief Executive Officer
 
 
 
(Principal Executive Officer)
 
 
 
 
Date:
August 8, 2019
By:
/s/ Collin L. Cochrane
 
 
 
Collin L. Cochrane
 
 
 
Chief Financial Officer
 
 
 
(Principal Financial Officer)
 
 
 
 
Date:
August 8, 2019
By:
/s/ Lola Bondar
 
 
 
Lola Bondar
 
 
 
Managing Director, Chief Accounting Officer
 
 
 
(Principal Accounting Officer)

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