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Edited Transcript of RWT earnings conference call or presentation 1-Aug-19 9:00pm GMT

Q2 2019 Redwood Trust Inc Earnings Call

Mill Valley Aug 10, 2019 (Thomson StreetEvents) -- Edited Transcript of Redwood Trust Inc earnings conference call or presentation Thursday, August 1, 2019 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Christopher J. Abate

Redwood Trust, Inc. - CEO & Director

* Collin Lee Cochrane

Redwood Trust, Inc. - CFO

* Dashiell I. Robinson

Redwood Trust, Inc. - President

* Lisa Hartman

Redwood Trust, Inc. - Senior VP & Head of IR

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Conference Call Participants

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* Bose Thomas George

Keefe, Bruyette, & Woods, Inc., Research Division - MD

* Douglas Michael Harter

Crédit Suisse AG, Research Division - Director

* Stephen Albert Laws

Raymond James & Associates, Inc., Research Division - Research Analyst

* Steven Cole Delaney

JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst

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Presentation

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Operator [1]

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Good afternoon, and welcome to the Redwood Trust, Inc. Second Quarter 2019 Financial Results Conference Call. (Operator Instructions) Today's conference is being recorded.

I'll now turn the call over to Lisa Hartman, Redwood's Senior Vice President and Head of Investor Relations, for opening remarks and introductions. Please go ahead.

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Lisa Hartman, Redwood Trust, Inc. - Senior VP & Head of IR [2]

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Thank you, Rob. Hello, everyone. Thank you for participating in Redwood's Second Quarter 2019 Financial Results Call. Joining me on the call today are Chris Abate, Redwood's Chief Executive Officer; Dash Robinson, Redwood's President; and Collin Cochrane, Redwood's Chief Financial Officer.

Before we begin, I want to remind you that certain statements made during management's presentation with respect to future financial or business performance may constitute forward-looking statements. Forward-looking statements are based on current expectations, forecasts and assumptions that involve risks and uncertainties that could cause actual results to differ materially. We encourage you to read the company's annual report on Form 10-K, which provides a description of some of the factors that could have a material impact on the company's performance and could cause actual results to differ from those that may be expressed in forward-looking statements.

On this call, we will also refer to both GAAP and non-GAAP financial measures. The non-GAAP financial measures provided should not be utilized in isolation or considered as a substitute for measures of financial performance prepared in accordance with GAAP. They are included to aid investors in further understanding the company's performance and to provide insight into one of the ways that management analyzes Redwood's performance.

A reconciliation between GAAP and non-GAAP financial measures is provided in both our second quarter earnings press release and Redwood review available on our website. Also note that the content of this conference call contains time-sensitive information that is accurate only as of today, August 1, 2019. The company does not intend and undertakes no obligation to update this information to reflect subsequent events or circumstances.

Finally, today's call is being recorded and will be available on the company's website later today. I will now turn to Chris over -- turn the call over to Chris, Redwood's Chief Executive Officer, for opening remarks and introductions.

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Christopher J. Abate, Redwood Trust, Inc. - CEO & Director [3]

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Thanks, Lisa, and good afternoon, everyone. During the second quarter, we demonstrated the strength and agility of our business model by delivering solid earnings on strong mortgage banking results as well as through our investment portfolio optimization activities. While a steep decline in rates, coupled with robust demand for yield had varying impacts on our business, we continue to make good progress on our strategic initiatives, scale our platform and implement operational efficiencies.

On a macro level, we saw some recurring themes from the first quarter, contributing to the broader market volatility, namely continued uncertainty around U.S.-China trade talks and speculation around Fed rate cuts, which, as you know, manifested just yesterday in a 25 basis point cut. Fed cited global trade tensions and downside risks from weaker global growth projections in its remarks.

Meanwhile, these global risks continue to contrast positive economic data for the U.S. economy with the lowest unemployment rates in 50 years and strength in consumer demand. Assuming the Fed may have some working knowledge of this Friday's payroll report, we aren't expecting any surprises that might have compelled the Fed to lower rates further. While we will continue to be responsive to near-term market conditions, we are playing the long game and believe we are well positioned to benefit from the shifts we see in the housing market.

Our second quarter GAAP book value remained stable at $16.01 per share, with GAAP net income covering our dividend. Our non-GAAP core earnings were $0.39 per share, up 8% from the first quarter. Our residential mortgage banking business benefited from the decline in interest rates, driving an almost 60% increase in loan purchase volume over the first quarter.

Additionally, gross margins exceeded our long-term target range. We are scaling our platform to grow profitably and the operational and capital efficiencies we achieved thus far in 2019 are benefiting our overall returns for this business. We continue to expand our reach across housing finance, with the second quarter marking our first full quarter of 5 Arches operating results. We are pleased with our progress as we deepened our market footprint in the business purpose lending space, and we continue to see a large market opportunity, driven by a fundamental supply-demand imbalance in housing.

With respect to capital, we have deployed $136 million of capital in new investments during the second quarter, but increased our net available capital after generating $243 million of capital through balance sheet optimization and sales of lower-yielding assets. We remain disciplined investors, given strong and in certain areas irrational market demand for yield and made the call to take some gains and wait for asset prices to become more attractive.

This didn't take long, as we deployed over $100 million into new investments in July alone. Dash and Colin will talk more about our operating results and capital position in their remarks. So I'd like to transition my remaining comments towards housing finance reform and some exciting changes we see unfolding. Over the last several months, we have dedicated a considerable amount of time working with leadership in Washington, demonstrate the private sector's ability to partner with the GSEs in providing solutions for a broad array of borrowers, including through non-QM loans.

In support of this work, in May, we published an extensive presentation on our perspectives on private capital and the so-called QM patch, which is the regulatory exemption currently enjoyed by the GSEs. In the presentation, we advanced a robust data-driven argument that if the patch was allowed to expire at a proper cadence, additional crowding in of private capital could occur in a safe and sound manner and benefit all stakeholders, including borrowers and taxpayers alike. Our presentation focused on potential solutions pertaining to the QM patch, highlighting that Redwood is ideally positioned and uniquely qualified to participate with the public sector in establishing a framework for non-QM lending on a level playing field.

As you all know, Redwood has led the private sector resurgence in housing finance since issuing the first post-crisis securitization in 2010. Our next securitization will actually be our 100th transaction, quite a feat for a private organization that received no stimulus or other taxpayer subsidies before, during or after the financial crisis.

Even on an unlevel playing field, the private sector has been financing an increasing share of certain market segments that have long been dominated by the GSEs, and we believe the private sector can speak for significantly more without a meaningful impact on rates available to borrowers. We presented this analysis to key policymakers in Washington, and so far have been incredibly encouraged by the feedback we've received. We were further encouraged just last week when the CFPB released a notice post 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 GSC patch. CFPB directors referenced to a more transparent level playing field that ultimately benefits consumers, speaks directly to the core of our May publication. More broadly, the Director of the Federal Housing Finance Agency has been regularly stating his determination to shift GSE market shares 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 GSC eligibility for certain loan products, such as high balance loans and our second home financings, requiring the GSEs to sell more first loss risk as part of their risk transfer programs or even raising GSE guarantee fees to create a more level playing field with the private sector.

In addition, the director has suggested changes to GSE's 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 for 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.

We have noted in the past 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 and the quality of the scores of the past several months, leaves room for more optimism than we have had in quite some time.

Before I turn it over to Dash and Colin, I'd sum things up by saying, we continue to make good progress executing on our strategic initiatives. We're entering the second half of the year with a healthy balance sheet, disciplined cost management and a portfolio built on strong credit performance. We will continue to be responsive to market conditions, while pursuing investments aimed at driving higher returns that can position us to support higher sustainable dividends and overall returns for shareholders.

With that, I'll hand the call off to Dash, Redwood's President.

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Dashiell I. Robinson, Redwood Trust, Inc. - President [4]

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Thank you, Chris, and good afternoon, everyone. The second quarter was marked by improved operating and capital efficiencies in our mortgage banking business, continued progress in expanding the scope of our platform. And as always, a focus on managing our risks through what proved a volatile macroeconomic environment.

As Chris noted, the sharp rally in rates, coupled with renewed demand for yield in the credit markets, created opportunities and challenges within our business model. Overall, we are pleased with our results and our ability to continue allocating capital in areas where we see potential for the highest risk-adjusted returns.

During the second quarter, we benefited from strong returns in our mortgage banking business, which drove growth in our overall core earnings per share. Falling interest rates provided a tailwind for loan purchase volumes, which totaled $1.6 billion, up almost 60% from the first quarter.

Importantly, we meaningfully increased loan purchase volumes with a capital allocation that remained relatively flat from the first quarter. Overall, capital utilization and mortgage banking is down 35% since the fourth quarter of 2018, when we purchased a similar amount of loans to this past quarter's volumes. This is the direct result of increased efficiencies in how we sell and securitize loans as well as more favorable financing terms on our associated warehouse lines.

For the second quarter, gross margins in mortgage banking exceeded our long-term target range for both securitization and whole loan sale execution. The demand for whole loans remains robust, and we expect to continue using a balanced approach in our loan distribution efforts. During the quarter, we completed one Select securitization of $400 million and sold $800 million of whole loans to third parties. The mix of Select and Choice loan lock volumes was consistent with the first quarter and second quarter Choice loan lock volumes were up 30%, representing the second highest quarter for lock volumes since the program's inception in 2016. Increased efficiency and deep diversified sourcing and distribution channels continued to be the pillars of mortgage banking's earnings power. In markets such as these, where demand for responsibly underwritten mortgage credit far outstrips supply, these hallmarks resonate powerfully for our overall business model.

Turning to our new operating platform. We continue to make good progress in the business purpose lending space and are pleased with the early returns on our 5 Arches integration efforts. During the second quarter, the 5 Arches platform produced attractive loans for our portfolio as we remain focused on originations that drive superior risk-adjusted returns, including single-family rental loans and further development of small balance multifamily and other bridge loans [eat] around rental demand.

Overall, DPL originations for the quarter totaled $175 million. In particular, we continue to grow our single-family rental pipeline with our increased market penetration efforts bearing fruit as we continue to execute for these borrowers. Additionally, we continue to evolve the production mix for short-term bridge loans. The completion of more efficient financing structures for these loans drove attractive cash-on-cash returns for the portfolio during the second quarter. We are now purchasing close to 100% of loans produced by the 5 Arches platform, but continue to assess alternative avenues of distribution to the extent they represent better overall execution for certain segments of our originations.

While overall volumes in the second quarter were slightly below our expectations, production since quarter end has increased as we continue to execute on the pipeline, supportive of higher run rates in the second half of the year. Today marks 5 months since we completed the 5 Arches acquisition. We are pleased with all that we have achieved in that relatively short period of time. And while more work remains, the overall integration process is on schedule, and we are more convicted than ever about the competencies of the platform, given the secular trends we see in housing.

Turning to our investment portfolio, a tightening bias in credit spreads during the second quarter constrained overall purchase activity, and our capital deployment was highlighted by [sticker] investments and more proprietary opportunities. Specifically, our $136 million of deployment, included a $75 million investment in a Freddie Mac multifamily B-piece, our fourth overall and an additional $25 million allocation to loans originated by 5 Arches. We exited the second quarter optimistic about prospects for further deployment in key strategic areas, including multifamily securities, Choice loans, reperforming loan securities and business purpose residential loans.

July represented a strong start to the second half of the year, with over $100 million in deployment, including $75 million to our second investment in subordinate reperforming loan securities issued by Freddie Mac. The second quarter proved to be an opportune time to continue organically generating investable capital. We were aggressive in locking in gains across the book through security sales and in procuring attractive financing on previously unencumbered securities.

In total from these activities, we netted $243 million of capital for redeployment. And in the process captured $16 million of realized gains. Security sales were focused in subordinate CRT securities, many of which we sold at substantial premiums to par value, notwithstanding the rally in rates.

In addition, we completed a financing arrangement on a portion of our multifamily securities. And as noted earlier, secured incremental leverage on our business purpose lending investments, meaningfully improving returns in these areas. Increased hedging costs, driven by the rate volatility, impacted second quarter returns for certain segments of our portfolio, specifically jumbo loans financed at the Federal Home Loan Bank and mortgage servicing rights we create through our Sequoia securitization activities.

Higher realized prepayment speeds compressed economic net interest income in these portfolios.

So the substantial seasoning of the loans financed at the Federal Home Loan Bank led to a more muted pickup in prepayment speeds versus what we observed broadly across newer vintage mortgages. We actively hedged these portfolios and recently added optionality to our hedge position, which has proven helpful thus far. Our overall book value stability during the quarter reinforces the positive credit convexity of our portfolio and underlying intrinsic value that doesn't always show up in mark to markets. Elevated prepayment speeds, coupled with continued strong credit performance, bring us closer to unlocking the discounts at which we hold many of our securities.

Pro forma, this leaves us holding thicker slices of the capital structure, that, over time, are well positioned to benefit from continued delevering over time. Now to recap our financial results, I'm going to turn it over to Colin.

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Collin Lee Cochrane, Redwood Trust, Inc. - CFO [5]

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Thanks, Dash, and good afternoon, everyone. To summarize our financial results for the second quarter, our GAAP earnings were $0.30 per share compared with $0.49 for the first quarter, and core earnings were $0.39 per share compared with $0.36 in the first quarter. The decrease in GAAP earnings in the second quarter was primarily driven by a reduced benefit from spread tightening to investment fair value changes and lower realized gains from the sales of available for sale securities. Core earnings increased in the second quarter, driven primarily by higher residential mortgage banking results, which benefited from higher volumes and stronger margins as well as higher overall realized gains that resulted from increased portfolio optimization.

While increased portfolio optimization benefited gains during the quarter, growth in economic net interest income was dampened due to a higher average balance of undeployed capital, as there are more opportunities to sell assets and harvest gains than there were to deploy capital at attractive risk-adjusted returns.

Economic net interest income was also impacted by the sharp decline in rates during the quarter, which negatively impacted certain segments of our portfolio, more sensitive to interest rates and prepayments. While we hedge our investment portfolio to insulate us from changes in rates, in periods of elevated rate volatility, we can experience increased hedging costs as we did in the second quarter. Our GAAP book value increased during the second quarter to $16.01 per share, which along with our dividend, contributed to a 1.9% economic return for the quarter. Book value remained stable as GAAP earnings covered the dividend and increases in the value of available for sale securities from spread tightening were mostly offset by a decrease in the value of our long-term debt hedges.

As Dash discussed, the second quarter marked our first full quarter of integrated operating results from 5 Arches, which we report as a component of our mortgage banking segment. Exclusive of amortization of purchase intangibles, our business purpose mortgage banking platform generated about $6 million of gross income, with around $6 million of expenses, resulting in breakeven core results for the second quarter.

We expect origination volumes to increase in subsequent quarters, which should drive higher mortgage banking income from this platform, and we expect this level of expenses to represent a reasonable run rate for the near term. Turning to the balance sheet and our capital position. We ended the quarter with approximately $200 million of available capital. This was an increase from the end of the first quarter as capital generated from our portfolio optimization activities outpaced the capital we deployed during the quarter.

As Dash mentioned, in addition to security sales, we also generated additional capital for new and incremental financing we added to segments of the portfolio during the quarter. After the inclusion of this new financing, we ended the quarter with about $640 million of unencumbered securities. Moving into the second half of the year, we believe our available capital, along with additional capital from continued portfolio optimization, should be sufficient to meet our near-term needs and provide us with flexibility as we approach November maturity of our $201 million of exchangeable debt.

While the capital markets are open to us to refinance this upcoming maturity, we are evaluating all of our options and are focused on how we could fund our business most efficiently, including through the utilization of our unencumbered securities. On a related note, regarding leverage, our recourse debt-to-equity leverage ratio was 3.1x at the end of the second quarter. The increase from the first quarter was driven by the incremental financing our investment securities and BPO loans, which increased available capital, and over time, will contribute to higher risk-adjusted returns for the portfolio.

We expect our leverage to further increase as we continue to deploy capital and optimize our balance sheet. Over the longer term, we expect to operate with a recourse leverage ratio closer to our historical average of around 3.5x. I'll close with an update on our 2019 financial outlook. Our results for the first half of the year, which included strong performance from our mortgage banking operations and elevated gains from portfolio optimization activities have put us on track to generate returns near the high end of the overall range we initially provided in the beginning of the year.

For the remainder of 2019, we expect gains from portfolio optimization to moderate and for our residential mortgage banking platform, we expect gross margins to normalize more in line with our long-term target of 75 to 100 basis points and for volume growth to stabilize, subject to normal seasonal fluctuations.

We also expect returns from our business purpose mortgage banking platform to improve as integration activities subside. Further details on our outlook are provided in our second quarter 2019 Redwood review.

And with that, I'll conclude our prepared remarks. Operator, please open the call for Q&A.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question is coming from the line of Stephen Laws with Raymond James.

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Stephen Albert Laws, Raymond James & Associates, Inc., Research Division - Research Analyst [2]

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A couple of things seem to be going really well for you guys. And so I want to touch base on that as far as volumes. And interesting with the comment about monetizing some gains. And I guess looking for investment opportunities in the second half. But Chris, when you think about volumes and rate, if you freed up some capital in anticipation of an expected pickup in volume, given refinance activity is increasing. And I guess coupled with that, is there a specific rate that you're watching where you think refinance activity really turns on, if we hit a certain number? I think as one person, I saw in the media, put it the other day, originators that may be open 1 bottle of champagne, but not the entire case yet. I'm curious, at what level do they open the whole case?

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Christopher J. Abate, Redwood Trust, Inc. - CEO & Director [3]

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I think providing a specific number will just get me in trouble. So what I'll say is, we definitely -- we definitely expect this refinance cycle to continue for the foreseeable future. Obviously, as of yesterday, a 4-year period of tightening ended at the Fed. So we saw a rate decline there. And directionally speaking, on the follow rates appear poised to continue to go further down. So we certainly expect to see more refinance activity.

A lot of what we saw had been some of the higher coupon loans originated late last year. What you could start to see is more and more cohorts start to refi. Anecdotally, we're starting to see that, but we don't have enough data yet to say definitively how much. As far as raising capital is concerned, really, I think the way we describe it is we're playing a long game here, Stephen, and asset prices in many of our focus areas were just irrationally high in the second quarter, record tight credit spreads, in some cases.

So from our perspective, we didn't see some of the opportunities we had hoped to, and we ended up basically taking some gains.

I think at this point, we are seeing more and more opportunities. I mentioned that our July investment activity was fairly elevated, at over $100 million. So to me, freeing up the capital was more opportunistic than it was for any specific investment or strategy.

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Stephen Albert Laws, Raymond James & Associates, Inc., Research Division - Research Analyst [4]

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Great. Touching on GSE reform, I appreciate your prepared comments, and I really appreciate how public you guys have been providing information on your website around potential opportunities of what may happen. And now that we've gotten some commentary, I guess, about 10 or 12 days ago about the QM patch expiration. Clearly, they're not going to dump $150 give-or-take-billion or $185 billion I think you sized it, on the market on day 1. So how would you and Redwood -- how would Redwood Trust like to see that play out with the expiration?

Is there a way to slowly let the patch expire in steps? Or how do you -- how would you like to see that play out as that occurs?

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Christopher J. Abate, Redwood Trust, Inc. - CEO & Director [5]

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It's a great question, Stephen, and we are going to follow-up that May publication with an update that we'll attempt to answer some of these -- some of these questions. But I think in the last publication, we provided some heat maps. And a major point that we tried to make in Washington is many folks have framed this problem as insurmountable. And you talk about $150 billion or potentially more annually and how can the private market possibly absorb that? But the reality is, there's no market that could absorb that much volume overnight.

And what we've tried to provide through heat maps is really framing out the different aspects of non-QM and when you look at the patch universe, the vast majority of these non-QM loans are not sub-prime loans. These are loans where the private sector is either right on top of or through the GSEs today. You can see from our choice deals and other securitizations, how much demand there is for non-QM loans in the market.

And so I think if you focus on the different subsets or the different cohorts of the non-QM universe, you could really very gradually solve this issue. I think it's a very, very solvable issue. And I personally, from what we've seen with the data, there has not been a discernible difference in rate for the vast majority of non-QM borrowers. So we're very happy to see everybody on a level playing field. We're not advocating for any advantages by any stretch. We'd just like to see everybody with the same ATR requirements as well as risk retention.

So that's a big -- that's going to continue to be a big focus for us in Washington going forward.

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Stephen Albert Laws, Raymond James & Associates, Inc., Research Division - Research Analyst [6]

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Great. I look forward to that next deck, you guys provide -- look forward to seeing that. Lastly, first full quarter under the -- in the books now with 5 Arches. I think if I remember from the Analyst Day earlier this year, about 40% of your capital may be invested in asset classes, credit investments that are relatively new in the last 3 to 5 years.

Can you talk about any other pockets of residential credit assets that you're looking at that maybe aren't in the portfolio? Are there things you're identifying? I know the business purpose loans and figure out the financing side of that equation has kind of been what you worked on lately, but any new assets we should think about as investment opportunities as we look out over the next 12 or 18 months?

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Dashiell I. Robinson, Redwood Trust, Inc. - President [7]

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Yes. Stephen, this is Dash. We're always assessing that. I would say most of our energy is focused at this point on trying to go deeper with the more nascent areas we've already deployed capital. One of the things we -- like I said in the prepared remarks have become more convicted on is just how much green space there is out there in the business purpose lending area. When you combine dynamics in single-family housing stock, rental demand and deferred maintenance, demand for multifamily units in general and how that--how that really is consistent with natural support levels in the market in terms of supply-demand imbalance, consumer demand, things of that nature.

We think we're really in the very, very early innings of product development there and market penetration and really feel like there will be a lot more to say in the coming quarters and years, hopefully about how we continue to evolve the product development there. Beyond that, it's obviously continuing to look on the consumer side at the effectiveness in the market of Choice. Redwood Choice is a product that's now almost 4 years old, and has always evolved to try and meet the -- what we see is the needs of deserving consumers in the marketplace and what our loan sellers are telling us is in demand in the market and what we feel like we can originate prudently and safely.

So I think it's more of those things, there's always stuff that we're assessing and trying to keep our eyes on in other areas. But I would say, the real energy, the real calories we're burning at this point are really trying to go deeper with the newer areas that we're in at the moment.

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Operator [8]

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Our next question is from the line of Bose George with KBW.

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Bose Thomas George, Keefe, Bruyette, & Woods, Inc., Research Division - MD [9]

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Where are you guys currently seeing the best incremental returns? And also just in the Freddie Mac, the multifamily BP business, I was just curious, just how -- are you willing to or interested in getting a lot bigger? And that seems like some attractive opportunities there.

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Dashiell I. Robinson, Redwood Trust, Inc. - President [10]

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Yes, Bose, this is Dash. I'll go in reverse order. We just closed our fourth, early in the second quarter, and we're actively assessing more opportunities there. As of the end of the second quarter, our capital allocation was about 7% there, that's something I would expect to continue to grow over time. As we mentioned in the prepared remarks, we did put a little bit of leverage on some of the securities, which had previously been unencumbered.

So the capital allocation actually went down a little bit quarter-on-quarter for that reason. But those -- that broader housing thesis, combined with, frankly, a fantastic track record in Freddie Mac's multifamily program. Over the last many years, coupled with what we feel is a very strong strategic relationship with Freddie Mac, as manifested by what we're purchasing on the BP side, but also the light rehab fund that we participated in earlier in the year. These are all investments that are the result of what we feel is a really good partnership rather than just a bid on the screens.

And so we will certainly continue to try and allocate more. I won't put a number on it, but that's an area that's very central to our strategy in terms of being able to source unique investments that, again, are essential to what we're seeing in housing. Besides that, the business purpose lending space, we talked a lot about that, we are certainly intending to commit more capital into those areas and to what 5 Arches is producing.

I did mention in the prepared remarks that we put incremental $75 million to work on the single-family reperforming loan securities that Freddie Mac issued. We're thrilled to participate in our second one of those transactions, that will close later in the third quarter. So we're excited there. And the unique opportunity with those sorts of investments is not only what we view as positive credit trends in the underlying, but the attractiveness of the financing that Freddie Mac provides is very helpful for us with our capital structure.

So I would say those are the areas. And of course, choice, the loans on a risk-adjusted basis, continue to offer very much compelling returns to us.

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Christopher J. Abate, Redwood Trust, Inc. - CEO & Director [11]

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This is Chris. One other area, it's still early, but we find interesting or having a lot of conversations about is the end of the year when CECL becomes effective, just what that means for regional banks, especially and certain aspects of bank portfolios that are no longer efficient to hold so that's an area that we see on the horizon. It's impossible to scope at this point, but we have been having some interesting conversations, and would look to provide solutions there if the opportunity manifests itself.

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Bose Thomas George, Keefe, Bruyette, & Woods, Inc., Research Division - MD [12]

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Okay. That's interesting. So residential loan portfolios, largely, is that right?

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Christopher J. Abate, Redwood Trust, Inc. - CEO & Director [13]

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Yes.

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Bose Thomas George, Keefe, Bruyette, & Woods, Inc., Research Division - MD [14]

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Okay. That's great. That's interesting. And then actually, one just housekeeping question. The expectation for operating expenses going forward, can I just get thoughts on that?

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Collin Lee Cochrane, Redwood Trust, Inc. - CFO [15]

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Yes. I mean I think the level that we saw for this quarter, Bose, is probably a reasonable run rate. The number that moves around every quarter is variable comp, and that's tied to our GAAP results, and so that could kind of bounce up and down depending where that moves quarter-to-quarter. But I think this quarter, now that we had a full quarter of 5 Arches in there kind of represents a pretty good run rate for the next couple of quarters here.

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Operator [16]

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Our next question is from the line of Steve Delaney with JMP Securities.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [17]

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Congratulations on a solid quarter, both financial and operational. Collin, just to pick up on Bose's question. I had in my notes when I was prepping for your release, I had written down incremental expenses relative to 5 Arches of like $4 million to $5 million a quarter. And then I was delighted to see when -- in your -- on the Redwood review on Page 8 that it went to [26] from [23], and that's consistent with what I think you just told Bose. Did I--did I just -- the $4 million to $5 million that I had, was that just an inaccurate figure? Was that a figure that maybe you had out there earlier before you really got your hands on everything?

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Collin Lee Cochrane, Redwood Trust, Inc. - CFO [18]

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Yes. I'd have to go back, and I'm trying to recall the number you're referencing from last quarter. So I'm not recalling that right off hand, but the number we have in here is what we think represents the run rate at this point. And I think that is in line with basically what our expectations were.

So again, I'd have to go check what number you're looking at from last quarter, but...

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [19]

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I'll follow-up...

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Christopher J. Abate, Redwood Trust, Inc. - CEO & Director [20]

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I was going to say, Steve, some of that may be a function of in Q1, we had one month worth of 5 Arches expenses versus 3. So you're seeing a little bit of an incremental. So it's not like Q1 versus Q2, we made a full quarter worth of expense. So I think the delta between the [23] and the [26] may be a function of the fact that it's partly because we basically took 1/3 of a quarter's worth of expense in Q1 for 5A, and obviously a full quarter in Q2.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [21]

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Yes. Got it. Okay. And again, Collin, sorry to pick on you, but I was writing when you were talking about 5 Arches and the integration, did you imply that it was roughly breakeven in the quarter?

I thought I heard you say?

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Collin Lee Cochrane, Redwood Trust, Inc. - CFO [22]

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Yes. So...

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [23]

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You weren't specific about a number.

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Collin Lee Cochrane, Redwood Trust, Inc. - CFO [24]

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-- purchased intangible amortization, which we back out for core purposes. Excluding that, it was just around breakeven for the quarter. And I think I noted, we obviously expect that number to go up, I think that was impacted a little bit by some of the integration activities we've been focused on, but based on what we're seeing coming down the pipe, we do expect that to start to move up here beginning next quarter.

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Christopher J. Abate, Redwood Trust, Inc. - CEO & Director [25]

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One of the things, Steve, just to reemphasize there is those numbers don't reflect the benefits of the investments created by the platform. So in the prepared remarks, I was referring to the strong cash-on-cash returns from the shorter-term bridge loans. Those cash-on-cash returns are in the mid-teens. Those are all reflected in the investment portfolio.

And yes, you don't get the -- we break it out the way we do because we think it's the right way to do it. We obviously need to assess the operating metrics independently to measure outcomes. But if you look at the overall contribution of the business, it's important to include the really attractive cash-on-cash returns of the portfolio, that these investments are spitting off.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [26]

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Yes. Understood. Understood. We could probably say the same thing with your Sequoia securitization program as well. A lot of overhead -- it takes a lot of overhead to create those securities, but it pays dividends for quite a while. So I hear where you're going on that.

The gross margin on mortgage banking, you gave us, I think, a $174 million in the first quarter, I'm calculating $142 million. Is that in line with the way you guys see it? I just took that from the mortgage banking page, in the review.

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Dashiell I. Robinson, Redwood Trust, Inc. - President [27]

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It sounds a little high, Steve.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [28]

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Okay.

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Dashiell I. Robinson, Redwood Trust, Inc. - President [29]

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But it's -- we were certainly beyond our 75 to 100 this quarter. I think it was probably closer to 117 or 120.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [30]

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Okay. Got it. Okay. Yes. Now I had the interest income in there as well, not just the $19 million, but I was using $24 million as the numerator. I think it's -- okay, because I got $117 million the first time I ran it too. And then I said, I think, we -- the $174 million was based off, including net interest income and the direct mortgage banking contribution. And just one follow-up...

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Collin Lee Cochrane, Redwood Trust, Inc. - CFO [31]

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Let me -- real quick -- just one thing I might point out that might help with that. I'd have to check these numbers, but now that we have 5 Arches included in mortgage banking. If you just take the total mortgage banking, and you're taking that over the loan purchase commitments, that's going to give you a little higher number. In the Redwood review, we do break out between the platforms within mortgage banking, residential and business purpose.

So if you look at residential, mortgage banking income, I think you'll get to the number Chris was referring to that, that could be part of the issue there.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [32]

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Okay. Just have to get deeper into the review. I was just working on Page 12. And just one final thing. I know I've kind of been all over the Board here. But Dash, I mean your comments about whole loans. I'm hearing -- kind of hearing you guys say that it's kind of a best execution situation. I mean you did do one securitization, your brand is important for -- not only for you but for the industry.

So I'm sure you guys will continue to have a presence each quarter in the market. But clearly, this quarter, you tilted towards whole loans. And to that end, Annaly was very clear. They talked a lot on their call about their own securitization program. And I'm not asking specifically about Annaly, but that's a potentially a very big buyer. Are you seeing fresh, nonbank type of issuers or potential issuers coming in? In other words, the universal buyers, do you sense that, that is expanding as more people like Annaly or others are just looking to find yield in the market?

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Christopher J. Abate, Redwood Trust, Inc. - CEO & Director [33]

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Steve, I'll take that one. One thing -- one thing we do expect, as these -- as the QM patch exploration approaches, we would logically expect to see new issuers enter the market and some potentially might to break into the market, do things unprofitably for a period of time, which wouldn't be totally irrational, if a big opportunity is foreseen.

As far as today, currently, what we don't see is correspondent networks like we built. So there's a lot of bulk purchase activity with whole loan pools. We obviously were a big whole loan pool seller during the quarter. So we are seeing some folks who are buying pools of loans from a finite amount of -- or a smaller number of originators. But we haven't seen anybody particularly doing what we do. That said, to reiterate, I would expect to see more issuers as the QM patch expiration nears.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [34]

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Yes. Got it. Frankly, I don't think there are a lot of people that have the appetite to do the hard -- heavy lifting that you guys did to build what you built. I mean we've had a lot of people try and fail, as you know, over the years, and just shut it down. So good work. So I think there's more capital looking at it, than there are people trying to lease buildings and hire people is kind of where I see it going. So listen, thank you for all the comments, and we'll chat later.

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Operator [35]

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(Operator Instructions) The next question is from the line of Doug Harter with Credit Suisse.

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Douglas Michael Harter, Crédit Suisse AG, Research Division - Director [36]

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On your commentary that you expect the -- on the gain on sale revenue to come down to the normal levels. Is that something you've seen in July? Or is that just -- that's just kind of what you've seen over the long term. And over time, you expect that to happen?

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Collin Lee Cochrane, Redwood Trust, Inc. - CFO [37]

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Yes. I don't think that's necessarily based on anything we've seen in July. I mean every time, every quarter, the pricing basically resets, and that's generally the range that we're targeting, so we generally expect to earn something in that range. That's obviously dependent on how the market performs and where we can execute on securitization, all-in sales throughout the quarter, but that's generally the range we're targeting.

In the last couple of quarters, we -- from -- when we buy the loans, when we execute on the sales. We've seen some improvements in the performance and the demand on the bid side, which has helped us realize some higher returns there.

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Douglas Michael Harter, Crédit Suisse AG, Research Division - Director [38]

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All right. And Chris, just operationally, I guess, where are you in terms of kind of preparedness if the QM patch kind of expires, kind of as the CFPB kind of lays out, what do you need to do? Are there incremental kind of cost that you would need to add over the course of this year? And kind of what further signals are you looking for to know whether to sort of pull those levers?

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Christopher J. Abate, Redwood Trust, Inc. - CEO & Director [39]

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Sure. It's a good question. I think the one thing that we feel extremely good about is our distribution platform. So between whole loan sales and securitization, there's nobody in the private sector that has what we have.

We've got great capacity and enormous investor base to be able, I think, to be able to facilitate significantly more volume. As far as the transition goes, we would expect to spend a lot of time focused on the front end of the business. The QM patch loans that are getting done under the patch today are going through Fannie and Freddie's automated underwriting systems, which is a lot different than how the jumbo market, for instance, works today.

So we would expect to ensure that we're prepared to manage that transition with the loan officers so you could see a coordinated effort, certainly, on the training front, but also on the systems front. So we don't have an estimate. And like anything in Washington, we're a trust-but-verify approach here. So we like to see -- we'll get through the comment process with the CFPB, and we'd like to see a continued momentum here. But we will be prepared if the opportunity comes.

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Operator [40]

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We've reached the end of our question-and-answer session, and that will also conclude today's conference. You may disconnect your lines at this time. We thank you for your participation.