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Edited Transcript of RWT earnings conference call or presentation 3-Aug-17 9:00pm GMT

Thomson Reuters StreetEvents

Q2 2017 Redwood Trust Inc Earnings Call

Mill Valley Aug 13, 2017 (Thomson StreetEvents) -- Edited Transcript of Redwood Trust Inc earnings conference call or presentation Thursday, August 3, 2017 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. - President and CFO

* Kristin Brown

* Martin S. Hughes

Redwood Trust, Inc. - CEO and Director

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Conference Call Participants

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* Brocker Clinton Vandervliet

Nomura Securities Co. Ltd., Research Division - Executive Director

* Eric J. Hagen

Keefe, Bruyette, & Woods, Inc., Research Division - 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 2017 Earnings Conference Call. (Operator Instructions)

I would now like to turn the conference over to Kristin Brown, Vice President of Investor Relations. Please go ahead.

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Kristin Brown, [2]

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Thank you, Anne. Good afternoon, and thank you for joining us to review Redwood Trust second quarter 2017 quarter earnings report. Before we begin, I wanted to remind you that certain statements made during management's presentation with respect to future financial or business performance may constitute forward-looking statements. Forward-looking statements are based on current expectations, forecasts and assumptions and 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 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 the Redwood Review, which is available on our website redwoodtrust.com.

Also note that the content of this conference call contains time-sensitive information that is accurate only as of today, Thursday, August 3, 2017. The company does not intend and undertakes no duty to update this information to reflect subsequent events or circumstances. Finally, today's call is being recorded and will be available on the company's website later today. For opening remarks and introductions, I will now turn the call over to Marty Hughes, Redwood's Chief Executive Officer.

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Martin S. Hughes, Redwood Trust, Inc. - CEO and Director [3]

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Good afternoon, everyone. Thank you for participating in Redwood's second quarter 2017 earnings call. Joining me on the call is Chris Abate, Redwood's President and CFO. Following my remarks on our key financial metrics and accomplishments of the second quarter, Chris will discuss the quarter's investment and residential mortgage banking activities and in detail our financial results.

The second quarter was another productive one for Redwood. We put more capital to work, completed our fourth securitization of the year and our fifth early in the third quarter. We purchased some of our convertible debt at attractive levels and built additional momentum for our Redwood Choice loan program. We anticipated moving towards completing our first Choice securitization sometime late in the third quarter possibly early in the fourth quarter. In terms of our quarterly financial results, our debt book value increased to $15.29 at June 30 from $15.13 at March 31. Our GAAP earnings per share were $0.43, consistent with the first quarter and our non-GAAP core earnings per share were $0.35 versus $0.36 for the first quarter. Overall, we say the second quarter looked a lot like the first quarter, especially in terms of market conditions. Investor confidence remains bullish; volatility was subdued; credit spreads continue to tighten; and asset prices continued to climb to new highs. And all this in spite of ongoing drama down in DC, heightened geopolitical risk and a tepid pace of economic growth, and tightening action and talk by the Fed. Against this backdrop, we feel good that we aggressively added to our investment portfolio earlier in the year and also the tighter spreads have benefited the execution on our recent Sequoia securitization program. Through July, we have securitized almost $2 billion of loans, almost doubled our volume in 2006 -- 2016. Others in the marketplace have taken notice in RMBS market issuance volume through July has already eclipsed the activity for all of last year. There are benefits to us with new market entrants, namely a bigger and more liquid market, as well as more issuance of additional third-party securities that we could possibly acquire a key aspect of our overall investment strategy. While the recent RMBS market has been the most robust we've seen since 2013, I would like to touch on some recent development in litigation surrounding pre-crisis, legacy RMBS transactions. In June, 20 legacy RMBS deals with Wells Fargo as trustee were subject to a cleanup call. Despite being called at par, Wells held back more than $90 million from bondholders to cover its anticipated litigation cost as a trustee.

While we incurred a GAAP loss of about $500,000 on one of our legacy RMBS positions in the second quarter, as a result of the total holdback, our overall cash shortfall was $1.1 million. Important to note, that less than 1/10 of our legacy securities have exposure to this trustee. We believe the probability of a holdback materially affecting our position is low, since many of the securities are either not part of the ongoing trust litigation or are from a RMBS transaction that are not at this point in time economically callable. It is unclear at this point if other legacy RMBS trustees will adopt this practice, but from the same reasons we believe the probability of a holdback materially affecting our positions is low. We also don't believe our new Sequoia securitizations are vulnerable to similar trustee action because the new transactions contain structural protection for investors, contractual clarity on the trustee and other deal participants responsibilities and the due diligence performed prior to issuance to provide investors with upfront transparency on the risk. Most importantly, the overall credit quality is far better with full documentation underwriting, high FICO scores and low LTVs. Our most recent Sequoia transaction in July, priced after the holdback announcement by Wells Fargo and was not negatively impacted in its overall execution. We have provided additional background in this quarter spread with review and we're happy to give you further thoughts and our opinions during Q&A. So in conclusion, we feel good about our process during the first half of the year, underlying credit performance in our portfolio remain strong, our capital position is ready to take advantage of opportunities and our Sequoia and possibly Choice activity, we hope continues into the near-term future. We would note though, we still believe we are likely on at the outer bounds of spread tightening in this cycle. And while the prospect of return in market conditions are widening of credit spreads may negatively impact our near-term earnings and book value, we would welcome the prospect of being able to opportunistically acquire cheaper assets given our stronger capital position.

I will now turn the call over to Chris Abate, Redwood's President and CFO.

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Christopher J. Abate, Redwood Trust, Inc. - President and CFO [4]

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Thanks, Marty. And good afternoon, everyone. I'd like to start up as usual with our recent investment activity. We deployed $78 million of capital into new investments in the second quarter, and $236 million year-to-date. Despite competitive asset pricing, we continue to find pockets of attractive opportunities, including investments in Sequoia and third-party RMBS as well as residential CRT and agency multifamily securities. We also sold $72 million of securities and substantially all of our remaining conforming MSRs during the second quarter, bringing our $79 million of capital for reinvestment after repayment of the associated debt. Our capital available for investments is roughly $180 million at June 30. And we can potentially source additional capital for redeployment as needed through the continued optimization of our investment portfolio. For the second quarter, this included selling our conforming MSRs, financing our multifamily securities, which were previously held with equity and selling certain securities where the current market yield was below our cost of capital as a result of a very favorable pricing environment.

Overall, we were pleased with the performance of our investment portfolio during the second quarter. Our portfolio net interest income increased, driven by capital deployment in the first half of the year and the underlying credit performance of our investments remain very strong. Our investment portfolio represented $1.6 billion or about 90% of our $1.8 billion of total capital at June 30. The remaining 10% was allocated to residential mortgage banking, which had a strong first half of 2017. Our expanded prime Redwood Choice loan program continues to represent the most significant area of growth for our conduit. The second quarter lock volume for Choice loans increased almost 30% from the first quarter and accounted for about 20% of our total loan purchase volume in the second quarter. Rates and Choice loans continue to be approximately 100 to 125 basis points higher than rates in our traditional Select loans. Given the more attractive yield profiles, we are now accumulating almost all Choice loans for investment and plan to complete our first Choice securitization later this year. If successful, we believe that a Choice securitization program has the potential to create large credit investments for Redwood going forward. As for the our Select loan program, we completed our fourth Sequoia transaction in June and our fifth in July. Margins remained above our long-term expectations of 75 to 100 basis points, although lower relative to the first quarter. As new issuers emerge in RMBS, it will likely continue the upward pressure on loan prices and mortgage banking margins should veer towards our normalized long-term expectations. We still expect overall purchase volume levels in the $5 billion to $6 billion range in 2017, and estimate that the effective tax rate on our mortgage banking income would be approximately 25% to 30% in the second half of the year.

Now turning to our financial results for the second quarter. Our GAAP book value increased to $15.29 per share at June 30 from $15.13 per share at March 31, driven primarily by our quarterly earnings, exceeding our dividend and higher fair values on our available-for-sale securities. Our GAAP earnings were $0.43 per share consistent with the first quarter. Core earnings for the second quarter were $0.35 per share as compared with $0.36 per share for the first quarter. Net interest income increased due to capital deployment, offset by lower realized gains and mortgage banking margins, relative to the first quarter. Although our recent earnings run rate is trended above our annualized 2017 expectation, we are sensitive to the potential for sell-off in asset prices, that could impact earnings in the second half of the year. This did not occur in the second quarter, but as Marty mentioned, we still believe we are likely on the outer bounds of spread tightening in the cycle.

Turning to the balance sheet. Our recourse debt-to-equity leverage ratio was 3.1x at June 30, up from 2.7x at March 31. The increase was primarily related to higher warehouse borrowings as a result of higher balance of loans in inventory as compared with the first quarter. Additionally, as I noted, we financed our multifamily securities with the repurchase facilities during the quarter, opportunistically taking advantage of favorable financing terms, while still remaining within our target level of leverage. We also continue to fully utilize our $2 billion of borrowing capacity at our FHLB member subsidiary, with a weighted average maturity of approximately 8 years and a weighted average cost of 1.1% per annum. We repurchased $37 million of our convertible debt during the second quarter and had $250 million of remaining convertible debt and $201 million of exchangeable debt due in 2018 and 2019, respectively, at June 30. We were actively evaluating our options respect to these upcoming maturities.

And that concludes my prepared remarks. Operator, we are ready 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 comes from 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 [2]

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Guys, I'm sure you probably noticed you've been around in this business long time, as I have. And we have had more capital raising done by mortgage REITs in the first half of this year than I think we've had since 2011. 12 follow ons, $2.9 billion. As I hear you speak about your business, I come away with 2 observations: One, you have ample dry powder of $180 million and that your biggest challenge with the credit spread tightening is to find a place to put the $180 million, not another amount of money that you might want to raise. I'm just curious, your thoughts, Marty, you're saying you think we are at the extreme tights, and I guess, what I'm -- I'd like your thoughts on -- you've been around the industry a long time. This capital being deployed, whether it's in commercial, whether it's in agency MBS, it doesn't sound like that something that Redwood Trust would -- you don't view the market as one in which to double down on. I think is where I'm going.

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Martin S. Hughes, Redwood Trust, Inc. - CEO and Director [3]

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Okay. There are couple of parts to it. I mean, one thing when we think about capital, you're right. One of the first things is what are the opportunities. But the second thing we need to ultimately balance with is the convert that we have coming due in April next year, which is the principal amount of $250 million. So that would be one consideration that we would have. And the second would be, what we would need for business, but at the moment you're correct, we have capital.

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Christopher J. Abate, Redwood Trust, Inc. - President and CFO [4]

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I'd also add Steve. We have invested about $274 million year-to-date. We've also have some sales, we sold just over $100 million. So from an investment pace, we're still on track to deploy our excess capital. So from that perspective, we continue to do long-term planning for capital. And as Marty said, we've got to remain conscious of these upcoming maturities.

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Martin S. Hughes, Redwood Trust, Inc. - CEO and Director [5]

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And (inaudible)

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [6]

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Sure. And I would not. Yes, sir. Go ahead.

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Martin S. Hughes, Redwood Trust, Inc. - CEO and Director [7]

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Another consideration is, if we were able to complete a Choice securitization later on, the amount of capital that we would use towards those securitizations from an investment standpoint would be a lot higher than it would be for a normal Sequoia.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [8]

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Got it. Yes, no, definitely I would think the dealing with a debt maturity is an entirely different strategy with capital -- or for capital, more appropriate, use for capital than possibly just chasing the market if you will, is where kind of I was going, because I clearly heard you guys say that other than your own securitization program and obviously, hopefully, Choice has a even higher return profile than Select. You don't see a lot of CUSIP stuff to buy or in the market that would -- that has attractive returns it would seem. So I appreciate your...

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Martin S. Hughes, Redwood Trust, Inc. - CEO and Director [9]

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It could be third-party securitizations that we could participate. But in terms -- you're right, in terms of legacy CUSIP's, there is a melting ice cube.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [10]

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Yes, that's what we're hearing broadly. I'm curious one part of it, your program, your jumbo program and your relationship with Chicago was the MPF Direct and I was wondering if you could just give a brief update on that, how that's working?

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Christopher J. Abate, Redwood Trust, Inc. - President and CFO [11]

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It's been pretty consistent, it's been growing, but the numbers, I think, Choice has significantly eclipsed our expectations and most of our focus has shifted there. It continues to be a good program, we've got a number of MPF sellers, and it also, I think, that to us presents good optionality based on the direction of rates in the housing market. But for now I'd say, most of our efforts are focused towards Choice.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [12]

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So Chicago -- that program only uses Select, is that what you're implying?

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Christopher J. Abate, Redwood Trust, Inc. - President and CFO [13]

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Currently, but really, it's -- it has more to do with the base of participants that are members of the system and what the resources of liquidity are. So obviously, large banks are very competitive. And I think ultimately, it's going to potentially be more meaningful as rate shift.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [14]

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How many correspondence do you have using Choice at this point, roughly?

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Christopher J. Abate, Redwood Trust, Inc. - President and CFO [15]

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Almost all. I think 90% or so have kind of rolled it out and I think 75% or so have actually locked alone.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [16]

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And you have what -- you have about 200?

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Christopher J. Abate, Redwood Trust, Inc. - President and CFO [17]

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I think it's 185.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [18]

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185 correspondents, okay.

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Christopher J. Abate, Redwood Trust, Inc. - President and CFO [19]

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So close to 150 or so have actually been producing.

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Steven Cole Delaney, JMP Securities LLC, Research Division - MD, Director of Specialty Finance Research and Senior Research Analyst [20]

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Great. Okay. And just one final just a touch on the whole litigation big picture and I'll drop off. But just this kind of started, Marty, with the Pimco/BlackRock lawsuits. And now it's getting into a game, right? And this is it -- I'm sure Wells had -- basically, isn't very happy but the lawsuits, they said, here's what I'll do and then of course they get to -- sued after they hit did the holdback. I guess what I'm saying is, a trustee has a certain role and you guys have written white papers about how this private RMBS market should really work. Do you really think that -- we go through the credit crisis, do you think there actually can be liability for a trustee for the performance of the loans in a pool? So should -- I guess, I'm saying, should trustees be sued for in the manner in which the trustees were sued in the first place? If you are comfortable sharing any opinion on that.

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Christopher J. Abate, Redwood Trust, Inc. - President and CFO [21]

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So you know, Steve, I think, we want to avoid opining on any ongoing litigation, especially since we are not a direct part of it. But our frustration with this trustee matter should be pretty evident at this point. We've seen these type of things happen in the past, but, obviously, in much smaller amounts, nothing remotely close to the $90 million of losses that just got pushed through the system last month. It's just unfortunate, because we have great relationships throughout the industry, especially with our banking partners at Wells, presumably operate -- should be independent of the trustee division. They've done a tremendous job as our lead underwriter for all our recent Sequoias. So I just say it's unfortunate, but we are where we are. We've now taken some highly questionable shortfalls. So we're forced into a position here where we need to closely monitor the situation and ultimately, protect our interests. I should probably add, we have reviewed our investment portfolio and have taken steps to try and avoid any additional pain from these types of holdbacks. We took some steps in July, but regardless, we're frustrated, not just for us but for other market participants, given our role as you've noted. We've been kind of at this for the last 8 years, trying to reinvigorate and reform the market. It's been a core part of our strategy as you know. So I guess the good news, just a follow on to what Marty said, as we do feel really good that the structural enhancements we put into our 2.0 deals, as well as the credit quality should preclude this type of holdback, hopefully from even happening in the first place. We can wrote about it in the review and for now we'll just have to continue updating and educating new issue investors, and hope for a quick resolution to these legacy litigation issues.

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Operator [22]

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We'll take our next question from Bose George with KBW.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [23]

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This is Eric on for Bose. Appreciate the Wells disclosure that was really helpful. Do you have an early read on the return on securitizing the Redwood Choice versus Redwood Select, specifically the returns from holding the residual?

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Martin S. Hughes, Redwood Trust, Inc. - CEO and Director [24]

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It's hard, especially since we haven't completed our first deal, obviously, we said we intend to or hope to in the second half of the year. Generally speaking, we expect these subordination levels to be around 2x the credit enhancement or so. So from that perspective, we expect to meatier investment. And then when you factor in that there's an additional 1 to 1.5 points or so of coupon on the collateral, that should be good for something at least a few points higher on the subs. So I would say it's hard to give specifics at this point until we complete a deal and see where spreads fall out. But we certainly think the return profile will be quite a bit better than our Select program.

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Eric J. Hagen, Keefe, Bruyette, & Woods, Inc., Research Division - Analyst [25]

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Got it. Yes, the subordination that's helpful information. Is there -- and second question here. Is the strong home price appreciation that you're seeing in some of the coastal markets. A source of concern for you guys? Are you doing anything that's different from the underwriting perspective than any of the markets as a result of that?

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Martin S. Hughes, Redwood Trust, Inc. - CEO and Director [26]

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No, I mean our underwriting and due diligence has been pretty significant since we kind of helped to restart this market. So I think from a due diligence perspective, we continue to focus on appraisals and focused on borrow profiles and characteristics. We pay close attention to HPA, but at this point, again, just given where affordability is, given where rates are, given the fact that you see savings rates and FICOs where they're at. We feel pretty good about the credit environment certainly right now and for the foreseeable future.

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Operator [27]

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(Operator Instructions) We'll go next to Brock Vandervliet with UBS.

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Brocker Clinton Vandervliet, Nomura Securities Co. Ltd., Research Division - Executive Director [28]

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You covered a lot of it on Choice already. I was just curious what some of your correspondents are kind of informing you in terms of the -- who else maybe out there in the market. Is this still a leading-edge pioneer product? Or are you beginning to see others give this a harder look?

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Martin S. Hughes, Redwood Trust, Inc. - CEO and Director [29]

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Hey Brock, welcome back. We -- I still think we feel good about our position in the market. I think, what we talked about in the past, what's differentiated us is the sort of breadth of the rollout, we certainly see in certain areas or for certain products some competition. But I wouldn't say it's significantly increased. I think, what we've been trying to do is really bolt-on to some of the existing relationships and really focus on educating loan officers on the product and then really targeting purchase borrowers. So our purchase mix continues to be 2/3 or so plus purchase. And so I think, given that, we really -- we're hopefully getting our hooks in here and getting some traction with the seller base.

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Brocker Clinton Vandervliet, Nomura Securities Co. Ltd., Research Division - Executive Director [30]

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Got it. And anything to share of your total originations is already at, I think, what you had already talked about in terms of your goal of 20% or so. Any sense of where this could go? Or really too early until you crank out your first securitization and get further down the road?

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Martin S. Hughes, Redwood Trust, Inc. - CEO and Director [31]

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Yes, I mean, we're -- what we're really excited about is the percentage gains. So 20%, 30% gains in volume quarter is pretty significant from our perspective, which is why we placed a lot of energy here. I think, we plan at this point to maintain this range of run rate, which is why we feel good about rolling out a securitization program at this point. But really, the focus internally, we believe the Choice best leverages our credit competencies. And in-house service oriented platform that we have, so we certainly think we can do a lot more. At this point, I don't think we've really updated our guidance other than to say we still feel very good about the $5 billion to $6 billion of total production we hope to do in 2017, 15% to 20% of that would we Choice.

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Operator [32]

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And with no further questions in the queue, this concludes our conference. On behalf of management, we very much appreciate you taking time to participate in our earnings call.