Redwood Trust, Inc. (NYSE:RWT) Q3 2023 Earnings Call Transcript
Redwood Trust, Inc. (NYSE:RWT) Q3 2023 Earnings Call Transcript October 30, 2023
Operator: Ladies and gentlemen, good afternoon, and welcome to the Redwood Trust, Inc. Third Quarter 2023 Financial Results Conference Call. Today's conference is being recorded. I will now turn the call over to Kaitlyn Mauritz, Redwood's Senior Vice President of Investor Relations. Please go ahead, ma'am.
Kaitlyn Mauritz: Thank you, operator. Hello, everyone, and thank you for joining us today for our third quarter 2023 earnings conference call. With me on today's call are Chris Abate, Chief Executive Officer; Dash Robinson, President; and Brooke Carillo, Chief Financial Officer. Before we begin, I want to remind you that certain statements made during management's presentation today 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 cause actual results to differ from those that may be expressed in forward-looking statements.
On this call, we might 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. A reconciliation between GAAP and non-GAAP financial measures are provided in our third quarter Redwood Review, which is also available on our website redwoodtrust.com. Also note that the content of today's conference call contain time sensitive information that are only accurate as of today. And we do not intend and undertake no obligation to update this information to reflect subsequent events or circumstances. Finally, today's call is being recorded and will be available on our website later today.
I'll now turn the call over to Chris for opening remarks.
Chris Abate: Thanks, Kait, and welcome everyone to Redwood's third quarter earnings call. There is no question that our markets are in a state of transition, impacted by the final throes of a hyper aggressive Fed policy, ongoing geopolitical strife and proposed regulatory rule changes that will usher in a new era of housing finance. In the third quarter, the gravitational pull of an inverted yield curve continued to take its toll on the mortgage sector, particularly on the market values of fixed rate portfolio investments. Redwood's GAAP book value was down 5% for the third quarter, largely a mark-to-market adjustments directly attributable to the rapid rise in the 10-year treasury that took place in the final month of the quarter.
Since quarter end, we estimate our GAAP book value to be down approximately 2%. For those in our sector who have already reported their third quarter results, GAAP book values have been down 8% on average. Trying to make sense of this market and see through the fog [ph] of 8% mortgage rates is difficult for any of us, especially given the prospect of an extended period of higher for longer benchmark rates as the economy continues to outpace expectations. With housing affordability at the lowest levels we've seen since the 1970s and transaction activity at multi year lows, many market participants have simply retreated to the sidelines. In fact, as we head towards year-end, we've already started to see the same diminution of market activity that we observed a year ago.
That's why it's so important for us to keep our shareholders apprised of the transformational changes that we expect to become prominent in the coming months. Our perspective is informed by 30 years of cycles and market turns and learnings from things we've gotten wrong or missed, in order to best position our company for the future. And to summarize our view, we expect a major secular shift in how mortgage related assets will be owned and financed in the years ahead, particularly in the non-agency mortgage space, we have long stood as a critical provider of liquidity. In fact, we believe the option value of our franchise has never been higher than it is today. To contextualize our thinking, we expect a convergence in how both agency and non-agency mortgage markets function with a large percentage of non-agency loans getting distributed to match funded private credit institutions largely in securitized form and away from bank balance sheets.
In the agency mortgage market, Fannie Mae and Freddie Mac were created for this purpose to provide liquidity to banks and other lenders by aggregating and securitizing the residential loans for distribution to bond investors. In the non-agency mortgage space, similar intermediaries must emerge to provide that liquidity and reminiscent of Redwood's founding thesis, there's no one better position than us to do so. We are a natural non-competing partner to our loan sellers, allowing them to preserve their customer relationships while maintaining liquidity in an otherwise illiquid market. As we previously mentioned, our near-term production will remain risk minded given the challenging market backdrop. We will not be scaling volume at any cost.
Instead, we'll be focused on growing wallet share of large banks, many of whom have not needed a capital partner since the great financial crisis ended. The aftermath of that crisis, we would remind shareholders that the last time that regulatory rules significantly changed for the mortgage sector. In this sense, we are neither predicting nor in need of a major boost in industry wide transaction volumes to achieve our near-term objectives. Instead, we're focused on further solidifying relationships, providing much needed liquidity to our new and existing partners, with a goal of realizing transformative and durable market share gains as the yield curve normalizes. As you may recall, our second quarter earnings call in July, took place just hours after the Federal Reserve released newly proposed risk based capital rules for the U.S banking system.
Our thesis at the time was that while the final rules would likely evolve, bank management teams have looked to comply with the spirit of the rules well in advance of their passage. Three months later, our thinking has thus far been validated and our progress has been well timed with the emergence of fresh demand for our products from new sources of capital, complementary to our traditional distribution channels. As Dash will outline in his remarks, results and leading indicators we are tracking are pointing green, with a response from regional and other banks that has exceeded our expectations. Without the safety net of zero cost unlimited deposit capital, the asset liability mismatch that only mortgages proposes for banks is inherently risky.
We realize the large banks face a high degree of uncertainty and are naturally pushing back against the proposed risk capital rule changes. Our response will be to help our partners approach these changes constructively. We believe it's possible for banks to preserve lending footprints, including for first time homebuyers with the right capital partner. Our team has honed the degree of operational excellence in the non-agency mortgage market over decades, allowing us to support our bank partners with more than just a rate sheet. Many banks have understandably not had to flex their loan sale muscles in many years, creating uncertainty. Our ability to swiftly onboard and educate our lending partners provides incredible value to banks as they work to pivot from net buyers and portfolio lenders to net sellers on a forward flow basis.
Besides the long-term opportunity, we estimate the banks of over 1.4 trillion of jumbo loans held on their balance sheets today, before considering ongoing production. We further estimate that around 50% of the jumbo origination market, a number which could represent 100 billion to 150 billion or more of annual volume could pivot to an originate to sell model. Leading indicators suggest that the shift is now underway. We believe our third quarter mortgage banking results are indicative of how banks and other financial institutions will look to finance their mortgage production going forward. Given the changes we foresee for our markets, we've begun thinking more holistically about the Redwood platform, and believe that evolving our capital structure and procuring long-term private capital partnerships must be a top priority.
As I've emphasize, we continue to observe a transition occurring with the roles of banks, private credit institutions, and specialty finance companies such as Redwood rapidly evolving. In particular, regulatory cross currents are redefining the most efficient holders of real estate related assets, as well as those who will finance and service them. As evidenced by the joint venture that we announced this past summer, the value proposition that platforms like ours offer institutional credit investors has grown dramatically over the past few years, with investors seeking out the assets we create. These investors include the likes of pension funds, life insurance companies, sovereign wealth funds, and other non-publics who have accretive capital, but lack the origination or sourcing capabilities that we offer.
They also possess patient capital, a key advantage when holding less liquid non-agency investments such as ours. In keeping with these trends, our long-term strategic focus will be to further position our mortgage banking franchises to meet this unprecedented market opportunity. with ample working capital and access to a deep set of products. Our investment strategy will naturally evolve and kind. The continued focus on deployment of our organically created assets to third-party capital partners in lieu of traditional direct investing. This includes a strong internal focus on the next frontier of non-agency investing, which is credit risk transfers on bank portfolios are significant risk capital can be freed up at a relatively low cost. We expect progress on these efforts and partnerships to continue to play out in the coming quarters and look forward to keeping our shareholders current as we proceed.
I'll now turn the call over to Dash.
Dash Robinson: Thank you, Chris. I will now cover details of our operating platforms and investment portfolio during the third quarter before turning it over to Brooke to discuss our overall financial performance. As Chris highlighted in his opening remarks proposed changes to the bank regulatory capital regime, while far from final are turning into the tailwinds we expected for our residential mortgage banking business, in many cases ahead of schedule. While, we believe we are still in the early innings of this sizable market shift, it is clear that business models are evolving quickly, with important ramifications for how 30-year mortgage risk is funded and hedged. As always, our team has been already enabled partner. Third quarter loss for $1.6 billion close to triple second quarter production with approximately 40% of this volume coming from depositories.
Since March, our residential team has engaged with depositories from coast to coast, onboarding new partnerships and bringing our total count of active seller relationships to 185 and growing. This group now includes over 70 banks, including some of the nation's largest regionals and large financial institutions, many with assets over $200 billion in extensive mortgage origination footprints. Several of these institutions have just commenced lock activity with us in recent weeks, implying an attractive runway for growth notwithstanding persistently higher rates. In fact, our locked pipeline in Q3 carried some of the strongest credit characteristics we've seen in recent years. 772 Fico 72% LTV and 33% debt to income ratio. In keeping with the momentum we see for the business, we nearly doubled Our capital allocation to residential mortgage banking in the third quarter and expect that allocation to grow further heading into 2024.
Our estimated share of overall jumbo production in the third quarter approach 4% Well above our historical 2% to 3% range and up from just 1% the previous quarter reflective of both a growing salary base and deeper penetration with existing partners. Residential Purchase volume in the third quarter was $815 million, up over 340% from the second quarter. Thanks salaries accounted for 50% of total quarterly purchase activity up from just 10% in the second quarter and a de minimis amount and Q1. Of note, total bulk activity of over 90% of which was from banks was a key driver of third quarter purchase volume much of its season loans acquired at a significant discount to par. Notwithstanding the persistent rise in rates, we continue to evaluate both pools coming to market more evidence of the scarcity of shelf space for many banks seeking to balance pressures on capital, liquidity and net interest margin.
Distribution channels for jumbo remain open. And we sold $391 million of loans in the third quarter through a combination of securitization and hold on dispositions. The team followed up quickly in the fourth quarter by closing our fourth deploy securitization of the year just last week, bringing our total residential securitization activity for 2023 to over $1 billion. Both deals were distributed to a broad base of buyers, including several new insurance and money manager investors, and were executed within our target gain on sale range. Our most recent print was achieved amidst the 10-year treasury yield moving within close to a 50 basis point range in just over a week. An important statement about the power of our platform and the depth of capital that remains under invested in the space.
The same regulatory changes driving strategic progress in our residential business are also an opportunity for core vast our business purpose lending platform. Borrowers who have historically sought funding from banks now frequent our pipeline discussions. And while the overall credit environment calls for continued caution and selectivity, demand from capital partners remains strong for well underwritten BPL loans to quality sponsors. We've been in dialogue with several banks on partnership opportunities that would allow us to access their existing pipelines with an eye toward mutually beneficial outcomes. With a lifecycle lending platform that offers both bridge and stabilized term financing. We are well-positioned to capture incremental market share that we believe will continue to shift in to private lenders.
CoreVest funded $411 million of loans in the third quarter, a slight increase from the second quarter with a 10% increase in bridge volume being offset by a decline in term production. Within Bridge are built for rent aggregation product has seen increased demand from borrowers and carries a favorable risk profile, given the turnkey nature of the homes being financed. In keeping with broader market trends multifamily origination remains light as sources of capital become more selective, especially for that light, as sources of capital become more selective, especially for value add projects. And while we expect volumes for our fixed rate term loans to remain influenced by benchmark rates, our bridge portfolio remains fertile ground for refinances and the term loans as borrowers progress with projects.
As with residential, our distribution efforts within business purpose lending remain a key differentiator. We distributed over $350 million of BPL loans in the third quarter, including a highly accretive private securitization with a quality institutional partner, two bulk whole loan sales and initial contribution of bridge loans to our recently established joint venture with Oaktree. As Chris highlighted in his comments, given the elevated demand for and attractiveness of our assets, we see opportunities to further diversify these distribution and partnership structures. The BPL sector overall continues to manage through macro cross wins that have impacted sponsor sentiment and reduced transaction volumes across the industry. As we highlighted on our last earnings call, we remain focused on the impact that higher short-term interest rates have on sponsors, not withstanding overall strength and leasing trends.
In anticipation of this impacts, our team has continued to work with borrowers well in advance of their loan maturities to assess project plans and ensure they manage towards successful completions. Well, 90 plus day delinquencies across the bridge and term books declined slightly in the third quarter to 4%. We continue to manage through pockets of stress, particularly in our bridge portfolio, where some combination of rate modifications and fresh equity from new or existing sponsorship have eased the burden of rapidly rising rates across a small handful of sponsor relationships. Engagement with borrowers has been productive, particularly when it occurs in anticipation of the need to reassess the project. And we believe that these efforts provide ample runway for sponsors to complete their work while strengthening our position as lender.
High mortgage rates also continue to impact consumers ability to access equity in their homes, underscoring the importance of secondary financing products that fit the current environment. We were pleased last month to formally launch Aspire, our home equity investment or HEI origination platform. As a quick reminder, HEI are products that allow homeowners to monetize some of their home's equity without an additional monthly payment burden in exchange for sharing and a portion of the change in the home's price going forward. This launch comes after years of investing in and financing HEI and was a natural next step in the progression of our support for this nascent but growing sector. With our track record of supporting housing accessibility as well as our sizable connectivity with mortgage lenders, we believe we have a unique opportunity to help scale and institutionalize HEI in a way that will benefit consumers.
Aspire allows us to do so directly in part by leveraging our nationwide correspondent network of loan officers, a significant advantage over more traditional high cost marketing campaigns. Turning to our investment portfolio, while a rapid rise in 10-year treasury rates during the final month of the quarter significantly impacted fair values, we continue to see strong underlying credit performance. Our reperforming loan portfolio saw the lowest 90 plus day delinquencies in almost 3 years and delinquencies in our Sequoia book remained flat quarter-over-quarter at below 1%. These credit tailwinds created a window during the third quarter to optimize segments of the portfolio and supportive our long-term thesis and strategy. In that vein, we were able to free up over $30 million of capital net of financing for deployment in areas we believe to be more accretive to long-term shareholder returns, most notably in opportunities presented by continued shifts in mortgage funding markets overall, and other areas where we can invest alongside strategic capital Partners.
I will now turn the call over to Brooke to cover our financial results.
Brooke Carillo: Thank you, Dash. We reported earnings available for distribution or EAD of $11 million or $0.09 per basic common share as compared to $16 million or $0.14 per share in the second quarter resulting in an EAD return on common equity of 4.3%. The decrease in EAD was primarily due to lower net interest income from bridge loans and our investment portfolio inclusive of a higher balance of loans and inter nonaccrual status in the third quarter. We anticipate significant recovery of the associated interest going forward and expect an interest income to trend higher beginning in the fourth quarter. The decrease in net interest income was partially offset by higher mortgage banking revenues on the quarter, which increase over 20% versus Q2.
Adjusted for acquisition related intangibles, our combined mortgage banking businesses generated an 11% after tax return on the quarter. Income from residential mortgage banking activities increased $2 million on the strength of higher volumes, attractive execution on our securitization activity and overall market risk management. We were well hedged against basis exposure on our growing pipeline throughout the quarter and benefited from a steepening of the yield curve. As a result, margins were 80 basis points which is in line with our target gain on sale. Income from business purpose mortgage banking activities increased by $1 million, driven largely by the accretive term loan securitization financing that Dash described. G&A expenses decreased by $1 million from the second quarter as our operating businesses were able to demonstrate efficiencies on higher volume.
Both residential and business purpose mortgage banking saw a decrease in cost per loan, declining to levels that we believe support profitable growth going forward. G&A also declined in part due to lower expenses associated with performance-based long-term incentive compensation. GAAP net income related to common stockholders was negative $31 million or negative $0.29 per diluted share compared to $1 million or $0.0 in the second quarter. Negative earnings per share drove book value to $8.77, compared to $9.26 in the second quarter, reflecting a total economic return of negative 3.6 for the third quarter. GAAP earnings for the quarter reflected the impact of the sharp increase in rates later in the quarter on our reperforming loan securities despite the continued positive trends and fundamental performance that had been mentioned.
Fair value changes were impacted by certain nonperforming loans and loan modifications that Dash referenced and also by spread widening within the BPL bridge portfolio. The negative fair value changes were partially offset by fair value increases for HEI assets, as well as servicing assets which benefited from an increase in rates. Our unrestricted cash and cash equivalents as of September 30, were $204 million as we repaid the remainder of our convertible debt series that matured in August. Consequently, recourse leverage was 2.3 turns for the quarter, only 1 turn of which was against the investment portfolio. Over the last 12 months, we raised multiples of the cash needed to repair 2023 convert, and the vast majority of proceeds were raised organically through the optimization within our investment portfolio given the relatively low amount of secured financing leverage we carry there.
We have approximately $300 million of unencumbered assets that remain a continued potential source of capital, which can serve both to fuel growth of our mortgage banking businesses, or continue to repurchase corporate debt across our term structure. Through the fourth quarter, we have begun to repurchase our 2024 convertible maturity, and will continue to evolve our capital structure over the longer term to balance our corporate debt ratios with more permanent forms of equity capital to drive accretive growth. We continue to see strong demand from counterparties to finance our assets. We successfully renewed two maturing loan warehouse financing facilities, with 1 billion of capacity with key counterparties during the quarter. Overall, at September 30, we have excess capacity of 2.2 billion, which we are likely to further increase to support the continued growth of our BPL and residential businesses.
In the third quarter, we sold $49 million of securities that were largely nonstrategic above their second quarter values, recognizing fair value gains of $2 million. While these sales reinforce market appetite for our collateral, we retain roughly $390 million of embedded net discount or $3.26 per share that we carry forward into future quarters. We were able to redeploy this capital into the growing opportunity across our operating platforms, where we're seeing attractive target returns of 15% to 20% plus. As a result, residential mortgage banking capital grew to $150 million from $80 million in the second quarter. Given the efficiency of our distribution efforts, we believe that our near-term volume targets could be supported by roughly $200 million of capital.
Given the work we've done in both residential and business purpose mortgage banking, we forecast our operating businesses are positioned for profitability and continued growth. And with that operator, we will now open the call for questions.
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