Marty Hughes - CEO Brett Nicholas - President Chris Abate - CFO Mike McMahone - Managing Director, IR.

Vik Agrawal - Wells Fargo Securities Steve DeLaney - JMP Securities Matthew Howlett - UBS Bose George - KBW Brock Vandervliet - Nomura Securities.

Welcome to the Redwood Trust, Inc. 2015 First Quarter Earnings Conference Call. [Operator Instructions].

Management has requested that I remind you that certain information presented and certain statements made during management's presentation with respect to future financial or business performance, strategies or expectations 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.

Management encourages you to read the company's most recent annual report on Form 10-K filed with the SEC 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.

I have also been asked to note that the content of the conference contains time-sensitive information that is accurate only as of today, Monday, May 4, 2015. 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 access to the recording of the call will be available on the company's website at www.redwoodtrust.com later today. For opening remarks and introductions, I would now like to turn the call over to Marty Hughes, Redwood's Chief Executive Officer. Please go ahead, Mr. Hughes..

Good afternoon, everyone. Thank you for participating in Redwood 2015 first quarter earnings call. Joining me on the call are Brett Nicholas, Redwood's President; and Chris Abate, Redwood's CFO. The first quarter was challenging as increase interest rates volatility created a headwind primarily for jumbo and commercial businesses.

While our first quarter earnings per share were disappointed, our book value was relatively flat as our hedging strategy remained effective and enabled us to navigate through the market turbulence.

At the same time we were able to further advance our residential and commercial business franchises to capitalize on opportunities we see evolving in the mortgage markets. Similar to the fourth quarter the continued decline in U.S. benchmark interest rates during the first quarter resulted in a negative mark-to-market on our mortgage servicing assets.

For accounting purposes the negative mark on our servicing was recorded to our income statement while the offsetting positive market on the assets we use to hedge our servicing were recorded to our balance sheet. This largely explains the decline in EPS without a substantial decrease in book value per share during the first quarter.

Brett and Chris will go through the metrics in greater detail shortly. Interest rates volatility poses a challenge to our businesses overall but it is particularly disadvantageous for our jumbo, residential and commercial mortgage banking activities.

That is because when we commit upfront to acquire or originate loans which we typically intend to securitize or sale, high interest rates volatility creates a pricing uncertainty that generally results in a AAA investors and whole loan buyers demanding higher liquidity premiums or lower prices to compensate them to the heightened risk of uncertainty.

We assume this risk as part of our business model and address it by adjusting our loan acquisition and origination pricing which we did for both businesses during the first quarter. As a result of the challenging market conditions during the first quarter, our Sequoia jumbo securitizations execution and jumbo whole loan sales were adversely impacted.

The financial statement impact was exacerbated as the market value data point gleaned from these transactions were used to revalue of our entire jumbo residential pipeline and loan inventory at quarter end. Early in the second quarter our jumbo product line is off to a good start. Interest rates volatility has calmed and loan pricing has firmed.

During the second quarter we expect to clear the vast majority of our first quarter jumbo pipeline and inventory at or above our quarter end mark.

To date in the second quarter we had new loan sales totaling $480 million through [indiscernible] loans sales and a Sequoia transaction that taken together were executed at pricing levels significantly above our March 31 quarter end mark.

I would also note that to the extent that interest rates continue to stay above quarter end levels we would expect to benefit from positive marks on our servicing values which will go to our earnings in the second quarter.

We remain highly focused on jump starting private securitizations by among other things trying to win back AAA investors' confidence to improving structural protection mechanism in our transaction.

Our most recent transaction which closed at the end of the April included a new structural feature intended to address the potential conflicts of interest relating to servicers advances. We're pleased not only with the pricing execution on this transaction but also with the level and depth of AAA investor interest.

In a future Sequoia transaction we expect to add a transaction manager or traffic cop which we had talk about in our guide, another feature which is designed to protect the interest of investors.

Our conforming product line remains an important strategic piece of our business plan as it enables us to generate fees and create attractive servicing and credit risk investment while leveraging our residential platform fixed cost.

A major focus of ours remains on credit risk transfer transactions with the GSEs which have the potential to be significant investment opportunity for us. We're confident that we can enter into additional risk sharing arrangements over the next several quarters.

And finally although our commercial business is also impacted by the interest rates volatility in the first quarter we have high expectations for this business line in 2015 based on the underlying fundamental business trend specifically amongst an advancing economy which is good for commercial real estate and a large number of CMBS loans that are expected to mature starting in 2015 through 2017.

Before I hand it off to Brett, I wanted to note that tomorrow you will see a public disclosure explaining that I sold 27,000 shares at the beginning of May.

This sale was made under a 10b5-1 plan that was established last year and was made solely to satisfy my personal income tax liability arising from the delivery of common stock delivered to me on May 1 under a long-term equity award plan. All of the proceeds I receive from these sales will go to the taxing authorities.

Now I would like to turn the call over to Brett Nicholas, Redwood's President..

Thank you, Marty. Let me run through some key operating metrics in the first quarter then I will comment on our business operations. In the first quarter residential loans identified for purchase were up 32% to $3.7 billion as compared to $2.8 billion in the fourth quarter.

At March 31 our locked pipeline of residential loans was $1.8 billion up from $1.2 billion at the end of the fourth quarter. Both the amount of loans identified for purchase and our pipeline bode well for loan acquisition in the second quarter.

We issued one residential jumbo loan securitizations of $335 million in the first quarter, had $511 million of jumbo whole loan sales and $1.4 billion of conforming loan sales. We transferred $447 million of jumbo loans to our captive insurance subsidiary for investment with long-term financing from the Federal Home Loan Bank.

Our investment in mortgage servicing rights totaled $120 million. And lastly we originated $93 million of senior commercial loans and $8 million of mezzanine loans. I will first comment on our residential businesses. We had a productive quarter of residential loan acquisitions. Total acquisitions were $2.5 billion up 127% from a year ago level.

But we were 10% from the fourth quarter reflecting mainly seasonal and some competitive factors. Our correspondent seller network continues to grow. At March 31 we had 180 sellers up from 169 at the end of 2014 and up from 124 a year ago.

We continue to focus on lower our acquisition cost per loan and increasing our market penetration by growing our seller network. We're making progress on the MPF direct program with the Federal Home Loan Bank of Chicago. We had ten active MPFs sellers in the first quarter and approximately 100 more under application.

We expect other Federal Home Loan Bank will be participating in the MPF direct program later this year.

We completed one private residential mortgage securitizations during the first quarter bringing our total completed securitizations beginning in 2010 to 26 transactions totaling just over $10 billion which represents a market leading 32% market share.

In the first quarter whole loan sales continued to be a more attractive distribution alternative than securitizations. We sold $511 million of jumbo loans to seven buyers versus our one $339 million securitizations. We expect demand for whole loans will remain strong.

However we have seen the spread between whole loan and securitizations execution tighten in the second quarter which could bode well for more securitizations issuance and investments for our portfolio.

Lastly, we transferred $447 million of jumbo loans to Federal Home Loan Bank member captive bringing our total whole loan investments at the captive to $1 billion that are financed with Federal Home Loan Bank borrowings. We're quite pleased with the growth of our conforming business in one year of operations.

Our conforming loan acquisitions increased by $73 million to $1.4 billion in the first quarter over the fourth quarter and up substantially from $300 million a year ago. As I mentioned last quarter, conforming loan margins remain under pressure as there is still excess capacity in the conforming loan correspondence lending markets.

Our investment in mortgage servicing rights decreased by about $20 million to $120 million at the end of the March. We invested $19 million in MSRs in the first quarter but that drop was from a MSR sale transaction and payment amortization. As we have stated before, we look at servicing as a financial investment.

We will invest and grow and the portfolio to the extent we believe the assets is fairly priced. We continue to actively work with both Fannie Mae and Freddie Mac on different potential risk sharing structures outside their existing large capital market structures known as cash and stagger.

Although we did not complete a risk share transaction the first quarter, we remain actively engaged with both agency and we expect to complete additional transactions in 2015. I will now talk about our commercial business.

We originated $100 million in the first quarter in what is typically the slowest quarter of each year for commercial and which we anticipated as I noted in my comments last quarter.

Similar to the jumbo market the commercial market suffered from increase interest rates volatility in the first quarter which are leader to wider credit spreads and lower prices for loans net of hedging. At the end of April our commercial pipeline of loans under application has increased significantly and stood at approximately $275 million.

We believe the wave of commercial loan demand for maturities related to the record industry CMBS issuance starting in 2005 through 2007 should show up late in the second quarter and propel us towards our 2015 origination goal of $1.5 billion. I will now hand it over to Chris Abate, our CFO, to run through the numbers..

Thank you, Brett and good afternoon everyone. Our first quarter earnings per share were $0.16 down from $0.31 in the fourth quarter. Falling interest rates combined with elevated interest rates volatility lead to spread widening on our jumbo loan pipeline adversely impacting our first quarter results.

Our book value is relatively stable at $15.01 per share down $0.04 from the prior quarter after a paying $0.28 per share dividend. Before I go into additional details in the quarter, I want to first address some accounting related items.

First, there were no material timing differences in the first quarter related to our jumbo loan pipeline unlike in recent prior quarters. We successfully amended all of our jumbo loan purchase agreements with our loan sellers such that we're now able to recognize loan purchase commitments as derivatives for accounting purposes.

This accounting will better align our pipeline valuation with the associated hedging off sets that are already being reflected through income during the period incurred.

Another accounting item relates to our first quarter early adoption of ASU 2014-13 which allowed us to change how we account for legacy Sequoia securitizations that are still consolidated on our balance sheet.

In the past the assets and liabilities of these consolidated entities were recorded at amortized costs resulting in a discrepancy between their impact on GAAP book value and the economic value of our investment interest in the entities.

By adopting this standard we're now able to reflect these entities on our books after inherent economic value to us. This change resulted in an onetime accumulative effect adjustment of positive $10 million to our March 31 reported book value. Accumulative adjustment entry did not impact earnings.

We believe that these two accounting items will improve the transparency and usability of our GAAP results going forever. However we continue to endure an accounting geography issue related to how we hedge our investment portfolio. In effect much of our portfolio hedging results for the first quarter were not fully reflected in our income statement.

A good illustration of this relates to the hedging of our MSR portfolio where we took $14 million of mark-to-market write downs through our income statement during the first quarter as a result of declining interest rates.

Offsetting adjustments including a $13 million positive change in market value primarily from our Sequoia mezzanine securities portfolio will be reflected in our balance sheet rather than our income statement during the first quarter.

Despite the accounting complexity, we believe that these cumulative hedging results are an important components of our overall returns and are the primary reason why our book value is down only marginally in the first quarter despite lower earnings. Turning back to our first quarter income statement.

Net interest income was $40 million for the first quarter. A decrease of $1 million from the fourth quarter. The decline was driven by lower average balances of loans held for sale and a recognition of a full quarter of interest expense on the convertible debt offering that we completed in the first quarter of 2014.

Importantly net interest income from our investment portfolio increased almost $3 million from the prior quarter largely as the result of $447 million of loans pledge with Federal Home Loan Bank of Chicago during the quarter.

At the end of the first quarter we had $1 billion of loans pledged with the FHLBC along with $851 million of associated borrowings. We expect these loans combined with our $1.2 billion securities portfolio to provide us with an attractive source of income and consistent with past quarters strong cash flow.

Income from residential mortgage banking activities was $2 million for the first quarter down from $10 million if the fourth quarter. Income from commercial mortgage banking activities was a loss of less than $1 million for the fourth quarter downed from income of $1 million from the fourth quarter.

As Brett and Marty mentioned the high level of interest rates volatility and the resulting spread widening not only reduced loan sale prices but also impacted the marks in our loan commitments and loan inventory at the end of the quarter. Turning to our cash position and our capital.

At March 31 our unrestricted cash was $304 million and our investment capacity which we define as the approximate amount of capital we have readily available to make long-term investments was $198 million. Consistent with the prior quarter our rate of capital deployment was elevated.

We invested in $133 million in the first quarter and $159 million in the fourth quarter up from $15 million in the first quarter of 2014. And that concludes my prepared remarks. Operator, I think we're ready for Q&A.

[Operator Instructions]. And we go first to Vik Agrawal with Wells Fargo Securities..

I know you took the $20 million MSR hit in Q1, post the quarter we have seen roughly 20 basis points increase in the ten year treasury.

Thus can you give me quarter to date how much of the MSR adverse impact in Q1 has been reversed?.

You are correct I think the 10 year last time I checked was around 213 or 214 this afternoon and if we're up 20 basis points to 25 basis points we were down 20 basis points to 25 basis points. So without remarking I think it is safe save to say there would be relatively similar increase.

The actual decline due to interest rates was closer to $14 million of the $19 million. We also use that line item to reflect normal downs and pay offs associated with MSR which was about $6 million..

Sure, that makes sense.

And then knowing that Q1 2015 interest rates volatility has been the highest in over a year and given that interest rate volatility leads to lower pricing as you mentioned for AAA investors, I think you mentioned this was addressed in Q1 and given the reduction in treasury volatility post Q1 can you give us a sense of, one, how much overall improvement in pricing has occurred.

And then two how much of a benefit has occurred from adjusting your loan acquisition and origination pricing?.

A few data points we did recently complete another Sequoia transaction and pricing there was marginally improved. I believe it was 15 basis points or 20 basis points inside of more recent transactions that we observed in the market. I think that was one positive data point.

We have also had a few whole loan sales that have been quite a bit above our marks in the range of 25 basis points to 50 basis points. I think we're seeing some improvement and we're also repricing our pipeline constantly. So that loans we're locking today are reflecting current levels.

So we're certainly more an optimistic given the turnaround in rates, just what we're seeing in the market. At this time though we're not prepared to release an actual forecast..

And we'll go now to Steve DeLaney with JMP Securities..

I would like to start with the commercial real estate origination and Brett as you said they were down sequentially about $100 million I believe. But I was looking back at first quarter of the last year it was just $119 million and then you recovered to do $900 million for the full year.

I was just wondering as you see things now and the pipeline that you have got at April 30 I think $275 million can you make any comment on the $1.5 billion guidance you gave us earlier or expectation maybe is better than guidance for commercial volume for the full year? Thanks..

One, we have more origination capacity in terms of more producers and our expectation which is why we said it earlier is to really hit that. We care a lot more about actually it is the balance of -- it is profitability versus volume. We're not going to do volume for the sake of giving up profitability. So there is a balance there.

It has been pretty competitive and also the dynamics of the BP market which I commented on last month or last quarter and pricing volatility also has put some pressure on the market. But we see signs that there should be some relief of that going through the end of the year..

And I read really quick looking through your letter in the review, but I believe there was a reference to maybe because of the volatility and some uncertainty in the CMBS market that you may look to originate loans for sale to other channels.

Did I read that correctly? We were thinking about insurance company's bank but are you thinking about other opportunities other than CMBS conduit?.

Well you know us we're always thinking about new ideas and new strategies, yes, but we don't have any anything specific to comment on today. I would just go back to what we put in the review..

Switching to the whole loan strategy, the whole loan held for investment with the transfer of the additional $400 million you're up to a $1 billion. How do we think about the status of those holdings? I think you said you had about $850 million advances so I assume maybe somewhere around $150 million in capital tied up there.

Is that something we could expect to go further and I don't know if you're at liberty but since that is a good carry spread income business we like to talk about things like net interest spread and leverage and ROE on those financed positions if you could add any color there it would be helpful..

You're correct, Steve $82 million of capital to work through those loans that we're financing with the Home Loan Bank. Very attractive return profile right now, I would say mid-teens. It has been a really positive source of net interest income for us and obviously the loans are performing very, very well.

We think we have capacity with them to do up to $1 billion of borrowings in the near term. And our relationship with the Home Loan Bank both on the MPF side and through the captive is very strong, so we're always having ongoing conversations about potentially increasing that in the future or looking at different products.

But that has been a strong source of carry for us over the past few quarters..

Your $1 billion in borrowings is that your informal credit line that you have negotiated with Chicago? I mean is that what they are telling you your limit is at this point?.

It has been in place for a little while, but that is the neighborhood where we would engaging in new discussions. So we have a little bit of capacity here we think. And like I said we're always having conversations, so...

With your mid-teen ROE you are lettering your advance maturities so you're not having to do any additional like fix based swaps or derivatives of the mortgages, is that correct?.

No, we're hedging the mortgages?.

You are?.

We're. So the ultimate source of financing we still believe is securitizations because it is fully non-recourse. It is important to note that the Home Loan Bank facility is recourse facility at the end of the day and we're managing the rate risk associated with it as part of our broader oversight of risk on our investment portfolio..

Okay. I think I may have misunderstood it. You are still looking at this as an alternative form of warehouse financing, I mean it has good carry and you are happy to hold the loans until the market is attractive.

But I thought I had heard that you are putting in these match funding of lock and load and they would be more held for investment rather than held for sale, but I am hearing now that I should think of it more like a warehouse..

No, no, no. I think you should think of it like an investment. These are ten year borrowings. This is ten year financing for the most part with a few expectation and at this point we're happy to hold those loans as investments for the long-term. We could decide to take some positions off and replace them with other positions.

But right now we still have some capacity and we expect most of those loans to stay on the facility for a while..

And we go now to Matthew Howlett with UBS..

Just to clarify, I get the timing difference now with the derivatives. It makes it a lot easier to look at the quarter and the mortgage banking. But when you look at the pipeline, you talk about that was marked down based on the first quarter and that you are going to see that up significantly.

If it is up half a point, do we think about it as another $0.11 that should have been the first quarter but is going to swing in the second quarter?.

Yes. We have said for a long time that our long-term expectation is 25 basis points to 50 basis points on jumbo basis points. So from soup to nuts, from the time you lock the loans to the time they're sold that's our expectation. At this point we said in the first quarter I think we said $7 billion was our target for jumbo.

We still expect to earn that 25 to 50 in the [indiscernible] time. We had a really volatility quarter and it certainly impacted our near-term pipeline. But we have since remarked and I think going forward that 25 basis points to 50 basis points is still our expectation..

So it is just an abnormal quarter and things have sort of been normalized now on the pipeline and going forward. Given that Chris you said about the $7 billion you talked about the commercial guidance your guidance on residential is $15 billion I think it $7 billion and $8 billion between jumbo and conforming.

Any update to that? I guess you did talk about the MPF partnership you are starting that again.

Is that embedded in the $7 billion guidance for jumbo, can you grow from that or what is embedded of that?.

That is a fully embedded and the one thing I want to clarify with the expectations is we wanted to put a volume number around where we thought the businesses were headed for the year, but we really are focused on margins.

So when you look at the $7 billion for jumbo and the $8 billion for conforming, we will achieve those results if we can generate our long-term 25 basis points to 50 basis points. If the markets are volatility and we don't think we can get there we probably will focus on margin over volume..

Right.

But as the second quarter -- as it stands now are you feeling good about where margins are on the whole loan sales and on the securitization, that stay the same for conforming as well?.

Yes, I think our conforming business along the same lines. One of the nice thing is you are able to much more efficiently hedge and the turn times are a lot a faster. So we don't have the same pipeline exposure that we typically do with our jumbo loans where we're waiting securitizations or bulk whole loan sale for instance.

So conforming is a different market though. It has been challenging for from a margin standpoint so we're very focused on it. But at this point I think things are pretty steady from where they have been the past couple of months..

And last question, as you grow the seller base any thought of added an FHABA product to the menu?.

It is certainly something we have been thinking about. Historically we have been really a buyer credit risk prime quality that fits pretty well with Fannie Freddie's box and our jumbo box. FHABA would be -- BA does have some credit retention but it would be purely a gain on sale model..

Is that something that could -- are your clients demanding that, is that something that you think is a better margin than the conforming and you might as well now that you are at critical mass added to the menu?.

There is clearly cross over with our seller network and there is clearly much higher profit margins in the business and we're clearly at a scale where adding new products whether it is that or different type of QM products the marginal cost would be pretty low. But it is still not something we were 100% on..

I wouldn't want you to leave the call here saying we're rolling out FHABA any time. I mean there is a lot of traps, it is something you consider. There is regulations to understand, the lines are not as bright there. Liability side of it needs to get thought through.

But, yes, the margins are better so it is something we would consider but not something that you would see in a week coming out from us..

Is that because of a licensing issue or is it just because you guys didn’t think it through?.

There is a lot of traps to run on the regulation side from licensing to what kind of liability would we have in this type of business, can we get our arms around it, all those things need to be thought through..

[Operator Instructions]. And we go now to Bose George with KBW..

Going back to the jumbo versus -- the whole loan versus securitizations spread.

You guys said it tightened in the second quarter, where did it stand now, what's the differential?.

Probably right now in terms of execution the whole loan sales execution is probably 25 basis points better than securitization..

And then actually on the conforming said you said now you guys are large enough to start pulling loans for securities execution through the GSEs.

How much of a potential benefit on the margin could that be?.

It really varies. It could be imparity, it could be 5 basis points to 20 basis points. It is going to give us more optionality so we're not exclusive of the cash window. But I think it's in the range of 0 basis points to 20 basis points..

We go now to Brock Vandervliet with Nomura Securities..

You touched on it earlier, but if you could just talk for a moment on the MPF program, the uptick you are seeing there? I noted the number of banks that were now selling, but if you could give any more color in terms of the actual volume you are seeing that would be helpful. Thanks..

We don't have specific volume numbers that we disclose through the MPF. It is rolling our slowly, that process moves a little differently than how we add our direct correspondence, but we do expect a pick up later this year from those banks. Those are much smaller lending institutions..

Is there anything you can directly control with respect to that volume or are you one step removed?.

Chicago manages the process and the process with each member's institution and we work directly with Chicago..

But how the pricing works is literally the same as any of our other sellers. How we distribute and offer pricing and underwriting is the same as any other seller that is out there. So we have as much control there as we did any other seller..

And there are no further questions at this time. I will turn the call back to Mr. Marty Hughes for closing remarks..

This is Mike McMahon. On behalf of management we very much appreciate you taking time to participate in our earnings call. I will be available should you have any questions after the call is over. Thank you very much..

This concludes our conference. Thank you for your participation..