Redwood Trust, Inc. (NYSE:RWT) Q4 2022 Earnings Call Transcript

Redwood Trust, Inc. (NYSE:RWT) Q4 2022 Earnings Call Transcript February 9, 2023

Operator: Good afternoon, and welcome to the Redwood Trust Incorporated Fourth Quarter 2022 Financial Results Conference Call. Today’s conference is being recorded. I’ll now turn the call over to Kaitlyn Mauritz of Investor Relations. Please go ahead, ma’am.

Kaitlyn Mauritz: Thank you, Operator. Hello, everyone, and thank you for joining us today for Redwood’s fourth quarter 2022 earnings conference call. With me on today’s call are Christopher 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 and 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 fourth quarter Redwood review, which is available on our website at www.redwoodtrust.com. As a reminder, the Company’s financial statement audit a year ended December 31, 2022 is now complete and the results of your reporting today are unaudited and may vary from the Company’s audited financial results for the year ended December 31, 2022, presented in our annual report on Form 10-K for 2022, including due to the completion audit procedures relating to the valuation of our deferred tax assets at December 31, 2022.

The Company’s 2022 annual financial statement audit is scheduled to conclude on schedule in late February in advance of our Form 10-K filing. Also note that the confident today’s conference call contains time sensitive information that’s only accurate as of today. And we do not intend and undertake no obligation to date 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.

Christopher Abate: Thanks, Kate, and thanks to everyone for tuning in this afternoon. We’re excited to have the opportunity to speak with you today in our fourth quarter results. Now also update you underperformance the first month or so 2023. We’ll also touch on how we viewed the opportunity in front of us for the remainder of the year. As you probably suspect a cover off and a high points and then Dash and Brooke will handle our business and financial performance in greater detail. Fourth quarter rounded out a year that brought about sudden change to the mortgage markets in a manner that was markedly different than we’ve seen through previous downturns and past housing cycles. In 2022, the Federal Reserve’s efforts to curb inflation led to the most pronounced jump and rates in over four years, largely freezing mortgage refinance activity and profoundly affecting consumer behavior in the housing market.

Significant increases in rates severe spread widening and ongoing bouts of volatility characterize much of the second half of the year. Our results during this period certainly didn’t meet our expectations. We focused on prudently protecting our book value, managing risk and positioning our company for the path forward. As we all know, long-term focal points such as these are sometimes only fully appreciated in hindsight. Such a challenging year and now behind us, we resolved to break the huddle in early January, and quickly build momentum towards our 2023 priorities. That’s exactly what we’ve done realizing a welcome uptick of activity and a few accomplishments worth noting that have helped to improve our GAAP book value thus far in 2023. Already this year, we’ve completed a preferred stock offering reopening a segment of the market that it seemed little activity last year, while expanding our balance sheet to an alternative source of capital.

Next up, we completed a sale of $230 million at business purpose lending or BPL loans to a top institutional partner at a creative turn of terms for both firms. Sell this pool of loans was a bellwether of sorts for us, we created forward momentum for the platform that’s positively impacted our new loan pricing and reaffirmed our BPL business potential to build from last year’s record volumes. Generally with our BPL loan sale, in late January, our residential team completed our first Sequoia securitization in over a year. Once again, this deal helped reset the market and is now influenced a significant expansion of the RMBs issuance calendar by other sponsors a good fact for all market participants. Investor demand for a securitization was the strongest we’ve seen for any private label deal in over a year and it allowed us to increase bond prices and boost our GAAP gain on sale.

Through these actions as well as other optimizations across our balance sheet, we grew our unrestricted cash position to just over 400 million at February 7th. This robust liquidity puts us in a strong position when considering our future debt maturities will allow us to proceed opportunistically in our markets, including through M&A, and other creative investments. Accompanying this boost in available capital has been a significant reduction in our go forward operating expenses. As Brooke will touch on the primary focus here has been to reduce costs that conflicts with loan volumes. We’ve been very strategic in this regard managing costs, while preserving full optionality to take advantage of market conditions as opportunities arise. As we think about capital allocation going forward, we expect consumer mortgage volumes to remain challenged, as the majority of homeowners are not financially incentivized to refinance their existing home or move to a new one with the prospect of assuming a much higher mortgage rate.

In response, we have reduced working capital allocated to our residential mortgage banking business by about 70% throughout 2022. We acknowledge that January brought about some much-needed stability to the market, which was partially due to a modest decline in mortgage rates. It’s simply too early to tell, however, if this is start of a trend or simply pent-up demand following a slow fourth quarter. In the meantime, a strategic focus of ours remains attending to our seller base and ensuring we have products that meet their needs as the market evolves. This includes refinement of our expanded prime products, as well as investor products that cater to consumers, who own second homes or looking to finance a single rental property. Despite our belief that consumer mortgage volumes will remain under pressure in the near-term, there remains heightened demand for BPL products in a sector that is very much still in growth mode.

BPL borrowers unlike consumers are locked into low 30 year rates and are therefore not content to sit on the sideline. They are transaction-oriented, executing on business plans and require liquidity from our loan products to fuel growth. With demand for rentals still elevated, we continue to see investors actively seeking the range of solutions we offer. Rental market has been tasked in providing more alternatives households, including multi-family, built for rents and workforce housing. Our focus remains on originating BPL loans secured by assets with strong fundamentals and quality sponsors. That’s why we remain particularly bullish on our BPL business, even with face for the prospect of the potential recession in 2023. Perhaps the overall positive market sentiment to start the year matters most with respect to our investment portfolio, as it remains the primary driver of our book value.

While the fourth quarter mirrored much of 2022 with further credit spread widening, thus far in 2023, the story has been different. Market prices for securities have begun to firm up, reflecting lower mortgage rates, increased housing market activity and positive deal flow in securitization markets. I’d like to continue emphasizing that, the vast majority of mark-to-market declines we incurred on the portfolio in 2022 remain largely detached from the underlying cash flows, with the book continuing to display strong credit fundamentals and low overall delinquencies. With a weighted average year-end carrying value of $0.62 to principal face value and a projected forward loss adjusted yield of 15%, our investment portfolio had approximately $500 million or $4.33 per share of net discount at year-end that we have the potential to realize to earnings overtime.

While the path of home prices and its impact on mortgage credit remains the critical question for 2023, we believe our portfolio construction with many seasoned assets and significant HPA realized to-date makes it resilient to a wide range of downturn scenarios for the economy. With our strong cash position, we remain intentional about steering capital and resources towards markets that we believe perform better in this environment and assets we believe to be undervalued, including Redwood’s corporate debt and equity. We repurchased $88 million of our own securities in 2022 and continue to be active in doing so in 2023. We intend to use our unrestricted cash position and other sources of available liquidity to address the remainder of our upcoming 2023 convertible bond maturity, and remain opportunistic in repurchasing elsewhere across our convertible debt stack.

While uncertainty is likely to linger well into 2023, we believe we’re in the late innings of this fed cycle, remain confident in our ability to navigate further challenges for the pillars of our diversification, strong balance sheet, and most importantly, our people. Our platform offers a compelling opportunity and a unique access point to invest in a very dynamic housing market. And with that, I’ll turn the call over to Dash Robinson, Redwood’s President.

Dash Robinson: Thank you, Chris. Following a turbulent 2022, we enter 2023 ready to take advantage of current market dynamics and drive a creative results across our operating businesses and investment portfolio. I will focus my commentary on the recent performance of these segments and our current outlook and positioning before turning the call over to Brooke current overview of our financial performance. Our investment portfolio, which now represents 84% of our allocated capital and remains a key driver of our dividends continue to deliver strong fundamental performance in the fourth quarter, notwithstanding further unrealized fair value changes that impacted book value. Cash flow durability remained robust across the book, an important input into our ability to realize the net discount and carrying value that Chris referenced.

Delinquency rates were stable to improving across the portfolio for our organically created assets of book that includes BPL loans and securities and retained bonds from our Sequoia shell, quarter and 90 plus day delinquency rates stood at 2% down from 2.1% at the end of Q3. Elsewhere, delinquency rates on our core reperforming loan positions, what we refer to as SLST also improved, with 90 plus day delinquencies 0.5% lower quarter-over-quarter. Even with the recent slowing in HPA, and modest home price declines in certain markets, equity continues to build in these underlying loans as far as remain consistent in their payments. In aggregate, we estimate that the loans underlying our securities portfolio of LTV is of approximately 50%. Results have also been favorable in our home equity investment option portfolio or ATI, the majority of which is either securitized or financed through the warehouse line that Brooke will touch on.

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Live to date speeds on our securitize portfolio have been approximately 20% and realized returns have been strong. Protected in part by an average discount to initial home value of approximately 18%, this allows the holder of the AGI to withstand meaningful downward pressure on home prices before incurring loss of investment. Notwithstanding Fundamental performance, fair values and our investment portfolio were once again impacted by spread widening during the fourth quarter in sympathy with trends across the market. As Brooke will describe in more detail, these adjustments continue to be largely unrealized that have begun to reverse meaningfully year-to-date. As Chris referenced, our portfolios net discount to face now stands at $4.33 per share, the realization of which comes into clearer view with each passing quarter.

We remained active in optimizing our capital deployment during the fourth quarter, putting in approximately $100 million to work across organic and third-party investments and repurchases of our near-term convertible debt maturities at attractive discounts. While spreads have stabilized meaningfully here today, we still see ample opportunity to deploy capital creatively across our operating platforms, third party securities, and our own capital structure. Our operating platforms have quickly turned the page on 2022 with strategic progress in the early weeks of the year, reversing some of the volatility induced P&L from the fourth quarter. In business purpose mortgage banking well broad market headwinds persisted through the end of the year, the team knocks and key winds that are already paying dividends in 2023, including advancing the Riverbend integration, growing our whole loan distribution capabilities, and adding a new non-recourse borrowing line for bridge loans that meaningfully enhanced our overall financing flexibility.

We originated $424 million of BPL loans in the fourth quarter, down 26% from Q3 but in line with our estimated volume trend for the market overall. Our production mix for the quarter between BPL bridge and term loans rebalance compared to other quarters in 2022, as more sponsors opted to lock in long-term fixed rates where possible in lieu of shorter term floating rate bridge step. BPL term production volume was up 36% quarter-over-quarter, driven by a significant increase in term multifamily funding. The fourth quarter’s fundings rounded out full year production volumes of $2.8 billion, a record year for the platform that lead increased importance to diversifying our distribution channels to position ourselves appropriately for 2023. We sold $92 million of BPL prison term loans during the fourth quarter and over $220 million more in January, recycling capital for a growing go forward pipeline across our products.

Distribution and profitability on new BPL term production has been particularly strong, as we complement a best-in-class securitization platform with a deeper whole loan buyer base attracted to the structure and quality of our loans. Importantly, the overall improvement in sentiment in January carried over to our sponsors. We’re once again leaning in on refinance opportunities or taking advantage of more constructive conditions to put fresh capital to work, either through traditional acquisition channels or newer partnerships emerging as a result of dynamics between the for sale and for rent markets. Our progress and loan distribution has proven well timed and it’s both improving sponsor demand and significant uncertainty around funding capacity and certain of our competitors.

Additionally, we continue to optimize financing on our bridge loan portfolio, inclusive of the $335 million financing line we completed in December, at year end 100% of our bridge portfolio continued to be financed on a non-marginal basis, with 70% of the financing also non-recourse. We maintain substantial excess capacity to support new production and future funding obligations on existing loans. Notwithstanding more favorable market conditions and the equity backing or BPL loans, given the overall environment, we continue to expect increased engagement from our asset management team in 2023, including with bridge loan sponsors seeking to refinance and managing earlier stage delinquencies within the turbo which are up modestly in Europe. As we have previously highlighted, our overall origination footprint and 2022 focus largely on sponsors with some sort of real estate stabilization strategy.

Approximately 90% of originations were in bridge loans the sponsors improving and leasing off single and multifamily properties where fixed rate loans on already stabilized well. Given our progress in integrating riverbed in the past six months, we expect to round out that production mix with an increased emphasis on single asset bridge loans, focused on repeat customers of the Riverbend platform with strong liquidity profiles and track records. Importantly, capital markets distribution for these types of loans is relatively mature and we are well positioned to broaden our whole loan buyer partnerships and begin leveraging existing and creative financing to keep more on balance sheet. Our residential mortgage banking business maintain its defensive posturing in the fourth quarter, locking $43 million of loans and managing our lowest level of inventory since early to mid 2020.

This was by design as jumbo mortgage rates during the quarter moved off their 7% plus highs down to the 60, an improvement but not enough to drive purchase money volumes higher in an environment in which refinance demand remains substantially muted. Improved market conditions in January allowed us to reverse much of the fourth quarters widening of our residential inventory, which at year end stood around $660 million and currently sits at roughly half that amount, after several small whole loan sales and the successful completion of our January Sequoia issuance are first in over a year. Execution on the securitization was indicative of improved market sentiment, with final pricing meaningfully through where the pipeline was carried at year end.

In monitoring market sentiment, we believe, we will be able to further distribute remaining pipeline at favorable levels. As Chris mentioned, capital and costs allocated to our residential business have been reduced commensurate with recent transaction volumes. However, we have preserved the optionality to lean back in as conditions warrant to continue serving our seller base, including through enhanced rollouts of our expanded prime product offerings. The recent exit of one of the largest players in the correspondent market, highlights the durability of our partnerships even after a period of reduced activity, as many of our sellers continue to prioritize capital efficiency and continued rightsizing the costs, they put as much value as ever in our consistent speed and reliability.

I will now turn the call over to Brook to cover our financial results.

Brooke Carillo: Thank you, Dash. In my comments today, I will provide an overview of our GAAP and non-GAAP results for the year end quarter ended December 31, 2022 and discuss select quarter to date metrics relating to the first quarter of 2023. We’ve reported GAAP book value of $9.55 per share, reflecting an economic return on equity of negative 3.9% for the fourth quarter. The primary drivers of book value were a $0.40 loss in basic earnings per share and our dividend of $0.23 per share. GAAP earnings were impacted by negative investment fair value changes of $0.21 per share, which continue to substantially reflect unrealized mark-to-market changes. Earnings available for distribution was negative $0.11 per share in the fourth quarter, as compared to $0.16 per share in the third quarter, driven by a loss of $0.28 per share from mortgage banking, due to credit spread widening on both the residential and BPL inventories.

More specifically, our lower marks on our inventories reflected a lack of activity and available distribution channels at year end, a trend as noted by Chris that has reversed thus far in the first quarter. Overall, GAAP net interest income decreased from the third quarter due to lower mortgage banking inventory as volumes and average balances declined in the fourth quarter, while our cost of debt increased, partially offset by higher average coupons for our bridge loan. As Dash mentioned, during the fourth quarter, we closed a new $150 million borrowing facility for HEI investment, which contributed to the increase in interest expense. Importantly, economic net interest income was nearly $6 million higher than GAAP, primarily due to higher average balance of economic investments from capital deployment.

Liquidity was solid as of year end and has been building. Unrestricted cash and equivalents increased by $141 million to $400 million from December 31st to February 7th. This is a function of various activities already covered such as the $70 million preferred stock offering as well as — sales, securitization and financing optimization efforts. As we noted in the review, we also see incremental opportunities to generate over $100 million of liquidity beyond our existing cash position, by financing a portion of our $300 million plus of unencumbered assets. While our total recourse debt balance of $2.9 billion was unchanged quarter-over-quarter, the decline in tangible equity drove a modest increase in leverage from 2.6x to 2.8x. Given the financing and capital markets activities we conducted thus far in 2023, our estimated total recourse leverage ratio fell to 2.2x at February 7th.

This decline in leverage is also attributable to our repurchase of nearly $60 million of convertible debt since the end of the third quarter, contributing both to reduce interest expense and realized gains for our shareholders. With respect to the term structure of our liabilities, we have $1.8 billion of recourse leverage maturing in 2023. As financing markets remain orderly, we foresee no issues rolling these facilities in normal floors. To further illustrate during 2022 we renewed or establish eight team financing facilities representing 6 billion of total financing capacity. In terms of our outlook, we are currently estimating book value to be of 2% through February 7th, and both GAAP and EAD earnings to re-approach our dividend level for the first quarter.

We see several factors that support the return to more normalized return levels for the business throughout 2023. With the mark-to-market changes we’ve experienced, we are carrying the investment portfolio at a forward yield of approximately 15% and credit spreads affirming. Across both mortgage banking platforms we have largely clear the inventory overhang from last year, which further improves our gain on sale and volume outlets. Furthermore, in the business purpose lending we are building on our origination volumes from 2022 and are seen profitable execution fueled by improved distribution alternatives. Our nimble capital allocation has underscored the diversity of our revenue streams and our ability to optimize the business dynamically based on where the best risk adjusted returns are in the market.

We have a variable cost driven model which has allowed us to reduce operating expenses at the residential mortgage banking segment by 40% year-over-year, reduced capital allocated to the business by 70%. Debt preserve the optionality of a flagship platform that is historically generated ROE is in excess of 15%. Given the changes we’ve made, even with the smaller opportunities that maintaining our historical market share and margins are sufficient to generate normalized returns for this business. And finally, in response to the challenging market conditions we face this year, we have been focused on rationalizing our overall operating footprint. General and administrative or G&A expenses increased slightly from the third quarter, primarily due to employee severance, and related transition expenses.

However, for the full year 2022 G&A expenses were down 20% relative to the prior year. Pro forma for expense reduction initiatives completed since September 30th. We currently expect 2023 run rate units and be 5% to 10% lower than full year 2022 comparable levels, in line with our guidance on last quarter’s earnings call. We expect these changes to our cost structure to lead to improved profitability in 2023. And with that, I will turn the call over to operator to open the line for Q&A.

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Q&A Session

Operator: Thank you. And ladies and gentlemen, at this time, we will be conducting a question-and-answer session. Our first question comes from Stephen Laws with Raymond James. Please state your question.

Stephen Laws: I guess first want to touch on the conduit business and I remember a year where we’ve seen it kind of move like it did as volatile through the year. As you look forward, what do we need to see to kind of see more stabilized margins there and solid profitability, although obviously lower volumes and much you’ve seen in the first Sequoia deal and some other transactions in the market year-to-date. Do you feel we’ve turned the corner there kind of what’s your outlook on margins and margin volatility is for ’23?

Christopher Abate: Hi, Stephen, it’s Chris. Good question. I think for resi in particular, obviously, it was a really tough year for mortgage banking and volumes and there’s pretty well-known reasons for that. As far as turning the corner goes, I think the first thing that we got done this year was a Sequoia deal. We saw a much greater demand for the issuance. That was the first deal that we’d done in over a year. And I think that as demand returns, in the PLS markets, that will create greater confidence, certainly for aggregators like ourselves to begin acquiring and leaning in on rate. Now, that said, we’re still I think a ways off in rate as far as where most people would be interested in refined homes, versus, where current rates stand north of 6%, and some cases 7%.

So, I think we’re cautious in declaring victory here in the first quarter as far as things fully stabilizing, but we’ve built some optionality, as Brooke said, we’ve taken a lot of capital out of the business. And one of the great things about Redwood is, you know, we’re 29-year old business, and we’ve got the ability to shift capital and resources to their highest and best use. And so I think, when it’s not a tremendously a great time to be issuing, it’s usually a good time to be investing. And so, I think we’ve created a lot of optionality there to be an investor in resi. And so, I think, in 2023, we’re going to proceed cautiously, hopefully, we can continue issuing. We’d like to issue and other securitization gear at some point in the next in the coming months.

But in the meantime, I think we’re focusing on growth areas across the business and in Dash had a lot of comments on the BPL business earlier on. And I think that, for a lot of reasons, you know, that businesses is something we’re going to focus on the first couple of quarters of the year.

Stephen Laws: And we’re going to follow-up on one of the options on the resi side, the home equity investments, seeing the DAC, new financing facility put in place in the fourth quarter. Can you talk about the opportunities there? Is that an area you view as attractive now, or kind of how do you force rank your options for the investment side as far as new capital being deployed?

Christopher Abate: Yes, I think it’s very exciting. That’s a great example of some of the optionality that we’ve built into the platform. Certainly, if people are not incentivized to move or refinanced their homes, they’d like to extract trapped equity within their homes, and anybody that’s bought a home in the last two or three years is putting on quite a bit of equity, by and large. And so, our HEI initiative is really meant to sort of modernize the home equity process. And we’ll have a lot more to say about it, I think in the coming months, but certainly, we see strong demand. We’ve completed a securitization in the past and Brooke’s team completed a financing or warehouse financing of that product very recently. So, we’re excited about things starting to institutionalize there, and we expect that to be a big focus area of ours in 2023.