| REDWOOD TRUST INC Item 1A RISK FACTORS The following is a summary of the risk factors that we believe are most relevant to our business |
| These are factors that, individually or in the aggregate, we think could cause our actual results to differ significantly from anticipated or historical results |
| You should understand that it is not possible to predict or identify all such factors |
| Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties |
| We undertake no obligation to publicly update forward-looking statements, whether as a result of new information, future events, or otherwise |
| You are advised, however, to consult any further disclosure we make on related subjects in our reports on forms 10-Q and 8-K filed with the SEC Risks Related to our Business The securities we own expose us to concentrated risks and thus are likely to lead to variable returns |
| Many of the securities we own employ a high degree of internal structural leverage and concentrated credit, interest rate, prepayment, or other risks |
| No amount of risk management or mitigation can change the variable nature of the cash flows, market values, and financial results generated by concentrated risks in our investments backed by real estate loans and securities, which, in turn, can result in variable returns to us and our stockholders |
| We only acquire securities that we believe can earn a high enough yield to enable us to provide our stockholders with an attractive equity rate of return |
| In general, we expect to earn an internal rate of return, or IRR, of cash flows of at least 14prca on a pre-tax and pre-overhead basis from most of our assets in most circumstances |
| In order to earn this rate of return on a financially un-leveraged basis, we generally acquire the most risky securities from any securitization |
| Most securitizations of residential and commercial real estate loans concentrate almost all the credit risk of all the securitized assets into one or more CES or CDO equity securities |
| To the extent that there is significant prepayment risk or interest rate risk internal to these securitization structures, those risks are generally also concentrated in one or more securities |
| Securities with these types of concentrated risks are typically the securities we buy |
| Residential real estate loan delinquencies, defaults, and credit losses could reduce our earnings, dividends, cash flows, and access to liquidity |
| We assume credit risk with respect to residential real estate loans primarily through the ownership of residential loan CES and similarly structured securities acquired from securitizations sponsored by others and from Sequoia securitizations sponsored by us |
| These securities have below investment-grade credit ratings due to their high degree of credit risk with respect to the residential real estate loans within the securitizations that issued these securities |
| Credit losses from any of the loans in the securitized loan pools reduce the principal value of and economic returns from residential loan CES Credit losses on residential real estate loans can occur for many reasons, including: poor origination practices; fraud; faulty appraisals; documentation errors; poor underwriting; legal errors; poor servicing practices; weak economic conditions; decline in the value of homes; special hazards; earthquakes and other natural events; over-leveraging of the borrower; changes in legal protections for lenders; reduction in personal incomes; job loss; and personal events such as divorce or health problems |
| In addition, if the US economy or the housing market weakens, our credit losses could be increased beyond levels that we have anticipated |
| The interest rate is adjustable for most of the loans securitized by securitization trusts sponsored by us and for a portion of the loans underlying residential loan CES we have acquired from securitizations sponsored by others |
| Accordingly, when short-term interest rates rise, required monthly payments from homeowners will rise under the terms of these adjustable-rate mortgages, and this may increase borrowers’ delinquencies and defaults |
| If we incur increased 6 _________________________________________________________________ [60]Table of Contents credit losses, our taxable income would be reduced, our GAAP earnings might be reduced (if these increased credit losses are greater than we have anticipated), and our cash flows, asset market values, access to short-term borrowings (typically used to acquire assets for sale to securitization entities), and our ability to securitize assets might be harmed |
| The amount of capital and cash reserves that we hold to help us manage credit and other risks may prove to be insufficient to protect us from earnings volatility, dividend cuts, liquidity issues, and solvency issues |
| Significant losses on residential credit-enhancement securities could diminish our equity capital base, reduce our earnings, and otherwise negatively affect our business |
| The credit performance of residential loans underlying residential loan CES directly affects our results for the CES we own and also affects our returns from CDO equity securities that we have acquired from Acacia CDO securitization entities that own residential loan CES The total amount of residential real estate loans underlying residential loan CES (acquired from securitizations sponsored by others and Sequoia) was dlra184 billion at December 31, 2005 |
| Our total potential credit loss from the underlying residential real estate loans is limited to our total investment in residential loan CES and Acacia CDO equity securities |
| This total potential loss is smaller than our equity capital base of dlra935 million at December 31, 2005 |
| Nevertheless, significant realized losses from residential CES could harm our results from operations and significantly diminish our capital base |
| If we incur increased credit losses, our taxable income would be reduced, our GAAP earnings might be reduced (if these increased credit losses are greater than we have anticipated), and our cash flows, asset market values, our access to short-term borrowings (typically used to acquire assets for sale to securitization entities), and our ability to securitize assets might be harmed |
| The amount of capital and cash reserves that we hold to help us manage credit and other risks may prove to be insufficient to protect us from earnings volatility, dividend cuts, liquidity issues, and solvency issues |
| Significant credit losses could also reduce our ability to sponsor new securitizations of residential loans |
| We generally expect to increase our portfolio of residential loan CES and our credit exposure to the residential real estate loan pools that underlie these securities |
| The timing of credit losses can harm our economic returns |
| The timing of credit losses can be a material factor in our economic returns from residential loan CES If unanticipated losses occur within the first few years after a securitization is completed, they will have a larger negative impact on CES investment returns |
| In addition, larger levels of delinquencies and cumulative credit losses within a securitized loan pool can delay our receipt of the principal and interest that is due to us |
| This would also lower our economic returns |
| Our efforts to manage credit risk may not be successful in limiting delinquencies and defaults in underlying loans or losses on our investments |
| Despite our efforts to manage credit risk, there are many aspects of credit that we cannot control |
| Our quality control and loss mitigation operations may not be successful in limiting future delinquencies, defaults, and losses |
| Our underwriting reviews may not be effective |
| The securitizations in which we have invested may not receive funds that we believe are due from mortgage insurance companies and other counter-parties |
| Loan servicing companies may not cooperate with our loss mitigation efforts, or such efforts may be ineffective |
| Service providers to securitizations, such as trustees, bond insurance providers, and custodians, may not perform in a manner that promotes our interests |
| The value of the homes collateralizing residential loans may decline |
| The frequency of default, and the loss severity on loans upon default, may be greater than we anticipated |
| Interest-only loans, negative amortization loans, adjustable-rate loans, loans with balances over dlra1 million, reduced documentation loans, sub-prime loans, HELOCs, second lien loans, loans in certain locations, and loans that are partially collateralized by non-real estate assets may have special risks |
| If loans become “real estate owned” (REO), 7 _________________________________________________________________ [61]Table of Contents servicing companies will have to manage these properties and may not be able to sell them |
| Changes in consumer behavior, bankruptcy laws, tax laws, and other laws may exacerbate loan losses |
| In some states and circumstances, the securitizations in which we invest have recourse as owner of the loan against the borrower’s other assets and income in the event of loan default; however, in most cases, the value of the underlying property will be the sole source of funds for any recoveries |
| Expanded loss mitigation efforts in the event that defaults increase could increase our operating costs |
| We have significant credit risk in California |
| We also have credit risk in other states and our business may be adversely affected by a slowdown in the economy or by natural disasters in these states |
| As of December 31, 2005, approximately 46prca of the residential real estate loans that underlie the residential loan CES we owned were secured by property in California |
| As of December 31, 2005, approximately 25prca of our commercial real estate loans, and 16prca of loans underlying our commercial loan CES were secured by properties located in California |
| Factors specific to California could aversely affect our results |
| As of December 31, 2005, approximately 3prca to 6prca of our residential real estate loans that underlie the residential loan CES we owned were secured by properties in each of Florida, Virginia, New York, New Jersey, Illinois, and Texas |
| We have residential credit risk in all states, although we do not have more than 1prca of our loans in any one zip code |
| As of December 31, 2005, our commercial loan CES had more than 5prca of real estate properties in each of New York, Texas, and Florida |
| Factors specific to each of these states’ economies could adversely affect our results |
| An overall decline in the economy or the real estate market could decrease the value of residential and commercial properties |
| This, in turn, would increase the risk of delinquency, default, or foreclosure on real estate loans underlying our CES portfolios |
| This could adversely affect our credit loss experience and other aspects of our business, including our ability to securitize real estate loans |
| The occurrence of a natural disaster (such as an earthquake or a flood) may cause a sudden decrease in the value of real estate and would likely reduce the value of the properties collateralizing the underlying mortgage loans in the securities we own |
| Since certain natural disasters may not typically be covered by the standard hazard insurance policies maintained by borrowers, the borrowers may have to pay for repairs due to such disasters |
| Borrowers may not repair their property or may stop paying their mortgage loans under such circumstances, especially if the property is damaged |
| This would likely cause foreclosures to increase and lead to higher credit losses on the underlying pool of mortgage loans on which we are providing credit-enhancement |
| We assume credit risk on a variety of residential and commercial mortgage assets |
| In addition to residential and commercial loan CES we own, the Acacia entities we sponsor (sometimes collectively referred as Acacia) own investment-grade and non-investment grade securities (typically rated AAA through B, and in a second-loss position or better, or otherwise effectively more senior in the credit structure as compared to a first-loss residential loan CES or equivalent) issued by residential and commercial real estate loan securitization entities |
| The Acacia securities are reported as part of our consolidated securities portfolio on our Consolidated Balance Sheets |
| Generally, we do not control or influence the underwriting, servicing, management, or loss mitigation efforts with respect to the underlying assets in these securities |
| Some of the securities Acacia owns are backed by sub-prime loans that have substantially higher risk characteristics than prime-quality loans |
| These lower-quality loans can be expected to have higher rates of delinquency and loss, and losses to Acacia (and thus Redwood as owner of the Acacia CDO equity securities) could occur |
| Some of the assets Acacia has acquired are investment-grade and non-investment grade residential loan securities from the Sequoia securitization entities we have sponsored |
| Although we may have a limited degree of control or influence over the selection and management of the loans underlying Sequoia 8 _________________________________________________________________ [62]Table of Contents securitizations, we believe the possibility of loss on these assets remains approximately the same as it is for securities issued from securitizations of equivalent-quality loans that we did not sponsor |
| If the pools of residential loans underlying any of these securitizations were to experience poor credit results, Acacia’s securities could have their credit ratings down-graded, could suffer losses in market value, or could experience principal losses |
| If any of these events occurs, it would likely reduce our long-term returns and near-term cash flows from the Acacia CDO equity securities we have acquired, and may also reduce our ability to sponsor Acacia transactions in the future |
| The commercial real estate assets in which we have a direct or indirect interest may have significant degrees of credit and other risks, including various environmental and legal risks |
| The net operating income and market values of commercial real estate properties may vary with economic cycles and as a result of other factors, so that debt service coverage is unstable |
| The value of the property may not protect the value of the loan if there is a default |
| Each commercial real estate loan is at risk for local and regional factors |
| Many commercial real estate loans are not fully amortizing and, therefore, the timely recovery of principal is dependent on the borrower’s ability to refinance or sell the property at maturity |
| For some commercial real estate loans in which we have an economic interest, the real estate is in transition |
| Such lending entails higher risks than traditional commercial property lending against stabilized properties |
| Initial debt service coverage ratios, loan-to-value ratios, and other indicators of credit quality may not meet standard market criteria for stabilized commercial real estate loans |
| The underlying properties may not transition or stabilize as expected |
| The personal guarantees and forms of cross-collateralization that we benefit from on some loans may not be effective |
| We own some mezzanine loans that do not have a direct lien on the underlying property |
| We generally do not service commercial real estate loans; we rely on our servicers to a great extent to manage commercial assets and workout loans and properties if there are delinquencies or defaults |
| As part of the workout process of a troubled commercial real estate loan, we may assume ownership of the property, and the ultimate value of this asset would depend on our management of, and eventual sale of, the property that secured the loan |
| Our commercial loans are illiquid; if we choose to sell them, we may not be able to do so in a timely manner or for a satisfactory price |
| Financing these loans may be difficult, and may become more difficult if credit quality deteriorates |
| We have purchased distressed commercial loans at discount prices where there is a reasonable chance we may not recover full principal value |
| We have sold senior loan participations on some of our loans, with the result that the asset we retain is junior |
| Mezzanine loans, distressed assets, and loan participations have concentrated credit, servicing, and other risks |
| We have directly originated some of our commercial loans and participated in the origination of others |
| This may expose us to certain credit, legal, and other risks that may be greater than is usually present with acquired loans |
| We have acquired and intend to acquire commercial loans for sale to Acacia that require a specific credit rating to be efficient as a securitized asset, and we may not be able to get the rating on the loan that we need |
| Our first-loss and second-loss commercial loan CES have concentrated risks with respect to commercial real estate loans |
| In general, losses on an asset securing a commercial real estate loan included in a securitization will be borne first by the owner of the property (ie, the owner will first lose the equity invested in the property) and, thereafter, by a cash reserve fund or letter of credit, if any, and then by the first-loss commercial loan CES holder |
| In the event of default and the exhaustion of any equity support, reserve fund, letter of credit, and any classes of securities junior to those in which we invest, we will not be able to recover all of our principal investment in the securities we purchase |
| In addition, if the underlying properties have been overvalued by the originating appraiser or if the values subsequently decline and, as a result, less collateral is available to satisfy interest and principal payments due on the related ABS, the first-loss securities may suffer a total loss of principal, and the second-loss (or more highly rated) 9 _________________________________________________________________ [63]Table of Contents securities in which we invest (or have an indirect interest) may effectively become the first-loss position behind the more senior securities, which may result in significant losses to us |
| The prices of commercial loan CES are more sensitive to adverse economic downturns or individual issuer developments than more highly rated commercial real estate securities |
| A projection of an economic downturn, for example, could cause a decline in the price of commercial loan CES because of increasing concerns regarding the ability of obligors of loans underlying commercial ABS to continue to make principal and interest payments |
| We acquire and manage a portion of our commercial assets in conjunction with partners |
| Our partners may have greater control over the management of commercial securitizations than we do |
| Working with partners in this manner may expose us to increased risks |
| Investments in diverse types of assets and businesses could expose us to new, different, or increased risks |
| We have invested in and intend to invest in a variety of real estate and non-real estate related assets that may not be closely related to our current core business |
| Additionally, we may enter various securitization, service, and other operating businesses that may not be closely related to our current business |
| Any of these actions may expose us to new, different, or increased investment, operational, financial, or management risks |
| We have made investments in CDO debt and equity securities issued by CDO securitizations other than Acacia that own various types of assets, generally real estate related |
| These CDOs (as well as the Acacia entities) have invested in manufactured housing securities, sub-prime residential securities, and other residential securities backed by lower-quality borrowers |
| They also own a variety of commercial real estate loans and securities, corporate debt issued by REITs that own commercial real estate properties, and other assets that have diverse credit risks |
| We may invest in CDO equity securities issued by CDOs that own trust preferred securities issued by banks or other types of non-real estate assets |
| We may invest directly or indirectly in real property |
| We may invest in non-real estate ABS or corporate debt or equity |
| We have invested in diverse types of IO securities from residential and commercial securitizations sponsored by us or by others |
| The higher credit and/or prepayment risks associated with these types of investments may increase our exposure to losses |
| We may invest in non-US assets that may expose us to currency risks (which we may choose not to hedge) and different types of credit, prepayment, hedging, interest rate, liquidity, and other risks |
| We establish credit reserves for GAAP accounting purposes, but there are no reserves established for tax accounting purposes |
| In determining our REIT taxable income (which drives our minimum dividend distribution requirements as a REIT), no current tax deduction is available for future credit losses that are anticipated to occur |
| Credit losses can only be deducted for tax purposes when they are actually realized |
| As a result, for tax purposes, there is no credit reserve or reduction of yield accruals based on anticipated losses, and an increase in our credit losses in the future will reduce our taxable income (and dividend distribution requirements) |
| Since, for GAAP purposes, we are able to incorporate an assumption about the amount and timing of credit losses, the occurrence of these losses as assumed will not directly impact our future GAAP income (although they could lead to additional provisions or credit reserve designations to provide for potential additional losses) |
| We have exposure under representations and warranties we make in the contracts of sale of loans to securitization entities |
| With respect to loans that have been securitized by entities sponsored by us, we have potential credit and liquidity exposure for loans that default and are the subject of fraud, irregularities in their loan files or process, or other issues that potentially could expose us to liability as a result of representations and warranties in the contract of sale of loans to the securitization entity |
| In these cases, we may be obligated to repurchase loans from the securitization entities at principal value |
| However, we have obtained representations and warranties from the counter-parties that 10 _________________________________________________________________ [64]Table of Contents sold the loans to us that generally parallel the representations and warranties we have provided to the entities |
| As a result, we believe that we should, in most circumstances, be able to compel the original seller of the loan to repurchase any loans that we are obligated to repurchase from the securitization trusts |
| However, if the representations and warranties are not parallel, or if the original seller is not in a financial position to be able to repurchase the loan, we may have to use some of our cash resources to repurchase loans |
| Our results could be harmed by counter-party credit risk |
| We have other credit risks that are generally related to the counter-parties with which we do business |
| In the event a counterparty to our short-term borrowings becomes insolvent, we may fail to recover the full value of our pledged collateral, thus reducing our earnings and liquidity |
| In the event a counter-party to our interest rate agreements becomes insolvent or interprets our agreements with it in a manner unfavorable to us, our ability to realize benefits from hedging may be diminished, and any cash or collateral that we pledged to such a counter-party may be unrecoverable |
| We may be forced to unwind these agreements at a loss |
| In the event that one of our servicers becomes insolvent or fails to perform, loan delinquencies and credit losses may increase |
| We attempt to diversify our counter-party exposure and limit our counter-party exposure to strong companies with investment-grade credit ratings; however, we are not always able to do so |
| Our counter-party risk management strategy may prove ineffective and, accordingly, our earnings could be harmed |
| We may be subject to the risks associated with inadequate or untimely services from third-party service providers, which may harm our results of operations |
| Our loans and loans underlying securities are serviced by third-party service providers |
| These arrangements allow us to increase the volume of the loans we purchase and securitize without incurring the expenses associated with servicing operations |
| However, as with any external service provider, we are subject to the risks associated with inadequate or untimely services |
| Many borrowers require notices and reminders to keep their loans current and to prevent delinquencies and foreclosures |
| A substantial increase in our delinquency rate that results from improper servicing or loan performance in general could harm our ability to securitize our real estate loans in the future and may have an adverse effect on our earnings |
| Interest rate fluctuations can have various negative effects on us, and could lead to reduced earnings and/or increased earnings volatility |
| Our balance sheet and asset/liability operations are complex and diverse with respect to interest rate movements |
| We do not seek to eliminate all interest rate risk |
| Changes in interest rates, the interrelationships between various interest rates, and interest rate volatility could have negative effects on our earnings, the market value of our assets and liabilities, loan prepayment rates, and our access to liquidity |
| We seek to hedge some interest rate risks |
| Our hedging may not work effectively, or we may change our hedging strategies or the degree or type of interest rate risk we want to assume |
| We generally fund most of our permanent asset portfolio with equity, so there is no asset/liability mismatch for these assets |
| The cash flows we receive from these assets may vary as a function of interest rates, as do the GAAP earnings generated by these assets |
| We also own loans and securities as inventory prior to sale to a securitization entity |
| We fund these assets with equity and with one-month floating rate debt |
| To the extent these assets have fixed or hybrid interest rates (or are adjustable with an adjustment period longer than one month), an interest rate mismatch exists and we would earn less (and incur market value declines) if interest rates rise |
| We usually seek to reduce asset/liability mismatches for these inventory assets with a hedging program using interest rate swaps and futures |
| Interest rate changes have diverse and sometimes unpredictable effects on the prepayment rates of real estate loans |
| Change in prepayment rates can lower the returns we earn from our 11 _________________________________________________________________ [65]Table of Contents assets, diminish or delay our cash flows, reduce the market value of our assets, and decrease our liquidity |
| Higher interest rates generally reduce the market value of our assets (except perhaps our adjustable rate assets) |
| This may affect our earnings results, reduce our ability to re-securitize or sell our assets, or reduce our liquidity |
| Higher interest rates could reduce the ability of borrowers to make interest payments or to refinance |
| Higher interest rates could reduce property values and increased credit losses could result |
| Higher interest rates could reduce mortgage originations, thus reducing our opportunities to acquire new assets, and possibly driving asset acquisition prices higher |
| When short-term interest rates are high relative to long-term interest rates, an increase in adjustable-rate residential loan prepayments may occur, which would likely reduce our returns from owning IO securities backed by these ARM loans |
| Changes in prepayment rates of residential real estate loans could reduce our earnings, dividends, cash flows, and access to liquidity |
| The economic returns we expect to earn from most of the residential real estate securities we (or Sequoia or Acacia) own are affected by the rate of prepayment of the underlying residential real estate loans |
| Adverse changes in the rate of prepayment could reduce our earnings and dividends |
| They could delay cash payments or reduce the total of cash payments we would otherwise eventually receive |
| Adverse changes in cash flows would likely reduce an affected asset’s market value, which would likely reduce our access to liquidity if we borrowed against that asset and may cause a market value write-down for GAAP purposes, which would reduce our reported earnings |
| While we estimate prepayment rates to determine the effective yield of our assets and valuations, these estimates are not precise, and prepayment rates do not necessarily change in a predictable manner as a function of interest rate changes |
| Prepayment rates can change rapidly |
| As a result, such changes can cause volatility in our financial results, affect our ability to securitize assets, affect our ability to fund acquisitions, and have other negative impacts on our ability to grow and generate earnings |
| Hedging activities may reduce long-term earnings and may fail to reduce earnings volatility or to protect our capital in difficult economic environments |
| Our failure to hedge may also harm our results |
| We attempt to hedge certain interest rate risks (and, to a much lesser degree, prepayment risks) by balancing the characteristics of our assets with respect to these risks and by entering into various interest rate agreements |
| The amount and level of interest rate agreements that we utilize may vary significantly over time |
| We generally attempt to enter into interest rate hedges that provide an appropriate and efficient method for hedging the desired risk |
| Hedging against interest rate risks using interest rate agreements and other instruments usually has the effect over long periods of time of lowering long-term earnings |
| To the extent that we hedge, it is usually to protect us from some of the effects of short-term interest rate volatility, to lower short-term earnings volatility, to stabilize liability costs or market values, to stabilize our economic returns from securitization, or to stabilize the future cost of anticipated ABS issuance by a securitization entity |
| Such hedging may not achieve its desired goals |
| Using interest rate agreements to hedge may increase short-term earnings volatility, especially if we do not elect hedge accounting treatment for our hedges (ie, our hedges are accounted for as trading instruments) |
| Reductions in market values of interest rate agreements may not be offset by increases in market values of the assets or liabilities being hedged |
| Conversely, increases in market values of interest rate agreements may not fully offset declines in market values of assets or liabilities being hedged |
| Changes in market values of interest rate agreements may require us to pledge significant amounts of collateral or cash |
| Hedging exposes us to counter-party risks |
| We also may hedge by taking short, forward, or long positions in US Treasuries, mortgage securities, or other cash instruments |
| Such hedges may have special basis, liquidity, and other risks to us |
| 12 _________________________________________________________________ [66]Table of Contents Our quarterly earnings may reflect volatility in earnings as a result of the accounting treatment for certain interest rate agreements, as a result of accounting treatments for assets or liabilities that do not necessarily match those used for interest rate agreements, or our failure to meet the requirements to obtain desired hedge accounting treatment for certain interest rate agreements |
| New assets we acquire may not generate yields as attractive as yields on our current assets, resulting in a decline in our earnings per share over time |
| We believe the assets we are acquiring today are unlikely to generate economic returns or GAAP yields at the same levels as our historical assets generated |
| We receive monthly payments from most of our assets, consisting of principal and interest |
| In addition, occasionally some of our residential loan CES are called (effectively sold) |
| Principal payments and calls reduce the size of our current portfolio and generate cash for us |
| We also sell assets from time to time as part of our portfolio management and capital recycling strategies |
| In order to maintain our portfolio size and our earnings, we need to reinvest a portion of the cash flows we receive from principal, interest, calls, and sales into new earning assets |
| If the assets we acquire today earn lower GAAP yields than the assets we currently own, our reported earnings per share will likely decline over time as the older assets pay down, are called, or are sold |
| Under the effective yield method of accounting that we use for GAAP accounting purposes for most of our assets, we recognize yields on assets based on our assumptions regarding future cash flows |
| A portion of the cash flows we receive that exceeds the anticipated cash flows reduces our basis in these assets |
| As a result of these various factors, our basis for GAAP amortization purposes for many of our current assets is lower than their current market values |
| Assets with a lower GAAP basis generate higher GAAP yields, yields that are not necessarily available on newly acquired assets |
| Business conditions, including credit results, prepayment patterns, and interest rate trends in the future are unlikely to be as favorable as they have been for the last few years |
| Our securitization operations expose us to liquidity, market value, and execution risks |
| In order to continue our securitization operations, we require access to short-term debt to finance inventory accumulation prior to sale to securitization entities |
| In times of market dislocation, this type of short-term debt might become unavailable from time to time |
| We pledge the inventory assets we buy to secure our short-term debt |
| This debt is recourse to us, and if the market value of the collateral declines we will need to use our liquidity to increase the amount of collateral pledged to secure the debt or to reduce the debt amount |
| Our goal is to sell these assets to a securitization entity; however, if our ability to sponsor a securitization is disrupted, we may need to sell these assets (most likely at a loss) into the secondary mortgage or securities markets, or we would need to extend the term of the short-term debt used to fund these assets |
| When we acquire assets for a securitization, we make assumptions about the cash flows that will be generated from the securitization of these assets |
| Widening ABS spreads, rising ABS yields, incorrect estimation of rating agency securitization requirements, poor hedging results, and other factors could result in a securitization execution that provides a lower amount of proceeds than initially assumed |
| This could result in a loss to us for tax purposes and reduced on-going earnings for GAAP purposes |
| Our short-term borrowing arrangements used to support our securitization operations subject us to debt covenants |
| While these covenants have not meaningfully restricted our operations to date, as a practical matter, they could be restrictive or harmful to our stockholders’ interests and us in the future |
| In the event we violate debt covenants, we may incur expenses, losses, or a reduced ability to access debt |
| Our payment of commitment fees and other expenses to secure borrowing lines may not protect us from liquidity issues or losses |
| Variations in lenders’ ability to access funds, lender confidence in us, lender collateral requirements, available borrowing rates, the acceptability and market values of our collateral, and other factors could force us to utilize our liquidity reserves or to sell assets, and, thus, affect our liquidity, financial soundness, and earnings |
| 13 _________________________________________________________________ [67]Table of Contents We recently initiated a collateralized commercial paper program to supplement the current short-term debt arrangements we use for our securitization program, and this could expose us to new risks and expenses |
| Our cash balances and cash flows may become limited relative to our cash needs |
| We need cash to meet our interest expense payments, working capital, minimum REIT dividend distribution requirements, and other needs |
| Cash could be required to pay down our recourse short-term borrowings in the event that the market values of our assets that collateralize our debt decline, the terms of short-term debt become less attractive, or for other reasons |
| Cash flows from principal repayments could be reduced should prepayments slow or credit quality trends deteriorate (in the latter case since, for certain of our assets, credit tests must be met for us to receive cash flows) |
| For some of our assets, cash flows are “locked-out” and we receive less than our pro-rata share of principal payment cash flows in the early years of the investment |
| Operating cash flows could be reduced if earnings are reduced, if discount amortization income significantly exceeds premium amortization expense, or for other reasons |
| Our minimum dividend distribution requirements could become large relative to our cash flows if our income as calculated for tax purposes significantly exceeds our cash flows from operations |
| In the event, that our liquidity needs exceed our access to liquidity, we may need to sell assets at an inopportune time, thus reducing our earnings |
| In an adverse cash flow situation our REIT status or our solvency could be threatened |
| Our reported GAAP financial results differ from the taxable income results that drive our dividend distributions |
| We manage our business based on long-term opportunities to earn cash flows |
| Our dividend distributions are driven by our minimum dividend distribution requirements under the REIT tax laws and our taxable income as calculated for tax purposes pursuant to Code |
| Our reported results for GAAP purposes differ materially, however, from both the cash flows and our taxable income |
| We own residential loan CES acquired from securitizations sponsored by others and also from securitizations we have sponsored |
| These securities do not differ materially in their structure or cash flow generation characteristics, yet under GAAP we consolidate all the assets and liabilities of entities we have sponsored (and thus do not show the residential loan CES we own as an asset) while we show only the net investment as an asset for CES acquired from others |
| The same issue arises with residential IO securities and other securities investments that we make and with CDO securitizations that we sponsor |
| As a result of this and other accounting treatments, stockholders and analysts must undertake a complex analysis to understand our economic cash flows, actual financial leverage, and dividend distribution requirements |
| This complexity may cause trading in our stock to be relatively illiquid or volatile |
| Market values for our assets, liabilities, and hedges can be volatile |
| A decrease in market value may not necessarily be the result of deterioration in future cash flows |
| For GAAP purposes we mark-to-market some, but not all, of our consolidated assets and liabilities through our Consolidated Balance Sheets |
| In addition, under various circumstances, some market valuation adjustments on assets may be realized in our Consolidated Statements of Income |
| As a result, assets that are funded with certain liabilities and interest-rate matched with certain liabilities and hedges may have differing mark-to-market treatment than the liability or hedge |
| If we sell an asset that has not been marked to market through our Consolidated Statements of Income at a reduced market price relative to its basis, our reported earnings will be reduced |
| Changes in our Consolidated Statements of Income and Consolidated Balance Sheets due to market value adjustments should be interpreted with care |
| 14 _________________________________________________________________ [68]Table of Contents Our reported income depends on accounting conventions and assumptions about the future that may change |
| Accounting rules for the various aspects of our business change from time to time |
| Changes in GAAP, or the accepted interpretation of these accounting principles, can affect our reported income, earnings, and stockholders’ equity |
| Our revenue recognition and other aspects of our reported results are based on estimates of future events |
| These estimates can change in a manner that harms our results or can demonstrate, in retrospect, that revenue recognition in prior periods was too high or too low |
| The Financial Accounting Standards Board has issued exposure drafts for a number of proposed amendments to FASB Nodtta 140, Accounting for Transfers of Financial Assets (FAS 140), and has indicated that additional revisions to FAS 140 are under consideration |
| While the proposals released to date would not have a material impact on our operations or results, any future amendments that required a change in the way we account for our securitizations through our Sequoia or Acacia programs could adversely after our business strategy and reported results |
| We use the effective yield method of GAAP accounting for many of our consolidated assets and ABS issued |
| We calculate projected cash flows for each of these assets and ABS issued, incorporating assumptions about the amount and timing of credit losses, loan prepayment rates, and other factors |
| The yield we recognize for GAAP purposes generally equals the discount rate that produces a net present value for actual and projected cash flows that equals our GAAP basis in that asset or ABS issued |
| We change the yield we recognize on these assets and ABS issued based on actual performance and as we change our estimates of future cash flows |
| The assumptions that underlie our projected cash flows and effective yield analysis may prove to be overly optimistic |
| In these cases, we reduce the GAAP yield we recognize for an asset and/or we write down the basis of the asset to its current market value (if the market value is lower than the basis) |
| For a consolidated ABS-issued liability, a change in assumptions could lead to a higher consolidated interest expense |
| Risks Related To Our Company Structure Failure to qualify as a REIT would adversely affect our dividend distributions and could adversely affect the value of our securities |
| We believe that we have met all requirements for qualification as a REIT for federal income tax purposes for all tax years since 1994 and we intend to continue to operate so as to qualify as a REIT in the future |
| However, many of the requirements for qualification as a REIT are highly technical and complex and require an analysis of factual matters and an application of the legal requirements to such factual matters in situations where there is only limited judicial and administrative guidance |
| Thus, no assurance can be given that the Internal Revenue Service (IRS) or a court would agree with our conclusion that we have qualified as a REIT or that future changes in our factual situation or the law will allow us to remain qualified as a REIT If we failed to qualify as a REIT for federal income tax purposes and did not meet the requirements for statutory relief, we would be subject to federal income tax at regular corporate rates on all of our income and we could possibly be disqualified as a REIT for four years thereafter |
| Failure to qualify as a REIT would adversely affect our dividend distributions and could adversely affect the value of our common stock |
| Maintaining REIT status may reduce our flexibility |
| To maintain REIT status, we must follow certain rules and meet certain tests |
| In doing so, our flexibility to manage our operations may be reduced |
| For instance: • If we make frequent asset sales from our REIT entities to persons deemed customers, we could be viewed as a “dealer,” and thus subject to 100prca prohibited transaction taxes or other entity level taxes on income from such transactions |
| • Compliance with the REIT income and asset rules may limit the type or extent of hedging that we can undertake |
| 15 _________________________________________________________________ [69]Table of Contents • Our ability to own non-real estate related assets and earn non-real estate related income is limited |
| If we fail to comply with these limits, we may be forced to liquidate attractive assets on short notice on unfavorable terms in order to maintain our REIT status |
| • Our ability to invest in taxable subsidiaries is limited under the REIT rules |
| Maintaining compliance with this limit could require us to constrain the growth of our taxable REIT affiliates in the future |
| • Meeting minimum REIT dividend distribution requirements could reduce our liquidity |
| Earning non-cash REIT taxable income could necessitate our selling assets, incurring debt, or raising new equity in order to fund dividend distributions |
| • Stock ownership tests may limit our ability to raise significant amounts of equity capital from one source |
| • Historically, our stated goal has been to not generate excess inclusion income that would be taxable as unrelated business taxable income, or UBTI, to our tax-exempt stockholders |
| Achieving this goal has limited our flexibility in pursuing certain transactions |
| Despite our efforts to do so, we may not be able to avoid creating or distributing UBTI to our stockholders |
| Changes in tax rules could adversely affect REITs |
| The requirements for maintaining REIT status and/or the taxation of REITs could change in a manner adverse to our operations |
| Rules regarding the taxation of dividends are enacted from time to time and future legislative or regulatory changes may limit the tax benefits accorded to REITs, either of which may reduce some of a REIT’s competitive edge relative to non-REIT corporations |
| Failure to qualify for the Investment Company Act exclusion could harm us |
| Under the Investment Company Act of 1940, as amended, an investment company is required to register with the SEC and is subject to extensive restrictive and potentially adverse regulations relating to, among other things, operating methods, management, capital structure, dividends, and transactions with affiliates |
| However, companies primarily engaged in the business of acquiring mortgages and other liens on and interests in real estate (ie, qualifying interests) are excluded from the requirements of the Investment Company Act |
| To qualify for the Investment Company Act exclusion, we, among other things, must maintain at least 55prca of our assets in certain qualifying real estate assets (the 55prca Requirement) and are also required to maintain an additional 25prca in qualifying assets or other real estate-related assets (the 25prca Requirement) |
| If we failed to meet the 55prca Requirement and the 25prca Requirement, we could, among other things, be required either (i) to change the manner in which we conduct our operations to avoid being required to register as an investment company or (ii) to register as an investment company, either of which could harm us |
| Further, if we were deemed an unregistered investment company, we could be subject to monetary penalties and injunctive relief |
| We may be unable to enforce contracts with third parties and third parties could seek to obtain rescission of transactions undertaken during the period we were deemed an unregistered investment company, unless the court found that under the circumstances, enforcement (or denial of rescission) would produce a more equitable result than no enforcement (or grant of rescission) and would not be inconsistent with the Investment Company Act |