Basis of Presentation

9 Months Ended

Sep. 30, 2019

The consolidated financial statements presented herein are at September 30, 2019 and December 31, 2018, and for the three and nine months ended September 30, 2019 and 2018. These interim unaudited consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission ("SEC"). Certain information and note disclosures normally included in our annual financial statements prepared in accordance with U.S. generally accepted accounting principles ("GAAP") — as prescribed by the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) — have been condensed or omitted in these interim financial statements according to these SEC rules and regulations. Management believes that the disclosures included in these interim financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the company's Annual Report on Form 10-K for the year ended December 31, 2018. In the opinion of management, all normal and recurring adjustments to present fairly the financial condition of the company at September 30, 2019 and results of operations for all periods presented have been made. The results of operations for the three and nine months ended September 30, 2019 should not be construed as indicative of the results to be expected for the full year.

Principles of Consolidation

In accordance with GAAP, we determine whether we must consolidate transferred financial assets and variable interest entities (“VIEs”) for financial reporting purposes. We currently consolidate the assets and liabilities of certain Sequoia securitization entities issued prior to 2012 where we maintain an ongoing involvement ("Legacy Sequoia"), as well as entities formed in connection with the securitization of Redwood Choice expanded-prime loans beginning in the third quarter of 2017 ("Sequoia Choice"). In addition, we consolidated the assets and liabilities of certain Freddie Mac K-Series securitizations we invested in beginning in the third quarter of 2018, and the assets and liabilities of certain Freddie Mac SLST securitizations we invested in beginning in the fourth quarter of 2018. Each securitization entity is independent of Redwood and of each other and the assets and liabilities are not owned by and are not legal obligations of Redwood Trust, Inc. Our exposure to these entities is primarily through the financial interests we have purchased or retained, although for the consolidated Sequoia entities we are exposed to certain financial risks associated with our role as a sponsor, servicing administrator, or depositor of these entities or as a result of our having sold assets directly or indirectly to these entities.

For financial reporting purposes, the underlying loans owned at the consolidated Sequoia and Freddie Mac SLST entities are shown under Residential loans, held-for-investment, at fair value, and the underlying loans at the consolidated Freddie Mac K-Series are shown under Multifamily loans, held-for-investment, at fair value, on our consolidated balance sheets. The asset-backed securities (“ABS”) issued to third parties by these entities are shown under ABS issued. In our consolidated statements of income, we recorded interest income on the loans owned at these entities and interest expense on the ABS issued by these entities as well as other income and expenses associated with these entities' activities. See Note 14 for further discussion on ABS issued.

Beginning in the fourth quarter of 2018, we consolidated two partnerships ("Servicing Investment" entities) through which we have invested in servicing-related assets. We maintain an 80% ownership interest in each entity and have determined that we are the primary beneficiary of these partnerships.

Beginning in the first quarter of 2019, we consolidated 5 Arches, LLC ("5 Arches"), an originator of business purpose residential loans, pursuant to the exercise of our purchase option and the acquisition of the remaining equity in the company.

See Note 4 for further discussion on principles of consolidation.

Use of Estimates

The preparation of financial statements requires us to make a number of significant estimates. These include estimates of fair value of certain assets and liabilities, amounts and timing of credit losses, prepayment rates, and other estimates that affect the reported amounts of certain assets and liabilities as of the date of the consolidated financial statements and the reported amounts of certain revenues and expenses during the reported periods. It is likely that changes in these estimates (e.g., valuation changes due to supply and demand, credit performance, prepayments, interest rates, or other reasons) will occur in the near term. Our estimates are inherently subjective in nature and actual results could differ from our estimates and the differences could be material.

Acquisition of 5 Arches, LLC

On March 1, 2019, we completed the acquisition of the remaining 80% interest in 5 Arches, an originator of business purpose residential loans. In May 2018, Redwood acquired a 20% minority interest in 5 Arches for $10 million in cash, with a one-year option to purchase all remaining equity in the company. At closing, we paid approximately $13 million of cash, and the remainder of the consideration, which could total up to an additional $27 million, will be paid in a mix of cash and Redwood common stock and is contingent on the achievement of certain specified loan origination thresholds over the next two years.

We accounted for the acquisition of 5 Arches under the acquisition method of accounting pursuant to ASC 805. We performed the preliminary purchase price allocation and recorded underlying assets acquired and liabilities assumed based on their estimated fair values using the information available as of the acquisition date, with the excess of the purchase price allocated to goodwill. Through September 30, 2019, there have been no significant changes to our preliminary purchase price allocation, which is summarized in the following table.

Table 2.1 – 5 Arches Purchase Price Allocation



(In Thousands)	March 1, 2019
Purchase price:
Cash	$	12,575
Contingent consideration, at fair value	24,621
Purchase option, at fair value	5,082
Equity method investment, at fair value	8,052
Total consideration	$	50,330

Allocated to:
Tangible net assets acquired ⁽¹⁾	$	985
Goodwill	28,747
Intangible assets	24,800
Deferred tax liability	(4,202		)
Total net assets acquired	$	50,330


(1)	5 Arches net assets acquired consisted of assets of $19 million and liabilities of $18 million as of March 1, 2019.

Because we owned a 20% noncontrolling interest in 5 Arches immediately before obtaining full control, we remeasured our initial minority investment and purchase option at their acquisition-date fair values using the income approach, which resulted in a gain of $2 million that was recorded in Other income, net on our consolidated statements of income during the three months ended March 31, 2019.

As part of this acquisition, we identified and recorded finite-lived intangible assets totaling $25 million. The amortization period for each of these assets and the activity for the period from March 1, 2019 to September 30, 2019 is summarized in the table below.

Table 2.2 – Intangible Assets – Activity



(Dollars in Thousands)	Carrying Value at December 31, 2018		Additions		Amortization Expense			Carrying Value at September 30, 2019		Weighted Average Amortization Period (in years)
Finite-lived intangible assets:
Broker network	$	—	$	18,100	$	(2,112	)	$	15,988	5
Non-compete agreements	—		2,900		(564		)	2,336		3
Loan administration fees on existing loan assets	—		2,600		(1,517		)	1,083		1
Tradename	—		1,200		(233		)	967		3
Total	$	—	$	24,800	$	(4,426	)	$	20,374	4

All of our intangible assets are amortized on a straight-line basis. Estimated amortization expense for the remainder of 2019 and the following years is summarized in the table below.

Table 2.3 – Intangible Asset Amortization Expense by Year



(In Thousands)	September 30, 2019
2019 (3 months)	$	1,897
2020	5,420
2021	4,987
2022	3,848
2023 and thereafter	4,222
Total Future Intangible Asset Amortization	$	20,374

We recorded goodwill of $29 million as a result of the total consideration exceeding the fair value of the net assets acquired. The goodwill was attributed to the expected business synergies and expansion into business purpose loan markets, as well as access to the knowledgeable and experienced workforce continuing to provide services to the business. We expect $3 million of our goodwill balance to be deductible for tax purposes. The following table presents the goodwill activity for the nine months ended September 30, 2019.

Table 2.4 – Goodwill – Activity



(In Thousands)	Nine Months Ended September 30, 2019
Beginning balance	$	—
Goodwill recognized from 5 Arches acquisition	28,728
Measurement period adjustment	19
Impairment	—
Ending Balance	$	28,747

The liability resulting from the contingent consideration arrangement was recorded at its acquisition-date fair value of $25 million as part of total consideration for the acquisition of 5 Arches. At September 30, 2019, our estimated fair value of this contingent liability was $25 million and was recorded as a component of Accrued expenses and other liabilities on our consolidated balance sheets. See Note 16 for additional information on our contingent consideration liability.

The following unaudited pro forma financial information presents Net interest income, Non-interest income, and Net income of Redwood and 5 Arches combined, as if the acquisition occurred as of January 1, 2018. These pro forma amounts have been adjusted to include the amortization of intangible assets for both periods, and to exclude the income statement impacts related to our equity method investment in 5 Arches. The unaudited pro forma financial information is not intended to represent or be indicative of the consolidated financial results of operations that would have been reported if the acquisition had been completed as of January 1, 2018 and should not be taken as indicative of our future consolidated results of operations. During the period from March 1, 2019 to September 30, 2019, 5 Arches had mortgage banking income of $12 million and a net loss of $3 million. Included in the net loss for this period was intangible asset amortization expense of $4 million.

Table 2.5 – Unaudited Pro Forma Financial Information



	Three Months Ended September 30,				Nine Months Ended September 30,
(In Thousands)	2019		2018		2019		2018
Supplementary pro forma information:
Net interest income	$	33,513	$	35,231	$	98,101	$	105,660
Non-interest income	27,498		22,280		98,780		84,684
Net income	34,310		32,636		115,809		111,072