Derivative Financial Instruments

6 Months Ended

Jun. 30, 2011

Derivative Financial Instruments

Note 9. Derivative Financial Instruments

The following table presents the aggregate fair value and notional amount of derivative financial instruments held by Redwood and the consolidated Acacia entities at June 30, 2011 and December 31, 2010. The derivatives held at Acacia entities are not assets or obligations of Redwood.

June 30, 2011 (In Thousands)	Redwood					Acacia					Total
	Fair Value			Notional Amount		Fair Value			Notional Amount		Fair Value			Notional Amount
Assets – Risk Management Derivatives
Interest rate swaps	$	—		$	—	$	806		$	5,796	$	806		$	5,796
TBAs		274			69,000		—			—		274			69,000
Futures		2			44,000		—			—		2			44,000
Interest rate caps purchased		—			—		2,931			705,400		2,931			705,400
Total Assets		276			113,000		3,737			711,196		4,013			824,196
Liabilities – Cash Flow Hedges
Interest rate swaps		(13,823	)		165,000		—			—		(13,823	)		165,000
Liabilities – Risk Management Derivatives
Interest rate swaps		(1,624	)		89,500		(65,766	)		612,746		(67,390	)		702,246
TBAs		(1,036	)		56,000		—			—		(1,036	)		56,000
Futures		(390	)		568,000		—			—		(390	)		568,000
Total Liabilities		(16,873	)		878,500		(65,766	)		612,746		(82,639	)		1,491,246
Total Derivative Financial Instruments, Net	$	(16,597	)	$	991,500	$	(62,029	)	$	1,323,942	$	(78,626	)	$	2,315,442

	Redwood					Acacia					Total
December 31, 2010 (In Thousands)	Fair Value			Notional Amount		Fair Value			Notional Amount		Fair Value			Notional Amount
Assets – Risk Management Derivatives
Interest rate swaps	$	175		$	44,000	$	813		$	18,037	$	988		$	62,037
TBAs		348			35,000		—			—		348			35,000
Futures		703			433,000		—			—		703			433,000
Interest rate caps purchased		—			—		6,012			703,400		6,012			703,400
Total Assets		1,226			512,000		6,825			721,437		8,051			1,233,437
Liabilities – Cash Flow Hedges
Interest rate swaps		(11,449	)		155,500		—			—		(11,449	)		155,500
Liabilities – Risk Management Derivatives
Interest rate swaps		(1,283	)		26,000		(69,373	)		663,604		(70,656	)		689,604
TBAs		(951	)		124,000		—			—		(951	)		124,000
Futures		(59	)		225,000		—			—		(59	)		225,000
Total Liabilities		(13,742	)		530,500		(69,373	)		663,604		(83,115	)		1,194,104
Total Derivative Financial Instruments, Net	$	(12,516	)	$	1,042,500	$	(62,548	)	$	1,385,041	$	(75,064	)	$	2,427,541

Risk Management Derivatives

To offset — to varying degrees — the changes in the value of mortgage products to which we have exposure, we may enter into interest rate agreements, TBA contracts, and Eurodollar futures contracts. (Eurodollar futures contracts, unlike our other derivatives, have maturities of only three months. Therefore, in order to achieve the desired interest rate offset necessary to manage our risk, consecutively maturing contracts are required resulting in a stated notional amount higher than would be needed with our other derivatives.) We account for our risk management derivatives as trading instruments, and record any changes in value (including any associated interest income or expense) in our consolidated statements of income through market valuation adjustments, net.

Risks Related to Unsecuritized Residential and Commercial Loans at Redwood

In order to manage risks associated with residential loans we own or plan to acquire and securitize, and commercial loans we invest in, at June 30, 2011, we were party to interest rate agreements with an aggregate notional amount of $89 million, TBA contracts sold with a notional amount of $125 million, and financial futures with an aggregate notional amount of $612 million. Net negative market valuation adjustments on these derivatives were $5 million and $2 million for the three and six months ended June 30, 2011, respectively.

Risks Related to Liabilities at Acacia Entities

Net valuation adjustments on interest rate agreements at Acacia were negative $13 million and negative $21 million for the three months ended June 30, 2011 and 2010, respectively. Net valuation adjustments on interest rate agreements at Acacia were negative $14 million and negative $41 million for the six months ended June 30, 2011 and 2010, respectively.

Derivatives Designated as Cash Flow Hedges

To hedge the variability in interest expense related to our long-term debt and certain adjustable-rate securitization entity liabilities that are included in our consolidated balance sheets for financial reporting purposes, we designated interest rate swaps as cash flow hedges during 2010 and during the second quarter of 2011 with an aggregate notional balance of $165 million. For the three and six months ended June 30, 2011, these hedges decreased in value by $5 million and $2 million, respectively, which was recorded as a decrease to accumulated other comprehensive income, a component of equity.

For interest rate agreements currently or previously designated as cash flow hedges, our total unrealized loss reported in accumulated other comprehensive income was $29 million at both June 30, 2011 and December 31, 2010. For both the three months ended June 30, 2011 and 2010 we reclassified $1 million of unrealized losses on derivatives to interest expense. For both the six months ended June 30, 2011 and 2010, we reclassified $2 million of unrealized losses on derivatives to interest expense.

The following table illustrates the impact on interest income (expense) of our interest rate agreements accounted for as cash flow hedges for the three and six months ended June 30, 2011 and 2010.

Impact on Interest Income (Expense) of Our Interest Rate Agreements Accounted for as Cash Flow Hedges

	Three Months Ended June 30,						Six Months Ended June 30,
(In Thousands)	2011			2010			2011			2010
Net interest expense on cash flow interest rate agreements	$	(1,628	)	$	(1,036	)	$	(3,166	)	$	(1,036	)
Realized net expense due to net ineffective portion of hedges		(12	)		(26	)		(13	)		(26	)
Realized net losses reclassified from other comprehensive income		(1,080	)		(1,051	)		(2,144	)		(1,546	)
Total Interest Expense	$	(2,720	)	$	(2,113	)	$	(5,323	)	$	(2,608	)

Credit Derivatives

At June 30, 2011 and December 31, 2010, we had no outstanding CDS contracts or obligations. During the six months ended June 30, 2010, the reference securities underlying our CDS experienced principal losses and corresponding obligations of $17 million.

Counterparty Credit Risk

We incur credit risk to the extent that counterparties to our derivative financial instruments do not perform their obligations under specified contractual agreements. If a derivative counterparty does not perform, we may not receive the proceeds to which we may be entitled under these agreements. To mitigate this risk, we enter into agreements that are either a) transacted on a national exchange or b) transacted with counterparties that are either i) designated by the Federal Reserve Bank of New York as a primary government dealer, ii) affiliates of primary government dealers, or iii) rated A or higher. We also attempt to transact with several different counterparties in order to reduce our specific counterparty exposure. We consider counterparty risk as part of our fair value assessments of all derivative financial instruments.

At June 30, 2011, Redwood had outstanding derivative agreements with eight bank counterparties and Acacia entities had outstanding derivative agreements with five bank counterparties. At June 30, 2011, Redwood and the Acacia entities were in compliance with International Swaps and Derivatives Association (ISDA) agreements governing these open derivative positions.