e10vk

10-K 1 f17170e10vk.htm FORM 10-K e10vk

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K


[X]		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		For the fiscal year ended: December 31, 2005
OR
[ ]		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		For the transition period from to

Commission file number: 1-13759

REDWOOD TRUST, INC.

(Exact name of registrant as specified in its charter)


Maryland		68-0329422
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

One Belvedere Place, Suite 300 Mill Valley, California (Address of principal executive offices)		94941 (Zip Code)

(415) 389-7373

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:


Title of Each Class:		Name of Exchange on Which Registered:

Common Stock, par value $0.01 per share		New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [X] No [ ]

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes [ ] No [X]

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer [X] Accelerated filer [ ] Non-accelerated filer [ ]

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X]

At June 30, 2005, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $1,271,783,291 based on the closing sale price as reported on the New York Stock Exchange.

The number of shares of the registrant’s Common Stock outstanding on February 23, 2006 was 25,189,950.

Documents Incorporated by Reference

Portions of the registrant’s definitive Proxy Statement to be filed with the Securities and Exchange Commission under Regulation 14A within 120 days after the end of registrant’s fiscal year covered by this Annual Report are incorporated by reference into Part III.

REDWOOD TRUST, INC.

2005 FORM 10-K ANNUAL REPORT


		Page
	TABLE OF CONTENTS
PART I

Item 1.	BUSINESS		2

Item 1A.	RISK FACTORS		6

Item 1B.	UNRESOLVED STAFF COMMENTS		16

Item 2.	PROPERTIES		17

Item 3.	LEGAL PROCEEDINGS		17

Item 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS		17

PART II

Item 5.	MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES		18

Item 6.	SELECTED FINANCIAL DATA		19

Item 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		20

Item 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		56

Item 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA		59

Item 9.	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE		59

Item 9A.	CONTROLS AND PROCEDURES		59

Item 9B.	OTHER INFORMATION		59
PART III

Item 10.	DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT		60

Item 11.	EXECUTIVE COMPENSATION		60

Item 12.	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT		60

Item 13.	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS		60

Item 14.	PRINCIPAL ACCOUNTING FEES AND SERVICES		60

PART IV

Item 15.	EXHIBITS, FINANCIAL STATEMENT SCHEDULES		61
CONSOLIDATED FINANCIAL STATEMENTS			F-1
EXHIBITS
EXHIBIT 21
EXHIBIT 23.1
EXHIBIT 23.2
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PART I


Item 1.	BUSINESS


	CAUTIONARY STATEMENT

This Annual Report on Form 10-K and the documents incorporated by reference herein contain forward-looking statements within the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Statements that are not historical in nature, including the words “anticipated,” “estimated,” “should,” “expect,” “believe,” “intend,” and similar expressions, are intended to identify forward-looking statements. These forward-looking statements are subject to risks and uncertainties, including, among other things, those described in this Annual Report on Form 10-K under Item 1A “Risk Factors.” Other risks, uncertainties, and factors that could cause actual results to differ materially from those projected are detailed from time to time in reports filed by us with the Securities and Exchange Commission (SEC), including Forms 10-Q and 8-K. Important factors that may impact our actual results include changes in interest rates and market values; changes in prepayment rates; general economic conditions, particularly as they affect the price of earning assets and the credit status of borrowers; the level of liquidity in the capital markets as it affects our ability to finance our real estate asset portfolio and other factors not presently identified. In light of these risks, uncertainties, and assumptions, the forward-looking events mentioned, discussed in, or incorporated by reference into this Annual Report on Form 10-K might not occur. Accordingly, our actual results may differ from our current expectations, estimates, and projections. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.


	REDWOOD TRUST, INC.


	Redwood Trust, Inc., together with its subsidiaries (Redwood, we, or us), is a specialty finance company that invests in, credit-enhances, and securitizes residential and commercial real estate loans and securities. In general, we invest in real estate loans by acquiring and owning asset-backed securities (ABS) backed by these loans. Our primary focus is investing in first-loss and second-loss credit-enhancement securities (CES) issued by real estate loan securitizations, thereby partially guaranteeing (credit-enhancing) the credit performance of residential or commercial real estate loans owned by the issuing securitization entity.

	Most of the real estate loans we credit-enhance are above average in terms of loan quality as compared to other securitized real estate loans. As a result, our delinquency and loss rates have been significantly lower than average. When market conditions are favorable, we intend to expand our credit-enhancement activities for loans that have average or below-average quality characteristics. Nevertheless, it is likely that most of the real estate loans we credit-enhance will continue to be high quality loans.

	On an economic basis, most of our assets consist of residential and commercial CES that we have acquired from securitizations that have been sponsored by others. We also sponsor residential loan securitizations. We acquire residential whole loans from originators, accumulate loans over a period of a few weeks or months, and then sell the loans to newly-created securitization entities (Sequoia entities) that create and sell securities backed by these loans. We may also acquire some of the interest-only securities (prepayment rate sensitive securities) from these securitizations.

	We also acquire and aggregate pools of diverse types of investment-grade and non-investment grade residential and commercial real estate securities. We then sell these pools of assets to newly-created securitization entities (Acacia entities) that create and sell ABS. We earn on-going management fees from outstanding Acacia transactions. We may also acquire the equity from collateralized debt obligation (CDO) transactions.

	As a real estate investment trust (REIT), we are required to distribute to stockholders as dividends at least 90% of our REIT taxable income, which is our income as calculated for tax

purposes, exclusive of income earned in non-REIT subsidiaries. In order to meet our dividend distribution requirements, we have been paying both a regular quarterly dividend and a year-end special dividend. We set our regular quarterly dividend at a rate that we believe is more likely than not to be sustainable over time. If we earn more taxable income than is required to fund the regular dividend, we have generally paid a special dividend in December. We expect our special dividend amount to be highly variable, and we may not pay a special dividend in every year. Our dividend policies and distribution practices are determined by our Board of Directors and may change over time.

Redwood was incorporated in the State of Maryland on April 11, 1994, and commenced operations on August 19, 1994. We have our executive offices at One Belvedere Place, Suite 300, Mill Valley, California 94941.


	BUSINESS MODEL AND STRATEGY


	Our business model and strategy are based on our belief that an efficiently structured specialty finance company can achieve an attractive level of profitability through investing in, credit-enhancing, and securitizing residential and commercial real estate loans and securities in a disciplined manner. Our primary financial goal is to generate steady regular dividends for our stockholders.

	Our primary source of revenue is interest income paid to us from the securities and loans we own, which in turn consists of the monthly loan payments made by homeowners (and to a lesser degree, commercial property owners) on their real estate loans. Our primary product focus is credit-enhancing residential and commercial loans that are high quality. “High quality” means real estate loans that typically have features such as low loan-to-value ratios, borrowers with strong credit histories, and other indications of quality relative to the range of loans within U.S. real estate markets as a whole.

	We seek to maintain a structured balance sheet that we believe should allow us to weather potential general economic downturns and liquidity crises. We generally seek to put ourselves in a position where changes in interest rates would not be likely to materially harm our ability to meet our long-term goals or maintain our regular dividend rate. We use debt to finance loans and securities that we are accumulating as inventory for sale to securitization entities sponsored by us.

	We currently sponsor the securitization through our Sequoia program of all the residential real estate loans we acquire. Our residential loan securitization activities focus primarily on jumbo residential loans products. We typically retain a credit-enhancement security from these securitizations. We may also acquire and retain an interest-only security that has investment return characteristics primarily related to the rate of prepayment of the loans owned by the Sequoia securitization entity.

	We also sponsor the re-securitization through our Acacia CDO program of investment-grade (and, to a lesser degree, non-investment grade) real estate securities. We typically acquire and retain the CDO equity securities issued by the Acacia securitization entities. CDO equity securities bear the first-loss and second-loss credit risk with respect to the securities owned by the Acacia entities.

	We seek to invest in assets that have the potential to provide high cash flow returns over a long period of time to help support our goal of maintaining steady regular dividends over time. We typically fund these assets entirely with equity (i.e., no debt). We refer to the assets we own that meet these criteria as “permanent assets”. Thus, our goal is to build a permanent asset portfolio that consists primarily of various ABS. The ABS in our permanent asset portfolio are collateralized by residential and commercial loans and generally represent the types of securities that have the most concentrated credit risk with respect to the underlying loans. In some instances, we may also invest in ABS that have the most concentrated prepayment risk (and/or interest rate risk, if any). Our permanent assets also include commercial real estate loan

investments. By acquiring and managing these ABS, our permanent asset portfolio is designed to generate long-term cash flows that will fund dividend distributions to our stockholders.

By funding our permanent assets with equity, we have no liquidity risk, debt roll-over risk, or margin call risk with respect to these assets. We use a combination of debt and equity to fund “inventory” assets that we acquire for re-sale to a securitization entity. Our balance sheet is strong because our maximum economic loss with respect to the credit risks associated with our permanent assets is limited to our investment in CES. In other words, our maximum loss on these investments is less than our equity capital base.

As a result of the form of securitization we have chosen to utilize for most of the securitizations we sponsor, we consolidate and report under GAAP all of the assets of the securitization entities we have sponsored as assets on our Consolidated Balance Sheets, and we consolidate and report all of the ABS issued by those entities and held by unrelated third parties as liabilities on our Consolidated Balance Sheets. Thus, the ABS we acquire for our permanent asset portfolio from securitizations we sponsor are not shown as specific assets on our Consolidated Balance Sheets, but rather are represented by the excess of the recorded value of the securitized pool of assets over the related liabilities, in each case consolidated from the securitization entities we have sponsored. As a result of this GAAP treatment, no gain on sale is recognized for GAAP purposes from the securitizations we sponsor even if these securitizations result in taxable gains on sales for us.

Although we currently invest in residential and commercial real estate securities including interest only (IO) securities, home equity lines of credit (HELOC), commercial real estate loan participations, and CDO equity securities backed by diverse types of residential and commercial real estate loans and securities, we are open to investing in, credit-enhancing, and securitizing other types of real estate assets that may complement and benefit our core business activities. We also may make non-real estate investments or enter non-real estate businesses.


	COMPETITION


	We believe we are more efficient than banks and thrifts at owning, credit-enhancing, securitizing, and financing residential and commercial real estate loans. As a non-regulated specialty finance company, we have greater freedom to operate in the capital markets and securitization markets than do other financial institutions such as banks and insurance companies. Also our operating costs are lower. As a public company with permanent capital, we have an advantage in making investments in illiquid assets relative to investment companies and partnerships that might suffer investor withdrawals and liquidity issues. As a REIT, we have tax advantages relative to non-REITs that have to pay corporate income taxes, typically one of the largest costs of doing business. As a market leader, we have size advantages that bring economies of scale as well as marketing and operating advantages. As a company with a small number of employees, we have a strong culture that is entrepreneurial, focused, and disciplined.

	We believe that the business of acquiring and owning residential and commercial loan CES is highly fragmented. Companies that credit-enhance residential and commercial loan securitizations include banks and thrifts (generally credit-enhancing their own loan originations), Fannie Mae and Freddie Mac, Wall Street broker-dealers, hedge funds, private investment firms, mortgage REITs, business development companies, asset management firms, pension funds, and others. In addition, our credit-enhancement business competes with banks and similar financial institutions to the extent that they hold real estate loans in portfolio rather than securitizing them.

	The volume of high-quality CES has declined recently as a result of lower overall origination levels as interest rates have risen and a lower percentage of loans are being securitized, particularly hybrid loans, as they are being held in portfolio by banks and other financial institutions. Additionally, the supply of high-quality loans is impacted by a general deterioration in underwriting standards. This decline in volume has led to excess capacity in the residential

mortgage industry, which in turn continues to put pressure on prices for new residential loan CES.

We believe that the business of acquiring and owning residential IO securities generated through the securitization of jumbo residential loans is also fragmented. A deeper and more active market for more complex IO securities has developed in the last several years, in part due to interest from asset management firms, mutual funds, hedge funds, Wall Street broker-dealers, and other capital markets participants seeking attractive fixed income yields.

Our sponsorship of Sequoia residential loan securitizations competes with Wall Street broker-dealers, mortgage REITs, and various mortgage conduits that acquire loans to create economic gains through securitization. We also compete with banks, loan origination companies, and REITs that securitize their own real estate loan origination.

Our sponsorship of Acacia CDO securitizations and our investment in CDO equity securities competes with a large variety of asset management organizations, financial institutions, and institutional investors worldwide.

A reduction in securitization volume or profitability, caused by increased competition, reduced asset supply, market fluctuations, ABS spread widening, poor hedging results, or other factors, could have a material adverse impact on our taxable income and also on our GAAP income. Competition in the business of sponsoring securitizations of the type we focus on is increasing as Wall Street broker-dealers, mortgage REITs, investment management companies, and other financial institutions expand their activities or enter this field. In general, this has reduced our taxable gains on sales as we have had to pay a higher price for securitizable assets relative to the proceeds available from securitization.

We believe competitive pressures within the commercial loan origination business are generally leading to a decline in origination standards. Furthermore, the underlying commercial properties are generally valued at high prices compared to their cash flow (relative to commercial real estate prices in the last ten years). In addition, competition to acquire commercial loan CES has increased, thus raising effective current prices for the commercial loan CES we buy. These market factors may make expansion or prudent investing difficult.


	INFORMATION AVAILABLE ON OUR WEBSITE

Our website can be found at www.redwoodtrust.com. We make available, free of charge on or through our website, access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after those materials are filed with, or furnished to, the SEC. We also make available, free of charge, access to our Code of Ethics, Corporate Governance Standards, Audit Committee Charter, Compensation Committee Charter, and Governance and Nominating Committee Charter.


	CERTIFICATIONS

Our Chief Executive Officer and Chief Financial Officer have executed certifications dated February 23, 2006, as required by Sections 302 and 906 of the Sarbanes-Oxley Act of 2002, and we have included those certifications as exhibits to our Annual Report on Form 10-K for the year ended December 31, 2005. In addition, our Chief Executive Officer certified to the New York Stock Exchange (NYSE) on May 26, 2005 that he is unaware of any violations by Redwood Trust, Inc. of the NYSE’s corporate governance listing standards in effect as of that date.


	EMPLOYEES


	As of December 31, 2005, Redwood employed 79 people.


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 14% 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 U.S. 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

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 $184 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 $935 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 $1 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),

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 46% 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 25% of our commercial real estate loans, and 16% 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 3% to 6% 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 1% of our loans in any one zip code. As of December 31, 2005, our commercial loan CES had more than 5% 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

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 risks of credit-enhancing commercial real estate loans may exceed those of credit-enhancing residential loans.*


	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. This may not work to our advantage. 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 (i.e., 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)

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-U.S. 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

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 may not receive funds to which we are entitled. In other aspects of our business, we depend on the performance of third parties that we do not control. 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. Changes in interest rates can also harm the credit performance of our assets. 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. A portion our equity-funded assets have adjustable-rate coupons. 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

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 (i.e., 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 U.S. Treasuries, mortgage securities, or other cash instruments. Such hedges may have special basis, liquidity, and other risks to us.


	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.


	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.


	*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 No. 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. These types of actions reduce our reported GAAP earnings.


	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 100% 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.

           • Our ability to own non-real estate related assets and earn non-real estate related income is limited. Our ability to own equity interests in other entities 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 (i.e., 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 55% of our assets in certain qualifying real estate assets (the 55% Requirement) and are also required to maintain an additional 25% in qualifying assets or other real estate-related assets (the 25% Requirement).

	If we failed to meet the 55% Requirement and the 25% 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.


Item 1B.	UNRESOLVED STAFF COMMENTS


	None.


Item 2.	PROPERTIES


	Redwood leases space for executive and administrative offices at One Belvedere Place, Suite 300, Mill Valley, California 94941. The lease expires in 2013 and our 2006 rent obligation is approximately $0.7 million.


Item 3.	LEGAL PROCEEDINGS


	At December 31, 2005, there were no legal proceedings to which Redwood was a party or to which any of its property was subject.


Item 4.	SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS


	No matters were submitted to a vote of Redwood’s stockholders during the fourth quarter of 2005.

PART II

Item 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

Redwood’s Common Stock is listed and traded on the NYSE under the symbol RWT. Redwood’s Common Stock was held by over 2,000 holders of record on February 23, 2006 and the total number of beneficial stockholders holding stock through depository companies was over 33,000. As of February 23, 2006, there were 25,189,950 shares outstanding. The high and low sales prices of shares of the Common Stock as reported on the NYSE and the cash dividends declared on the Common Stock for the periods indicated below were as follows:


					Common Dividends Declared
	Stock Prices
					Record		Payable		Per		Dividend
	High		Low		Date		Date		Share		Type

Year Ended December 31, 2005

Fourth Quarter	$	47.59	$	41.26		12/30/05		1/23/06	$	0.70		Regular
						11/25/05		12/9/05	$	3.00		Special
Third Quarter	$	54.98	$	48.61		9/30/05		10/21/05	$	0.70		Regular
Second Quarter	$	54.08	$	49.97		6/30/05		7/21/05	$	0.70		Regular
First Quarter	$	62.45	$	48.73		3/31/05		4/21/05	$	0.70		Regular

Year Ended December 31, 2004

Fourth Quarter	$	65.98	$	57.54		12/31/04		1/21/05	$	0.67		Regular
						11/30/04		12/10/04	$	5.50		Special
Third Quarter	$	62.42	$	54.60		9/30/04		10/21/04	$	0.67		Regular
Second Quarter	$	62.10	$	43.45		6/30/04		7/21/04	$	0.67		Regular
First Quarter	$	62.69	$	49.15		3/31/04		4/21/04	$	0.67		Regular
						3/31/04		4/21/04	$	0.50		Special

Redwood intends to distribute to its stockholders substantially all of its REIT taxable income. All dividend distributions will be made by Redwood with the authorization of the Board of Directors at its discretion and will depend on the taxable earnings of Redwood, financial condition of Redwood, maintenance of REIT status, and such other factors as the Board of Directors may deem relevant from time to time.


	Issuer Purchases of Equity Securities

					Total Number of		Maximum Number
	Total				Shares Purchased as		Of Shares Available
	Number of		Average		Part of Publicly		For Purchase Under
	Shares		Price Paid		Announced		Publicly Announced
Period	Purchased		Per Share		Programs		Programs

October 1 - October 31, 2005		—		—		—		—
November 1 - November 30, 2005		1,025	$	44.01		—		—
December 1 - December 31, 2005		—		—		—		—

Total		1,025	$	44.01		—		1,000,000


	The Company announced stock repurchase plans on various dates from September 1997 through November 1999 for the total repurchase of a total of 7,455,000 shares. None of these plans have expiration dates. As of December 31, 2005, 1,000,000 shares remained available for repurchase under those plans.


*Item 6.*	*SELECTED FINANCIAL DATA*

The following selected financial data is for the years ended December 31, 2005, 2004, 2003, 2002, and 2001. It is qualified in its entirety by, and should be read in conjunction with the more detailed information contained in the Consolidated Financial Statements and Notes thereto and, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Annual Report on Form 10-K. Certain amounts for prior periods have been reclassified to conform to the 2005 presentation.


(In thousands, except per share data)		2005			2004			2003			2002			2001

Statement of Operations Data:
	Interest income	$	959,951		$	648,084		$	330,976		$	163,216		$	144,539
	Interest expense		(757,524	)		(431,918	)		(202,861	)		(91,705	)		(98,069	)

	Net interest income		202,427			216,166			128,115			71,511			46,470
	Operating expenses		(45,882	)		(34,661	)		(36,895	)		(20,005	)		(12,747	)
	Net recognized market value gains		60,848			59,127			46,676			5,111			1,532
	Provision for income taxes		(17,521	)		(7,997	)		(5,502	)		—			—
	Dividends on Class B preferred stock		—			—			(681	)		(2,724	)		(2,724	)
	Undistributed earnings allocated to Class B preferred stock		—			—			(15	)		(452	)		(150	)

	Net income available to common stockholders before change in accounting principle		199,872			232,635			131,698			53,441			32,381
	Cumulative effect of adopting EITF 99-20 ⁽¹⁾		—			—			—			—			(2,368	)

	Net income available to common stockholders	$	199,872		$	232,635		$	131,698		$	53,441		$	30,013
Average common shares — basic			24,637,016			21,437,253			17,759,346			15,177,449			10,163,581
Net income per share — basic		$	8.11		$	10.85		$	7.42		$	3.52		$	2.95
Average common shares — diluted			25,121,467			22,228,929			18,812,166			15,658,623			10,474,764
Net income per share — diluted		$	7.96		$	10.47		$	7.04		$	3.41		$	2.87
Dividends declared per Class B preferred share			—			—		$	0.755		$	3.020		$	3.020
Regular dividends declared per common share		$	2.80		$	2.68		$	2.600		$	2.510		$	2.220
Special dividends declared per common share		$	3.00		$	6.00		$	4.750		$	0.375		$	0.330

Total dividends declared per common share		$	5.80		$	8.68		$	7.350		$	2.885		$	2.550
Balance Sheet Data: end of period
	Earning assets	$	16,529,286		$	24,572,723		$	17,543,487		$	6,971,794		$	2,409,271
	Total assets	$	16,776,960		$	24,778,065		$	17,670,386		$	7,028,939		$	2,439,136
	Redwood debt	$	169,707		$	203,281		$	236,437		$	99,714		$	796,811
	Asset-backed securities issued	$	15,585,277		$	23,630,162		$	16,826,202		$	6,418,187		$	1,317,207
	Total liabilities	$	15,842,000		$	23,913,909		$	17,117,058		$	6,555,906		$	2,131,363
	Total stockholders’ equity	$	934,960		$	864,156		$	553,328		$	473,033		$	307,773
	Number of Class B preferred shares outstanding		—			—			—			902,068			902,068
	Number of common shares outstanding		25,132,625			24,153,576			19,062,983			16,277,285			12,661,749
	Book value per common share	$	37.20		$	35.78		$	29.03		$	27.43		$	22.21
Other Data:
	Average assets	$	21,797,922		$	21,559,604		$	11,058,272		$	4,039,652		$	2,223,280
	Average borrowings	$	20,710,057		$	20,748,658		$	10,489,614		$	3,616,506		$	1,945,820
	Average reported total equity	$	970,269		$	730,499		$	526,808		$	402,986		$	254,021
	Net income/average common equity		20.6	%		31.8	%		25.3	%		14.2	%		13.2	%


	(1)	The provisions of Emerging Issues Task Force 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets (EITF 99-20) became effective January 1, 2001. At that date, our projections of cash flows in certain of Redwood’s residential CES were less than the cash flows anticipated at acquisition and the fair value had declined below the carrying value. Accordingly, Redwood recorded a $2.4 million charge ($0.23 per share using both basic and diluted shares outstanding in 2001) through the Consolidated Statements of Income at that time as a cumulative effect of a change in accounting principle.


Item 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


	SUMMARY AND OUTLOOK


	Our primary source of revenue is interest income paid to us from the securities and loans we own, which in turn consists of the monthly loan payments made by homeowners (and to a lesser degree, commercial property owners) on their real estate loans. Our primary product focus is credit-enhancing residential and commercial loans that are high quality. “High quality” means real estate loans that typically have features such as low loan-to-value ratios, borrowers with strong credit histories, and other indications of quality relative to the range of loans within U.S. real estate markets as a whole. We currently sponsor the securitization through our Sequoia program of all the residential real estate loans we acquire. We also sponsor the re-securitization through our Acacia CDO program, of investment-grade (and, to a lesser degree, non-investment grade) real estate securities. We seek to invest in assets that have the potential to provide high cash flow returns over a long period of time to help support our goal of maintaining steady dividends over time.

	Our reported GAAP net income was $200 million ($7.96 per share) for 2005. In 2004, GAAP net income was $233 million ($10.47 per share) and was $132 million ($7.04 per share) in 2003. Our results for 2005 were not as strong as the extraordinary results we achieved during 2004, but are still at a level that we consider attractive. Our GAAP return on equity was 21% for 2005 compared to 32% for 2004 and 25% in 2003. Better than expected credit results on the loans we credit-enhance has been the primary driver of our continued strong earnings results. For the residential real estate loans we credit-enhance, delinquencies remain at historically low levels and annual credit losses continue to be less than one basis point (0.01%) of the current balance of these loans. Credit results for the commercial real estate loans we credit-enhance have also been excellent.


	*Table 1 Net Income*


(In thousands, except share data)	2005			2004			2003

Total interest income	$	959,951		$	648,084		$	330,976
Total interest expense		(757,524	)		(431,918	)		(202,861	)

Net interest income		202,427			216,166			128,115
Operating expenses		(45,882	)		(34,661	)		(36,895	)
Net recognized gains and valuation adjustments		60,848			59,127			46,676
Provision for income taxes		(17,521	)		(7,997	)		(5,502	)
Dividends and Income allocated to Class B		—			—			(696	)

Net income	$	199,872		$	232,635		$	131,698

Diluted Common Shares		25,121,467			22,228,929			18,812,166
Net income per share	$	7.96		$	10.47		$	7.04


	We declared four regular quarterly dividends of $0.70 per share in 2005 and, in the fourth quarter, declared and paid a special dividend of $3.00 per share. We permanently retained approximately 10% of the ordinary real estate investment trust (REIT) taxable income we earned during 2005 and we intend to declare and distribute the remainder of our 2005 REIT taxable income as dividends by September 2006. In addition, we also retained the after-tax profits earned in our non-REIT subsidiaries. We anticipate following a similar pattern of retention and distribution in 2006.

	In the second half of 2005 we sold single B-rated residential loan CES. This portfolio adjustment was made to reduce overall residential credit risk levels and to raise cash for future investment opportunities. We retained most of our first-loss (non-rated) CES while primarily selling second-loss CES. By changing our asset mix in this manner, we reduced our downside risk within our residential portfolio should credit losses increase, but retained most of the upside potential inherent in our portfolio that should be realized over time if residential credit losses continue to be low.


	Our net discount on all consolidated residential and commercial real estate loans and securities (ARM, fixed, and hybrid) is $623 million, or $24.79 per share outstanding at December 31, 2005. The net discount at December 31, 2005 is $449 million or $17.87 per share on residential real estate assets and is $174 million or $6.92 per share on commercial real estate assets. We will realize this $623 million net discount as income over the next 10 years to the extent it is not diminished by credit losses. If faster residential prepayments continue, we will realize the residential portion of this income more quickly.

	The health of the real estate industry is cyclical. The tremendous growth in residential real estate prices appears to be slowing. We believe it is probable that real estate fundamentals may deteriorate over the next two years, causing our credit losses to increase but also reducing acquisition prices for the assets we seek to buy. As a result, our current plan, which is subject to change, is to invest our excess capital ($189 million at December 31, 2005) steadily over the next two to three years so that we maintain reduced risk levels while also capturing opportunities to acquire cheaper assets. We will likely modify this plan as the market environment changes. Nevertheless, as a result of this general plan of action, it is likely that we will continue to have relatively high cash balances for some time. Our strong balance sheet and cash balances will be particularly helpful in the event (unlikely, but possible, in our view) that real estate credit fundamentals deteriorate significantly.

	Our mortgage conduit’s residential loan securitization business is in transition. In 2004 and prior years, we generated attractive levels of economic gains (gain on sale through securitization) by acquiring high-quality one- and six-month LIBOR adjustable-rate residential loans from originators, selling the loans to Sequoia securitization entities, and then sponsoring Sequoia securitizations of these loans. In today’s flat to inverted yield curve environment however, LIBOR-indexed ARMs are not an attractive option for homeowners, causing origination volume of this product to decrease dramatically. In addition, several Wall Street firms have recently entered the residential conduit business, increasing competition and reducing securitization gain-on-sale opportunities.

	We are responding to these changes by broadening our residential conduit’s product line (both in terms of product type and loan quality characteristics) and by expanding our mortgage originator customer base. We are focusing on market areas and relationships where we believe we have, or can develop, a competitive advantage. We expect our residential conduit business will break-even economically this year while also not absorbing much capital. Even at break-even levels, our residential conduit brings multiple benefits to our business as a whole and is an excellent source of assets for us to invest in. In the longer term, we expect our residential conduit to develop in a manner that will once again generate attractive returns for our shareholders.

	We continue to be large and active investors in the market for residential credit-enhancement securities created by others, and we continue to allocate the greater part of our capital to these assets. In the fourth quarter, we took advantage of some excellent acquisition opportunities. Acquisition pricing for some new assets improved, in part due to seasonal trends (as a result of supply/demand trends, the fourth quarter is usually a good time to buy assets) and also due to concerns about the housing markets.

	We are continuing to build our business of credit-enhancing securitized commercial real estate loans. Commercial real estate properties as a whole continue to improve their cash flows and valuations. Due to the level of competition in commercial credit-enhancement, and due to weakening commercial loan origination standards, the prospective returns from commercial credit-enhancement securities at the moment are acceptable, but not overwhelming. We will continue to develop this business as part of our long-term growth and diversification strategy, and are pleased with our accomplishments to date in this area.

	The market for sponsoring CDO securitizations continues to be attractive, although it is has become more volatile. We expect to continue sponsoring Acacia CDO transactions during 2006. After we complete each securitization, we expect to acquire and invest in all or a portion of the CDO equity securities created in these transactions. We expect that these will be attractive investments over time. We believe that the CDO business is a fertile area for innovation. In 2005, we completed our first predominately commercial real estate CDO. We may also incorporated

synthetic assets in Acacia’s asset pools. Over the next few years, we expect our CDO sponsorship business to grow and evolve in interesting new ways and to continue to generate attractive new investments and asset management fees.

We seek to maintain a structured balance sheet that we believe should allow us to weather potential general economic downturns and liquidity crises. We generally seek to put ourselves in a position where changes in interest rates would not be likely to materially harm our ability to meet our long-term goals or maintain our regular dividend rate. We use debt to finance loans and securities that we are accumulating as inventory for sale to securitization entities sponsored by us.

In our view, the long-term outlook for our business is good. Housing price increases over the past several years have reduced our risk of credit loss in the future for our existing residential assets. For most of our risk assets, the underlying loans were originated in 2003 and 2004. Commercial property values and cash flows are increasing in many areas. Our portfolio of assets as a whole has the ability to generate attractive earnings, cash flows, and dividends in the future, assuming real estate credit losses do not increase materially.

In general, we expect per share earnings and the special dividend in 2006 will be lower than 2005 as a result of much higher cash balances, a newer portfolio on average (the higher-yielding seasoned assets have largely been sold or called), few gains from sales (as we are not planning significant amount of sales at this time) and calls (as we have few callable assets), continued high premium amortization expenses on the residential loans consolidated from Sequoia trusts as these loans continue to prepay rapidly, and for other reasons. If we reduce our excess cash balances over the next few years, invest wisely, and start to realize some of the upside potential inherent in our existing assets, earnings and special dividends in 2007 and 2008 could increase from 2006 levels.

Over the long-term we believe it is reasonably likely that we will be able to continue to find attractive investment opportunities, because we are an efficient competitor and because our market segments are growing (as the amount of real estate loans outstanding increases and the percentage of these loans that are securitized increases).


	RESULTS OF OPERATIONS


	*2005 AS COMPARED TO 2004*


	*Acquisitions, Securitizations, Sales, and Calls*


	During 2005, we acquired $268 million residential loan CES. This was similar to the $269 million we acquired in 2004. The loans underlying the CES we acquired during 2005 were generally of above-average quality as compared to securitized residential loans as a whole.

	In 2005, we had calls of our residential loan CES of $36 million principal value for GAAP gains of $19 million. This was a decrease from the calls realized in 2004 of $99 million principal value that generated GAAP gains of $59 million. We had fewer of these assets become callable during 2005. At the end of 2005, we had residential loan CES securities with principal value totaling $1 million that were callable.

	During 2005, we sold $207 million residential loan CES generating GAAP gains of $40 million. During 2004, sales of residential loan CES totaled $22 million generated GAAP gains of $6 million. Sales in 2005 where higher due to our portfolio restructuring activities.

	We acquired $25 million commercial real estate loans during 2005, a decrease from the $38 million acquired during 2004. We sold $11 million commercial real estate loans during 2005 and $2 million during 2004. Our commercial real estate loan activity provides additional collateral to the “Acacia” CDO securitizations we sponsor.


	During 2005, we acquired $43 million commercial loan CES, a significant increase from the $13 million acquired in 2004. This increase reflects our ongoing efforts to increase our ability to analyze, source, and manage commercial real estate loan CES. No commercial loan CES were sold during these periods.

	In 2005, our residential real estate loan acquisitions totaled $1.9 billion. We sold $1.5 billion of these loans to Sequoia entities and also sold $507 million loans as whole loans to others, leaving us with an inventory of loans of $45 million at December 31, 2005. Sequoia entities issued $1.5 billion asset-backed securities (ABS) during 2005. This level of residential loan securitization activity was a significant decrease from 2004 when Sequoia entities acquired loans of $10.0 billion and issued a like amount of ABS. Typically we acquire London Inter-Bank Offer Rate (LIBOR) adjustable-rate mortgage (ARM) residential loans for the Sequoia securitization program we sponsor; the flatter yield curve reduced the amount of LIBOR ARM residential loans originated in 2005.

	We acquired $684 million of other residential and commercial real estate securities during 2005 as inventory for sale to our Acacia CDO securitization program. This was an increase from the $598 million of these acquisitions we made for Acacia during 2004. We sold securities to Acacia entities totaling $665 million during 2005 and $584 million during 2004. At December 31, 2005, we had securities of $214 million for sale to future Acacias entities. In both 2005 and 2004, Acacia entities issued $900 million CDO ABS.


	*Net Income*


	Our reported GAAP net income was $200 million ($7.96 per share) for 2005, a decrease from the $233 million ($10.47 per share) earned in 2004. Our GAAP return on equity was 21% for 2005 compared to 32% for 2004.

	The reduction in our net income of $33 million from 2004 to 2005 resulted from a decrease in net interest income of $14 million, an increase in operating expenses of $11 million, an increase in provisions for income taxes of $10 million, partially offset by an increase in net gains on sales and calls (net of market valuation adjustments) of $2 million.


	*Net Interest Income*


	Net interest income decreased to $202 million in 2005 compared to $216 million in 2004. The reduction in net interest income of $14 million resulted from increased ARM prepayments rates on residential loans consolidated from Sequoia securitization entities and lower yields on our portfolio of residential CES as our older higher-yielding securities were called or sold, and from higher levels of unvested cash. In addition, net interest income was higher in 2004 due to the effect of a cumulative correcting adjustment of an error on previously reported earnings of $4.1 million (which is further discussed below on page 36). Net interest income in 2005 benefited from a reduction in credit provision expenses of $7 million as a result of excellent loan credit performance and reduced loan balances (as prepayments for loans owned by Sequoia accelerated while Sequoia securitization volume dropped).

	Prepayment rates (CPR) for residential ARM loans owned by Sequoia entities increased from an average of 17% in 2004 to 43% in 2005. Faster prepayments on ARMs have been caused primarily by the flatter yield curve (higher than average short-term interest rates relative to long-term interest rates) and the increase in popularity of negative amortization loans. Borrowers are more inclined to refinance out of ARMs and into hybrid or fixed rate loans when the effective interest rates on ARMs are not significantly lower than the fixed rate alternatives. Additionally, new forms of adjustable-rate mortgages (negative amortization, “option ARMs”, and Moving Treasury Average ARMs) represent an increased share of the ARM market and have increased ARM-to-ARM refinancing.

	These faster prepayment rates for consolidated ARM loans had a negative impact on our net interest income in 2005. However, in the long term we believe we will likely benefit from faster

residential loan prepayments due to our significant investment in discount-priced residential loan CES.


	*Interest Income*


	Total interest income consists of interest earned on consolidated earning assets, plus income from amortization of discount for assets acquired at prices below principal value, less expenses for amortization of premium for assets acquired at prices above principal value, less credit provision expenses on loans.


	*Table 2 Interest Income and Yield*


(Dollars in thousands)	2005			2004

Interest income	$	965,594		$	651,661
Discount amortization		42,361			36,071
Premium amortization		(48,434	)		(32,412	)
Reversal of (provision for) credit losses		430			(7,236	)

Total interest income	$	959,951		$	648,084


Average earning assets	$	21,048,582		$	21,208,757
Yield as a result of:
Interest income		4.59	%		3.07	%
Discount amortization		0.20	%		0.17	%
Premium amortization		(0.23	)%		(0.15	)%
Reversal of (provision for) credit losses		0.00	%		(0.03	)%

Yield on earning assets		4.56	%		3.06	%


	Interest income increased to $960 million in 2005 from $648 million in 2004 primarily due to an overall increase in yield caused by an increase in short-term interest rates. Since a majority of the assets on our Consolidated Balance Sheets are adjustable-rate residential real estate loans, yields on these loans increase as short-term interest rates rise. As a result, total interest income was higher, even though the residential real estate loans consolidated balances decreased slightly from the prior year’s level.

	In addition to the impact of higher short-term interest rates, the contribution from the other portfolios increased in 2005, also leading to higher interest income. The table below presents the contribution to interest income and yield from each of our portfolios.


	*Table 3 Interest Income and Yield by Portfolio*


(Dollars in thousands)
	December 31, 2005

			Percent of
			Total
	Interest		Interest			Average
	Income		Income			Balance		Yield

Residential real estate loans, net of provision for credit losses	$	773,854		80.62	%	$	18,642,020		4.15	%
Residential loan credit-enhancement securities		86,564		9.02	%		541,224		15.99	%
Commercial loans, net of provision for credit losses		5,285		0.55	%		52,008		10.16	%
Commercial loan credit-enhancement securities		2,613		0.27	%		30,234		8.64	%
Securities portfolio		86,431		9.00	%		1,601,837		5.40	%
Cash and cash equivalents		5,204		0.54	%		181,259		2.87	%

Totals	$	959,951		100.00	%	$	21,048,582		4.56	%

Table 3 (continued)


(Dollars in thousands)
	December 31, 2004

			Percent of
			Total
	Interest		Interest			Average
	Income		Income			Balance		Yield

Residential real estate loans, net of provision for credit losses	$	529,842		81.76	%	$	19,665,096		2.69	%
Residential loan credit-enhancement securities		64,602		9.97	%		349,779		18.47	%
Commercial loans, net of provision for credit losses		3,769		0.58	%		30,469		12.37	%
Commercial loan credit-enhancement securities		675		0.10	%		5,261		12.83	%
Securities portfolio		48,274		7.45	%		1,062,901		4.54	%
Cash and cash equivalents		922		0.14	%		95,251		0.97	%

Totals	$	648,084		100.00	%	$	21,208,757		3.06	%


	The table below details our interest income by portfolio as a result of changes in consolidated asset balances (“volume”) and yield (“rate”) for 2005 as compared to 2004.


	*Table 4 Volume and Rate Changes for Interest Income*


(In thousands)
	Change in Interest Income
	2005 Versus 2004

							Total
	Volume			Rate			Change

Residential real estate loans, net of provisions for credit losses	$	(27,565	)	$	271,577		$	244,012
Residential loan credit-enhancement securities		35,359			(13,397	)		21,962
Commercial loans, net of provision for credit losses		2,664			(1,148	)		1,516
Commercial loan credit-enhancement securities		3,204			(1,266	)		1,938
Securities portfolio		24,477			13,680			38,157
Cash and cash equivalents		833			3,449			4,282

Total interest income	$	38,972		$	272,895		$	311,867


	Volume change is the change in average portfolio balance between periods multiplied by the rate earned in the earlier period. Rate change is the change in rate between periods multiplied by the average portfolio balance in the prior period. Interest income changes that result from changes in both rate and volume were allocated to the rate change amounts shown in the table.

	A discussion of the changes in total income, average balances, and yields for each of our portfolios is provided below.


	*Table 5 Consolidated Residential Real Estate Loans — Interest Income and Yield*


(Dollars in thousands)	2005			2004

Interest income	$	818,783		$	568,765
Net premium discount amortization		(45,174	)		(31,687	)
Reversal of (provision for) credit losses		245			(7,236	)

Total interest income	$	773,854		$	529,842

Average consolidated residential real estate loans	$	18,642,020		$	19,665,096
Yields as a result of:
Interest income		4.39	%		2.89	%
Net (premium) discount amortization		(0.24	)%		(0.16	)%
Reversal of (provision for) credit losses		0.00	%		(0.04	)%

Yield		4.15	%		2.69	%


	Interest income on residential real estate loans increased primarily as a result of higher short-term interest rates. Almost all these loans have coupon rates that adjust monthly or every six

months based on the one or six-month LIBOR interest rate. Yields on these residential real estate loans increased as short-term interest rates rose. The average balance decreased as loan prepayments exceeded new acquisitions.

Higher premium amortization expenses (as a percentage of current loan balances) in 2005 were caused primarily by increasing prepayment speeds on these loans.


	*Table 6 Residential Loan Credit-Enhancement Securities — Interest Income and Yield*


(Dollars in thousands)	2005			2004

Interest income	$	48,413		$	30,492
Net discount amortization		38,151			34,110

Total interest income	$	86,564		$	64,602

Average residential loan credit-enhancement securities	$	541,224		$	349,779
Yield as a result of:
Interest income		8.94	%		8.72	%
Net discount amortization		7.05	%		9.75	%

Yield		15.99	%		18.47	%


	Interest income recognized from residential loan CES increased primarily due to growth in our portfolio over the past year, partially offset by lower yields. Portfolio growth reflected our ability to find new assets at a pace in excess of our sales, calls, and principal prepayments. Yields decreased as many of our more seasoned, higher-yielding assets (higher yielding as a result of several years of strong credit performance and favorable prepayments) were called or sold over the last few years. The more recently acquired residential loan CES generally are being carried at lower effective yields because we do not expect the same strong credit performance or favorable prepayment patterns as we have had in the past, and because on average we acquired these assets at higher prices than in the past.

	The yields we currently recognize on recently acquired residential loan CES may be less than the yields we will actually realize over the lives of these residential loan CES. To determine yields on residential loan CES, we make assumptions regarding loan losses and prepayments. Since the market generally has a wide range for these assumptions (and not a specific estimate), we apply assumptions within a range that generally results in yields on these assets in early periods of ownership that are lower than what we might realize over the life of the assets if future performance turns out to be better than the low range of our expectations. Specifically, the initial yield we book on certain residential loan CES may be lower than the market mid-range expectation of performance (and below our hurdle rate of 14% pre-tax and pre-overhead internal rate of return). We review the actual performance of each residential loan CES and the market’s and our renewed range of expectations every quarter. We adjust the yield of the assets as a result of supportable changes in market conditions and anticipated performance. In addition, to the extent we credit-enhance loans with special credit risk (e.g., negative amortization loans), we may not recognize interest income that is not paid. We make ongoing determinations of the likelihood that any deferred interest payments will be collectible in recognizing current period yields.


	*Table 7 Commercial Real Estate Loans — Interest Income and Yield*


(Dollars in thousands)	2005			2004

Interest income	$	5,450		$	4,253
Net premium amortization		(350	)		(484	)
Reversal of credit losses		185			—

Total interest income	$	5,285		$	3,769

Average earning assets	$	52,008		$	30,469
Yield as a result of:
Interest income		10.47	%		13.96	%
Net premium amortization		(0.67	)%		(1.59	)%
Reversal of credit losses		0.36	%		0.00	%

Yield		10.16	%		12.37	%


	The interest income earned on our commercial real estate loan portfolio increased due to the growth in our commercial loan portfolio. This increase was partially offset by lower yields recognized for newer commercial loans.


	*Table 8 Commercial Loan Credit-Enhancement Securities — Interest Income and Yield*


(Dollars in thousands)	2005			2004

Interest income	$	5,174		$	1,000
Net premium amortization		(2,561	)		(325	)

Total interest income	$	2,613		$	675

Average commercial loan credit-enhancement securities	$	30,234		$	5,261
Yield as a result of:
Interest income		17.11	%		19.01	%
Net premium amortization		(8.47	)%		(6.18	)%

Yield		8.64	%		12.83	%

Interest income recognized from commercial loan CES increased due to the growth in this portfolio. This increase was partially offset by lower yields on newer commercial loan CES. The yield on commercial loan CES is based on our projected cash flows over time. Although we acquire commercial loan CES at a discount, we designate the amount of credit protection based on the anticipated losses in the underlying pool of loans. Since these commercial loan CES are the first loss pieces, the amount of credit protection so designated results in a premium balance to be amortized over the remaining lives of the assets. Over time, if the loans underlying these commercial loan CES perform better than we expect, we would re-designate a portion of the credit protection to accretable discount, thereby reducing the unamortized premium balance and increasing the yield recognized on these assets.


	*Table 9 Consolidated Securities Portfolio — Interest Income and Yield*


(Dollars in thousands)	2005			2004

Interest income	$	82,571		$	46,229
Discount amortization		4,211			2,286
Premium amortization		(351	)		(241	)

Total interest income	$	86,431		$	48,274

Average securities portfolio balance	$	1,601,837		$	1,062,901
Yield as a result of:
Interest income		5.16	%		4.34	%
Discount amortization		0.26	%		0.22	%
Premium amortization		(0.02	)%		(0.02	)%

Yield		5.40	%		4.54	%


	Total interest income increased for the securities portfolio as the total size of the portfolio grew and as yields increased as the coupon rates on adjustable-rate loan securities (which comprise over half of the portfolio) adjusted upward with the increase in short-term interest rates.


	*Interest Expense*


	Interest expense consists of interest payments on Redwood debt and consolidated ABS issued from sponsored securitization entities, plus amortization of deferred ABS issuance costs and expenses related to certain interest rate agreements less the amortization of ABS issuance premiums. ABS issuance premiums are created when interest-only securities and other ABS are issued at prices greater than principal value.

	Total consolidated interest expense increased as a result of a higher cost of funds due to an increase in short-term interest rates as most of our debt and consolidated ABS issued is indexed to one-, three-, or six-month LIBOR. The average balance of debt and consolidated ABS issued outstanding was at similar levels during these years.


	*Table 10 Total Interest Expense*


(Dollars in thousands)	2005		2004

Interest expense on Redwood debt	$	11,929	$	9,933
Interest expense on ABS issued		745,595		421,985

Total interest expense	$	757,524	$	431,918


Average Redwood debt balance	$	261,322	$	434,662
Average ABS issued balance		20,448,735		20,313,996

Average total obligations	$	20,710,057	$	20,748,658


Cost of funds of Redwood debt		4.56%		2.29%
Cost of funds of ABS issued		3.65%		2.08%
Cost of funds of total obligations		3.66%		2.08%


	For purposes of calculating the weighted average borrowing costs of ABS issued, we include the amortization of the deferred ABS issuance costs with interest expense. We include the average deferred ABS issuance costs in the average balances below.


	*Table 11 Average Balances of Asset-Backed Securities Issued*


(In thousands)	2005			2004

Sequoia	$	18,492,465		$	19,129,555
Acacia		2,008,705			1,229,075
Commercial		6,367			5,654

Average balance of ABS issued	$	20,507,537		$	20,364,284

Average deferred ABS issuance costs		(58,802	)		(50,288	)

Average balance of ABS issued, net	$	20,448,735		$	20,313,996


	The table below details interest expense on debt and consolidated ABS issued as a result of changes in consolidated balances (“volume”) and cost of funds (“rate”) for 2005 as compared to 2004.


	*Table 12 Volume and Rate Changes for Interest Expense*


(In thousands)
	Change in Interest Expense
	2005 Versus 2004

						Total
	Volume			Rate		Change

Interest expense on Redwood debt	$	(3,961	)	$	5,957	$	1,996
Interest expense on ABS issued		2,799			320,811		323,610

Total interest expense	$	(1,162	)	$	326,768	$	325,606

Volume change is the change in average balance of obligations between periods multiplied by the rate paid in the earlier period. Rate change is the change in rate between periods multiplied by the average outstanding obligations in the current period. Interest expense changes that resulted from changes in both rate and volume were allocated to the rate change amounts shown in the table.


	Details of the change in cost of funds of debt and consolidated ABS issued are provided in the tables below.


	*Table 13 Cost of Funds of Redwood Debt*


(Dollars in thousands)	2005		2004

Interest expense on Redwood debt	$	11,929	$	9,933
Average Redwood debt balance	$	261,322	$	434,662
Cost of funds of Redwood debt		4.56%		2.29%


	The increase in the cost of funds of Redwood debt is the result of higher short-term interest rates.


	*Table 14 Cost of Funds of Asset-Backed Securities Issued*


(Dollars in thousands)	2005			2004

ABS issued interest expense	$	742,659		$	399,193
ABS issuance expense amortization		21,890			16,828
Net ABS interest rate agreement (income) expense		(6,541	)		13,235
Net ABS issuance premium amortization		(12,413	)		(7,271	)

Total ABS issued interest expense	$	745,595		$	421,985

Average balance of ABS	$	20,448,735		$	20,313,996
ABS interest expense		3.63	%		1.97	%
ABS issuance expense amortization		0.11	%		0.08	%
Net ABS interest rate agreement (income) expense		(0.03	)%		0.07	%
Net ABS issuance premium amortization		(0.06	)%		(0.04	)%

Cost of funds of issued ABS		3.65	%		2.08	%


	The coupon payments on the consolidated ABS issued are primarily indexed to one-, three-, and six-month LIBOR. Over the past year, short-term interest rates have risen and, thus, so has the cost of funds of the consolidated ABS issued by securitization entities consolidated on our reported balance sheet.


	*Operating Expenses*

Total operating expenses increased by 32% from 2004 to 2005 due to investments in systems and infrastructure, increases in the scale of our operations, increased excise taxes, and increased accounting, consulting fees, and internal control costs. Generally, the scale of our business over the last few years has increased more rapidly than our operating expenses. Our operating costs continue to increase in part because of increased personnel needs resulting from both prior and anticipated growth. The reconciliation of GAAP operating expense to

operating expense before excise tax and variable stock option income (or expense) is provided in the table below.


	*Table 15 Operating Expenses*


(Dollars in thousands)	2005			2004

Total operating expenses	$	45,882		$	34,661
Less: Excise tax		(1,180	)		(626	)
Less: Variable stock option income/(expense) (VSOI/ VSOE)		123			(1,018	)

Total operating expenses before excise tax and VSOE/ VSOI	$	44,825		$	33,017

Components of total operating expense before excise tax and VSOE/ VSOI
Fixed compensation expense	$	11,082		$	8,040
Other operating expense		14,635			8,593
Incentive stock expense		1,077			1,289
Variable compensation expense		18,031			15,095

Total operating expenses before excise tax and VSOE/ VSOI	$	44,825		$	33,017

Net interest income (NII)	$	202,427		$	216,166
Adjusted efficiency ratio (Operating expense before excise tax and VSOE/ VSOI)/net interest income		22%			15%


	Our operating efficiency ratio was higher in 2005 than in 2004 due to continued growth in systems and infrastructure at a time when we are selling assets. Management excludes excise tax and variable option expense or income (VSOE/ VSOI) in determining the efficiency ratio. By excluding these items, management believes that we are providing a performance measure comparable to measures commonly used by other companies in our industry because these two types of excluded expenses do not reflect ongoing costs of day-to-day operations of our company. Stock option grant expenses under FAS 123, however, are an on-going expense and are included in operating expense before excise tax and VSOE/ VSOI.

	Excise tax is a function of the timing of dividend distributions. In years when we delay distributing dividends on a portion of our REIT taxable income, under the REIT tax rules, we may pay excise taxes on a portion of this delayed distribution. Excise tax is included in operating expenses on our Consolidated Statements of Income.

	VSOE/VSOI is a non-cash expense or income item that varies as a function of Redwood’s stock price. If our stock price increases during a quarter and the stock price is above the exercise price of certain “variable” options, we record a GAAP expense in that period equal to the increase in the stock price times the number of in-the-money “variable” options that remain outstanding. If our stock price decreases during a quarter, we record income in that period equal to the decrease in the stock price times the number of in-the-money “variable” options that remain outstanding. With the adoption of Financial Accounting Statement No. 123R, Share-Based Payment (FAS 123R), effective January 1, 2006, we will not have VSOE/VSOI, in future periods.

	Fixed compensation expenses include employee salaries and related employee benefits. Other operating expenses include office costs, systems, legal and accounting fees, and other business expenses. We expect to continue to make significant investments in expanding our staff and developing our business processes and information technologies in order to meet the operating needs we will face as we grow in the long term. As a result, we expect these fixed and other operating expenses will continue to increase.

	Incentive stock (income) expense represents the cost of equity compensation as determined under FAS 123 for options and option equity awards granted to employees and directors after December 31, 2002. Beginning January 1, 2006, with the adoption of FAS 123R, all remaining unvested incentive awards and all future awards will be accounted for under this principle. Beginning January 1, 2006, there will no longer be dividend equivalent right (DER) expenses for GAAP purposes as all remaining stock awards will be accounted for under FAS 123R (and the value of additional DERs on an award is already included in the value at the time of grant and is expensed over the requisite service period of the award).


	Variable compensation includes employee bonuses (which are based on individual employee performance and the adjusted return on equity earned by Redwood) and DER expenses on certain options still outstanding and granted prior to December 31, 2002. The primary drivers of this expense are the profitability (return on equity) of Redwood, taxable income at the REIT (which determines total dividend distribution requirements), the number of employees, and the number of incentive stock awards outstanding that receive DER payments that are expensed (options granted prior to January 1, 2003).

	We currently anticipate that our fixed costs will increase in 2006 relative to 2005, as we continue to add additional staff and systems for meeting our future growth. However, we also expect that expenses for variable compensation will decline as our performance is not anticipated to be as strong. Thus, we anticipate total operating expenses will be at a similar level in 2006 as in 2005. The adoption of FAS 123R will change the nature of our expenses but is not anticipated to have a significant impact on our overall costs.


	*Net Recognized Gains (Losses) and Valuation Adjustments*


	For 2005, our net recognized gains and valuation adjustments totaled $60.8 million as compared to $59.1 million for 2004. Realized gains due to calls were significantly less in 2005 at $19.1 million than in 2004 at $58.7 million as we had fewer securities that had reached their call factor. Gains in sales we initiated as part of our portfolio restructuring were greater in 2005 at $43.6 million than in 2004 at $7.6 million.

	Accounting rules (FAS 115, EITF 99-20, and SAB 5(m)) require us to review the projected discounted cash flows on certain of our assets (based on credit, prepayment, and other assumptions), and to mark-to-market through our income statement those assets that have experienced any deterioration in discounted projected cash flows (as compared to the previous projection) that could indicate permanent impairment as defined by GAAP. Assets with reduced discounted projected cash flows are written down in value (through a non-cash income statement charge) if the current market value for that asset is below our current basis. If the market value is above our basis, our basis remains unchanged and there is no gain recognized in income. It is difficult to predict the timing or magnitude of these adjustments; the quarterly adjustment could be substantial. Under the accounting rules (FAS 115, EITF 99-20, and SAB 5(m)), we recognized other-than-temporary impairments of $4.4 million for 2005 and $6.4 million for 2004.

	Some of our interest rate agreements are accounted for as trading instruments and in 2005 we de-designated one agreement (as part of our call of an Acacia securitization). As a result, we recognized gains of $2.5 million in 2005 and losses of $0.5 million in 2004 on these interest rate agreements.


	*Provisions for Income Taxes*


	As a REIT, we are required to distribute at least 90% of our REIT taxable income each year. Therefore, we generally pass through substantially all of our earnings to stockholders without paying federal income tax at the corporate level. We pay income tax on this income and the income we earn at our taxable subsidiaries. Taxable income calculations differ from GAAP income calculations. We provide for income taxes for GAAP purposes based on our estimates of our taxable income, the amount of taxable income we permanently retain, and the taxable income we estimate was earned at our taxable subsidiaries.

	Our income tax provision in 2005 was $17.5 million, an increase from the $8.0 million income tax provision taken in 2004. In 2005, our income tax provision under GAAP benefited slightly from state net operating losses. In 2004, we were able to use state and Federal net operating losses to reduce our tax liability. In addition, in 2004, we recognized a reversal of previously existing valuation allowances related to net operating losses (NOLs), thus recognizing the future value of remaining net operating losses at that time.

Furthermore, in 2004 we generated taxable gains-on-sales from our securitization activities at the taxable subsidiaries. Gains on these activities were much lower in 2005 due to decreased volumes and a significant decrease in the gains generated by each securitization. Since these securitizations were treated as financings under GAAP, deferred tax assets were created. The deferred tax assets are amortized through the deferred tax provision as the related GAAP income is recognized.


	*Taxable Income and Dividends*

Total taxable income is not a measure calculated in accordance with GAAP. It is the pre-tax income calculated for tax purposes. Estimated total taxable income is an important measure as it is the basis of our dividend distributions to shareholders. Taxable income calculations differ significantly from GAAP income calculations. REIT taxable income is that portion of our taxable income that we earn in our parent company and REIT subsidiaries. It does not include taxable income earned in taxable non-REIT subsidiaries. We must distribute at least 90% of REIT taxable income as dividends to shareholders over time. As a REIT we are not subject to corporate income taxes on the REIT taxable income we distribute. The remainder of our taxable income is income we earn in taxable subsidiaries. We pay income tax on this income as we generally retain the after-tax income at the subsidiary level. We also pay income tax on the REIT taxable income we retain (we can retain up to 10% of the total). The table below reconciles GAAP net income to total taxable income and REIT taxable income for 2005 and 2004.


	*Table 16 Differences Between GAAP Net Income and Total Taxable and REIT Taxable Income*


(In thousands, except per share data)		Estimated			Actual
		2005			2004

GAAP net income		$	199,872		$	232,635
GAAP/ Tax differences in accounting for:
	Interest income and interest expense		(24,001	)		(27,402	)
	Credit losses		(2,134	)		6,352
	Operating expenses		5,549			(14,701	)
	Gains (losses) and valuation adjustments		(7,453	)		38,223
	Provisions for taxes		12,278			5,870

Total taxable income (pre-tax)			184,111			240,977
Earnings from taxable subsidiaries			(12,626	)		(39,104	)

REIT taxable income (pre-tax)		$	171,485		$	201,873

GAAP net income per share			$7.96			$10.47
Total taxable income per share			$7.44			$10.89
REIT taxable income per share			$6.93			$9.12


	Total taxable income per share and REIT taxable income per share are measured as, respectively, the estimated pretax total taxable income and REIT taxable income earned in a calendar quarter divided by the number of shares outstanding at the end of that quarter. Annual total taxable income per share and annual REIT taxable income per share are, respectively, the sum of the four quarterly total taxable income per share and REIT taxable income per share calculations.

	Total taxable income and total taxable income per share decreased in 2005 from 2004. The primary reason for this was decreased levels of capital invested in assets (not only CES but also IO and other securities), and fewer gains on sales on securitizations (at the taxable subsidiaries) as a result of lower volume of securitizations and less gain per transaction. In addition, the current yield we report for tax purposes on our new assets is much higher than the yield we report for GAAP purposes. This is true for those assets that have concentrated credit risk as, for tax purposes, credit losses are not anticipated but rather are only expensed as incurred. It is also true for other assets as, due to fast prepayments, some premium amortization expense for tax purposes has been delayed because we cannot recognize a negative yield for tax purposes on interest-only securities; this delayed premium amortization expense will likely impact the taxable gain or loss on sale or call in a future period.


	Dividends to stockholders during 2005 totaled $144 million, approximately $37 million of which represented the distribution of the balance of REIT taxable income earned in 2004. Based on our estimates of 2005 REIT taxable income, we will enter 2006 with $51 million of undistributed REIT taxable income which we will pay as dividends to our stockholders during 2006. We currently project that most of the first three regular quarterly dividends we pay in 2006 will consist of REIT taxable income earned in 2005. Our estimates of total taxable income and REIT taxable income are subject to change due to changes in interest rates and other market factors as well as changes in applicable income tax laws and regulations.

	During 2005, a portion of taxable income was in the form of net capital gains resulting from the sales and calls of some of our residential loan CES. Our income from this activity was long-term capital gain income for tax purposes. Thus, during 2005, 23.291% of our dividends distributed was characterized as a distribution of long-term capital gain income and the remaining 76.709% was characterized as a distribution of ordinary income. Our tax-paying stockholders may benefit to the degree they can take advantage of the lower tax rate on capital gains versus ordinary income.

	As of December 31, 2005, we had met all of the dividend distribution requirements of a REIT. We generally attempt to avoid acquiring assets or structuring financings or sales at the REIT level that would be likely to generate distributions of Unrelated Business Taxable Income (UBTI) or excess inclusion income to our stockholders, or that would cause prohibited transaction taxes on the REIT; however, there can be no assurance that we will be successful in doing so.


	*2004 AS COMPARED TO 2003*


	*Acquisitions, Securitizations, Sales, and Calls*


	For the year ended 2004, residential real estate loan acquisitions totaled $10.1 billion, sales to Sequoia entities totaled $10.0 billion, and Sequoia entities issued $10.0 billion ABS. This activity was a slight decrease from the volume of residential loan acquisitions ($11.4 billion), sales to Sequoia ($11.5 billion), and ABS issued ($11.5 billion) in 2003.

	During 2004, we acquired $269 million residential loan CES. This was an increase from the $149 million acquired in 2003. In 2004, we had calls of our residential loan CES of $99 million principal value for GAAP gains of $59 million. This was a decrease from the calls realized in 2003 of $117 million principal value that generated GAAP gains of $57 million. In 2004, we sold $22 million market value residential real estate CES loans generating GAAP gains of $6 million. During 2003, sales of residential real estate CES totaled $1 million market value generated minimal GAAP gains.

	We acquired $38 million commercial real estate loans during 2004, an increase from the $6 million acquired during 2003. We sold $2 million commercial real estate loans during 2004 and $1 million during 2003.

	During 2004, we acquired $13 million commercial loan CES; we did not acquire any such securities in 2003. No commercial loan CES were sold during these periods.

	We acquired $598 million of other residential and commercial real estate securities during 2004 for our Acacia CDO securitization program. This was similar to the level of such acquisitions ($566 million) during 2003. During 2004, we sold $584 million of securities to Acacia entities and during 2003, we sold $415 million to Acacia entities. In 2004, Acacia entities issued $900 million of CDO ABS, compared to $600 million in 2003.


	*Net Income*


	Our reported GAAP net income was $233 million ($10.47 per share) for 2004, an increase from the $132 million ($7.04 per share) earned in 2003. Our GAAP return on equity was 32% for 2004 compared to 25% for 2003.

Our 2004 results were driven by the quality of our existing real estate loan backed investments, a favorable operating environment, excellent credit results, favorable prepayment patterns, increased book value per share (giving us a greater amount of equity per share with which to generate earnings), increased capital efficiencies, increased operating efficiencies, and income generated from residential CES that we owned at a discount to face value that were called during 2004 at full face value. A significant portion of our income in 2004 and 2003 has come from gains from calls and sales of residential CES securities. Returns from these sources are highly variable and not readily predictable.


	*Interest Income*

Total interest income for 2004 was $648 million, an increase from the $331 million of total interest income in 2003. Interest income for 2004 increased from 2003 as a result of 95% growth in the average balance of consolidated earning assets. Total consolidated earning assets grew primarily as a result of increased sponsorship of securitizations of residential real estate loans. The yield remained at similar levels (from 3.06% to 3.05%) as a result of an increase in interest rates offset by a change in the mix of assets as well as changes in net discount and premium amortization and lower credit provision expenses.


	*Table 17 Interest Income and Yield*


(Dollars in thousands)	2004			2003

Interest income	$	651,661		$	332,033
Discount amortization		36,071			37,752
Premium amortization		(32,412	)		(30,163	)
Provision for credit losses		(7,236	)		(8,646	)

Total interest income	$	648,084		$	330,976

Average earning assets	$	21,208,757		$	10,858,311
Yield as a result of:
Interest income		3.07	%		3.06	%
Discount amortization		0.17	%		0.35	%
Premium amortization		(0.15	)%		(0.28	)%
Provision for credit losses		(0.03	)%		(0.08	)%

Yield on earning assets		3.06	%		3.05	%


	The table below presents the contribution to interest income and yield from each of our portfolios. Further discussions of changes in yields and balances are presented below by portfolio.


	*Table 18 Interest Income and Yield by Portfolio*


(Dollars in thousands)
	December 31, 2004

			Percent of
			Total
	Interest		Interest			Average
	Income		Income			Balance		Yield

Residential real estate loans, net of provision for credit losses	$	529,842		81.76	%	$	19,665,096		2.69	%
Residential loan credit-enhancement securities		64,602		9.97	%		349,779		18.47	%
Commercial loans, net of provision for credit losses		3,769		0.58	%		30,469		12.37	%
Commercial loan credit-enhancement securities		675		0.10	%		5,261		12.83	%
Securities portfolio		48,274		7.45	%		1,062,901		4.54	%
Cash and cash equivalents		922		0.14	%		95,251		0.97	%

Totals	$	648,084		100.00	%	$	21,208,757		3.06	%

Table 18 (continued)


(Dollars in thousands)
	December 31, 2003

			Percent of
			Total
	Interest		Interest			Average
	Income		Income			Balance		Yield

Residential real estate loans, net of provision for credit losses	$	235,978		71.30	%	$	9,932,961		2.38	%
Residential loan credit-enhancement securities		68,091		20.57	%		275,308		24.73	%
Commercial loans, net of provision for credit losses		2,959		0.89	%		29,473		10.04	%
Commercial loan credit-enhancement securities		—		0.00	%		—		0.00	%
Securities portfolio		23,530		7.11	%		532,683		4.42	%
Cash and cash equivalents		418		0.13	%		87,886		0.48	%

Totals	$	330,976		100.00	%	$	10,858,311		3.05	%


	The table below details our interest income by portfolio as a result of changes in consolidated asset balances (“volume”) and yield (“rate”) for 2004 as compared to 2003.


	*Table 19 Volume and Rate Changes for Interest Income*


(In thousands)
	Change in Interest Income
	2004 Versus 2003

						Total
	Volume		Rate			Change

Residential real estate loans, net of provisions for credit losses	$	231,207	$	62,657		$	293,864
Residential loan credit-enhancement securities		18,409		(21,898	)		(3,489	)
Commercial loans, net of provision for credit losses		100		710			810
Commercial loan credit-enhancement securities		—		675			675
Securities portfolio		23,450		1,294			24,744
Cash and equivalents		35		469			504

Total interest income	$	273,201	$	43,907		$	317,108


	Volume change is the change in average portfolio balance between periods multiplied by the rate earned in the earlier period. Rate change is the change in rate between periods multiplied by the average portfolio balance in the prior period. Interest income changes that result from changes in both rate and volume were allocated to the rate change amounts shown in the table.

	A discussion of the changes in total income, average balances, and yields for each of our portfolios is provided below.


	*Table 20 Consolidated Residential Real Estate Loans — Interest Income and Yield*


(Dollars in thousands)	2004			2003

Interest income	$	568,765		$	273,739
Net Premium amortization		(31,687	)		(29,615	)
Provision for credit losses		(7,236	)		(8,146	)

Total interest income	$	529,842		$	235,978

Average consolidated residential real estate loans	$	19,665,096		$	9,932,961
Yields as a result of:
Interest income		2.89	%		2.76	%
Net Premium amortization		(0.16	)%		(0.30	)%
Provision for credit losses		(0.04	)%		(0.08	)%

Yield		2.69	%

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	purposes, exclusive of income earned in non-REIT subsidiaries. In order to meet our dividend distribution requirements, we have been paying both a regular quarterly dividend and a year-end special dividend. We set our regular quarterly dividend at a rate that we believe is more likely than not to be sustainable over time. If we earn more taxable income than is required to fund the regular dividend, we have generally paid a special dividend in December. We expect our special dividend amount to be highly variable, and we may not pay a special dividend in every year. Our dividend policies and distribution practices are determined by our Board of Directors and may change over time.

	Redwood was incorporated in the State of Maryland on April 11, 1994, and commenced operations on August 19, 1994. We have our executive offices at One Belvedere Place, Suite 300, Mill Valley, California 94941.


	investments. By acquiring and managing these ABS, our permanent asset portfolio is designed to generate long-term cash flows that will fund dividend distributions to our stockholders.

	By funding our permanent assets with equity, we have no liquidity risk, debt roll-over risk, or margin call risk with respect to these assets. We use a combination of debt and equity to fund “inventory” assets that we acquire for re-sale to a securitization entity. Our balance sheet is strong because our maximum economic loss with respect to the credit risks associated with our permanent assets is limited to our investment in CES. In other words, our maximum loss on these investments is less than our equity capital base.

	As a result of the form of securitization we have chosen to utilize for most of the securitizations we sponsor, we consolidate and report under GAAP all of the assets of the securitization entities we have sponsored as assets on our Consolidated Balance Sheets, and we consolidate and report all of the ABS issued by those entities and held by unrelated third parties as liabilities on our Consolidated Balance Sheets. Thus, the ABS we acquire for our permanent asset portfolio from securitizations we sponsor are not shown as specific assets on our Consolidated Balance Sheets, but rather are represented by the excess of the recorded value of the securitized pool of assets over the related liabilities, in each case consolidated from the securitization entities we have sponsored. As a result of this GAAP treatment, no gain on sale is recognized for GAAP purposes from the securitizations we sponsor even if these securitizations result in taxable gains on sales for us.

	Although we currently invest in residential and commercial real estate securities including interest only (IO) securities, home equity lines of credit (HELOC), commercial real estate loan participations, and CDO equity securities backed by diverse types of residential and commercial real estate loans and securities, we are open to investing in, credit-enhancing, and securitizing other types of real estate assets that may complement and benefit our core business activities. We also may make non-real estate investments or enter non-real estate businesses.


	mortgage industry, which in turn continues to put pressure on prices for new residential loan CES.

	We believe that the business of acquiring and owning residential IO securities generated through the securitization of jumbo residential loans is also fragmented. A deeper and more active market for more complex IO securities has developed in the last several years, in part due to interest from asset management firms, mutual funds, hedge funds, Wall Street broker-dealers, and other capital markets participants seeking attractive fixed income yields.

	Our sponsorship of Sequoia residential loan securitizations competes with Wall Street broker-dealers, mortgage REITs, and various mortgage conduits that acquire loans to create economic gains through securitization. We also compete with banks, loan origination companies, and REITs that securitize their own real estate loan origination.

	Our sponsorship of Acacia CDO securitizations and our investment in CDO equity securities competes with a large variety of asset management organizations, financial institutions, and institutional investors worldwide.

	A reduction in securitization volume or profitability, caused by increased competition, reduced asset supply, market fluctuations, ABS spread widening, poor hedging results, or other factors, could have a material adverse impact on our taxable income and also on our GAAP income. Competition in the business of sponsoring securitizations of the type we focus on is increasing as Wall Street broker-dealers, mortgage REITs, investment management companies, and other financial institutions expand their activities or enter this field. In general, this has reduced our taxable gains on sales as we have had to pay a higher price for securitizable assets relative to the proceeds available from securitization.

	We believe competitive pressures within the commercial loan origination business are generally leading to a decline in origination standards. Furthermore, the underlying commercial properties are generally valued at high prices compared to their cash flow (relative to commercial real estate prices in the last ten years). In addition, competition to acquire commercial loan CES has increased, thus raising effective current prices for the commercial loan CES we buy. These market factors may make expansion or prudent investing difficult.


	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.


	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.


	•	Our ability to own non-real estate related assets and earn non-real estate related income is limited. Our ability to own equity interests in other entities 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.


	synthetic assets in Acacia’s asset pools. Over the next few years, we expect our CDO sponsorship business to grow and evolve in interesting new ways and to continue to generate attractive new investments and asset management fees.

	We seek to maintain a structured balance sheet that we believe should allow us to weather potential general economic downturns and liquidity crises. We generally seek to put ourselves in a position where changes in interest rates would not be likely to materially harm our ability to meet our long-term goals or maintain our regular dividend rate. We use debt to finance loans and securities that we are accumulating as inventory for sale to securitization entities sponsored by us.

	In our view, the long-term outlook for our business is good. Housing price increases over the past several years have reduced our risk of credit loss in the future for our existing residential assets. For most of our risk assets, the underlying loans were originated in 2003 and 2004. Commercial property values and cash flows are increasing in many areas. Our portfolio of assets as a whole has the ability to generate attractive earnings, cash flows, and dividends in the future, assuming real estate credit losses do not increase materially.

	In general, we expect per share earnings and the special dividend in 2006 will be lower than 2005 as a result of much higher cash balances, a newer portfolio on average (the higher-yielding seasoned assets have largely been sold or called), few gains from sales (as we are not planning significant amount of sales at this time) and calls (as we have few callable assets), continued high premium amortization expenses on the residential loans consolidated from Sequoia trusts as these loans continue to prepay rapidly, and for other reasons. If we reduce our excess cash balances over the next few years, invest wisely, and start to realize some of the upside potential inherent in our existing assets, earnings and special dividends in 2007 and 2008 could increase from 2006 levels.

	Over the long-term we believe it is reasonably likely that we will be able to continue to find attractive investment opportunities, because we are an efficient competitor and because our market segments are growing (as the amount of real estate loans outstanding increases and the percentage of these loans that are securitized increases).


	months based on the one or six-month LIBOR interest rate. Yields on these residential real estate loans increased as short-term interest rates rose. The average balance decreased as loan prepayments exceeded new acquisitions.

	Higher premium amortization expenses (as a percentage of current loan balances) in 2005 were caused primarily by increasing prepayment speeds on these loans.