Note 4. Principles of Consolidation

GAAP requires us to consider whether securitizations and other transfers of financial assets should be treated as sales or financings, as well as whether any VIEs – for example, certain legal entities often used in securitization and other structured finance transactions – should be included in our consolidated financial statements. The GAAP principles we apply require us to reassess our requirement to consolidate VIEs each quarter and therefore our determination may change based upon new facts and circumstances pertaining to each VIE. This could result in a material impact to our consolidated financial statements during subsequent reporting periods.

Analysis of Consolidated VIEs

The VIEs we are required to consolidate include certain Sequoia securitization entities, the Residential Resecuritization entity, and the Commercial Securitization entity. Each of these entities is independent of Redwood and of each other and the assets and liabilities are not owned by and are not legal obligations of ours, although we are exposed to certain financial risks associated with our role as the sponsor or manager of these entities. Prior to the fourth quarter of 2012, we were also required to consolidate certain other securitization entities. The following table presents a summary of the assets and liabilities of these VIEs. Intercompany balances have been eliminated for purposes of this presentation.

Assets and Liabilities of Consolidated VIEs at June 30, 2013


June 30, 2013 (Dollars in Thousands)	Sequoia Entities		Residential Resecuritization		Commercial Securitization		Total
Residential loans, held-for-investment	$	1,998,178	$	-	$	-	$	1,998,178
Commercial loans, held-for-investment		-		-		270,449		270,449
Real estate securities, at fair value		-		294,771		-		294,771
Restricted cash		148		2		138		288
Accrued interest receivable		3,461		751		1,939		6,151
Other assets		3,965		-		-		3,965

Total Assets	$	2,005,752	$	295,524	$	272,526	$	2,573,802

Accrued interest payable	$	1,509	$	33	$	748	$	2,290
Asset-backed securities issued		1,920,614		134,156		159,526		2,214,296

Total Liabilities	$	1,922,123	$	134,189	$	160,274	$	2,216,586

Number of VIEs		24		1		1		26

We consolidate the assets and liabilities of certain Sequoia securitization entities, as we did not meet the GAAP sale criteria at the time we transferred financial assets to these entities. Our involvement in consolidated Sequoia entities continues in the following ways: (i) we continue to hold subordinate investments in each entity, and for certain entities, more senior investments; (ii) we maintain certain discretionary rights associated with our sponsorship of, or subordinate investments in, each entity; and (iii) we continue to hold a right to call the assets of certain entities (once they have been paid down below a specified threshold) at a price equal to, or in excess of, the current outstanding principal amount of the entity’s asset-backed securities issued. These factors have resulted in our continuing to consolidate the assets and liabilities of these Sequoia entities in accordance with GAAP.

We consolidate the assets and liabilities of the Residential Resecuritization entity as we did not meet the GAAP sale criteria at the time the financial assets were transferred to this entity based on our role in the entity’s inception and design. We transferred senior residential securities to Credit Suisse First Boston Mortgage Securities Corp., which subsequently sold them to CSMC 2011-9R, the Residential Resecuritization entity. In connection with this transaction, we acquired certain senior and subordinate securities that we continue to hold. We engaged in the Residential Resecuritization primarily for the purpose of obtaining permanent non-recourse financing on a portion of our senior residential securities portfolio.

We consolidate the assets and liabilities of the Commercial Securitization entity, as we did not meet the GAAP sale criteria at the time the financial assets were transferred to this entity based on our role in the entity’s inception and design. We transferred subordinate commercial loans to RCMC 2012-CREL1, a securitization entity. In connection with this transaction, we acquired certain subordinate securities that we continue to hold. We engaged in the Commercial Securitization primarily for the purpose of obtaining permanent non-recourse financing on a portion of our commercial mezzanine portfolio. Our credit risk exposure is largely unchanged as a result of engaging in the transaction, as we remain economically exposed to the financed loans through our subordinate investment in the Commercial Securitization.

Analysis of Unconsolidated VIEs with Continuing Involvement

During 2012 and the six months ended June 30, 2013, we transferred residential loans to 14 Sequoia securitization entities sponsored by us and accounted for these transfers as sales for financial reporting purposes. We also determined we were not the primary beneficiary of these VIEs as we lacked the power to direct the activities that will have the most significant economic impact on the entities. For the transferred loans where we held the servicing rights prior to the transfer and continue to hold the servicing rights, we recorded MSRs on our consolidated balance sheet at June 30, 2013, and classify those MSRs as Level 3 assets. We also retained senior and subordinate securities in these securitizations that we classify as Level 3 assets.

The following table presents information related to securitization transactions that occurred during the three and six months ended June 30, 2013 and 2012.

Securitization Activity Related to Unconsolidated VIEs Sponsored by Redwood


	Three Months Ended June 30,				Six Months Ended June 30,
(In Thousands)	2013		2012		2013		2012
Principal balance of loans transferred	$	1,802,058	$	293,590	$	4,042,710	$	1,036,856
Trading securities retained, at fair value		40,642		5,610		91,850		26,786
AFS securities retained, at fair value		92,367		17,267		207,095		56,717
Gains on sale		-		4,243		-		11,609
MSRs recognized		16,148		1,029		28,614		2,608

Our continuing involvement in these securitizations is limited to customary servicing obligations associated with retaining residential MSRs (which we retain a third-party servicer to perform) and the receipt of interest income associated with the securities we retained. The following table summarizes the cash flows between us and the unconsolidated VIEs sponsored by us for the three and six months ended June 30, 2013 and 2012.

Cash Flows Related to Unconsolidated VIEs Sponsored by Redwood


	Three Months Ended June 30,				Six Months Ended June 30,
(In Thousands)	2013		2012		2013		2012
Cash proceeds	$	1,705,504	$	277,269	$	3,859,354	$	972,073
MSR fees received		2,099		137		3,075		154
Funding of compensating interest		(145)		(13)		(263)		(16)
Cash flows received on retained securities		9,883		2,071		14,950		3,099

The following table presents the key weighted-average assumptions to measure MSRs at the date of securitization.

MSR Assumptions Related to Unconsolidated VIEs Sponsored by Redwood


	Issued During
	Three Months Ended June 30,				Six Months Ended June 30,
At Date of Securitization	2013		2012		2013		2012
Prepayment speeds		5 - 12 %		5 - 21 %		5 - 14 %		5 - 19 %
Discount rates		12 %		10 %		12 %		9 %

The following table presents additional information at June 30, 2013 and December 31, 2012, related to unconsolidated securitizations sponsored by us during 2012 and the six months ended June 30, 2013.

Unconsolidated VIEs Sponsored by Redwood


(In Thousands)	June 30, 2013		December 31, 2012
On-balance sheet assets, at fair value:
Interest-only securities, classified as trading	$	123,591	$	10,409
Subordinate securities, classified as AFS		318,789		113,681
Maximum loss exposure ⁽¹⁾		442,380		124,090
Principal balance of loans outstanding		5,383,219		1,736,331

(1)

Maximum loss exposure from our involvement with unconsolidated VIEs pertains to the carrying value of our securities retained from these VIEs and represents estimated losses that would be incurred under severe, hypothetical circumstances, such as if the value of our interests and any associated collateral declines to zero. This does not include, for example, any potential exposure to representation and warranty claims associated with our initial transfer of loans into a securitization.

The following table presents key economic assumptions for assets retained from unconsolidated VIEs and the sensitivity of their fair values to immediate adverse changes in those assumptions at June 30, 2013 and December 31, 2012.

Key Assumptions and Sensitivity Analysis for Assets Retained from Unconsolidated VIEs Sponsored by Redwood


June 30, 2013 (Dollars in Thousands)	MSRs		Senior Interest-only Securities		Subordinate Securities
Fair value at June 30, 2013	$	43,098	$	123,591	$	318,789
Expected weighted-average life (in years)		8		6		13

Prepayment speed assumption (annual CPR)		8 %		13 %		14 %
Decrease in fair value from:
10% adverse change	$	1,367	$	4,275	$	844
25% adverse change		3,284		34,398		1,974

Discount rate assumption		12 %		5 %		6 %
Decrease in fair value from:
100 basis point increase	$	1,822	$	5,931	$	28,365
200 basis point increase		3,309		11,357		52,835

Credit loss assumption		N/A		0.22 %		0.22 %
Decrease in fair value from:
10% higher losses		N/A	$	39	$	1,128
25% higher losses		N/A		98		2,816


December 31, 2012 (Dollars in Thousands)	MSRs		Senior Interest-only Securities		Subordinate Securities
Fair value at December 31, 2012	$	5,315	$	10,409	$	113,681
Expected weighted-average life (in years)		3		3		10

Prepayment speed assumption (annual CPR)		33 %		29 %		24 %
Decrease in fair value from:
10% adverse change	$	351	$	724	$	858
25% adverse change		812		1,674		1,909

Discount rate assumption		12 %		17 %		6 %
Decrease in fair value from:
100 basis point increase	$	121	$	20	$	901
200 basis point increase		235		40		1,791

Credit loss assumption		N/A		0.48 %		0.47 %
Decrease in fair value from:
10% higher losses		N/A	$	5	$	578
25% higher losses		N/A		12		1,446

Continuing Involvement with VIEs with No Economic Interest

During 2012, we sold all of our remaining economic interests in Acacia entities and, pursuant to an accounting analysis, deconsolidated the Acacia entities and derecognized the associated assets and liabilities for financial reporting purposes. We maintain limited continuing involvement through our role as collateral manager for all but one of these Acacia entities. Our role as collateral manager has, under the terms of the applicable management agreements, been significantly curtailed or eliminated with respect to the Acacia entities, as all but two of these entities have experienced events of default. Additionally, we will continue to receive the collateral management fee for these entities, which has decreased significantly and will continue to do so as the balance on which the fee is determined continues to decline.

Analysis of Third-Party VIEs

Third-party VIEs are securitization entities for which we maintain an economic interest but do not sponsor. Our economic interest may include several securities from the same third-party VIE, and in those cases, the consolidation analysis is performed in consideration of all of our interests. The following table presents a summary of our interests in third-party VIEs at June 30, 2013, grouped by collateral type and ownership interest.

Third-Party VIE Summary


June 30, 2013 (Dollars in Thousands)	Fair Value
Residential real estate securities at Redwood
Senior	$	481,190
Re-REMIC		154,167
Subordinate		384,176

Total Investments in Third-Party Real Estate Securities	$	1,019,533

We determined that we are not the primary beneficiary of any third-party residential or commercial entities, as we do not have the required power to direct the activities that most significantly impact the economic performance of these entities. Specifically, we do not service or manage these entities or otherwise hold decision making powers that are significant. As a result of this assessment, we do not consolidate any of the underlying assets and liabilities of these third-party VIEs – we only account for our specific interests in them.

Our assessments of whether we are required to consolidate a VIE may change in subsequent reporting periods based upon changing facts and circumstances pertaining to each VIE. Any related accounting changes could result in a material impact to our financial statements.