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 as well as from retained financial interests we hold in certain of these 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, 2014


June 30, 2014 (Dollars in Thousands)	Sequoia Entities		Residential Resecuritization		Commercial Securitization		Total
Residential loans, held-for-investment	$	1,616,504	$	-	$	-	$	1,616,504
Commercial loans, held-for-investment		-		-		254,615		254,615
Real estate securities, at fair value		-		245,853		-		245,853
Restricted cash		145		-		138		283
Accrued interest receivable		2,391		549		1,826		4,766
Other assets		3,323		-		79		3,402

Total Assets	$	1,622,363	$	246,402	$	256,658	$	2,125,423

Accrued interest payable	$	1,078	$	17	$	678	$	1,773
Asset-backed securities issued		1,553,669		69,709		144,700		1,768,078

Total Liabilities	$	1,554,747	$	69,726	$	145,378	$	1,769,851


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 our 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. Our credit risk exposure is largely unchanged as a result of engaging in the transaction, as we remain economically exposed to the financed securities through our senior and subordinate investment in the Residential Resecuritization.

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 loan 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

Since 2012, we have transferred residential loans to 19 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 sheets, and classified those MSRs as Level 3 assets. We also retained senior and subordinate securities in these securitizations that we classified as Level 3 assets.

The following table presents information related to securitization transactions that occurred during the three and six months ended June 30, 2014 and 2013.

Securitization Activity Related to Unconsolidated VIEs Sponsored by Redwood


	Three Months Ended June 30,				Six Months Ended June 30,
(In Thousands)	2014		2013		2014		2013
Principal balance of loans transferred	$	347,305	$	1,802,058	$	347,305	$	4,042,710
Trading securities retained, at fair value		69,563		40,642		69,563		91,850
AFS securities retained, at fair value		20,428		92,367		20,428		207,095
Gains on sale		-		-		-		-
MSRs recognized		2,186		16,148		2,186		28,614

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 during the three and six months ended June 30, 2014 and 2013.

Cash Flows Related to Unconsolidated VIEs Sponsored by Redwood


	Three Months Ended June 30,				Six Months Ended June 30,
(In Thousands)	2014		2013		2014		2013
Cash proceeds	$	267,776	$	1,705,504	$	267,776	$	3,859,354
MSR fees received		3,624		2,099		7,047		3,075
Funding of compensating interest		(43)		(145)		(76)		(263)
Cash flows received on retained securities		15,924		9,883		28,227		14,950

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	2014 2013	2014 2013

Prepayment speeds	5 - 15 % 5 - 12 %	5 - 15 % 5 - 14 %
Discount rates	11 % 12 %	11 % 12 %

The following table presents additional information at June 30, 2014 and December 31, 2013, related to unconsolidated securitizations accounted for as sales since 2012. Loans at these securitization entities have not incurred any credit losses.

Unconsolidated VIEs Sponsored by Redwood


(In Thousands)	June 30, 2014		December 31, 2013
On-balance sheet assets, at fair value:
Interest-only and senior securities, classified as trading	$	159,311	$	110,505
Senior and subordinate securities, classified as AFS		449,863		405,415
Maximum loss exposure ⁽¹⁾		609,174		515,920
Assets transferred:
Principal balance of loans outstanding		6,730,820		6,627,874
Principal balance of delinquent loans 30+ days delinquent		7,041		14,587

(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, 2014 and December 31, 2013.

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


June 30, 2014	MSRs		Senior Securities		Subordinate Securities
(Dollars in Thousands)	MSRs		Senior Securities		Subordinate Securities
Fair value at June 30, 2014	$	54,712	$	159,311	$	449,863
Expected life (in years) ⁽¹⁾		7		7		11

Prepayment speed assumption (annual CPR) ⁽¹⁾		12 %		9 %		10 %
Decrease in fair value from:
10% adverse change	$	2,088	$	7,254	$	1,345
25% adverse change		4,908		12,104		3,519

Discount rate assumption ⁽¹⁾		11 %		5 %		6 %
Decrease in fair value from:
100 basis point increase	$	2,194	$	7,929	$	34,532
200 basis point increase		4,212		15,159		65,057

Credit loss assumption ⁽¹⁾		N/A		0.23 %		0.23 %
Decrease in fair value from:
10% higher losses		N/A	$	89	$	1,197
25% higher losses		N/A		222		2,380
December 31, 2013	MSRs		Senior Interest-only Securities		Subordinate Securities
(Dollars in Thousands)	MSRs		Senior Interest-only Securities		Subordinate Securities
Fair value at December 31, 2013	$	60,318	$	110,505	$	405,415
Expected life (in years) ⁽¹⁾		8		7		11

Prepayment speed assumption (annual CPR) ⁽¹⁾		8 %		10 %		11 %
Decrease in fair value from:
10% adverse change	$	1,649	$	5,773	$	1,658
25% adverse change		4,218		13,555		4,354

Discount rate assumption ⁽¹⁾		11 %		5 %		6 %
Decrease in fair value from:
100 basis point increase	$	2,468	$	5,632	$	30,644
200 basis point increase		4,828		10,757		57,836

Credit loss assumption ⁽¹⁾		N/A		0.23 %		0.23 %
Decrease in fair value from:
10% higher losses		N/A	$	70	$	1,369
25% higher losses		N/A		175		3,420

(1)	Expected life, prepayment speed assumption, discount rate assumption, and credit loss assumption presented in the tables above represent weighted averages.

Continuing Involvement with VIEs with No Economic Interest

We maintain limited continuing involvement in certain Acacia securitization entities we sponsored, but have no current economic interest in these entities. Our continuing involvement 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 one of these entities have experienced events of default. We will continue to receive the collateral management fees for these entities, which have decreased significantly and will continue to do so as the balances on which the fees are determined continue 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 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, 2014, grouped by collateral type.

Third-Party Sponsored VIE Summary


(In Thousands)	June 30, 2014
Residential real estate securities at Redwood
Senior	$	663,587
Re-REMIC		192,596
Subordinate		133,857

Total Investments in Third-Party Real Estate Securities	$	990,040

We determined that we are not the primary beneficiary of any third-party residential, commercial, or collateralized debt obligation 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.

Other Transfers of Financial Assets

Certain of our senior commercial mortgage loans were bifurcated into a senior portion that was sold to a third party and a junior portion that we retained as an investment. When the transfer of the senior portion did not meet the criteria for sale treatment under GAAP, the entire loan (the senior and junior portions) remains on our consolidated balance sheet classified as a held-for-investment loan and we account for the transfer of the senior portion as a secured borrowing.

The following table presents commercial loan transfers accounted for as secured borrowings for the three and six months ended June 30, 2014.

Loan Transfers Accounted for as Secured Borrowings


(In Thousands)	Three Months Ended June 30, 2014		Six Months Ended June 30, 2014
Principal balance	$	29,500	$	63,375
Cash proceeds		30,274		65,048