UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended: March 31, 2004

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.

(415) 389-7373
(Registrant’s telephone number, including area code)

     Indicate by check mark whether the Registrant (1) has filed all documents and 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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).       Yes     X    No        

APPLICABLE ONLY TO CORPORATE ISSUERS:

     Indicate the number of shares outstanding of each of the issuer’s classes of stock, as of the last practicable date.

REDWOOD TRUST, INC.
FORM 10-Q

INDEX

PART I. FINANCIAL INFORMATION

Item 1. CONSOLIDATED FINANCIAL STATEMENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
(Unaudited)

The accompanying notes are an integral part of these consolidated financial
statements

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REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except share data)
(Unaudited)

The accompanying notes are an integral part of these consolidated financial
statements

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REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In thousands)
(Unaudited)

The accompanying notes are an integral part of these consolidated financial
statements

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REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(In thousands, except share data)
(Unaudited)

For the three months ended March 31, 2004:

For the three months ended March 31, 2003:

The accompanying notes are an integral part of these consolidated financial
statements

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REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

The accompanying notes are an integral part of these consolidated financial
statements

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2004
(Unaudited)

NOTE 1. REDWOOD TRUST

Redwood Trust, Inc. (Redwood Trust) together with its subsidiaries is an investor in real estate loans. Our primary business is owning and credit enhancing high-quality jumbo residential real estate loans nationwide. We also invest in diverse types of real estate loans through our residential and commercial real estate securities portfolio and our commercial real estate loan portfolio. Our primary source of revenue is monthly loan payments made by homeowners and property owners on their loans, and our primary expense is the cost of borrowed funds. Redwood Trust is structured as a Real Estate Investment Trust (REIT) and therefore the majority of our taxable income (exclusive of income earned in taxable subsidiaries) is distributed to shareholders as dividends.

NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The accompanying consolidated financial statements are unaudited. The unaudited interim consolidated financial statements have been prepared on the same basis as the annual consolidated financial statements and, in our opinion, reflect all adjustments (which include only normal recurring adjustments) necessary for a fair statement of our financial position, results of operations, and cash flows. These consolidated financial statements and notes thereto are unaudited and should be read in conjunction with our audited consolidated financial statements included in the Redwood Trust Form 10-K for the year ended December 31, 2003. The results for the three months ended March 31, 2004 are not necessarily indicative of the expected results for the year ended December 31, 2004.

The March 31, 2004 and December 31, 2003 consolidated financial statements include the accounts of Redwood Trust and its wholly-owned subsidiaries, Sequoia Mortgage Funding Corporation, Acacia CDO 1 LTD, Acacia CDO 2 LTD, Acacia CDO 3 LTD, and RWT Holdings, Inc. (Holdings), and Holdings’ wholly-owned subsidiaries including Sequoia Residential Funding, Inc. For financial reporting purposes, references to Sequoia mean Sequoia Mortgage Funding Corporation and Sequoia Residential Funding, Inc. References to Acacia mean Acacia CDO 1, LTD, Acacia CDO 2, LTD, and Acacia CDO 3, LTD. References to the REIT mean Redwood Trust exclusive of its taxable subsidiaries.

Substantially all of the assets of Sequoia, consisting primarily of residential real estate loans as part of residential real estate loans on our Consolidated Balance Sheets, are pledged to support long-term debt in the form of collateralized mortgage-backed securities. Substantially all of the assets of Acacia, consisting primarily of residential and commercial real estate loan securities and other asset-backed securities included in our residential loan credit-enhancement securities and securities portfolio, are pledged to support long-term debt in the form of collateralized asset-backed securities. The assets of Sequoia and Acacia are not available for the satisfaction of general claims of Redwood Trust. Our exposure to loss on the assets, which are collateral for long-term debt, is limited to our net equity investment in Sequoia and Acacia, as the long-term debt is non-recourse to Redwood Trust.

All significant intercompany balances and transactions with Sequoia, Acacia, and Holdings have been eliminated in the consolidation of Redwood Trust as of March 31, 2004 and December 31, 2003. Certain amounts for prior periods have been reclassified to conform to the March 31, 2004 presentation.

Use of Estimates

The preparation of financial statements in conformity with Generally Accepted Accounting Principles (GAAP) requires us to make estimates and assumptions that affect the reported amounts of certain assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of certain revenues and expenses during the reported

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period. Our estimates are inherently subjective in nature and actual results could differ from those estimates. The primary estimates inherent in the accompanying consolidated financial statements are discussed below.

Fair Value. We estimate the fair value of our financial instruments using available market information and other appropriate valuation methodologies. Where applicable, certain fair value estimates made by management are validated against prices provided by certain dealers who make a market in these financial instruments. The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced liquidation sale. Our estimates are inherently subjective in nature and involve matters of uncertainty and judgment to interpret relevant market and other data. Accordingly, amounts realized in actual sales may differ from the fair values presented in Notes 3, 5, and 9.

Reserves for Credit Losses. We establish and maintain credit reserves for estimated credit losses in our residential and commercial held-for-investment real estate loan portfolios. The reserves consist of a component for individual loan impairment and one or more components of collective impairment. Impairment exists when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. The credit reserves are based upon our assessment of various factors affecting the credit quality of our assets. The reserves are reviewed on a regular basis and adjusted as deemed necessary. The reserve for credit losses on our real estate loans is established by taking credit provisions through our Consolidated Statements of Income. Summary information regarding the reserve for credit losses on real estate loans is presented in Note 4.

In addition to reserves for credit losses established for our real estate loan portfolios, we also estimate credit protection levels for certain assets purchased at discounts related to credit quality. Our residential loan credit-enhancement securities represent subordinated interests in pools of high-quality jumbo residential real estate loans. These securities are generally rated below investment-grade and, as a result, are typically purchased at a deep discount. A portion of the purchase discount is considered a designated form of credit protection while the remaining component of the purchase discount is accreted as interest income under the effective yield method.

Recognition of Interest Income and Impairment on Investments in Beneficial Interests. Our investment in residential loan credit-enhancement securities and certain investments in our securities portfolio are investments in beneficial interests. We generally purchase these assets at premiums or discounts and amortize or accrete the premiums and discounts into expense or income using the effective yield method – a method that estimates a constant effective yield over the effective life of each security. To apply the effective yield method we calculate a yield of each beneficial interest by estimating the cash flows attributable to each beneficial interest. If the estimated future cash flows change, then we recalculate the yield and adjust the periodic accretion recognized as income prospectively. In addition, if a decline in cash flows is not from a temporary condition and the fair value of the beneficial interest declines to below its carrying amount, we record a mark-to-market loss under net recognized gains and valuation adjustments on our Consolidated Statements of Income. Beneficial interests are included as part of our securities available-for-sale on our Consolidated Balance Sheets.

Risks and Uncertainties

We take certain risks inherent in financial institutions including, but not limited to, credit risk, liquidity risk, interest rate risk, prepayment risk, market value risk, reinvestment risk, and capital risk. In addition, there are several risks and uncertainties specific to our business. We seek to actively manage such risks while also providing our stockholders an appropriate rate of return for risks taken. There can be no assurances that such risks and uncertainties are adequately provided for in our financial statements.

A significant portion of our liabilities represents non-recourse long-term debt; our measure of long-term debt consists entirely of mortgage-backed securities issued by bankruptcy-remote securitization trusts. The owners of these securities have no recourse to us and must look only to the assets of the securitization trust for repayment.

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Earning Assets

Our earning assets consist primarily of residential and commercial real estate loans and securities. Real estate loans and securities pledged as collateral under borrowing arrangements in which the secured party has the right by contract or custom to sell or repledge the collateral have been classified as “pledged” as discussed in Note 3. Coupon interest is recognized as revenue when earned according to the terms of the loans and securities and when, in our opinion, it is collectible. Purchase discounts and premiums related to earning assets are amortized into interest income over their estimated lives considering the prepayments of the earning assets using the effective yield method. Gains or losses on the sale of earning assets are based on the specific identification method.

Residential and Commercial Real Estate Loans: Held-for-Investment

Real estate loans held-for-investment are carried at their unpaid principal balance adjusted for net unamortized premiums or discounts and net of any allowance for credit losses. All of our residential real estate loans are classified as held-for-investment. Commercial real estate loans for which we have secured financing through the term of the loan or we otherwise have the intent and the ability to hold to maturity are classified as held-for-investment. While we generally do not sell real estate loans as part of our normal business operations, real estate loans classified as held-for-investment may be sold from time to time, especially subsequent to a call of Sequoia long-term debt.

Residential and Commercial Real Estate Loans: Held-for-Sale

Real estate loans held-for-sale (residential and commercial) are carried at the lower of original cost or market value. Any lower of cost or market adjustments on these loans are recognized in net recognized gains and valuation adjustments on our Consolidated Statements of Income. Real estate owned (REO) assets are included in real estate loans held-for-sale.

Securities: Available-for-Sale

Securities available-for-sale are carried at their estimated fair value. Cumulative unrealized gains and losses are classified as accumulated other comprehensive income in Stockholders’ Equity. Unrealized losses on these securities are reported as a component of net recognized gains and valuation adjustments in our Consolidated Statements of Income if the decline in value is considered to represent a permanent impairment.

Cash and Cash Equivalents

Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less.

Restricted Cash

Restricted cash may include principal and interest payments on real estate loans or securities held as collateral for long-term debt, cash pledged as collateral on certain interest rate agreements, and cash held from borrowers until certain loan agreement requirements have been met. Any corresponding liability for cash held from borrowers is included in accrued expenses and other liabilities on our Consolidated Balance Sheets.

Other Assets

Other assets on our Consolidated Balance Sheets include fixed assets, prepaid interest, and other prepaid expenses.

Interest Rate Agreements

We maintain an overall interest rate risk management strategy that incorporates the use of derivative interest rate agreements for a variety of reasons, including minimizing significant fluctuations in earnings or market values on certain assets or liabilities that may be caused by interest rate volatility. Interest rate agreements we use as part of our interest rate risk management strategy may include interest rate options, swaps, options on swaps, futures contracts, options on futures contracts, and options on forward purchases (collectively referred to as interest rate agreements). On the date an interest rate agreement is entered into, we designate the interest rate agreement as (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge), (2) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge), or (3) held for trading (trading instruments).

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We elect to account for the majority of our interest rate agreements as cash flow hedges. Accordingly, these interest rate agreements are recorded at their estimated fair market value and changes in their fair value are generally reported in accumulated other comprehensive income on our Consolidated Balance Sheets. The accumulated other comprehensive income is reclassified to our Consolidated Statements of Income over the effective hedge period as the hedged items affect earnings. The income or expense related to interest rate agreements is recognized on an accrual basis and is included in interest expense in our Consolidated Statements of Income. Any ineffective portions of the cash flow hedges are included in our Consolidated Statements of Income (see Note 5). We designate certain interest rate agreements that we elect not to treat as hedges for GAAP purposes as trading instruments. These interest rate agreements are recorded at their estimated fair market value with changes in their fair value reported in current-period earnings in net recognized gains and valuation adjustments on our Consolidated Statements of Income.

We formally document all relationships between hedging instruments and hedged items, as well as our risk-management objective and strategy for undertaking various hedge transactions. This process includes identifying all derivatives that are designated as fair value or cash flow hedges to (1) specific assets and liabilities on our Consolidated Balance Sheets or (2) specific firm commitments or forecasted transactions. We also formally assess (both at the hedge’s inception and on an ongoing basis) whether the derivatives that are used in hedging transactions are highly effective in offsetting changes in the fair value or cash flows of hedged items and whether those derivatives may be expected to remain highly effective in future periods.

We discontinue hedge accounting prospectively when (1) we determine that the derivative is no longer effective in offsetting changes in the fair value or cash flows of a hedged item (including hedged items such as firm commitments or forecasted transactions); (2) it is no longer probable that the forecasted transaction will occur; (3) a hedged firm commitment no longer meets the definition of a firm commitment; or (4) we determine that designating the derivative as a hedging instrument is no longer appropriate.

Debt

Short-term debt and long-term debt are carried at their unpaid principal balances net of any unamortized discount or premium and any unamortized bond issuance costs. The amortization of any discount or premium is recognized as an adjustment to interest expense using the effective yield method based on the repayment schedule of the related borrowings. Bond issuance costs incurred in connection with the issuance of long-term debt are deferred and amortized to interest expense over the estimated lives of the related securitized assets using the effective yield method, adjusted for the effects of actual principal paydown rates.

Taxes

We have elected to be taxed as a REIT under the Internal Revenue Code (the Code) and the corresponding provisions of state law. In order to qualify as a REIT, we must distribute at least 90% of our annual REIT taxable income (exclusive of undistributed taxable income of taxable subsidiaries) to stockholders within the time frame set forth in the tax rules and meet certain other requirements. If these requirements are met, we generally will not be subject to Federal or state income taxation at the corporate level with respect to the REIT taxable income we distribute to our stockholders. We may retain up to 10% of our ordinary REIT taxable income and pay corporate income taxes on this retained income while continuing to maintain our REIT status. At this time, we intend to retain 10% of our 2004 REIT taxable income and, accordingly, we have recorded a provision for income taxes based upon our estimated liability for Federal and state income tax purposes in our Consolidated Statements of Income. We have not recorded a provision for deferred taxes as there is no assurance that there will be taxable income available in future periods to realize net deductible temporary differences.

Under the Code, a dividend declared by a REIT in October, November, or December of a calendar year and payable to shareholders of record as of a specified date in such year will be deemed to have been paid by the REIT and received by the shareholders on the last day of that calendar year, provided the dividend is actually paid before February 1st of the following calendar year, and provided that the REIT has any remaining undistributed REIT taxable income on the record date. Therefore, the regular

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dividends declared in the fourth quarter of 2003, which were paid in January 2004, are considered taxable income to stockholders in 2003 (the year declared).

The taxable income of Holdings and its subsidiaries is not included in REIT taxable income and is subject to state and Federal income taxes at the applicable statutory rates. Holdings provides for any deferred income taxes to reflect estimated future tax effects. Deferred income taxes, to the extent they exist, reflect estimated future tax effects of temporary differences between the amount of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws and regulations. See Note 8 for further discussion on income taxes at Holdings.

To the extent a REIT’s distributions declared before calendar year-end and paid on or before January 31 of the following calendar year are less than 85% of its REIT taxable income in the calendar year plus the undistributed REIT taxable income from prior calendar years, a REIT incurs a 4% excise tax on the shortfall. Similar to 2003, we plan to have dividend distributions declared before calendar year-end and distributed on or before January 31, 2005 that are less than 85% of REIT taxable income for the 2004 calendar year. Therefore, we will incur a 4% excise tax provision on the shortfall. Accordingly, we recorded a provision for excise tax in our Consolidated Statements of Income during the three months ended March 31, 2004 and 2003 (See Note 8).

Net Income Per Share

Basic net income per share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing the net income available to common stockholders by the weighted average number of common shares and common equivalent shares outstanding during the period. The common equivalent shares are calculated using the treasury stock method, which assumes that all dilutive common stock equivalents are exercised and the funds generated by the exercise are used to buy back outstanding common stock at the average market price during the reporting period.

The following table provides reconciliation of the numerators and denominators of the basic and diluted net income per share computations.

For the three months ended March 31, 2004 and 2003, the number of common equivalent shares issued that were anti-dilutive totaled 5,729 and 380,372 respectively.

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Comprehensive Income

Current period net unrealized gains and losses on assets available-for-sale and current period net unrealized gains and losses on interest rate agreements are reported as a component of comprehensive income on our Consolidated Statements of Stockholders’ Equity with cumulative unrealized gains and losses classified as accumulated other comprehensive income in Stockholders’ Equity. As of both March 31, 2004 and December 31, 2003, accumulated other comprehensive income consisted of net unrealized gains and losses on both real estate loan securities available-for-sale and interest rate agreements classified as cash flow hedges.

The following table provides reconciliation of accumulated other comprehensive income for real estate loan securities available-for-sale and interest rate agreements classified as cash flow hedges as of March 31, 2004 and December 31, 2003.

Stock-Based Compensation

As of March 31, 2004 and December 31, 2003, we had one stock-based employee compensation plan and one employee stock purchase plan, which are described more fully in Note 10. In the fourth quarter of 2003, we adopted, effective January 1, 2003, SFAS No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure – An Amendment of FASB Statement No. 123, using the prospective method. Through the adoption of this pronouncement, all stock-based compensation awards issued in 2003 and future awards are accounted for under the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation.

We continue to account for all stock-based compensation awards issued prior to 2003 under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Under these provisions, when we grant stock-based compensation awards we do not include any stock-based employee compensation cost in net income as awards granted under the plan have an exercise price equal to the market value of the underlying common stock on the date of grant. In accordance with the disclosure requirements of SFAS No. 148, the following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to all stock-based employee compensation awards.

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For purposes of determining option fair values for use in the above table, the values are based on the Black-Scholes option pricing model as of the various grant dates using the following principal assumptions: expected option life of five years, expected stock price volatility of 22%, risk free rates of return based on the five-year Treasury rate at the date of grant, and a dividend yield of zero. The Company does not estimate future forfeitures when reporting option expense under SFAS No. 123. The Company adjusts future stock option expense once forfeitures occur. The actual value, if any, which the option recipient will realize from these options may be materially different from the amounts expensed.

Recent Accounting Pronouncements

In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51 (FIN 46). In December 2003, FASB issued FIN No. 46R which replaced FIN 46 and clarified ARB No. 51. This interpretation provides guidance on how to identify a variable interest entity (VIE) and when a company should include in its financial statements the assets, liabilities, and activities of a VIE. Under FIN 46, a company must consolidate a VIE when it is considered to be its primary beneficiary. The primary beneficiary is the entity that will absorb a majority (50% or more) of the risk of expected losses and/or receive most of the expected residual benefit from taking on that risk.

Our principal business activity involves issuing various series of non-recourse long-term debt collateralized by residential and commercial real estate loans and mortgage-backed securities. The collateral specific to each long-term debt series is the sole source of repayment of the debt and, therefore, our exposure to loss is limited to our net investment in the collateral. Historically we have consolidated the assets, liabilities, and activities of these transactions under pre-existing GAAP. Under FIN 46, these interests may be deemed VIEs and we may be considered the primary beneficiary. Regardless, our involvement remains unchanged, as does our accounting treatment. In addition, we consolidate our interest in a warehouse agreement where we are acquiring assets prior to securitization. We disclose our interests in VIEs under FIN 46 throughout these financial statements and footnotes.

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NOTE 3. EARNING ASSETS

As of March 31, 2004 and December 31, 2003, our earning assets generally consisted of investments in adjustable-rate, hybrid, and fixed-rate residential and commercial real estate loans and securities. Hybrid loans have an initial fixed coupon rate for three to ten years followed by periodic (usually annual) adjustments. The original maturity of the majority of our residential real estate loans and residential and commercial real estate securities is twenty-five to thirty years. The original maturity of our commercial real estate loans is from two to ten years. The actual amount of principal outstanding is subject to change based on the prepayments of the underlying loans.

For the three months ended March 31, 2004 and 2003, the average balance of earning assets was $18.2 billion and $7.4 billion, respectively.

As of March 31, 2004 and December 31, 2003, earning assets consisted of the following:

Residential Real Estate Loans

We acquire residential real estate loans from third party originators for securitization under the Sequoia program. These loans are transferred to securitization trusts and are the primary source of collateral for the non-recourse long-term debt on our Consolidated Balance Sheets. For the three months ended March 31, 2004 and 2003, we acquired $2.3 billion and $1.3 billion, respectively, of residential real estate loans. Principal paydowns on our residential real estate loans for the three months ended March 31, 2004 and 2003 totaled $0.5 billion and $0.2 billion, respectively. As of March 31, 2004 and December 31, 2003, unsecuritized residential real estate loans with a net carrying value of $97 million and $43 million, respectively, were pledged as collateral under short-term borrowing arrangements to third parties. These assets are financed with short-term borrowings prior to securitization through our Sequoia program. As of March 31, 2004 and December 31, 2003, residential real estate loans with a net carrying value of $18.0 billion and $16.2 billion, respectively, were pledged as collateral for long-term debt through our Sequoia program.

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Residential Loan Credit-Enhancement Securities

We credit enhance pools of high-quality jumbo residential real estate loans by acquiring subordinated securities in third-party securitizations. The subordinated interests in a securitization transaction bear the majority of the credit risk for the securitized pool of loans, thus allowing the more senior securitized interests to qualify for investment-grade ratings and to be sold in the capital markets. We therefore commit capital that partially “credit enhances” a securitized pool of residential real estate loans. For the three months ended March 31, 2004 and 2003, we acquired $38 million and $37 million, respectively, in carrying value of residential loan credit-enhancement securities. Principal paydowns for the three months ended March 31, 2004 and 2003 totaled $35 million and $23 million, respectively. Of the $35 million of principal paydowns in 2004, $26 million represented calls of the security issues in accordance with the original issue provisions of the individual securitization trusts. For the three months ended March 31, 2004, we sold residential loan credit-enhancement securities for proceeds of $22.4 million. These sales resulted in realized gains of $6.2 million reported under net recognized gains and valuation adjustments in our Consolidated Statements of Income. For the three months ended March 31, 2003, we did not sell any residential loan credit-enhancement securities.

Our residential loan credit-enhancement securities are first loss, second loss, and third loss securities. First loss securities are generally allocated actual credit losses on the entire underlying pool of loans within each specific residential loan credit-enhancement security up to a maximum of the principal amount of the first loss security. First loss securities provide credit-enhancement principal protection from the initial losses in the underlying pool for the second loss, third loss, and more senior securities. Any first loss securities that are owned by others and that are junior to our second and third loss securities provide our interests with some protection from losses, as they serve as external credit enhancement. Our residential loan credit-enhancement securities provided some level of credit enhancement on $71 billion and $68 billion of residential real estate loans securitized by third parties as of March 31, 2004 and December 31, 2003, respectively.

When we purchase residential loan credit-enhancement securities, a portion of the discount for each security may be designated as a credit reserve, with the remaining portion of the discount to be amortized into income using the effective yield method based on projected cash flows over the life of the security. Yields on each security vary as a function of credit results, prepayment rates, and interest rates. The designated credit protection is specific to each residential loan credit-enhancement security. If estimated future credit losses exceed our prior expectations, or credit losses occur more quickly than expected, or prepayment rates occur more slowly than expected, the yield over the remaining life of the security may be adjusted downward or we may take a mark-to-market earnings charge to write down our investment in the security to current market value to reflect permanent impairment. If estimated future credit losses are less than our prior estimate, or credit losses occur later than expected, or prepayment rates are faster than expected, the yield over the remaining life of the security may be adjusted upwards over time. For both the three months ended March 31, 2004 and 2003, we recognized market value losses of $0.6 million reported under net recognized gains (losses) and valuation adjustments in our Consolidated Statements of Income from our residential loan credit-enhancement securities to reflect permanent impairment under the provisions of EITF 99-20.

Our residential loan credit-enhancement securities are classified as available-for-sale and are carried at their estimated fair value. Gross unrealized gains and losses represent the differences between the net amortized cost and the fair value of the individual securities. As of March 31, 2004 and December 31,

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2003, gross unrealized gains were $72 million and $84 million, respectively. As of March 31, 2004 and December 31, 2003, gross unrealized losses were $3.1 million and $4.7 million, respectively. The gross unrealized losses as of March 31, 2004 and December 31, 2003 represented temporary declines in market value that was not considered to be permanent. Of the gross unrealized losses of $4.7 million as of December 31, 2003, $0.3 million was recognized as permanent impairment on the Consolidated Statements of Income in the three months ended March 31, 2004 under the provisions of EITF 99-20. Total permanent impairment for both the three months ended March 31, 2004 and 2003 totaled $0.6 million, and is included as part of net recognized gains (losses) and valuation adjustments in the Consolidated Statements of Income. Gross unrealized gains and losses are a component of accumulated other comprehensive income on our Consolidated Balance Sheets.

The following table shows the gross unrealized losses, fair value, and length of time that securities have been in a continuous unrealized loss position of all residential loan credit-enhancement securities as of March 31, 2004. These unrealized losses are not considered to be other-than-temporary impairments and have not been recognized as such through the Consolidated Statements of Income.

As of March 31, 2004, no residential loan credit-enhancement securities were pledged as collateral under short-term borrowing arrangements to third parties. As of December 31, 2003, $39 million of residential loan credit-enhancement securities were pledged as collateral under short-term borrowing arrangements to third parties. As of March 31, 2004 and December 31, 2003, residential loan credit-enhancement securities with a net carrying value of $119 million and $128 million, respectively, were pledged as collateral under long-term securitizations (see Note 7).

Commercial Real Estate Loans

Commercial real estate loans represent first lien interests in multifamily, office, retail, and industrial properties. Commercial real estate loans held-for-investment represent junior participations in first lien interests where we provide credit enhancement to a senior interest. Commercial real estate loans held-for-sale represent first lien interests in commercial properties where we have sole interest. For the three months ended March 31, 2004, we did not acquire any commercial real estate loans. For the three months ended March 31, 2003, we acquired $2.0 million of commercial real estate loans. Principal paydowns for both the three months ended March 31, 2004 and 2003 were $0.1 million. As of both March 31, 2004 and December 31, 2003, no commercial real estate loans were pledged as collateral under short-term borrowing arrangements to third parties. During the fourth quarter of 2003, we established a credit reserve on a commercial loan classified as held-for-investment for $500,000 due to vacancies at the underlying property. As of both March 31, 2004 and December 31, 2003, commercial real estate loans held-for-investment with a net carrying value of $9 million were pledged as collateral under long-term borrowing arrangements to third parties (see Note 7). For the three months ended March 31, 2004, we recognized impairment on a commercial loan held-for-sale through recognized gains and valuation adjustments on our Consolidated Statements of Income for $75,000. This impairment was precipitated by vacancies within the underlying commercial property.

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Securities Portfolio

Securities portfolio assets represent investment-grade security interests in prime residential, sub-prime residential, commercial, second lien residential, and corporate REIT debt securities. For the three months ended March 31, 2004 and 2003, acquisitions in our securities portfolio totaled $87 million and $43 million, respectively. Principal paydowns in our securities portfolio totaled $10 million and $11 million, respectively, for the three months ended March 31, 2004 and 2003. For the three months ended March 31, 2004, we did not incur any valuation adjustments from our securities portfolio through our Consolidated Statements of Income. For the three months ended March 31, 2003, we incurred valuation adjustments of $0.1 million from our securities portfolio through our Consolidated Statements of Income.

Our securities portfolio securities are classified as available-for-sale and are carried at their estimated fair value. Gross unrealized gains and losses represent the differences between the net amortized cost and the fair value of the individual securities. As of March 31, 2004 and December 31, 2003, gross unrealized gains were $21.9 million and $9.4 million, respectively. As of March 31, 2004 and December 31, 2003, gross unrealized losses were $2.5 million and $6.2 million, respectively. The gross unrealized losses as of March 31, 2004 and December 31, 2003 represented temporary declines in market value that were not considered to be permanent. No securities portfolio securities were considered permanently impaired for the three months ended March 31, 2004. Total permanent impairment for the three months ended March 31, 2003 totaled $0.1 million, and is included as part of net recognized gains (losses) and valuation adjustments in the Consolidated Statements of Income. Gross unrealized gains and losses are a component of accumulated other comprehensive income on our Consolidated Balance Sheets.

The following table shows the gross unrealized losses, fair value, and length of time that securities have been in a continuous unrealized loss position of all securities portfolio securities as of March 31, 2004. These unrealized losses are not considered to be other-than-temporary impairments and have not been recognized as such through the Consolidated Statements of Income.

As of March 31, 2004 and December 31, 2003, securities portfolio assets with a net carrying value of $167 million and $59 million were pledged as collateral under a warehouse agreement (see Note 6). As of March 31, 2004 and December 31, 2003, securities portfolio assets with a net carrying value of $22 million and $64 million, respectively, were pledged as collateral under short-term borrowing arrangements to third parties. As of March 31, 2004 and December 31, 2003, securities portfolio assets with a net carrying value of $698 million and $736 million, respectively, were pledged as collateral under long-term securitizations (see Note 7).

Net Recognized Gains (Losses) and Valuation Adjustments

Certain assets are marked to market through accumulated other comprehensive income; these adjustments affect our book value but not our net income. During the first quarter of 2004, we reported a net decrease in accumulated other comprehensive income of $3.7 million, as compared to a decrease of $1.0 million during the first quarter of 2003. Changes in this account may reflect increases or decreases in the fair value of our earning assets or interest rate agreements during the period, and may also reflect changes due to calls of our securities, write downs to fair value of a portion of our securities, premium or discount amortization of our securities, or amortization of realized gains and losses on our interest rate agreements.

Fluctuations in the market value of certain of our real estate loan assets and interest rate agreements may also affect our net income. The $17.4 million of net recognized gains and valuation adjustments reported during the first quarter of 2004 on our Consolidated Statements of Income was comprised of $11.8 million of net realized gains related to redemptions (calls) of residential credit-enhancement securities, $6.2 million of realized gains related to the sale of seasoned residential credit-enhancement securities that had significantly appreciated, offset by $0.6 million of fair value adjustments of a portion of our securities and a commercial real estate loan. The $0.9 million of net recognized gains and valuation adjustments reported during the first quarter of 2003 on our Consolidated Statements of Income was comprised of $0.9 million of net realized gains related to redemptions (calls) of residential credit-enhancement securities, $0.7 million of net gains from the sale of residential real estate loans, offset by $0.7 million of fair value adjustments of a portion of our securities.

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NOTE 4. RESERVES FOR CREDIT LOSSES

We provide for credit losses on our residential and commercial real estate loans held-for-investment by maintaining reserves for credit losses. The reserves for credit losses are adjusted by taking provision for credit losses recorded as a reduction in interest income on residential and commercial real estate loans on our Consolidated Statements of Income. The reserves for credit losses are reflected as a component of residential and commercial real estate loans on our Consolidated Balance Sheets. The following table summarizes the activity in the reserves for credit losses.

Residential Real Estate Loans

Commercial Real Estate Loans

We establish and maintain credit reserves that we believe represent probable credit losses that will result from impairment and inherent losses existing in our residential real estate loan portfolio as of the date of the financial statements. To calculate the reserve, we determine a level of impairment and inherent losses by first determining loss factors that can be specifically applied to each of our loan pools. We may consider various factors including, but not limited to, the age of our loans, underwriting standards, business climate, economic conditions, geographical considerations, past performance of similar loans, and other observable data. Once we determine applicable loss factors, we estimate the expected losses of each pool of loans over their expected lives. We then estimate the timing of these losses and the losses probable to occur over an effective loss confirmation period. This period is defined as the range of time between the probable occurrence of a credit loss (such as the initial deterioration of the borrower’s financial condition) and the confirmation of that loss (the actual impairment or charge-off of the loan). The losses expected to occur within the effective loss confirmation period are the basis of our credit reserves because we believe those losses are existing as of the reported date of the financial statements. We reevaluate the level of our credit reserves on at least a quarterly basis and record provision, charge-offs, and recoveries monthly.

NOTE 5. INTEREST RATE AGREEMENTS

We generally attempt to structure our balance sheet to address many of the interest rate risks inherent in our assets and liabilities. We enter into certain interest rate agreements with the objective of matching the interest rate characteristics of our assets and liabilities.

We may enter into interest rate agreements consisting of interest rate options, interest rate swaps, interest rate futures, and other types of hedging instruments. We designate our interest rate agreements as trading instruments or cash flow hedges. In general, we use cash flow hedges to hedge our variable interest rate debt payments associated with certain existing and/or future liabilities.

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Interest rate options, which include caps and call corridors (options), are agreements that transfer, modify, or reduce interest rate risk in exchange for the payment of a premium when a contract is initiated. Interest rate cap agreements provide cash flows to the extent that a specific interest rate index exceeds a fixed rate. Interest rate corridor agreements provide cash flows to us to the extent that a specific interest rate falls between two fixed rates.

Interest rate swaps (swaps) are agreements in which a series of cash flows are exchanged with a counterparty over a prescribed period based on fixed and indexed interest rates. The notional amount on which the interest payments are based is not exchanged. Most of our swaps involve the exchange of a floating interest payment for a fixed interest payment based on a periodically resetting index. Most of the swaps require that we provide collateral, such as securities or cash, to the counterparty when their fair values decrease significantly. Should the counterparty fail to return the collateral, we would be at risk for the fair market value of those assets pledged as collateral.

Interest rate futures are contracts for the delivery of securities or cash in which the seller agrees to deliver on a specified future date, a specified instrument or cash equivalent, at a specified price or yield. Under these agreements, if we have sold the futures, we will generally receive additional cash flows if interest rates rise. Conversely, we will generally pay additional cash flows if interest rates fall. The credit risk on futures is limited by the requirement that the exchange and its members make good on obligations of any member that fails to perform.

We elect hedge accounting treatment on the majority of our interest rate agreements and account for other interest rate agreements as trading instruments. For the three months ended March 31, 2004 and 2003, we did not recognize any market value gains or losses on our interest rate agreements accounted for as trading instruments on our Consolidated Statements of Income.

We report our interest rate agreements at fair value. As of March 31, 2004, the fair value of our interest rate agreements was negative $11.4 million and was reported as $0.9 million in other assets and $12.3 million in accrued expenses and other liabilities on our Consolidated Balance Sheets. As of December 31, 2003, the fair value of our interest rate agreements was negative $1.8 million and was reported as $2.2 million in other assets and $4.0 million in accrued expenses and other liabilities on our Consolidated Balance Sheets.

The following table shows the aggregate fair value of our interest rate agreements as of March 31, 2004 and December 31, 2003.

Changes in the fair value of our cash flow hedges are recorded in accumulated other comprehensive income on our Consolidated Balance Sheets and reclassified to our Consolidated Statements of Income over the effective hedge period as the hedged item affects earnings. In the event the hedged transaction does not occur, we would immediately reclassify the entire balance related to the cash flow hedge from accumulated other comprehensive income to our Consolidated Statements of Income.

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The following table depicts the balances in accumulated other comprehensive income as of March 31, 2004 and December 31, 2003 for our cash flow hedges. The $0.6 million and $0.5 million, respectively, of realized net losses included in other comprehensive income as of March 31, 2004 and December 31, 2003 represents interest rate agreements designated as cash flow hedges that have expired or terminated. These realized net losses will be reclassified to interest expense in our Consolidated Statements of Income over the effective period for the hedged transactions as forecasted transactions occur. Of the $0.6 million of realized net losses included in other comprehensive income as of March 31, 2004, $0.4 million will be recognized in interest expense in our Consolidated Statements of Income over the next twelve months. The $8.8 million of unrealized net losses as of March 31, 2004 and the $0.1 million of unrealized net gains as of December 31, 2003 included in other comprehensive income represent interest rate agreements designated as cash flow hedges that are currently outstanding.

Certain of our interest rate agreements accounted for as cash flow hedges have expired or terminated and the effective period for the hedged transactions has commenced. This has caused a portion of our accumulated other comprehensive income to be reclassified to our Consolidated Statements of Income. For the three months ended March 31, 2004 and 2003, we reclassified $0.4 million and $0.1 million, respectively, of net losses from accumulated other comprehensive income on our Consolidated Balance Sheets to interest expense on long-term debt in our Consolidated Statements of Income.

The following table depicts the activity for the three months ended March 31, 2004 and 2003 for interest rate agreements accounted for as cash flow hedges. The realized net losses on closed transactions represent amounts reclassified from accumulated other comprehensive income to interest expense for the effective period on hedged transactions. The net ineffective portion of hedges represents amounts recorded in interest expense to the extent the interest rate agreements are ineffective related to the hedged transaction.

The following table summarizes the aggregate notional amounts of all of our interest rate agreements as well as the credit exposure related to these instruments as of March 31, 2004 and December 31, 2003. The credit exposure reflects the fair market value of any cash and collateral of Redwood Trust held by

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counterparties. Sequoia and Acacia did not hold collateral of the third party financial institutions for its swaps as of March 31, 2004 and December 31, 2003. The cash and collateral held by counterparties are included in restricted cash on our Consolidated Balance Sheets.

In general, we incur credit risk to the extent that the counterparties to the interest rate agreements do not perform their obligations under the interest rate agreements. If one of the counterparties does not perform, we may not receive the cash to which we would otherwise be entitled under the interest rate agreement. In order to mitigate this risk, we only enter into interest rate agreements that are either a) transacted on a national exchange or b) transacted with counterparties that are either i) designated by the U.S. Department of Treasury as a primary government dealer, ii) affiliates of primary government dealers, or iii) rated BBB or higher. Furthermore, we generally enter into interest rate agreements with several different counterparties in order to diversify our credit risk exposure.

NOTE 6. SHORT-TERM DEBT

We enter into repurchase agreements, bank borrowings, and other forms of collateralized short-term borrowings (short-term debt) to finance a portion of our earning assets. We generally intend to use short-term debt only while we accumulate assets prior to issuing non-recourse long-term debt to finance real estate loan assets to maturity.

As of March 31, 2004, we had $278 million of short-term debt outstanding with a weighted-average borrowing rate of 2.89% and a weighted-average remaining maturity of 60 days. This debt was collateralized with $96 million of residential real estate loans and $191 million of securities, including $14 million of securities created through the securitization of residential real estate loans through the Sequoia program. As of December 31, 2003, we had $236 million of short-term debt outstanding with a weighted-average borrowing rate of 1.98% and a weighted-average remaining maturity of 76 days. This debt was collateralized with $43 million of residential real estate loans and $226 million of securities, including $65 million of securities created through the securitization of residential real estate loans through the Sequoia program.

As of March 31, 2004 and December 31, 2003, our short-term debt had the following remaining maturities:

For the three months ended March 31, 2004, the average balance of short-term debt was $0.4 billion with a weighted-average interest cost of 2.57%. For the three months ended March 31, 2003, the average balance of short-term debt was $0.4 billion with a weighted-average interest cost of 1.94%. The maximum balance outstanding for the three months ended March 31, 2004 and 2003 was $1.0 billion and $0.8 billion, respectively.

Through March 31, 2004, we were in compliance with all of our debt covenants for all of our short-term borrowing arrangements and credit facilities. Covenants associated with a portion of our short-term debt generally relate to our tangible net worth, liquidity reserves, and leverage requirements. We have not had, nor do we currently anticipate having, any problems in meeting these covenants.

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We have uncommitted facilities available with several banks and Wall Street firms for financing residential real estate securities. As of March 31, 2004 and December 31, 2003, we had borrowings under these facilities of $21 million and $119 million, respectively. The collateral pledged under these borrowings include retained interests in previously issued adjustable-rate residential real estate loan securitizations through our Sequoia program and other retained interests. Borrowings under these facilities bear interest based on a specified margin over the one-month LIBOR interest rate. As of March 31, 2004 and December 31, 2003, the weighted average borrowing rate under these facilities was 1.31% and 1.54%, respectively. It is our intention to renew committed and uncommitted facilities as needed, as well as pursue additional facilities and other types of financing.

As of March 31, 2004 and December 31, 2003, we had short-term facilities with three Wall Street firms totaling $1.4 billion to fund residential real estate loans. Borrowings under these facilities bear interest based on a specified margin over the one-month LIBOR interest rate. As of March 31, 2004 and December 31, 2003, we had borrowings under these facilities of $92 million and $39 million, respectively, with weighted average borrowing rates of 1.61% and 1.65%, respectively. These facilities expire between April 2004 and October 2004. We will likely seek to renew these facilities and may pursue additional facilities and do not anticipate any problems doing so at this time.

In November 2003, we entered into a warehouse agreement and an engagement letter with a bank designed to enable us to pursue the issuance of a collateralized debt obligation (CDO) through the Acacia program. As of March 31, 2004 and December 31, 2003, we had borrowings under this agreement of $165 million and $59 million, respectively. Borrowings under the warehouse agreement are secured by mortgage securities in our securities portfolio with market values of $167 million and $59 million, respectively, at March 31, 2004 and December 31, 2003. This agreement was terminated upon the issuance of Acacia CDO 4, LTD in April 2004.

As of March 31, 2004 and December 31, 2003, we had one facility with a Wall Street firm totaling $60 million for financing subordinated securities. This facility is intended to finance residential real estate loan securities with lower-than-investment-grade ratings and it terminates in June 2004. We do not anticipate any problems renewing this credit facility but we may not seek renewal at its expiration. In addition to this committed facility, we may also finance residential real estate loan securities with lower-than-investment-grade ratings through non-committed borrowing arrangements. As of March 31, 2004, we did not have any short-term borrowings to finance subordinated securities. As of December 31, 2003, we had borrowings of $30 million to finance subordinated securities. Borrowings under these facilities bear interest based on a specified margin over the one-month LIBOR interest rate.

NOTE 7. LONG-TERM DEBT

Through securitizations we issue long-term debt in the form of collateralized mortgage-backed securities. Each series of long-term debt consists of various classes at variable and fixed rates of interest. The maturity of each class is directly affected by the rate of principal prepayments on the related bond collateral. Each series is also subject to redemption according to the specific terms of the respective governing documents. As a result, the actual maturity of any class of a long-term debt series is likely to occur earlier than its stated maturity.

Sequoia long-term debt is secured by residential real estate loans and residential real estate loan mortgage-backed securities (Sequoia bond collateral). The Sequoia bond collateral consists primarily of adjustable-rate and hybrid, conventional, 25- or 30-year residential real estate loans secured by first liens on one to four-family residential properties. All Sequoia bond collateral is pledged to secure repayment of the related Sequoia long-term debt obligation. During the three months ended March 31, 2004 and 2003, we issued $2.2 billion and $1.0 billion, respectively, of Sequoia long-term debt to fund residential real estate loans. During the three months ended March 31, 2004, we issued $16 million of Sequoia long-term debt secured by interest-only certificates, which we had retained from prior Sequoia securitizations.

As of both March 31, 2004 and December 31, 2003, Acacia long-term debt is secured by residential and commercial real estate loan mortgage-backed securities (Acacia bond collateral). All Acacia bond collateral is pledged to secure repayment of the related Acacia long-term debt obligation.

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As of both March 31, 2004 and December 31, 2003, commercial long-term debt was secured by one hybrid commercial real estate loan (commercial loan collateral) with a maturity date in 2009, which was secured by a first lien on the related commercial real estate property reported on our Consolidated Balance Sheets as commercial real estate loans held-for-investment.

Our exposure to loss on the Sequoia bond collateral, Acacia bond collateral, and the commercial loan collateral is limited to our net investment, as the residential and commercial long-term debt are non-recourse to Redwood Trust. As required by the governing documents related to each series of long-term debt, the Sequoia and Acacia bond collateral is held in the custody of trustees. Trustees collect principal and interest payments (less servicing and related fees) on the bond collateral and make corresponding principal and interest payments on the long-term debt. Obligations under our long-term debt are payable solely from the bond collateral and are otherwise non-recourse to Redwood Trust.

The components of the collateral for our long-term debt are summarized as follows:

The components of our long-term debt as of March 31, 2004 and December 31, 2003, along with other selected information are summarized below:

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For the three months ended March 31, 2004 and 2003, the average balance of Sequoia long-term debt was $16.4 billion and $6.2 billion, respectively. As of March 31, 2004 and December 31, 2003, accrued interest payable on Sequoia long-term debt was $16.7 million and $14.7 million, respectively, and is reflected as a component of accrued interest payable on our Consolidated Balance Sheets. For the three months ended March 31, 2004 and 2003, the average balance of Acacia long-term debt was $0.8 billion and $0.3 billion, respectively. As of March 31, 2004 and December 31, 2003, accrued interest payable on Acacia long-term debt was $1.2 million and $1.8 million, respectively, and is reflected as a component of accrued interest payable on our Consolidated Balance Sheets. For three months ended March 31, 2004 and 2003, the average balance of commercial long-term debt was $5 million and $8 million, respectively.

NOTE 8. TAXES

As a REIT, Redwood Trust can deduct dividends paid from REIT taxable income and thus, effectively, reduce or eliminate corporate-level income taxes. However, a REIT can retain up to 10% of its taxable income and still maintain its REIT status. We plan to retain up to 10% of our 2004 REIT ordinary taxable income and we will therefore be subject to corporate level income taxes on this retained income for the 2004 calendar tax year. We retained 10% of our 2003 REIT ordinary taxable income and were subject to corporate level income taxes on this retained income for the 2003 calendar tax year. Holdings, Redwood Trust’s taxable subsidiary, is subject to corporate income taxes on 100% of its taxable income.

Our provision for corporate income taxes for Redwood Trust for the three months ended March 31, 2004 and 2003 was $1.9 million and $1.2 million, respectively.

Our provision for income taxes for Holdings for the three months ended March 31, 2004 and 2003 was $0.0 million and $0.1 million, respectively. Holdings’ California state net operating loss (NOL) carryforwards are available in 2004, but were not available during 2003 and 2002 due to California’s suspension of NOL carryforwards. California Revenue and Tax Code Section 24416.3 caused the deduction for California NOL carryforwards to be suspended for the tax years 2002 and 2003. In addition, this statute stated that for any California carryforward of a NOL for which a deduction is denied by reason of the suspension, the carryforward period is extended for one year for losses sustained in taxable years in 2002, and two years for NOLs sustained in taxable years beginning before 2002. No Federal tax provision for Holdings was recorded for the first quarter ended March 31, 2004 and 2003, as taxable income reported for these periods was offset by Federal net operating loss carryforwards from prior years.

Due to the uncertainty of realization of NOLs, no deferred tax benefit has been recorded for Holdings. A valuation allowance has been provided to offset the deferred tax assets related to the net operating loss carryforwards and other future temporary deductions as of March 31, 2004 and December 31, 2003. As of March 31, 2004 and December 31, 2003, Holdings had net operating loss carryforwards of approximately $13.8 million and $16.8 million for Federal tax purposes, respectively. As of March 31, 2004 and December 31, 2003, Holdings had net operating loss carryforwards of approximately $12.8 million and $15.8 million, respectively, for state tax purposes. The Federal loss carryforwards and a portion of the state loss carryforwards expire between 2018 and 2021, while most of the state loss carryforwards expire between 2005 and 2010.

For any one tax year, our distributions declared before calendar year-end and distributed on or before January 31 of the following calendar year may be less than 85% of REIT taxable income in that year requiring us to incur a 4% excise tax provision on the shortfall. For the three months ended March 31, 2004 and 2003, we provided for excise tax of $0.3 million and $0.9 million, respectively, which is reflected as a component of operating expenses on our Consolidated Statements of Income. As of March 31, 2004 and December 31, 2003, accrued excise tax payable was $0.3 million and $1.2 million, respectively, and is reflected as a component of accrued expenses and other liabilities on our Consolidated Balance Sheets.

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NOTE 9. FAIR VALUE OF FINANCIAL INSTRUMENTS

The following table presents the carrying values and estimated fair values of our financial instruments as of March 31, 2004 and December 31, 2003.

We estimate the fair value of certain assets and interest rate agreements using available market information and other appropriate valuation methodologies. Valuations of our residential real estate loans held-for-sale and held-for-investment are generally done on a pool basis while valuations of our commercial real estate loans held-for-sale and held-for-investment, securities available-for-sale, and securities issued through our Sequoia and Acacia programs that are classified as long-term debt are done on an individual basis. We believe the estimates we use reflect the values we may be able to receive should we choose to sell them. Our estimates are inherently subjective in nature and involve matters of uncertainty and judgment to interpret relevant market and other data. Many factors are necessary to estimate market values, including, but not limited to interest rates, prepayment rates, amount and timing of credit losses, supply and demand, liquidity, and other market factors.

In addition to our valuation processes, we are active acquirers and occasional sellers of the assets and interest rate agreements we own. Thus, we have the ability to understand and determine changes in assumptions that are taking place in the marketplace and make appropriate changes in our assumptions for valuing assets in our portfolio.

The carrying values of all other balance sheet accounts as reflected in the financial statements approximate fair value due to the short-term nature of these accounts.

NOTE 10. STOCKHOLDERS’ EQUITY

Class B 9.74% Cumulative Convertible Preferred Stock

On August 8, 1996, we issued 1,006,250 shares of Class B Preferred Stock. The preferred stock paid a dividend equal to the greater of (i) $0.755 per share, per quarter or (ii) an amount equal to the quarterly dividend declared per share on the common stock. The preferred stock ranked senior to our common stock as to the payment of dividends and liquidation rights. The liquidation preference entitled the holders of the preferred stock to receive $31.00 per share plus any accrued dividends before any distribution was made on the common stock.

Each share of the Preferred Stock was convertible at the option of the holder at any time into one share of common stock. Effective October 1, 1999, we could redeem the preferred stock (i) for one share of common stock plus accumulated, accrued and unpaid dividends through the end of the prior dividend

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period, provided that for 20 trading days within a period of 30 consecutive trading days, the closing price of the common stock equaled or exceeded the Conversion Price of $31.00 per share or (ii) for cash at a redemption price of $31.00 per share, plus any accumulated, accrued and unpaid dividends through the date of redemption. On May 2, 2003, we redeemed all outstanding shares of preferred stock by converting those shares into shares of common stock.

Stock Option Plan

In March 2002, we adopted our Incentive Stock Plan (the Plan) for executive officers, employees, and non-employee directors that was approved by our shareholders in May 2002. The Plan authorizes our Board of Directors (or a committee appointed by our Board of Directors) to grant incentive stock options as defined under Section 422 of the Code (ISOs), options not so qualified (NQSOs), deferred stock, restricted stock, performance shares, stock appreciation rights, limited stock appreciation rights (awards), and dividend equivalent rights (DERs) to such eligible recipients other than non-employee directors. ISOs and NQSOs awarded to employees have a maximum term of ten years and generally vest ratably over a four-year period. NQSOs awarded to non-employee directors have a maximum term of ten years and generally vest immediately or ratably over a three or four year period. Non-employee directors are automatically provided annual grants of NQSOs under the Plan. The Plan has been designed to permit our compensation committee to grant and certify awards that qualify as performance-based and otherwise satisfy the requirements of Section 162(m) of the Code; however, not all awards may so qualify. This plan replaced our prior stock option plan. As of March 31, 2004 and December 31, 2003, 126,724 and 152,487 shares of common stock, respectively, were available for grant. Our Board of Directors has adopted, subject to approval by stockholders in May 2004, an amendment to the Plan to increase the number of shares available for grant by 735,000.

ISOs

Of the total shares of common stock available for grant, no more than 963,637 shares of common stock are cumulatively available for grant as ISOs. As of both March 31, 2004 and December 31, 2003, 551,697 ISOs had been granted, respectively. The exercise price for ISOs granted under the Plan may not be less than the fair market value of shares of common stock at the time the ISO is granted.

Restricted Stock

As of March 31, 2004 and December 31, 2003 and 2002, 8,167 and 10,003 shares, respectively, of restricted stock were outstanding. We did not grant any shares of restricted stock for the three months ended March 31, 2004 and 2003. For both the three months ended March 31, 2004 and 2003, restrictions on 1,750 of these shares lapsed, respectively. Restrictions on the remaining shares of restricted stock lapse through January 1, 2006.

DERs

Redwood Trust has granted certain stock options that accrue and pay stock and cash DERs. This feature results in current expenses being incurred on stock and cash DERs that relate to stock option grants made prior to January 1, 2003. To the extent our REIT taxable income increases, our REIT dividend distribution requirement, and stock and cash DER expenses may increase. For the three months ended March 31, 2004 and 2003, we accrued cash and stock DER expenses of $2.6 million and $2.7 million, respectively. Stock and cash DER expenses are included in operating expenses in our Consolidated Statements of Income.

Stock DERs represent shares of stock, which are issuable when the holders exercise the underlying stock options. All stock options with stock DERs issued before January 1, 2003 are considered variable stock awards under the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. In addition to the stock DER expense on these options, for the three months ended March 31, 2004, and 2003, we recognized variable stock option expense of $1.4 million and $0.9 million, respectively. This expense is included in operating expenses in our Consolidated Statements of Income.

Stock DERs are accrued based on an estimate of our common stock dividend requirements. As of March 31, 2004 and 2003, there were 309,571 and 337,411 unexercised options with stock DERs under the Plan, respectively. Cash DERs are accrued based on an estimate of our common stock dividend requirements. As of March 31, 2004 and December 31, 2003, there were 1,268,114 and 1,546,042 unexercised options with cash DERs under the Plan, respectively. As of March 31, 2004 and December 31, 2003, there were 71,158 and 52,145 unexercised options with no DERs under the Plan, respectively.

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A summary of the status of the Plan and changes during the three months ended March 31, 2004 and 2003 is presented below.

Deferred Compensation Plan

In May 2002, our Board of Directors approved the Deferred Compensation Plan. The Deferred Compensation Plan allows eligible officers and directors to defer the payment of current salary and certain other forms of compensation and invest the deferrals with Redwood Trust. The plan allows for the investment of deferrals in either an interest crediting account or deferred stock units. For the three months ended March 31, 2004 and 2003, $0.3 million and $0.2 million, respectively, was deferred in an interest crediting account under the Deferred Compensation Plan. Deferrals in the Deferred Compensation Plan are credited with accrued interest earned on participant accounts. The rate of accrual is set forth in the Deferred Compensation Plan and is based on a calculation of the marginal rate of return on our portfolio during the year. For the three months ended March 31, 2004, $0.3 million of accrued interest was credited to the plan. For the three months ended March 31, 2003, a negligible amount of accrued interest was credited to the plan. As of both March 31, 2004 and December 31, 2003, 25,417 deferred stock units had been granted through deferrals under the plan, which represented a value of $0.8 million at the time of grant.

Employee Stock Purchase Plan

In May 2002, our common shareholders approved the 2002 Redwood Trust, Inc. Employee Stock Purchase Plan (ESPP). The purpose of the ESPP is to give our employees an opportunity to acquire an equity interest in Redwood Trust through the purchase of shares of common stock at a discount. A maximum of 100,000 shares of common stock may be purchased under the ESPP. Effective July 1, 2002, the ESPP allows eligible employees to have up to 15% of their annual gross compensation (including base salary, bonus, and cash DERs) withheld to purchase common stock at 85% of its market value. The maximum gross compensation any participant can contribute to the ESPP in any calendar quarter is $6,250. Market value under the ESPP is the lesser of the closing market price of the common stock as of the start of an offering period in the ESPP or the closing market price on the quarterly purchase date.The offering period starts on January 1st of each calendar year and consists of four quarterly purchase periods. For the three months ended March 31, 2004 and 2003, employees acquired an aggregate of 1,181 and 1,896 shares, respectively, of common stock at an average purchase price of $43.22 and $23.55 per share, respectively, under this Plan. As of both March 31, 2004 and December 31, 2003, there remained a negligible amount of uninvested employee contributions in the ESPP.

In the fourth quarter of 2003, we adopted, effective January 1, 2003, SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure – An Amendment of FASB Statement No. 123. Through the adoption of this pronouncement, all shares purchased through the ESPP in 2003 and beyond are accounted for under the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation. For the three months ended March 31, 2004, we recorded an expense of $0.1 million for shares issued under these provisions. For the year ended December 31, 2003, we recorded an expense of $0.2 million for shares issued under the ESPP through these provisions. In 2002 we

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accounted for the ESPP under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Under these provisions we did not include any stock-based employee compensation cost in net income as awards granted under the ESPP were deemed non-compensatory.

Common Stock Repurchases

Our Board of Directors has approved the repurchase of a total of 7,455,000 shares of our common stock. A total of 6,455,000 shares were repurchased in 1998 and 1999. We did not repurchase any shares of common stock during the three months ended March 31, 2004 and 2003. As of both March 31, 2004 and December 31, 2003, there remained 1,000,000 shares available under the authorization for repurchase. Repurchased shares have been returned to the authorized but unissued shares of Common Stock.

Common Stock Issuances

For the three months ended March 31, 2004 and 2003, we issued 443,738 and 324,415 shares, respectively, of common stock through our Direct Stock Purchase and Dividend Reinvestment Plan for net proceeds of $24.1 million and $9.2 million, respectively.

Components of Accumulated Other Comprehensive Income

The components of accumulated other comprehensive income on our Consolidated Balance Sheets as of March 31, 2004 include net unrealized gains of $68.5 million in our residential loan credit-enhancement portfolio, net unrealized gains of $19.3 million in our securities portfolio, net realized losses on our interest rate agreements of $0.6 million, and net unrealized losses on our interest rate agreements of $8.7 million, for total accumulated other comprehensive income of $78.5 million.

The components of accumulated other comprehensive income on our Consolidated Balance Sheets at December 31, 2003 include net unrealized gains of $79.3 million in our residential loan credit-enhancement portfolio, net unrealized gains of $3.3 million in our securities portfolio, and net realized losses on our interest rate agreements of $0.5 million, and net unrealized gains on our interest rate agreements of $0.1 million, for total accumulated comprehensive income of $82.2 million.

NOTE 11. COMMITMENTS AND CONTINGENCIES

As of March 31, 2004, Redwood Trust was obligated under non-cancelable operating leases with expiration dates through 2013. The total future minimum lease payments under these non-cancelable leases are $7.9 million and are expected to be paid as follows: 2004 — $0.9 million; 2005 — $1.3 million; 2006 - - $0.9 million; 2007 — $0.7 million; 2008 — $0.7 million; 2009 — $0.7 million; 2010 — $0.7 million; 2011 — $0.8 million; 2012 — $0.8 million; 2013 — $0.4 million. The majority of the future lease payments are related to the operating lease for our executive offices that we relocated to in the third quarter of 2003.

At March 31, 2004, there were no pending legal proceedings to which Redwood Trust was a party or of which any of its property was subject.

As of March 31, 2004, we have committed to purchase $0.8 billion of adjustable-rate residential real estate loans, $11.5 million of other residential and commercial real estate loan securities, and $4.9 million of residential loan credit-enhancement securities for settlement in the second quarter of 2004. While purchase commitments represent derivative instruments under SFAS No. 149, the change in the fair value of these commitments as of March 31, 2004 was immaterial.

NOTE 12. SUBSEQUENT EVENTS

In April 2004, we issued $822 million of long-term debt through Sequoia Mortgage Trust 2004-4, a trust established by Sequoia. This debt is collateralized by pools of adjustable-rate residential real estate loans. We also issued $293 million of long-term debt through Acacia CDO 4, LTD. This debt is collateralized by residential and commercial real estate loan securities and other asset-backed securities. The proceeds received from these issuances were used to acquire loans and pay down a portion of our short-term debt.

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In April 2004, residential loan credit-enhancement securities with a principal value of $7.2 million were called pursuant to the original securitization documents. We recognized market value gains on these calls of $2.8 million through net recognized gains and valuation adjustments on our Consolidated Statements of Income.

In April 2004, we obtained a borrowing facility with a third party financial institution totaling $450 million. This facility will be used as short-term financing for the acquisition of residential real estate loans. This facility expires in April 2005.

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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the Consolidated Financial Statements and Notes as well as our Annual Report on Form 10-K for the fiscal year ended December 31, 2003.

SAFE HARBOR STATEMENT

Statutory “safe harbor” applies to “forward-looking” statements under the Private Securities Litigation Reform Act of 1995 within the meaning of the Securities Act of 1933 and of the Securities Exchange Act of 1934. Forward-looking statements inherently involve certain risks and uncertainties. Any matter discussed in this document that is not historical fact or contains estimates may constitute a forward-looking statement. Although we continuously update and revise our estimates, it is not practical to publish all such revisions and, thus no one should assume that any estimates or the results or trends projected in or contemplated by any forward-looking statements would prove to be accurate in the future. Forward-looking statements can be identified by the presence of words such as “may”, “will”, “believe”, “expect”, “anticipate”, “estimate”, “intend”, “plan”, or similar words and terminology. Actual results and the timing of certain events could differ materially from those addressed in forward-looking statements due to a number of factors, including, among other things: 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. For a discussion of risk factors, readers should review our Annual Report on Form 10-K for the year ended December 31, 2003. This Form 10-Q may contain certain data based on information obtained from third-party service providers.

SUMMARY AND OUTLOOK

Redwood Trust is a financial institution located in Mill Valley, California. We invest in residential real estate loans. In addition, we credit-enhance (assume the credit risk on) residential loans by acquiring and owning residential credit-enhancement securities. We also invest in other types of residential securities, in commercial real estate loans, and in commercial real estate securities.

We securitize most of the assets we acquire. In a securitization, we transfer acquired assets to a securitization trust. The trust creates a variety of new securities, each representing a different type of ownership interest in the underlying assets of the trust. These securities are generally called “asset-backed securities”. We acquire certain of these asset-backed securities from the trust, and the rest are sold (issued) to institutional capital markets investors worldwide.

Investors that acquire asset-backed securities issued by these trusts generally have little or no recourse to us for payments on the obligations of the asset-backed securities; except for certain limited representations and warranties furnished by us, the investors can look only to the assets collateralizing the asset-backed securities for satisfaction of their claims. Our risk is generally limited to our net investment in the securities we retain or acquire from these trusts. Nevertheless, we consolidate 100% of the assets and 100% of the liabilities of these trusts on our Consolidated Balance Sheet.

Our primary financial goal is to maintain steady regular dividend payments to our shareholders.

Our primary source of revenue is interest income consisting of the monthly loan payments made by homeowners and commercial property owners on their loans. Our expenses consist primarily of interest expense on asset-backed securities and debt, and operating expenses.

Redwood Trust is structured as a Real Estate Investment Trust (REIT). As a REIT, we are required to distribute to shareholders as dividends at least 90% of our REIT taxable income (the income we earn, as calculated for tax purposes, at our REIT parent company, excluding income earned in non-REIT taxable subsidiaries). During the first quarter of 2004, we estimate we earned $49 million ($2.48 per share) of taxable income, of which $46 million ($2.33 per share) was REIT taxable income.

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Our GAAP earnings (as calculated in accordance with Generally Accepted Accounting Principles) totaled $51 million or $2.49 per share for the first quarter of 2004, as compared to $15 million or $0.88 per share during the first quarter of 2003. Our first quarter 2004 results continue to be driven by the quality of our existing real estate loan investments, a favorable operating environment, excellent credit results, favorable prepayment patterns, increased capital efficiencies, and call income (generated from residential credit-enhancement securities that we own at a discount to principal value that were called at full principal value).

Our current regular dividend rate, as established by our Board of Directors, is $0.67 per share per quarter. In addition to this regular dividend, we also declared a special dividend of $0.50 during the first quarter of 2004. This special dividend represents the continued distribution of REIT taxable income we earned in 2003; we expect to complete the distribution of 2003’s REIT taxable income with the third quarter 2004 regular dividend. The first quarter regular and special dividends were paid on April 21, 2004, to shareholders of record on March 31, 2004.

Looking ahead, we believe our earnings will continue to benefit from the quality of our existing assets. However, the extraordinary market conditions of the last few years that increased our realized yields on our seasoned assets (attractive acquisition pricing, excellent credit results, and favorable prepayment rate patterns) are unlikely to continue or to be repeated.

We also expect to face increased competition, higher acquisition pricing, and a reduced supply of acquisition opportunities. The volume of fixed and hybrid securitizations has decreased as banks and thrifts purchase residential real estate loans and hold these assets in their portfolios instead of securitizing them. This increased competition from banks and thrifts may continue, and the supply of new loans originated will likely decrease if interest rates rise. In addition, we face increased competition when we acquire real estate loan securities, as institutional investors worldwide have increased their demand for fixed-income investments.

The strong market demand for income-producing assets also means that our sales of asset-backed securities (collateralized by our assets) has allowed us to obtain very low cost funding for our new asset acquisitions. Better funding levels offset the effect of higher asset prices. The net result is that we continue to structure new investments for our portfolio that we believe are likely to produce attractive yields and cash flows for our shareholders over time.

We structure our balance sheet in a manner that eliminates many potential interest rate risks. We match the interest rate characteristics of our assets and liabilities; over 94% of our assets and liabilities have interest rate adjustments tied to one-, three-, and six-month LIBOR interest rates.

Overall, we believe we will continue to be a leading competitor as a result of our operating efficiencies, our specialized business focus, and the relationships we have developed with our business partners. Although we believe it is unlikely we will be able to sustain our earnings and special dividend distributions on a per share basis at 2003’s extraordinary levels, we believe we will continue to generate earnings sufficient to sustain our regular dividend rate in the near future.

SECOND QUARTER 2004 UPDATE

During the second quarter 2004, through May 4, 2004, we have completed the purchase of $1.2 billion of adjustable-rate residential real estate loans, $76.0 million of residential and commercial mortgage-backed securities (most of which will be financed on a long-term basis through our Acacia program), and $10.5 million of residential credit-enhancement securities intended to be financed with equity capital (without leverage). In addition, for settlement later in the second quarter, we have committed to purchase $0.8 billion of adjustable-rate residential real estate loans, $13.5 million “Acacia” securities, and $1.8 million of residential-credit enhancement securities. Included in these figures are a small amount of commercial real estate loan credit-enhancement securities; we intend to acquire more of these securities in the future. In addition, we have also committed to purchase $310 million of home equity line of credit (HELOC) loans made to high-quality borrowers; this is also a new product for us. We intend to securitize these loans during the second or third quarters of 2004.

We completed a “Sequoia” program securitization of residential loans during April 2004 (Sequoia 2004-4), issuing asset-backed securities (long-term debt) totaling $822 million. We also completed our fourth Acacia CDO in April 2004, issuing asset-backed securities totaling $293 million. We were able to issue securities at tighter spreads to LIBOR than in the past; tighter spreads reduce our cost of funds and partially offset the effect of the higher prices we are paying for loans.

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In April 2004, residential loan credit-enhancement securities with a principal value of $7 million were called, generating a GAAP gain of $3 million. Rapid prepayments, strong credit results, and rising housing prices continue to benefit this portfolio.

SUPPLEMENTAL FINANCIAL DATA

Supplemental financial data and additional financial measures regarding our operations are available on our web site at www.redwoodtrust.com. None of the information on or hyperlinked from our website is incorporated into this Form 10-Q.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of certain assets and liabilities at the date of the financial statements and the reported amounts of certain revenues and expenses during the reported period. Actual results could differ from those estimates. The critical accounting policies and how changes in estimates might affect our financial results and statements are discussed below. Management discusses the ongoing development and selection of these critical accounting policies with the Audit Committee of the Board of Directors, and the Audit Committee has reviewed the disclosures provided in this Form 10-Q.

Establishing Valuations and Accounting for Changes in Valuations

We estimate the fair value of certain assets and interest rate agreements using available market information and other appropriate valuation methodologies. Valuations of our residential real estate loans held-for-sale are generally done on a pool basis while valuations of our commercial real estate loans held-for-sale, and securities available-for-sale are done on an asset-specific basis. We believe the estimates we use reflect the values we may be able to receive should we choose to sell them. Our estimates are inherently subjective in nature and involve matters of uncertainty and judgment to interpret relevant market and other data. Many factors are necessary to estimate market values, including, but not limited to interest rates, prepayment rates, amount and timing of credit losses, supply and demand, liquidity, and other market factors.

In addition to our valuation processes, we are active acquirers and occasional sellers of the assets and interest rate agreements we own. Thus, we have the ability to understand and determine changes in assumptions that are taking place in the marketplace and make appropriate changes in our assumptions for valuing assets in our portfolio. In addition, on a periodic basis, we use third party sources to validate our estimates.

Valuation adjustments to our real estate loans held-for-sale and our trading securities are reported as net recognized gains (losses) and valuation adjustments on our Consolidated Statements of Income in the applicable period of the adjustment. In general, adjustments to the fair value of our securities available-for-sale are reported through our balance sheet as a component of accumulated other comprehensive income in Stockholders’ Equity within the cumulative unrealized gains and losses classified as accumulated other comprehensive income. The exception to this treatment of our securities available-for-sale is when a specific impairment is identified or a decrease in fair value results from a decline in estimated cash flows that may be considered an other-than-temporary change. In such cases, the resulting decrease in fair value is recorded in net recognized gains (losses) and valuation adjustments on our Consolidated Statements of Income in the applicable period of the adjustment.

We review our fair value calculations on an ongoing basis. We monitor the critical performance factors for each loan and security. Our expectations of future performance are shaped by input and analyses received from external sources, internal models, and our own judgment and experience. We constantly review our existing assumptions relative to our and the market’s expectations of future events and make adjustments to the assumptions that may change our market values and yields. Changes in perceptions regarding future events can have a material impact on the value of our assets. Should such changes, or other factors, result in significant changes in the market values, our net income and/or book value could be adversely affected.

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Revenue Recognition

When recognizing revenue on our earning assets, we employ the effective yield method to account for purchase premiums, discounts, and other net capitalized fees or costs associated with purchasing and financing our real estate loans and securities. The use of this method requires us to project cash flows over the remaining life of each asset and certain liabilities. These projections include assumptions about interest rates, prepayment rates, timing and amount of credit losses, when certain tests will be met that may allow for changes in payments made under the structure of securities, estimates regarding the likelihood and timing of calls of securities at par, and other factors. We review our cash flow projections on an ongoing basis and monitor these projections based on input and analyses received from external sources, internal models, and our own judgment and experience. We constantly review our assumptions and make adjustments to the cash flows as deemed necessary. There can be no assurance that our assumptions used to generate future cash flows, or the current period’s yield for each asset, will prove to be accurate.

Under the effective yield method, decreases in our credit loss assumptions embedded in our cash flow forecasts could result in increasing yields being recognized from our current portfolio of residential loan credit-enhancement securities. In addition, faster-than-anticipated prepayment rates would also tend to increase realized yields over the remaining life of the asset. In contrast, increases in our credit loss assumptions and/or slower than anticipated prepayment rates could result in lower yields being recognized under the effective yield method and may represent a permanent impairment, in which case the asset may be written down to its fair value through the Consolidated Statement of Income.

Credit Reserves

The credit reserve for our residential real estate loans is adjusted by taking credit provisions through our Consolidated Statements of Income. The reserves are the result of estimates of collective loan impairment and inherent losses considering historical loss experience (including industry and rating agency data), current conditions, and adjustments to historic conditions. Our collective loan impairment and inherent loss evaluation considers several components including, but not limited to, such factors as the age of loans, underwriting standards, business climate, economic conditions, geographic considerations, past performance of similar loans and other observable data including our extensive industry experience.

The amount of credit protection for our residential loan credit-enhancement securities is a designated component of the purchase discount. Our residential loan credit-enhancement securities have below-investment-grade credit ratings and represent subordinated interests in pools of high-quality jumbo residential real estate loans. As a result of these characteristics, we purchase credit-enhancement securities at a discount. A portion of the purchase discount is subsequently accreted as interest income under the effective yield method while the remaining portion of the purchase discount is considered credit protection. The amount of credit protection is based upon our assessment of various factors affecting our assets, including economic conditions, characteristics of the underlying loans, delinquency status, past performance of similar loans, and external credit protection. We use a variety of internal and external credit risk, cash flow modeling, and portfolio analytical tools to assist us in our assessment.

The credit reserve for our commercial loans is established based on expected credit losses associated with individually impaired loans at the time an expected loss becomes probable and can be reasonably estimated.

Many of the assets in our securities portfolio benefit from material forms of credit-enhancement, and, thus no credit reserves have been established to date for these assets. Unrealized losses on these securities are reported as a component of net recognized gains (losses) and valuation adjustments in our Consolidated Statements of Income if the decline in value is considered to represent a permanent impairment.

For all of our earning assets, actual credit losses and the timing of these losses may differ from our estimated losses. Although we continually review and update, as appropriate, all of our assumptions, there can be no assurance that our assumptions used to estimate credit losses, cash flows, fair values,

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and effective yields will prove to be correct as interest rates, economic conditions, real estate conditions, and the market’s perception of the future constantly change.

Accounting for Derivatives Instruments (Interest Rate Agreements)

We incorporate the use of derivative instruments to manage certain risks such as market value risk and interest rate risk. The derivative instruments we employ include, but are not limited to, interest rate swaps, interest rate options, options on swaps, futures contracts, options on futures contracts, options on forward purchases, and other similar derivatives. We collectively refer to these derivative instruments as “interest rate agreements”.

On the date the interest rate agreement is entered into, we designate the interest rate agreement as either (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge), (2) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge), or (3) held for trading (trading instrument).

We elect to account for certain interest rate agreements as cash flow hedges. We record these derivatives at their estimated fair market value, and generally record changes in their fair value in accumulated other comprehensive income on our Consolidated Balance Sheets. These amounts are reclassified to our Consolidated Statements of Income over the effective hedge period as the hedged item affects earning. Any ineffective portions of the cash flow hedges are included in our Consolidated Statements of Income.

We may discontinue hedge accounting prospectively when we determine (1) that the derivative is no longer effective in offsetting changes in the fair value or cash flows of a hedged item; (2) it is no longer probable that the forecasted transaction will occur; (3) a hedged firm commitment no longer meets the definition of a firm commitment; or (4) that designating the derivative as a hedging instrument is no longer appropriate.

RESULTS OF OPERATIONS

Our earnings for the first quarter of 2004 were $51 million, or $2.49 per share, an increase from the $0.88 per share we earned in the first quarter of 2003.

The increase in our earnings for first quarter of 2004 as compared to the same period in 2003 was primarily a result of improved capital efficiencies, additional assets, increasing yields on our residential credit-enhancement securities, and realized gains from calls and sales of assets. The table below shows earnings and the related per share amounts for the three months ended March 31, 2004 and 2003.

Table 1
Net Income Available to Common Stockholders
(dollars in thousands, except per share data)

Net Interest Income

Net interest income was $45 million for the first quarter of 2004, as compared to $24 million for the same period in 2003. Growth in our equity capital employed drove our growth in net interest income. We also benefited from faster than anticipated prepayment rates on loans underlying our residential loan credit-

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enhancement securities resulting in increased amortization of the unamortized discount into income, an improved asset mix, and strong credit results.

Table 2
Net Interest Income
(dollars in thousands)

Interest Income

Our total interest income was $125 million in for the first quarter of 2004, an increase from the $61 million we earned during the first quarter of 2003.

Table 3
Total Interest Income and Yield
(dollars in thousands)