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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
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For the quarter ended June 30, 2003 Commission file number 1-10360
CRIIMI MAE INC.
(Exact name of registrant as specified in its charter)
Maryland 52-1622022
(State or other jurisdiction of (I.R.S. Employer
Incorporation or organization) Identification No.)
11200 Rockville Pike
Rockville, Maryland 20852
(301) 816-2300
(Address, including zip code, and telephone number,
including area code, of registrant's principal executive offices)
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Securities Registered Pursuant to Section 12(b) of the Act:
Name of each exchange on
Title of each class which registered
- ------------------- ------------------------------
Common Stock New York Stock Exchange, Inc.
Series B Cumulative Convertible New York Stock Exchange, Inc.
Preferred Stock
Series F Redeemable Cumulative Dividend New York Stock Exchange, Inc.
Preferred Stock
Series G Redeemable Cumulative Dividend New York Stock Exchange, Inc.
Preferred Stock
Securities Registered Pursuant to Section 12(g) of the Act:
None
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Sections 12, 13 or 15 (d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes [X] No[ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [X] No [ ]
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
Class Outstanding as of August 12, 2003
----- ---------------------------------
Common Stock, $0.01 par value 15,204,985
2
CRIIMI MAE INC.
Quarterly Report on Form 10-Q
Page
PART I. Financial Information
Item 1. Financial Statements
Consolidated Balance Sheets as of June 30, 2003
(unaudited) and December 31, 2002............................. 3
Consolidated Statements of Income for the three months and six
months ended June 30, 2003 and 2002 (unaudited)............... 4
Consolidated Statements of Changes in Shareholders' Equity
for the six months ended June 30, 2003 (unaudited)............ 5
Consolidated Statements of Cash Flows for the six
months ended June 30, 2003 and 2002 (unaudited)............... 6
Notes to Consolidated Financial Statements (unaudited)......... 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations........................... 39
Item 3. Quantitative and Qualitative Disclosures about Market Risk..... 66
Item 4. Controls and Procedures........................................ 68
PART II. Other Information
Item 4. Submission of Matters to a Vote of Security Holders ........... 69
Item 6. Exhibits and Reports on Form 8-K............................... 69
Signature ............................................................... 71
3
PART I
ITEM 1. FINANCIAL STATEMENTS
CRIIMI MAE INC.
CONSOLIDATED BALANCE SHEETS
June 30, December 31,
2003 2002
---------------------- ----------------------
(Unaudited)
Assets:
Mortgage assets:
Subordinated CMBS pledged to secure recourse debt, at fair value $ 533,553,192 $ 535,507,892
CMBS pledged to secure Securitized Mortgage
Obligation - CMBS, at fair value 339,661,921 326,472,580
Other MBS, at fair value 2,510,958 5,247,771
Insured mortgage securities, at fair value 221,185,172 275,340,234
Equity investments 5,101,234 6,247,868
Other assets 27,886,513 24,987,348
Receivables 14,881,924 16,293,489
Servicing other assets 8,342,242 13,775,138
Servicing cash and cash equivalents 3,728,241 12,582,053
Other cash and cash equivalents 8,912,224 16,669,295
Restricted cash and cash equivalents - 7,961,575
------------------- - -------------------
Total assets $ 1,165,763,621 $ 1,241,085,243
=================== ===================
Liabilities:
Bear Stearns variable rate secured debt $ 298,750,000 $ -
BREF senior subordinated secured note 31,266,667 -
Securitized mortgage obligations:
Collateralized bond obligations-CMBS 287,092,325 285,844,933
Collateralized mortgage obligations-
insured mortgage securities 204,312,861 252,980,104
Mortgage payable 7,273,309 7,214,189
Payables and accrued expenses 10,363,786 26,675,724
Servicing liabilities 877,202 756,865
Exit variable-rate secured borrowing - 214,672,536
Series A senior secured notes - 92,788,479
Series B senior secured notes - 68,491,323
------------------- -------------------
Total liabilities 839,936,150 949,424,153
------------------- -------------------
Shareholders' equity:
Preferred stock, $0.01 par; 75,000,000 shares
authorized; 3,424,992 shares issued and outstanding 34,250 34,250
Common stock, $0.01 par; 300,000,000 shares
authorized; 15,201,685 and 13,945,068 shares
issued and outstanding, respectively 152,017 139,451
Accumulated other comprehensive income 121,445,455 102,122,057
Deferred compensation - (19,521)
Warrants outstanding 2,564,729 -
Additional paid-in capital 630,762,116 619,197,711
Accumulated deficit (429,131,096) (429,812,858)
------------------- -------------------
Total shareholders' equity 325,827,471 291,661,090
------------------- -------------------
Total liabilities and shareholders' equity $ 1,165,763,621 $ 1,241,085,243
=================== ===================
The accompanying notes are an integral part of these consolidated
financial statements.
4
CRIIMI MAE INC.
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
For the three For the six
months ended June 30, months ended June 30,
2003 2002 2003 2002
--------------- -------------- --------------- --------------
Interest income:
CMBS $ 22,113,768 $ 25,600,119 $ 44,185,745 $ 51,136,504
Insured mortgage securities 4,275,108 6,143,229 8,927,001 12,638,723
--------------- -------------- --------------- --------------
Total interest income 26,388,876 31,743,348 53,112,746 63,775,227
--------------- -------------- --------------- --------------
Interest and related expenses:
Bear Stearns variable rate secured debt 3,669,301 - 6,496,936 -
BREF senior subordinated secured note 1,207,790 - 2,258,889 -
Exit variable-rate secured borrowing - 3,825,304 859,106 7,696,951
Series A senior secured notes - 2,928,412 2,130,722 5,892,821
Series B senior secured notes - 3,444,073 2,697,006 6,809,205
Fixed-rate collateralized bond obligations-CMBS 6,202,624 6,573,995 12,743,002 12,939,900
Fixed-rate collateralized mortgage obligations
- insured securities 4,115,623 6,160,178 9,675,763 12,654,718
Other interest expense 234,954 253,400 471,377 497,982
--------------- -------------- --------------- --------------
Total interest expense 15,430,292 23,185,362 37,332,801 46,491,577
--------------- -------------- --------------- --------------
Net interest margin 10,958,584 8,557,986 15,779,945 17,283,650
--------------- -------------- --------------- --------------
General and administrative expenses (2,859,711) (2,679,860) (5,808,353) (5,882,474)
Depreciation and amortization (145,534) (368,564) (318,824) (608,540)
Servicing revenue 2,765,026 2,494,037 4,889,587 5,257,573
Servicing general and administrative expenses (2,093,154) (2,134,890) (4,324,125) (4,625,984)
Servicing amortization, depreciation, and impairment expenses (554,490) (402,931) (887,752) (910,810)
Servicing restructuring expenses (144,371) (141,240) (144,371) (141,240)
Servicing gain on sale of servicing rights - 4,817,598 - 4,817,598
Income tax benefit (expense) 13,854 (975,220) 186,230 (908,776)
Equity in (losses) earnings from investments (6,933) 118,438 121,335 232,742
Other income, net 352,483 585,528 695,659 1,430,431
Net gains (losses) on mortgage security dispositions 38,290 (146,473) 226,500 (256,292)
Impairment on CMBS (8,947,878) (5,151,091) (8,947,878) (5,151,091)
Hedging expense (274,166) (306,569) (626,488) (396,327)
BREF maintenance fee (424,356) - (795,667) -
Recapitalization expenses (531,863) (244,444) (3,148,841) (244,444)
Gain on extinguishment of debt - - 7,337,424 -
--------------- -------------- --------------- --------------
(12,812,803) (4,535,681) (11,545,564) (7,387,634)
--------------- -------------- --------------- --------------
Net (loss) income before cumulative effect of change
in accounting principle (1,854,219) 4,022,305 4,234,381 9,896,016
Cumulative effect of adoption of SFAS 142 - - - (9,766,502)
--------------- -------------- --------------- --------------
Net (loss) income before dividends paid or accrued
on preferred shares (1,854,219) 4,022,305 4,234,381 129,514
Dividends paid or accrued on preferred shares (1,726,560) (1,726,560) (3,552,619) (4,661,750)
--------------- -------------- --------------- --------------
Net (loss) income to common shareholders $ (3,580,779) $ 2,295,745 $ 681,762 $ (4,532,236)
=============== ============== =============== ==============
Net (loss) income to common shareholders per common share:
Basic - before cumulative effect of change
in accounting principle $ (0.24) $ 0.16 $ 0.05 $ 0.39
=============== ============== =============== ==============
Basic - after cumulative effect of change
in accounting principle $ (0.24) $ 0.16 $ 0.05 $ (0.34)
=============== ============== =============== ==============
Diluted - before cumulative effect of change
in accounting principle $ (0.24) $ 0.16 $ 0.04 $ 0.38
=============== ============== =============== ==============
Diluted - after cumulative effect of change
in accounting principle $ (0.24) $ 0.16 $ 0.04 $ (0.34)
=============== ============== =============== ==============
Shares used in computing basic income (loss) per share 15,176,070 13,915,490 15,068,051 13,487,773
=============== ============== =============== ==============
The accompanying notes are an integral part of these consolidated
financial statements.
5
CRIIMI MAE INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
For the six months ended June 30, 2003
(Unaudited)
Preferred Common Accumulated
Stock Stock Additional Other Total
Par Par Paid-in Accumulated Comprehensive Warrants Deferred Shareholders'
Value Value Capital Deficit Income Outstanding Compensation Equity
-------- ----- ---------- ------------ ------------- ----------- -------- -------------
Balance at December 31, 2002 $ 34,250 $ 139,451 $ 619,197,711 $(429,812,858) $102,122,057 $ - $ (19,521) $291,661,090
Net income before dividends paid or
accrued on preferred shares - - - 4,234,381 - - - 4,234,381
Adjustment to unrealized gains and
losses on mortgage assets - - - - 18,764,241 - - 18,764,241
Adjustment to unrealized losses
on derivative financial instruments - - - - 559,157 - - 559,157
Dividends paid on preferred shares - - - (3,552,619) - - - (3,552,619)
Common stock issued - 12,566 13,581,534 - - - - 13,594,100
Amortization of deferred compensation - - - - - - 19,521 19,521
Accelerated vesting of stock options - - 547,600 - - - - 547,600
Warrants issued - - (2,564,729) - - 2,564,729 - -
-------- --------- ------------- -------------- ------------- ---------- ------ ------------
Balance at June 30, 2003 $ 34,250 $ 152,017 $ 630,762,116 $(429,131,096) $121,445,455 $2,564,729 $ - $325,827,471
======== ========= ============= ============== ============ ========== ====== =============
The accompanying notes are an integral part of these consolidated
financial statements.
6
CRIIMI MAE INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
For the six months ended June 30,
2003 2002
------------------ -----------------
Cash flows from operating activities:
Net income before dividends paid or accrued on preferred shares $ 4,234,381 $ 129,514
Adjustments to reconcile net income before dividends paid or accrued on
preferred shares to net cash provided by operating activities:
Gain on extinguishment of debt (non-cash portion) (7,787,370) -
Amortization of discount and deferred financing costs on debt 4,003,449 3,075,631
Discount amortization on mortgage assets, net (5,549,199) (5,677,819)
Accrual of extension fees related to Exit Debt 336,921 2,137,877
Depreciation and other amortization 318,824 608,540
Net (gains) losses on mortgage security dispositions (226,500) 256,292
Equity in earnings from investments (121,335) (232,742)
Servicing amortization, depreciation and impairment 887,752 910,810
Hedging expense 626,488 396,327
Recapitalization expenses (non-cash portion) 1,079,463 -
Amortization of deferred compensation 19,521 76,690
Impairment on CMBS 8,947,878 5,151,091
Gain on sale of servicing rights - 4,817,598
Cumulative effect of adoption of SFAS 142 - 9,766,502
Changes in assets and liabilities:
Decrease in restricted cash and cash equivalents 7,961,575 30,186,877
Decrease (increase) in receivables and other assets 2,409,711 (6,975,698)
Decrease in payables and accrued expenses (3,010,059) (4,366,333)
Decrease (increase) in servicing other assets 1,240,256 (6,715,966)
Increase (decrease) in servicing liabilities 120,337 (2,610,804)
Sales of other MBS, net 2,774,560 873,048
------------------ -----------------
Net cash provided by operating activities 18,266,653 31,807,435
------------------ -----------------
Cash flows from investing activities:
Proceeds from mortgage security prepayments and dispositions 54,146,348 37,115,941
Distributions received from AIM Limited Partnerships 1,229,885 1,464,075
Receipt of principal payments from insured mortgage securities 1,622,803 1,980,474
Cash received in excess of income recognized on subordinated CMBS 3,022,847 1,857,293
Proceeds from sale of servicing rights by CMSLP - 8,230,561
Purchases of investment-grade CMBS by CMSLP - (9,905,520)
Sales of investment-grade CMBS by CMSLP 3,316,508 -
------------------ -----------------
Net cash provided by investing activities 63,338,391 40,742,824
------------------ -----------------
Cash flows from financing activities:
Principal payments on securitized mortgage debt obligations (49,876,799) (32,907,210)
Principal payments on recourse debt (377,202,338) (18,900,334)
Principal payments on secured borrowings and other debt obligations (53,944) (50,161)
Proceeds from issuance of debt 330,000,000 -
Payment of debt issuance costs (5,944,647) -
Payment of dividends on preferred shares (8,732,299) -
Proceeds from the issuance of common stock, net 13,594,100 24,049
Redemption of Series E Preferred Stock, including accrued dividends - (18,733,912)
------------------ -----------------
Net cash used in financing activities (98,215,927) (70,567,568)
------------------ -----------------
Net (decrease) increase in other cash and cash equivalents (16,610,883) 1,982,691
Cash and cash equivalents, beginning of period (1) 29,251,348 17,298,873
------------------ -----------------
Cash and cash equivalents, end of period (1) $ 12,640,465 $ 19,281,564
================== =================
(1) Comprised of Servicing cash and cash equivalents and Other cash and
cash equivalents.
The accompanying notes are an integral part of these consolidated
financial statements.
7
CRIIMI MAE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
1. ORGANIZATION
General
CRIIMI MAE Inc. (together with its consolidated subsidiaries, unless the
context otherwise indicates, We or CRIIMI MAE) is a commercial mortgage company
structured as a self-administered real estate investment trust (or REIT). We
currently own, and manage, primarily through our servicing subsidiary, CRIIMI
MAE Services Limited Partnership (CMSLP or CRIIMI MAE Services), a significant
portfolio of commercial mortgage-related assets. We have focused primarily on
non-investment grade (rated below BBB- or unrated) commercial mortgage-backed
securities (subordinated CMBS). As the holder of the most subordinate tranches,
we are exposed to a higher risk of losses, but we also have the potential for
enhanced returns.
Our core holdings are subordinated CMBS ultimately backed by pools of
commercial mortgage loans on hotel, multifamily, retail and other commercial
real estate. We also own directly and indirectly government-insured mortgage
backed securities and a limited number of other assets. We also are a trader in
CMBS, residential mortgage-backed securities, agency debt securities and other
fixed income securities.
January 2003 Recapitalization
On January 23, 2003, we completed a recapitalization of the secured debt
incurred upon our emergence from Chapter 11 in April 2001 (the Exit Debt). This
recapitalization was funded with approximately $344 million in proceeds from
debt and equity financings and a portion of our available cash and liquid
assets. The recapitalization included:
o BREF Equity and Secured Debt. - We issued approximately $14 million in
common equity and $30 million in secured subordinated debt to Brascan
Real Estate Finance Fund I L.P., a private asset management fund
established by Brascan Corporation and a New York-based management
team. We refer to the secured subordinated debt as the BREF Debt and
Brascan Real Estate Finance Fund I L.P. as BREF Fund.
o Bear Stearns Secured Financing. - We received $300 million in secured
financing in the form of a repurchase transaction from a unit of Bear,
Stearns & Co., Inc. We refer to the secured financing as the Bear
Stearns Debt and the unit of Bear Stearns and Co., Inc. as Bear
Stearns.
o New Leadership. - Additions to management, including Barry S. Blattman
as Chairman of the Board, Chief Executive Officer and President.
Mr. Blattman has more than 15 years of experience in commercial real
estate finance, which included overseeing the real estate debt group at
Merrill Lynch from 1996 to 2001. Mr. Blattman is also the managing
member of Brascan Real Estate Financial Partners LLC, which owns 100%
of the general partner of BREF Fund. In addition on August 13, 2003,
our Board of Directors appointed Mark R. Jarrell, a Director, as
President and Chief Operating Officer effective September 15, 2003 as
discussed in Note 14. Mr. Blattman will continue as our Chairman of
the Board and Chief Executive Officer.
See Notes 6 and 11 for a further discussion of these debt and equity
financings.
Other
We were incorporated in Delaware in 1989 under the name CRI Insured
Mortgage Association, Inc. In July 1993, we changed our name to CRIIMI MAE Inc.
and reincorporated in Maryland. In June 1995, certain mortgage businesses
affiliated with C.R.I., Inc. (CRI) were merged into CRIIMI MAE Inc. (the
Merger). We are not a government sponsored entity or in any way affiliated with
the United States government or any United States government agency.
8
REIT Status/Net Operating Loss for Tax Purposes
REIT Status. We have elected to qualify as a REIT for tax purposes under
sections 856-860 of the Internal Revenue Code. We are required to meet income,
asset, ownership and distribution tests to maintain our REIT status. Although
there can be no assurance, we believe that we have satisfied the REIT
requirements for all years through, and including 2002. There can also be no
assurance that we will maintain our REIT status for 2003 or subsequent years. If
we fail to maintain our REIT status for any taxable year, we will be taxed as a
regular domestic corporation subject to federal and state income tax in the year
of disqualification and for at least the four subsequent years. Depending on the
amount of any such federal and state income tax, we may have insufficient funds
to pay any such tax and also may be unable to comply with some or all of our
obligations, including the Bear Stearns and BREF Debt.
We and two of our subsidiaries incorporated in 2001 jointly elected to
treat such two subsidiaries as taxable REIT subsidiaries (TRS) effective January
1, 2001. The TRSs allow us to earn non-qualifying REIT income while maintaining
our REIT status. These two subsidiaries hold all of the partnership interests of
CMSLP.
Net Operating Loss for Tax Purposes/Trader Election. For tax purposes we
have elected to be classified as a trader in securities. We trade in both short
and longer duration fixed income securities, including CMBS, residential
mortgage-backed securities and agency debt securities (such securities traded
and all other securities of the type described constituting the "Trading Assets"
to the extent owned by us or any qualified REIT subsidiary, meaning generally
any wholly owned subsidiary that is not a taxable REIT subsidiary). Such Trading
Assets are classified as Other MBS on our balance sheet.
As a result of our election in 2000 to be taxed as a trader, we recognized
a mark-to-market tax loss on our Trading Assets on January 1, 2000 of
approximately $478 million (the January 2000 Loss). Such loss is being
recognized evenly for tax purposes over four years beginning with the year 2000
and ending in 2003. We expect such loss to be ordinary, which allows us to
offset our ordinary income.
We generated a net operating loss (or NOL) for tax purposes of
approximately $83.6 million during the year ended December 31, 2002. As such,
our taxable income was reduced to zero and, accordingly, our REIT distribution
requirement was eliminated for 2002. As of December 31, 2002, our accumulated
and unused net operating loss (or NOL) was $223.8 million. Any accumulated and
unused net operating losses, subject to certain limitations, generally may be
carried forward for up to 20 years to offset taxable income until fully
utilized. Accumulated and unused net operating losses cannot be carried back
because we are a REIT.
There can be no assurance that our position with respect to our election as
a trader in securities will not be challenged by the Internal Revenue Service
(or IRS) and, if challenged, will be defended successfully by us. As such, there
is a risk that the January 2000 Loss will be limited or disallowed, resulting in
higher tax basis income and a corresponding increase in REIT distribution
requirements. It is possible that the amount of any under-distribution for a
taxable year could be corrected with a "deficiency dividend" as defined in
Section 860 of the Internal Revenue Code, however, interest may also be due to
the IRS on the amount of this under-distribution.
If we are required to make taxable income distributions to our shareholders
to satisfy required REIT distributions, all or a substantial portion of these
distributions, if any, may be in the form of non-cash dividends. There can be no
assurance that such non-cash dividends would satisfy the REIT distribution
requirements and, as such, we could lose our REIT status or may not be able to
satisfy some or all of our obligations, including the Bear Stearns and BREF
Debt.
Our future use of NOLs for tax purposes could be substantially limited in
the event of an "ownership change" as defined under Section 382 of the Internal
Revenue Code. As a result of these limitations imposed by Section 382 of the
Internal Revenue Code, in the event of an ownership change, our ability to use
our NOL carryforwards in future years may be limited and, to the extent the NOL
carryforwards cannot be fully utilized under these limitations within the
carryforward periods, the NOL carryforwards would expire unutilized.
Accordingly, after any ownership change, our ability to use our NOLs to reduce
or offset taxable income would be substantially limited or not available under
Section 382. In general, a company reaches the "ownership change" threshold if
the
9
"5% shareholders" increase their aggregate ownership interest in the
company over a three-year testing period by more than 50 percentage points. The
ownership interest is measured in terms of total market value of the company's
capital stock. If an "ownership change" occurs under Section 382 of the Internal
Revenue Code, our prospective use of our accumulated and unused NOL and the
remaining January 2000 Loss of a combined total amount of approximately $328.1
million as of June 30, 2003 will be limited.
We do not believe BREF Fund's investment in our common stock and warrant to
purchase common stock has created an "ownership change" under Section 382. In
addition, we are not aware of any other acquisition of shares of our capital
stock that has created an "ownership change" under Section 382. We have adopted
a shareholder rights plan and amended our charter to minimize the chance of an
ownership change within the meaning of Section 382 of the Internal Revenue Code;
however there can be no assurance that an ownership change will not occur.
Investment Company Act
Under the Investment Company Act of 1940, as amended, an investment company
is required to register with the Securities and Exchange Commission (SEC) and is
subject to extensive restrictive and potentially adverse regulation relating to,
among other things, operating methods, management, capital structure, dividends
and transactions with affiliates. However, as described below, companies
primarily engaged in the business of acquiring mortgages and other liens on and
interests in real estate (Qualifying Interests) are excluded from the
requirements of the Investment Company Act.
To qualify for the Investment Company Act exclusion, we, among other
things, must maintain at least 55% of our assets in Qualifying Interests (the
55% Requirement) and are also required to maintain an additional 25% in
Qualifying Interests or other real estate-related assets (Other Real Estate
Interests and such requirement, the 25% Requirement). According to current SEC
staff interpretations, we believe that all of our government-insured mortgage
securities constitute Other Real Estate Interests and that substantially all of
our government insured mortgage securities constitute Qualifying Interests. In
accordance with current SEC staff interpretations, we believe that all of our
subordinated CMBS constitute Other Real Estate Interests and that certain of our
subordinated CMBS also constitute Qualifying Interests. On certain of our
subordinated CMBS, we, along with other rights, have the unilateral right to
direct foreclosure with respect to the underlying mortgage loans. Based on such
rights and our economic interest in the underlying mortgage loans, we believe
that the related subordinated CMBS constitute Qualifying Interests. As of June
30, 2003, we believe that we were in compliance with both the 55% Requirement
and the 25% Requirement.
If the SEC or its staff were to take a different position with respect to
whether such subordinated CMBS constitute Qualifying Interests, we could, among
other things, be required either (i) to change the manner in which we conduct
our operations to avoid being required to register as an investment company or
(ii) to register as an investment company, either of which could have a material
adverse effect on us. If we were required to change the manner in which we
conduct our business, we would likely have to dispose of a significant portion
of our subordinated CMBS or acquire significant additional assets that are
Qualifying Interests. Alternatively, if we were required to register as an
investment company, we expect that our operating expenses would significantly
increase and that we would have to significantly reduce our indebtedness, which
could also require us to sell a significant portion of our assets. No assurances
can be given that any such dispositions or acquisitions of assets, or
deleveraging, could be accomplished on favorable terms, or at all. There are
restrictions under certain of the operative documents evidencing the Bear
Stearns and BREF Debt, which could limit possible actions we may take in
response to any need to modify our business plan in order to register as an
investment company or avoid the need to register. Certain dispositions or
acquisitions of assets could require approval or consent of certain holders of
this Debt. Any such results could have a material adverse effect on us.
Further, if we were deemed an unregistered investment company, we could be
subject to monetary penalties and injunctive relief. We would be unable to
enforce contracts with third parties and third parties could seek to obtain
rescission of transactions undertaken during the period we were deemed an
unregistered investment company, unless the court found that under the
circumstances, enforcement (or denial of rescission) would produce a more
equitable result than nonenforcement (or grant of rescission) and would not be
inconsistent with the Investment Company Act.
10
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
Our consolidated financial statements are prepared on the accrual basis of
accounting in accordance with accounting principles generally accepted in the
United States (or GAAP). The preparation of financial statements in conformity
with GAAP requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
In our opinion, the accompanying unaudited consolidated financial
statements contain all adjustments (consisting of only normal recurring
adjustments and consolidating adjustments) necessary to present fairly the
consolidated balance sheets as of June 30, 2003 and December 31, 2002 (audited),
the consolidated results of operations for the three and six months ended June
30, 2003 and 2002, and the consolidated cash flows for the six months ended June
30, 2003 and 2002. The accompanying consolidated financial statements include
the financial results of CRIIMI MAE and all of our majority-owned and controlled
subsidiaries. All significant intercompany accounts and transactions have been
eliminated in consolidation.
These consolidated financial statements have been prepared pursuant to the
rules and regulations of the SEC. Certain information and note disclosures
normally included in annual financial statements prepared in accordance with
GAAP have been condensed or omitted. While management believes that the
disclosures presented are adequate to make the information not misleading, these
consolidated financial statements should be read in conjunction with the
consolidated financial statements and the notes included in our Annual Report on
Form 10-K for the year ended December 31, 2002.
Reclassifications
Certain 2002 amounts have been reclassified to conform to the 2003
presentation.
Income Recognition and Carrying Basis
Subordinated CMBS and Other Mortgage-Backed Securities
We recognize income on our subordinated CMBS in accordance with Emerging
Issues Task Force (EITF) Issue No. 99-20, "Recognition of Interest Income and
Impairment on Purchased and Retained Beneficial Interests in Securitized
Financial Assets". Under EITF 99-20, we calculate a revised yield based on the
current amortized cost of the investment and the revised future cash flows when
there has been a change in estimated future cash flows from the cash flows
previously projected (due to credit losses and/or prepayment speeds). This
revised yield is applied prospectively to recognize interest income. We classify
our subordinated CMBS as "available for sale" and carry them at fair market
value and temporary changes in fair value are recorded as a component of
shareholders' equity.
Interest income on other mortgage-backed securities (or Other MBS) consists
of amortization of the discount or premium on primarily investment-grade
securities, plus the stated investment interest payments received or accrued on
Other MBS. The difference between the cost and the unpaid principal balance at
the time of purchase is carried as a discount or premium and amortized over the
remaining contractual life of the investment using the effective interest
method. The effective interest method provides a constant yield of income over
the term of the investment. Our Other MBS are classified as "available for
sale." As a result, we carry these securities at fair value and changes in fair
value are recorded as a component of shareholders' equity. Upon the sale of such
securities, any gain or loss is recognized in the income statement.
11
Insured Mortgage Securities
Our consolidated investment in insured mortgage securities consists of
participation certificates generally evidencing a 100% undivided beneficial
interest in government-insured multifamily mortgages issued or sold pursuant to
programs of the Federal Housing Administration, or FHA, and mortgage-backed
securities guaranteed by the Government National Mortgage Association, or GNMA.
Payment of principal and interest on FHA-insured certificates is insured by the
U.S. Department of Housing and Urban Development, or HUD, pursuant to Title 2 of
the National Housing Act. Payment of principal and interest on GNMA
mortgage-backed securities is guaranteed by GNMA pursuant to Title 3 of the
National Housing Act. Our insured mortgage securities are classified as
"available for sale." As a result, we carry our insured mortgage securities at
fair value and changes in fair value are recorded as a component of
shareholders' equity.
Insured mortgage securities income consists of amortization of the discount
or premium plus the stated mortgage interest payments received or accrued. The
difference between the cost and the unpaid principal balance at the time of
purchase is carried as a discount or premium and amortized over the remaining
contractual life of the mortgage using the effective interest method. The
effective interest method provides a constant yield of income over the term of
the mortgage security.
Impairment
Subordinated CMBS
We assess each subordinated CMBS for other than temporary impairment when
the fair market value of the asset declines below amortized cost and when one of
the following conditions also exists: (1) our revised projected cash flows
related to the subordinated CMBS and the subordinated CMBS's current cost basis
result in a decrease in the yield compared to what was previously used to
recognize income, or (2) fair value has been below amortized cost for a
significant period of time and we conclude that we no longer have the ability or
intent to hold the security for the period that fair value is expected to be
below amortized cost through the period of time we expect the value to recover
to amortized cost. This decrease in yield would be primarily a result of the
credit quality of the security declining and a determination that the current
estimate of expected future credit losses exceeds credit losses as originally
projected or that expected credit losses will occur sooner than originally
projected. The amount of impairment loss is measured by comparing the fair
value, based on available market information and management's estimates, of the
subordinated CMBS to its current amortized cost basis; the difference is
recognized as a loss in the income statement. We assess current economic events
and conditions that impact the value of our subordinated CMBS and the underlying
real estate in making judgments as to whether or not other than temporary
impairment has occurred. During the three and six months ended June 30, 2003, we
recognized impairment charges of $8.9 million on our subordinated CMBS. During
the three and six months ended June 30, 2002, we recognized approximately $5.2
million of impairment charges on our subordinated CMBS. See Note 4 for further
discussion of the impairment charges.
Insured Mortgage Securities
We assess each insured mortgage security for other than temporary
impairment when the fair market value of the asset declines below amortized cost
for a significant period of time and we conclude that we no longer have the
ability to hold the security through the market downturn. The amount of
impairment loss is measured by comparing the fair value of an insured mortgage
security to its current amortized cost basis, with the difference recognized as
a loss in the income statement. We did not recognize any impairment on our
insured mortgage securities during the three and six months ended June 30, 2003
and 2002.
Equity Investments
We recognize impairment on our investments accounted for under the equity
method if a decline in the market value of the investment below its carrying
basis is judged to be "other than temporary". During the six months ended June
30, 2003, American Insured Mortgage Investors, American Insured Mortgage
Investors - Series 85, L.P., American Insured Mortgage Investors L.P. - Series
86 and American Insured Mortgage Investors L.P. -
12
Series 88 (collectively referred to as the AIM Limited Partnerships for
which we serve through a subsidiary as the general partner, own a partnership
interest from 2.9% to 4.9% in each of the partnerships, and own a 20% interest
in the advisor to each partnership) experienced a significant amount of
prepayments of their insured mortgages. These prepayments reduced cash flows on
our 20% investment in the advisor to the AIM Limited Partnerships. As a result,
in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets," and
SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets,"
the advisor to the AIM Limited Partnerships evaluated its investment in the
advisory contracts for impairment. The estimated future undiscounted cash flows
from this investment were projected to be less than the book value of the
investment as of June 30, 2003. As a result, the advisor believed that its
investment in the advisory contracts was impaired at June 30, 2003. The advisor
estimated the fair value of its investment using a discounted cash flow
methodology. The advisor wrote down the value of its investment in the advisory
contracts to the AIM Limited Partnerships and recorded an impairment charge. We
recorded our portion of the impairment charge, totaling approximately $109,000,
during the three and six months ended June 30, 2003. This impairment charge is
included in Equity in (losses) earnings from investments in our Consolidated
Statement of Income. This investment is included in our Portfolio Investment
segment. We did not recognize any impairment charges on our equity investments
during the three and six months ended June 30, 2002.
As a result of the significant prepayments experienced by the AIM Limited
Partnerships, CMSLP's cash flows from its subadvisory contracts with the AIM
Limited Partnerships have been reduced. As a result, in accordance with SFAS No.
142 and SFAS No. 144, we evaluated CMSLP's investment in the subadvisory
contracts for impairment. Our estimated future undiscounted cash flows from this
investment were projected to be less than the book value on the investment at
June 30, 2003. As a result, we believed that CMSLP's investment in the
subadvisory contracts was impaired at June 30, 2003. We estimated the fair value
of the investment using a discounted cash flow methodology. We wrote down the
value of CMSLP's investment in the subadvisory contracts with the AIM Limited
Partnerships and recorded an impairment charge of approximately $198,000 during
the three and six months ended June 30, 2003, which is included in Servicing
amortization, depreciation and impairment expenses in our Consolidated Statement
of Income.
Consolidated Statements of Cash Flows
The following is the supplemental cash flow information:
Three months ended June 30, Six months ended June 30,
2003 2002 2003 2002
------------ ------------ ------------ --------------
Cash paid for interest $13,639,643 $20,420,677 $34,822,386 $37,155,371
Non-cash investing and financing activities:
Restricted stock issued -- -- -- 129,675
Preferred stock dividends paid in shares of
common stock -- 3,444,792 -- 3,444,792
Comprehensive Income
The following table presents comprehensive income for the three and six
months ended June 30, 2003 and 2002:
Three months ended June 30, Six months ended June 30,
2003 2002 2003 2002
------------- ----------------- -------------- ---------------
Net (loss) income before dividends
paid or accrued on preferred shares $ (1,854,219) $ 4,022,305 $ 4,234,381 $ 129,514
Adjustment to unrealized
gains/losses on mortgage assets 15,737,268 35,548,935 18,764,241 36,668,028
Adjustment to unrealized losses on
derivative financial instruments 211,071 (812,055) 559,157 (741,474)
------------- -------------- ------------- --------------
Comprehensive income $ 14,094,120 $ 38,759,185 $23,557,779 $ 36,056,068
============= ============== ============= ==============
13
The following table summarizes our accumulated other comprehensive income:
June 30, December 31,
2003 2002
--------------- --------------
Unrealized gains on mortgage assets $ 121,874,063 $ 103,109,822
Unrealized losses on derivative
financial instruments (428,608) (987,765)
--------------- --------------
Accumulated other comprehensive income $ 121,445,455 $ 102,122,057
=============== ==============
Stock-Based Compensation
We account for our stock-based compensation arrangements in accordance with
the intrinsic value method as defined by Accounting Principles Board Opinion
(APB) No. 25, "Accounting for Stock Issued to Employees". SFAS No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure", which was
effective January 1, 2003 for us, requires certain disclosures related to our
stock-based compensation arrangements. The following table presents 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 our stock-based compensation (in thousands, except per share
amounts):
Three months ended June 30, Six months ended June 30,
2003 2002 2003 2002
---------- ----------- -------------- --------------
Net income (loss) to common shareholders (1) $ (3,581) $ 2,296 $ 682 $ (4,532)
Less: Stock-based compensation expense
determined under the fair value based
method for all awards (182) (560) (414) (704)
---------- ----------- --------------- -------------
Pro forma net income (loss) to common
shareholders $(3,763) $ 1,736 $ 268 $ (5,236)
========== =========== =============== =============
Earnings per share:
Basic - as reported $ (0.24) $ 0.16 $ 0.05 $ (0.34)
========== =========== =============== =============
Basic - pro forma $ (0.25) $ 0.12 $ 0.02 $ (0.39)
========== =========== =============== =============
Diluted - as reported $ (0.24) $ 0.16 $ 0.04 $ (0.34)
========== =========== =============== =============
Diluted - pro forma $ (0.25) $ 0.12 $ 0.02 $ (0.39)
========== =========== =============== =============
(1) Includes approximately $3 and $17 of stock-based compensation expense
during the three months ended June 30, 2003 and 2002, respectively, and
approximately $567 and $77 during the six months ended June 30, 2003 and 2002,
respectively.
Recent Accounting Pronouncements
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities," which replaces Emerging Issues
Task Force Issue No. 94-3, "Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity (including Certain
Costs Incurred in a Restructuring)." The new standard requires companies to
recognize costs associated with exit or disposal activities when they are
incurred rather than at the date of a commitment to an exit or disposal plan.
The statement is to be applied prospectively to exit or disposal activities
initiated after December 31, 2002. See Notes 9 and 10 for a discussion of the
effect of this new pronouncement on our financial statements.
In January 2003, the FASB issued FASB Interpretation (or FIN) No. 46,
"Consolidation of Variable Interest Entities", an interpretation of Accounting
Research Bulletin No. 51, "Consolidated Financial Statements." FIN No. 46
explains how to identify variable interest entities and how an enterprise
assesses its interests in a variable interest entity to decide whether to
consolidate that entity. This Interpretation requires existing unconsolidated
variable interest entities to be consolidated by their primary beneficiaries if
the entities do not effectively disperse risks among parties involved. FIN No.
46 is effective immediately for variable interest entities created after January
31, 2003, and to variable interest entities in which an enterprise obtains an
interest after that date. The Interpretation applies in the first fiscal year or
interim period beginning after June 15, 2003, to variable interest entities in
which an enterprise holds a variable interest that it acquired before February
1, 2003. We do not expect the adoption of FIN No. 46 to have a material effect
on our financial position or results of operations.
As the result of recent guidance from the SEC, 2002 earnings per share
recomputations will be reduced to reflect amounts of initial preferred stock
offering costs related to preferred stock redeemed in 2002 beginning in our
third quarter 2003 consolidated financial statements.
14
3. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following estimated fair values of our consolidated financial
instruments are presented in accordance with GAAP, which define fair value as
the amount at which a financial instrument could be exchanged in a current
transaction between willing parties, in other than a forced sale or liquidation.
These values do not represent our liquidation value or the value of the
securities under a portfolio liquidation.
As of June 30, 2003 As of December 31, 2002
(in thousands) Amortized Cost Fair Value Amortized Cost Fair Value
- -------------- -------------- ---------- -------------- ----------
ASSETS:
Subordinated CMBS pledged to secure
recourse debt (1) $ 465,542 $ 533,553 $ 473,571 $ 535,508
CMBS pledged to secure Securitized Mortgage
Obligation - CMBS (1) 288,677 339,662 287,040 326,473
Other MBS (1) 2,534 2,511 5,308 5,248
Insured mortgage securities (1) 218,412 221,185 273,655 275,340
Interest rate protection agreements (1) 366 -- 992 4
Servicing other assets See footnote (2) See footnote (2) See footnote (2) See footnote (2)
Servicing cash and cash equivalents 3,728 3,728 12,582 12,582
Other cash and cash equivalents 8,912 8,912 16,669 16,669
Restricted cash and cash equivalents -- -- 7,962 7,962
LIABILITIES:
BREF senior subordinated secured note 31,267 35,087 -- --
Bear Stearns variable rate secured debt 298,750 298,750 -- --
Exit variable-rate secured borrowing -- -- 214,673 214,673
Series A senior secured notes -- -- 92,788 92,788 (3)
Series B senior secured notes -- -- 68,491 68,491 (3)
Securitized mortgage obligations:
Collateralized bond obligations-CMBS 287,092 339,662 285,845 326,473
Collateralized mortgage obligations-insured
mortgage securities 204,313 213,318 252,980 266,367
Mortgage payable 7,273 7,446 7,214 7,341
Interest rate swap (1) -- 63 -- --
(1) Recorded at fair value in the accompanying Consolidated Balance Sheet.
(2) CMSLP owned subordinated CMBS and interest-only strips with an aggregate
amortized cost basis of approximately $1.7 million and $1.9 million and a
fair value of approximately $1.8 million and $2.1 million as of June 30,
2003 and December 31, 2002, respectively. Additionally, CMSLP owned
investment-grade CMBS with an aggregate cost basis and fair value of
approximately $3.3 million as of December 31, 2002. The investment-grade
CMBS were sold in January 2003 in connection with the company's
recapitalization.
(3) Since these notes were redeemed in January 2003 at face value, we disclosed
the face value as the fair value as of December 31, 2002.
The following methods and assumptions were used to estimate the fair value
of each class of financial instruments:
CMBS
Our determination of fair values for our CMBS portfolio is a subjective
process. The process begins with the compilation and evaluation of pricing
information (such as nominal spreads to U.S. Treasury securities or nominal
yields) that, in our view, is commensurate with the market's perception of value
and risk of comparable assets. We use a variety of sources to compile such
pricing information including: (i) recent offerings and/or secondary trades of
comparable CMBS (i.e., securities comparable to our CMBS or to the CMBS (or
collateral) underlying our CMBS issued in connection with CRIIMI MAE Trust I
Series 1996-C1 (or CBO-1) and CRIIMI MAE Commercial Mortgage Trust Series
1998-C1 (or CBO-2)), (ii) communications with dealers and active CMBS investors
regarding the pricing and valuation of comparable securities, (iii)
institutionally available research reports, (iv) analyses prepared by the
nationally recognized rating organizations responsible for the initial rating
assessment and on-going surveillance of such CMBS, and (v) other qualitative and
quantitative factors that may impact the value of the CMBS such as the market's
perception of the issuers of the CMBS and the credit fundamentals of the
15
commercial properties securing each pool of underlying commercial mortgage
loans. We make further fair value adjustments to such pricing information based
on our specific knowledge of our CMBS and the impact of relevant events, which
is then used to determine the fair value of our CMBS using a discounted cash
flow approach. Expected future gross cash flows are discounted at market yields
for our rated CMBS, depending on the rating, and at a fixed discount rate for
our unrated/issuer's equity. Furthermore, the fair value for those CMBS
incurring principal losses and interest shortfalls (i.e., B- and CCC rated
bonds, and our unrated/issuer's equity) based on our overall expected loss
estimate are valued at a loss adjusted yield to maturity that, in our view, is
commensurate with the market's perception of value and risk of comparable
securities, using the same discounted cash flow approach. Such anticipated
principal losses and interest shortfalls, as well as potential recoveries of
such shortfalls, have been taken into consideration in the calculation of fair
values and yields to maturity used to recognize interest income as of June 30,
2003. We have disclosed the range of discount rates by rating category used in
determining the fair values as of June 30, 2003 in Note 4.
The liquidity of the subordinated CMBS market has historically been
limited. Additionally, during adverse market conditions, the liquidity of such
market has been severely limited. For this reason, among others, management's
estimate of the value of our subordinated CMBS could vary significantly from the
value that could be realized in a current transaction between a willing buyer
and a willing seller in other than a forced sale or liquidation.
Other MBS
The fair value of the Other MBS is an estimate based on the indicative
market price from publicly available pricing services, as well as management
estimates. We normally apply a slight discount to such prices as we believe it
better reflects fair value between willing buyers and sellers due to the
relatively smaller sizes of this component of the trading securities.
Insured Mortgage Securities
We calculated the estimated fair value of the insured mortgage securities
portfolio as of June 30, 2003 and December 31, 2002, using a discounted cash
flow methodology. The cash flows were discounted using a discount rate and other
assumptions that, in our view, was commensurate with the market's perception of
risk and value. We used a variety of sources to determine the discount rate
including (i) institutionally available research reports and (ii) communications
with dealers and active insured mortgage security investors regarding the
valuation of comparable securities.
Servicing, Restricted and Other Cash and Cash Equivalents
The carrying amount approximates fair value because of the short maturity
of these instruments.
Obligations Under Financing Facilities
The fair values of the securitized mortgage obligations as of June 30, 2003
and December 31, 2002 were calculated using a discounted cash flow methodology
similar to that discussed for CMBS above. The carrying amount of the Bear
Stearns Debt (and at December 31, 2002, the Exit Variable-Rate Secured
Borrowing) approximates fair value because the current rate on the debt resets
monthly based on market rates. The fair value of the BREF Debt was estimated by
applying a discount rate to the debt's future cash flows. The discount rate was
determined by considering the BREF Debt's relative position in our capital
structure in relation to our other capital. The fair value of the mortgage
payable is estimated based on current market interest rates of commercial
mortgage debt. As of December 31, 2002, the fair values of the Series A and
Series B Senior Secured Notes are the same as the face values since the notes
were redeemed in January 2003.
Derivative Financial Instruments
The fair values of our interest rate swaps and interest rate caps are the
estimated amounts that we would realize to terminate the agreements as of June
30, 2003 and December 31, 2002, taking into account current interest rates and
the current creditworthiness of the counterparties. The amounts were determined
based on quotes received from the counterparties to the agreements.
16
4. CMBS
As of June 30, 2003, we owned, in accordance with GAAP, CMBS with an
aggregate face amount of approximately $1.5 billion rated from A+ to CCC and
unrated. Such CMBS had an aggregate fair value of approximately $873 million
(representing approximately 75% of our total consolidated assets) and an
aggregate amortized cost of approximately $754 million. Such CMBS represent
investments in securities issued in connection with CBO-1, CBO-2 and Nomura
Asset Securities Corporation Series 1998-D6 (or Nomura). The following is a
summary of the ratings of our CMBS as of June 30, 2003 (in millions):
Rating (1) Fair Value % of CMBS
---------- ---------- ---------
A+, BBB+ or BBB (2) $ 339.6 39%
BB+, BB or BB- $ 346.1 40%
B+, B, B- or CCC $ 168.8 19%
Unrated $ 18.7 2%
(1) Ratings are provided by Standard & Poor's.
(2) Represents investment grade securities that we reflect as assets on our
balance sheet as a result of CBO-2. As indicated in footnote 4 to the table
below, GAAP requires both these assets (reflected as "CMBS pledged to Secure
Securitized Mortgage Obligation-CMBS") and their related liabilities (reflected
as "Collateralized bond obligations - CMBS") to be reflected on our balance
sheet. All cash flows related to the investment grade CMBS are used to service
the corresponding debt. As a result, we currently receive no cash flows from the
investment grade CMBS.
As of June 30, 2003, the weighted average interest rate and the loss
adjusted weighted average life (based on face amount) of the investment grade
securities was 7.0% and 8.3 years, respectively. The weighted average interest
rate and the loss adjusted weighted average life (based on face amount) of the
BB+ through unrated CMBS securities, sometimes referred to as the retained
portfolio, were 4.6% and 10.8 years, respectively. The aggregate investment by
the rating of the CMBS is as follows:
Discount Rate
or Range of
Weighted Loss Discount Rates
Face Amount Average Adjusted Fair Value Used to Amortized Cost Amortized Cost
as of Pay Weighted as of Calculate Fair as of 6/30/03 as of 12/31/02
Security Rating 6/30/03 (in Rate as of Average 6/30/03 (in Value as of (in millions) (in millions)
millions) 6/30/03 Life (1) millions) 6/30/03 (9) (5) (6)
- ------------------------------------------------------------------------------------------------------------------------------
Investment Grade Portfolio
- --------------------------
A+ (4) $ 62.6 7.0% 3 years $ 66.8 4.1% $ 59.8 $ 59.4
BBB+ (4) 150.6 7.0% 9 years 158.0 6.2% 132.9 132.3
BBB (4) 115.2 7.0% 10 years 114.8 7.1% 95.9 95.3
Retained Portfolio
- ------------------
BB+ 319.0 7.0% 12 years 265.6 9.5%-9.9% 225.1 223.0
BB 70.9 7.0% 14 years 54.9 10.5% 47.2 46.8
BB- 35.5 7.0% 14 years 25.6 11.4% 21.0 20.8
B+ 88.6 7.0% 14 years 50.6 14.7% 46.5 46.0
B 177.2 6.9% 17 years 94.9 15.2%-15.5% 85.9 85.1
B- (2) 118.3 0.8% 24 years 22.1 (9) 21.7 28.1
CCC (2) 70.9 0.0% 2 years 1.2 (9) 1.2 3.8
Unrated/Issuer's
Equity (2) (3) 309.4 1.7% 1 year 18.7 (9) 17.0 20.0
--------- -------- ---------- --------
Total (8) $ $ 1,518.2 5.1% 10 years $ 873.2 (8) $ 754.2 (7) $ 760.6
========== ======== ========== ========
17
(1) The loss adjusted weighted average life represents the weighted average
expected life of the CMBS based on our current estimate of future losses.
As of June 30, 2003, the fair values of the B-, CCC and the
unrated/issuer's equity in Nomura, CBO-1, and CBO-2 were derived primarily
from interest cash flow anticipated to be received since our current loss
expectation assumes that the full principal amount of these securities
will not be recovered. See also "Advance Limitations, Appraisal Reductions
and Losses on CMBS" below.
(2) The CBO-1, CBO-2 and Nomura CMBS experience interest shortfalls when the
weighted average net coupon rate on the underlying CMBS is less than the
weighted average stated coupon payments on our subordinated CMBS. Such
interest shortfalls will continue to accumulate until they (i) are repaid
through either excess interest and/or recoveries on the underlying CMBS or
a recharacterization of principal cash flows, or (ii) are realized as a
loss of principal on the subordinated CMBS. Such anticipated losses,
including shortfalls, have been taken into consideration in the
calculations of fair market values and yields to maturity used to
recognize interest income as of June 30, 2003.
(3) The unrated subordinated CMBS from CBO-2 currently does not have a stated
coupon rate since this security is only entitled to the residual cash flow
payments, if any, remaining after paying the securities with a higher
payment priority. As a result, effective coupon rates on these securities
are highly sensitive to the effective coupon rates and monthly cash flow
payments received from the underlying CMBS that represent the collateral
for CBO-2.
(4) In connection with CBO-2, $62.6 million (originally A rated, currently A+
rated) and $60.0 million (originally BBB rated, currently BBB+ rated) face
amount of investment grade CMBS were sold with call options and $345
million (originally A rated, currently A+ rated) face amount were sold
without call options. Also in connection with CBO-2, in May 1998, we
initially retained $90.6 million (originally BBB rated, currently BBB+
rated) and $115.2 million (originally BBB- rated, currently BBB rated)
face amount of CMBS, both with call options, with the intention to sell
these CMBS at a later date. Such sale occurred March 5, 1999. Since we
retained call options on certain sold CMBS (currently rated A+, BBB+ and
BBB bonds), we did not surrender control of these CMBS pursuant to the
requirements of SFAS No. 125, and thus these CMBS are accounted for as a
financing and not a sale. Since the transaction is recorded as a partial
financing and a partial sale, we have retained these CMBS with call
options, from which we currently receive no cash flows, and reflected them
in our CMBS on the balance sheet.
(5) Amortized cost reflects approximately $8.9 million of impairment charges
related to the unrated/issuer's equity bonds, the CCC bond and the B- bond
in CBO-2, which were recognized during the three months ended June 30,
2003. These impairment charges are in addition to the cumulative
impairment charges of approximately $248.4 million that were recognized
through December 31, 2002. The impairment charges are discussed later in
this Note 4.
(6) Amortized cost reflects approximately $248.4 million of cumulative
impairment charges related to certain CMBS (all bonds except those rated
A+ and BBB+), which were recognized through December 31, 2002.
(7) See Notes 1 and 8 to Notes to Consolidated Financial Statements for
information regarding the subordinated CMBS for tax purposes.
(8) As of June 30, 2003, the aggregate fair values of the CBO-1, CBO-2 and
Nomura bonds were approximately $19.1 million, $848.7 million and
$5.4 million, respectively.
(9) As a result of the estimated loss of principal on these CMBS, we have used
a significantly higher discount rate to determine a reasonable fair value
of these CMBS. The weighted average loss adjusted yield-to-maturity of the
B-, CCC and unrated/issuer's equity is 15.3%, 15.0% and 21.8%,
respectively.
Mortgage Loan Pool
Through CMSLP, our servicing subsidiary, we perform servicing functions on
commercial mortgage loans totaling $16.5 billion and $17.4 billion as of June
30, 2003 and December 31, 2002, respectively. The mortgage loans underlying our
subordinated CMBS portfolio are secured by properties of the types and in the
geographic locations identified below:
06/30/03 12/31/02 Geographic 06/30/03 12/31/02
Property Type Percentage(i) Percentage(i) Location(ii) Percentage(i) Percentage(i)
- ------------- ------------- ------------- ----------- ------------- -------------
Retail........ 31% 31% California........ 16% 17%
Multifamily... 27% 28% Texas............. 12% 12%
Hotel......... 16% 15% Florida........... 8% 8%
Office........ 14% 13% Pennsylvania...... 6% 5%
Other (iv).... 12% 13% Georgia........... 4% 4%
---- --------- Other(iii)........ 54% 54%
Total..... 100% . 100% ---- -----------
==== ========= Total......... 100% 100%
==== ===========
18
(i) Based on a percentage of the total unpaid principal balance of the
underlying loans.
(ii) No significant concentration by region.
(iii) No other individual state makes up more than 5% of the total.
(iv) Our ownership interest in one of the 20 CMBS transactions underlying
CBO-2 includes subordinated CMBS in which our exposure to losses
arising from certain healthcare and senior housing mortgage loans is
limited by other subordinated CMBS (referred to herein as the
Subordinated Healthcare/Senior-Housing CMBS). These other CMBS are not
owned by us and are subordinate to our CMBS in this transaction. As a
result, our investment in such underlying CMBS will only be affected
if interest shortfalls and/or realized losses on such healthcare and
senior housing mortgage loans are in excess of the Subordinated
Healthcare/Senior-Housing CMBS. We currently estimate that the
interest shortfalls and/or realized losses on such healthcare and
senior housing mortgage loans will exceed the Subordinated
Healthcare/Senior Housing CMBS.
Specially Serviced Mortgage Loans
CMSLP performs special servicing on the loans underlying our subordinated
CMBS portfolio. A special servicer typically provides asset management and
resolution services with respect to nonperforming or underperforming loans
within a pool of mortgage loans. When serving as special servicer of a mortgage
loan pool, CMSLP has the authority, subject to certain restrictions in the
applicable CMBS pooling and servicing documents, to deal directly with any
borrower that fails to perform under certain terms of its mortgage loan,
including the failure to make payments, and to manage any loan workouts and
foreclosures. As special servicer, CMSLP earns fee income on services provided
in connection with any loan servicing function transferred to it from the master
servicer. We believe that because we own the first loss unrated or lowest rated
bond of virtually all of the CMBS transactions related to our subordinated CMBS,
CMSLP has an incentive to efficiently and effectively resolve any loan workouts.
As of June 30, 2003 and December 31, 2002, specially serviced mortgage loans
included in the commercial mortgage loans described above were as follows:
06/30/03 12/31/02
--------- --------
Specially serviced loans due to monetary default (a) $ 908.8 million $736.1 million
Specially serviced loans due to covenant default/other 260.0 million 74.7 million
---------------- --------------
Total specially serviced loans (b) $1,168.8 million $810.8 million
================ ==============
Percentage of total mortgage loans (b) 7.1% 4.7%
================ ===============
(a) Includes $134.7 million and $130.5 million, respectively, of real estate
owned by the underlying securitization trusts. See also the table below
regarding property type concentrations for further information on real
estate owned by underlying trusts.
(b) As of July 31, 2003, total specially serviced loans were approximately $1.1
billion, or 6.8% of the total mortgage loans. See discussion below for
additional information regarding specially serviced loans.
The specially serviced mortgage loans as of June 30, 2003 were secured by
properties of the types and located in the states identified below:
Property Type $ (in millions) Percentage Geographic Location $ (in millions) Percentage
- ------------- --------------- ---------- ------------------- --------------- ----------
Hotel......... $ 715.4 (1) 61% Florida.............. $ 169.9 14%
Retail........ 240.5 (2) 21% Texas................ 122.8 10%
Healthcare.... 93.6 8% California........... 103.2 9%
Office........ 52.1 4% Oregon............... 91.4 8%
Multifamily... 38.2 3% Georgia ............. 55.6 5%
Industrial.... 19.5 2% Other................ 625.9 54%
Other......... 9.5 1% ---------- ---------
-------- ----- Total................ $1,168.8 100%
Total..... $1,168.8 100% ========== =========
======== =====
(1) Approximately $87.4 million of these loans in special servicing are
real estate owned by the underlying securitization trusts.
(2) Approximately $32.6 million of these loans in special servicing are
real estate owned by the underlying securitization trusts.
19
As reflected above, as of June 30, 2003, approximately $715.4 million, or
61%, of the specially serviced mortgage loans were secured by mortgages on hotel
properties. The hotel properties that secure the mortgage loans underlying our
CMBS are geographically diverse, with a mix of hotel property types and
franchise affiliations. The following table summarizes the hotel mortgage loans
underlying our CMBS as of June 30, 2003:
Total Outstanding Percentage of Amount in
Principal Balance Total Hotel Loans Special Servicing
----------------- ----------------- -----------------
Full service hotels (1) $ 1.4 billion 54% $ 237.3 million
Limited service hotels (2) 1.2 billion 46% 478.1 million
-------------- ---- ---------------
Totals $ 2.6 billion 100% $ 715.4 million
============== ==== ===============
(1) Full service hotels are generally mid-price, upscale or luxury hotels
with restaurant and lounge facilities and other amenities.
(2) Limited service hotels are generally hotels with room-only operations
or hotels that offer a bedroom and bathroom, but limited other
amenities, and are often in the budget or economy group.
Of the $715.4 million of hotel loans in special servicing as of June 30,
2003, approximately $488.8 million, or 68%, relate to eight borrowing
relationships more fully described as follows:
o Twenty-seven loans with scheduled principal balances as of June 30,
2003 totaling approximately $136.2 million spread across three CMBS
transactions secured by hotel properties in the western and Pacific
northwestern states. As of June 30, 2003, our total exposure,
including advances, on these loans was approximately $167.9 million.
The borrower filed for bankruptcy protection in February 2002. The
borrower indicated that the properties had experienced reduced
operating performance due to new competition, the economic recession,
and reduced travel resulting from the September 11, 2001 terrorist
attacks. We entered into a consensual settlement agreement dated
February 25, 2003 pursuant to which the loan terms were amended and
modified, which was subsequently approved and confirmed by the
bankruptcy court on March 28, 2003. The borrower continues to make
payments under the modified terms, and, during the three months ended
June 30, 2003, the borrower sold one of the properties that secured
these loans. In addition, the borrower has remitted approximately
$1.5 million in funds from debtor-in-possession accounts, which is
expected to be applied to arrearages. The parties are currently
proceeding toward closing a comprehensive loan modification that is
expected to return the loans to performing status in the near future.
o One loan with a scheduled principal balance as of June 30, 2003
totaling approximately $128.4 million, secured by 93 limited service
hotels located in 29 states. As of June 30, 2003, our total exposure,
including advances, on this loan was approximately $128.4 million.
The loan was transferred to special servicing in January 2003. The loan
is current for payments, but was transferred to special servicing due
to the unauthorized leasing of some of the collateral properties by the
borrower, and unapproved franchise changes by the borrower, among other
reasons. We entered into a Confidentiality and Pre-Negotiation
Agreement in an attempt to reach a consensual resolution of this
matter, but, subsequent to June 30, 2003, the borrower filed for
bankruptcy.
o One loan with a scheduled principal balance as of June 30, 2003
totaling approximately $80.7 million secured by 13 extended stay hotels
located throughout the U.S. This loan was transferred to special
servicing in January 2003 due to the borrower's request for forbearance
and the resulting possibility of an imminent payment default. In its
request, the borrower cited continuing reduced operating performance at
its hotel properties, which it did not expect to improve in the
foreseeable future. Subsequent to June 30, 2003, this loan was sold to
a third party.
o Five loans with scheduled principal balances as of June 30, 2003
totaling approximately $45.3 million secured by hotel properties in
Florida and Texas. As of June 30, 2003, our total exposure, including
advances, on these loans was approximately $49.5 million. The loans are
past due for the July 2002 and all subsequent payments. We have reached
a preliminary agreement with the borrower on a consensual modification
of the loan terms, and are working toward a formal modification
agreement that is expected to return the loans to performing status in
the first quarter of 2004.
20
o Eight real estate owned properties with scheduled principal balances as
of June 30, 2003 totaling approximately $26.1 million secured by hotel
properties. As of June 30, 2003, our total exposure, including
advances, on these loans was approximately $31.9 million. The loans
were transferred into special servicing in December 2001 due to the
bankruptcy filing of each special purpose borrowing entity and their
parent company. As part of a consensual plan, eight properties were
foreclosed and became real estate owned by underlying securitization
trusts. Subsequent to June 30, 2003, two of these properties with an
aggregate unpaid balance of $5.9 million were sold.
o One loan with a scheduled principal balance as of June 30, 2003
totaling approximately $27.7 million, secured by 9 limited service
hotels located in 8 states. As of June 30, 2003 the loan was current.
The loan is currently in special servicing due to an unauthorized
transfer of the properties to an entity which assumed the controlling
interest in the borrowing entity. Subsequent to the transfer, the new
controlling party in interest has requested payment relief citing
reduced operating performance at the properties.
o One loan with a scheduled principal balance as of June 30, 2003 of
approximately $25.6 million, secured by a full service hotel in Boston,
Massachusetts. As of June 30, 2003, our total exposure, including
advances, on this loan was approximately $27.0 million. This loan was
transferred into special servicing in March 2003. The borrower has
stated an inability to make payments, and has requested a loan
restructuring due to reduced operating performance at the property.
o Nine loans with scheduled principal balances as of June 30, 2003
totaling approximately $18.8 million secured by limited service hotels
in midwestern states. As of June 30, 2003, our total exposure,
including advances, on these loans was approximately $23.6 million. The
loans are past due for the April 2002 and all subsequent payments. The
borrower cites reduced occupancy related to the downturn in travel as
the cause for a drop in operating performance at the properties. We
were attempting to negotiate a workout with the borrower when the
borrower filed for bankruptcy protection in February 2003. A cash
collateral order has been entered into and we are working with the
borrower towards a consensual emergence plan.
For each of the borrowing relationships described in the paragraphs above,
we believe that we have made an appropriate estimate of losses that we may incur
in the future, which are used in determining our CMBS yields and fair values.
There can be no assurance that any of the loans described above will return to
performing status. Circumstances which could prevent them from returning to
performing status include, but are not limited to, a continuing or more
pronounced downturn in the economy or in the real estate market, a change in
local market conditions, a drop in performance of the property, an increase in
interest rates, and terrorist attacks. There can be no assurance that the losses
incurred in the future will not exceed our current estimates (see discussion
below regarding the increase in loss estimates).
The following table provides a summary of the change in the balance of
specially serviced loans from December 31, 2002 to March 31, 2003 and from April
1, 2003 to June 30, 2003 (in millions):
April - June Jan. - March
2003 2003
------------- -------------
Specially Serviced Loans, beginning of period $1,154.0 $ 810.8
Transfers in due to monetary default 166.3 239.7
Transfers in due to covenant default and other 7.4 158.6
Transfers out of special servicing (153.2) (48.5)
Loan amortization (1) (5.7) (6.6)
----------- ---------
Specially Serviced Loans, end of period $1,168.8 $1,154.0
=========== =========
(1) Represents the reduction of the scheduled principal balances due to
borrower payments or, in the case of loans in monetary default,
advances made by master servicers.
21
Advance Limitations, Appraisal Reductions and Losses on CMBS
We experience shortfalls in expected cash flow on our CMBS prior to the
recognition of a realized loss primarily due to servicing advance limitations
resulting from appraisal reductions. An appraisal reduction event generally
results in reduced master servicer principal and interest advances based on the
amount by which the sum of the unpaid principal balance of the loan, accumulated
principal and interest advances and other expenses exceeds 90% (in most cases)
of the newly appraised value of the property underlying the mortgage loan. As
the holder of the lowest rated and first loss bonds, our bonds are the first to
experience interest shortfalls as a result of the reduced advancing requirement.
In general, the master servicer can advance up to a maximum of the difference
between 90% of the property's appraised value and the sum of accumulated
principal and interest advances and expenses. As an example, assuming a weighted
average coupon of 6% on a first loss subordinated CMBS, a $1 million appraisal
reduction would reduce our net cash flows by $60,000 on an annual basis. The
ultimate disposition or work-out of the mortgage loan may result in a higher or
lower realized loss on our subordinated CMBS than the calculated appraisal
reduction amount. Appraisal reductions for the CMBS transactions in which we
retain an ownership interest as reported by the underlying trustees or as
calculated by CMSLP* were as follows (in thousands):
CBO-1 CBO-2 Nomura Total
----- ----- ------- -----
Year 2000 $ 1,872 $ 18,871 $ -- $ 20,743
Year 2001 15,599 31,962 874 48,435
Year 2002 9,088 48,953 13,530 71,571
January 1, 2003 through June 30, 2003 9,169 46,969 4,328 60,466
------- -------- ------- ---------
Cumulative Appraisal Reductions through June 30, 2003 $35,728 $146,755 $18,732 $ 201,215
======= ======== ======= =========
* Not all underlying CMBS transactions require the calculation of an
appraisal reduction; however, when CMSLP obtains a third-party appraisal, it
calculates one.
As previously discussed, certain securities from the CBO-1, CBO-2 and
Nomura transactions are expected to experience principal write-downs over their
expected lives. The following tables summarize the actual realized losses on our
CMBS through June 30, 2003 (including realized mortgage loan losses expected to
pass through to our CMBS during the next month) and the expected future losses
through the life of the CMBS (in thousands):
CBO-1 CBO-2 Nomura Total
----- ----- ------- -----
Year 1999 actual realized losses $ 738 $ -- $ -- $ 738
Year 2000 actual realized losses 3,201 1,087 -- 4,288
Year 2001 actual realized losses 545 8,397 238 9,180
Year 2002 actual realized losses 11,554 25,113 563 37,230
Actual realized losses, January 1 through June 30, 2003 2,006 16,229 662 18,897
-------- -------- ------- ----------
Cumulative actual realized losses through June 30, 2003 $ 18,044 $ 50,826 $ 1,463 $ 70,333
======== ======== ======= ==========
Cumulative expected realized loss estimates (including
cumulative actual realized losses) through the year 2003 $ 31,014 $123,247 $ 8,566 $ 162,827
Expected loss estimates for the year 2004 54,441 122,314 14,921 191,676
Expected loss estimates for the year 2005 17,355 71,376 8,484 97,215
Expected loss estimates for the years 2006-2008 8,548 43,765 8,173 60,486
Expected loss estimates for the years 2009-2011 6,492 18,463 3,955 28,910
Expected loss estimates for the remaining life of CMBS 3,938 12,292 1,790 18,020
-------- -------- ------- ---------
Cumulative expected loss estimates (including cumulative
actual realized losses) through life of CMBS $121,788 $391,457 $45,889 $ 559,134
======== ======== ======= =========
As of June 30, 2003, we revised our overall expected loss estimate related
to our subordinated CMBS from $503 million to $559 million, with such total
losses occurring or expected to occur through the life of the subordinated CMBS
portfolio. These revisions to the overall expected loss estimate were primarily
the result of increased projected losses due to lower than anticipated
appraisals and lower internal estimates of values on real estate owned by
underlying trusts and properties underlying certain defaulted mortgage loans,
which, when combined with the updated loss severity experience and changes in
the timing of resolution and disposition of the specially serviced assets, has
resulted in higher projected loss severities on loans and real estate owned by
underlying trusts currently or anticipated to be in special servicing. The
primary reasons for lower appraisals and lower estimates of value resulting in
higher projected loss severities on mortgage loans and real estate owned by the
22
underlying securitization trusts include the poor performance of certain
properties and related markets and failed workout negotiations due, in large
part, to the continued softness in the economy, the continued downturn in travel
and, in some cases, over-supply of hotel properties, and a shift in retail
activity in some markets, including the closing of stores by certain national
and regional retailers. There can be no assurance that our revised overall
expected loss estimate of $559 million will not be exceeded as a result of
additional or existing adverse events or circumstances. Such events or
circumstances include, but are not limited to, the receipt of new or updated
appraisals at lower than anticipated amounts, legal proceedings (including
bankruptcy filings) involving borrowers, a continued weak economy or recession,
continued hostilities in the Middle East or elsewhere, terrorism, unexpected
delays in the disposition or other resolution of specially serviced mortgage
loans, additional defaults, or an unforeseen reduction in expected recoveries,
any of which could result in additional future credit losses and/or further
impairment to our subordinated CMBS, the effect of which could be materially
adverse to us.
We have also determined that there has been an adverse change in expected
future cash flows for the unrated/issuer's equity bonds, the CCC bond and the B-
bond in CBO-2 as of June 30, 2003 due to the factors mentioned in the preceding
paragraph. As a result, we believe these bonds have been impaired under EITF
99-20 and SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," as of June 30, 2003. As the fair values of these impaired bonds
aggregated approximately $8.9 million below the amortized cost basis as of June
30, 2003, we recorded other than temporary impairment charges through the income
statement of that same amount during the three months ended June 30, 2003.
Yield to Maturity
The following table summarizes yield-to-maturity information relating to
our CMBS on an aggregate pool basis:
Current
Anticipated Anticipated Anticipated
Yield-to- Yield-to- Yield-to-
Maturity Maturity Maturity
Pool as of 1/1/02 (1) as of 1/1/03 (1) as of 7/1/03 (1)
---- ----------------- ----------------- -----------------
CBO-2 CMBS 12.1% (2) 11.6% (2) 11.5% (2)
CBO-1 CMBS 14.3% (2) 11.6% (2) 21.6% (2)
Nomura CMBS 28.7% (2) 8.0% (2) 16.9% (2)
------ ------ ------
Weighted Average (3) 12.4% (2) 11.6% (2) 11.7% (2)
(1) Represents the anticipated weighted average yield over the expected average
life of the CMBS as of January 1, 2002, January 1, 2003 and July 1, 2003
based on our estimate of the timing and amount of future credit losses and
other significant items that are anticipated to affect future cash flows.
(2) As previously discussed, as of December 31, 2001, June 30, 2002, September
30, 2002, December 31, 2002 and June 30, 2003, we revised our overall
expected loss estimate related to our subordinated CMBS from $307 million
to $335 million, $351 million, $448 million, $503 million and $559 million,
respectively, which resulted in impairment recognition to certain
subordinated CMBS. As a result of recognizing impairment, we revised the
anticipated yields as of January 1, 2002, July 1, 2002, October 1, 2002,
January 1, 2003 and July 1, 2003, which were or are, in the case of revised
anticipated yields as of July 1, 2003, used to recognize interest income
beginning on each of those dates. These anticipated revised yields took
into account the lower cost basis due to the impairment recognized on the
subordinated CMBS as of dates the losses were revised, and contemplated
larger than previously anticipated losses.
(3) GAAP requires that the income on CMBS be recorded based on the effective
interest method using the anticipated yield over the expected life of these
mortgage assets. This method can result in accounting income recognition
which is greater than or less than cash received. During the six months
ended June 30, 2003, we recognized approximately $5.6 million of discount
amortization, partially offset by approximately $3.0 million of cash
received in excess of income recognized on subordinated CMBS due to the
effective interest method. During the six months ended June 30, 2002, we
recognized approximately $5.7 million of discount amortization, partially
offset by approximately $1.9 million of cash received in excess of income
recognized on subordinated CMBS due to the effective interest method.
Determining Fair Value of CMBS
We use a discounted cash flow methodology for determining the fair value of
our subordinated CMBS. See Note 3 for a discussion of our fair value
methodology.
23
Key Assumptions in Determining Fair Value
The gross mortgage loan cash flows from each commercial mortgage loan pool
and their corresponding distribution on the CMBS may be affected by numerous
assumptions and variables including:
(i) changes in the timing and/or amount of credit losses on the commercial
mortgage loans (credit risk), which are a function of:
o the percentage of mortgage loans that experience a default either
during the mortgage term or at maturity (referred to in the industry as
a default percentage);
o the recovery period represented by the time that elapses between the
default of a commercial mortgage loan and the subsequent foreclosure
and liquidation of the corresponding real estate (a period of time
referred to in the industry as a lag); and,
o the percentage of mortgage loan principal lost as a result of the
deficiency in the liquidation proceeds resulting from the foreclosure
and sale of the commercial real estate (referred to in the industry as
a loss severity);
(ii) the discount rate used to derive fair value, which is comprised of the
following:
o a benchmark risk-free rate, calculated by using the current,
"on-the-run" U.S. Treasury curve and interpolating a comparable
risk-free rate based on the weighted-average life of each CMBS; plus,
o a credit risk premium; plus,
o a liquidity premium;
(iii) delays and changes in monthly cash flow distributions relating to
mortgage loan defaults and/or extensions in the loan's term
to maturity (see Extension Risk below); and
(iv) the receipt of mortgage payments earlier than projected (prepayment).
Sensitivities of Key Assumptions
Since we use a discounted cash flow methodology to derive the fair value of
our CMBS, changes in the timing and/or the amount of cash flows received from
the underlying commercial mortgage loans, and their allocation to the CMBS, will
directly impact the value of such securities. Accordingly, delays in the receipt
of cash flows and/or decreases in future cash flows resulting from higher than
anticipated credit losses will result in an overall decrease in the fair value
of our CMBS. Furthermore, any increase/(decrease) in the required rate of return
for CMBS will result in a corresponding (decrease)/increase in the value of such
securities. We have included the following narrative and numerical disclosures
to demonstrate the sensitivity of such changes to the fair value of our CMBS.
Key Assumptions Resulting in an Adverse Impact to Fair Value
Factors which could adversely affect the valuation of our CMBS include: (i)
the receipt of future cash flows less than anticipated due to higher credit
losses (i.e., higher credit losses resulting from a larger percentage of loan
defaults, and/or losses occurring sooner than projected, and/or longer periods
of recovery between the date of default and liquidation, and/or higher loss of
principal, see "Sensitivity of Fair Value to Changes in Credit Losses" below),
(ii) an increase in the required rate of return (see "Sensitivity of Fair Value
to Changes in the Discount Rate" below) for CMBS, and/or (iii) the receipt of
cash flows later than anticipated (see "Sensitivity of Fair Value to Extension
Risk" below).
Sensitivity of Fair Value to Changes in Credit Losses
For purposes of this disclosure, we used a market convention for simulating
the impact of increased credit losses on CMBS. Generally, the industry uses a
combination of an assumed percentage of loan defaults (referred to in the
industry as a Constant Default Rate or "CDR"), a lag period and an assumed loss
severity. For purposes of this disclosure, we assumed the following loss
scenarios, each of which was assumed to begin immediately following June 30,
2003: (i) 3.0% per annum of the commercial mortgage loans were assumed to
default and 30% of the then outstanding principal amount of the defaulted
commercial mortgage loans
24
were assumed to be lost (referred to in the industry as a 3.0% CDR and 30%
loss severity, and referred to herein as the "3%/30% CDR Loss Scenario"), and
(ii) 3.0% per annum of each commercial mortgage was assumed to default and 40%
of the then outstanding principal amount of each commercial mortgage loan was
assumed to be lost (referred to in the industry as a 3.0% CDR and 40% loss
severity, and referred to herein as the "3%/40% CDR Loss Scenario"). The
reduction in amount of cash flows resulting from the 3%/30% CDR Loss Scenario
and the 3%/40% CDR Loss Scenario would result in a corresponding decline in the
fair value of our aggregate CMBS by approximately $49.4 million (or 5.7%) and
$248.5 million (or 28.5%), respectively. The reduction in amount of cash flows
resulting from the 3%/30% CDR Loss Scenario and the 3%/40% CDR Loss Scenario
would result in a corresponding decline in the fair value of our subordinated
CMBS (BB+ through unrated/issuer's equity) by approximately $49.4 million (or
9.3%) and $248.5 million (or 46.6%), respectively.
The aggregate amount of credit losses assumed under the 3%/30% CDR Loss
Scenario and the 3%/40% CDR Loss Scenario totaled approximately $727 million and
$970 million, respectively. These amounts are in comparison to the aggregate
amount of anticipated credit losses expected by us as of June 30, 2003 of
approximately $559 million used to calculate GAAP income yields. It should be
noted that the amount and timing of the anticipated credit losses assumed by us
related to the GAAP income yields are not directly comparable to those assumed
under the 3%/30% CDR Loss Scenario and the 3%/40% CDR Loss Scenario.
Sensitivity of Fair Value to Changes in the Discount Rate
The required rate of return used to determine the fair value of our CMBS is
comprised of many variables, such as a risk-free rate, a liquidity premium and a
credit risk premium. These variables are combined to determine a total rate
that, when used to discount the CMBS's assumed stream of future cash flows,
results in a net present value of such cash flows. The determination of such
rate is dependent on many quantitative and qualitative factors, such as, but not
limited to, the market's perception of the issuers and the credit fundamentals
of the commercial real estate underlying each pool of commercial mortgage loans.
For purposes of this disclosure, we assumed that the discount rate used to
determine the fair value of our CMBS increased by 100 basis points and 200 basis
points. The increase in the discount rate by 100 and 200 basis points,
respectively, would result in a corresponding decline in the value of our
aggregate CMBS by approximately $50.8 million (or 5.8%) and $97.4 million (or
11.2%), respectively, and our subordinated CMBS by approximately $32.5 million
(or 6.1%) and $62.1 million (or 11.6%), respectively.
The sensitivities above are hypothetical and should be used with caution.
As the figures indicate, changes in fair value based on variations in
assumptions generally cannot be extrapolated because the relationship of the
change in assumption to the change in fair value may not be linear. Also, the
effect of a variation in a particular assumption on the fair value of the
retained interest is calculated without changing any other assumption; in
reality, changes in one factor may result in changes in another (for example,
increases in market interest rates may result in lower prepayments and increased
credit losses), which might magnify or counteract the sensitivities.
Sensitivity of Fair Value to Extension Risk
For purposes of this disclosure, we assumed that the maturity date of each
commercial mortgage loan underlying the CMBS was extended for a period of 12
months and 24 months beyond the contractual maturity date specified in each
mortgage loan. The delay in the timing and receipt of such cash flows for an
extended period of time consisting of 12 months and 24 months, respectively,
would result in a corresponding decline in the value of our aggregate CMBS by
approximately $5.5 million (or 0.5%) and $11.0 million (or 1.0%), respectively,
and our subordinated CMBS by approximately $4.3 million (or 0.6%) and $8.5
million (or 1.2%), respectively.
Impact of Prepayment Risk on Fair Value
Our investments in subordinated CMBS are purchased at a discount to their
face amount due to their subordinated claim to principal and interest cash flows
and priority of allocation of realized losses. As a result of the discounted
purchase price, the return of principal sooner than anticipated from
prepayments, and/or in amounts
25
greater than initially assumed when determining the discounted purchase
price, would result in an increase in the value of our subordinated CMBS. Such
appreciation in value would result from the higher subordination level of the
CMBS transaction relative to comparable CMBS and the potential for an upgrade in
the ratings category of the security. Since the effects of prepayments would
enhance the value of our subordinated CMBS, the effects of increased prepayments
were excluded from the sensitivity analysis above. It should be noted that the
effects of a decline in prepayments is reflected in the Sensitivity of Fair
Value to Extension Risk above.
5. INSURED MORTGAGE SECURITIES
We own the following insured mortgage securities directly or indirectly
through wholly owned subsidiaries (in thousands):
As of June 30, 2003
-------------------
Number of Weighted Weighted
Mortgage Average Effective Average
Securities Fair Value Amortized Cost Interest Rate Remaining Term (4)
----------- ------------ --------------- ------------------ ------------------
CRIIMI MAE Financial Corporation 18 $ 68,216 $ 67,252 8.45% 25 years
CRIIMI MAE Financial Corporation II 23 117,671 116,347 7.20% 22 years
CRIIMI MAE Financial Corporation III (3) 13 35,298 34,813 8.00% 26 years
-- --------- -------- ----- --------
54 (1) $221,185 $218,412 7.71% (2) 24 years (2)
== ========= ======== ===== ========
As of December 31, 2002
-----------------------
Number of Weighted Weighted
Mortgage Average Effective Average
Securities Fair Value Amortized Cost Interest Rate Remaining Term (4)
----------- ------------ --------------- ------------------ ------------------
CRIIMI MAE 1 $ 5,730 $ 5,340 8.00% 32 years
CRIIMI MAE Financial Corporation 22 77,454 76,653 8.40% 25 years
CRIIMI MAE Financial Corporation II 28 145,576 145,396 7.19% 23 years
CRIIMI MAE Financial Corporation III 16 46,580 46,266 7.92% 27 years
-- --------- -------- ----- --------
67 $ 275,340 $273,655 7.67% (2) 25 years (2)
== ========= ======== ===== ========
(1) During the six months ended June 30, 2003, twelve mortgage loans underlying
our mortgage securities were prepaid and one mortgage loan was partially
prepaid. These prepayments generated net proceeds of approximately $48.1
million and resulted in a financial statement net loss of approximately
$(131), which is included in net gains (losses) on mortgage security
dispositions in the accompanying consolidated statement of income for the
six months ended June 30, 2003. In addition, we sold one insured mortgage
security that was owned by CRIIMI MAE Inc. for approximately $5.7 million,
which resulted in a gain of approximately $357 during the six months ended
June 30, 2003. Approximately 20% (based on amortized cost) of our insured
mortgage loans prepaid, partially prepaid or were sold during the six
months ended June 30, 2003. In July 2003, an insured mortgage with an
amortized cost of approximately $28.1 million was prepaid. This prepayment
will result in the recognition of a loss on disposition of approximately
$615 during the three months ended September 30, 2003, due to the
write-off of related unamortized premium and costs.
(2) Weighted averages were computed using total face value of the mortgage
securities. It is possible that some of the underlying mortgage loans may
prepay due to the low current mortgage interest rates.
(3) We currently have the option of prepaying the CRIIMI MAE Financial
Corporation III debt since the current face value of the debt is less than
20% of the original face value.
(4) The weighted average lives are one year or less based on our prepayment
assumptions.
26
6. OBLIGATIONS UNDER FINANCING FACILITIES
The following table summarizes our debt outstanding as of June 30, 2003 and
December 31, 2002 and for the six months ended June 30, 2003 (in thousands):
As of and for the six months ended June 30, 2003
----------------------------------------------------------
Effective Average
Rate at Average Effective December 31, 2002
Ending Balance Quarter End Balance Rate Ending Balance
-------------- ----------- ------- ---------- --------------
Recourse to CRIIMI MAE:
- ----------------------
Bear Stearns debt (1) $ 298,750 4.9% $ 277,866 4.7% $ --
BREF debt (2) 31,267 16.1% 27,772 16.3% --
Exit variable-rate secured borrowing (3) -- -- 25,983 6.7% 214,673
Series A senior secured notes (4) -- -- 35,944 11.9% 92,789
Series B senior secured notes (5) -- -- 26,636 20.3% 68,491
Non-Recourse to CRIIMI MAE:
- --------------------------
Securitized mortgage obligations:
CMBS (6) 287,092 9.1% 286,553 8.9% 285,845
Freddie Mac funding note (7) 111,347 7.6% 120,051 9.0% 139,550
Fannie Mae funding note (8) 33,615 7.4% 37,394 9.4% 44,902
CMO (9) 59,351 7.5% 62,850 8.1% 68,527
Mortgage payable (10) 7,273 12.0% 7,239 12.0% 7,214
--------- -------- --------
Total debt $ 828,695 7.5% $908,288 8.2% $921,991
========= ======== ========
(1) The effective interest rate reflects the amortization of deferred financing
fees. During the six months ended June 30, 2003, we recognized $720 of
interest expense related to the amortization of the deferred financing
fees.
(2) The effective interest rate reflects the amortization of deferred financing
fees. During the six months ended June 30, 2003, we recognized $163 of
interest expense related to the amortization of the deferred financing
fees.
(3) The effective interest rate during the six months ended June 30, 2003
reflects the accrual of estimated extension fees through January 23, 2003.
During the six months ended June 30, 2003 and 2002, we recognized interest
expense of $251 and $1,636 related to these estimated extension fees. This
debt was repaid in full on January 23, 2003, and the cumulative accrued
extension fees (from April 17, 2001 through January 23, 2003) were reversed
into income in gain on extinguishment of debt in 2003.
(4) The effective interest rate during the six months ended June 30, 2003
reflects the accrual of estimated extension fees through January 23, 2003.
During the six months ended June 30, 2003 and 2002, we recognized interest
expense of $34 and $163 related to these estimated extension fees. This
debt was repaid in full on March 10, 2003, and the cumulative accrued
extension fees (from April 17, 2001 through January 23, 2003) were reversed
into income in gain on extinguishment of debt in 2003.
(5) The effective interest rate during the six months ended June 30, 2003
reflects the accrual of estimated extension fees through January 23, 2003.
During the six months ended June 30, 2003 and 2002, we recognized interest
expense of $52 and $339 related to these estimated extension fees. This
debt was repaid in full on March 10, 2003, and the cumulative accrued
extension fees (from April 17, 2001 through January 23, 2003) were reversed
into income in gain on extinguishment of debt in 2003.
(6) As of June 30, 2003 and December 31, 2002, the face amount of the debt was
$328,446 with unamortized discount of $41,354 and $42,601, respectively.
During the six months ended June 30, 2003 and 2002, discount amortization
of $1,247 and $1,444, respectively, was recorded as interest expense.
(7) As of June 30, 2003 and December 31, 2002, the face amount of the note was
$114,114 and $143,067, respectively, with unamortized discount of $2,766
and $3,516, respectively. During the six months ended June 30, 2003 and
2002, discount amortization of $750 and $703, respectively, was recorded as
interest expense. The average effective interest rate reflects
approximately $600 of additional interest expense during the six months
ended June 30, 2003 due to the mortgages underlying the insured mortgage
securities prepaying at a faster rate than anticipated. Under the effective
interest method of recognizing interest expense, the prepayments of the
debt required an adjustment to cumulative interest expense related to the
amortization of discount and deferred fees.
(8) As of June 30, 2003 and December 31, 2002, the face amount of the note was
$34,241 and $45,750, respectively, with unamortized discount of $626 and
$847, respectively. During the six months ended June 30, 2003 and 2002,
discount amortization of $221 and $118, respectively, was recorded as
interest expense. The average effective interest rate reflects
approximately $277 of additional interest expense
27
during the six months ended June 30, 2003 due to the mortgages underlying
the insured mortgage securities prepaying at a faster rate than
anticipated. Under the effective interest method of recognizing
interest expense, the prepayments of the debt required an adjustment to
cumulative interest expense related to the amortization of discount and
deferred fees.
(9) As of June 30, 2003 and December 31, 2002, the face amount of the note was
$60,567 and $69,982, respectively, with unamortized discount of $1,216 and
$1,455, respectively. During the six months ended June 30, 2003 and 2002,
discount amortization of $238 and $246, respectively, was recorded as
interest expense. The average effective interest rate reflects
approximately $179 of additional interest expense during the six months
ended June 30, 2003 due to the mortgages underlying the insured mortgage
securities prepaying at a faster rate than anticipated. Under the effective
interest method of recognizing interest expense, the prepayments of the
debt required an adjustment to cumulative interest expense related to the
amortization of discount and deferred fees.
(10) As of June 30, 2003 and December 31, 2002, the unpaid principal balance of
this mortgage payable was $8,670 and $8,724, respectively, and the
unamortized discount was $1,397 and $1,510, respectively. The coupon rate
on the mortgage payable is 7.34%. The effective interest rate on the
mortgage payable is 12.00% as a result of the discount amortization. The
discount is being amortized to interest expense through maturity in 2008.
During the six months ended June 30, 2003 and 2002, discount amortization
of $113 and $103, respectively, was recorded as interest expense.
Debt Incurred in Connection with January 2003 Recapitalization
Bear Stearns Debt
Bear Stearns provided $300 million in secured financing to two of our
subsidiaries, in the form of a repurchase transaction under the January 2003
recapitalization. The Bear Stearns Debt matures in 2006, bears interest at a
rate equal to one-month LIBOR plus 3%, payable monthly, and requires quarterly
principal payments of $1.25 million. The principal payments will increase to
$1.875 million per quarter if a collateralized debt obligation transaction (or
CDO) is not completed by January 23, 2004. The interest rate will increase by
1%, to one-month LIBOR plus 4%, if Bear Stearns structures a CDO that meets
certain rating requirements and we decline to enter into such transaction.
Although CRIIMI MAE Inc. (unconsolidated) is not a primary obligor of the Bear
Stearns Debt, it has guaranteed all obligations under the debt. We paid a
commitment fee of 0.5% of the Bear Stearns Debt to Bear Stearns. We also paid
$250,000 of Bear Stearns' legal expenses.
On the effective date of our January 2003 recapitalization, we effected an
affiliate reorganization principally to indirectly secure the Bear Stearns Debt
with the equity interests in CBO-1 and CBO-2. As a result of the affiliate
reorganization, our REIT subsidiary (CBO REIT II), owns all bonds previously
pledged to secure the Exit Debt and indirectly owns all of the equity interests
in CBO-1 and CBO-2 (through its ownership of the two qualified REIT subsidiaries
which hold the equity interests in CBO-1 and CBO-2).
The Bear Stearns Debt is collateralized by first direct and/or indirect
liens on all of our subordinated CMBS, and is subject to a number of terms,
conditions and restrictions including, without limitation, scheduled principal
and interest payments, and restrictions and requirements with respect to the
collection and application of funds. The indirect first liens are first liens on
the equity interests of three of our subsidiaries that hold certain subordinated
CMBS. If the outstanding loan amount under the Bear Stearns Debt exceeds 85% of
the aggregate market value of the collateral securing the Bear Stearns Debt, as
determined by Bear Stearns in its sole good faith discretion, then Bear Stearns,
if, and as, permitted after the application of the terms of a netting agreement
entered into in connection with an interest rate swap (as described below), can
require us to transfer cash, cash equivalents or securities so that the
outstanding loan amount will be less than or equal to 80% of the aggregate
market value of the collateral (including any additional collateral provided).
Failure to meet any margin call could result in an event of default which would
enable Bear Stearns to exercise various rights and remedies including
acceleration of the maturity date of the Bear Stearns Debt and the sale of the
collateral. In order to meet a margin call, we may be required to sell assets at
prices lower than their carrying value which could result in losses.
Interest Rate Swap Agreement and Netting Agreement
During the second quarter of 2003, two of our subsidiaries (the primary
obligors of the Bear Stearns Debt) entered into an interest rate swap agreement
for the purpose of hedging the variability of expected future interest payments
on our anticipated CDO, as more fully described under Note 7. We have entered
into two interest rate swap transactions under this agreement in which we agreed
to pay Bear Stearns fixed interest rates of 3.946% and 4.055% per annum in
exchange for floating payments based on one-month LIBOR on notional amounts of
$50 million and $25 million, respectively. These swaps are effective on October
15, 2003, terminate on October 15, 2013 and provide for monthly interest
payments commencing November 15, 2003.
28
We anticipate that the interest rate swaps will be terminated or otherwise
disposed of, in each case subject to the consent of Bear Stearns, upon issuance
of the CDO.
Under the interest rate swap documents, our two subsidiaries have granted
to Bear Stearns a security interest in all of their rights, title and interest
in certain assets, including property now or hereafter held by Bear Stearns in
connection with the Bear Stearns Debt or the interest rate swap documents and
certain contract rights under the Bear Stearns Debt and interest rate swap
documents (including the subsidiaries' rights to any "margin excess" related to
the collateral securing the Bear Stearns Debt, with margin excess as defined in
the Bear Stearns Debt documents), to secure their obligations under the interest
rate swap documents and the Bear Stearns Debt. This security interest
constitutes additional collateral for the Bear Stearns Debt. Also under the
interest rate swap documents, on any day on which there exists any obligation
for us to deliver cash or additional eligible collateral under either the
interest rate swap or under the Bear Stearns Debt, such obligation will be
deemed satisfied to the extent there exists a margin excess under the Bear
Stearns Debt or an obligation for Bear Stearns to deliver cash or eligible
collateral under the interest rate swap. CRIIMI MAE Inc. has guaranteed all of
its subsidiaries' obligations under the interest rate swap documents, as well as
the Bear Stearns Debt.
BREF Debt
In connection with the January 2003 recapitalization, BREF Fund purchased
$30 million of our newly issued subordinated debt and, at our option, BREF Fund
will purchase up to an additional $10 million of subordinated debt prior to
January 23, 2004. The BREF Debt matures on January 23, 2006 and bears interest
at an annual rate of 15%. The interest on the BREF Debt is payable semi-annually
and there are no principal payments until maturity. If we decide to sell the
additional $10 million of subordinated debt to BREF Fund, it will bear interest
at an annual rate of 20% and mature on January 23, 2006. We have a right to
defer two-thirds of the interest on the BREF Debt, which we are currently
deferring, (and half on the additional $10 million, if sold to BREF Fund) during
its term. The BREF Debt is secured by first liens on the equity interests of two
of our subsidiaries. Although this effectively provides BREF Fund with an
indirect lien on all of our subordinated CMBS that are held by three of our
other lower-tier subsidiaries, Bear Stearns has first liens on the equity
interests of these three lower tier subsidiaries and on certain of the
subordinated CMBS held by one of these lower tier subsidiaries. Pursuant to an
intercreditor agreement between Brascan Real Estate Financial Investments LLC,
which we refer to as BREF Investments, and Bear Stearns, BREF Investments has
agreed that its indirect liens on Bear Stearns' first lien collateral are
subordinate to Bear Stearns' liens and has further agreed to contractual
restrictions on its ability to realize upon its indirect interest in the Bear
Stearns first lien collateral. We paid an origination fee of 0.67% to BREF
Investments related to the BREF Debt and an aggregate of $1 million for expenses
in connection with the transactions. Pursuant to the Investment Agreement with
BREF Investments, we are also obligated to pay BREF Investments a quarterly
maintenance fee of $434,000 through January 2006.
Exit Debt
The Exit Debt consisted of the Exit Variable-Rate Secured Borrowing, the
Series A Senior Secured Notes and the Series B Senior Secured Notes. The annual
interest rate on the Exit Variable-Rate Secured Borrowing, Series A Senior
Secured Notes and Series B Senior Secured Notes was LIBOR plus 3.25%, 11.75% and
20%, respectively. The Exit Debt was repaid in full during the three months
ended March 31, 2003.
Gain on Extinguishment of Exit Debt
During the three months ended March 31, 2003, we reversed approximately
$7.8 million of accrued extension fees related to the Exit Debt since the debt
was repaid and the extension fees were no longer payable. This reversal is
reflected as a gain on extinguishment of debt in our consolidated statement of
income. This reversal was partially offset by approximately $403,000 of breakage
fee paid to the lender of the Exit Variable-Rate Secured Borrowing and legal
fees of approximately $47,000, resulting in a gain on extinguishment of debt of
approximately $7.3 million.
Other Debt Related Information
Fluctuations in interest rates will continue to impact the value of our
mortgage assets and could result in margin calls and impact the net interest
margin through increased cost of funds on our variable rate debt and the
anticipated CDO. We have an interest rate cap and swaps to partially limit the
adverse effects of rising interest rates on our variable rate debt and the
anticipated CDO. When the cap expires, we will have interest rate risk to
29
the extent interest rates increase on our variable rate debt unless the cap is
replaced with another hedge or other steps, including the anticipated CDO, are
taken to mitigate this risk. Furthermore, with respect to the cap, we currently
have interest rate risk to the extent that the LIBOR interest rate increases
between the current rate and the cap rate. See Note 7 for further discussion of
our derivative financial instruments. As of June 30, 2003, our debt-to-equity
ratio was approximately 2.5 to 1 and our non-match-funded debt-to-equity ratio
was approximately 1 to 1.
The following table lists the fair market value of the collateral related
to our securitized mortgage obligations (in millions):
Collateral Fair Value as of
Securitized Mortgage Obligations June 30, 2003 December 31, 2002
- -------------------------------- ------------- -----------------
CMBS $ 340 $ 326
Freddie Mac Funding Note 118 146
Fannie Mae Funding Note 35 47
CMO 68 77
7. DERIVATIVE FINANCIAL INSTRUMENTS
In the second quarter of 2003, we entered into two interest rate swaps to
hedge the variability of the future interest payments on the anticipated CDO
attributable to changes in the U.S. swap rates. Our obligations to Bear Stearns
under the interest rate swap documents are collateralized by certain assets as
described in Note 6. These swaps are treated as cash flow hedges for GAAP. The
following is a summary of the terms of the interest rate swaps:
Date entered May 16, 2003 June 27, 2003
Notional amount $50 million $25 million
Effective date October 15, 2003 October 15, 2003
Maturity date October 15, 2013 October 15, 2013
Fixed rate 3.946% 4.055%
Floating rate 1 month U.S. LIBOR 1 month U.S. LIBOR
The swaps are intended to protect our cost of financing in connection with
our anticipated CDO transaction. We intend to terminate the swaps simultaneously
with the issuance of the CDO. As of June 30, 2003, the aggregate fair value of
the interest rate swaps was a liability of approximately $63,000.
As of June 30, 2003, we have an interest rate cap indexed to one-month
LIBOR to partially limit the adverse effects of potential rising interest rates
on our variable-rate debt. The interest rate cap provides protection to the
extent interest rates, based on a readily determinable interest rate index,
increase above the stated interest rate cap, in which case, we will receive
payments based on the difference between the index and the cap. At June 30,
2003, our interest rate cap had a fair value of $0 and had the following terms:
Notional Amount Effective Date Maturity Date Cap Index
- --------------- -------------- -------------- ---- -----
$ 175,000,000 (1) May 1, 2002 November 3, 2003 3.25% 1 month LIBOR (2)
(1) Our designated (as defined in SFAS No. 133) interest rate cap hedges
approximately 59% of our variable-rate secured debt as of June 30, 2003.
(2) One-month LIBOR was 1.12% at June 30, 2003.
We are exposed to credit loss in the event of non-performance by the
counterparties to the interest rate cap and interest rate swaps should interest
rates exceed the cap rate, or if the floating rate exceeds the fixed swap rates
respectively, however, we do not anticipate non-performance by the
counterparties. The counterparties (or the parent to the counterparty in the
case of the interest rate swaps) have long-term debt ratings of A or above by
S&P and A2 or above by Moody's. Although neither the cap nor swaps are
exchange-traded, there are a number of financial institutions which enter into
these types of transactions as part of their day-to-day activities.
30
8. DIFFERENCES BETWEEN FINANCIAL STATEMENT NET INCOME (LOSS) AND TAXABLE
LOSS
The differences between financial statement (GAAP) net income (loss) and
taxable income (loss) are generally attributable to differing treatment of
unrealized/realized gains and losses associated with certain assets; the bases,
income, impairment, and/or credit loss recognition related to certain assets;
and amortization of various costs. The distinction between GAAP net income
(loss) and taxable income (loss) is important to our shareholders because
dividends or distributions, if any, are declared and paid on the basis of
taxable income or taxable loss. We do not pay Federal income taxes as long as we
satisfy the requirements for exemption from taxation pursuant to the REIT
requirements of the Internal Revenue Code. We calculate our taxable income or
taxable loss, as if we were a regular domestic corporation. This taxable income
or taxable loss level determines the amount of dividends, if any, we are
required to distribute over time in order to eliminate our tax liability.
As a result of our trader election in early 2000, we recognized a
mark-to-market tax loss of approximately $478 million on certain trading
securities on January 1, 2000. The January 1, 2000 mark-to-market loss is
expected to be recognized evenly over four years through 2003 for tax purposes
(i.e., approximately $120 million per year) beginning with the year 2000.
A summary of our year-to-date net operating loss as of June 30, 2003 is as
follows (in millions):
January 2000 Loss $ (478.2)
LESS: Amounts recognized in 2002, 2001 and 2000 358.6
LESS: Amounts recognized during the six months ended June 30, 2003 59.8
---------
Balance remaining of January 2000 Loss to be recognized during the remainder of 2003 $ (59.8)
=========
Taxable income for the six months ended June 30, 2003 before recognition $ 15.3
of January 2000 Loss
LESS: January 2000 Loss recognized during the six months ended June 30, 2003 (59.8)
---------
Net Operating Loss for the six months ended June 30, 2003 $ (44.5)
=========
Accumulated Net Operating Loss through December 31, 2002 $ (223.8)
Net Operating Loss for the six months ended June 30, 2003 (44.5)
Net Operating Loss utilization -
---------
Net Operating Loss carried forward for use in future periods $ (268.3)
=========
Accumulated and unused net operating loss and remaining January 2000 Loss $ (328.1)
=========
31
9. SERVICING RESTRUCTURING AND SALE OF CMBS MASTER AND DIRECT SERVICING
RIGHTS
In April 2003, CMSLP restructured its property servicing group. In
connection with the restructuring, 15 employee positions are being eliminated in
the second and third quarters of 2003. The elimination of these positions
resulted in the termination of 11 employees. We recognized approximately
$144,000 of servicing restructuring expenses, representing employee severance
and related benefits, during the three months ended June 30, 2003. We expect to
recognize approximately $7,000 of restructuring expenses during the three months
ended September 30, 2003. In conjunction with this restructuring, we are
exploring various alternatives related to the servicing functions performed by
the property servicing group, including, but not limited to, outsourcing certain
responsibilities. There can be no assurance that we will be able to achieve such
alternatives. The table below provides a summary of the change in the liability
balance associated with the restructuring of our property servicing group. All
amounts in the accrual are severance and other employee benefits.
Balance, April 1, 2003 $ --
Amounts accrued 144,371
Amounts paid (113,822)
---------
Balance, June 30, 2003 $ 30,549
=========
In February 2002, CMSLP sold all of its rights and obligations under its
CMBS master and direct servicing contracts because the contracts were not
profitable, given the relatively small volume of master and direct CMBS
servicing that CMSLP was performing. In connection with this restructuring, 34
employee positions were eliminated. During the three months ended June 30, 2002,
CMSLP recognized a gain of approximately $4.8 million related to the sale. GAAP
required the gain to be deferred until the second quarter of 2002 due to the
contingencies related to the sale. As a result of this sale and related
restructuring, CMSLP recorded restructuring expenses in the fourth quarter of
2001. During the three months ended June 30, 2002, CMSLP recorded additional
restructuring expenses of $141,000 primarily related to rent on vacant office
space that was taking longer to sublease than originally anticipated.
10. RECAPITALIZATION EXPENSES
We consolidated our office space in connection with our January 2003
recapitalization and, as a result, we recorded approximately $532,000 of expense
for vacant office space during the three months ended June 30, 2003. The accrual
for the vacant space represents the fair value of lease payments through 2007, a
tenant improvement allowance and a broker commission, all net of estimated
sublease revenue in accordance with SFAS No. 146. In addition, as discussed in
Note 14, we recognized approximately $2.6 million of expenses related to the
termination of our former Chairman and former President during the three months
ended March 31, 2003.
During the three and six months ended June 30, 2002, we recognized
approximately $244,000 of recapitalization expenses related to the services
performed by our investment banking firm during the initial stages of our
exploration of strategic alternatives.
11. COMMON STOCK
We had 300,000,000 authorized shares and 15,201,685 and 13,945,068 issued
and outstanding shares of $0.01 par value common stock as of June 30, 2003 and
December 31, 2002, respectively. In connection with the January 2003
recapitalization, BREF Fund acquired 1,212,617 shares of our newly issued common
stock, or approximately 8% of our outstanding common stock after giving effect
to the share acquisition, at $11.50 per share, or approximately $13.9 million.
32
The following table summarizes the common stock activity through June 30,
2003:
Common Shares Balance of Common
Date Description Issued Shares Outstanding
- ------------------------- ----------------------------------------- ----------------- -------------------
December 31, 2002 Beginning balance 13,945,068
Shares issued to BREF Fund 1,212,617
Stock options exercised 5,000
- -------------------------------------------------------------------------------------------------------------
March 31, 2003 Balance 15,162,685
- -------------------------------------------------------------------------------------------------------------
Stock options exercised 39,000
- -------------------------------------------------------------------------------------------------------------
June 30, 2003 Balance 15,201,685
- -------------------------------------------------------------------------------------------------------------
In connection with the January 2003 recapitalization, BREF Fund also
received seven-year warrants to purchase up to 336,835 additional shares of
common stock at $11.50 per share. The fair value of the warrants was calculated
as approximately $2.6 million using the Black-Scholes option pricing model. The
assumptions we used to value the warrants are consistent with the assumptions
used to value our stock options. The warrants are a component of equity.
12. PREFERRED STOCK
As of June 30, 2003 and December 31, 2002, 75,000,000 shares of preferred
stock were authorized. As of June 30, 2003 and December 31, 2002, 3,000,000
shares were designated as Series B Cumulative Convertible Preferred Stock,
1,610,000 shares were designated as Series F Redeemable Cumulative Dividend
Preferred Stock, 3,760,000 shares were designated as Series G Redeemable
Cumulative Dividend Preferred Stock and 45,000 shares were designated as Series
H Junior Preferred Stock.
As of June 30, 2003, there were no accrued and unpaid dividends for any
series of our preferred stock. On August 14, 2003, we declared cash dividends of
$0.68, $0.30 and $0.375 per share of Series B, Series F and Series G Preferred
Stock, respectively, payable on September 30, 2003 to shareholders of record on
September 17, 2003.
Series B Cumulative Convertible Preferred Stock
As of June 30, 2003 and December 31, 2002, there were 1,593,982 shares of
Series B Preferred Stock issued and outstanding. The Series B Preferred Stock
provides for a dividend in an amount equal to the sum of (i) $0.68 per share per
quarter plus (ii) the product of the excess over $3.00, if any, of the quarterly
cash dividend declared and paid with respect to each share of common stock times
a conversion ratio of 0.4797 times one plus a conversion premium of 3%, subject
to further adjustment upon the occurrence of certain events. The following table
summarizes the 2003 dividend payment activity for the Series B Preferred Stock:
Time Period for
Dividends per Amount of Dividends which dividends
Declaration Date Payment Date Series B Share were accrued
-------------------------------------------------------------------------------------------------
March 5, 2003 March 31, 2003 $ 0.68 $ 1,083,908 4/01/02-6/30/02
May 15, 2003 June 30, 2003 $ 0.68 $ 1,083,908 7/01/02-9/30/02
June 3, 2003 June 30, 2003 $ 2.04 $ 3,251,723 10/01/02-6/30/03
As of June 30, 2003, each share of Series B Preferred Stock was convertible
into 0.4797 shares of common stock.
Series E Cumulative Convertible Preferred Stock
In March 2002, we redeemed all 173,000 outstanding shares of the Series E
Preferred Stock at the stated redemption price of $106 per share in cash plus
accrued and unpaid dividends through and including the date of redemption. The
total redemption price was $18,734,000 ($396,000 of which represented accrued
and unpaid dividends for the period October 1, 2001 through March 21, 2002). The
$1,038,000 difference between the
33
aggregate liquidation value and the redemption price is reflected as a
dividend on preferred stock during the six months ended June 30, 2002.
Series F Redeemable Cumulative Dividend Preferred Stock
As of June 30, 2003 and December 31, 2002, there were 586,354 shares of
Series F Preferred Stock issued and outstanding. The Series F Preferred Stock
provides for dividends at a fixed annual rate of 12%. The following table
summarizes the 2003 dividend payment activity for the Series F Preferred Stock:
Time Period for
Dividends per Amount of Dividends which dividends
Declaration Date Payment Date Series F Share were accrued
-------------------------------------------------------------------------------------------------
March 5, 2003 March 31, 2003 $ 0.30 $ 175,906 4/01/02-6/30/02
May 15, 2003 June 30, 2003 $ 0.30 $ 175,906 7/01/02-9/30/02
June 3, 2003 June 30, 2003 $ 0.90 $ 527,719 10/01/02-6/30/03
Series G Redeemable Cumulative Dividend Preferred Stock
As of June 30, 2003 and December 31, 2002, there were 1,244,656 shares of
Series G Preferred Stock issued and outstanding. The Series G Preferred Stock
provides for dividends at a fixed annual rate of 15%. The following table
summarizes the 2003 dividend payment activity for the Series G Preferred Stock:
Time Period for
Dividends per Amount of Dividends which dividends
Declaration Date Payment Date Series G Share were accrued
-------------------------------------------------------------------------------------------------
March 5, 2003 March 31, 2003 $ 0.375 $ 466,746 4/01/02-6/30/02
May 15, 2003 June 30, 2003 $ 0.375 $ 466,746 7/01/02-9/30/02
June 3, 2003 June 30, 2003 $ 1.125 $ 1,400,238 10/01/02-6/30/03
Series H Junior Preferred Stock
As of June 30, 2003 and December 31, 2002, there were no issued and
outstanding shares of Series H Preferred Stock.
34
13. EARNINGS PER SHARE
The following tables reconcile basic and diluted earnings per share for the
three and six months ended June 30, 2003 and 2002.
For the three months ended June 30, 2003 For the three months ended June 30, 2002
Per Share Per Share
Income Shares Amount Income Shares (2) Amount
--------------- --------------- -------------- --------------- --------------- -------------
Basic (loss) income per share:
Net (loss) income to common
shareholders $ (3,580,779) 15,176,070 $ (0.24) $ 2,295,745 13,915,490 $0.16
Dilutive effect of securities (1):
Stock options -- -- -- -- 151,459 --
Warrants outstanding -- -- -- -- -- --
Convertible preferred stock -- -- -- -- -- --
------------- ------------ ------------ ------------- --------------- --------
Diluted (loss) income per share:
(Loss) income to common shareholders
and assumed conversions $ (3,580,779) 15,176,070 $ (0.24) $ 2,295,745 14,066,949 $0.16
============= ============ ============ ============= =============== =========
For the six months ended June 30, 2003 For the six months ended June 30, 2002
Per Share Per Share
Income Shares Amount Income Shares (2) Amount
--------------- --------------- -------------- --------------- --------------- -------------
Net income before cumulative effect of
change in accounting principle $ 681,762 15,068,051 $ 0.05 $ 5,234,266 13,487,773 $ 0.39
Cumulative effect of change in
accounting principle related to
SFAS 142 -- -- -- (9,766,502) 13,487,773 (0.72)
------------- ------------ ---------- ------------- ------------- ---------
Basic income (loss) per share:
Net income (loss) to common
shareholders 681,762 15,068,051 0.05 (4,532,236) 13,487,773 (0.34)
Dilutive effect of securities (1):
Stock options -- 339,058 (0.01) -- -- --
Warrants outstanding -- -- -- -- -- --
Convertible preferred stock -- -- -- -- -- --
------------- ------------ ---------- ------------- ------------- ---------
Diluted income (loss) per share:
Income (loss) to common shareholders
and assumed conversions $ 681,762 15,407,109 $ 0.04 $ (4,532,236) 13,487,773 $ (0.34)
============= ============= ========== ============= =============== =========
(1) The common stock equivalents for stock options, the Preferred Stock that
is convertible and the warrants outstanding are not included in the
calculation of diluted EPS if the effect would be anti-dilutive.
(2) Includes the weighted average number of common shares payable or paid to
preferred stockholders related to dividends as of the respective dividend
declaration dates.
35
14. TRANSACTIONS WITH RELATED PARTIES
The following is a summary of the related party transactions which occurred
during the three and six months ended June 30, 2003 and 2002:
Three months ended June 30, Six months ended June 30,
2003 2002 2003 2002
---- ---- ---- ----
Amounts received or accrued from the AIM Limited
- ------------------------------------------------
Partnerships
------------
Income(1) $ 106,710 $ 144,182 $ 222,690 $ 290,631
Return of capital(2) 720,860 206,946 954,402 1,052,048
---------- ---------- ------------ ------------
Total $ 827,570 $ 351,128 $ 1,177,092 $ 1,342,679
========== ========== ============ ============
Amounts received or accrued from AIM Acquisition
Limited Partnership (1) $ 42,423 $ 60,418 $ 90,881 $ 121,394
========== ========== ============ ============
Expense reimbursements from AIM Limited
Partnerships (3) $ 69,623 $ 43,729 $ 111,107 $ 95,227
========== ========== ============ ============
Expense reimbursements to affiliates of BREF
Fund and employees of those affiliates (3) $ 10,660 $ - $ 18,112 $ -
========== ========== ============ ============
Expense reimbursement (to) from CRI:
- ------------------------------------
Expense reimbursement to CRI (3) (4) $ (26,217) $ (46,305) $ (75,991) $ (89,762)
Expense reimbursement from CRI (3) (4) 19,044 53,538 72,479 76,438
---------- ---------- ------------ ------------
Net expense reimbursement (to) from CRI $ (7,173) $ 7,233 $ (3,512) $ (13,324)
========== ========== ============ ============
(1) Included as equity in (losses) earnings from investments on the accompanying
consolidated statements of income.
(2) Included as a reduction of equity investments on the accompanying
consolidated balance sheets.
(3) Included in general and administrative expenses on the accompanying
consolidated statements of income.
(4) Pursuant to an administrative services agreement between us and CRI, CRI
provided us with certain administrative and office facility services and
other services, at cost, with respect to certain aspects of our business.
We used the services provided under the administrative services agreement to
the extent such services were not performed by CRIIMI MAE Management or
provided by another service provider. The administrative services agreement
was terminable on 30 days notice at any time. The majority of such services
under this agreement were terminated in March 2003. Our former Chairman, who
is currently one of our directors, is a director, executive officer and
principal shareholder of CRI.
As previously discussed, Barry Blattman, our Chairman, CEO and President,
is affiliated with BREF Fund and BREF Investments. The Board's Compensation and
Stock Option Committee is considering various alternatives with respect to the
employment arrangement for Mr. Blattman. We have accrued approximately $289,000
in estimated compensation as of June 30, 2003 which is expected to be payable in
connection with Mr. Blattman's employment.
As discussed in Note 6, we paid BREF Investments an origination fee of
0.67% related to the BREF Debt and an aggregate of $1.0 million for expenses in
connection with the January 2003 recapitalization transactions. Pursuant to the
Investment Agreement with BREF Investments, we are obligated to pay BREF
Investments a quarterly maintenance fee of $434,000. As discussed in Note 11, in
connection with the January 2003 recapitalization, we issued seven-year warrants
to BREF Fund to purchase up to 336,835 shares of our common stock at $11.50 per
share. There are also other existing and potential relationships, transactions
and agreements with BREF Fund and/or certain of its affiliates (including BREF
Investments) relating to the composition of our Board of Directors, additional
subordinated debt financing, non-competition and other matters.
In connection with the January 2003 recapitalization, we amended the
employment contracts of our former Chairman, William B. Dockser, and former
President, H. William Willoughby, to provide for their termination on January
23, 2003. During the three months ended March 31, 2003, we recognized
approximately $2.6 million of expenses related to severance and related benefit
payments, and accelerated vesting of certain outstanding stock options held by
Messrs. Dockser and Willoughby. These expenses are reflected as
recapitalization expenses in our consolidated statement of income.
36
In addition to the transactions listed above, in connection with the Merger
in 1995, we entered into a deferred compensation arrangement with William
Dockser, Chairman until January 23, 2003 (a Director after January 23, 2003),
and H. William Willoughby, President and a Director until January 23, 2003, in
an original aggregate amount of $5,002,183 pursuant to which we agreed to pay
Messrs. Dockser and Willoughby for services performed in connection with the
structuring of the Merger. Our obligation to pay the deferred compensation is
limited, with certain exceptions, to the creation of an irrevocable grantor
trust for the benefit of Messrs. Dockser and Willoughby and the transfer to such
trust of the right to receive such deferred compensation (the Note Receivable)
in the original aggregate principal amount of $5,002,183. The deferred
compensation is fully vested and payable only to the extent that payments are
made by CRI on the Note Receivable. Payments of principal and interest on the
Note Receivable/deferred compensation are payable quarterly and terminate in
June 2005. The Note Receivable/deferred compensation bears interest at the prime
rate (4.00% as of June 30, 2003) plus 2% per annum. During the six months ended
June 30, 2003 and 2002, aggregate payments of approximately $292,000 and
$313,000, respectively, were made on the Note Receivable/deferred compensation.
These aggregate payments were split approximately equally among Messrs. Dockser
and Willoughby. The unpaid aggregate principal balance on the note
receivable/deferred compensation was $1,125,478 at June 30, 2003. The financial
statement impact of these transactions is immaterial.
On July 24, 2003, we entered into amendments to the employment agreements
with Mr. David B. Iannarone (our Executive Vice President), Mrs. Cynthia O.
Azzara (our Senior Vice President, Chief Financial Officer and Treasurer) and
Mr. Brian L. Hanson (our Senior Vice President), pursuant to which the
employment term was changed to August 25, 2003. We are obligated to pay
severance and related benefit payments to the executives if we and the
executives have not reached a mutual agreement with respect to continued
employment. These severance and related benefit payments are estimated to
aggregate approximately $3.3 million and would be reflected as an expense in our
Consolidated Statement of Income during the three months ended September 30,
2003.
On August 13, 2003, our Board of Directors appointed Mark Jarrell, a
Director, as our President and Chief Operating Officer effective September 15,
2003. Mr. Jarrell resigned from our Board on August 13, 2003 after his
appointment by the Board. In conjunction with the appointment of Mr. Jarrell,
Mr. Blattman resigned as our President effective September 15, 2003. Mr.
Blattman will continue as our Chairman and Chief Executive Officer. Mr. Jarrell
will be paid an annual base salary of $400,000 with a guaranteed minimum bonus
of $200,000 annually ($100,000 for the remainder of 2003). In connection with
his appointment, Mr. Jarrell is being granted approximately 58,000 shares of
restricted common stock on September 15, 2003, valued at $666,667 based on the
closing price of our common stock on August 12, 2003, under our 2001 Stock
Incentive Plan. This initial grant will vest 25% on December 31, 2003 and 75% on
December 31, 2004. In addition, Mr. Jarrell will be granted shares of common
stock equivalent to $500,000 on each of December 31, 2005 and 2006, provided he
is employed by us on those dates and subject to certain terms of his Employment
Offer Letter Agreement dated August 11, 2003 as included in an Exhibit herein.
We expect to recognize approximately $167,000 of compensation expense related to
the restricted common stock award during the remainder of 2003 and approximately
$500,000 of compensation expense during 2004.
15. SEGMENT REPORTING
Management assesses our performance and allocates capital principally on
the basis of two lines of business: portfolio investment and mortgage servicing.
These two lines of business are managed separately as they provide different
sources and types of revenues.
Portfolio investment primarily includes (i) acquiring subordinated CMBS,
(ii) securitizing pools of mortgage loans and pools of CMBS, (iii) direct and
indirect investments in government insured mortgage securities and entities that
own government insured mortgage securities and mezzanine loans and (iv)
securities trading activities. Our income from this segment is primarily
generated from these assets.
Mortgage servicing, which consists of all the operations of CMSLP,
primarily includes performing servicing functions with respect to the mortgage
loans underlying our CMBS. CMSLP performs a variety of servicing including
special servicing and loan management. For these services, CMSLP earns a
servicing fee which is calculated as a percentage of the principal amount of the
servicing portfolio typically paid when the related service is rendered. These
services may include either routine monthly services, non-monthly periodic
services or event-triggered services. In acting as a servicer, CMSLP also earns
other income which includes, among other things, assumption fees and
modification fees. Overhead expenses, such as administrative expenses, are
allocated either directly to each business line or through estimates based on
factors such as number of personnel or square footage of office space.
The following tables detail the financial performance of these operating
segments for the three and six months ended June 30, 2003 and 2002. The basis of
accounting used in the tables is GAAP.
37
As of and for the three months ended June 30, 2003
------------------------------------------------------------------------------------
Elimination of
Portfolio Mortgage Intercompany
Investment Servicing Transactions Consolidated
------------------- ---------------- ------------------- ------------------
Interest income $ 26,388,876 $ - $ - $ 26,388,876
Interest expense (15,430,292) - - (15,430,292)
------------------- ---------------- ------------------- ------------------
Net interest margin 10,958,584 - - 10,958,584
------------------- ---------------- ------------------- ------------------
General and administrative expenses (2,583,244) - (276,467) (2,859,711)
Depreciation and amortization (145,534) - - (145,534)
Impairment on CMBS (8,947,878) - - (8,947,878)
Servicing income - 2,765,026 - 2,765,026
Servicing general and administrative expenses - (2,369,621) 276,467 (2,093,154)
Servicing amortization, depreciation
and impairment - (554,490) - (554,490)
Servicing restructuring expenses - (144,371) - (144,371)
Income tax benefit (expense) - 13,854 - 13,854
Equity in (losses) earnings from investments (6,933) - - (6,933)
Other, net 116,607 - - 116,607
BREF Maintenance fee (424,356) - - (424,356)
Recapitalization expenses (531,863) - - (531,863)
Gain on extinguishment debt - - - -
------------------- ---------------- ------------------- ------------------
(12,523,201) (289,602) - (12,812,803)
------------------- ---------------- ------------------- ------------------
Net income (loss) before changes in
accounting principles $ (1,564,617) $ (289,602) $ - $ (1,854,219)
=================== ================ =================== ==================
Total assets $ 1,153,752,894 $ 12,010,727 $ - $ 1,165,763,621
=================== ================ =================== ==================
As of and for the three months ended June 30, 2002
------------------------------------------------------------------------------------
Elimination of
Portfolio Mortgage Intercompany
Investment Servicing Transactions Consolidated
------------------- ---------------- ------------------- ------------------
Interest income $ 31,743,348 $ - $ - $ 31,743,348
Interest expense (23,185,362) - - (23,185,362)
------------------- ---------------- ------------------- ------------------
Net interest margin 8,557,986 - - 8,557,986
------------------- ---------------- ------------------- ------------------
General and administrative expenses (2,738,135) - 58,275 (2,679,860)
Depreciation and amortization (368,564) - - (368,564)
Impairment on CMBS (5,151,091) - - (5,151,091)
Servicing income - 2,620,190 (126,153) 2,494,037
Servicing general and administrative expenses - (2,202,768) 67,878 (2,134,890)
Servicing amortization, depreciation
and impairment - (402,931) - (402,931)
Servicing restructuring expenses - (141,240) - (141,240)
Servicing gain on sale of servicing rights - 4,817,598 - 4,817,598
Income tax benefit (expense) - (975,220) - (975,220)
Equity in (losses) earnings from investments 118,438 - - 118,438
Other, net 132,486 - - 132,486
Recapitalization expenses (244,444) - - (244,444)
------------------- ---------------- ------------------- ------------------
(8,251,310) 3,715,629 - (4,535,681)
------------------- ---------------- ------------------- ------------------
Net income (loss) before changes in
accounting principles $ 306,676 $ 3,715,629 $ - $ 4,022,305
=================== ================ =================== ==================
Total assets $ 1,251,963,947 $ 26,380,307 $ - $ 1,278,344,254
=================== ================ =================== ==================
38
As of and for the six months ended June 30, 2003
------------------------------------------------------------------------------------
Elimination of
Portfolio Mortgage Intercompany
Investment Servicing Transactions Consolidated
------------------- ---------------- ------------------- ------------------
Interest income $ 53,112,746 $ - $ - $ 53,112,746
Interest expense (37,335,503) - 2,702 (37,332,801)
------------------- ---------------- ------------------- ------------------
Net interest margin 15,777,243 - 2,702 15,779,945
------------------- ---------------- ------------------- ------------------
General and administrative expenses (5,392,926) - (415,427) (5,808,353)
Depreciation and amortization (318,824) - - (318,824)
Impairment on CMBS (8,947,878) - - (8,947,878)
Servicing income - 4,892,289 (2,702) 4,889,587
Servicing general and administrative expenses - (4,739,552) 415,427 (4,324,125)
Servicing amortization, depreciation
and impairment - (887,752) - (887,752)
Servicing restructuring expenses - (144,371) - (144,371)
Income tax benefit (expense) - 186,230 - 186,230
Equity in (losses) earnings from investments 121,335 - - 121,335
Other, net 295,671 - - 295,671
BREF Maintenance fee (795,667) - - (795,667)
Recapitalization expenses (3,148,841) - - (3,148,841)
Gain on extinguishment debt 7,337,424 - - 7,337,424
------------------- ---------------- ------------------- ------------------
(10,849,706) (693,156) (2,702) (11,545,564)
------------------- ---------------- ------------------- ------------------
Net income (loss) before changes in
accounting principles $ 4,927,537 $ (693,156) $ - $ 4,234,381
=================== ================ =================== ==================
Total assets $ 1,153,752,894 $ 12,010,727 $ - $ 1,165,763,621
=================== ================ =================== ==================
As of and for the six months ended June 30, 2002
------------------------------------------------------------------------------------
Elimination of
Portfolio Mortgage Intercompany
Investment Servicing Transactions Consolidated
------------------- ---------------- ------------------- ------------------
Interest income $ 63,775,227 $ - $ - $ 63,775,227
Interest expense (46,491,577) - - (46,491,577)
------------------- ---------------- ------------------- ------------------
Net interest margin 17,283,650 - - 17,283,650
------------------- ---------------- ------------------- ------------------
General and administrative expenses (6,008,075) - 125,601 (5,882,474)
Depreciation and amortization (608,540) - - (608,540)
Impairment on CMBS (5,151,091) - - (5,151,091)
Servicing income - 5,582,308 (324,735) 5,257,573
Servicing general and administrative expenses - (4,825,118) 199,134 (4,625,984)
Servicing amortization, depreciation
and impairment - (910,810) - (910,810)
Servicing restructuring expenses - (141,240) - (141,240)
Servicing gain on sale of servicing rights - 4,817,598 - 4,817,598
Income tax benefit (expense) - (908,776) - (908,776)
Equity in (losses) earnings from investments 232,742 - - 232,742
Other, net 777,812 - - 777,812
Recapitalization expenses (244,444) - - (244,444)
------------------- ---------------- ------------------- ------------------
(11,001,596) 3,613,962 - (7,387,634)
------------------- ---------------- ------------------- ------------------
Net income (loss) before changes in
accounting principles $ 6,282,054 $ 3,613,962 $ - $ 9,896,016
=================== ================ =================== ==================
Total assets $ 1,251,963,947 $ 26,380,307 $ - $ 1,278,344,254
=================== ================ =================== ==================
39
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS. When used in this Quarterly Report on Form 10-Q, in
future filings with the Securities and Exchange Commission (the SEC or the
Commission), in our press releases or in our other public or shareholder
communications, the words "believe," "anticipate," "expect," "contemplate,"
"may," "will" and similar expressions are intended to identify forward-looking
statements. Statements looking forward in time are included in this Quarterly
Report on Form 10-Q pursuant to the "safe harbor" provision of the Private
Securities Litigation Reform Act of 1995. Such statements are subject to certain
risks and uncertainties, which could cause actual results to differ materially,
including, but not limited to, the risk factors contained or referenced herein
and in our reports filed with the SEC pursuant to the Securities Exchange Act of
1934, as amended, including our Annual Report on Form 10-K for the year ended
December 31, 2002. Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date hereof. We undertake
no obligation to publicly revise these forward-looking statements to reflect
events or circumstances occurring after the date hereof or to reflect the
occurrence of anticipated or unanticipated events.
Business
CRIIMI MAE Inc. (together with its consolidated subsidiaries, unless the
context otherwise indicates, We or CRIIMI MAE) is a commercial mortgage company
structured as a self-administered real estate investment trust (or REIT). We
currently own and manage, primarily through our servicing subsidiary, CRIIMI MAE
Services Limited Partnership (CMSLP or CRIIMI MAE Services), a significant
portfolio of commercial mortgage-related assets. We have focused primarily on
non-investment grade (rated below BBB- or unrated) commercial mortgage-backed
securities (subordinated CMBS). As the holder of the most subordinate tranches,
we are exposed to a higher risk of losses, but we also have the potential for
enhanced returns.
Our core holdings are subordinated CMBS ultimately backed by pools of
commercial mortgage loans on hotel, multifamily, retail and other commercial
real estate. We also own directly and indirectly government-insured mortgage
backed securities and a limited number of other assets. We also are a trader in
CMBS, residential mortgage-backed securities, agency debt securities and other
fixed income securities.
January 2003 Recapitalization
On January 23, 2003, we completed a recapitalization of the secured debt
incurred upon our emergence from Chapter 11 in April 2001 (the Exit Debt). This
recapitalization was funded with approximately $344 million in proceeds from
debt and equity financings and a portion of our available cash and liquid
assets.
The recapitalization included:
o BREF Equity and Secured Debt. - We issued approximately $14 million in
common equity and $30 million in secured subordinated debt to Brascan
Real Estate Finance Fund I L.P., a private asset management fund
established by Brascan Corporation and a New York-based management
team. We refer to the secured subordinated debt as the BREF Debt and
Brascan Real Estate Finance Fund I L.P. as BREF Fund.
o Bear Stearns Secured Financing. - We received $300 million in secured
financing in the form of a repurchase transaction from a unit of Bear,
Stearns & Co., Inc. We refer to the secured financing as the Bear
Stearns Debt and the unit of Bear Stearns and Co., Inc. as Bear
Stearns.
o New Leadership. - Additions to management, including Barry S.
Blattman as Chairman of the Board, Chief Executive Officer and
President. Mr. Blattman has more than 15 years of experience in
commercial real estate finance, which included overseeing the real
estate debt group at Merrill Lynch from 1996 to 2001. Mr. Blattman is
also the managing member of Brascan Real Estate Financial Partners LLC,
which owns 100% of the general partner of BREF Fund. In addition on
August 13, 2003, our Board of Directors appointed Mark R. Jarrell, a
Director, as President and Chief Operating Officer effective
September 15, 2003 as discussed in "Executive Employment Agreements".
Mr. Blattman will continue as our Chairman of the Board and Chief
Executive Officer.
40
The recapitalization increases our financial flexibility primarily through
the elimination of the requirement to use virtually all of our net cash flow to
pay down principal on the Exit Debt. This, along with the elimination of REIT
distribution requirements due to our net operating losses (NOLs), provides us
with additional liquidity for mortgage-related investments and acquisitions and
other corporate purposes. We presently intend to use substantially all of our
net cash flow for acquisitions and investments, hedging activities and general
working capital purposes. See "Financial Condition, Liquidity and Capital
Resources" for a more complete description of the recapitalization.
Risks
Our business is subject to a number of risks and uncertainties including,
but not limited to: (1) risks associated with substantial indebtedness or
leverage; (2) borrowing and refinancing risks; (3) risks associated with
potential margin or collateral calls under the Bear Stearns Debt and interest
rate swap documents; (4) the limited protection provided by hedging
transactions; (5) inherent risks in owning subordinated CMBS; (6) the limited
liquidity of the subordinated CMBS market; (7) continuing adverse effects of
terrorist attacks, threats of further terrorist attacks, acts of war, the
economic slowdown and/or recession and other matters on defaults and losses
related to the mortgages underlying our CMBS portfolio; (8) risks associated
with our ability to implement business strategies and achieve business goals;
(9) failure to manage the mismatch between long-term assets and short-term
funding; (10) risk of loss of REIT status and other tax matters; (11) the effect
of interest rate compression on the market price of our stock; (12) the effect
of the yield curve on borrowing costs; (13) results of operations adversely
affected by factors beyond our control; (14) competition; (15) risk of becoming
subject to the requirements of the Investment Company Act of 1940; (16) the
effect of phantom (non-cash) income on total income; and (17) taxable mortgage
pool risk.
Business Segments
Management assesses our performance and allocates resources principally on
the basis of two lines of business: portfolio investment and mortgage servicing.
These two lines of business, or operating segments, are managed separately as
they provide different sources and types of revenues.
2003 compared to 2002
Results of Operations
Financial statement net loss to common shareholders for the three months
ended June 30, 2003 was approximately $(3.6) million, or $(0.24) per diluted
share. This compares to net income available to common shareholders of
approximately $2.3 million, or $0.16 per diluted share, for the three months
ended June 30, 2002. Results for the three months ended June 30, 2003, which are
discussed in further detail below, include approximately $8.9 million of
impairment charges related to certain subordinated CMBS. Results for the three
months ended June 30, 2002, which are discussed in further detail below,
include, approximately $5.2 million of impairment charges related to certain
subordinated CMBS and approximately $4.8 million from the gain on the sale of
master and direct servicing rights by CMSLP.
Financial statement net income available to common shareholders for the six
months ended June 30, 2003 was approximately $682,000, or $0.04 per diluted
share. This compares to a net loss to common shareholders of approximately
$(4.5) million, or $(0.34) per diluted share, for the six months ended June 30,
2002.
Results for the six months ended June 30, 2003, which are discussed in
further detail below, include:
o approximately $8.9 million of impairment charges related to certain
subordinated CMBS;
o approximately $7.3 million of gain on extinguishment of debt;
o approximately $3.1 million of recapitalization expenses;
o approximately $3.1 million of additional interest expense during the
45 day redemption notice period for the Series A and Series B Senior
Secured Notes; and
o approximately $1.0 million of higher interest expense during the first
23 days of 2003 under the Exit Debt as compared to the remainder of
the quarter with respect to the Bear Stearns and BREF Debt.
41
Results for the six months ended June 30, 2002, which are discussed in
further detail below, include:
o approximately $5.2 million of impairment charges related to certain
subordinated CMBS;
o an approximate $9.8 million charge to write-off goodwill upon the
adoption of Statement of Financial Accounting Standards (or SFAS)
No. 142;
o approximately $4.8 million from the gain on the sale of master and
direct servicing rights by CMSLP; and
o approximately $1.0 million reflected as an additional dividend on
preferred stock in connection with the redemption of the Series E
Preferred Stock (representing the difference between the aggregate
liquidation value and the redemption price).
Interest Income - CMBS
Interest income from CMBS decreased by approximately $3.5 million, or 14%,
to $22.1 million during the three months ended June 30, 2003 as compared to
$25.6 million during the three months ended June 30, 2002. Interest income from
CMBS decreased by approximately $6.9 million, or 14%, to $44.2 million during
the six months ended June 30, 2003 as compared to $51.1 million during the six
months ended June 30, 2002. These decreases in interest income were primarily
due to changes in our loss estimates related to CMBS and the resulting reduction
in the weighted average yield-to-maturity on our CMBS. The changes resulted in
the aggregate $70.2 million of non-cash impairment charges that were recognized
during the second through fourth quarters of 2002.
Accounting principles generally accepted in the United States, or GAAP,
require that interest income earned on CMBS be recorded based on the effective
interest method using the anticipated yield over the expected life of the CMBS.
Based upon assumptions as to the timing and amount of future credit losses and
certain other items estimated by management, the weighted average anticipated
unleveraged yield for our CMBS for financial statement purposes was
approximately 12.4% as of January 1, 2002, approximately 11.6% as of January 1,
2003 and approximately 11.7% as of July 1, 2003. These yields were determined
based on the anticipated yield over the expected life of our CMBS, which
considers, among other things, anticipated losses and any other than temporary
impairment.
The effective interest method of recognizing interest income on CMBS
results in income recognition that differs from cash received. During the six
months ended June 30, 2003, we recognized approximately $5.6 million of discount
amortization, partially offset by approximately $3.0 million of cash received in
excess of income recognized on subordinated CMBS due to the effective interest
method. During the six months ended June 30, 2002, we recognized approximately
$5.7 million of discount amortization, partially offset by approximately $1.9
million of cash received in excess of income recognized on subordinated CMBS due
to the effective interest method.
Interest Income - Insured Mortgage Securities
Interest income from insured mortgage securities decreased by approximately
$1.9 million, or 30%, to $4.3 million for the three months ended June 30, 2003
from $6.1 million for the three months ended June 30, 2002. This decrease was
principally due to the prepayment or partial prepayment of 26 mortgages
underlying the insured mortgage securities, representing approximately 28% of
the total insured mortgage portfolio, from June 30, 2002 through June 30, 2003.
Interest income from insured mortgage securities decreased by approximately
$3.7 million, or 29%, to $8.9 million for the six months ended June 30, 2003
from $12.6 million for the six months ended June 30, 2002. As discussed above,
this decrease was primarily due to the prepayment of mortgages underlying the
insured mortgage securities.
During the six months ended June 30, 2003, twelve mortgages prepaid and one
mortgage partially prepaid resulting in net proceeds of $48.1 million. The
prepayment activity corresponds with the low mortgage interest rate environment
during this period and the expiration of prepayment lock-out periods on many of
the underlying mortgages. These prepayments result in corresponding reductions
in the outstanding principal balances of the collateralized mortgage
obligations-insured mortgage securities and the related interest expense. In
addition, in January 2003 we sold an unencumbered GNMA security for
approximately $5.7 million. Approximately 20% (based on amortized cost) of the
insured mortgage loans prepaid, partially prepaid or were sold during the six
months ended June 30, 2003.
42
Interest Expense
Interest expense of approximately $15.4 million for the three months ended
June 30, 2003 was approximately $7.8 million lower than interest expense of
approximately $23.2 million for the same period in 2002. The net decrease is
primarily attributable to a lower average debt balance during the second quarter
of 2003 ($831 million) compared to 2002 ($988 million) and a lower average
effective interest rate on the total debt outstanding during the second quarter
of 2003 (7.4%) compared to 2002 (9.4%).
Interest expense of approximately $37.3 million for the six months ended
June 30, 2003 was approximately $9.2 million lower than interest expense of
approximately $46.5 million for the same period in 2002. The net decrease is
primarily attributable to a lower average debt balance during the six months
ended June 30, 2003 ($908 million) compared to 2002 ($999 million) and a lower
average effective interest rate on the total debt outstanding during 2003
(8.2%), including approximately $3.1 million of additional interest as discussed
below, compared to 2002 (9.3%).
On January 23, 2003, amounts were deposited with the indenture trustee to
pay all principal and interest on our outstanding Series A and Series B Senior
Secured Notes on the March 10, 2003 redemption date. This redemption required 45
days prior notice. These notes were not considered repaid for GAAP purposes
until the March 10, 2003 redemption date. The 45 day notice period resulted in
approximately $3.1 million of additional interest expense during the period
January 23, 2003 through March 10, 2003 since the Bear Stearns Debt, BREF Debt,
and the senior secured notes were outstanding at the same time. In addition, our
interest expense was approximately $1.0 million higher during the first 23 days
of 2003 under the Exit Debt as compared to the remainder of the quarter with
respect to the Bear Stearns and BREF Debt.
The overall weighted average effective interest rate on the Bear Stearns
and BREF Debt was 5.9% and 5.8% for the three and six months ended June 30,
2003, respectively, and the weighted average coupon (pay) rate on the Bear
Stearns and BREF Debt was 4.4% and 4.3% during the same periods. The difference
in the weighted average effective interest rate and the weighted average coupon
(pay) rate primarily relates to the deferral of two-thirds of the interest on
the BREF Debt. The weighted average effective interest rate on the Exit Debt was
10.3% for the three and six months ended June 30, 2002. The weighted average
coupon (pay) rate on the Exit Debt was 8.0% during the same periods.
Interest expense on the collateralized mortgage obligations-insured
mortgage securities decreased following significant prepayments of mortgages
underlying the insured mortgage securities, as discussed previously. The
decrease in interest expense on the collateralized mortgage obligations-insured
mortgage securities was partially offset by approximately $85,000 and $1.1
million of additional discount and deferred fees amortization expenses during
the three and six months ended June 30, 2003, respectively, which are reflected
as interest expense, compared to approximately $397,000 and $759,000 of
additional amortization expenses during the three and six months ended June 30,
2002, respectively. These additional expenses are the result of the mortgages
prepaying faster than anticipated which, under the effective interest method of
recognizing interest expense, required an adjustment to cumulative interest
expense.
General and Administrative Expenses
General and administrative expenses increased by approximately $180,000 to
$2.9 million during the three months ended June 30, 2003 as compared to $2.7
million during the three months ended June 30, 2002 primarily due to lower legal
fees during the three months ended June 30, 2002.
General and administrative expenses decreased by approximately $74,000 to
$5.8 million during the six months ended June 30, 2003 as compared to $5.9
million during the six months ended June 30, 2002 primarily due to a decrease in
legal fees in 2003, partially offset by an increase in office rent expense.
43
Depreciation and Amortization
Depreciation and amortization was approximately $146,000 and $369,000
during the three months ended June 30, 2003 and 2002, respectively, and
approximately $319,000 and $609,000 during the six months ended June 30, 2003
and 2002, respectively. The decreases in depreciation and amortization are
primarily attributable to a lower balance of depreciable assets in 2003 as
compared to 2002.
Mortgage Servicing
The following is a summary of the consolidated results of operations of
CMSLP (in thousands):
Three months ended June 30, Six months ended June 30,
Description 2003 2002 2003 2002
----------- ---- ---- ---- ----
Servicing revenue $ 2,765 $ 2,494 $ 4,890 $ 5,258
Servicing general and administrative expenses (2,093) (2,135) (4,324) (4,626)
Servicing amortization, depreciation and
impairment (555) (403) (888) (911)
Servicing restructuring expenses (144) (141) (144) (141)
Servicing gain on sale of servicing rights -- 4,818 -- 4,818
---------- -------- --------- --------
GAAP net (loss) income from CMSLP $ (27) $ 4,633 $ (466) $ 4,398
========== ======== ========= ========
The net loss from CMSLP of approximately $(27,000) for the three months
ended June 30, 2003 compares to net income of approximately $4.6 million for the
three months ended June 30, 2002. CMSLP's 2002 results include a $4.8 million
gain from the sale of servicing rights. CMSLP's total revenue increased by
approximately $271,000 to approximately $2.8 million during the three months
ended June 30, 2003 compared to $2.5 million during the three months ended June
30, 2002. This increase is primarily the result of the recovery of $285,000 of
legal fees that were paid in a previous year. General and administrative
expenses were $2.1 million during the three months ended June 30, 2003 and 2002.
During the three months ended June 30, 2003, amortization, depreciation and
impairment expenses were approximately $555,000 as compared to $403,000 in 2002.
This increase was primarily the result of an impairment charge of approximately
$198,000 during 2003 related to the subadvisory contracts with the AIM Limited
Partnerships (which are four publicly traded limited partnerships that hold
insured mortgages and whose general partner is one of our subsidiaries), as
discussed below.
The net loss from CMSLP of approximately $(466,000) for the six months
ended June 30, 2003 compares to net income of approximately $4.4 million for the
six months ended June 30, 2002. As previously discussed, CMSLP's 2002 results
include a $4.8 million gain from the sale of servicing rights. CMSLP's total
revenue decreased by approximately $368,000 to approximately $4.9 million during
the six months ended June 30, 2003 compared to $5.3 million during the six
months ended June 30, 2002. This decrease is primarily the result of CMSLP's
sale of its master and direct servicing contracts in February 2002 which reduced
mortgage servicing income and interest income earned on the escrow balances,
partially offset by a recovery of $285,000 of legal fees that were paid in a
previous year. General and administrative expenses were $4.3 million and $4.6
million during the six months ended June 30, 2003 and 2002, respectively. The
$302,000 decrease in general and administrative expenses was primarily
attributable to the staff reductions that occurred in the first quarter of 2002
following the sale of the servicing contracts. During the six months ended June
30, 2003, amortization, depreciation and impairment expenses aggregated
approximately $888,000 as compared to $911,000 in 2002. This decrease was
primarily the result of the sale of servicing rights in February 2002, which
reduced amortization expense, partially offset by an impairment charge of
approximately $198,000 during 2003 related to the subadvisory contracts with the
AIM Limited Partnerships, as discussed below.
During the six months ended June 30, 2003, the AIM Limited Partnerships
experienced a significant amount of prepayments of their insured mortgages
(which corresponded with the low interest rate environment). These prepayments
reduced CMSLP's cash flow from its subadvisory contracts with the AIM Limited
Partnerships. As a result, in accordance with SFAS No. 142, "Goodwill and Other
Intangible Assets," and SFAS No. 144, "Accounting for the Impairment or Disposal
of Long-Lived Assets," we evaluated CMSLP's investment in the subadvisory
contracts for impairment. Our estimated future undiscounted cash flows from this
investment were
44
projected to be less than the book value on the investment as of June 30,
2003. As a result, we believed that CMSLP's investment in the subadvisory
contracts was impaired at June 30, 2003. We estimated the fair value of the
investment using a discounted cash flow methodology. We wrote down the value of
CMSLP's investment in the subadvisory contracts with the AIM Limited
Partnerships and recorded an impairment charge of approximately $198,000 as of
June 30, 2003.
In April 2003, CMSLP restructured its property servicing group. In
connection with the restructuring, 15 employee positions are being eliminated in
the second and third quarters of 2003. The elimination of these positions
resulted in the termination of 11 employees. We recognized approximately
$144,000 of servicing restructuring expenses, representing employee severance
and related benefits, during the three months ended June 30, 2003. We expect to
recognize approximately $7,000 of restructuring expenses during the three months
ended September 30, 2003. In conjunction with this restructuring, we are
exploring various alternatives related to the servicing functions performed by
the property servicing group, including, but not limited to, outsourcing certain
responsibilities. There can be no assurance that we will be able to achieve such
alternatives.
Equity in (Losses) Earnings from Investments
Total equity in (losses) earnings from investments of approximately
$(7,000) and $118,000 for the three months ended June 30, 2003 and 2002,
respectively, and approximately $121,000 and $233,000 for the six months ended
June 30, 2003, respectively, includes our net equity from the AIM Limited
Partnerships (which are four publicly traded limited partnerships that hold
insured mortgages and whose general partner is one of our subsidiaries) and the
net equity from our 20% limited partnership interest in the advisor to the AIM
Limited Partnerships. The 2003 results also include an impairment charge on our
equity investment in the advisor to the AIM Limited Partnerships.
During the six months ended June 30, 2003, the AIM Limited Partnerships
experienced a significant amount of prepayments of their insured mortgages.
These prepayments reduced cash flows on our 20% investment in the advisor to the
AIM Limited Partnerships. As a result, in accordance with SFAS No. 142,
"Goodwill and Other Intangible Assets," and SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets," the advisor to the AIM Limited
Partnerships evaluated its investment in the advisory contracts for impairment.
The estimated future undiscounted cash flows from this investment were projected
to be less than the book value of the investment as of June 30, 2003. As a
result, the advisor believed that its investment in the advisory contracts was
impaired at June 30, 2003. The advisor estimated the fair value of its
investment using a discounted cash flow methodology. The advisor wrote down the
value of its investment in the advisory contracts to the AIM Limited
Partnerships and recorded an impairment charge. We recorded our portion of the
impairment charge, totaling approximately $109,000, during the three and six
months ended June 30, 2003. This impairment charge is included in Equity in
(losses) earnings from investments in our Consolidated Statement of Income. This
investment is included in our Portfolio Investment segment.
Income Tax Benefit (Expense)
During the three and six months ended June 30, 2003, we recorded an income
tax benefit of approximately $14,000 and $186,000, respectively. During the
three and six months ended June 30, 2002, we recorded income tax expense of
approximately $975,000 and $909,000, respectively. The income tax benefit
(expense) was recognized by our taxable REIT subsidiaries (TRSs) that own all of
the partnership interests in CMSLP. These TRSs are separately taxable entities.
The income tax benefit (expense) that was recognized by our TRSs was the result
of CMSLP's financial results. The expense in 2002 was primarily the result of
the gain on the sale of servcing rights by CMSLP.
Other Income
Other income decreased by approximately $233,000 to approximately $352,000
during the three months ended June 30, 2003 from approximately $586,000 during
the three months ended June 30, 2002. Other income decreased by approximately
$735,000 to approximately $696,000 during the six months ended June 30, 2003
from approximately $1.4 million during the six months ended June 30, 2002. These
decreases were primarily attributable to lower interest income earned on reduced
cash balances during 2003 as compared to 2002 and a decrease in net
45
income (before interest expense and depreciation expense) from a shopping
center that we account for as real estate owned, as discussed below.
We own a shopping center in Orlando, Florida, which we account for as real
estate owned. The following is a summary of the financial results of the
shopping center (in thousands):
Three months ended June 30, Six months ended June 30,
2003 2002 2003 2002
------------ --------------- -------------- ----------------
Interest expense $ (217) $ (214) $ (434) $ (427)
Depreciation expense (38) (35) (75) (79)
Other, net 65 101 54 154
------------ --------------- -------------- ----------------
Net loss $ (190) $ (148) $ (455) $ (352)
============ =============== ============== ================
The other, net amount is included in other income. Interest expense and
depreciation expense are included in their respective captions in our
Consolidated Statements of Income. We hope to reposition and stabilize this
asset to increase its value, although there can be no assurance.
Impairment on CMBS
The projected loss severities of the underlying mortgage loans currently in
special servicing have increased (including a change in the estimated resolution
and disposition dates of certain specially serviced loans) which has resulted in
an increase in our overall expected loss estimate related to our subordinated
CMBS from $503 million as of December 31, 2002 to $559 million as of June 30,
2003. The revision to the overall expected loss estimate is primarily the result
of lower than anticipated appraisals and lower internal estimates of values on
real estate owned by underlying trusts and properties underlying certain
defaulted mortgage loans, which, when combined with the updated loss severity
experience and increased expectation of defaults, has resulted in higher
projected loss severities on mortgage loans and real estate owned by underlying
trusts currently or anticipated to be in special servicing. Primary reasons for
lower appraisals and lower estimates of value resulting in higher projected loss
severities on mortgage loans and real estate owned by the underlying
securitization trusts include the poor performance of certain properties and
related markets, failed workout negotiations, and extended time needed to
liquidate assets due, in large part, to the continued softness in the economy,
the continued downturn in travel and, in some cases, over-supply of hotel
properties, and a shift in retail activity in some markets, including the
closing of stores by certain national and regional retailers. Since we
determined that there had been an adverse change in expected future cash flows,
we believed the unrated/issuer's equity bonds, CCC bond and B- bond in CBO-2 had
been impaired under EITF 99-20 and SFAS No. 115, "Accounting for Certain
Investments in Debt and Equity Securities," as of June 30, 2003. As the fair
values of the impaired subordinated CMBS aggregated approximately $8.9 million
below the amortized cost basis as of June 30, 2003, we recorded an other than
temporary impairment charge through the income statement of this same amount
during the three months ended June 30, 2003.
There can be no assurance that our revised overall expected loss estimate
of $559 million will not be exceeded as a result of additional or existing
adverse events or circumstances. Such events or circumstances include, but are
not limited to, the receipt of new or updated appraisals at lower than
anticipated amounts, legal proceedings (including bankruptcy filings) involving
borrowers, a continued weak economy or recession, continued hostilities in the
Middle East or elsewhere, terrorism, unexpected delays in the disposition or
other resolution of specially serviced mortgage loans, additional defaults, or
an unforeseen reduction in expected recoveries, any of which could result in
additional future credit losses and/or further impairment to our subordinated
CMBS, the effect of which could be materially adverse to us.
During the three months ended June 30, 2002, we revised our overall
expected loss estimate related to our subordinated CMBS portfolio. The revisions
to the overall expected loss estimate during 2002 were primarily the result of
the same factors as those listed in the paragraph above. As we determined that
there had been an adverse change in expected future cash flows, we believed our
Nomura and CBO-2 unrated/issuer's equity bonds had been impaired under EITF
99-20 and SFAS No. 115 as of June 30, 2002. As the fair value of the impaired
subordinated CMBS was approximately $5.2 million below the amortized cost as of
June 30, 2002, we recorded other than
46
temporary impairment charge through the income statement of this same
amount during the three months ended June 30 , 2002.
Net Gains (Losses) on Mortgage Security Dispositions
The following is a summary of mortgage security dispositions:
Three months ended June 30, Six months ended June 30,
2003 2002 2003 2002
---------------- --------------- ---------------- ----------------
Gain (loss) recognized $ 38,290 $ (146,473) $ 226,500 $ (256,292)
Number of dispositions 4 7 14 13
Percentage of amortized cost (1) 2.2% 5.5% 19.6% 10.6%
(1) Based on amortized cost as of December 31 of the previous year.
The net gains in 2003 were primarily attributable to the sale of the GNMA
security that was owned by CRIIMI MAE Inc. during the first quarter of 2003 and
the receipt of prepayment penalties, partially offset by losses due to the
write-off of unamortized costs associated with disposed mortgages. The net
losses in 2002 were primarily due to the write-off of unamortized costs
associated with the disposed mortgages at the disposition dates, partially
offset by prepayment penalties, if applicable. For any period, gains or losses
on mortgage dispositions are based on the number, carrying amounts and proceeds
of mortgages disposed of during the period. In July 2003, an insured mortgage
with an amortized cost of approximately $28.1 million was prepaid. This
prepayment will result in the recognition of a loss on disposition of
approximately $615,000 during the three months ended September 30, 2003.
Hedging Expense
During the three months ended June 30, 2003 and 2002, we recognized hedging
expense of approximately $274,000 and $307,000 on our interest rate caps,
respectively. During the six months ended June 30, 2003 and 2002, we recognized
hedging expense of approximately $626,000 and $396,000 on our interest rate
caps, respectively. Our interest rate cap that matures on November 3, 2003
(which we purchased in April 2002) sets one-month LIBOR at a rate of 3.25%. As
of June 30, 2003, the one-month LIBOR rate was 1.12%. As of June 30, 2003, the
fair value of this interest rate cap was $0.
BREF Maintenance Fee
Pursuant to the Investment Agreement with BREF Investments, we are
obligated to pay BREF Investments a quarterly maintenance fee of $434,000
through January 2006. The expense of approximately $424,000 and $796,000 during
the three and six months ended June 30, 2003, respectively, represents the
maintenance fee for the period January 14 through June 30, 2003.
Recapitalization Expenses
In connection with the January 2003 recapitalization, we amended the
employment contracts of our former Chairman, William B. Dockser, and former
President, H. William Willoughby, to provide for their termination on January
23, 2003. During the three months ended March 31, 2003, we recognized
approximately $2.6 million of expenses related to severance and related benefit
payments, and accelerated vesting of certain outstanding stock options held by
Messrs. Dockser and Willoughby.
We consolidated our office space in connection with our January 2003
recapitalization and, as a result, we recorded approximately $532,000 of expense
for vacant office space during the three months ended June 30, 2003. The accrual
for the vacant space represents the fair value of lease payments through 2007, a
tenant improvement allowance and a broker commission, all net of estimated
sublease revenue in accordance with SFAS No. 146.
47
During the three and six months ended June 30, 2002, we recognized
approximately $244,000 of recapitalization expenses related to the services
performed by our investment banking firm during the initial stages of our
exploration of strategic alternatives.
Gain on Extinguishment of Debt
During the three months ended March 31, 2003, we reversed approximately
$7.8 million of accrued extension fees related to the Exit Debt since the debt
was repaid and the extension fees were no longer payable. This reversal is
reflected as a gain on extinguishment of debt in our consolidated statement of
income. This reversal was partially offset by approximately $403,000 of breakage
fee paid to the lender of the Exit Variable-Rate Secured Borrowing and legal
fees of approximately $47,000, resulting in a net gain on extinguishment of debt
of $7.3 million.
Cumulative effect of adoption of SFAS 142
In June of 2001, the Financial Accounting Standards Board issued SFAS No.
142, "Goodwill and Other Intangible Assets". SFAS No. 142, among other things,
prohibits the amortization of existing goodwill and certain types of other
intangible assets and establishes a new method of testing goodwill for
impairment. Under SFAS No. 142, the method for testing goodwill for impairment
occurs at the reporting unit level (as defined in SFAS No. 142) and is performed
using a fair value based approach. SFAS No. 142 was effective for us on January
1, 2002. Effective upon adoption on January 1, 2002, we wrote off our goodwill
and recorded a resulting impairment charge of approximately $9.8 million for
this change in accounting principle. The goodwill relates to the Portfolio
Investment reporting unit (as defined in Note 15 of the Notes to Consolidated
Financial Statements). The fair value of the reporting unit was determined using
a market capitalization approach, and the impairment was primarily a result of
the significant decrease in the price of our common stock price since the Merger
in 1995. This change in accounting principle reduced our annual amortization
expense by approximately $2.8 million through June 2005.
REIT Status and Other Tax Matters
REIT Status. We have elected to qualify as a REIT for tax purposes under
sections 856-860 of the Internal Revenue Code. We are required to meet income,
asset, ownership and distribution tests to maintain our REIT status for federal
and state tax purposes. We believe that we have satisfied the REIT requirements
for all years through, and including 2002, although there can be no assurance.
There can also be no assurance that we will maintain our REIT status for 2003 or
subsequent years. If we fail to maintain our REIT status for any taxable year,
we will be taxed as a regular domestic corporation subject to federal and state
income tax in the year of disqualification and for at least the four subsequent
years. Depending on the amount of any such federal and state income tax, we may
have insufficient funds to pay any such tax and also may be unable to comply
with some or all of our obligations, including the Bear Stearns and BREF Debt.
Net Operating Loss for Tax Purposes/Trader Election. For tax purposes we
have elected to be classified as a trader in securities. We trade in both short
and longer duration fixed income securities, including CMBS, residential
mortgage-backed securities and agency debt securities (such securities traded
and all other securities of the type described constituting the "Trading Assets"
to the extent owned by us or any qualified REIT subsidiary, meaning generally
any wholly owned subsidiary that is not a taxable REIT subsidiary). Such Trading
Assets are classified as Other MBS on our balance sheet.
As a result of our election in 2000 to be taxed as a trader, we recognized
a mark-to-market tax loss on our Trading Assets on January 1, 2000 of
approximately $478 million (the January 2000 Loss). Such loss is being
recognized evenly for tax purposes over four years beginning with the year 2000
and ending in 2003. We expect such loss to be ordinary, which allows us to
offset our ordinary income.
We generated a net operating loss for tax purposes of approximately $83.6
million during the year ended December 31, 2002. As such, our taxable income was
reduced to zero and, accordingly, our REIT distribution requirement was
eliminated for 2002. As of December 31, 2002, our accumulated and unused net
operating loss (or NOL) was $223.8 million. Any accumulated and unused net
operating losses, subject to certain limitations,
48
generally may be carried forward for up to 20 years to offset taxable
income until fully utilized. Accumulated and unused net operating losses cannot
be carried back because we are a REIT.
There can be no assurance that our position with respect to our election as
a trader in securities will not be challenged by the Internal Revenue Service
(or IRS) and, if challenged, will be defended successfully by us. As such, there
is a risk that the January 2000 Loss will be limited or disallowed, resulting in
higher tax basis income and a corresponding increase in REIT distribution
requirements. It is possible that the amount of any under-distribution for a
taxable year could be corrected with a "deficiency dividend" as defined in
Section 860 of the Internal Revenue Code, however, interest may also be due to
the IRS on the amount of this under-distribution.
If we are required to make taxable income distributions to our shareholders
to satisfy required REIT distributions, all or a substantial portion of these
distributions, if any, may be in the form of non-cash dividends. There can be no
assurance that such non-cash dividends would satisfy the REIT distribution
requirements and, as such, we could lose our REIT status or may not be able to
satisfy some or all of our obligations, including the Bear Stearns and BREF
Debt.
Our future use of NOLs for tax purposes could be substantially limited in
the event of an "ownership change" as defined under Section 382 of the Internal
Revenue Code. As a result of these limitations imposed by Section 382 of the
Internal Revenue Code, in the event of an ownership change, our ability to use
our NOL carryforwards in future years may be limited and, to the extent the NOL
carryforwards cannot be fully utilized under these limitations within the
carryforward periods, the NOL carryforwards would expire unutilized.
Accordingly, after any ownership change, our ability to use our NOLs to reduce
or offset taxable income would be substantially limited or not available under
Section 382. In general, a company reaches the "ownership change" threshold if
the "5% shareholders" increase their aggregate ownership interest in the company
over a three-year testing period by more than 50 percentage points. The
ownership interest is measured in terms of total market value of the company's
capital stock. If an "ownership change" occurs under Section 382 of the Internal
Revenue Code, our prospective use of our accumulated and unused NOL and the
remaining January 2000 Loss of a combined total amount of approximately $328.1
million as of June 30, 2003 will be limited.
We do not believe BREF Fund's investment in our common stock and warrant to
purchase common stock has created an "ownership change" under Section 382. In
addition, we are not aware of any other acquisition of shares of our capital
stock that has created an "ownership change" under Section 382. We have adopted
a shareholder rights plan and amended our charter to minimize the chance of an
ownership change within the meaning of Section 382 of the Internal Revenue Code;
however there can be no assurance that an ownership change will not occur.
Net Operating Loss for Tax Purposes-Six months ended June 30, 2003. We
generated a net operating loss for tax purposes of approximately $44.5 million
during the six months ended June 30, 2003. A summary of our year-to-date net
operating loss as of June 30, 2003 is as follows (in millions):
January 2000 Loss $ (478.2)
LESS: Amounts recognized in 2002, 2001 and 2000 358.6
LESS: Amounts recognized during the six months ended June 30, 2003 59.8
---------
Balance remaining of January 2000 Loss to be recognized during the remainder of 2003 $ (59.8)
=========
Taxable income for the six months ended June 30, 2003 before recognition $ 15.3
of January 2000 Loss
LESS: January 2000 Loss recognized during the six months ended June 30, 2003 (59.8)
---------
Net Operating Loss for the six months ended June 30, 2003 $ (44.5)
=========
Accumulated Net Operating Loss through December 31, 2002 $ (223.8)
Net Operating Loss for the six months ended June 30, 2003 (44.5)
Net Operating Loss utilization -
---------
Net Operating Loss carried forward for use in future periods $ (268.3)
=========
Accumulated and unused net operating loss and remaining January 2000 Loss $ (328.1)
=========
49
Cash Flow
2003 compared to 2002
Net cash provided by operating activities decreased by approximately $13.5
million to $18.3 million during the six months ended June 30, 2003 from $31.8
million during the six months ended June 30, 2002. The decrease was primarily
attributable to a decrease in cash received from our subordinated CMBS, an
increase in cash paid for interest on our recourse debt as discussed below, and
$2.1 million of severance paid to our former Chairman and former President.
Net cash provided by investing activities increased by approximately $22.6
million to $63.3 million during the six months ended June 30, 2003 from $40.7
million during the six months ended June 30, 2002. The increase was primarily
attributable to:
o a $17.0 million increase in proceeds from mortgage security prepayments and a
sale of a GNMA security;
o $3.3 million of proceeds from the sale of investment-grade CMBS by CMSLP
during 2003;
o a $1.2 million increase in cash received in excess of income recognized on
subordinated CMBS; and
o $9.9 million of purchases of investment-grade CMBS by CMSLP during 2002;
partially offset by
o $8.2 million of proceeds from the sale of servicing rights during 2002.
Net cash used in financing activities increased by approximately $27.6
million to $98.2 million during the six months ended June 30, 2003 from $70.6
million during the six months ended June 30, 2002. The increase is primarily
attributable to the January 2003 recapitalization. We repaid approximately
$373.6 million of Exit Debt through the incurrence of an aggregate $330.0
million of Bear Stearns and BREF Debt, the net proceeds of $13.5 million from
the issuance of common stock to BREF Fund, and used of $30.1 million of our
available cash and liquid assets. In addition, we paid approximately $5.9
million in debt issuance costs during the six months ended June 30, 2003. The
total transaction costs of approximately $10.1 million includes $5.9 million of
debt issuance costs, $478,000 of equity issuance costs, $2.6 million of
executive severance costs and $1.0 million of costs expensed during the year
ended December 31, 2002. The increase in cash used in financing activities was
also affected by the payment of approximately $8.7 million in preferred stock
dividends during the six months ended June 30, 2003 and a $17.0 million increase
in principal payments on the securitized mortgage debt obligations (due to
higher insured mortgage security prepayments as discussed previously). During
2002, we paid $18.7 million (approximately $396,000 of which represented accrued
and unpaid dividends) to redeem the Series E Preferred Stock. We redeemed all
173,000 outstanding shares of the Series E Preferred Stock at the stated
redemption price of $106 per share plus accrued and unpaid dividends through and
including the date of redemption. The approximate $1.0 million difference
between the aggregate liquidation value and the redemption price is reflected as
a dividend on preferred stock in the first quarter of 2002.
The cash flows described above include the following cash generated by our
assets:
o Approximately $14.5 million and $18.1 million of cash that we
received from our CMBS rated BB+ through unrated during the three
months ended June 30, 2003 and 2002, respectively, and
approximately $31.2 million and $36.1 million during the six
months ended June 30, 2003 and 2002, respectively;
o Cash distributions (which are primarily a return of investment)
from the AIM Limited Partnerships of approximately $398,000 and
$1.1 million during the three months ended June 30, 2003 and 2002,
respectively, and approximately $1.2 million and $1.6 million
during the six months ended June 30, 2003 and 2002, respectively;
o Cash received from the insured mortgage securities after
the related debt was serviced of approximately $574,000 and
$907,000 during the three months ended June 30, 2003 and 2002,
respectively, and approximately $1.2 million and $1.8 million
during the six months ended June 30, 2003 and 2002, respectively;
and
50
o Approximately $261,000 of cash received from our investment in
mezzanine loans during the three months ended June 30, 2003 and
2002 and approximately $519,000 during the six months ended
June 30, 2003 and 2002.
Our cash flows described above also reflect the following cash used to
service our recourse debt:
o Principal payments (excluding the retirement of recourse debt) on
our recourse debt of approximately $1.3 million and $9.3 million
during the three months ended June 30, 2003 and 2002,
respectively, and approximately $3.6 and $18.9 million during the
six months ended June 30, 2003 and 2002, respectively; and
o Interest payments on our recourse debt of approximately $3.9
million and $8.0 million during the three months ended June 30,
2003 and 2002, respectively, and approximately $13.6 and $16.1
million during the six months ended June 30, 2003 and 2002,
respectively.
We also made preferred dividend payments of approximately $6.9 million and
$0 during the three months ended June 30, 2003 and 2002, respectively, and
approximately $8.7 and $396,000 during the six months ended June 30, 2003 and
2002, respectively, which are included in our Consolidated Statement of Cash
Flows. Our Consolidated Statement of Income includes approximately $2.9 million
and $2.7 million of general and administrative expenses during the three months
ended June 30, 2003 and 2002, respectively, and approximately $5.8 and $5.9
million during the six months ended June 30, 2003 and 2002, respectively. In
addition, our Consolidated Statement of Income includes approximately $424,000
and $796,000 of expense related to the BREF maintenance fee during the three and
six months ended June 30, 2003, respectively.
Financial Condition, Liquidity and Capital Resources
Limited Summary of January 2003 Recapitalization
On January 23, 2003, we completed a recapitalization of all of the Exit
Debt, which was funded with approximately $44 million from common equity and
secured subordinated debt issuances to BREF Fund, $300 million in secured
financing in the form of a repurchase transaction from Bear Stearns and a
portion of our available cash and liquid assets.
BREF Fund acquired 1,212,617 shares of our newly issued common stock, or
approximately 8% of our outstanding common stock after giving effect to the
share acquisition, at $11.50 per share, or approximately $13.9 million. BREF
Fund received seven year warrants to purchase up to 336,835 additional shares of
common stock at $11.50 per share. BREF Fund also purchased $30 million of the
BREF Debt and, at our option, BREF Fund will purchase up to an additional $10
million of subordinated debt prior to January 23, 2004. The BREF Debt matures on
January 23, 2006 and bears interest at an annual rate of 15%. The interest on
the BREF Debt is payable semi-annually and there are no principal payments until
maturity. If we decide to sell the additional $10 million of subordinated debt
to BREF Fund, it will bear interest at an annual rate of 20% and also matures on
January 23, 2006. We have a right to defer two-thirds of the interest on the
BREF Debt, which we are currently deferring, (and half on the additional $10
million if sold to BREF Fund) during its term. The operative documents
evidencing the BREF Debt restrict our ability to take certain actions and engage
in certain transactions. One such restriction relates to our ability to incur
additional indebtedness. The BREF Debt is secured by first liens on the equity
interests of two of our subsidiaries. Although this effectively provides BREF
Fund with an indirect lien on all of our subordinated CMBS that are held by
three of our other lower tier subsidiaries, Bear Stearns has a first lien on the
equity interests of these three lower tier subsidiaries and on certain of the
subordinated CMBS held by one of these lower tier subsidiaries. BREF Investments
has agreed that its indirect liens on Bear Stearns' first lien collateral are
subordinate to Bear Stearns' liens and has further agreed to contractual
restrictions on its ability to realize upon its indirect interest in the Bear
Stearns first lien collateral. We paid an origination fee of 0.67% to BREF
Investments related to the BREF Debt and an aggregate of $1 million for expenses
in connection with the transactions. Pursuant to the Investment Agreement with
BREF Investments, we are also obligated to pay BREF Investments a quarterly
maintenance fee of $434,000. Please refer to our definitive proxy statement
relating to our 2003 annual shareholders meeting for a discussion of existing
and potential relationships, transactions and agreements (including a
non-competition agreement) with BREF Fund and/or certain of its affiliates
(including BREF Investments). As previously stated, BREF Fund is a principal
stockholder and a creditor of ours, and Barry Blattman, our Chairman,
51
CEO and President, is an affiliate of BREF Fund and BREF Investments. All
transactions between us and BREF Fund and BREF Investments or any of its
affiliates will be approved by disinterested directors and will be on terms no
less favorable than those which could have been obtained from unrelated third
parties.
Bear Stearns provided $300 million in secured financing in the form of a
repurchase transaction under the 2003 recapitalization. The Bear Stearns Debt
matures in 2006, bears interest at a rate equal to one-month LIBOR plus 3%,
payable monthly, and requires quarterly principal payments of $1.25 million. The
principal payments will increase to $1.875 million per quarter if a
collateralized debt obligation transaction (or CDO) is not completed by January
23, 2004. The interest rate will increase by 1%, to one-month LIBOR plus 4%, if
Bear Stearns structures a CDO that meets certain rating requirements and we
decline to enter into such transaction. The operative documents related to the
Bear Stearns Debt facility restrict our ability to take certain actions and
engage in certain transactions. Although CRIIMI MAE Inc. (unconsolidated) is not
a primary obligor of the Bear Stearns Debt, it has guaranteed all obligations
under the debt. We paid a commitment fee of 0.5% of the Bear Stearns Debt to
Bear Stearns. We also paid $250,000 of Bear Stearns' legal expenses.
The Bear Stearns Debt is collateralized by first direct and/or indirect
liens on all of our subordinated CMBS, and is subject to a number of terms,
conditions and restrictions including, without limitation, scheduled principal
and interest payments, and restrictions and requirements with respect to the
collection and application of funds. The indirect first liens are first liens on
the equity interests of three of our subsidiaries that hold certain subordinated
CMBS. If the outstanding loan amount under the Bear Stearns Debt exceeds 85% of
the aggregate market value of the collateral securing the Bear Stearns Debt, as
determined by Bear Stearns in its sole good faith discretion, then Bear Stearns,
if, and as permitted after the application of the terms of a netting agreement
entered into in connection with an interest rate swap (as described below), can
require us to transfer cash, cash equivalents or securities so that the
outstanding loan amount will be less than or equal to 80% of the aggregate
market value of the collateral (including any additional collateral provided).
Failure to meet any margin call could result in an event of default which would
enable Bear Stearns to exercise various rights and remedies including
acceleration of the maturity date of the Bear Stearns Debt and the sale of the
collateral. In order to meet a margin call, we may be required to sell assets at
prices lower than their carrying value which could result in losses.
During the second quarter of 2003, two of our subsidiaries (the primary
obligors of the Bear Stearns Debt) entered into an interest rate swap agreement
for the purpose of hedging the variability of expected future interest payments
on our anticipated CDO, as more fully described under Note 7. We have entered
into two interest rate swap transactions under this agreement in which we agreed
to pay Bear Stearns fixed interest rates of 3.946% and 4.055% per annum in
exchange for floating payments based on one-month LIBOR on notional amounts of
$50 million and $25 million, respectively. These swaps are effective on October
15, 2003, terminate on October 15, 2013 and provide for monthly interest
payments commencing November 15, 2003. We anticipate that the interest rate
swaps will be terminated or otherwise disposed of, in each case subject to the
consent of Bear Stearns, upon issuance of the CDO.
Under the interest rate swap documents, our two subsidiaries have granted
to Bear Stearns a security interest in all of their rights, title and interest
in certain assets, including property now or hereafter held by Bear Stearns in
connection with the Bear Stearns Debt or the interest rate swap documents and
certain contract rights under the Bear Stearns Debt and interest rate swap
documents (including the subsidiaries' rights to any "margin excess" related to
the collateral securing the Bear Stearns Debt, with margin excess as defined in
the Bear Stearns Debt documents), to secure their obligations under the interest
rate swap documents and the Bear Stearns Debt. This security interest
constitutes additional collateral for the Bear Stearns Debt. Also under the
interest rate swap documents, on any day on which there exists any obligation
for us to deliver cash or additional eligible collateral under either the
interest rate swap or under the Bear Stearns Debt, such obligation will be
deemed satisfied to the extent there exists a margin excess under the Bear
Stearns Debt or an obligation for Bear Stearns to deliver cash or eligible
collateral under the interest rate swap. CRIIMI MAE Inc. has guaranteed all of
its subsidiaries' obligations under the interest rate swap documents, as well as
the Bear Stearns Debt.
There can be no assurance that our hedging activities will have the desired
beneficial impact. No hedging activity can completely protect us from the risks
associated with changes in interest rates. Hedging involves risk and typically
involves costs, including transaction costs. Such costs increase dramatically as
the period covered by the hedging increases and during periods of rising and
volatile interest rates. We may not be able to dispose of or close out a hedging
position without the consent of a counterparty, and we may not be able to enter
into an offsetting contract in order to cover our risk. There can be no
assurance that a liquid market will exist for the purchase or sale or hedging
instruments, and we may be required to maintain a position until expiration,
which could result in losses. There can be no assurance that we will be able to
replace a hedge upon expiration which could result in increased interest rate
risk.
Our ability to meet our debt service obligations will depend on a number of
factors, including management's ability to maintain cash flow (which is impacted
by, among other things, the credit performance of the underlying mortgage loans
and changes in interest rates and spreads) and to generate capital internally
from operating and investing activities and expected reductions in REIT
distribution requirements to shareholders due to net operating losses for tax
purposes, in each case consistent with the terms and conditions of the operative
documents evidencing our obligations. There can be no assurance that targeted
levels of cash flow will actually be achieved, that reductions in REIT
distribution requirements will be realized, or that, if required, new capital
will be available to us. Our ability to maintain or increase cash flow and
access new capital will depend upon, among other
52
things, interest rates (including hedging costs and margin calls),
prevailing economic conditions, restrictions under the operative documents
evidencing our obligations, and other factors, many of which are beyond our
control. Our cash flow will also be negatively affected by realized losses,
interest payment shortfalls and appraisal reduction amounts on properties
related to mortgages underlying our subordinated CMBS. We expect realized losses
on our CMBS to continue to increase in 2003, resulting, generally, in decreased
CMBS cash flows as compared to 2002. Our cash flows are also likely to decrease
as a result of any prepayments of mortgage loans underlying our insured mortgage
securities and any prepayments of mortgages held by the AIM Limited
Partnerships. Prepayments of these mortgage loans will result in reductions in
the respective mortgage bases. As a result, the net cash flows to us are likely
to decrease over time. Our net cash flows will also decrease due to the failure
to close the CDO transaction prior to January 23, 2004, or if we refinance the
Bear Stearns Debt with debt which has a higher interest rate and/or greater
amortization requirements. In addition, our net cash flows may be adversely
affected by the CDO transaction, if and when closed and depending on the terms
of such transaction, and our swap transactions including any required payments
under such transactions. Cash flows are also likely to be affected if we incur
further debt to acquire additional CMBS or for other corporate purposes. See
"QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK." Our high level of
debt limits our ability to obtain additional capital, significantly reduces
income available for other activities, restricts our ability to react quickly to
changes in our business, limits our ability to hedge our assets and liabilities,
and makes us more vulnerable to economic downturns.
Our ability to make mortgage related investments and acquisitions depends
on, among other things, our ability to engage in such activities under the terms
and conditions of our operative documents evidencing our obligations, our
internally generated cash flows, and our ability to access additional capital.
Factors which could affect our ability to access additional capital include,
among other things, the cost and availability of such capital, the availability
of investment product at attractive rates of return, changes in interest rates
and interest rate spreads, changes in the commercial mortgage industry and the
commercial real estate market, the effects of terrorism, general economic
conditions, perceptions in the capital markets of our business, restrictions
under the operative documents evidencing our obligations, results of our
operations, and our financial leverage, financial condition, and business
prospects. There can be no assurance that we will be able to resume mortgage
related investments and acquisitions or obtain additional capital, or that the
terms of any such capital will be favorable to us.
Executive Employment Agreements
On July 24, 2003, we entered into amendments to the employment agreements
with Mr. David B. Iannarone (our Executive Vice President), Mrs. Cynthia O.
Azzara (our Senior Vice President, Chief Financial Officer and Treasurer) and
Mr. Brian L. Hanson (our Senior Vice President), pursuant to which the
employment term was changed to August 25, 2003. We are obligated to pay
severance and related benefit payments to the executives if we and the
executives have not reached a mutual agreement with respect to continued
employment. These severance and related benefit payments are estimated to
aggregate approximately $3.3 million and would be reflected as an expense in our
Consolidated Statement of Income during the three months ended September 30,
2003.
On August 13, 2003, our Board of Directors appointed Mark Jarrell, a
Director, as our President and Chief Operating Officer effective September 15,
2003. Mr. Jarrell resigned from our Board on August 13, 2003 after his
appointment by the Board. In conjunction with the appointment of Mr. Jarrell,
Mr. Blattman resigned as our President effective September 15, 2003. Mr.
Blattman will continue as our Chairman and Chief Executive Officer. Mr. Jarrell
will be paid an annual base salary of $400,000 with a guaranteed minimum bonus
of $200,000 annually ($100,000 for the remainder of 2003). In connection with
his appointment, Mr. Jarrell is being granted approximately 58,000 shares of
restricted common stock on September 15, 2003, valued at $666,667 based on the
closing price of our common stock on August 12, 2003, under our 2001 Stock
Incentive Plan. This initial grant will vest 25% on December 31, 2003 and 75% on
December 31, 2004. In addition, Mr. Jarrell will be granted shares of common
stock equivalent to $500,000 on each of December 31, 2005 and 2006, provided he
is employed by us on those dates and subject to certain terms of his Employment
Offer Letter Agreement dated August 11, 2003 as included in an Exhibit herein.
We expect to recognize approximately $167,000 of compensation expense related to
the restricted common stock award during the remainder of 2003 and approximately
$500,000 of compensation expense during 2004.
Summary of Cash Position and Shareholders' Equity
As of June 30, 2003, our cash and cash equivalents aggregated approximately
$12.6 million, including cash and cash equivalents of approximately $3.7 million
held by CMSLP. In addition to our cash, we had additional liquidity at June 30,
2003 comprised of $2.5 million in Other MBS, which is included elsewhere in our
balance sheet. As of August 11, 2003, our liquidity included approximately
$18.3 million of cash and cash equivalents and approximately $3.6 million of
Other MBS.
As of June 30, 2003 and December 31, 2002, shareholders' equity was
approximately $325.8 million or $17.20 per diluted share and approximately
$291.7 million or $16.32 per diluted share, respectively. These diluted book
value per share amounts are based on shareholders' equity presented in
accordance with GAAP. These amounts include, among other things, the net assets
related to our CMBS rated A+ through BBB, which we do not actually own, but they
are required by GAAP to be included on our balance sheet (see "Summary of CMBS"
below for a further discussion). These CMBS are reflected at fair value and the
related match-funded debt at amortized cost, in each case in accordance with
GAAP. The increase in shareholder's equity
53
is primarily the result of the increase in the fair value of our CMBS
following the reduction in U.S. Treasury rates as of June 30, 2003, the
tightening of spreads on our investment grade CMBS and the issuance of common
stock to BREF Fund as previously discussed.
Summary of CMBS
As of June 30, 2003, we owned, in accordance with GAAP, CMBS with an
aggregate face amount of approximately $1.5 billion rated from A+ to CCC and
unrated. Such CMBS had an aggregate fair value of approximately $873 million
(representing approximately 75% of our total consolidated assets) and an
aggregate amortized cost of approximately $754 million. Such CMBS represent
investments in securities issued in connection with CRIIMI MAE Trust I Series
1996-C1 (or CBO-1), CRIIMI MAE Commercial Mortgage Trust Series 1998-C1 (or
CBO-2) and Nomura Asset Securities Corporation Series 1998-D6 (or Nomura). The
following is a summary of the ratings of our CMBS as of June 30, 2003 (in
millions):
Rating (1) Fair Value % of CMBS
---------- ---------- ---------
A+, BBB+ or BBB (2) $339.6 39%
BB+, BB or BB- $346.1 40%
B+, B, B- or CCC $168.8 19%
Unrated $ 18.7 2%
(1) Ratings are provided by Standard & Poor's.
(2) Represents investment grade CMBS that we reflect as assets on our
balance sheet as a result of CBO-2. As indicated in footnote 4 to
the table below, GAAP requires both these assets (reflected as
"CMBS pledged to Secure Securitized Mortgage Obligation-CMBS") and
their related liabilities (reflected as "Collateralized bond
obligations - CMBS") to be reflected on our balance sheet. All
cash flows related to the investment grade CMBS are used to
service the corresponding debt. As a result, we currently receive
no cash flows from the investment grade CMBS.
As of June 30, 2003, the weighted average interest rate and the loss
adjusted weighted average life (based on face amount) of the investment grade
securities was 7.0% and 8.3 years, respectively. The weighted average interest
rate and the loss adjusted weighted average life (based on face amount) of the
BB+ through unrated CMBS securities, sometimes referred to as the retained
portfolio, were 4.6% and 10.8 years, respectively. The aggregate investment by
the rating of the CMBS is as follows:
54
Discount Rate
or Range of
Weighted Loss Discount Rates
Face Amount Average Adjusted Fair Value Used to Amortized Cost Amortized Cost
as of Pay Weighted as of Calculate Fair as of 6/30/03 as of 12/31/02
Security Rating 6/30/03 (in Rate as of Average 6/30/03 (in Value as of (in millions) (in millions)
millions) 6/30/03 Life (1) millions) 6/30/03 (9) (5) (6)
- ------------------------------------------------------------------------------------------------------------------------------
Investment Grade Portfolio
- --------------------------
A+ (4) $ 62.6 7.0% 3 years $ 66.8 4.1% $ 59.8 $ 59.4
BBB+ (4) 150.6 7.0% 9 years 158.0 6.2% 132.9 132.3
BBB (4) 115.2 7.0% 10 years 114.8 7.1% 95.9 95.3
Retained Portfolio
- ------------------
BB+ 319.0 7.0% 12 years 265.6 9.5%-9.9% 225.1 223.0
BB 70.9 7.0% 14 years 54.9 10.5% 47.2 46.8
BB- 35.5 7.0% 14 years 25.6 11.4% 21.0 20.8
B+ 88.6 7.0% 14 years 50.6 14.7% 46.5 46.0
B 177.2 6.9% 17 years 94.9 15.2%-15.5% 85.9 85.1
B- (2) 118.3 0.8% 24 years 22.1 (9) 21.7 28.1
CCC (2) 70.9 0.0% 2 years 1.2 (9) 1.2 3.8
Unrated/Issuer's
Equity (2) (3) 309.4 1.7% 1 year 18.7 (9) 17.0 20.0
--------- -------- ---------- --------
Total (8) $ $ 1,518.2 5.1% 10 years $ 873.2 (8) $ 754.2 (7) $ 760.6
========== ======== ========== ========
(1) The loss adjusted weighted average life represents the weighted average
expected life of the CMBS based on our current estimate of future losses.
As of June 30, 2003, the fair values of the B-, CCC and the
unrated/issuer's equity in Nomura, CBO-1, and CBO-2 were derived
primarily from interest cash flow anticipated to be received since our
current loss expectation assumes that the full principal amount of these
securities will not be recovered. See also "Advance Limitations,
Appraisal Reductions and Losses on CMBS" below.
(2) The CBO-1, CBO-2 and Nomura CMBS experience interest shortfalls when the
weighted average net coupon rate on the underlying CMBS is less than the
weighted average stated coupon payments on our subordinated CMBS. Such
interest shortfalls will continue to accumulate until they (i) are repaid
through either excess interest and/or recoveries on the underlying CMBS
or a recharacterization of principal cash flows, or (ii) are realized as
a loss of principal on the subordinated CMBS. Such anticipated losses,
including shortfalls, have been taken into consideration in the
calculations of fair market values and yields to maturity used to
recognize interest income as of June 30, 2003.
(3) The unrated subordinated CMBS from CBO-2 currently does not have a stated
coupon rate since this security is only entitled to the residual cash
flow payments, if any, remaining after paying the securities with a
higher payment priority. As a result, effective coupon rates on these
securities are highly sensitive to the effective coupon rates and monthly
cash flow payments received from the underlying CMBS that represent the
collateral for CBO-2.
(4) In connection with CBO-2, $62.6 million (originally A rated, currently A+
rated) and $60.0 million (originally BBB rated, currently BBB+ rated)
face amount of investment grade CMBS were sold with call options and $345
million (originally A rated, currently A+ rated) face amount were sold
without call options. Also in connection with CBO-2, in May 1998, we
initially retained $90.6 million (originally BBB rated, currently BBB+
rated) and $115.2 million (originally BBB- rated, currently BBB rated)
face amount of CMBS, both with call options, with the intention to sell
these CMBS at a later date. Such sale occurred March 5, 1999. Since we
retained call options on certain sold CMBS (currently rated A+, BBB+ and
BBB bonds), we did not surrender control of these CMBS pursuant to the
requirements of SFAS No. 125, and thus these CMBS are accounted for as a
financing and not a sale. Since the transaction is recorded as a partial
financing and a partial sale, we have retained these CMBS with call
options, from which we currently receive no cash flows, and reflected
them in our CMBS on the balance sheet.
(5) Amortized cost reflects approximately $8.9 million of impairment charges
related to the unrated/issuer's equity bonds, the CCC bond and B- bond in
CBO-2, which were recognized during the three months ended June 30, 2003.
These impairment charges are in addition to the cumulative impairment
charges of approximately $248.4 million that were recognized through
December 31, 2002. The impairment
55
charges are discussed in Note 4.
(6) Amortized cost reflects approximately $248.4 million of cumulative
impairment charges related to certain CMBS (all CMBS except those rated
A+ and BBB+), which were recognized through December 31, 2002.
(7) See "REIT Status and Other Tax Matters" for information regarding the
subordinated CMBS for tax purposes.
(8) As of June 30, 2003, the aggregate fair values of the CBO-1, CBO-2 and
Nomura bonds were approximately $19.1 million, $848.7 million and
$5.4 million, respectively.
(9) As a result of the estimated loss of principal on these CMBS, we have
used a significantly higher discount rate to determine a reasonable fair
value of these CMBS. The weighted average loss adjusted yield-to-maturity
of the B-, CCC and unrated/issuer's equity is 15.3%, 15.0% and 21.8%,
respectively.
Determination of Fair Value of CMBS
Our determination of fair values for our CMBS portfolio is a subjective
process. The process begins with the compilation and evaluation of pricing
information (such as nominal spreads to U.S. Treasury securities or nominal
yields) that, in our view, is commensurate with the market's perception of value
and risk of comparable assets. We use a variety of sources to compile such
pricing information including: (i) recent offerings and/or secondary trades of
comparable CMBS (i.e., securities comparable to our CMBS or to the CMBS (or
collateral) underlying our CMBS issued in connection with CBO-1 and CBO-2), (ii)
communications with dealers and active CMBS investors regarding the pricing and
valuation of comparable securities, (iii) institutionally available research
reports, (iv) analyses prepared by the nationally recognized rating
organizations responsible for the initial rating assessment and on-going
surveillance of such CMBS, and (v) other qualitative and quantitative factors
that may impact the value of the CMBS such as the market's perception of the
issuers of the CMBS and the credit fundamentals of the commercial properties
securing each pool of underlying commercial mortgage loans. We make further fair
value adjustments to such pricing information based on our specific knowledge of
our CMBS and the impact of relevant events, which is then used to determine the
fair value of our CMBS using a discounted cash flow approach. Expected future
gross cash flows are discounted at market yields for our rated CMBS, depending
on the rating, and at a fixed discount rate for our unrated/issuer's equity.
Furthermore, the fair value for those CMBS incurring principal losses and
interest shortfalls (i.e., B-and CCC rated bonds, and our unrated/issuer's
equity) based on our overall expected loss estimate are valued at a loss
adjusted yield to maturity that, in our view, is commensurate with the market's
perception of value and risk of comparable securities, using the same discounted
cash flow approach. Such anticipated principal losses and interest shortfalls,
as well as potential recoveries of such shortfalls, have been taken into
consideration in the calculation of fair values and yields to maturity used to
recognize interest income as of June 30, 2003. We have disclosed the range of
discount rates by rating category used in determining the fair values as of June
30, 2003 in the table above.
The liquidity of the subordinated CMBS market has historically been
limited. Additionally, during adverse market conditions, the liquidity of such
market has been severely limited. For this reason, among others, management's
estimate of the value of our subordinated CMBS could vary significantly from the
value that could be realized in a current transaction between a willing buyer
and a willing seller in other than a forced sale or liquidation. See Note 4 of
Notes to Consolidated Financial Statements for a sensitivity analysis related to
the fair value of our CMBS due to changes in assumptions related to losses on
the underlying commercial mortgage loan collateral and discount rates.
Mortgage Loan Pool
Through CMSLP, our servicing subsidiary, we perform servicing functions on
commercial mortgage loans underlying our CMBS totaling $16.5 billion and $17.4
billion as of June 30, 2003 and December 31, 2002, respectively. The mortgage
loans underlying our subordinated CMBS are secured by properties of the types
and in the geographic locations identified below:
56
06/30/03 12/31/02 Geographic 06/30/03 12/31/02
Property Type Percentage(i) Percentage(i) Location(ii) Percentage(i) Percentage(i)
- ------------- ------------- ------------- ----------- ------------- -------------
Retail........ 31% 31% California........ 16% 17%
Multifamily... 27% 28% Texas............. 12% 12%
Hotel......... 16% 15% Florida........... 8% 8%
Office........ 14% 13% Pennsylvania...... 6% 5%
Other (iv).... 12% 13% Georgia........... 4% 4%
---- --------- Other(iii)........ 54% 54%
Total..... 100% . 100% ---- -----------
==== ========= Total......... 100% 100%
==== ===========
(i) Based on a percentage of the total unpaid principal balance of
the underlying loans.
(ii) No significant concentration by region.
(iii) No other individual state makes up more than 5% of the total.
(iv) Our ownership interest in one of the 20 CMBS transactions
underlying CBO-2 includes subordinated CMBS in which our exposure
to losses arising from certain healthcare and senior housing
mortgage loans is limited by other subordinated CMBS (referred to
herein as the Subordinated Healthcare/Senior-Housing CMBS). These
other CMBS are not owned by us and are subordinate to our CMBS in
this transaction. As a result, our investment in such underlying
CMBS will only be affected if interest shortfalls and/or realized
losses on such healthcare and senior housing mortgage loans are
in excess of the Subordinated Healthcare/Senior-Housing CMBS. We
currently estimate that the interest shortfalls and/or realized
losses on such healthcare and senior housing mortgage loans will
exceed the Subordinated Healthcare/Senior Housing CMBS.
Specially Serviced Mortgage Loans
CMSLP performs special servicing on the loans underlying our
subordinated CMBS portfolio. A special servicer typically provides asset
management and resolution services with respect to nonperforming or
underperforming loans within a pool of mortgage loans. When serving as special
servicer of a mortgage loan pool, CMSLP has the authority, subject to certain
restrictions in the applicable CMBS pooling and servicing documents, to deal
directly with any borrower that fails to perform under certain terms of its
mortgage loan, including the failure to make payments, and to manage any loan
workouts and foreclosures. As special servicer, CMSLP earns fee income on
services provided in connection with any loan servicing function transferred to
it from the master servicer. We believe that because we own the first loss
unrated or lowest rated bond of virtually all of the CMBS transactions related
to our subordinated CMBS, CMSLP has an incentive to efficiently and effectively
resolve any loan workouts. As of June 30, 2003 and December 31, 2002, specially
serviced mortgage loans included in the commercial mortgage loans described
above were as follows:
06/30/03 12/31/02
--------- --------
Specially serviced loans due to monetary default (a) $ 908.8 million $736.1 million
Specially serviced loans due to covenant default/other 260.0 million 74.7 million
---------------- --------------
Total specially serviced loans (b) $1,168.8 million $810.8 million
================ ==============
Percentage of total mortgage loans (b) 7.1% 4.7%
================ ===============
(a) Includes $134.7 million and $130.5 million, respectively, of real estate
owned by the underlying securitization trusts. See also the table below
regarding property type concentrations for further information on real
estate owned by underlying trusts.
(b) As of July 31, 2003, total specially serviced loans were approximately $1.1
billion, or 6.8% of the total mortgage loans. See discussion below for
additional information regarding specially serviced loans.
57
The specially serviced mortgage loans as of June 30, 2003 were secured by
properties of the types and located in the states identified below:
Property Type $ (in millions) Percentage Geographic Location $ (in millions) Percentage
- ------------- --------------- ---------- ------------------- --------------- ----------
Hotel......... $ 715.4 (1) 61% Florida.............. $ 169.9 14%
Retail........ 240.5 (2) 21% Texas................ 122.8 10%
Healthcare.... 93.6 8% California........... 103.2 9%
Office........ 52.1 4% Oregon............... 91.4 8%
Multifamily... 38.2 3% Georgia ............. 55.6 5%
Industrial.... 19.5 2% Other................ 625.9 54%
Other......... 9.5 1% ---------- ---------
-------- ----- Total................ $1,168.8 100%
Total..... $1,168.8 100% ========== =========
======== =====
(1) Approximately $87.4 million of these loans in special servicing are
real estate owned by the underlying securitization trusts.
(2) Approximately $32.6 million of these loans in special servicing are
real estate owned by the underlying securitization trusts.
As reflected above, as of June 30, 2003, approximately $715.4 million, or
61%, of the specially serviced mortgage loans were secured by mortgages on hotel
properties. The hotel properties that secure the mortgage loans underlying our
CMBS are geographically diverse, with a mix of hotel property types and
franchise affiliations. The following table summarizes the hotel mortgage loans
underlying our CMBS as of June 30, 2003:
Total Outstanding Percentage of Amount in
Principal Balance Total Hotel Loans Special Servicing
----------------- ----------------- -----------------
Full service hotels (1) $ 1.4 billion 54% $ 237.3 million
Limited service hotels (2) 1.2 billion 46% 478.1 million
-------------- ---- ---------------
Totals $ 2.6 billion 100% $ 715.4 million
============== ==== ===============
(1) Full service hotels are generally mid-price, upscale or luxury hotels
with restaurant and lounge facilities and other amenities.
(2) Limited service hotels are generally hotels with room-only operations
or hotels that offer a bedroom and bathroom, but limited other
amenities, and are often in the budget or economy group.
Of the $715.4 million of hotel loans in special servicing as of June 30,
2003, approximately $488.8 million, or 68%, relate to eight borrowing
relationships more fully described as follows:
o Twenty-seven loans with scheduled principal balances as of June 30,
2003 totaling approximately $136.2 million spread across three CMBS
transactions secured by hotel properties in the western and Pacific
northwestern states. As of June 30, 2003, our total exposure,
including advances, on these loans was approximately $167.9 million.
The borrower filed for bankruptcy protection in February 2002. The
borrower indicated that the properties had experienced reduced
operating performance due to new competition, the economic recession,
and reduced travel resulting from the September 11, 2001 terrorist
attacks. We entered into a consensual settlement agreement dated
February 25, 2003 pursuant to which the loan terms were amended and
modified, which was subsequently approved and confirmed by the
bankruptcy court on March 28, 2003. The borrower continues to make
payments under the modified terms, and, during the three months ended
June 30, 2003, the borrower sold one of the properties that secured
these loans. In addition, the borrower has remitted approximately
$1.5 million in funds from debtor-in-possession accounts, which is
expected to be applied to arrearages. The parties are currently
proceeding toward closing a comprehensive loan modification that is
expected to return the loans to performing status in the near future.
o One loan with a scheduled principal balance as of June 30, 2003
totaling approximately $128.4 million, secured by 93 limited service
hotels located in 29 states. As of June 30, 2003, our total exposure,
including advances, on this loan was approximately $128.4 million.
The loan was transferred to special servicing in January 2003. The loan
is current for payments, but was transferred to special servicing due
to the unauthorized leasing of some of the collateral properties by the
borrower, and unapproved franchise changes by the borrower, among other
reasons. We entered into a Confidentiality and Pre-Negotiation
Agreement in an attempt to reach a consensual resolution of this
matter, but, subsequent to June 30, 2003, the borrower filed for
bankruptcy.
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o One loan with a scheduled principal balance as of June 30, 2003
totaling approximately $80.7 million secured by 13 extended stay hotels
located throughout the U.S. This loan was transferred to special
servicing in January 2003 due to the borrower's request for forbearance
and the resulting possibility of an imminent payment default. In its
request, the borrower cited continuing reduced operating performance at
its hotel properties, which it did not expect to improve in the
foreseeable future. Subsequent to June 30, 2003, this loan was sold to
a third party.
o Five loans with scheduled principal balances as of June 30, 2003
totaling approximately $45.3 million secured by hotel properties in
Florida and Texas. As of June 30, 2003, our total exposure, including
advances, on these loans was approximately $49.5 million. The loans are
past due for the July 2002 and all subsequent payments. We have reached
a preliminary agreement with the borrower on a consensual modification
of the loan terms, and are working toward a formal modification
agreement that is expected to return the loans to performing status in
the first quarter of 2004.
o Eight real estate owned properties with scheduled principal balances as
of June 30, 2003 totaling approximately $26.1 million secured by hotel
properties. As of June 30, 2003, our total exposure, including
advances, on these loans was approximately $31.9 million. The loans
were transferred into special servicing in December 2001 due to the
bankruptcy filing of each special purpose borrowing entity and their
parent company. As part of a consensual plan, eight properties were
foreclosed and became real estate owned by underlying securitization
trusts. Subsequent to June 30, 2003, two of these properties with an
aggregate unpaid balance of $5.9 million were sold.
o One loan with a scheduled principal balance as of June 30, 2003
totaling approximately $27.7 million, secured by 9 limited service
hotels located in 8 states. As of June 30, 2003 the loan was current.
The loan is currently in special servicing due to an unauthorized
transfer of the properties to an entity which assumed the controlling
interest in the borrowing entity. Subsequent to the transfer, the new
controlling party in interest has requested payment relief citing
reduced operating performance at the properties.
o One loan with a scheduled principal balance as of June 30, 2003 of
approximately $25.6 million, secured by a full service hotel in Boston,
Massachusetts. As of June 30, 2003, our total exposure, including
advances, on this loan was approximately $27.0 million. This loan was
transferred into special servicing in March 2003. The borrower has
stated an inability to make payments, and has requested a loan
restructuring due to reduced operating performance at the property.
o Nine loans with scheduled principal balances as of June 30, 2003
totaling approximately $18.8 million secured by limited service hotels
in midwestern states. As of June 30, 2003, our total exposure,
including advances, on these loans was approximately $23.6 million. The
loans are past due for the April 2002 and all subsequent payments. The
borrower cites reduced occupancy related to the downturn in travel as
the cause for a drop in operating performance at the properties. We
were attempting to negotiate a workout with the borrower when the
borrower filed for bankruptcy protection in February 2003. A cash
collateral order has been entered into and we are working with the
borrower towards a consensual emergence plan.
For each of the borrowing relationships described in the paragraphs above,
we believe that we have made an appropriate estimate of losses that we may incur
in the future, which are used in determining our CMBS yields and fair values.
There can be no assurance that any of the loans described above will return to
performing status. Circumstances which could prevent them from returning to
performing status include, but are not limited to, a continuing or more
pronounced downturn in the economy or in the real estate market, a change in
local market conditions, a drop in performance of the property, an increase in
interest rates, and terrorist attacks. There can be no assurance that the losses
incurred in the future will not exceed our current estimates (see discussion
below regarding the increase in loss estimates).
59
The following table provides a summary of the change in the balance of
specially serviced loans from December 31, 2002 to March 31, 2003 and from April
1, 2003 to June 30, 2003 (in millions):
April - June Jan. - March
2003 2003
------------- -------------
Specially Serviced Loans, beginning of period $1,154.0 $ 810.8
Transfers in due to monetary default 166.3 239.7
Transfers in due to covenant default and other 7.4 158.6
Transfers out of special servicing (153.2) (48.5)
Loan amortization (1) (5.7) (6.6)
----------- ---------
Specially Serviced Loans, end of period $1,168.8 $1,154.0
=========== =========
(1) Represents the reduction of the scheduled principal balances due to
borrower payments, or in the case of loans in monetary default, advances
made by master servicers.
See Exhibit 99.1 to this Quarterly Report on Form 10-Q for a detailed
listing of all specially serviced loans underlying our subordinated CMBS as of
June 30, 2003.
Advance Limitations, Appraisal Reductions and Losses on CMBS
We experience shortfalls in expected cash flow on our CMBS prior to the
recognition of a realized loss primarily due to servicing advance limitations
resulting from appraisal reductions. An appraisal reduction event generally
results in reduced master servicer principal and interest advances based on the
amount by which the sum of the unpaid principal balance of the loan, accumulated
principal and interest advances and other expenses exceeds 90% (in most cases)
of the newly appraised value of the property underlying the mortgage loan. As
the holder of the lowest rated and first loss bonds, our bonds are the first to
experience interest shortfalls as a result of the reduced advancing requirement.
In general, the master servicer can advance up to a maximum of the difference
between 90% of the property's appraised value and the sum of accumulated
principal and interest advances and expenses. As an example, assuming a weighted
average coupon of 6% on a first loss subordinated CMBS, a $1 million appraisal
reduction would reduce our net cash flows by $60,000 on an annual basis. The
ultimate disposition or work-out of the mortgage loan may result in a higher or
lower realized loss on our subordinated CMBS than the calculated appraisal
reduction amount. Appraisal reductions for the CMBS transactions in which we
retain an ownership interest as reported by the underlying trustees or as
calculated by CMSLP* were as follows (in thousands):
CBO-1 CBO-2 Nomura Total
----- ----- ------- -----
Year 2000 $ 1,872 $ 18,871 $ -- $ 20,743
Year 2001 15,599 31,962 874 48,435
Year 2002 9,088 48,953 13,530 71,571
January 1, 2003 through June 30, 2003 9,169 46,969 4,328 60,466
------- -------- ------- ---------
Cumulative Appraisal Reductions through June 30, 2003 $35,728 $146,755 $18,732 $ 201,215
======= ======== ======= =========
* Not all underlying CMBS transactions require the calculation of an
appraisal reduction; however, when CMSLP obtains a third-party appraisal, it
calculates one.
As previously discussed, certain securities from the CBO-1, CBO-2 and
Nomura transactions are expected to experience principal write-downs over their
expected lives. The following tables summarize the actual realized losses on our
CMBS through June 30, 2003 (including realized mortgage loan losses expected to
pass through to our CMBS during the next month) and the expected future losses
through the life of the CMBS (in thousands):
60
CBO-1 CBO-2 Nomura Total
----- ----- ------- -----
Year 1999 actual realized losses $ 738 $ -- $ -- $ 738
Year 2000 actual realized losses 3,201 1,087 -- 4,288
Year 2001 actual realized losses 545 8,397 238 9,180
Year 2002 actual realized losses 11,554 25,113 563 37,230
Actual realized losses, January 1 through June 30, 2003 2,006 16,229 662 18,897
-------- -------- ------- ----------
Cumulative actual realized losses through June 30, 2003 $ 18,044 $ 50,826 $ 1,463 $ 70,333
======== ======== ======= ==========
Cumulative expected realized loss estimates (including
cumulative actual realized losses) through the year 2003 $ 31,014 $123,247 $ 8,566 $ 162,827
Expected loss estimates for the year 2004 54,441 122,314 14,921 191,676
Expected loss estimates for the year 2005 17,355 71,376 8,484 97,215
Expected loss estimates for the years 2006-2008 8,548 43,765 8,173 60,486
Expected loss estimates for the years 2009-2011 6,492 18,463 3,955 28,910
Expected loss estimates for the remaining life of CMBS 3,938 12,292 1,790 18,020
-------- -------- ------- ---------
Cumulative expected loss estimates (including cumulative
actual realized losses) through life of CMBS $121,788 $391,457 $45,889 $ 559,134
======== ======== ======= =========
As of June 30, 2003, we revised our overall expected loss estimate related
to our subordinated CMBS from $503 million to $559 million, with such total
losses occurring or expected to occur through the life of the subordinated CMBS
portfolio. These revisions to the overall expected loss estimate were primarily
the result of increased projected losses due to lower than anticipated
appraisals and lower internal estimates of values on real estate owned by
underlying trusts and properties underlying certain defaulted mortgage loans,
which, when combined with the updated loss severity experience and changes in
the timing of resolution and disposition of the specially serviced assets, has
resulted in higher projected loss severities on loans and real estate owned by
underlying trusts currently or anticipated to be in special servicing. The
primary reasons for lower appraisals and lower estimates of value resulting in
higher projected loss severities on mortgage loans and real estate owned by the
underlying securitization trusts include the poor performance of certain
properties and related markets and failed workout negotiations due, in large
part, to the continued softness in the economy, the continued downturn in travel
and, in some cases, over-supply of hotel properties, and a shift in retail
activity in some markets, including the closing of stores by certain national
and regional retailers. There can be no assurance that our revised overall
expected loss estimate of $559 million will not be exceeded as a result of
additional or existing adverse events or circumstances. Such events or
circumstances include, but are not limited to, the receipt of new or updated
appraisals at lower than anticipated amounts, legal proceedings (including
bankruptcy filings) involving borrowers, a continued weak economy or recession,
continued hostilities in the Middle East or elsewhere, terrorism, unexpected
delays in the disposition or other resolution of specially serviced mortgage
loans, additional defaults, or an unforeseen reduction in expected recoveries,
any of which could result in additional future credit losses and/or further
impairment to our subordinated CMBS, the effect of which could be materially
adverse to us.
We have also determined that there has been an adverse change in expected
future cash flows for the unrated/issuer's equity bonds, the CCC bond and the B-
bond in CBO-2 as of June 30, 2003 due to the factors mentioned in the preceding
paragraph. As a result, we believe these bonds have been impaired under EITF
99-20 and SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," as of June 30, 2003. As the fair values of these impaired bonds
aggregated approximately $8.9 million below the amortized cost basis as of June
30, 2003, we recorded other than temporary impairment charges through the income
statement of that same amount during the three months ended June 30, 2003.
61
Yield to Maturity
The following table summarizes yield-to-maturity information relating to
our CMBS on an aggregate pool basis:
Current
Anticipated Anticipated Anticipated
Yield-to- Yield-to- Yield-to-
Maturity Maturity Maturity
Pool as of 1/1/02 (1) as of 1/1/03 (1) as of 7/1/03 (1)
---- ----------------- ----------------- -----------------
CBO-2 CMBS 12.1% (2) 11.6% (2) 11.5% (2)
CBO-1 CMBS 14.3% (2) 11.6% (2) 21.6% (2)
Nomura CMBS 28.7% (2) 8.0% (2) 16.9% (2)
------ ------ ------
Weighted Average (3) 12.4% (2) 11.6% (2) 11.7% (2)
(1) Represents the anticipated weighted average yield over the expected average
life of the CMBS as of January 1, 2002, January 1, 2003 and July 1, 2003
based on our estimate of the timing and amount of future credit losses and
other significant items that are anticipated to affect future cash flows.
(2) As previously discussed, as of December 31, 2001, June 30, 2002, September
30, 2002, December 31, 2002 and June 30, 2003, we revised our overall
expected loss estimate related to our subordinated CMBS from $307 million
to $335 million, $351 million, $448 million, $503 million and $559 million,
respectively, which resulted in impairment recognition to certain
subordinated CMBS. As a result of recognizing impairment, we revised the
anticipated yields as of January 1, 2002, July 1, 2002, October 1, 2002,
January 1, 2003 and July 1, 2003, which were or are, in the case of revised
anticipated yields as of July 1, 2003, used to recognize interest income
beginning on each of those dates. These anticipated revised yields took
into account the lower cost basis due to the impairment recognized on the
subordinated CMBS as of dates the losses were revised, and contemplated
larger than previously anticipated losses.
(3) GAAP requires that the income on CMBS be recorded based on the effective
interest method using the anticipated yield over the expected life of these
mortgage assets. This method can result in accounting income recognition
which is greater than or less than cash received. During the six months
ended June 30, 2003, we recognized approximately $5.6 million of discount
amortization, partially offset by approximately $3.0 million of cash
received in excess of income recognized on subordinated CMBS due to the
effective interest method. During the six months ended June 30, 2002, we
recognized approximately $5.7 million of discount amortization, partially
offset by approximately $1.9 million of cash received in excess of income
recognized on subordinated CMBS due to the effective interest method.
Summary of Other Assets
Portfolio Investment
As of June 30, 2003 and December 31, 2002, our other assets consisted
primarily of insured mortgage securities, equity investments, mezzanine loans,
Other MBS, cash and cash equivalents (as previously discussed), principal and
interest receivables and real estate owned.
We had $221.2 million and $275.3 million (in each case, at fair value)
invested in insured mortgage securities as of June 30, 2003 and December 31,
2002, respectively. The reduction in fair value is primarily attributable to the
prepayment, partial prepayment, or sale of approximately 20% (based on amortized
cost) of the insured mortgages during the six months ended June 30, 2003. As of
June 30, 2003, 86% of our investments in insured mortgage securities were GNMA
mortgage-backed securities and approximately 14% were FHA-insured certificates.
As of June 30, 2003 and December 31, 2002, we had approximately $5.1
million and $6.2 million, respectively, in investments accounted for under the
equity method of accounting. Included in equity investments are (a) the general
partnership interests (2.9% to 4.9% ownership interests) in the AIM Limited
Partnerships, and (b) a 20% limited partnership interest in the advisor to the
AIM Limited Partnerships. The decrease in these investments is primarily the
result of partner distributions declared by the AIM Limited Partnerships due to
loan pay-offs and normal cash flow distributions, and impairment of
approximately $109,000 that we recognized on our investments in the adviser to
the AIM Limited Partnerships during the three months ended June 30, 2003 (see
discussion in "Equity in (Losses) Income from Investments"). The carrying values
of our equity investments are
62
expected to continue to decline over time as the AIM Limited Partnerships'
asset bases decrease and proceeds are distributed to partners.
Our Other MBS primarily include investment grade CMBS, investment grade
residential mortgage-backed securities and other fixed income securities. As of
June 30, 2003 and December 31, 2002, the fair values of our Other MBS were
approximately $2.5 million and $5.2 million, respectively.
As previously discussed, we own a shopping center in Orlando, Florida,
which we account for as real estate owned. As of June 30, 2003 and December 31,
2002, we had approximately $8.9 million and $8.8 million, respectively, in real
estate owned assets included in other assets ($8.4 million relating to the
actual building and land). In addition, we had $7.3 million and $7.2 million of
mortgage payable (net of discount) related to the real estate as of June 30,
2003 and December 31, 2002, respectively. We hope to reposition and stabilize
this asset to increase its value, although there can be no assurance we will be
able to do so.
Mortgage Servicing
As of June 30, 2003 and December 31, 2002, CMSLP's other assets consisted
primarily of advances receivable, investments in CMBS, fixed assets, investments
in interest-only strips and investments in subadvisory contracts. The servicing
other assets have decreased by approximately $5.4 million from $13.8 million at
December 31, 2002 to $8.3 million at June 30, 2003. The decrease is primarily
the result of the sale of investment grade CMBS in January 2003 in connection
with our recapitalization, which had a fair value of approximately $3.3 million
as of December 31, 2002, and a $713,000 decrease in advances receivable.
Summary of Liabilities
Portfolio Investment
As of June 30, 2003 and December 31, 2002, our liabilities consisted
primarily of debt, accrued interest and accrued payables. Total recourse debt
decreased by approximately $45.9 million to $330.0 million as of June 30, 2003
from $376.0 million as of December 31, 2002 primarily due to the repayment of
the Exit Debt during the first quarter of 2003 principally through the
incurrence of the Bear Stearns and BREF Debt. Total non-recourse debt decreased
by approximately $47.4 million to $498.7 million at June 30, 2003 from $546.0
million at December 31, 2002. This decrease is primarily attributable to
significant prepayments of mortgages underlying the insured mortgage securities
during the six months ended June 30, 2003, which resulted in a corresponding
reduction in the principal balances of the securitized mortgage obligations. Our
payables and accrued liabilities decreased by approximately $16.3 million to
$10.4 million as of June 30, 2003 from $26.7 million as of December 31, 2002
primarily due to the January 2003 recapitalization and the payment of preferred
stock dividends that were previously deferred. During the three months ended
March 31, 2003, we reversed approximately $7.5 million of extension fees that
were accrued at December 31, 2002 on the Exit Debt since they were no longer
payable. In addition, we paid $2.9 million of interest that was accrued, as of
December 31, 2002, on the Series B Senior Secured Notes. As of December 31,
2002, we had accrued approximately $5.2 million of preferred stock dividends. As
of June 30, 2003, there were no accrued and unpaid dividends on our preferred
stock.
Mortgage Servicing
As of June 30, 2003 and December 31, 2002, CMSLP's liabilities consisted
primarily of operating accounts payable and accrued expenses. The servicing
liabilities increased by approximately $120,000 to $877,000 as of June 30, 2003
from $757,000 as of December 31, 2002.
Dividends/Other
On May 15, 2003, the Board of Directors declared a cash dividend for the
third quarter of 2002 on our Series B, Series F and Series G Preferred stock
payable on June 30, 2003 to shareholders of record on June 18, 2003.
63
On June 3, 2003, the Board of Directors declared a cash dividend for the
fourth quarter of 2002 and the first and second quarters of 2003 on our Series
B, Series F and Series G Preferred stock payable on June 30, 2003 to
shareholders of record on June 18, 2003. No cash dividends were paid to common
shareholders during the six months ended June 30, 2003. Unlike the Exit Debt,
which significantly restricted the amount of cash dividends that could be paid,
the Bear Stearns and BREF Debt do not contain a restrictive covenant restricting
our ability to pay cash dividends; however the Bear Stearns Debt does require us
to first pay the principal and interest payment due to Bear Stearns. Based on
current taxable income estimates, it is expected that preferred or common
dividends paid in 2004 and thereafter will be taxable to the shareholders.
Dividends paid in 2001, 2002, and 2003 were, or are expected to be, considered
"return of capital" for tax purposes.
On August 14, 2003, we declared cash dividends of $0.68, $0.30 and $0.375
per share of Series B, Series F and Series G Preferred Stock, respectively,
payable on September 30, 2003 to shareholders of record on September 17, 2003.
Other factors which could impact dividends, if any, include (i) the level
of income earned on uninsured mortgage assets, such as subordinated CMBS
(including, but not limited to, the amount of original issue discount income,
interest shortfalls and realized losses on subordinated CMBS), (ii) net
operating losses, (iii) the fluctuating yields on short-term, variable-rate debt
and the rate at which our LIBOR-based debt is priced, as well as the rate we pay
on our other borrowings and fluctuations in long-term interest rates, (iv)
changes in operating expenses, including hedging costs, (v) margin calls, (vi)
the level of income earned on our insured mortgage securities depending
primarily on prepayments and defaults, (vii) the rate at which cash flows from
mortgage assets, mortgage dispositions, and, to the extent applicable,
distributions from our subsidiaries can be reinvested, (viii) cash dividends
paid on preferred shares, (ix) to the extent applicable, whether our taxable
mortgage pools continue to be exempt from corporate level taxes, (x) realized
losses on certain transactions, and (xi) the timing and amounts of cash flows
attributable to our other lines of business - mortgage servicing. Cash dividends
on our common stock are subject to the prior payment of all accrued and unpaid
dividends on our preferred stock, and cash dividends on our junior classes of
preferred stock are subject to the prior payment of all accrued and unpaid
dividends on our senior preferred stock.
Investment Company Act
Under the Investment Company Act of 1940, as amended, an investment company
is required to register with the Securities and Exchange Commission (SEC) and is
subject to extensive restrictive and potentially adverse regulation relating to,
among other things, operating methods, management, capital structure, dividends
and transactions with affiliates. However, as described below, companies
primarily engaged in the business of acquiring mortgages and other liens on and
interests in real estate (Qualifying Interests) are excluded from the
requirements of the Investment Company Act.
To qualify for the Investment Company Act exclusion, we, among other
things, must maintain at least 55% of our assets in Qualifying Interests (the
55% Requirement) and are also required to maintain an additional 25% in
Qualifying Interests or other real estate-related assets (Other Real Estate
Interests and such requirement, the 25% Requirement). According to current SEC
staff interpretations, we believe that all of our government-insured mortgage
securities constitute Other Real Estate Interests and that substantially all of
our government insured mortgage securities constitute Qualifying Interests. In
accordance with current SEC staff interpretations, we believe that all of our
subordinated CMBS constitute Other Real Estate Interests and that certain of our
subordinated CMBS also constitute Qualifying Interests. On certain of our
subordinated CMBS, we, along with other rights, have the unilateral right to
direct foreclosure with respect to the underlying mortgage loans. Based on such
rights and our economic interest in the underlying mortgage loans, we believe
that the related subordinated CMBS constitute Qualifying Interests. As of June
30, 2003, we believe that we were in compliance with both the 55% Requirement
and the 25% Requirement.
If the SEC or its staff were to take a different position with respect to
whether such subordinated CMBS constitute Qualifying Interests, we could, among
other things, be required either (i) to change the manner in which we conduct
our operations to avoid being required to register as an investment company or
(ii) to register as an investment company, either of which could have a material
adverse effect on us. If we were required to change the manner in which we
conduct our business, we would likely have to dispose of a significant portion
of our subordinated CMBS or acquire significant additional assets that are
Qualifying Interests. Alternatively, if we were required to register as an
investment company, we expect that our operating expenses would significantly
increase and that we would have to significantly reduce our indebtedness, which
could also require us to sell a significant portion of our assets. No assurances
can be given that any such dispositions or acquisitions of assets, or
deleveraging, could be accomplished on favorable terms, or at all. There are
restrictions under certain of the
64
operative documents evidencing our obligations which could limit possible
actions we may take in response to any need to modify our business plan in order
to register as an investment company or avoid the need to register. Certain
dispositions or acquisitions of assets could require approval or consent of
certain holders of these obligations. Any such results could have a material
adverse effect on us.
Further, if we were deemed an unregistered investment company, we could be
subject to monetary penalties and injunctive relief. We would be unable to
enforce contracts with third parties and third parties could seek to obtain
rescission of transactions undertaken during the period we were deemed an
unregistered investment company, unless the court found that under the
circumstances, enforcement (or denial of rescission) would produce a more
equitable result than nonenforcement (or grant of rescission) and would not be
inconsistent with the Investment Company Act.
Critical Accounting Estimates
The preparation of financial statements in conformity with GAAP requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities, the disclosure of contingent assets and liabilities at
the date of the financial statements, and the reported amounts of revenues and
expenses during the reporting periods. We continually evaluate the estimates we
use to prepare the consolidated financial statements, and update those estimates
as necessary. In general, management's estimates are based on historical
experience, on information from third party professionals, and other various
assumptions that are believed to be reasonable under the facts and
circumstances. Actual results could differ materially from those estimates.
Management considers an accounting estimate to be critical if:
o it requires assumptions to be made that were uncertain at the time the
estimate was made; and
o changes in the estimate or different estimates that could have been
selected could have a material impact on our consolidated results of
operations or financial condition.
We believe our critical accounting estimates include the determination of
fair value of our subordinated CMBS and interest income recognition related to
our subordinated CMBS.
o Fair Value of subordinated CMBS - Due to the limited liquidity of
the subordinated CMBS market and the resulting lack of a secondary
market, we estimate the values of our subordinated CMBS internally.
These estimates require significant judgment regarding assumptions
for defaults on the underlying commercial mortgage loan collateral,
timing of loss realization and resultant loss severity and discount
rates. Note 4 to Notes to Consolidated Financial Statements
contains a detailed discussion of the methodology used to determine
the fair value of our subordinated CMBS as well as a sensitivity
analysis related to the fair value of these subordinated CMBS due
to changes in assumptions related to losses on the underlying
commercial mortgage loan collateral and discount rates.
o Interest Income recognition related to subordinated CMBS - Interest
income recognition under EITF No. 99-20 requires us to make
estimates regarding expected prepayment speeds as well as expected
losses on the underlying commercial mortgage loan collateral (which
directly impact the cash flows on our subordinated CMBS in the form
of interest shortfalls and loss of principal) and the impact these
factors would have on future cash flow. Note 4 to Notes to
Consolidated Financial Statements details the expected realized
losses by year that we expect to incur related to our subordinated
CMBS. The cash flows we project to arrive at the effective
interest rate to recognize interest income are adjusted for these
expected losses. The judgment regarding future expected credit
losses is subjective as credit performance is particular
to an individual deal's specific underlying commercial mortgage
loan collateral. In general, if we increase our expected
losses or determine such losses will occur sooner than previously
projected and the CMBS's fair value is below cost, then the CMBS
will be considered impaired and adjusted to fair value with the
impairment charge recorded through earnings.
Recent Accounting Pronouncements
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities," which replaces Emerging Issues
Task Force Issue No. 94-3, "Liability Recognition for Certain
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Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring)." The new standard
requires companies to recognize costs associated with exit or disposal
activities when they are incurred rather than at the date of a commitment to an
exit or disposal plan. The statement is to be applied prospectively to exit or
disposal activities initiated after December 31, 2002. As discussed previously,
we recognized approximately $144,000 of restructuring expenses in the second
quarter of 2003 as a result of CMSLP's restructuring of its property servicing
group. We expect to recognize approximately $7,000 in additional restructuring
expenses in the third quarter of 2003. We also recognized approximately $532,000
of expense for vacant office space related to the consolidation of our office
space in connection with our January 2003 recapitalization during the second
quarter of 2003.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure," which amended SFAS No. 123
"Accounting for Stock-Based Compensation." The new standard provides alternative
methods of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation. Additionally, the statement
amends the disclosure requirements of SFAS No. 123 to require prominent
disclosures in the annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect of the method
used on reported results. This statement is effective for financial statements
for fiscal years ending after December 15, 2002. In accordance with SFAS No.
148, we have elected to continue to follow the intrinsic value method in
accounting for our stock-based employee compensation arrangements as defined by
Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued
to Employees," and have made the applicable disclosures in Note 2 to the
consolidated financial statements.
In January 2003, the FASB issued FASB Interpretation (or FIN) No. 46,
"Consolidation of Variable Interest Entities", an interpretation of Accounting
Research Bulletin No. 51, "Consolidated Financial Statements." FIN No. 46
explains how to identify variable interest entities and how an enterprise
assesses its interests in a variable interest entity to decide whether to
consolidate that entity. This Interpretation requires existing unconsolidated
variable interest entities to be consolidated by their primary beneficiaries if
the entities do not effectively disperse risks among parties involved. FIN No.
46 is effective immediately for variable interest entities created after January
31, 2003, and to variable interest entities in which an enterprise obtains an
interest after that date. The Interpretation applies in the first fiscal year or
interim period beginning after June 15, 2003, to variable interest entities in
which an enterprise holds a variable interest that it acquired before February
1, 2003. We do not expect the adoption of FIN No. 46 to have a material effect
on our financial position or results of operations.
As a result of recent guidance from the SEC, 2002 earnings per share
recomputations will be reduced to reflect amounts of initial preferred stock
offering costs related to preferred stock redeemed in 2002 beginning in our
third quarter 2003 consolidated financial statements.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our principal market risk is exposure to changes in interest rates related
to the U.S. Treasury market as well as the LIBOR market. We will have
fluctuations in the amount of interest expense paid on our variable rate debt
primarily due to changes in one-month LIBOR. We will also experience
fluctuations in the market value of our mortgage assets related to changes in
the yields of U.S. Treasury securities as well as changes in the spread between
U.S. Treasury securities and the mortgage assets. The combination of the risk
free rate (U.S. Treasury yields) and the related spread is the discount rate
used to determine the fair value of our mortgage assets. The U.S. Treasury yield
used to determine the fair value of our mortgage assets is the current yield on
a U.S. Treasury which has the same weighted average life of the related mortgage
asset. As of June 30, 2003, the average U.S. Treasury rate used to price our
CMBS, excluding the B-, CCC and unrated/issuer's equity CMBS, had decreased by
30 basis points, compared to December 31, 2002. As of June 30, 2003, credit
spreads used to price our investment grade CMBS tightened and there was no
significant change in credit spreads used to price our subordinated CMBS,
excluding the B-, CCC and unrated/issuer's equity CMBS, compared to December 31,
2002. The fair values of our B- and CCC CMBS in CBO-2 and our unrated/issuer's
equity are determined using a loss adjusted yield to maturity, which is
commensurate with the market's perception of value and risk of comparable
assets. As described, interest rates impact the fair values of our CMBS, which
affects our collateral coverage. See "MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS-Financial Condition, Liquidity and
Capital Resources" for a discussion of our collateral coverage requirements
under the Bear Stearns Debt.
CMBS
The required rate of return used to determine the fair values of our CMBS
is comprised of many variables, such as a risk-free rate, a liquidity premium
and a credit risk premium. These variables are combined to determine a total
rate that, when used to discount the CMBS's assumed stream of future cash flows,
results in the fair value of such cash flows. The determination of such rate is
dependent on many quantitative and qualitative factors, such as, but not limited
to, the market's perception of the issuers of the CMBS and the credit
fundamentals of the commercial properties underlying each underlying pool of
commercial mortgage loans.
If we assumed that the discount rate used to determine the fair values of
our CMBS (A+ through unrated bonds) increased by 100 basis points and 200 basis
points, the increase in the discount rate would have resulted in a corresponding
decrease in the fair values of our CMBS (A+ through unrated bonds) by
approximately $50.8 million (or 5.8%) and approximately $97.4 million (or
11.2%), respectively, as of June 30, 2003. A 100 basis point and 200 basis point
increase in the discount rate would have resulted in a corresponding decrease in
the value of our subordinated CMBS (BB+ through unrated bonds) by approximately
$32.5 million (or 6.1%) and $62.1 million (or 11.6%), respectively, as of June
30, 2003.
See also Note 4 of Notes to Consolidated Financial Statements for a
discussion of other factors that could affect the fair values of our CMBS,
including changes in the timing and/or amount of credit losses on underlying
mortgage loans, the receipt of mortgage payments earlier than projected due to
prepayments, and delays in the receipt of monthly cash flow distributions on
CMBS due to mortgage loan defaults and/or extensions in loan maturities.
Interest Rate Swap
In the second quarter of 2003, we entered into two interest rate swaps to
hedge the variability of the future interest payments on the anticipated CDO
attributable to changes in the U.S. swap rates. Our obligations to Bear Stearns
under the interest rate swap documents are collateralized by certain assets as
described in Note 6. These swaps are treated as cash flow hedges for GAAP. The
following is a summary of the terms of the interest rate swaps:
Date entered May 16, 2003 June 27, 2003
Notional amount $50 million $25 million
Effective date October 15, 2003 October 15, 2003
Maturity date October 15, 2013 October 15, 2013
Fixed rate 3.946% 4.055%
Floating rate 1 month U.S. LIBOR 1 month U.S. LIBOR
The swaps are intended to protect our cost of financing in connection with
our anticipated CDO transaction. We intend to terminate the swaps simultaneously
with the issuance of the CDO. As of June 30, 2003, the aggregate fair value of
the interest rate swaps was a liability of approximately $63,000.
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Variable Rate Debt
We have an interest rate cap to mitigate the adverse effects of rising
interest rates on the amount of interest expense payable under our variable rate
debt. This interest rate cap, which was effective on May 1, 2002, is for a
notional amount of $175.0 million, caps LIBOR at 3.25%, and matures on November
3, 2003. As of June 30, 2003, our interest rate cap had a fair value of $0. This
cap provides protection to the extent interest rates, based on a readily
determinable interest rate index (typically one-month LIBOR), increase above the
stated interest rate cap, in which case, we will receive payments based on the
difference between the index and the cap. The terms of the cap as well as the
stated interest rate of the cap, which is currently above the current rate of
the index, will limit the amount of protection that the cap offers. The average
one-month LIBOR index was 1.30% during the six months ended June 30, 2003, which
was a 8 basis point decrease from December 31, 2002.
A 100 basis point change in the one-month LIBOR index would have changed
our interest expense on our Bear Stearns Debt by approximately $755,000 and $1.4
million during the three and six months ended June 30, 2003, respectively.
Insured Mortgage Securities
There would not be a material change in the fair values of our insured
mortgage securities if we assumed that the discount rate used to determine the
fair values increased by 100 basis points and 200 basis points as of June 30,
2003.
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ITEM 4. CONTROLS AND PROCEDURES
Within the 90 days prior to the filing date of this report, we carried out
an evaluation, under the supervision and with the participation of our
management, including our Chief Executive Officer and Chief Financial Officer,
of the effectiveness of the design and operation of our disclosure controls and
procedures pursuant to Securities Exchange Act Rule 15d-15. Our management,
including the Chief Executive Officer and Chief Financial Officer, does not
expect that our disclosure controls and procedures will prevent all error and
all fraud. A control system, no matter how well conceived and operated, can
provide only reasonable assurance that the objectives of the control system are
met. Further, the design of a control system must reflect the fact that there
are resource constraints, and the benefits of controls must be considered
relative to their costs. Because of the inherent limitations in all control
systems, no evaluation of controls can provide absolute assurance that all
control issues within the company have been detected. These inherent limitations
include the realities that judgments in decision-making can be faulty, and that
breakdowns can occur because of simple error or mistake. The design of any
system of controls also is based in part upon certain assumptions about the
likelihood of future events, and there can be no assurance that any design will
succeed in achieving its stated goals under all potential future conditions.
Over time, control may become inadequate because of changes in conditions, or
the degree of compliance with the policies or procedures may deteriorate.
Because of the inherent limitations in a cost-effective control system,
misstatements due to error or fraud may occur and not be detected. Our Chief
Executive Officer and Chief Financial Officer have concluded, based on our
evaluation of our disclosure controls and procedures, that our disclosure
controls and procedures under Rule 13a-14(c) and Rule 15d-14(c) of the
Securities Exchange Act of 1934 are effective. Subsequent to our evaluation,
there were no significant changes in internal controls or other factors that
could significantly affect these internal controls; however, we intend to
continue to implement certain actions in the current quarter designed to improve
our credit loss estimation process, as discussed below.
Although we believe our overall credit loss estimate is reasonable and
correct, based upon our evaluation of our internal controls in connection with
our recent Annual Report on Form 10-K and written observations, recommendations
and a report received from our independent auditors, we commenced implementing
actions to improve our credit loss estimation process. This process is important
to our CMBS income recognition, CMBS fair value determination and CMBS
impairment assessment. We and our independent auditors determined that
significant improvement was needed in this process, particularly in connection
with mortgage loan valuation and credit loss estimation. To address these
matters, we have substantially completed the initial re-underwriting of the
mortgage loans underlying our CMBS and are continuing with the implementation of
additional actions designed to improve our credit loss estimation process
including (a) created a new underwriting internal valuation group, (b)
developing additional policies and procedures to better standardize our process,
and (c) employing, as appropriate, additional resources and expertise to the
management of the loan loss estimation process. Our independent auditors were
not specifically engaged to evaluate or assess the internal controls over our
overall loss estimate.
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PART II
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company held its Annual Meeting of Stockholders on May 15, 2003. The
following is a summary of matters voted upon by stockholders.
The stockholders elected each of the following Class III Nominees to the
Board of Directors for terms expiring at the 2006 annual meeting of stockholders
and until their successors have been duly elected and qualified:
For Withhold
Director % Shares % Shares
-------- - ------ - ------
Robert J. Merrick 98.3% 12,072,984 1.7% 202,931
Jeffrey N. Blidner 99.2% 12,179,882 0.8% 96,033
Arthur N. Haut 98.3% 12,067,321 1.7% 208,594
The following individuals continue to serve on the Board of Directors:
Barry S. Blattman, William B. Dockser, Joshua B. Gillon, Mark R. Jarrell, Donald
J. MacKinnon, and Robert E. Woods.
The stockholders approved the appointment of Ernst & Young, LLP as the
Company's independent accountants for the fiscal year ending December 31, 2003.
Common Stockholders
--------------------
% Shares
- ------
For 90.1% 11,059,610
Against 9.8% 1,204,213
Abstain 0.1% 12,092
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
Exhibit No. Description
3.1 Amended and Restated Limited Liability
Company Agreement of CRIIMI Newco,
LLC, dated as of June 24, 2003
(filed herewith).
3.2 Articles of Amendment and Restatement
of CBO REIT II, Inc., filed with the
Maryland State Department of
Assessments and Taxation on June 25,
2003 (filed herewith).
10.1 ISDA Master Agreement dated as of
June 26, 2003, between Bear, Stearns
International Limited and CRIIMI
Newco, LLC and CBO REIT II, Inc.
(filed herewith).
10.2 Schedule to the ISDA Master Agreement
dated as of June 26, 2003, between
Bear, Stearns International Limited
and each of CRIIMI Newco, LLC and CBO
REIT II, Inc. (filed herewith).
10.3 ISDA Credit Support Annex dated as of
June 26, 2003, between Bear, Stearns
International and CRIIMI Newco, LLC
and CBO REIT II, Inc. (filed
herewith).
10.4 Netting and Security Agreement dated
as of June 26, 2003, between and among
Bear, Stearns International Limited,
CRIIMI Newco LLC and CBO REIT II Inc.
(filed herewith).
70
10.5 Amendment No. 1 to Repurchase
Agreement, dated as of June 26, 2003,
between Bear, Stearns International
Limited, CRIIMI Newco LLC and CBO REIT
II, Inc. (filed herewith).
10.6 Amendment No. 1 to Guarantee, dated as
of June 26, 2003, between Bear,
Stearns International Limited, and
CRIIMI MAE Inc. (filed herewith).
10.7 First Amendment to Employment
Agreement, dated and effective as of
July 24, 2003, between CRIIMI MAE Inc.
and David B. Iannarone (filed
herewith).
10.8 First Amendment to Employment
Agreement, dated and effective as of
July 24, 2003, between CRIIMI MAE Inc.
and Cynthia O. Azzara (filed
herewith).
10.9 First Amendment to Employment
Agreement, dated and effective as of
July 24, 2003, between CRIIMI MAE Inc.
and Brian L. Hanson (filed herewith).
10.10 Employment Offer Letter Agreement,
dated as of August 11, 2003 and
effective as of September 15, 2003,
between CRIIMI MAE Inc. and Mark R.
Jarrell (filed herewith).
31.1 Certification of Chief Executive
Officer pursuant to Exchange Act
Rule 13a-14(a) (filed herewith).
31.2 Certification of Chief Financial
Officer pursuant to Exchange Act
Rule 13a-14(a) (filed herewith).
32.1 Certification of Chief Executive
Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 (filed
herewith).
32.2 Certification of Chief Financial
Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 (filed
herewith).
99.1 Special Serviced Loan Report relating
to specially serviced loans underlying
the Company's CMBS as of June 30, 2003
(filed herewith).
(b) REPORTS ON FORM 8-K
Date Purpose
May 12, 2003 To report a press release dated
May 12, 2003 announcing our earnings
for the first quarter ended
March 31, 2003.
May 19, 2003 To report: (1) a press release dated
May 16, 2003 announcing the
declaration of a cash dividend
previously deferred for the third
quarter of 2002 on our Series B,
Series F, and Series G Preferred
Stock, and (2) a press release dated
May 16, 2003 announcing the
re-election of Robert J. Merrick, and
the election of Arthur N. Haut and
Jeffrey M. Blidner, as directors at
our Annual Meeting of Stockholders
held on May 15, 2003.
June 3, 2003 To report a press release dated
June 3, 2003 announcing the
declaration of all cash
dividends previously deferred for
each of the fourth quarter of 2002 and
the first and second quarters of 2003
on our Series B, Series F, and
Series G Preferred Stock.
71
Signature
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the Registrant has duly caused this Quarterly
Report on Form 10-Q to be signed on its behalf by the undersigned, thereunto
duly authorized.
CRIIMI MAE INC.
August 14, 2003 /s/Cynthia O. Azzara
- --------------------------- ----------------------------------------
DATE Cynthia O. Azzara
Senior Vice President,
Chief Financial Officer and
Treasurer (Principal Accounting Officer)