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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED: DECEMBER 31, 1997
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
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COMMISSION FILE NUMBER: 1-13447
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ANNALY MORTGAGE MANAGEMENT, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS GOVERNING INSTRUMENTS)
MARYLAND 22-3479661
(STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER
OF INCORPORATION OF ORGANIZATION) IDENTIFICATION NUMBER)
12 EAST 41ST STREET, SUITE 700, NEW YORK, NEW YORK 10017
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
(201)696-0100
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
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SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
NAME OF EACH EXCHANGE
TITLE OF EACH CLASS ON WHICH REGISTERED
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COMMON STOCK, PAR VALUE NEW YORK STOCK EXCHANGE
$.01 PER SHARE
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 if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
At March 24, 1998 the aggregate market value of the voting stock held by
non-affiliates of the Registrant was $138,542,380.
The number of shares of the Registrant's Common Stock outstanding on March
24, 1998 was 12,757,676.
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the Registrant's definitive Proxy Statement issued in connection
with the 1998 Annual Meeting of Stockholders of the Registrant to be held on May
18, 1998 are incorporated by reference into Parts I and III.
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ANNALY MORTGAGE MANAGEMENT, INC.
1997 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PAGE
----
PART I
ITEM 1. BUSINESS....................................................... 1
ITEM 2. PROPERTIES..................................................... 33
ITEM 3. LEGAL PROCEEDINGS.............................................. 33
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............ 33
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER
MATTERS........................................................ 33
ITEM 6. SELECTED FINANCIAL DATA........................................ 35
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.......................................... 36
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.................... 45
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE........................................... 45
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............. 46
ITEM 11. EXECUTIVE COMPENSATION......................................... 46
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. 46
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................. 46
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-
K.............................................................. 46
FINANCIAL STATEMENTS..................................................... F-1
SIGNATURES............................................................... 55
EXHIBIT INDEX
i
PART I
ITEM 1. BUSINESS
THE COMPANY
Annaly Mortgage Management, Inc. (the "Company") was incorporated in the
State of Maryland on November 25, 1996. The Company commenced operations on
February 18, 1997 upon the consummation of its sale of 3,600,000 shares of
Common Stock in an offering exempt from registration under the Securities Act
and state securities laws (the "Private Placement"). The Company raised
additional capital on July 31, 1997 upon the consummation of the its sale of
87,800 shares of Common Stock to certain directors, officers and employees of
the Company (the "Direct Offering"). The Company completed its initial public
offering of 8,946,100 shares on October 14, 1997.
Annaly Mortgage Management, Inc. specializes in investing in Mortgage-Backed
Securities. Its principal business objective is to generate net income for
distribution to stockholders from the spread between the interest income on
its Mortgage-Backed Securities and the costs of borrowing to finance its
acquisition of Mortgage-Backed Securities. The Company has elected to be taxed
as a Real Estate Investment Trust ("REIT"). The Company is self-advised and
self-managed. The management of the Company manages the day-to-day operations,
subject to the supervision of the Company's Board of Directors.
Certain statements contained herein are not, and certain statements
contained in future filings by the Company with the Securities and Exchange
Commission (the "Commission") in the Company's press releases or in the
Company's other public or shareholder communications may not be, based on
historical facts and are "Forward-looking statements" within the meaning of
the Private Securities Litigation Reform Act of 1995. Forward-looking
statements which are based on various assumptions (some of which are beyond
the Company's control) may be identified by reference to a future period or
periods, or by the use of forward-looking terminology, such as "may," "will,"
"believe," "expect," "anticipate," "continue," or similar terms or variations
on those terms, or the negative of those terms. Actual results could differ
materially from those set forth in forward-looking statements due to a variety
of factors, including, but not limited to, changes in interest rates, changes
in yield curve, changes in prepayment rates, the availability of Mortgage-
Backed Securities for purchase, the availability of financing and, if
available, the terms of any such financing. For a discussion of the risks and
uncertainties which could cause actual results to differ from those contained
in the forward-looking statements, see "Risk Factors" commencing on page 23 of
this Form 10-K. The Company does not undertake, and specifically disclaims any
obligation, to publicly release the result of any revisions which may be made
to any forward-looking statements to reflect the occurrence of anticipated or
unanticipated events or circumstances after the date of such statements.
Reference is made to the Glossary commencing on page 48 of this report for
definitions of terms used in the following description of the Company's
business and elsewhere in this report.
BUSINESS STRATEGY
GENERAL
The Company's principal business objective is to generate income for
distribution to its stockholders, primarily from the net cash flows on its
Mortgage-Backed Securities which qualify as Qualified REIT Real Estate Assets.
The Company's net cash flows result primarily from the difference between (i)
the interest income on its Mortgage-Backed Security investments and (ii) the
borrowing and financing costs of the Mortgage-Backed Securities. To achieve
its business objective and generate dividend yields, the Company's strategy
is:
. to purchase Pass-Through Certificates, CMOs and other Mortgage-Backed
Securities, substantially all of which are expected to have adjustable
interest rates based on changes in short-term market interest rates;
1
. to acquire only those Mortgage-Backed Securities which the Company
believes it has the necessary expertise to evaluate and manage, which
can be readily financed and which are consistent with the Company's
balance sheet guidelines and risk management objectives and generally to
seek to acquire assets whose investment returns are attractive in more
than a limited range of scenarios;
. to finance purchases of Mortgage-Backed Securities with the proceeds of
equity offerings and, to the extent permitted by the Company's Capital
Investment Policy, to utilize leverage to increase potential returns to
stockholders through borrowings (primarily under repurchase agreements);
. to attempt to structure its borrowings to have interest rate adjustment
indices and interest rate adjustment periods that, on an aggregate
basis, generally correspond (within a range of one to six months) to the
interest rate adjustment indices and interest rate adjustment periods of
the adjustable and floating rate Mortgage-Backed Securities purchased by
the Company;
. to utilize interest rate caps, swaps and similar instruments to mitigate
the risk of the cost of its variable rate liabilities increasing at a
faster rate than the earnings on its assets during a period of rising
interest rates;
. to seek to minimize prepayment risk by structuring a diversified
portfolio with a variety of prepayment characteristics and through other
means; and
. to issue new equity or debt and increase the size of the balance sheet
when opportunities in the market for Mortgage-Backed Securities are
likely to allow growth in earnings per share.
The Company believes it is able to obtain cost efficiencies through its
facilities-sharing arrangement with Fixed Income Discount Advisory Company
("FIDAC") and by virtue of management's experience in managing portfolios of
Mortgage-Backed Securities and in arranging collateralized borrowings. The
Company will strive to become even more cost-efficient over time by:
. seeking to raise additional capital from time to time in order to
increase its ability to invest in Mortgage-Backed Securities as
operating costs are not anticipated to increase as quickly as assets and
because growth will increase the Company's purchasing influence with
suppliers of Mortgage-Backed Securities;
. striving to lower its effective borrowing costs over time through
seeking direct funding with collateralized lenders rather than using
financial intermediaries and investigating the possibility of using
commercial paper and medium term note programs;
. improving the efficiency of its balance sheet structure by investigating
the issuance of uncollateralized subordinated debt, preferred stock and
other forms of capital; and
. utilizing information technology to the fullest extent possible in its
business, which technology the Company believes can be developed to
improve the Company's ability to monitor the performance of its
Mortgage-Backed Securities, improve its ability to assess credit risk,
improve hedge efficiency and lower operating costs.
"Mortgage-Backed Securities" which may be acquired by the Company include
(i) securities (or interests therein) evidencing undivided ownership interests
in a pool of mortgage loans, the holders of which receive a "pass-through" of
the principal and interest paid in connection with the underlying mortgage
loans in accordance with the holders' respective, undivided interests in the
pool ("Pass-Through Certificates"), and (ii) adjustable- or fixed-rate debt
obligations (bonds) that are collateralized by mortgage loans or mortgage
certificates ("CMOs"). "Pass-Through Certificates" include mortgage
participation certificates issued by the Federal Home Loan Mortgage
Corporation ("FHLMC"), mortgage pass-through certificates issued by the
Federal National Mortgage Association ("FNMA"), fully modified pass-through
mortgage-backed certificates guaranteed by the Government National Mortgage
Association ("GNMA"), and privately-issued pass-through certificates
("Privately-Issued Certificates") issued by a third party issuer other than
FHLMC, FNMA and GNMA. The term "Qualified REIT Real Estate Assets" means
Mortgage-Backed Securities and other assets of the type described in section
856(c) (6)(B) of the Internal Revenue Code of 1986, as amended (the "Code").
2
The Company's "Capital Investment Policy" is a set of policies established
by the Company, including a majority of its independent directors,
establishing guidelines for management relating to asset acquisitions, credit
risk management, capital and leverage, interest rate risk management and
prepayment risk management.
MORTGAGE-BACKED SECURITIES
General
The Company's Capital Investment Policy provides that at least 75% of its
total assets will be comprised of High Quality Mortgage-Backed Securities and
High Quality Short-Term Investments. The term "High Quality" as used herein
means securities (i) which are rated within one of the two highest rating
categories by at least one of the nationally recognized rating agencies, (ii)
that are unrated but are either guaranteed by the United States government or
an agency of the United States government, or (iii) that are unrated or whose
ratings have not been updated but are determined to be of comparable quality
to rated High Quality Mortgage-Backed Securities on the basis of credit
enhancement features that meet the High Quality credit criteria approved by
the Company's Board of Directors. To date, all of the Mortgage-Backed
Securities acquired by the Company have been High Quality Mortgage-Backed
Securities which, although not rated, carry an implied "AAA" rating. The term
"Short-Term Investments" means short-term bank certificates of deposit, short-
term United States treasury securities, short-term United States government
agency securities, commercial paper, reverse repurchase agreements, short-term
CMOs, short-term asset-backed securities and other similar types of short-term
investment instruments, all of which have maturities or average durations of
less than one year.
In accordance with the Company's Capital Investment Policy, the remainder of
the Company's assets, comprising not more than 25% of total assets, may
consist of Mortgage-Backed Securities and other Qualified REIT Real Estate
Assets which are unrated or rated less than High Quality, but which are at
least "investment grade" (rated "BBB" or better by Standard & Poors
Corporation ("S&P") or the equivalent by another nationally recognized rating
organization) or, if not rated, are determined by the Company to be of
comparable credit quality to an investment which is rated "BBB" or better. The
foregoing-described Mortgage-Backed Securities, comprising in the aggregate
not more than 25% of the Company's total assets, are sometimes referred to
herein as "Limited Investment Assets." The Company intends to structure its
portfolio to maintain a minimum weighted average rating (including the
Company's deemed comparable ratings for unrated Mortgage-Backed Securities
based on a comparison to rated Mortgage-Backed Securities with like
characteristics) of its Mortgage-Backed Securities of at least single "A"
under the S&P rating system and at the comparable level under the other rating
systems.
Allocation of the Company's investments among the permitted investment types
may vary from time-to-time based on the evaluation by the Company's Board of
Directors of economic and market trends and the Company's perception of the
relative values available from such types of investments, provided that in no
event will the Company's investment in Limited Investment Assets exceed 25% of
the Company's total assets.
To date, all of the Mortgage-Backed Securities acquired by the Company have
been Agency Certificates which carry an implied "AAA" rating. Prior to
acquiring any unrated securities, the Company intends to engage an independent
consultant with expertise in rating "investment grade" securities to assist
the Company in evaluating the creditworthiness of such securities and
determining whether such securities are qualified to be purchased under the
Capital Investment Policy. In making such evaluations, the Company will look
at similar criteria utilized by S&P and other nationally recognized rating
organizations. Such criteria may include a review of the cash flow and other
characteristic of the security, an analysis of the components of the security
and a valuation of comparable assets.
The Company acquires only those Mortgage-Backed Securities which the Company
believes it has the necessary expertise to evaluate and manage, which are
consistent with the Company's balance sheet guidelines and risk management
objectives and which the Company believes can be readily financed. Since the
intention of the Company is generally to hold its Mortgage-Backed Securities
until maturity, the Company generally does not seek to acquire assets whose
investment returns are only attractive in a limited range of scenarios. The
3
Company believes that future interest rates and mortgage prepayment rates are
very difficult to predict. Therefore, the Company seeks to acquire Mortgage-
Backed Securities which the Company believes will provide acceptable returns
over a broad range of interest rate and prepayment scenarios.
The Mortgage-Backed Securities acquired and to be acquired by the Company
consist of (i) Pass-Through Certificates, (ii) CMOs, and (iii) other Mortgage-
Backed Securities, including mortgage derivative securities representing the
right to receive interest only or a disproportionately large amount of
interest. It is expected that the Pass-Through Certificates acquired by the
Company for its investment portfolio will continue to consist primarily of
adjustable-rate Agency Certificates, which include adjustable-rate mortgage
participation certificates issued by FHLMC ("FHLMC Certificates"), mortgage
Pass-Through Certificates issued by FNMA ("FNMA certificates") and fully
modified Pass-Through Certificates guaranteed by GNMA ("GNMA Certificates").
To date, all of the Mortgage-Backed Securities acquired by the Company have
been FHLMC Certificates, FNMA Certificates or GNMA Certificates (collectively,
"Agency Certificates"). The Company has not and will not invest in REMIC
residuals, other CMO residuals or Mortgage-Backed Securities, such as inverse
floaters, which have imbedded leverage as part of their structural
characteristics.
Description of Mortgage-Backed Securities
The Mortgage-Backed Securities in which the Company invests provide funds
for mortgage loans made primarily to residential homeowners. These include
securities which represent interests in pools of mortgage loans made by
lenders such as savings and loan institutions, mortgage bankers and commercial
banks. Pools of mortgage loans are assembled for sale to investors (such as
the Company) by various governmental, government-related and private
organizations.
Interests in pools of Mortgage-Backed Securities differ from other forms of
traditional debt securities, which normally provide for periodic payments of
interest in fixed amounts with principal payments at maturity or specified
call dates. Instead, Mortgage-Backed Securities provide for a monthly payment,
which consists of both interest and principal. In effect, these payments are a
"pass-through" of the monthly interest and principal payments made by the
individual borrower on its residential mortgage loans, net of any fees paid to
the issuer or guarantor of such securities. Additional payments result from
prepayments of principal resulting from the sale of the underlying residential
property, refinancing or foreclosure, net of fees or costs which may be
incurred. Some mortgage-backed securities, such as securities issued by GNMA,
are described as "modified pass-through." These securities entitle the holder
to receive all interest and principal payments owed on the mortgage pool, net
of certain fees, regardless of whether or not the mortgagors actually make
mortgage payments when due.
The investment characteristics of pass-through Mortgage-Backed Securities
differ from those of traditional fixed-income securities. The major
differences include the payment of interest and principal on the mortgage-
backed securities on a more frequent schedule, as described above, and the
possibility that principal may be prepaid at any time due to prepayments on
the underlying mortgage loans or other assets. These differences can result in
significantly greater price and yield volatility than is the case with
traditional fixed-income securities.
The occurrences of mortgage prepayments are affected by factors including
the level of interest rates, general economic conditions, the location and age
of the mortgage and other social and demographic conditions. Generally
prepayments on pass-through mortgage-backed securities increase during periods
of falling mortgage interest rates and decrease during periods of rising
mortgage interest rates. Reinvestment of prepayments may occur at higher or
lower interest rates than the original investment, thus affecting the yield of
the Company's investments.
FHLMC Certificates
FHLMC is a privately owned government-sponsored enterprise created pursuant
to an Act of Congress (Title III of the Emergency Home Finance Act of 1970, as
amended, 12 U.S.C. (S)(S) 1451-1459), on July 24, 1970. The principal activity
of FHLMC currently consists of the purchase of conventional Conforming
Mortgage Loans
4
or participation interests therein and the resale of the loans and
participations so purchased in the form of guaranteed Mortgage-Backed
Securities. FHLMC guarantees to each holder of FHLMC Certificates the timely
payment of interest at the applicable pass-through rate and ultimate
collection of all principal on the holder's pro rata share of the unpaid
principal balance of the related Mortgage Loans, but does not guarantee the
timely payment of scheduled principal of the underlying Mortgage Loans. The
obligations of FHLMC under its guarantees are solely those of FHLMC and are
not backed by the full faith and credit of the United States. If FHLMC were
unable to satisfy such obligations, distributions to holders of FHLMC
Certificates would consist solely of payments and other recoveries on the
underlying Mortgage Loans and, accordingly, monthly distributions to holders
of FHLMC Certificates would be affected by delinquent payments and defaults on
such Mortgage Loans.
FHLMC Certificates may be backed by pools of Single-Family Mortgage Loans or
Multifamily Mortgage Loans. Such underlying Mortgage Loans may have original
terms to maturity of up to 40 years. FHLMC Certificates may be issued under
Cash Programs (composed of Mortgage Loans purchased from a number of sellers)
or Guarantor Programs (composed of Mortgage Loans purchased from one seller in
exchange for participation certificates representing interests in the Mortgage
Loans purchased). FHLMC Certificates may pay interest at a fixed rate or
adjustable rate. The interest rate paid on FHLMC ARM Certificates adjusts
periodically within 60 days prior to the month in which the interest rates on
the underlying Mortgage Loans adjust. The interest rates paid on FHLMC ARM
Certificates issued under FHLMC's standard ARM programs adjust in relation to
the Treasury Index. Other specified indices used in FHLMC ARM programs include
the 11th District Cost of Funds Index published by the Federal Home Loan Bank
of San Francisco, LIBOR and other indices. Interest rates paid on fully-
indexed FHLMC ARM Certificates equal the applicable index rate plus a
specified number of basis points ranging typically from 125 to 250 basis
points. In addition, the majority of series of FHLMC ARM Certificates issued
to date have evidenced pools of Mortgage Loans with monthly, semi-annual or
annual interest adjustments. Adjustments in the interest rates paid are
generally limited to an annual increase or decrease of either 100 or 200 basis
points and to a lifetime cap of 500 or 600 basis points over the initial
interest rate. Certain FHLMC programs include Mortgage Loans which allow the
borrower to convert the adjustable mortgage interest rate to a fixed rate.
Adjustable-Rate Mortgage Loans ("ARMs") which are converted into fixed-rate
Mortgage Loans are repurchased by FHLMC or by the seller of such loan to FHLMC
at the unpaid principal balance thereof plus accrued interest to the due date
of the last adjustable rate interest payment. An "ARM Certificate" means a
Mortgage-Backed Security that features adjustments of the underlying interest
rate at predetermined times based on an agreed margin to an established index,
such as LIBOR, the Treasury Index or the CD Rate. "LIBOR" means the London
Interbank Offered Rate as it may be defined, and for a period of time
specified, in a Mortgage-Backed Security or borrowing of the Company.
"Treasury Index" means the monthly/weekly average yield of the benchmark U.S.
Treasury securities, as published by the Board of Governors of the Federal
Reserve System. "CD Rate" means the weekly average of secondary market
interest rates on six-month negotiable certificates of deposit, as published
by the Federal Reserve Board in its Statistical Release H.15(519), Selected
Interest Rates.
FNMA Certificates
FNMA is a privately owned, federally chartered corporation organized and
existing under the Federal National Mortgage Association Charter Act (12
U.S.C. (S)1716 et seq.). FNMA provides funds to the mortgage market primarily
by purchasing home Mortgage Loans from local lenders, thereby replenishing
their funds for additional lending. FNMA guarantees to the registered holder
of a FNMA Certificate that it will distribute amounts representing scheduled
principal and interest (at the rate provided by the FNMA Certificate) on the
Mortgage Loans in the pool underlying the FNMA Certificate, whether or not
received, and the full principal amount of any such mortgage loan foreclosed
or otherwise finally liquidated, whether or not the principal amount is
actually received. The obligations of FNMA under its guarantees are solely
those of FNMA and are not backed by the full faith and credit of the United
States. If FNMA were unable to satisfy such obligations, distributions to
holders of FNMA Certificates would consist solely of payments and other
recoveries on the underlying Mortgage Loans and, accordingly, monthly
distributions to holders of FNMA Certificates would be affected by delinquent
payments and defaults on such Mortgage Loans.
5
FNMA Certificates may be backed by pools of Single-Family or Multifamily
Mortgage Loans. The original terms to maturities of the Mortgage Loans
generally do not exceed 40 years. FNMA Certificates may pay interest at a
fixed rate or adjustable rate. Each series of FNMA ARM Certificates bears an
initial interest rate and margin tied to an index based on all loans in the
related pool, less a fixed percentage representing servicing compensation and
FNMA's guarantee fee. The specified index used in each such series has
included the Treasury Index, the 11th District Cost of Funds Index published
by the Federal Home Loan Bank of San Francisco, LIBOR and other indices.
Interest rates paid on fully-indexed FNMA ARM Certificates equal the
applicable index rate plus a specified number of basis points ranging
typically from 125 to 250 basis points. In addition, the majority of series of
FNMA ARM Certificates issued to date have evidenced pools of Mortgage Loans
with monthly, semi-annual or annual interest rate adjustments. Adjustments in
the interest rates paid are generally limited to an annual increase or
decrease of either 100 or 200 basis points and to a lifetime cap of 500 or 600
basis points over the initial interest rate. Certain FNMA programs include
Mortgage Loans which allow the borrower to convert the adjustable mortgage
interest rate of its ARM to a fixed rate. ARMs which are converted into fixed-
rate Mortgage Loans are repurchased by FNMA or by the seller of such loans to
FNMA at the unpaid principal balance thereof plus accrued interest to the due
date of the last adjustable rate interest payment. Adjustments to the interest
rates on FNMA ARM Certificates are typically subject to lifetime caps and
periodic rate or payment caps.
GNMA Certificates
GNMA is a wholly owned corporate instrumentality of the United States within
the Department of Housing and Urban Development ("HUD"). Section 306(g) of
Title III of the National Housing Act of 1934, as amended (the "Housing Act"),
authorizes GNMA to guarantee the timely payment of the principal of and
interest on certificates which represent an interest in a pool of mortgages
insured by the FHA under the Housing Act or Title V of the Housing Act of
1949, or partially guaranteed by the VA under the Servicemen's Readjustment
Act of 1944, as amended, or Chapter 37 of Title 38, United States Code and
other loans eligible for inclusion in mortgage pools underlying GNMA
Certificates. Section 306(g) of the Housing Act provides that "the full faith
and credit of the United States is pledged to the payment of all amounts which
may be required to be paid under any guaranty under this subsection." An
opinion, dated December 12, 1969, of an Assistant Attorney General of the
United States provides that such guarantees under section 306(g) of GNMA
Certificates of the type which may be purchased or received in exchange by the
Company are authorized to be made by GNMA and "would constitute general
obligations of the United States backed by its full faith and credit."
At present, most GNMA Certificates are backed by Single-Family Mortgage
Loans. The interest rate paid on GNMA Certificates may be fixed rate or
adjustable rate. The interest rate on GNMA Certificates issued under GNMA's
standard ARM program adjusts annually in relation to the Treasury Index.
Interest rates paid on GNMA ARM Certificates typically equal the index rate
plus 150 basis points. Adjustments in the interest rate are generally limited
to an annual increase or decrease of 100 basis points and to a lifetime cap of
500 basis points over the initial coupon rate.
Single-Family and Multifamily Privately-Issued Certificates
Single-Family and Multifamily Privately-Issued Certificates are Pass-Through
Certificates that are not issued by FHLMC, FNMA or GNMA (the "Agencies") and
that are backed by a pool of conventional Single-Family or Multifamily
Mortgage Loans, respectively. Single-Family and Multifamily Privately-Issued
Certificates are issued by originators of, investors in, and other owners of
Mortgage Loans, including savings and loan associations, savings banks,
commercial banks, mortgage banks, investment banks and special purpose
"conduit" subsidiaries of such institutions.
While Agency Certificates are backed by the express obligation or guarantee
of one of the Agencies, as described above, Single-Family and Multifamily
Privately-Issued Certificates are generally covered by one or more forms of
private (i.e., non-governmental) credit enhancements. Such credit enhancements
provide an extra layer of loss coverage in the event that losses are incurred
upon foreclosure sales or other liquidations of underlying mortgaged
properties in amounts that exceed the equity holder's equity interest in the
property and
6
result in Realized Losses. Forms of credit enhancements include, but are not
limited to, limited issuer guarantees, reserve funds, private mortgage
guaranty pool insurance, over-collateralization and subordination.
Subordination is a form of credit enhancement frequently used and involves
the issuance of multiple classes of Senior-Subordinated Mortgage-Backed
Securities. Such classes are structured into a hierarchy of levels for
purposes of allocating Realized Losses and also for defining priority of
rights to payment of principal and interest. Typically, one or more classes of
Senior Securities are created which are rated in one of the two highest rating
levels by one or more nationally recognized rating agencies and which are
supported by one or more classes of Mezzanine Securities and Subordinated
Securities that bear Realized Losses prior to the classes of Senior
Securities. Mezzanine Securities for purposes of this Prospectus will refer to
any classes that are rated below the two highest levels but no lower than a
single "B" level under the S&P rating system (or comparable level under other
rating systems) and are supported by one or more classes of Subordinated
Securities which bear Realized Losses prior to the classes of Mezzanine
Securities. For purposes of this Prospectus, Subordinated Securities will
refer to any class that bears the "first loss" from Realized Losses or that is
rated below a single "B" level (or, if unrated, is deemed by the Company to be
below such level based on a comparison of characteristics of such class with
other rated Subordinated Securities with like characteristics). In some cases,
only classes of Senior Securities and Subordinated Securities are issued. By
adjusting the priority of interest and principal payments on each class of a
given series of Senior-Subordinated Mortgage-Backed Securities, issuers are
able to create classes of Mortgage-Backed Securities with varying degrees of
credit exposure, prepayment exposure and potential total return, tailored to
meet the needs of sophisticated institutional investors.
Collateralized Mortgage Obligations and Multi-Class Pass-Through Securities
Mortgage-Backed Securities in which the Company may invest may include
collateralized mortgage obligations ("CMOs") and multi-class pass-through
securities. CMOs are debt obligations issued by special purpose entities that
are secured by mortgage-backed certificates, including, in many cases,
certificates issued by government and government-related guarantors,
including, GNMA, FNMA and FHLMC, together with certain funds and other
collateral. Multi-class pass-through securities are equity interests in a
trust composed of mortgage loans or other mortgage-backed securities. Payments
of principal and interest on underlying collateral provide the funds to pay
debt service on the CMO or make scheduled distributions on the multi-class
pass-through securities. CMOs and multi-class pass-through securities may be
issued by agencies or instrumentalities of the U.S. Government or by private
organizations. The discussion of CMOs in the following paragraphs is similarly
applicable to multi-class pass-through securities.
In a CMO, a series of bonds or certificates is issued in multiple classes.
Each class of CMOs, often referred to as a "tranche," is issued at a specific
coupon rate (which, as discussed below, may be an adjustable rate subject to a
cap) and has a stated maturity or final distribution date. Principal
prepayments on collateral underlying a CMO may cause it to be retired
substantially earlier than the stated maturities or final distribution dates.
Interest is paid or accrues on all classes of a CMO on a monthly, quarterly or
semi-annual basis. The principal and interest on underlying mortgages may be
allocated among the several classes of a series of a CMO in many ways. In a
common structure, payments of principal, including any principal prepayments,
on the underlying mortgages are applied to the classes of the series of a CMO
in the order of their respective stated maturities or final distribution
dates, so that no payment of principal will be made on any class of a CMO
until all other classes having an earlier stated maturity or final
distribution date have been paid in full.
Other types of CMO issues include classes such as parallel pay CMOs, some of
which, such as Planned Amortization Class CMOs ("PAC Bonds"), provide
protection against prepayment uncertainty. Parallel pay CMOs are structured to
provide payments of principal on certain payment dates to more than one class.
These simultaneous payments are taken into account in calculating the stated
maturity date or final distribution date of each class which, as with other
CMO structures, must be retired by its stated maturity date or final
distribution date but may be retired earlier. PAC Bonds generally require
payment of a specified amount of principal on each payment date so long as
prepayment speeds on the underlying collateral fall within a specified range.
PAC Bonds are always parallel pay CMOs with the required principal payment on
such securities having the highest priority after interest has been paid to
all classes.
7
Other types of CMO issues include Targeted Amortization Class CMOs ("TAC
Bonds"), which are similar to PAC Bonds. While PAC Bonds maintain their
amortization schedule within a specified range of prepayment speeds, TAC Bonds
are generally targeted to a narrow range of prepayment speeds or a specified
prepayment speed. TAC Bonds can provide protection against prepayment
uncertainty since cash flows generated from higher prepayments of the
underlying mortgage-related assets are applied to the various other pass-
through tranches so as to allow the TAC Bonds to maintain their amortization
schedule.
CMOs may be subject to certain rights of issuers thereof to redeem such CMOs
prior to their stated maturity dates, which may have the effect of diminishing
the Company's anticipated return on its investment. Privately-Issued Single-
Family and Multifamily CMOs are supported by private credit enhancements
similar to those used for Privately-Issued Certificates and are often issued
as Senior-Subordinated Mortgage-Backed Securities. The Company will only
acquire CMOs or multi-class pass-through certificates that constitute debt
obligations or beneficial ownership in grantor trusts holding Mortgage Loans,
or regular interests in REMICs, or that otherwise constitute Qualified REIT
Real Estate Assets (provided that the Company has obtained a favorable opinion
of its tax advisor or a ruling from the IRS to that effect).
One or more tranches of a CMO may have coupon rates which reset periodically
at a specified increment over an index such as LIBOR. These adjustable rate
tranches known as "floating rate CMOs" or "floaters" may be backed by fixed or
adjustable-rate mortgages. To date, fixed-rate mortgages have been more
commonly utilized for this purpose. Floating rate CMOs are typically issued
with lifetime caps on the coupon rate thereon. These caps, similar to the caps
on adjustable-rate mortgages described in "Floating Rate Mortgage-Backed
Securities" below, represent a ceiling beyond which the coupon rate on a
floating rate CMO may not be increased regardless of increases in the interest
rate index to which the floating rate CMO is geared.
Floating Rate Mortgage-Backed Securities
CMOs in which the Company may invest include floating rate CMOs
("Floaters"). The interest rates on Floaters are reset at periodic intervals
to an increment over some predetermined interest rate index. There are two
main categories of indices: (i) those based on U.S. Treasury securities, and
(ii) those derived from calculated measures such as a cost of funds index or a
moving average of mortgage rates. Commonly utilized indices include the one-
year Treasury rate, the three-month Treasury bill rate, the six-month Treasury
bill rate, rates on long-term Treasury securities, the 11th District Federal
Home Loan Bank Costs of Funds Index, the National Median Cost of Funds, the
one-month or three-month LIBOR, the prime rate of a specific bank, or
commercial paper rates. Some indices, such as the one-year Treasury rate,
closely mirror changes in market interest rate levels. Others, such as the
11th District Home Loan Bank Cost of Funds Index, tend to lag changes in
market rate level. The Company will seek to diversify its investments in
Floaters among a variety of indices and reset periods so that the Company is
not at any one time unduly exposed to the risk of interest rate fluctuations.
In selecting the type of Floaters for investment, the Company will also
consider the liquidity of the market for such Floaters.
The Company believes that Floaters are particularly well-suited to
facilitate its ability to accomplish the Company's investment objective of
high current income, consistent with modest volatility of net asset value,
because the value of the Floaters should remain relatively stable as compared
to that of traditional fixed-rate debt securities paying comparable rates of
interest. While the value of Floaters, like other debt securities, generally
varies inversely with changes in market interest rates (increasing in value
during periods of declining interest rates and decreasing in value during
periods of increasing interest rates), the value of Floaters should generally
be more resistant to price swings than other debt securities because the
interest rates of Floaters move with market interest rates. Accordingly, as
interest rates change, the value of the Company's shares should be more stable
than that of funds which invest primarily in securities backed by fixed-rate
mortgages or in other non-mortgage-backed debt securities, which do not
provide for adjustment in the interest rates thereon in response to change in
interest rates.
8
Floaters typically have caps, which limit the maximum amount by which the
interest rate may be increased or decreased at periodic intervals or over the
life of the Floater. To the extent that interest rates rise faster than the
allowable caps on Floaters, such Floaters will behave more like fixed-rate
securities. Consequently, interest rate increases in excess of caps can be
expected to cause Floaters to behave more like traditional debt securities
than adjustable-rate securities and, accordingly, to decline in value to a
greater extent than would be the case in the absence of such caps.
Floaters, like other Mortgage-Backed Securities, differ from conventional
bonds in that principal is to be paid back over the life of Floaters rather
than at maturity. As a result, the holder of the Floaters (i.e., the Company)
receives monthly scheduled payments of principal and interest and may receive
unscheduled principal payments representing prepayments on the underlying
mortgages. When the holder reinvests the payments and any unscheduled
prepayments it receives, it may receive a rate of interest on the reinvestment
which is lower than the rate on the existing Floaters. For this reason,
Floaters are less effective than longer-term debt securities as a means of
"locking in" longer-term interest rates.
Floaters, while having less risk of price decline during periods of rapidly
rising rates than certain fixed-rate Mortgage-Backed Securities of comparable
maturities, could have less potential for capital appreciation than such
securities. In addition, to the extent Floaters are purchased at a premium,
mortgage foreclosures and unscheduled principal prepayments will result in
some loss of the holders' principal investment to the extent of the premium
paid. On the other hand, if Floaters are purchased at a discount, an
unscheduled prepayment of principal could increase total return and accelerate
the recognition of income to the Company and, as a result, could increase the
amount of income received by stockholders to the extent that the Company
distributes such income.
Other Floating Rate Instruments
The Company may also invest in structured floating rate notes issued or
guaranteed by government agencies, such as FNMA and FHLMC. Such instruments
are typically structured to reflect an interest rate arbitrage (i.e., the
difference between the agency's cost of funds and the income stream from
specified assets of the agency) and their reset formulas may provide more
attractive returns than other floating rate instruments. The indices used to
determine resets are the same as those referred to under "--Floating Rate
Mortgage-Backed Securities" above.
Subordinated Interests
The Company may acquire Subordinated Interests which are classes of
Mortgage-Backed Securities that are junior to other classes of such series of
Mortgage-Backed Securities in the right to receive payments from the
underlying mortgages. The subordination is for credit enhancement and may be
for all payment failures on the Mortgage Loans securing or underlying such
series of Mortgage-Backed Securities. The subordination will not be limited to
those resulting from certain types of risks, such as those resulting from war,
earthquake or flood, or the bankruptcy of a mortgagor. The subordination may
be for the entire amount of the series of Mortgage-Backed Securities or may be
limited in amount. The Subordinated Interests held by the Company will be part
of its Limited Investment Assets that in the aggregate will not constitute
more than 25% of the Company's total assets.
It is anticipated that substantially all of the Subordinated Interests which
the Company may acquire will be rated at least investment grade by one of the
rating agencies. If not so rated, the Company will establish reserves against
future potential losses in an amount equivalent to the credit enhancement
required to achieve an investment grade credit rating.
Any Subordinated Interests acquired by the Company will be limited in amount
and bear yields which the Company believes are commensurate with the risks
involved. The market for Subordinated Interests is not extensive and may be
illiquid. In addition, the Company's ability to sell Subordinated Interests
will be limited by Sections 856 through 860 of the Code (the "REIT Provisions
of the Code"). Accordingly, the Company
9
intends to purchase Subordinated Interests for investment purposes only.
Although publicly offered Subordinated Interests generally will be rated, the
risks of ownership will be substantially the same as the ownership of unrated
Subordinated Interests because the rating does not address the possibility
that the Company might suffer a lower than anticipated yield or fail to
recover its initial investment. The Company will not purchase any Subordinated
Interests that do not qualify as Qualified REIT Real Estate Assets.
Mortgage Loans
The Company may from time to time invest a small percentage of its assets
directly in Single-Family, Multi-Family or Commercial Mortgage Loans. The
Company expects that substantially all of such Mortgage Loans acquired by it
would be ARMs. The interest rate on an ARM is typically tied to an index (such
as LIBOR or the interest rate on United States Treasury Bills), and is
adjustable periodically at various intervals. Such Mortgage Loans are
typically subject to lifetime interest rate caps and periodic interest rate
and/or payment caps. The acquisition of Mortgage Loans generally involves
credit risk. The Company may obtain credit enhancement to mitigate such risk;
however, there can be no assurances that the Company will able to obtain such
credit enhancement or that such credit enhancement will mitigate the credit
risk of the underlying Mortgage Loans.
POLICIES AND PROCEDURES
Capital Investment Policies
Under the Capital Investment Policy adopted by the Company, at least 75% of
the Company's total assets are comprised of "High Quality" Mortgage-Backed
Securities and "High Quality" Short-Term Investments. The term "High Quality"
as used herein means securities (i) which are rated within one of the two
highest rating categories by at least one of the nationally recognized rating
agencies, (ii) that are unrated but are either guaranteed by the United States
government or an agency of the United States government, or (iii) that are
unrated or whose ratings have not been updated but are determined to be of
comparable quality to rated High Quality Mortgage-Backed Securities on the
basis of credit enhancement features that meet the High Quality credit
criteria approved by the Company's Board of Directors. The remainder of the
Company's assets, comprising not more than 25% of total assets, may consist of
other Qualified REIT Real Estate Assets which are unrated or rated less than
High Quality but which are at least "investment grade" (rated "BBB" or better
by S&P or the equivalent by another nationally recognized rating organization
(each, a "Rating Agency")) or, if not rated, are determined by the Company to
be of comparable credit quality to an investment which is rated "BBB" or
better. Prior to investing in any unrated securities, the Company will follow
certain procedures described under "--Mortgage-Backed Securities--General."
See "Risk Factors--Operations Risks--Risks of Unrated Assets." Mortgage-Backed
Securities to be acquired by the Company may include, but will not be limited
to, Mortgage-Backed Securities backed by single-family residential mortgage
loans ("Single-Family Mortgage Loans") and Mortgage-Backed Securities backed
by loans on multi-family, commercial or other real estate-related properties.
At December 31, 1997, all of the Mortgage-Backed Securities held by the
Company were "Agency Certificates" which, although not rated, carry an implied
"AAA" rating. All such Agency Certificates held by the Company at December 31,
1997 were backed by Single-Family Mortgage Loans, of which at December 31,
1997, approximately 87% had coupon rates which adjust over time (subject to
certain limitations and lag periods) in conjunction with changes in short-term
interest rates, reflecting the Company's strategy of investing primarily in
adjustable-rate Mortgage-Backed Securities. The Company intends to continue to
invest primarily in adjustable-rate Mortgage-Backed Securities. The Company
may also invest on a limited basis in mortgage derivative securities
representing the right to receive interest only or a disproportionately large
amount of interest. The Company has not and will not invest in real estate
mortgage investment conduit ("REMIC") residuals, other CMO residuals or any
Mortgage-Backed Securities, such as inverse floaters, which have imbedded
leverage as part of their structural characteristics. At December 31, 1997,
the weighted average yield on the Company's portfolio of earning assets was
6.57%, and the weighted average term to next rate adjustment was twenty-two
months.
10
The Company attempts to structure its borrowings to have interest rate
adjustment indices and interest rate adjustment periods that, on an aggregate
basis, correspond generally (within a range of one to six months) to the
interest rate adjustment indices and periods of the adjustable-rate Mortgage-
Backed Securities owned by the Company. However, the Company is subject to the
risk that periodic rate adjustments on borrowings may be less frequent than
rate adjustments on its Mortgage-Backed Securities. At December 31, 1997, the
weighted average cost of funds for all of the Company's borrowings was 6.16%
and the weighted average term to next rate adjustment of such borrowings was
16 days. See "Risk Factors--Operations Risks--Risks Associated with
Differences Between Mortgage-Backed Security and Borrowing Characteristics;
Rate Adjustment Caps."
The Company generally expects to maintain a ratio of debt-to-equity of
between 8:1 and 12:1, although the ratio may vary from time to time depending
upon market conditions and other factors deemed relevant by management of the
Company. For purposes of calculating this ratio, the Company's equity is equal
to the value of the Company's investment portfolio on a mark-to-market basis,
less the book value of the Company's obligations under repurchase agreements
and other collateralized borrowings. At December 31, 1997, the ratio of debt-
to-equity of the Company was 7:1.
To the extent consistent with its election to qualify as a REIT, the Company
may enter into hedging transactions to attempt to protect its portfolio of
Mortgage-Backed Securities and related borrowings against the effects of major
interest rate changes. Such hedging would be used to mitigate declines in the
market value of the Company's Mortgage-Backed Securities during periods of
increasing or decreasing interest rates and to limit or cap the rate on the
Company's borrowings. Such transactions would be entered into solely for the
purpose of hedging interest rate or prepayment risk and not for speculative
purposes. These hedging transactions may include interest rate swaps, the
purchase or sale of interest rate collars, caps or floors, and the purchase of
"interest only" Mortgage-Backed Securities. No hedging strategy can totally
eliminate interest rate risk and the Company's ability to enter into such
hedging transactions may be limited by provisions of the Code relating to
qualifying assets and qualifying income and transaction costs associated with
entering into such transactions. To date, the Company has not entered into any
hedging transactions. See "Capital Investment Policy" and "Certain Federal
Income Tax Considerations."
The Company constantly monitors its Mortgage-Backed Securities and the
income from such assets and, to the extent the Company enters into hedging
transactions in the future, will monitor income from its hedging transactions
as well, so as to ensure at all times that the Company maintains its
qualification as a REIT and its exempt status under the Investment Company Act
of 1940, as amended (the "Investment Company Act"). See "Certain Federal
Income Tax Considerations" and "Risk Factors--Legal and Other Risks."
Credit Risk Management
The Company has not taken on credit risk to date, but may do so in the
future. In such event, the Company will review credit risk and other risk of
loss associated with each investment and determine the appropriate allocation
of capital to apply to such investment under its Capital Investment Policy.
The Board of Directors will monitor the overall portfolio risk and determine
appropriate levels of provision for loss.
Capital and Leverage
The Company expects generally to maintain a ratio of debt-to-equity of
between 8:1 and 12:1, although the ratio may vary from time to time depending
upon market conditions and other factors deemed relevant by management,
including the composition of the Company's balance sheet, haircut levels
required by lenders, the market value of the Mortgage-Backed Securities in the
Company's portfolio and "Excess Capital Cushion" percentages (as described
below) set by the Board of Directors from time to time. For purposes of
calculating this ratio, the Company's equity is equal to the value of the
Company's investment portfolio on a mark-to-market basis less the book value
of the Company's obligations under repurchase agreements and other
collateralized borrowings. At December 31, 1997, the Company's ratio of debt-
to-equity was 7:1.
11
The Company's goal is to strike a balance between the under-utilization of
leverage, which reduces potential returns to stockholders, and the over-
utilization of leverage, which could reduce the Company's ability to meet its
obligations during adverse market conditions. The Company's Capital Investment
Policy limits management's ability to acquire additional assets during times
when the Company's debt-to-equity ratio exceeds 12:1. In this way, the Company
intends that use of balance sheet leverage will be controlled. The actual
capital base as defined for the purpose of this policy is equal to the market
value of total assets less the book value of total collateralized borrowings.
The actual capital base, as so defined, represents the approximate liquidation
value of the Company and approximates the market value of assets that can be
pledged or sold to meet over-collateralization requirements for the Company's
borrowings. The unpledged portion of the Company's actual capital base is
available to be pledged or sold as necessary to maintain over-
collateralization levels for the Company's borrowings.
Management is prohibited from acquiring additional assets during periods
when the actual capital base of the Company is less than the minimum amount
required under the Capital Investment Policy (except when such asset
acquisitions may be necessary to maintain REIT status or the Company's
exemption from the Investment Company Act). In addition, when the actual
capital base falls below the risk-managed capital requirement, management will
be required to submit to the Board a plan for bringing the actual capital base
into compliance with the Capital Investment Policy guidelines. It is
anticipated that in most circumstances this goal will be achieved over time
without overt management action through the natural process of mortgage
principal repayments and increases in the market values of Mortgage-Backed
Securities as their coupon rates adjust upwards to market levels. Management
anticipates that the actual capital base is likely to exceed the risk-managed
capital requirement during periods following new equity offerings and during
periods of falling interest rates and that the actual capital base could fall
below the risk-managed capital requirement during periods of rising interest
rates.
The first component of the Company's capital requirements is the current
aggregate over-collateralization amount or "haircut" the lenders require the
Company to hold as capital. The haircut for each Mortgage-Backed Security is
determined by the lender based on the risk characteristics and liquidity of
that asset. Haircut levels on individual borrowings generally range from 3% to
5% for Agency Certificates to 20% for certain Privately-Issued Certificates,
and the Company anticipates that haircut levels will average 3% to 10% for the
Company as a whole. At December 31, 1997, the weighted average haircut level
on the Company's securities was 3.6%. Should the market value of the pledged
assets decline, the Company will be required to deliver additional collateral
to the lenders in order to maintain a constant over-collateralization level on
its borrowings.
The second component of the Company's capital requirement is the "Excess
Capital Cushion." The Excess Capital Cushion is an additional amount of
capital in excess of the haircut maintained by the Company in order to help
the Company meet the demands of the lenders for additional collateral should
the market value of the Company's Mortgage-Backed Securities decline. The
aggregate Excess Capital Cushion equals the sum of liquidity cushion amounts
assigned under the Capital Investment Policy to each of the Company's
Mortgage-Backed Securities. Excess Capital Cushions are assigned to each
Mortgage-Backed Security based on management's assessment of the Mortgage-
Backed Security's market price volatility, credit risk, liquidity and
attractiveness for use as collateral by lenders. The process of assigning
Excess Capital Cushions relies on management's ability to identify and weigh
the relative importance of these and other factors. Consideration is also
given to hedges associated with the Mortgage-Backed Security and any effect
such hedges may have on reducing net market price volatility, concentration or
diversification of credit and other risks in the balance sheet as a whole and
the net cash flows that can be expected to arise from the interaction of the
various components of the Company's balance sheet. The Board of Directors thus
reviews on a periodic basis various analyses prepared by management of the
risks inherent in the Company's balance sheet, including an analysis of the
effects of various scenarios on the Company's net cash flow, earnings,
dividends, liquidity and net market value. Should the Board of Directors
determine that the minimum required capital base set by the Company's Capital
Investment Policy is either too low or too high, the Board of Directors may
raise or lower the capital requirement accordingly.
12
The Capital Investment Policy stipulates that at least 25% of the capital
base maintained to satisfy the Excess Capital Cushion shall be invested in
Agency Certificates, AAA-rated adjustable-rate Mortgage-Backed Securities or
assets with similar or better liquidity characteristics. To date, 100% of the
Company's Mortgage-Backed Securities are Agency Certificates, though this may
change in the future.
Pursuant to the Company's overall business strategy, a substantial portion
of the Company's borrowings are short-term or variable-rate. The Company's
borrowings are implemented primarily through repurchase agreements (a
borrowing device evidenced by an agreement to sell securities or other assets
to a third-party and a simultaneous agreement to repurchase them at a
specified future date and price, the price difference constituting interest on
the borrowing), but in the future may also be obtained through loan
agreements, lines of credit, Dollar-Roll Agreements (an agreement to sell a
security for delivery on a specified future date and a simultaneous agreement
to repurchase the same or a substantially similar security on a specified
future date) and other credit facilities with institutional lenders and
issuance of debt securities such as commercial paper, medium-term notes, CMOs
and senior or subordinated notes. The Company enters into financing
transactions only with institutions that it believes are sound credit risks
and follows other internal policies designed to limit its credit and other
exposure to financing institutions.
It is expected that repurchase agreements will continue to be the principal
financing devices utilized by the Company to leverage its Mortgage-Backed
Securities portfolio. The Company anticipates that, upon repayment of each
borrowing in the form of a repurchase agreement, the collateral will
immediately be used for borrowing in the form of a new repurchase agreement.
To date, the Company has entered into uncommitted facilities with nineteen
(19) lenders for borrowings in the form of repurchase agreements. The Company
has not at the present time entered into any commitment agreements under which
the lender would be required to enter into new repurchase agreements during a
specified period of time, nor does the Company presently plan to have
liquidity facilities with commercial banks. The Company, however, may enter
into such commitment agreements in the future if deemed favorable to the
Company. The Company enters into repurchase agreements primarily with national
broker/dealers, commercial banks and other lenders which typically offer such
financing. The Company enters into collateralized borrowings only with
financial institutions meeting credit standards approved by the Company's
Board of Directors, and monitors the financial condition of such institutions
on a regular basis.
A repurchase agreement, although structured as a sale and repurchase
obligation, acts as a financing under which the Company effectively pledges
its Mortgage-Backed Securities as collateral to secure a short-term loan.
Generally, the other party to the agreement makes the loan in an amount equal
to a percentage of the market value of the pledged collateral. At the maturity
of the repurchase agreement, the Company is required to repay the loan and
correspondingly receives back its collateral. While used as collateral,
Mortgage-Backed Securities continue to pay principal and interest which inure
to the benefit of the Company. In the event of the insolvency or bankruptcy of
the Company, certain repurchase agreements may qualify for special treatment
under Title 11 of the United States Code (the "Bankruptcy Code") , the effect
of which is, among other things, to allow the creditor under such agreements
to avoid the automatic stay provisions of the Bankruptcy Code and to foreclose
on the collateral agreements without delay. In the event of the insolvency or
bankruptcy of a lender during the term of a repurchase agreement, the lender
may be permitted, under applicable insolvency laws, to repudiate the contract,
and the Company's claim against the lender for damages therefrom may be
treated simply as an unsecured creditor. In addition, if the lender is a
broker or dealer subject to the Securities Investor Protection Act of 1970, or
an insured depository institution subject to the Federal Deposit Insurance
Act, the Company's ability to exercise its rights to recover its securities
under a repurchase agreement or to be compensated for any damages resulting
from the lender's insolvency may be further limited by those statutes. These
claims would be subject to significant delay and, if and when received, may be
substantially less than the damages actually suffered by the Company.
Substantially all of the Company's borrowing agreements require the Company
to deposit additional collateral in the event the market value of existing
collateral declines, which may require the Company to sell assets to reduce
the Company's borrowings. The Company's liquidity management policy is
designed to maintain a cushion of equity sufficient to provide required
liquidity to respond to the effects under its borrowing
13
arrangements of interest rate movements and changes in market value of its
Mortgage-Backed Securities, as described above. However, a major disruption of
the repurchase or other market relied on by the Company for short-term
borrowings would have a material adverse effect on the Company unless the
Company were able to arrange alternative sources of financing on comparable
terms. See "Risk Factors--Operations Risks--Risks Associated with Leverage"
and "--Risk of Decrease in Net Interest Income Due to Interest Rate
Fluctuations."
The Company's Bylaws do not limit its ability to incur borrowings, whether
secured or unsecured.
Interest Rate Risk Management
To the extent consistent with its election to qualify as a REIT, the Company
follows an interest rate risk management program intended to protect its
portfolio of Mortgage-Backed Securities and related debt against the effects
of major interest rate changes. Specifically, the Company's interest rate risk
management program is formulated with the intent to offset the potential
adverse effects resulting from rate adjustment limitations on its Mortgage-
Backed Securities and the differences between interest rate adjustment indices
and interest rate adjustment periods of its adjustable-rate Mortgage-Backed
Securities and related borrowings. The Company's interest rate risk management
program encompasses a number of procedures, including the following: (i) the
Company attempts to structure its borrowings to have interest rate adjustment
indices and interest rate adjustment periods that, on an aggregate basis,
generally correspond to the interest rate adjustment indices and interest rate
adjustment periods of the adjustable-rate Mortgage-Backed Securities purchased
by the Company, so as to limit any mismatching of such aggregates to a range
of one to six months, and (ii) the Company attempts to structure its borrowing
agreements relating to adjustable-rate Mortgage-Backed Securities to have a
range of different maturities and interest rate adjustment periods (although
substantially all will be less than one year). As a result, the Company
expects to be able to adjust the average maturity/adjustment period of such
borrowings on an ongoing basis by changing the mix of maturities and interest
rate adjustment periods as borrowings come due and are renewed. Through use of
these procedures, the Company intends to minimize any differences between
interest rate adjustment periods of adjustable-rate Mortgage-Backed Securities
and related borrowings that may occur.
Although it has not done so to date, the Company may purchase from time to
time interest rate caps, interest rate swaps, interest rate collars, caps or
floors, "interest only" Mortgage-Backed Securities and similar instruments to
attempt to mitigate the risk of the cost of its variable rate liabilities
increasing at a faster rate than the earnings on its assets during a period of
rising interest rates or to mitigate prepayment risk. In this way, the Company
may hedge as much of the interest rate risk as management determines is in the
best interests of the stockholders of the Company, given the cost of such
hedging transactions and the need to maintain the Company's status as a REIT.
See "Certain Federal Income Tax Considerations--General--Gross Income Tests."
This determination may result in management electing to have the Company bear
a level of interest rate risk that could otherwise be hedged when management
believes, based on all relevant facts, that bearing such risk is advisable.
The Company seeks to build a balance sheet and undertake an interest rate
risk management program which is likely, in management's view, to enable the
Company to generate positive earnings and maintain an equity liquidation value
sufficient to maintain operations given a variety of potentially adverse
circumstances. Accordingly, the hedging program addresses both income
preservation, as discussed in the first part of this section, and capital
preservation concerns. With regard to the latter, the Company monitors its
"duration." This is the expected percentage change in market value of the
Company's assets that would be caused by a 1% change in short and long term
interest rates. To monitor duration and the related risks of fluctuations in
the liquidation value of the Company's equity, the Company models the impact
of various economic scenarios on the market value of the Company's Mortgage-
Backed Securities, liabilities and interest rate agreements. See "Risk
Factors--Operations Risks--Risk of Decrease in Net Interest Income Due to
Interest Rate Fluctuations." At December 31, 1997, the Company estimates that
the duration of the Company's assets was 2%. The Company believes that the
Company's interest rate risk management program will allow the Company to
maintain operations throughout a wide variety of potentially adverse
circumstances. Nevertheless, in order to further
14
preserve the Company's capital base (and lower its duration) during periods
when management believes a trend of rapidly rising interest rates has been
established, management may decide to enter into or increase hedging
activities and/or sell assets. Each of these types of actions may lower the
earnings and dividends of the Company in the short term in order to further
the objective of maintaining attractive levels of earnings and dividends over
the long term.
The Company may elect to conduct a portion of its hedging operations through
one or more subsidiary corporations which would not be a Qualified REIT
Subsidiary and would be subject to Federal and state income taxes. "Qualified
REIT Subsidiary" means a corporation whose stock is entirely owned by the REIT
at all times during such corporation's existence. In order to comply with the
nature of asset tests applicable to the Company as a REIT, the value of the
securities of any subsidiary held by the Company (other than a Qualified REIT
Subsidiary) must be limited to less than 5% of the value of the Company's
total assets as of the end of each calendar quarter and no more than 10% of
the voting securities of any such subsidiary may be owned by the Company. See
"Certain Federal Income Tax Considerations--General--Asset Tests." A taxable
subsidiary would not elect REIT status and would distribute any net profit
after taxes to the Company and its other stockholders. Any dividend income
received by the Company from any such taxable subsidiary (combined with all
other income generated from the Company's assets, other than Qualified REIT
Real Estate Assets) must not exceed 25% of the gross income of the Company.
See "Certain Federal Income Tax Considerations--General--Gross Income Tests."
Before the Company forms any such taxable subsidiary corporation for its
hedging activities, the Company will obtain an opinion of counsel to the
effect that the formation and contemplated method of operation of such
corporation will not cause the Company to fail to satisfy the nature of assets
and sources of income tests applicable to it as a REIT.
The Company believes that it has developed a cost-effective asset/liability
management program to provide a level of protection against interest rate and
prepayment risks. However, no strategy can completely insulate the Company
from interest rate changes, prepayment risks and defaults by counter-parties.
Further, as noted above, certain of the Federal income tax requirements that
the Company must satisfy to qualify as a REIT limit the Company's ability to
fully hedge its interest rate and prepayment risks. The Company monitors
carefully, and may have to limit, its asset/liability management program to
assure that it does not realize excessive hedging income, or hold hedging
assets having excess value in relation to total assets, which would result in
the Company's disqualification as a REIT or, in the case of excess hedging
income, the payment of a penalty tax for failure to satisfy certain REIT
income tests under the Code, provided such failure was for reasonable cause.
See "Certain Federal Income Tax Considerations--General." In addition,
asset/liability management involves transaction costs which increase
dramatically as the period covered by the hedging protection increases.
Therefore, the Company may be prevented from effectively hedging its interest
rate and prepayment risks.
Prepayment Risk Management
The Company seeks to minimize the effects of faster or slower than
anticipated prepayment rates through structuring a diversified portfolio with
a variety of prepayment characteristics, investing in Mortgage-Backed
Securities with prepayment prohibitions and penalties, investing in certain
Mortgage-Backed Security structures which have prepayment protections, and
balancing assets purchased at a premium with assets purchased at a discount.
Prepayment risk is monitored by management and the Board of Directors through
periodic review of the impact of a variety of prepayment scenarios on the
Company's revenues, net earnings, dividends, cash flow and net balance sheet
market value.
15
CERTAIN FEDERAL INCOME TAX CONSIDERATIONS
GENERAL
The following discussion summarizes certain Federal income tax
considerations to the Company and holders of the Common Stock. This discussion
is based on existing Federal income tax law, which is subject to change,
possibly retroactively. The following summary does not purport to describe all
of the tax considerations that may be relevant to a prospective stockholder.
This discussion does not address tax considerations applicable to certain
types of investors subject to special treatment under the Federal income tax
laws (including financial institutions, insurance companies, broker-dealers
and, except to the extent discussed below, tax-exempt entities and foreign
taxpayers) and it does not discuss any aspects of state, local or foreign tax
law. This discussion assumes that stockholders hold their Common Stock as a
"capital asset" (generally, property held for investment) under the Code.
Stockholders are advised to consult their tax advisors as to the specific tax
consequences of purchasing, holding and disposing of the Common Stock,
including the application and effect of Federal, state, local and foreign
income and other tax laws.
The Company has elected to become subject to tax as a REIT, for Federal
income tax purposes, commencing with the taxable year ending December 31,
1997. The Board of Directors of the Company currently expects that the Company
will continue to operate in a manner that will permit the Company to maintain
its qualification as a REIT for the taxable year ending December 31, 1997, and
in each taxable year thereafter. This treatment will permit the Company to
deduct dividend distributions to its stockholders for Federal income tax
purposes, thus effectively eliminating the "double taxation" that generally
results when a corporation earns income and distributes that income to its
stockholders in the form of dividends.
The continued qualification and taxation of the Company as a REIT will
depend upon the Company's ability to meet, on a continuing basis, distribution
levels and diversity of stock ownership, and the various qualification tests
imposed by the Code as discussed below. If the Company were not to qualify as
a REIT in any particular year, it would be subject to Federal income tax as a
regular, domestic corporation, and its stockholders would be subject to tax in
the same manner as stockholders of such corporation. In this event, the
Company could be subject to potentially substantial income tax liability in
respect of each taxable year that it fails to qualify as a REIT, and the
amount of earnings and cash available for distribution to its stockholders
could be significantly reduced or eliminated.
The following is a brief summary of certain technical requirements that the
Company must meet on an ongoing basis in order to qualify, and remain
qualified, as a REIT under the Code:
Stock Ownership Tests
(i) The capital stock of the Company must be transferable, (ii) the capital
stock of the Company must be held by at least 100 persons during at least 335
days of a taxable year of 12 months (or during a proportionate part of a
taxable year of less than 12 months), and (iii) no more than 50% of the value
of such capital stock may be owned, directly or indirectly, by five or fewer
individuals (as defined in the Code to include certain entities) at any time
during the last half of the taxable year. Tax-exempt entities, other than
private foundations and certain unemployment compensation trusts, are
generally not treated as individuals for these purposes. The requirements of
items (ii) and (iii) above are not applicable to the first taxable year for
which an election to be taxed as a REIT is made. However, these stock
ownership requirements must be satisfied in the Company's second taxable year
and in each subsequent taxable year. The Company's Articles of Incorporation
provide restrictions regarding the transfer of the Company's shares in order
to aid in meeting the stock ownership requirements. See "Description of
Capital Stock--Restrictions on Ownership and Transfer."
16
Asset Tests
The Company must generally meet the following asset tests (the "REIT Asset
Tests") at the close of each quarter of each taxable year:
(a) at least 75% of the value of the Company's total assets must consist
of Qualified REIT Real Estate Assets, government securities, cash and cash
items (the "75% Asset Test"); and
(b) the value of securities held by the Company but not taken into
account for purposes of the 75% Asset Test must not exceed (i) 5% of the
value of the Company's total assets in the case of securities of any one
issuer, or (ii) 10% of the outstanding voting securities of any such
issuer.
At December 31, 1997, 100% of the Company's assets were Qualified REIT Real
Estate Assets. The Company expects that substantially all of its assets will
continue to be Qualified REIT Real Estate Assets. In addition, the Company
does not expect that the value of any security of any one entity would ever
exceed 5% of the Company's total assets, and the Company does not expect to
own more than 10% of any one issuer's voting securities.
The Company monitors closely the purchase, holding and disposition of its
assets in order to comply with the REIT Asset Tests. In particular, the
Company intends to limit and diversify its ownership of any assets not
qualifying as Qualified REIT Real Estate Assets to less than 25% of the value
of the Company's assets and to less than 5%, by value, of any single issuer.
If it is anticipated that these limits would be exceeded, the Company intends
to take appropriate measures, including the disposition of non-qualifying
assets, to avoid exceeding such limits.
Gross Income Tests
The Company must generally meet the following gross income tests (the "REIT
Gross Income Tests") for each taxable year:
(a) at least 75% of the Company's gross income must be derived from
certain specified real estate sources including interest income and gain
from the disposition of Qualified REIT Real Estate Assets or "qualified
temporary investment income" (i.e., income derived from "new capital"
within one year of the receipt of such capital) (the "75% Gross Income
Test");
(b) at least 95% of the Company's gross income for each taxable year must
be derived from sources of income qualifying for the 75% Gross Income Test,
dividends, interest, and gains from the sale of stock or other securities
(including certain interest rate swap and cap agreements entered into to
hedge variable rate debt incurred to acquire Qualified REIT Real Estate
Assets) not held for sale in the ordinary course of business (the "95%
Gross Income Test"); and
(c) less than 30% of the Company's gross income is derived from the sale
of Qualified REIT Real Estate Assets held for less than four years, stock
or securities held for less than one year (including certain interest rate
swap and cap agreements entered into to hedge variable rate debt incurred
to acquire Qualified Real Estate Assets) and certain "dealer" property (the
"30% Gross Income Test"). Pursuant to recently enacted legislation, the 30%
Gross Income tax has been repealed for taxable years beginning after
August 5, 1997. See "--Recent Legislation."
The Company intends to maintain its REIT status by carefully monitoring its
income, including income from hedging transactions and sales of Mortgage-
Backed Securities, to comply with the REIT Gross Income Tests. In particular,
the Company will treat income generated by its interest rate caps and other
hedging instruments as non-qualifying income for purposes of the 95% Gross
Income Test unless it receives advice from its tax advisor that such income
constitutes qualifying income for purposes of such test. Under certain
circumstances, for example, (i) the sale of a substantial amount of Mortgage-
Backed Securities to repay borrowings in the event that other credit is
unavailable or (ii) an unanticipated decrease in the qualifying income
17
of the Company which may result in the non-qualifying income exceeding 5% of
gross income or a breach of the 30% Gross Income Test, the Company may be
unable to comply with certain of the REIT Gross Income Tests. See "--Taxation
of the Company" for a discussion of the tax consequences of failure to comply
with the REIT Provisions of the Code.
Recent Legislation
Under legislation which was enacted as part of the Taxpayer Relief Act of
1997, the 30% Gross Income Test has been repealed, facilitating disposition of
Qualified REIT Real Estate Assets or other stock or securities held by the
Company. In addition, the categories of hedges of the Company's liabilities
(incurred to acquire Qualified REIT Real Estate Assets) which may produce
income or gain on sale qualifying under the 95% Gross Income Test has been
expanded to include options, futures contracts, forward rate agreements or
similar financial instruments. However, hedges of the Company's Qualified REIT
Real Estate Assets themselves would still not produce income qualifying under
either the 95% Gross Income Test or the 75% Gross Income Test, limiting the
Company's ability to hedge its interest rate and prepayment risks.
Under the recent legislation, a REIT may elect to retain, rather than
distribute, its net long-term capital gains and pay the tax on such gains,
while its stockholders include their proportionate share of the undistributed
long-term capital gains in income and receive a credit for their share of the
tax paid by the REIT.
This legislation is effective for taxable years of the Company beginning
after August 5, 1997.
Distribution Requirement
The Company must generally distribute to its stockholders an amount equal to
at least 95% of the Company's REIT taxable income before deductions of
dividends paid and excluding net capital gain.
Taxation of the Company
In any year in which the Company qualifies as a REIT, the Company will
generally not be subject to Federal income tax on that portion of its REIT
taxable income or capital gain which is distributed to its stockholders. The
Company will, however, be subject to Federal income tax at normal corporate
income tax rates upon any undistributed taxable income or capital gain.
Notwithstanding its qualification as a REIT, the Company may also be subject
to tax in certain other circumstances. If the Company fails to satisfy either
the 75% or the 95% Gross Income Test, but nonetheless maintains its
qualification as a REIT because certain other requirements are met, it will
generally be subject to a 100% tax on the greater of the amount by which the
Company fails either the 75% or the 95% Gross Income Test. The Company will
also be subject to a tax of 100% on net income derived from any "prohibited
transaction," and if the Company has (i) net income from the sale or other
disposition of "foreclosure property" which is held primarily for sale to
customers in the ordinary course of business or (ii) other non-qualifying
income from foreclosure property, it will be subject to Federal income tax on
such income at the highest corporate income tax rate. In addition, if the
Company fails to distribute during each calendar year at least the sum of (i)
85% of its REIT ordinary income for such year and (ii) 95% of its REIT capital
gain net income for such year, the Company would be subject to a 4% Federal
excise tax on the excess of such required distribution over the amounts
actually distributed during the taxable year, plus any undistributed amount of
ordinary and capital gain net income from the preceding taxable year. The
Company may also be subject to the corporate alternative minimum tax, as well
as other taxes in certain situations not presently contemplated.
If the Company fails to qualify as a REIT in any taxable year and certain
relief provisions of the Code do not apply, the Company would be subject to
Federal income tax (including any applicable alternative minimum tax) on its
taxable income at the regular corporate income tax rates. Distributions to
stockholders in any year in which the Company fails to qualify as a REIT would
not be deductible by the Company, nor would they generally be required to be
made under the Code. Further, unless entitled to relief under certain other
provisions of the Code, the Company would also be disqualified from re-
electing REIT status for the four taxable years following the year during
which it became disqualified.
18
The Company intends to monitor on an ongoing basis its compliance with the
REIT requirements described above. In order to maintain its REIT status, the
Company will be required to limit the types of assets that the Company might
otherwise acquire, or hold certain assets at times when the Company might
otherwise have determined that the sale or other disposition of such assets
would have been more prudent.
Taxable Subsidiaries
Hedging activities and the creation of Mortgage-Backed Securities through
securitization may be done through a taxable subsidiary of the Company. The
Company and one or more other entities may form and capitalize one or more
taxable subsidiaries. In order to ensure that the Company would not violate
the more than 10% voting stock of a single issuer limitation described above,
the Company would own only nonvoting preferred and common stock and the other
entities would own all of the voting common stock. The value of the Company's
investment in such a subsidiary must also be limited to less than 5% of the
value of the Company's total assets at the end of each calendar quarter so
that the Company can also comply with the 5% of value, single issuer asset
limitation described above under "--General--Asset Tests." The taxable
subsidiary would not elect REIT status and would distribute only net after-tax
profits to its stockholders, including the Company. Before the Company engages
in any hedging or securitization activities or forms any such taxable
subsidiary corporation, the Company will obtain an opinion of its tax advisor
to the effect that such activities or the formation and contemplated method of
operation of such corporation will not cause the Company to fail to satisfy
the REIT Asset and REIT Gross Income Tests.
Taxation of Stockholders; Common Stock
Distributions (including constructive distributions) made to holders of
Common Stock, other than tax-exempt entities, will generally be subject to tax
as ordinary income to the extent of the Company's current and accumulated
earnings and profits as determined for Federal income tax purposes. If the
amount distributed exceeds a stockholder's allocable share of such earnings
and profits, the excess will be treated as a return of capital to the extent
of the stockholder's adjusted basis in the Common Stock, which will reduce the
stockholder's basis in the Common Stock but not be subject to tax, and
thereafter as a gain from the sale or exchange of a capital asset.
Distributions designated by the Company as capital gain dividends will
generally be subject to tax as long-term capital gain to stockholders, to the
extent that the distribution does not exceed the Company's actual net capital
gain for the taxable year. Distributions by the Company, whether characterized
as ordinary income or as capital gain, are not eligible for the corporate
dividends received deduction. In the event that the Company realizes a loss
for the taxable year, stockholders will not be permitted to deduct any share
of that loss. Further, if the Company (or a portion of its assets) were to be
treated as a taxable mortgage pool, any "excess inclusion income" that is
allocated to a stockholder would not be allowed to be offset by a net
operating loss of such stockholder. Future Treasury Department regulations may
require that the stockholders take into account, for purposes of computing
their individual alternative minimum tax liability, certain tax preference
items of the Company.
Dividends declared during the last quarter of a taxable year and actually
paid during January of the following taxable year are generally treated as if
received by the stockholder on December 31 of the taxable year in which
declared and not on the date actually received. In addition, the Company may
elect to treat certain other dividends distributed after the close of the
taxable year as having been paid during such taxable year, but stockholders
will be treated as having received such dividend in the taxable year in which
the distribution is actually made.
Upon a sale or other disposition of the Common Stock, a stockholder will
generally recognize a capital gain or loss in an amount equal to the
difference between the amount realized and the stockholder's adjusted basis in
such stock, which gain or loss will be long-term if the stock has been held
for more than one year. Any loss on the sale or exchange of a share of Common
Stock held by a stockholder for six months or less will generally be treated
as a long-term capital loss to the extent of any long-term capital gain
dividends received by such stockholder with respect to such share of its
stock.
19
The Company is required under Treasury Department regulations to demand
annual written statements from the record holders of designated percentages of
its capital stock disclosing the actual and constructive ownership of such
stock and to maintain permanent records showing the information it has
received as to the actual and constructive ownership of such stock and a list
of those persons failing or refusing to comply with such demand.
In any year in which the Company does not qualify as a REIT, distributions
made to its stockholders would be taxable in the same manner discussed above,
except that no distributions could be designated as capital gain dividends,
distributions would be eligible for the corporate dividends received
deduction, the excess inclusion income rules would not apply to the
stockholders, and stockholders would not receive any share of the Company's
tax preference items. In such event, however, the Company could be subject to
potentially substantial Federal income tax liability, and the amount of
earnings and cash available for distribution to its stockholders could be
significantly reduced or eliminated.
Taxation of Tax-Exempt Entities
Subject to the discussion below regarding a "pension-held REIT," a tax-
exempt stockholder is generally not subject to tax on distributions from the
Company or gain realized on the sale of the Common Stock, provided that such
stockholder has not incurred indebtedness to purchase or hold its Common
Stock, that its shares are not otherwise used in an unrelated trade or
business of such stockholder, and that the Company, consistent with its
present intent, does not hold a residual interest in a REMIC that gives rise
to "excess inclusion" income as defined under section 860E of the Code. If the
Company were to be treated as a "taxable mortgage pool," however, a
substantial portion of the dividends paid to a tax-exempt stockholder may be
subject to tax as UBTI. Although the Company does not believe that the
Company, or any portion of its assets, will be treated as a taxable mortgage
pool, no assurance can be given that the IRS might not successfully maintain
that such a taxable mortgage pool exists.
If a qualified pension trust (i.e., any pension or other retirement trust
that qualifies under section 401(a) of the Code) holds more than 10% by value
of the interests in a "pension-held REIT" at any time during a taxable year, a
substantial portion of the dividends paid to the qualified pension trust by
such REIT may constitute UBTI. For these purposes, a "pension-held REIT" is
any REIT (i) that would not have qualified as a REIT but for the provisions of
the Code which look through qualified pension trust stockholders to the
qualified pension trust's beneficiaries in determining ownership of stock of
the REIT and (ii) in which at least one qualified pension trust holds more
than 25% by value of the interests of such REIT or one or more qualified
pension trusts (each owning more than a 10% interest by value in the REIT)
hold in the aggregate more than 50% by value of the interests in such REIT.
Assuming compliance with the Ownership Limit provisions it is unlikely that
pension plans will accumulate sufficient stock to cause the Company to be
treated as a pension-held REIT.
Distributions to certain types of tax-exempt stockholders exempt from
Federal income taxation under sections 501(c)(7), (c)(9), (c)(17), and (c)(20)
of the Code may also constitute UBTI, and such prospective investors should
consult their tax advisors concerning the applicable "set aside" and reserve
requirements.
State and Local Taxes
The Company and its stockholders may be subject to state or local taxation
in various jurisdictions, including those in which it or they transact
business or reside. The state and local tax treatment of the Company and its
stockholders may not conform to the Federal income tax consequences discussed
above. Consequently, prospective stockholders should consult their own tax
advisors regarding the effect of state and local tax laws on an investment in
the Common Stock.
Certain United States Federal Income Tax Considerations Applicable to Foreign
Holders
The following discussion summarizes certain United States Federal tax
consequences of the acquisition, ownership and disposition of the Common Stock
by a purchaser of the Common Stock that, for United States
20
Federal income tax purposes, is not a "United States person" (a "Non-United
States Holder"). For purposes of this discussion, a "United States person"
means: a citizen or resident of the United States; a corporation, partnership,
or other entity created or organized in the United States or under the laws of
the United States or of any political subdivision thereof; or an estate or
trust whose income is includible in gross income for United States Federal
income tax purposes regardless of its source. This discussion does not
consider any specific facts or circumstances that may apply to a particular
Non-United States Holder. Prospective investors are urged to consult their tax
advisors regarding the United States Federal tax consequences of acquiring,
holding and disposing of Common Stock, as well as any tax consequences that
may arise under the laws of any foreign, state, local or other taxing
jurisdiction.
Dividends
Dividends paid by the Company out of earnings and profits, as determined for
United States Federal income tax purposes, to a Non-United States Holder will
generally be subject to withholding of United States Federal income tax at the
rate of 30%, unless reduced or eliminated by an applicable tax treaty or
unless such dividends are treated as effectively connected with a United
States trade or business. Distributions paid by the Company in excess of its
earnings and profits will be treated as a tax-free return of capital to the
extent of the holder's adjusted basis in his Common Stock, and thereafter as
gain from the sale or exchange of a capital asset as described below. If it
cannot be determined at the time a distribution is made whether such
distribution will exceed the earnings and profits of the Company, the
distribution will be subject to withholding at the same rate as dividends.
Amounts so withheld, however, will be refundable or creditable against the
Non-United States Holder's United States Federal tax liability if it is
subsequently determined that such distribution was, in fact, in excess of the
earnings and profits of the Company. If the receipt of the dividend is treated
as being effectively connected with the conduct of a trade or business within
the United States by a Non-United States Holder, the dividend received by such
holder will be subject to the United States Federal income tax on net income
that applies to United States persons generally (and, with respect to
corporate holders and under certain circumstances, the branch profits tax).
Gain on Disposition
A Non-United States Holder will generally not be subject to United States
Federal income tax on gain recognized on a sale or other disposition of the
Common Stock unless (i) the gain is effectively connected with the conduct of
a trade or business within the United States by the Non-United States Holder,
(ii) in the case of a Non-United States Holder who is a nonresident alien
individual and holds the Common Stock as a capital asset, such holder is
present in the United States for 183 or more days in the taxable year and
certain other requirements are met, or (iii) the Non-United States Holder is
subject to tax under the FIRPTA rules discussed below. Gain that is
effectively connected with the conduct of a trade or business within the
United States by a Non-United States Holder will be subject to the United
States Federal income tax on net income that applies to United States persons
generally (and, with respect to corporate holders and under certain
circumstances, the branch profits tax) but will not be subject to withholding.
Non-United States Holders should consult applicable treaties, which may
provide for different rules.
The Company does not expect to hold assets that would be treated as "United
States real property interests" under the provisions of the Foreign Investment
in Real Property Tax Act of 1980 ("FIRPTA"). Therefore, the FIRPTA provisions
relating to certain distributions to foreign persons and to certain gains
realized by foreign persons on the sale of stock should not apply to non-
United States Holders of the Common Stock.
Information Reporting and Backup Withholding
Under temporary United States Treasury regulations, United States
information reporting requirements and backup withholding tax will generally
not apply to dividends paid on the Common Stock to a Non-United States Holder
at an address outside the United States. Payments by a United States office of
a broker of the proceeds of a sale of the Common Stock is subject to both
backup withholding at a rate of 31% and information reporting
21
unless the holder certifies its Non-United States Holder status under
penalties of perjury or otherwise establishes an exemption. Information
reporting requirements (but not backup withholding) will also apply to
payments of the proceeds of sales of the Common Stock by foreign offices of
United States brokers, or foreign brokers with certain types of relationships
to the United States, unless the broker has documentary evidence in its
records that the holder is a Non-United States Holder and certain other
conditions are met, or the holder otherwise establishes an exemption.
Backup withholding is not an additional tax. Any amounts withheld under the
backup withholding rules will be refunded or credited against the Non-United
States Holder's United States Federal income tax liability, provided that the
required information is furnished to the Internal Revenue Service.
These information reporting and backup withholding rules are under review by
the United States Treasury and their application to the Common Stock could be
changed by future regulations.
FUTURE REVISIONS IN POLICIES AND STRATEGIES
The Board of Directors has established the investment policies and operating
policies and strategies set forth in this Prospectus. The Board of Directors
has the power to modify or waive such policies and strategies without the
consent of the stockholders to the extent that the Board of Directors
determines that such modification or waiver is in the best interests of
stockholders. Among other factors, developments in the market which affect the
policies and strategies mentioned herein or which change the Company's
assessment of the market may cause the Board of Directors to revise the
Company's policies and strategies.
COMPETITION
The Company believes that its principal competition in the business of
acquiring and holding Mortgage-Backed Securities is financial institutions
such as banks and savings and loans, life insurance companies, institutional
investors such as mutual funds and pension funds, and certain mortgage REITs.
The existence of these competitive entities, as well as the possibility of
additional entities forming in the future, may increase the competition for
the acquisition of Mortgage-Backed Securities resulting in higher prices and
lower yields on such assets.
22
RISK FACTORS
OPERATIONS RISKS
General
The results of the Company's operations are affected by various factors,
many of which are beyond the control of the Company. The results of the
Company's operations depend on, among other things, the level of net interest
income generated by the Company's Mortgage-Backed Securities, the market value
of such Mortgage-Backed Securities and the supply of and demand for such
Mortgage-Backed Securities. The Company's net interest income varies primarily
as a result of changes in short-term interest rates, borrowing costs and
prepayment rates, the behavior of which involves various risks and
uncertainties as set forth below. Prepayment rates, interest rates and
borrowing costs depend on the nature and terms of the Mortgage-Backed
Securities, conditions in financial markets, the fiscal and monetary policies
of the United States government and the Board of Governors of the Federal
Reserve System, international economic and financial conditions, competition
and other factors, none of which can be predicted with any certainty. Since
changes in interest rates may significantly affect the Company's activities,
the operating results of the Company depend, in large part, upon the ability
of the Company to effectively manage its interest rate and prepayment risks
while maintaining its status as a REIT. See "--Risks Associated with Interest
Rate Changes and Hedging" and "Business Strategy--Capital Investment Policy--
Interest Rate Risk Management."
Risks Associated with Differences Between Mortgage-Backed Security and
Borrowing Characteristics; Rate Adjustment Caps
At December 31, 1997, all of the Mortgage-Backed Securities held by the
Company were Agency Certificates backed by Single-Family Mortgage Loans, of
which approximately 87% had coupon rates which adjust over time (subject to
certain limitations and lag periods) in conjunction with changes in short-term
interest rates, such adjustments being based on an objective index such as
LIBOR, the Treasury Index or the CD Rate. It is expected in the future that a
substantial portion of the Company's Mortgage-Backed Securities will consist
of adjustable-rate Pass-Through Certificates ("ARM Certificates") or floating
rate CMOs which also will be subject to periodic interest rate adjustments
based on such objective indices ("Floaters").
Interest rates on the Company's borrowings are expected to continue to be
based on short-term indices. To the extent any of the Company's Mortgage-
Backed Securities are financed with borrowings bearing interest based on or
varying with an index different from that used for the related Mortgage-Backed
Securities, so-called "basis" interest rate risk results. In such event, if
the index used for the Mortgage-Backed Securities is a "lagging" index that
reflects market interest rate changes on a delayed basis, and the rate borne
by the related borrowings reflects market rate changes more rapidly, the
Company's net interest income will be adversely affected in periods of
increasing market interest rates.
The Company's adjustable-rate Mortgage-Backed Securities are subject to
periodic rate adjustments which may not be matched precisely with increases or
decreases in rates borne by the borrowings or financings utilized by the
Company. Accordingly, in a period of increasing interest rates, the Company
could experience a decrease in net interest income or a net loss because the
interest rates on borrowings could adjust faster than the interest rates on
the Company's adjustable-rate Mortgage-Backed Securities.
Interest rates on the Company's Mortgage-Backed Securities are subject
typically to periodic and lifetime interest rate caps which limit the amount
an interest rate can change during any given period. The Company's borrowings
are not subject to similar restrictions. Hence, in a period of rapidly
increasing interest rates, the Company could also experience a decrease in net
interest income or a net loss because the interest rates on borrowings could
increase without limitation while the interest rates on the Company's
Mortgage-Backed Securities (consisting primarily of ARM Certificates and
Floaters) would be limited by caps. While the Company may hedge certain risks
associated with interest rate increases, no hedging strategy can insulate the
Company
23
completely from interest rate risk. To date, the Company has not entered into
any interest rate hedging agreements.
The Company expects that the net effect of these factors, all other factors
being equal, could be to lower the Company's net interest income or cause a
net loss during periods of rapidly rising market interest rates, which could
negatively impact the level of dividend distributions and reduce the market
price of the Common Stock. This reduction in net income, or net loss, could
occur in an increasing interest rate environment as a result of interest rate
increases in borrowings which are more rapid than interest rate increases on
the Company's Mortgage-Backed Securities or as a result of periodic and
lifetime interest rate caps on the Company's Mortgage-Backed Securities.
Prepayment Risks of Mortgage-Backed Securities
Prepayment rates on Mortgage-Backed Securities vary from time to time and
may cause changes in the amount of the Company's net interest income.
Prepayments of ARM Certificates and Floaters usually can be expected to
increase when mortgage interest rates fall below the then-current interest
rates on ARMs and decrease when mortgage interest rates exceed the then-
current interest rate on ARMs, although such effects are not predictable.
Prepayment experience also may be affected by the conditions in the housing
and financial markets, general economic conditions and the relative interest
rates on fixed-rate and adjustable-rate mortgage loans underlying Mortgage-
Backed Securities. Some Mortgage-Backed Securities are structured so that
certain classes are provided protection from prepayments for a period of time.
However, in a period of extremely rapid prepayments, during which earlier-
paying classes may be retired faster than expected, the protected classes may
receive unscheduled payments of principal earlier than expected and would have
average lives that, while longer than the average lives of the earlier-paying
classes, would be shorter than originally expected. The Company seeks to
minimize prepayment risk through a variety of means, including structuring a
diversified portfolio with a variety of prepayment characteristics, investing
in certain Mortgage-Backed Security structures which have prepayment
protection, and balancing assets purchased at a premium with assets purchased
at a discount. No strategy, however, can completely insulate the Company from
prepayment risks arising from the effects of interest rate changes. Prepayment
risk may be increased if the Company purchases interest-only strips to protect
against interest rate increases. Certain Mortgage-Backed Securities may have
underlying mortgage loans which are convertible to fixed-rate loans. Since
converted loans are required to be repurchased by the applicable Agency
(FHLMC, FNMA or GNMA) or servicer, the conversion of a loan results, in
effect, in the prepayment of such loan.
Changes in anticipated prepayment rates of Mortgage-Backed Securities could
affect the Company in several adverse ways. A portion of the Mortgage-Backed
Securities to be acquired by the Company may be recently originated and bear
initial interest rates which are lower than their "fully-indexed" rates (the
applicable index plus margin). In the event that such a Mortgage-Backed
Security is prepaid faster than anticipated prior to or soon after the time of
adjustment to a fully-indexed rate, the Company will experience an adverse
effect on its net interest income during the time it holds such Mortgage-
Backed Security compared with holding a fully-indexed Mortgage-Backed Security
and will lose the opportunity to receive interest at the fully-indexed rate
over the expected life of the Mortgage-Backed Security. In addition, the
faster than anticipated prepayment of any Mortgage-Backed Security that is
purchased at a premium by the Company would generally result in a faster than
anticipated write-off of any remaining capitalized premium amount and
consequent reduction of the Company's net interest income by such amount. At
December 31, 1997, a majority of the Company's Mortgage-Backed Securities had
been acquired at a premium. While the effects of prepayments may be mitigated
to the extent the Company acquires Mortgage-Backed Securities at a discount,
to date, a substantial majority of the Company's Mortgage-Backed Securities
have been acquired at a premium, rather than a discount.
Risks Associated with Leverage
The Company's financing strategy is designed to increase the size of its
Mortgage-Backed Security investment portfolio by borrowing a substantial
portion (which may vary depending upon the mix of the
24
Mortgage-Backed Securities in the Company's portfolio and the application of
the Company's Capital Investment Policy requirements to such mix of Mortgage-
Backed Securities) of the market value of its Mortgage-Backed Securities. If
the coupon income on the Mortgage-Backed Securities purchased with borrowed
funds fails to cover the cost of the borrowings, the Company will experience
net interest losses and may experience net losses. Such losses could be
increased substantially as a result of the Company's substantial leverage.
The Company expects generally to maintain a ratio of debt-to-equity of
between 8:1 and 12:1, although the ratio may vary from time to time depending
upon market conditions and other factors deemed relevant by management.
However, the Company is not limited under its Bylaws in respect of the amount
of its borrowings, whether secured or unsecured, and the debt-to-equity ratio
could at times be greater than 12:1. For purposes of calculating the debt-to-
equity ratio, the Company's equity equals the value of the Company's
investment portfolio on a mark-to-market basis less the book value of the
Company's obligations under repurchase agreements and other collateralized
borrowings. At December 31, 1997, the debt-to-equity ratio of the Company was
7:1.
The ability of the Company to achieve its investment objectives depends on
its ability to borrow money in sufficient amounts and on favorable terms.
Through increases in haircuts (i.e., the over-collateralization amount
required by a lender), decreases in the market value of the Company's
Mortgage-Backed Securities, increases in interest rate volatility, changes in
the availability of financing in the market, conditions then applicable in the
lending market and other factors, the Company may not be able to achieve the
degree of leverage it believes to be optimal, which may cause the Company to
be less profitable than it would be otherwise. In addition, as a result of the
Company's intention to structure its investment portfolio to qualify for an
exemption from regulation as an investment company, the Company may be limited
in the types and amounts of Mortgage-Backed Securities it can purchase which,
in turn, may affect the ability of the Company to achieve the degree of
leverage it believes to be optimal.
Risk of Decline in Market Value of Mortgage-Backed Securities; Margin Calls
and Defaults
Although, at December 31, 1997 and as of the date hereof, none of the
Company's Mortgage-Backed Securities were or are cross-collateralized to
secure multiple borrowing obligations of the Company to a single lender, the
Company's Mortgaged-Backed Securities may be cross-collateralized in the
future. A decline in the market value of such assets may limit the Company's
ability to borrow or result in lenders initiating margin calls (i.e.,
requiring a pledge of cash or additional Mortgage-Backed Securities to re-
establish the ratio of the amount of the borrowing to the value of the
collateral). The Company's fixed-rate Mortgage-Backed Securities generally are
more susceptible to margin calls as increases in interest rates tend to more
negatively affect the market value of fixed-rate Mortgage-Backed Securities
than adjustable-rate Mortgage-Backed Securities. This remains true despite
effective hedging against such fluctuations as the hedging instruments may not
be part of the collateral securing the collateralized borrowings.
Additionally, it may be difficult to realize the full value of the hedging
instrument when desired for liquidity purposes due to the applicable REIT
Provisions of the Code. The Company could be required to sell Mortgage-Backed
Securities under adverse market conditions in order to maintain liquidity.
Such sales may be effected by the Company when deemed necessary in order to
preserve the capital base of the Company. If these sales were made at prices
lower than the amortized cost of the Mortgage-Backed Securities, the Company
would experience losses. A default by the Company under its collateralized
borrowings could also result in a liquidation of the collateral, including any
cross-collateralized assets, and a resulting loss of the difference between
the value of the collateral and the amount borrowed.
Additionally, in the event of a bankruptcy of the Company, certain
repurchase agreements may qualify for special treatment under the Bankruptcy
Code, the effect of which is, among other things, to allow the creditors under
such agreements to avoid the automatic stay provisions of the Bankruptcy Code
and to liquidate the collateral under such agreements without delay.
To the extent the Company is compelled to liquidate Mortgage-Backed
Securities qualifying as Qualified REIT Real Estate Assets to repay
borrowings, the Company may be unable to comply with the REIT Provisions
25
of the Code regarding assets and sources of income requirements, ultimately
jeopardizing the Company's status as a REIT. The Code does not provide for any
mitigating provisions with respect to the 30% Gross Income Test. Accordingly,
if the Company failed to meet the 30% Gross Income Test, its status as a REIT
would terminate automatically. The 30% Gross Income Test means the requirement
for each taxable year that less than 30% of the Company's gross income is
derived from the sale of Qualified REIT Real Estate Assets held for less than
four years, stock or securities held for less than one year (including certain
interest rate swap and cap agreements entered into to hedge variable rate debt
incurred to acquire Qualified Real Estate Assets) and certain "dealer"
property. Pursuant to recently enacted legislation, the 30% Gross Income Test
has been repealed for taxable years beginning after August 5, 1997. See
"Certain Federal Income Tax Considerations--General--Asset Tests", "--Income
Tests" and "--Recent Legislation."
Risks of Increased Borrowing Costs and Failure to Refinance Outstanding
Borrowings
Currently, all of the Company's borrowings are collateralized borrowings in
the form of repurchase agreements. The ability of the Company to enter into
repurchase agreements in the future will depend on the market value of the
Mortgage-Backed Securities pledged to secure the specific borrowings, the
availability of financing, and other conditions then applicable in the lending
market. The Company may effect additional borrowings through using other types
of collateralized borrowings, loan agreements, lines of credit, Dollar-Roll
Agreements and other credit facilities with institutional lenders or through
the issuance of debt securities. A "Dollar-Roll Agreement" is an agreement to
sell a security for delivery on a specified future date entered into
simultaneously with an agreement to repurchase the same or a substantially
similar security (with the same coupon and original maturity periods) on a
specified future date. The cost of borrowings under repurchase agreements
generally corresponds to LIBOR plus or minus a margin, although such
agreements may not expressly incorporate a LIBOR index. The cost of borrowings
under other sources of funding which the Company may use may refer or
correspond to other short-term indices, plus or minus a margin. The margins on
such borrowings over or under LIBOR or such other short-term indices may vary
depending on the lender, the nature and liquidity of the underlying
collateral, the movement of interest rates, the availability of financing in
the market and other factors. Increased borrowing costs could adversely impact
the Company's net income.
The Company's business strategy relies primarily on short-term borrowings to
fund Mortgage-Backed Securities with adjustable-rate coupons and long-term
maturities. Thus, the ability of the Company to achieve its investment
objectives depends not only on its ability to borrow money in sufficient
amounts and on favorable terms but also on the Company's ability to renew or
replace on a continuous basis its maturing short-term borrowings. In the event
the Company is not able to renew or replace maturing borrowings, the Company
could be required to sell Mortgage-Backed Securities under possibly adverse
market conditions and could incur losses as a result. In addition, in such
event, the Company may be required to terminate any hedging positions, which
could result in further costs to the Company. At the same time, the market
value of the assets in which the Company's liquidity capital is invested may
have decreased. A number of such factors in combination could cause
difficulties for the Company and might result in a liquidation of a major
portion of the Company's Mortgage-Backed Securities at disadvantageous prices
with consequent losses, which could have a material adverse effect on the
Company and its solvency.
Risk of Decrease in Net Interest Income Due to Interest Rate Fluctuations
At December 31, 1997, approximately 87% of the Company's Mortgage-Backed
Securities had adjustable interest or pass-through rates based on short-term
interest rates, and substantially all of the Company's borrowings bore
interest at short-term rates and had maturities of less than one year.
Consequently, changes in short-term interest rates may significantly influence
the Company's net interest income. While increases in short-term interest
rates will generally increase the yields on the Company's adjustable-rate
Mortgage-Backed Securities, rising short-term rates will also increase the
costs of borrowings by the Company which will be utilized to fund the
Mortgage-Backed Securities and, to the extent such costs rise more rapidly
than the yields, the Company's net interest income may be reduced or a net
loss may result. Increases in short-term rates relative to long-term rates
could adversely impact the Company's net income. In periods of high interest
rates, the
26
Company's net income may be less than income generated through alternative
investments of equal or lower risk, which could negatively impact the price of
the Common Stock. No assurance can be given as to the amount or timing of
changes in interest rates or their effect on the Company's Mortgage-Backed
Securities or net interest income.
Risks Associated with Interest Rate Changes and Use of Interest Rate
Derivatives for Hedging
The Company's operating strategy subjects it to interest rate risks as
described under "--Risk of Decrease in Net Interest Income Due to Interest
Rate Fluctuations" above. The Company has adopted policies as part of its
Capital Investment Policy intended to protect against interest rate changes
and prepayments. See "Business Strategy--Capital Investment Policy--Interest
Rate Risk Management." The Company may purchase from time to time interest
rate caps, interest rate swaps and similar instruments to attempt to mitigate
the risk of the cost of its variable rate liabilities increasing at a faster
rate than the earnings on its assets during a period of rising rates. However,
it is not expected that such hedging strategies will completely insulate the
Company against interest rate risk. To date, the Company has not entered into
any hedging transactions.
Developing an effective asset/liability management strategy is complex, and
no strategy can completely insulate the Company from risks associated with
interest rate changes and prepayments. In addition, to the extent the Company
engages in hedging, there can be no assurance that the Company's hedging
activities will have the desired beneficial impact on the Company's results of
operations or financial condition. Hedging typically involves costs, including
transaction costs, which increase dramatically as the period covered by the
hedge increases and which also increase during periods of rising and volatile
interest rates. The Company may increase its hedging activity, and thus
increase its hedging costs, during such periods when interest rates are
volatile or rising and hedging costs have increased. Such hedging costs may
cause the Company to conclude that a particular hedging transaction is not
appropriate for the Company, thereby affecting the Company's ability to
mitigate interest rate risk.
Federal tax laws applicable to REITs may substantially limit the Company's
ability to engage in asset/liability management transactions. Such Federal tax
laws may prevent the Company from effectively implementing hedging strategies
that the Company determines, absent such restrictions, would best insulate the
Company from the risks associated with changing interest rates and
prepayments. See "Certain Federal Income Tax Considerations--General" and "--
Taxation of the Company." In this regard, the amount of income the Company may
earn from its interest rate caps and other hedging instruments may be subject
to substantial limitations under the REIT Provisions of the Code. In
particular, income generated by such instruments is non-qualifying income for
purposes of the 75% Gross Income Test and is income from the sale of a
security subject to the 30% Gross Income Test. Additionally, the Company will
treat such income as non-qualifying income for the 95% Gross Income Test
unless it receives advice from its tax advisors that such income constitutes
qualifying income for purposes of such test. Pursuant to recently enacted
legislation, the 30% Gross Income Test has been repealed for taxable years
beginning after August 5, 1997, but such income would still not qualify for
the 75% Gross Income Test or, subject to the preceding sentence, the 95% Gross
Income Test. See "Certain Federal Income Tax Considerations--General--Gross
Income Tests" and "--Recent Legislation." This determination may result in
management electing to have the Company bear a level of interest rate risk
that might otherwise be hedged. The "75% Gross Income Test" means the
requirement for each taxable year that at least 75% of the Company's gross
income must be derived from certain specified real estate sources including
interest income and gain from the disposition of Qualified REIT Real Estate
Assets or "qualified temporary investment income" (i.e., income derived from
"new capital" within one year of the receipt of such capital). The "95% Gross
Income Test" means the requirement for each taxable year that at least 95% of
the Company's gross income for each taxable year must be derived from sources
of income qualifying for the 75% Gross Income Test, dividends, interest, and
gains from the sale of stock or other securities (including certain interest
rate swap and cap agreements entered into to hedge variable rate debt incurred
to acquire Qualified REIT Real Estate Assets) not held for sale in the
ordinary course of business.
27
If the Company purchases interest rate caps or other interest rate
agreements to hedge against lifetime and periodic rate or payment caps, and
the provider of interest rate agreements becomes financially unsound or
insolvent, the Company may be forced to unwind its interest rate agreements
with such provider and may take a loss on such interest rate agreements.
Although the Company intends to purchase interest rate agreements only from
financially sound institutions and to monitor the financial strength of such
institutions on a periodic basis, no assurance can be given that the Company
can avoid such third party risks.
Credit Risks Associated with Investment Strategy
The Company's Capital Investment Policy provides that at least 75% of the
Company's total assets are to be comprised of High Quality Mortgage-Backed
Securities and High Quality Short-Term Investments. "Short-Term Investments"
means short-term bank certificates of deposit, short-term United States
treasury securities, short-term United States government agency securities,
commercial paper, reverse repurchase agreements, short-term CMOs, short-term
asset-backed securities and other similar types of short-term investment
instruments, all of which will have maturities or average lives of less than
one year. The Capital Investment Policy provides that the remainder of the
Company's assets, comprising not more than 25% of total assets, may consist of
Mortgage-Backed Securities and other Qualified REIT Real Estate Assets which
are unrated or rated less than High Quality. The Company's investment strategy
seeks to balance the risk and return potential of its investments in a manner
that attempts to maximize return while minimizing the risk of losses to the
Company through defaults on portfolio obligations. This strategy determines
the relative weightings within the Company's portfolio of Mortgage-Backed
Securities of different ratings. The Company attempts to structure its
portfolio to maintain a minimum weighted average rating (including the
Company's deemed comparable ratings for unrated Mortgage-Backed Securities
based on a comparison to rated Mortgage-Backed Securities with like
characteristics) of its Mortgage-Backed Securities of at least single "A"
under the S&P rating system and at the comparable level under the other rating
systems. There can be no assurance the Company's deemed comparable ratings
will agree with assessments by others as to how such Mortgage-Backed
Securities would be rated. In addition, to the extent that the Company invests
in High Quality investments, the yield on such assets may be lower than the
yield on lower rated securities. To date, the Company has invested solely in
Agency Certificates which, although not rated, carry an implied "AAA" rating.
Ability to Acquire Mortgage-Backed Securities at Favorable Yields;
Competition and Supply
The Company's net income depends, in large part, on the Company's ability to
acquire Mortgage-Backed Securities at favorable spreads over the Company's
borrowing costs. In acquiring Mortgage-Backed Securities, the Company competes
with other REITs, investment banking firms, savings and loan associations,
banks, insurance companies, mutual funds, other lenders, and other entities
purchasing Mortgage-Backed Securities, many of which have greater financial
resources than the Company. In addition, there are several mortgage REITs
similar to the Company, and others may be organized in the future. The effect
of the existence of additional REITs may be to increase competition for the
available supply of Mortgage-Backed Securities suitable for purchase by the
Company. Further, in fluctuating interest rate environments, the spread
between interest rates on adjustable-rate mortgage loans and interest rates on
fixed-rate mortgage loans may decrease, and may cease to exist or become
negative. Under such conditions, mortgagors tend to favor fixed-rate mortgage
loans, thereby decreasing the supply of adjustable-rate Mortgage-Backed
Securities available to the Company for purchase. The relative availability of
adjustable-rate Mortgage-Backed Securities may also be diminished by a number
of other market and regulatory considerations.
There can be no assurance that the Company will be able to continue to
acquire sufficient Mortgage-Backed Securities from mortgage suppliers at
spreads above the Company's cost of funds. The Company will also face
competition for financing sources, and the effect of the existence of
additional mortgage REITs may be to deny the Company access to sufficient
funds to carry out its business strategy and/or to increase the cost of funds
to the Company.
28
Risks of Limited Guarantees by FHLMC and FNMA
As of December 31, 1997, by principal amount, approximately 24% of the
Company's Mortgage-Backed Securities were FHLMC Certificates and approximately
61% of the Company's Mortgage-Backed Securities were FNMA Certificates.
FHLMC's guarantee to holders of FHLMC Certificates and FNMA's guarantee to
holders of FNMA Certificates are subject to certain limitations.
FHLMC guarantees to each holder of FHLMC Certificates the timely payment of
interest at the applicable pass-through rate and ultimate collection of all
principal on the holder's pro rata share of the unpaid principal balance of
the underlying Mortgage Loans, but does not guarantee the timely payment of
scheduled principal of the underlying Mortgage Loans. The obligations of FHLMC
under its guarantees are solely those of FHLMC and are not backed by the full
faith and credit of the United States. If FHLMC were unable to satisfy such
obligations, distributions to holders of FHLMC Certificates would consist
solely of payments and other recoveries on the underlying Mortgage Loans and,
accordingly, monthly distributions to holders of FHLMC Certificates would be
affected by delinquent payments and defaults on such Mortgage Loans.
FNMA guarantees to the registered holder of a FNMA Certificate that it will
distribute amounts representing scheduled principal and interest (at the rate
provided by the FNMA Certificate) on the Mortgage Loans in the pool underlying
the FNMA Certificate, whether or not received, and the full principal amount
of any such Mortgage Loan foreclosed or otherwise finally liquidated, whether
or not the principal amount is actually received. The obligations of FNMA
under its guarantees are solely those of FNMA and are not backed by the full
faith and credit of the United States. If FNMA were unable to satisfy such
obligations, distributions to holders of FNMA Certificates would consist
solely of payments and other recoveries on the underlying Mortgage Loans and,
accordingly, monthly distributions to holders of FNMA Certificates would be
affected by delinquent payments and defaults on such Mortgage Loans.
Limitations on Ratings of Mortgage-Backed Securities
A rating is not a recommendation to buy, sell or hold a security, inasmuch
as such rating does not comment as to the market price of the security or the
suitability of the security for a particular investor. There is no assurance
that a rating will remain for any given period of time or that a rating will
not be lowered or withdrawn entirely by a Rating Agency if in its judgment
circumstances so warrant.
Risks of Unrated Assets
The Company's Capital Investment Policy provides that the Company's assets
may include certain assets which are unrated but are determined by the Company
to be of comparable quality to rate High Quality Mortgage-Backed Securities
and certain assets which are unrated but are determined by the Company to be
of comparable credit quality to an investment which is at least "investment
grade" (rated "BBB" or better by S&P or the equivalent by another nationally
recognized rating organization). Prior to acquiring any such unrated
securities, the Company intends to engage an independent consultant with
expertise in rating "investment grade" securities to assist the Company in
evaluating the creditworthiness of such securities and determining whether
such securities are qualified to be purchased under the Company's Capital
Investment Policy. In making such evaluations, the Company will look at
similar criteria utilized by S&P and other nationally recognized rating
organizations. Such criteria may include a review of the cash flow and other
characteristic of the security, an analysis of the components of the security
and a valuation of comparable assets. However, the Company is not expert in
evaluating unrated assets, such unrated assets will not carry the rating of a
nationally recognized rating agency and there can be no guarantee that the
Company or any independent consultant engaged by the Company will be able to
make an accurate valuation of such unrated assets.
Risk of Asset Concentration
Although the Company seeks geographic diversification of the properties
underlying the Mortgage-Backed Securities which it acquires, it does not set
specific limitations on the aggregate percentage of underlying
29
properties which may be located in any one area. Consequently, properties
underlying such Mortgage-Backed Securities may be located in the same or a
limited number of geographical regions. Adverse changes in the economic
conditions of the geographic regions in which the properties underlying the
Mortgage-Backed Securities are concentrated likely would have an adverse
effect on real estate values, interest rates and prepayment rates and increase
the risk of default by the obligors on the underlying mortgage loans;
accordingly, the Company's results of operations could be adversely affected.
In addition, the properties underlying all of the Mortgage-Backed Securities
owned by the Company are single-family (one- to four-units) properties. While,
the Company believes that asset concentration in Mortgage-Backed Securities
backed by Single-Family Mortgage Loans provides less risk than Mortgage-Backed
Securities backed by Multifamily and Commercial Mortgage Loans, a downturn in
the residential housing market could adversely affect the Company.
LEGAL AND OTHER RISKS
Dependence on Key Personnel
The Company's operations depend in significant part upon the contributions
of its executive officers who presently devote at least 90% of their working
time to the business of the Company and intend in the future, as between the
Company and FIDAC, to devote at least 90% of their working time to the
Company's business. Although Michael Farrell, Chairman of the Board and Chief
Executive Officer, Timothy Guba, President and Chief Operating Officer
Wellington St. Claire, Vice Chairman of the Board, and Kathryn F. Fagan, Chief
Financial Officer currently have employment agreements with the Company, there
can be no assurance of the continued employment of all such officers. The loss
of any key person could have a material adverse effect on the Company's
business and results of operations.
Loss of Investment Company Act Exemption Would Adversely Affect the Company
The Company at all times intends to conduct its business so as not to become
regulated as an investment company under the Investment Company Act.
Accordingly, the Company does not expect to be subject to the restrictive
provisions of the Investment Company Act. The Investment Company Act exempts
entities that are "primarily engaged in the business of purchasing or
otherwise acquiring mortgages and other liens on and interests in real estate"
("Qualifying Interests"). Under the current interpretation of the staff of the
Commission, in order to qualify for this exemption, the Company must maintain
at least 55% of its assets directly in mortgage loans, qualifying Pass-Through
Certificates and certain other qualifying interests in real estate. In
addition, unless certain Mortgage-Backed Securities represent all the
certificates issued with respect to an underlying pool of mortgages, such
Mortgage-Backed Securities may be treated as securities separate from the
underlying mortgage loans and, thus, may not qualify as Qualifying Interests
for purposes of the 55% requirement. Therefore, the Company's ownership of
certain Mortgage-Backed Securities may be limited by the provisions of the
Investment Company Act. In addition, in meeting the 55% requirement under the
Investment Company Act, the Company considers mortgage pass-through
certificates issued with respect to an underlying pool as to which the Company
holds all issued certificates as Qualifying Interests. If the Securities and
Exchange Commission, or its staff, adopts a contrary interpretation with
respect to such securities, the Company could be required to restructure its
activities to the extent its holdings of such mortgage pass-through
certificates did not comply with the interpretation. Such a restructuring
could require the sale of a substantial amount of mortgage pass-through
certificates held by the Company at a time it would not otherwise do so, which
sale could occur under adverse market conditions and the Company could incur
losses as a result. Further, in order to insure that the Company at all times
continues to qualify for the above exemption from the Investment Company Act,
the Company may be required at times to adopt less efficient methods of
financing certain of its Mortgage-Backed Securities than would otherwise be
the case and may be precluded from acquiring certain types of Mortgage-Backed
Securities whose yield is somewhat higher than the yield on Mortgage-Backed
Securities that could be purchased in a manner consistent with the exemption.
The net effect of these factors may be to lower at times the Company's net
interest income. If the Company fails to qualify for exemption from
registration as an investment company, its ability to use leverage would be
substantially reduced and it would be unable to conduct its business as
described herein. Any such failure to qualify for such exemption could have a
material adverse effect on the
30
Company. The Company believes that, as of the date hereof, the Company's
portfolio of Mortgage-Backed Securities would qualify the Company for such
exemption.
Failure to Maintain REIT Status Would Subject the Company to Additional Tax
In order to maintain its qualification as a REIT for Federal income tax
purposes, the Company must comply with the REIT Provisions of the Code,
including satisfying certain tests with respect to the sources of its income,
the nature and diversification of its assets, the amount of its distributions
to stockholders and the ownership of its stock.
The Company intends, at all times, to operate so as to qualify as a REIT for
Federal income tax purposes. To qualify as a REIT, the Company must satisfy a
series of complicated tests related to the nature of its assets and income and
it must also distribute substantially all of its income (as specially defined
for these purposes) to its stockholders. If the Company fails to qualify as a
REIT in any taxable year and certain relief provisions of the Code do not
apply, the Company would be subject to Federal income tax as a regular
domestic corporation, and its stockholders would be subject to tax in the same
manner as stockholders of such corporation. Distributions to stockholders in
any year in which the Company fails to qualify as a REIT would not be
deductible by the Company in computing its taxable income. As a result, the
Company could be subject to income tax liability, thereby significantly
reducing or eliminating the amount of cash available for distribution to its
stockholders. Further, the Company could also be disqualified from re-electing
REIT status for the four taxable years following the year during which it
became disqualified.
No assurance can be given that future legislation, regulations,
administrative interpretations or court decisions will not significantly
change the tax laws with respect to the Company's qualification as a REIT or
the Federal income tax consequences of such qualification, which changes may
reduce or eliminate the Company's competitive advantage over non-REIT
competitors. See "Certain Federal Income Tax Considerations--Taxation of the
Company."
Risk of Future Revisions in Policies and Strategies
The Board of Directors has established the investment policies and operating
policies and strategies set forth in this Form 10-K as the investment
policies and operating policies and strategies of the Company. However, these
policies and strategies may be modified or waived by the Board of Directors,
subject in certain cases to approval by a majority of the Independent
Directors, without stockholder consent. Although a majority of the Board of
Directors will be comprised of Independent Directors, the initial selection of
the Independent Directors was made by the initial stockholders of the Company
who are also officers or directors of the Company. "Independent Director"
means a director of the Company who is not an officer or employee of the
Company.
Dilution; Risk of Potential Future Offerings
The Company may in the future increase its capital resources by making
additional offerings of equity and debt securities, including classes and
series of preferred stock, additional classes and series of common stock,
commercial paper, medium-term notes and senior or subordinated notes. All debt
securities and classes of preferred stock will be senior to the Common Stock
in a liquidation of the Company. The effect of additional equity offerings may
be the dilution of the equity of stockholders of the Company or the reduction
of the price of shares of the Company's Common Stock, or both. The Company is
unable to estimate the amount, timing or nature of additional offerings as
they will depend upon market conditions and other factors.
Illiquidity of Certain Investments
A small portion of the Company's portfolio may be invested in Mortgage-
Backed Securities for which the secondary trading market is not as well
developed as the market for certain other Mortgage-Backed Securities (or which
are otherwise considered less marketable or illiquid). Although the Company
expects that most of the
31
Company's investments will be in Mortgage-Backed Securities for which a resale
market exists, certain of the Company's investments may lack a regular trading
market and may be illiquid. In addition, during turbulent market conditions,
the liquidity of all of the Company's Mortgage-Backed Securities may be
adversely impacted. There is no limit on the percentage of the Company's
investments that may be invested in illiquid Mortgage-Backed Securities.
Issuance of Preferred Stock
The Articles of Incorporation authorize the Board of Directors to reclassify
any of the unissued shares of authorized capital stock into a class or classes
of preferred stock. The issuance of preferred stock could have the effect of
making an attempt to gain control of the Company more difficult by means of a
merger, tender offer, proxy contest or otherwise. Preferred stock, if issued,
could have a preference on dividend payments over the Common Stock which could
affect the ability of the Company to make dividend distributions to the
holders of Common Stock. At present, the Company has no intention to issue
preferred stock; however, the Company may decide, in the future, to issue
preferred stock based upon its consideration of various factors, including the
Company's determination as to the most efficient method for raising capital
and consideration of the effect which such issuance will have on the Common
Stock.
Restrictions on Ownership of Capital Stock
In order that the Company may meet the requirements for qualification as a
REIT, the Articles of Incorporation prohibit any person from acquiring or
holding, directly or constructively, ownership of a number of shares of
capital stock in excess of 9.8% in number of shares or value (the "Ownership
Limit") of the outstanding shares. For this purpose the term "ownership" is
defined as either direct ownership or constructive ownership in accordance
with the constructive ownership provisions of section 544 of the Code. Any
transfer of shares of capital stock that would result in disqualification of
the Company as a REIT or that would (a) create a direct or constructive
ownership of shares of stock in excess of the Ownership Limit, or (b) result
in the shares of stock being beneficially owned (within the meaning section
856(a) of the Code) by fewer than 100 persons (determined without reference to
any rules of attribution), or (c) result in the Company being "closely held"
within the meaning of section 856(h) of the Code, will be null and void, and
the intended transferee (the "purported transferee") will acquire no rights to
such shares. Any purported transfer of shares that would result in a person
owning (directly or constructively) shares in excess of the Ownership Limit
(except as otherwise waived by the Board of Directors) due to the
unenforceability of the transfer restrictions set forth above will constitute
"Excess Securities." Excess Securities will be transferred by operation of law
to a trust to be established by the Company for the exclusive benefit of a
charitable organization, until such time as the trustee of the trust, which
shall be a banking institution designated as trustee by the Company which is
unaffiliated with either the Company or the purported transferee, retransfers
the Excess Securities. Subject to the Ownership Limit, Excess Securities may
be transferred by the trust to any person (if such transfer would not result
in Excess Securities) at a price not to exceed the price paid by the purported
transferee (or, if no consideration was paid by the purported transferee, the
fair market value of the Excess Securities on the date of the purported
transfer), at which point the Excess Securities will automatically cease to be
Excess Securities. See "Certain Federal Income Tax Considerations--General--
Stock Ownership Tests."
Subject to certain limitations, the Board of Directors may increase or
decrease the Ownership Limit. In addition, to the extent consistent with the
REIT Provisions of the Code, the Board of Directors has the right, pursuant to
the Company's Articles of Incorporation, to waive the Ownership Limit for and
at the request of a purchaser of the Common Stock. In connection with any such
waiver, the Company may require that the stockholder requesting such a waiver
enter into an agreement with the Company providing for the repurchase by the
Company of shares from the stockholder under certain circumstances to ensure
compliance with the REIT Provisions of the Code. Such repurchase would be at
fair market value as set forth in the agreement between the Company and such
stockholder. The consideration received by the stockholder in such repurchase
might be characterized as the receipt by the stockholder of a dividend from
the Company, and any stockholder entering
32
into such an agreement with the Company should consult its tax advisor in
connection with its entering into such an agreement. At present, the Company
does not intend to waive the Ownership Limit for any purchaser of shares of
the Common Stock.
The provisions described above may inhibit market activity and a resulting
takeover or other transaction in which holders of some or a majority of the
Company's capital stock might receive a premium for their shares or which such
holders might believe to be otherwise in their best interests. Such provisions
also may make the Company an unsuitable investment vehicle for any person
seeking to obtain ownership of more than 9.8% of the outstanding shares of
capital stock.
Capital Stock Price Volatility Risk
With respect to the public market for the Common Stock, it is likely that
the market price of the Common Stock will be influenced by any variation
between the net yield on the company's Mortgage-Backed Securities and
prevailing market interest rates and by the market's perception of the
Company's ability to achieve earnings growth. The Company's earnings will be
derived primarily from any positive spread between the yield on the Company's
Mortgage-Backed Securities and the cost of the Company's borrowings. The
positive spread between the yield on the Company's Mortgage-Backed Securities
and the cost of borrowings will not necessarily be stable regardless of the
Company's business strategy to achieve such result over longer periods of
time. Accordingly, in periods of high interest rates, the net income of the
Company, and therefore the dividend yield on the Common Stock, may be less
attractive compared with alternative investments, which could negatively
impact the price of the Common Stock. If the anticipated or actual net yield
on the Company's Mortgage-Backed Securities declines or if prevailing market
interest rates rise, thereby decreasing the positive spread between the net
yield on the Mortgage-Backed Securities and the cost of the Company's
borrowing, the market price of the Common Stock may be adversely affected. The
market price of the Company's Common Stock may also be influenced by real or
perceived future earnings variability caused by changes in prepayment rates.
In addition, if the market price of other REIT stocks decline for any reason,
or there is a broad-based decline in real estate values or the Common Stock
has been adversely affected due to any of the foregoing reasons, the liquidity
of the Common Stock may be negatively impacted and investors who may desire or
be required to sell shares of Common Stock may experience losses.
ITEM 2. PROPERTIES
The Company's executive and administrative office is located at 12 East 41st
Street, Suite 700, New York, New York 10017, telephone 212-696-0100. This
office is leased under a lease expiring December 2007.
ITEM 3. LEGAL PROCEEDINGS
At December 31, 1997, there were no pending legal proceedings to which the
Company was a party, or of which any of its property was subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company's stockholders during the
fourth quarter of 1997.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock began trading publicly on October 8, 1997 and is
traded on the New York Stock Exchange under the trading symbol NLY. As of
March 16, 1998, the Company had 12,713,900 shares of common stock issued and
outstanding which was held by 65 holders of record and approximately 3,000
beneficial owners.
33
The following table sets forth, for the periods indicated, the high, low,
and closing sales prices per share of Common Stock as reported on the New York
Stock Exchange composite tape and the cash dividends declared per share of
Common Stock.
STOCK PRICES
--------------------
HIGH LOW CLOSE
------ ------ ------
Fourth Quarter ended December 31, 1997................. $12.81 $10.00 $11.00
CASH DIVIDENDS
DECLARED
PER SHARE
--------------
First Quarter ended March 31, 1997............................ $0.075
Second Quarter ended June 30, 1997............................ $0.255
Third Quarter ended September 30, 1997........................ $ 0.18
Fourth Quarter ended December 31, 1997........................ $ 0.22
The Company intends to pay quarterly dividends and to make such
distributions to its stockholders in amounts such that all or substantially
all of its taxable income in each year (subject to certain adjustments) is
distributed so as to qualify for the tax benefits accorded to a REIT under the
Code. All distributions will be made by the Company at the discretion of the
Board of Directors and will depend on the earnings of the Company, the
financial condition of the Company, maintenance of REIT status and such other
factors as the Board of Directors may deem relevant from time to time.
34
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data are derived from the audited financial
statements of the Company for the period from commencement of operations on
February 18, 1997 to December 31, 1997. The selected financial data should be
read in conjunction with the more detailed information contained in the
Financial Statements and Notes thereto and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" included elsewhere
in this Form 10-K.
PERIOD FROM FEBRUARY 18, 1997 TO DECEMBER 31, 1997
(DOLLARS IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
STATEMENT OF OPERATIONS DATA:
Days in period................................................... 317
Interest income.................................................. $ 24,713
Interest expense................................................. 19,677
----------
Net interest income.............................................. 5,036
Gain on sale of mortgage-backed securities....................... 735
General and administrative expenses (G&A expense)................ 852
----------
Net income....................................................... $ 4,919
==========
Basic net income per average share............................... $ 0.83
Diluted net income per average share............................. $ 0.78
Dividends declared per average share............................. $ 0.79
BALANCE SHEET DATA AT DECEMBER 31, 1997:
Mortgage-Backed Securities, net.................................. $1,161,779
Total assets..................................................... 1,167,740
Repurchase agreements............................................ 918,869
Total liabilities................................................ 1,032,654
Stockholders' equity............................................. 135,086
Number of common shares outstanding.............................. 12,713,900
OTHER DATA:
Average total assets............................................. $ 476,855
Average borrowings............................................... 404,140
Average equity................................................... 61,096
Yield on interest earning assets for the period ended December
31, 1997........................................................ 6.34%
Cost of funds on interest bearing liabilities for the period
ended December 31, 1997......................................... 5.61%
ANNUALIZED FINANCIAL RATIOS(1):
Net interest margin (net interest income/average total assets)... 1.22%
G&A expense as a percentage of average assets.................... 0.21%
G&A expense as a percentage of average equity.................... 1.61%
Return on average assets......................................... 1.19%
Return on average equity......................................... 9.27%
- --------
(1) Each ratio has been computed by annualizing the results for the 317-day
period ended December 31, 1997.
35
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
SAFE HARBOR STATEMENT
"Safe Harbor" Statement under the Private Securities Litigation Reform Act
of 1995: Statements in this discussion regarding the Company and its business
which are not historical facts are "forward-looking statements" that involve
risks and uncertainties. For a discussion of such risks and uncertainties,
which could cause actual results to differ from those contained in the
forward-looking statements, see "Risk Factors" commencing on page 23 of this
Form 10-K.
OVERVIEW
The Company is a real estate investment trust ("REIT") which acquires and
manages Mortgage-Backed Securities which can be readily financed. The Company
commenced operations on February 18, 1997 upon the closing of the Private
Placement which resulted in proceeds to the Company of approximately $33
million. The Company received additional proceeds of $878,000 upon the closing
of the Direct Offering on July 31, 1997. The Company's initial public offering
was completed on October 14, 1997 raising approximate net proceeds of $99.0
million.
The Company's principal business objective is to generate net income for
distribution to stockholders from the spread between the interest income on
its Mortgage-Backed Securities and the costs of borrowing to finance its
acquisition of Mortgage-Backed Securities. Since the commencement of
operations on February 18, 1997, the Company has been in the process of
building its balance sheet by acquiring Mortgage-Backed Securities. Therefore,
the operating results of the Company reflected in the financial statements
included in this Form 10-K should be interpreted in light of this growth
process and are not necessarily representative of what they may be in the
future.
The Company will seek to generate growth in earnings and dividends per share
in a variety of ways, including through (i) issuing new Common Stock and
increasing the size of the balance sheet when opportunities in the market for
Mortgage-Backed Securities are likely to allow growth in earnings per share,
(ii) seeking to improve productivity by increasing the size of the balance
sheet at a rate faster than the rate of increase in operating expenses, (iii)
continually reviewing the mix of Mortgage-Backed Security types on the balance
sheet in an effort to improve risk-adjusted returns, and (iv) attempting to
improve the efficiency of the Company's balance sheet structure through the
issuance of uncollateralized subordinated debt, preferred stock and other
forms of capital, to the extent management deems such issuances appropriate.
RESULTS OF OPERATIONS: FEBRUARY 18, 1997 TO DECEMBER 31, 1997
The Company's 1997 fiscal year commenced with the start of operations on
February 18, 1997 and concluded on December 31, 1997. The 317-day period from
February 18, 1997 to December 31, 1997 is referred to herein as "the period
ended December 31, 1997."
Net Income Summary
For the period ended December 31, 1997, net income, as calculated according
to Generally Accepted Accounting Principles ("GAAP"), was $4,919,494, or $0.83
per share. Taxable income was $4,884,308, or $0.82 per share. Net income per
share is computed by dividing net income by the weighted average number of
shares of outstanding Common Stock during the period, which was 5,952,123.
Dividends per weighted average number of shares outstanding was $0.79 per
share, $4,689,662 in total. Return on average equity was 9.27% on an
annualized basis.
Management's policy is to focus on income and expense measures as a
percentage of equity rather than as a percentage of assets. Therefore,
improvements in asset-based measures such as net interest margin or operating
expenses as a percentage of assets do not necessarily translate into improved
stockholder returns. Improvements in net interest income or operating expenses
as a percentage of equity, however, indicate that the Company is
36
effectively utilizing its equity capital base. The Company seeks to increase
net income as a percentage of equity consistent with its Capital Investment
Policy.
NET INCOME SUMMARY
PERIOD ENDED
DECEMBER 31,
1997
------------------
(DOLLARS IN
THOUSANDS, EXCEPT
PER SHARE AMOUNTS)
Interest Income......................................... $ 24,713
Interest Expense........................................ 19,677
----------
Net Interest Income..................................... 5,036
Gain on Sale of Mortgage-Backed Securities.............. 735
General and Administrative Expenses..................... 852
----------
Net Income.............................................. 4,919
==========
Average Number of Outstanding Shares.................... 5,952,123
Basic Net Income Per Share.............................. $ 0.83
Average Total Assets.................................... $ 476,855
Average Equity.......................................... $ 61,096
Annualized Return on Average Assets..................... 1.19%
Annualized Return on Average Equity..................... 9.27%
Taxable Income and GAAP Income
For the period ended December 31, 1997, income as calculated for tax
purposes (taxable income) differed from taxable income as calculated according
to generally accepted accounting principles (GAAP income). The differences
were in the calculations of premium amortization, gain on sale of securities,
and general and administrative expenses.
The distinction between taxable income and GAAP income is important to the
Company's stockholders because dividends are declared on the basis of taxable
income. While the Company does not pay taxes so long as it satisfies the
requirements for exemption from taxation pursuant to the REIT Provisions of
the Code, each year the Company completes a corporate tax form wherein taxable
income is calculated as if the Company were to be taxed. This taxable income
level determines the amount of dividends the Company can pay out over time.
The table below presents the major differences between GAAP and taxable income
for the Company
TAXABLE INCOME
TAXABLE
TAXABLE TAXABLE GAIN ON
GAAP GENERAL & MORTGAGE SALE OF TAXABLE
NET ADMINISTRATIVE AMORTIZATION SECURITIES NET
INCOME DIFFERENCES DIFFERENCES DIFFERENCES INCOME
------ -------------- ------------ ----------- -------
(DOLLARS IN THOUSANDS)
For the Period Ended
December 31, 1997...... $4,919 $ 3 $(92) $54 $4,884
37
Interest Income and Average Earning Asset Yield
The Company had average earning assets of $448.3 million for the period
ended December 31, 1997. The Company's primary source of income for the period
ended December 31, 1997 was interest income. A portion of income was generated
by gains on sales of Mortgage-Backed Securities. Interest income was $24.7
million for the period ended December 31, 1997. The yield on average earning
assets was 6.34% for the same period. The table below shows the Company's
average balance of cash equivalents and Mortgage-Backed Securities, the yields
earned on each type of earning assets, the yield on average earning assets and
interest income.
AVERAGE EARNING ASSET YIELD
YIELD ON
AVERAGE AVERAGE
AMORTIZED AMORTIZED
COST OF YIELD ON COST OF YIELD ON
AVERAGE MORTGAGE- AVERAGE AVERAGE MORTGAGE- AVERAGE
CASH BACKED EARNING CASH BACKED EARNING INTEREST
EQUIVALENTS SECURITIES ASSETS EQUIVALENTS SECURITIES ASSETS INCOME
----------- ---------- -------- ----------- ---------- -------- --------
(DOLLARS IN THOUSANDS)
For the Period Ended
December 31, 1997...... $30 $448,276 $448,306 4.20% 6.34% 6.34% $24,713
The Constant Prepayment Rate (or "CPR") on the Company's portfolio of
Mortgage-Backed Securities for the period ended December 31, 1997 was 17%.
"CPR" means an assumed rate of prepayment for the Company's Mortgage-Backed
Securities, expressed as an annual rate of prepayment relative to the
outstanding principal balance of the Company's Mortgage-Backed Securities.
This CPR does not purport to be either a historical description of the
prepayment experience of the Company's Mortgage-Backed Securities or a
prediction of the anticipated rate of prepayment of the Company's Mortgage-
Backed Securities. Since a large portion of the Company's assets was purchased
at a premium to par value and only a small portion of the Company's assets was
purchased at a discount to par value, the premium balance in the Company's
portfolio is substantially higher than the discount balance. Principal
prepayments had a negative effect on the Company's earning asset yield for the
period ended December 31, 1997 because the Company adjusts its rates of
premium amortization and discount accretion monthly based on actual payments
received.
Interest Expense and the Cost of Funds
The Company anticipates that its largest expense will usually be the cost of
borrowed funds. The Company had average borrowed funds of $404.1 million and
total interest expense of $19.7 million for the period ended December 31,
1997. The average cost of funds was 5.61% for the same period. Interest
expense is calculated in the same manner for GAAP and tax purposes.
With the Company's current asset/liability management strategy, changes in
the Company's cost of funds are expected to be closely correlated with changes
in short-term LIBOR, although the Company may choose to extend the maturity of
its liabilities at any time. The Company's average cost of funds was 0.06%
below one-month LIBOR for the period ended December 31, 1997. The Company
generally has structured its borrowings to adjust with one-month LIBOR because
the Company believes that one-month LIBOR may continue to be lower than six-
month LIBOR in the present interest rate environment. During the period ended
December 31, 1997, average one-month LIBOR, which was 5.67%, was 0.20% lower
than average six-month LIBOR, which was 5.87%.
38
The table below shows the Company's average borrowed funds and average cost
of funds as compared to average one- and average six-month LIBOR.
AVERAGE COST OF FUNDS
AVERAGE AVERAGE
ONE-MONTH COST OF AVERAGE
LIBOR FUNDS COST OF
RELATIVE RELATIVE FUNDS
TO TO RELATIVE TO
AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE
BORROWED INTEREST COST OF ONE-MONTH SIX-MONTH SIX-MONTH ONE-MONTH SIX-MONTH
FUNDS EXPENSE FUNDS LIBOR LIBOR LIBOR LIBOR LIBOR
-------- -------- ------- --------- --------- --------- --------- -----------
(DOLLARS IN THOUSANDS)
For the Period Ended
December 31, 1997...... $404,140 $19,677 5.61% 5.67% 5.87% (0.20)% (0.06)% (0.26)%
Net Interest Rate Agreement Expense
For the period ended December 31, 1997, the Company did not enter into any
interest rate agreements. As part of its asset/liability management process,
the Company may enter into interest rate agreements such as interest rate
caps, floors and swaps. These agreements would be entered into to reduce
interest rate risk and would be designed to provide income and capital
appreciation to the Company in the event of certain changes in interest rates.
The Company reviews the need for interest rate agreements on a regular basis
consistent with its Capital Investment Policy.
Net Interest Income
Net interest income, which equals interest income less interest expense,
totaled $5.0 million for the period ended December 31, 1997. Net interest
spread, which equals the yield on the Company's average assets for the period
less the average cost of funds for the period, was 0.73% for the period ended
December 31, 1997. Net interest margin, which equals net interest income
divided by average total assets, was 1.22% on an annualized basis. Taxable net
interest income was $92,406 less than GAAP net interest income because of
differing premium amortization. The principal reason that annualized net
interest margin exceeded net interest spread is that average assets exceeded
average liabilities. A portion of the Company's assets are funded with equity
rather than borrowings. The Company did not have any interest rate agreement
expenses for the period ended December 31, 1997.
The table below shows interest income by earning asset type, average earning
assets by type, total interest income, interest expense, average repurchase
agreements, average cost of funds, and net interest income for the period
ended December 31, 1997.
NET INTEREST INCOME
AVERAGE
AMORTIZED
COST OF INTEREST YIELD ON
MORTGAGE- INCOME ON INTEREST AVERAGE AVERAGE
BACKED MORTGAGE- AVERAGE INCOME ON TOTAL INTEREST BALANCE OF AVERAGE NET
SECURITIES BACKED CASH CASH INTEREST EARNING REPURCHASE INTEREST COST OF INTEREST
HELD SECURITIES EQUIVALENTS EQUIVALENTS INCOME ASSETS AGREEMENTS EXPENSE FUNDS INCOME
---------- ---------- ----------- ----------- -------- -------- ---------- -------- ------- --------
(DOLLARS IN THOUSANDS)
For the Period
Ended December
31, 1997......... $448,276 $24,682 $30 $31 $24,713 6.34% $404,140 $19,677 5.61% $5,036
Gains and Losses on Sales of Mortgage-Backed Securities
For the period ended December 31, 1997, the Company sold Mortgage-Backed
Securities with an aggregate historical amortized cost of $173.9 million for
an aggregate gain of $735,303. The difference between the sale price and the
historical amortized cost of the Mortgage-Backed Securities is a realized gain
and increased income
39
accordingly. Taxable gain on sale of Mortgage-Backed Securities was $54,502
greater than GAAP gain on sale of Mortgage-Backed Securities. The Company does
not expect to sell assets on a frequent basis, but may from time to time sell
existing assets to move into new assets which management believes might have
higher risk-adjusted returns or to manage its balance sheet as part of
management's asset/liability management strategy.
Credit Expenses
The Company has not experienced credit losses on its portfolio of Mortgage-
Backed Securities to date, but losses may be experienced in the future. At
December 31, 1997, the Company had limited its exposure to credit losses on
its portfolio of Mortgage-Backed Securities by purchasing only Agency
Certificates which, although not rated, carry an implied "AAA" rating.
General and Administrative Expenses
General and administrative expenses ("operating expense" or "G&A expense")
was $851,990 for the period ended December 31, 1997. Taxable G&A expenses were
$2,718 less than for GAAP purposes.
G&A EXPENSE AND OPERATING EXPENSE RATIOS
CASH COMP OTHER TOTAL TOTAL G&A TOTAL G&A
AND BENEFITS G&A G&A EXPENSE/AVERAGE EXPENSE/AVERAGE
EXPENSE EXPENSE EXPENSE ASSETS EQUITY
------------ ------- ------- --------------- ---------------
(ANNUALIZED) (ANNUALIZED)
(DOLLARS IN THOUSANDS)
For the Period Ended
December 31, 1997...... $492 $360 $852 0.21% 1.61%
The Company expects G&A expense to increase as a result of the consummation
of the Company's initial public offering. The Company plans to hire new
employees to expand the Company's capabilities with respect to acquiring and
monitoring its portfolio of Mortgage-Backed Securities. In addition, certain
compensation expenses will increase commensurate with growth in the Company's
equity base. Despite these increases in operating expenses, management
believes that the Company's operating expenses over time are likely to grow at
a slower rate than its asset or equity base and thus management believes that
the Company's operating expense ratios are likely to continue to improve over
time.
Net Income and Return on Average Equity
Net income was $4.9 million in the period ended December 31, 1997. Return on
average equity was 9.27% on an annualized basis. The table below shows, on an
annualized basis, the Company's net interest income, gain on sale of Mortgage-
Backed Securities and G&A expense each as a percentage of average equity, and
the return on average equity.
COMPONENTS OF RETURN ON AVERAGE EQUITY
GAIN ON SALE OF
NET INTEREST MORTGAGE-BACKED G&A RETURN ON
INCOME/AVERAGE SECURITIES/AVERAGE EXPENSE/AVERAGE AVERAGE
EQUITY EQUITY EQUITY EQUITY
-------------- ------------------ --------------- ---------
For the Period Ended
December 31, 1997
(on an annualized
basis)................ 9.49% 1.39% 1.61% 9.27%
Dividends and Taxable Income
The Company will elect to be taxed as a REIT under the Code. Accordingly,
the Company intends to distribute substantially all of its taxable income for
each year to stockholders, including income resulting from gains on sales of
Mortgage-Backed Securities. On a cumulative basis through December 31, 1997,
earned taxable
40
income exceeded dividend declarations by $194,646, or $0.015 per share, based
on the number of shares of Common Stock outstanding at period end.
DIVIDEND SUMMARY
WEIGHTED
AVERAGE CUMULATIVE
COMMON TAXABLE DIVIDENDS DIVIDEND UNDISTRIBUTED
TAXABLE SHARES NET INCOME DECLARED TOTAL PAY-OUT TAXABLE
NET INCOME OUTSTANDING PER SHARE PER SHARE DIVIDENDS RATIO INCOME
---------- ----------- ---------- --------- --------- -------- -------------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
For the Period Ended
December 31, 1997...... $4,884 5,952,123 $0.82 $0.79 $4,690 96.0% $194
FINANCIAL CONDITION
Mortgage-Backed Securities
All of the Company's Mortgage-Backed Securities at December 31, 1997 were
adjustable-rate or fixed-rate Mortgage-Backed Securities backed by Single-
Family Mortgage Loans. All of the mortgage assets underlying such Mortgage-
Backed Securities were secured with a first lien position with respect to the
underlying single-family properties. At December 31, 1997, all the Company's
Mortgage-Backed Securities were Agency Certificates which carry an implied
"AAA" rating. All of the Company's earning assets are marked-to-market at
liquidation value.
Discount balances are accreted as an increase in interest income over the
life of discount Mortgage-Backed Securities and premium balances are amortized
as a decrease in interest income over the life of premium Mortgage-Backed
Securities. At December 31, 1997, the Company had on its balance sheet a total
of $114,186 of unamortized discount (which is the difference between the
remaining principal value and current historical amortized cost of Mortgage-
Backed Securities acquired at a price below principal value) and a total of
$21.5 million of unamortized premium (which is the difference between the
remaining principal value and the current historical amortized cost of
Mortgage-Backed Securities acquired at a price above principal value).
Mortgage principal repayments received were $79.8 million for the period
ended December 31, 1997, which equals a CPR of 17%. Given the Company's
current portfolio composition, if mortgage principal prepayment rates increase
over the life of the Mortgage-Backed Securities comprising the current
portfolio, all other factors being equal, the Company's net interest income
should decrease during the life of such Mortgage-Backed Securities as the
Company will be required to amortize its net premium balance into income over
a shorter time period. Similarly, if mortgage principal prepayment rates
decrease over the life of such Mortgage-Backed Securities, all other factors
being equal, the Company's net interest income should increase during the life
of such Mortgage-Backed Securities as the Company will amortize its net
premium balance over a longer time period.
The table below summarizes the Company's Mortgage-Backed Securities at
December 31, 1997.
MORTGAGE-BACKED SECURITIES
ESTIMATED
AMORTIZED ESTIMATED FAIR VALUE/ WEIGHTED
PRINCIPAL NET AMORTIZED COST/PRINCIPAL FAIR PRINCIPAL AVERAGE
VALUE PREMIUM COST VALUE VALUE VALUE YIELD
---------- ------- ---------- -------------- ---------- ------------ --------
(DOLLARS IN THOUSANDS)
At December 31, 1997.... $1,138,365 $21,390 $1,159,755 101.88% $1,161,779 102.06% 6.57%
During the period ended December 31, 1997, the Company's Mortgage-Backed
Securities consisted solely of Agency Certificates. However, the Company may
purchase other types of Mortgage-Backed Securities in the future.
41
The tables below set forth certain characteristics of the Company's
Mortgage-Backed Securities at December 31, 1997. The index level for
adjustable-rate Mortgage-Backed Securities is the weighted average rate of the
various short-term interest rate indices which determine the coupon rate.
ADJUSTABLE-RATE MORTGAGE-BACKED SECURITY CHARACTERISTICS
PRINCIPAL
VALUE AT
WEIGHTED PERIOD END
WEIGHTED WEIGHTED WEIGHTED AVERAGE WEIGHTED AS % OF
AVERAGE AVERAGE AVERAGE TERM TO AVERAGE WEIGHTED MORTGAGE-
PRINCIPAL COUPON INDEX NET NEXT LIFETIME AVERAGE ASSET BACKED
VALUE RATE LEVEL MARGIN ADJUSTMENT CAP YIELD SECURITIES
--------- -------- -------- -------- ---------- -------- ------------- ----------
(DOLLARS IN THOUSANDS)
At December 31, 1997.... $994,653 7.13% 5.52% 1.61% 22 months 10.78% 6.50% 87.38%
FIXED-RATE MORTGAGE-BACKED SECURITY CHARACTERISTICS
WEIGHTED WEIGHTED
AVERAGE AVERAGE PRINCIPAL VALUE AS %
PRINCIPAL COUPON ASSET OF MORTGAGE-BACKED
VALUE RATE YIELD SECURITIES
--------- -------- -------- --------------------
(DOLLARS IN THOUSANDS)
At December 31, 1997........... $143,712 7.50% 7.08% 12.62%
At December 31, 1997, the Company held Mortgage-Backed Securities with
coupons linked to the one- and three-year Treasury Indices, one-month LIBOR
and the six-month CD rate. The table below segments the Company's adjustable-
rate Mortgage-Backed Securities by type of adjustment index, coupon adjustment
frequency and annual and lifetime cap adjustment.
ADJUSTABLE-RATE MORTGAGE-BACKED SECURITIES BY INDEX
1-YEAR 3-YEAR
ONE-MONTH SIX-MONTH TREASURY TREASURY
LIBOR CD RATE INDEX INDEX
--------- --------- -------- --------
Weighted Average Adjustment Frequency. 1 mo. 6 mo. 50 mo. 36 mo.
Weighted Average Term to Next Adjust-
ment................................. 1 mo. 4 mo. 46 mo. 12 mo.
Weighted Average Annual Period Cap.... none 2.00% 1.78% 2.00%
Weighted Average Lifetime Cap......... 9.21% 10.88% 11.77% 14.16%
Mortgage Principal Value as Percentage
of
Mortgage-Backed Securities........... 30.94% 7.81% 48.45% .18%
The table below shows unrealized gains and losses on the Mortgage-Backed
Securities in the Company's portfolio.
UNREALIZED GAINS AND LOSSES
AT DECEMBER 31,
1997
---------------
(DOLLARS IN
THOUSANDS)
Unrealized Gain............................................. $ 3,253
Unrealized Loss............................................. (1,229)
-----------
Net Unrealized Gain......................................... 2,024
===========
Net Unrealized Gain as % of Mortgage-Backed Securities Prin-
cipal Value................................................ 0.18%
Net Unrealized Gain as % of Mortgage-Backed Securities Amor-
tized Cost................................................. 0.17%
42
Interest Rate Agreements
Interest rate agreements are assets that are carried on a balance sheet at
estimated liquidation value. At December 31, 1997, there were no interest rate
agreements on the Company's balance sheet.
Borrowings
To date, the Company's debt has consisted entirely of borrowings
collateralized by a pledge of the Company's Mortgage-Backed Securities. These
borrowings appear on the balance sheet as repurchase agreements. At December
31, 1997, the Company had established uncommitted borrowing facilities in this
market with nineteen lenders in amounts which the Company believes are in
excess of its needs. All of the Company's Mortgage-Backed Securities are
currently accepted as collateral for such borrowings. The Company, however,
limits its borrowings, and thus its potential asset growth, in order to
maintain unused borrowing capacity and thus increase the liquidity and
strength of its balance sheet.
For the period ended December 31, 1997, the term to maturity of the
Company's borrowings has ranged from one day to six months, with a weighted
average original term to maturity of 50 days and a weighted average remaining
maturity of 16 days at December 31, 1997. Many of the Company's borrowings
have a cost of funds which adjust monthly based on a fixed spread over or
under one-month LIBOR or based on the daily Fed Funds rate. As a result, the
average term to the next rate adjustment for the Company's borrowings is
typically shorter than the term to maturity for the Company's Mortgage-Backed
Securities. At December 31, 1997, the weighted average cost of funds for all
of the Company's borrowings was 6.16% and the weighted average term to next
rate adjustment was 16 days.
Liquidity
Liquidity, which is the Company's ability to turn non-cash assets into cash,
allows the Company to purchase additional Mortgage-Backed Securities and to
pledge additional assets to secure existing borrowings should the value of
pledged assets decline. Potential immediate sources of liquidity for the
Company include cash balances and unused borrowing capacity. Unused borrowing
capacity will vary over time as the market value of the Company's Mortgage-
Backed Securities varies. The Company's balance sheet also generates liquidity
on an on-going basis through mortgage principal repayments and net earnings
held prior to payment as dividends. Should the Company's needs ever exceed
these on-going sources of liquidity plus the immediate sources of liquidity
discussed above, management believes that the Company's Mortgage-Backed
Securities could in most circumstances be sold to raise cash. The maintenance
of liquidity is one of the goals of the Company's Capital Investment Policy.
Under this policy, asset growth is limited in order to preserve unused
borrowing capacity for liquidity management purposes.
Stockholders' Equity
The Company uses "available-for-sale" treatment for its Mortgage-Backed
Securities; these assets are carried on the balance sheet at estimated market
value rather than historical amortized cost. Based upon such "available-for-
sale" treatment, the Company's equity base at December 31, 1997 was $135.1
million, or $10.62 per share. If the Company had used historical amortized
cost accounting, the Company's equity base at December 31, 1997 would have
been $133.1 million, or $10.47 per share.
With the Company's "available-for-sale" accounting treatment, unrealized
fluctuations in market values of assets do not impact GAAP or taxable income
but rather are reflected on the balance sheet by changing the carrying value
of the asset and reflecting the change in stockholders' equity under "Net
Unrealized Gain on Assets Available for Sale." By accounting for its assets
in this manner, the Company hopes to provide useful information to
stockholders and creditors and to preserve flexibility to sell assets in the
future without having to change accounting methods.
43
As a result of this mark-to-market accounting treatment, the book value and
book value per share of the Company are likely to fluctuate far more than if
the Company used historical amortized cost accounting. As a result,
comparisons with companies that use historical cost accounting for some or all
of their balance sheet may be misleading.
Unrealized changes in the estimated net market value of Mortgage-Backed
Securities have one direct effect on the Company's potential earnings and
dividends: positive market-to-market changes will increase the Company's
equity base and allow the Company to increase its borrowing capacity while
negative changes will tend to limit borrowing capacity under the Company's
Capital Investment Policy. A very large negative change in the net market
value of the Company's Mortgage-Backed Securities might impair the Company's
liquidity position, requiring the Company to sell assets with the likely
result of realized losses upon sale. "Net Unrealized Gain on Assets
Available for Sale" was $2.0 million, or 0.02% of the amortized cost of
Mortgage-Backed Securities at December 31, 1997.
The table below shows the Company's equity capital base as reported and on a
historical amortized cost basis at December 31, 1997. The historical cost
equity capital base is influenced by issuances of Common Stock, the level of
GAAP earnings as compared to dividends declared, and other factors. The GAAP
reported equity capital base is influenced by these factors plus changes in
the "Net Unrealized Gain on Assets Available for Sale" account.
STOCKHOLDERS' EQUITY
NET UNREALIZED HISTORICAL GAAP REPORTED
HISTORICAL GAIN ON ASSETS GAAP REPORTED AMORTIZED EQUITY (BOOK
AMORTIZED COST AVAILABLE EQUITY BASE COST EQUITY VALUE) PER
EQUITY BASE FOR SALE (BOOK VALUE) PER SHARE SHARE
-------------- ---------------- ------------- ----------- -------------
At December 31, 1997.... $133,063 $2,024 $135,087 $10.47 $10.62
Leverage
The Company's debt-to-GAAP reported equity ratio at December 31, 1997 was
7:1. The Company generally expects to maintain a ratio of debt-to-equity of
between 8:1 and 12:1, although the ratio may vary from time to time based upon
various factors, including management's opinion of the level of risk of its
assets and liabilities, the Company's liquidity position, the level of unused
borrowing capacity and over-collateralization levels required by lenders when
the Company pledges assets to secure borrowings.
The target debt-to-GAAP reported equity ratio is determined under the
Company's Capital Investment Policy. Should the actual debt-to-equity ratio of
the Company increase above the target level due to asset acquisition and/or
market value fluctuations in assets, management will cease to acquire new
assets. Management will, at such time, present a plan to its Board of
Directors to bring the Company back to its target debt-to-equity ratio; in
many circumstances, this would be accomplished in time by the monthly
reduction of the balance of Mortgage-Backed Securities through principal
repayments.
ASSET/LIABILITY MANAGEMENT AND EFFECT OF CHANGES IN INTEREST RATES
Management continually reviews the Company's asset/liability management
strategy with respect to interest rate risk, mortgage prepayment risk, credit
risk and the related issues of capital adequacy and liquidity. The Company
seeks attractive risk-adjusted stockholder returns while maintaining a strong
balance sheet.
The Company seeks to manage the extent to which net income changes as a
function of changes in interest rates by matching adjustable-rate assets with
variable-rate borrowings. In addition, although it has not done so to date,
the Company may seek to mitigate the potential impact on net income of
periodic and lifetime coupon adjustment restrictions in its portfolio of
Mortgage-Backed Securities by entering into interest rate agreements such as
interest rate caps and interest rate swaps.
44
Changes in interest rates may also have an effect on the rate of mortgage
principal prepayments and, as a result, prepayments on Mortgage-Backed
Securities. The Company will seek to mitigate the effect of changes in the
mortgage principal repayment rate from an economic point of view by balancing
assets purchased at a premium with assets purchased at a discount. To date,
the aggregate premium exceeds the aggregate discount on Mortgage-Backed
Securities in the Company's portfolio. As a result, prepayments, which result
in the expensing of unamortized premium, will reduce the Company's net income
compared to what net income would be absent such prepayments.
INFLATION
Virtually all of the Company's assets and liabilities are financial in
nature. As a result, interest rates and other factors drive the Company's
performance far more than does inflation. Changes in interest rates do not
necessarily correlate with inflation rates or changes in inflation rates. The
Company's financial statements are prepared in accordance with GAAP and the
Company's dividends are determined by the Company's net income as calculated
for tax purposes; in each case, the Company's activities and balance sheet are
measured with reference to historical cost or fair market value without
considering inflation.
OTHER MATTERS
The Company calculated its Qualified REIT Real Estate Assets (as defined in
the Code), to be 99.5% of is total assets, as compared to the Code requirement
that at least 75% of its total assets must be Qualified REIT Real Estate
Assets. The Company also calculates that 97.1% of its revenue qualifies for
the 75% source of income test and 100% of its revenue qualifies for the 95%
source of income test under the REIT rules. Furthermore, the Company's
revenues during the year ended December 31, 1997 subject to the 30% income
limitation under the REIT rules amount to 2.9% of total revenue. The Company
also met all REIT requirements regarding the ownership of its Common Stock and
the distributions of its net income. Therefore, as of December 31, 1997, the
Company believes that it qualified as a REIT under the provisions of the Code.
The Company at all times intends to conduct its business so as not to become
regulated as an investment company under the Investment Company Act of 1940.
If the Company were to become regulated as an investment company, then the
Company's use of leverage would be substantially reduced. The Investment
Company Act exempts entities that are "primarily engaged in the business of
purchasing or otherwise acquiring mortgages and other liens on and interests
in real estate" ("Qualifying Interests"). Under current interpretation of the
staff of the Commission, in order to qualify for this exemption, the Company
must maintain at least 55% of its assets directly in Qualifying Interests. In
addition, unless certain mortgage securities represent all the certificates
issued with respect to an underlying pool of mortgages, such mortgage
securities may be treated as securities separate from the underlying mortgage
loans and, thus, may not be considered Qualifying Interests for purposes of
the 55% requirement. As of December 31, 1997, the Company calculates that it
is in compliance with this requirement.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements of the Company and the related notes, together with
the Independent Auditors' Report thereon are set forth on pages F-1 through F-
11 on this Form 10-K.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
45
PART III
ITEM 10. DIRECTORS AND OFFICERS OF THE REGISTRANT
The information required by Item 10 is incorporated herein by reference to
the definitive Proxy Statement filed pursuant to Regulation 14A under the
headings "Election of Directors," "Management of the Company," and "Compliance
with Reporting Requirements."
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated herein by reference to
the definitive Proxy Statement filed pursuant to Regulation 14A under the
heading "Executive Compensation."
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 11 is incorporated herein by reference to
the definitive Proxy Statement filed pursuant to Regulation 14A under the
heading "Security Ownership of Certain Beneficial Owners and Management."
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 11 is incorporated herein by reference to
the definitive Proxy Statement filed pursuant to Regulation 14A under the
heading "Certain Transactions."
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Documents filed as part of this report:
1. Financial Statements.
2. Schedules to Financial Statements:
All financial statement schedules not included have been omitted because
they are either inapplicable or the information required is provided in the
Company's Financial Statements and Notes thereto, included in Part II, Item 8,
of this Annual Report on Form 10-K.
3. Exhibits:
3.1 Articles of Incorporation of the Registrant (incorporated by reference to
Exhibit 3.1 to the Company's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
3.2 Articles of Amendment and Restatement of the Articles of Incorporation of
the Registrant (incorporated by reference to Exhibit 3.2 to the
Company's Registration Statement on Form S-11 (Registration No. 333-
32913) filed with the Securities and Exchange Commission on August 5,
1997).
3.3 Bylaws of the Registrant, as amended (incorporated by reference to
Exhibit 3.3 to the Company's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
4.1 Specimen Common Stock Certificate (incorporated by reference to Exhibit
4.1 to Amendment No. 1 to the Company's Registration Statement on Form
S-11(Registration No. 333-32913) filed with the Securities and Exchange
Commission on September 17, 1997).
10.1 Purchase Agreement, dated February 12, 1997, between the Registrant and
Friedman, Billings, Ramsey & Co., Inc. ("FBR") (incorporated by
reference to Exhibit 10.1 to the Company's Registration Statement on
Form S-11 (Registration No. 333-32913) filed with the Securities and
Exchange Commission on August 5, 1997).
46
10.2 Registration Rights Agreement, dated February 12, 1997, between the
Registrant and FBR (incorporated by reference to Exhibit 10.2 to the
Company's Registration Statement on Form S-11 (Registration No. 333-
32913) filed with the Securities and Exchange Commission on August 5,
1997).
10.3 Long-Term Stock Incentive Plan (incorporated by reference to Exhibit 10.3
to the Company's Registration Statement on Form S-11 (Registration No.
333-32913) filed with the Securities and Exchange Commission on August
5, 1997).
10.4 Employment Agreement, effective as of January 27, 1997, between the
Company and Michael A.J. Farrell (incorporated by reference to Exhibit
10.4 to the Company's Registration Statement on Form S-11 (Registration
No. 333-32913) filed with the Securities and Exchange Commission on
August 5, 1997).
10.5 Employment Agreement, effective as of January 27, 1997, between the
Company and Timothy J. Guba (incorporated by reference to Exhibit 10.5
to the Company's Registration Statement on Form S-11 (Registration No.
333-32913) filed with the Securities and Exchange Commission on August
5, 1997).
10.6 Employment Agreement, effective as of January 27, 1997, between the
Company and Wellington J. St. Claire (incorporated by reference to
Exhibit 10.6 to the Company's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
10.7 Form of Master Repurchase Agreement (incorporated by reference to Exhibit
10.7 to the Company's Registration Statement on Form S-11 (Registration
No. 333-32913) filed with the Securities and Exchange Commission on
August 5, 1997).
10.8 Form of Purchase Agreement between the Company and the purchasers in the
Direct Offering (incorporated by reference to Exhibit 10.8 to the
Company's Registration Statement on Form S-11 (Registration No. 333-
32913) filed with the Securities and Exchange Commission on August 5,
1997).
10.9 Employment Agreement, effective as of November 1, 1997, between the
Company and Katherine F. Fagan.
27 Financial Data Schedule.
(b) Reports on Form 8-K
No reports on Form 8-K have been filed during the last quarter of the period
covered by this report.
47
GLOSSARY
As used in this Form 10K, the capitalized and other terms listed below have
the meanings indicated.
"Agency" means GNMA, FNMA or FHLMC.
"Agency Certificates" means GNMA Certificates, FNMA Certificates and FHLMC
Certificates.
"amortized cost" means, with respect to Mortgage-Backed Securities, the
purchase price as adjusted for subsequent amortization of discount or premium
and for principal repayments.
"ARM" means a Mortgage Loan or any mortgage loan underlying a Mortgage-
Backed Security that features adjustments of the underlying interest rate at
predetermined times based on an agreed margin to an established index. An ARM
is usually subject to periodic interest rate and/or payment caps and a
lifetime interest rate cap.
"ARM Certificate" means an adjustable-rate Pass-Through Certificate.
"Articles of Incorporation" means the Company's Articles of Incorporation,
as amended and restated by the Company's Articles of Amendment and
Restatement, filed with the State of Maryland.
"Bankruptcy Code" means Title 11 of the United State Code, entitled
"Bankruptcy."
"Board" or "Board of Directors" means the Board of Directors of the Company.
"Capital Investment Policy" means the policy established by the Company,
including a majority of the Independent Directors, establishing guidelines for
management relating to asset acquisitions, credit risk management, capital and
leverage, interest rate risk management and prepayment risk management, as
more fully described under "Business Strategy--Capital Investment Policy."
"capital stock" means the Common Stock and any additional classes of capital
stock authorized by the Board of Directors in the future.
"carrying value" means the value placed on an asset or liability for balance
sheet presentation purposes. With respect to Mortgage-Backed Securities and
interest rate cap agreements, the carrying value equals management's estimate
of the bid-side market value of that asset. Management will generally base its
estimate on the lowest of third-party bid-side indications of market value
obtained on a regular basis from firms making a market in or lending against
such assets. With respect to all other balance sheet items, carrying value
equals amortized cost.
"CD Rate" means the weekly average of secondary market interest rates on
six-month negotiable certificates of deposit, as published by the Federal
Reserve Board in its Statistical Release H.15(519), Selected Interest Rates.
"CMOs" or "Collateralized Mortgage Obligations" means adjustable- or fixed-
rate debt obligations (bonds) that are collateralized by Mortgage Loans or
mortgage certificates. CMOs are structured so that principal and interest
payments received on the collateral are sufficient to make principal and
interest payments on the bonds. Such bonds may be issued by United States
government sponsored entities or private issuers in one or more classes with
fixed or adjustable interest rates, maturities and degrees of subordination
which are characteristics designed for the investment objectives of different
bond purchasers.
"Code" means the Internal Revenue Code of 1986, as amended.
"Commercial Mortgage Loans" means Mortgage Loans secured by commercial
property.
"Commission" means the Securities and Exchange Commission.
48
"Common Stock" means the Company's shares of Common Stock, par value $0.01
per share.
"Company" means Annaly Mortgage Management, Inc., a Maryland corporation.
"Conforming Mortgage Loans" means Single-Family Mortgage Loans that either
comply with requirements for inclusion in credit support programs sponsored by
FHLMC or FNMA or are FHA or VA Loans.
"coupon rate" means, with respect to Mortgage-Backed Securities, the
annualized cash interest income actually received from the asset, expressed as
a percentage of the face value of the asset.
"CPR" means an assumed rate of prepayment for the Company's Mortgage-Backed
Securities, expressed as an annual rate of prepayment relative to the
outstanding principal balance of the Company's Mortgage-Backed Securities. CPR
does not purport to be either a historical description of the prepayment
experience of the Company's Mortgage-Backed Securities or a prediction of the
anticipated rate of prepayment of the Company's Mortgage-Backed Securities.
"Direct Offering" means the Company's sale on July 31, 1997 of an aggregate
of 87,800 shares of Common Stock to certain directors, officers and employees
of the Company.
"DOL" means the Department of Labor.
"Dollar-Roll Agreement" means an agreement to sell a security for delivery
on a specified future date and a simultaneous agreement to repurchase the same
or a substantially similar security (with the same coupon and original
maturity periods) on a specified future date.
"duration" means the expected percentage change in the market value of the
Company's assets that would be caused by a 1% change in short and long term
interest rates.
"efficiency ratio" means general and administrative expenses as a percentage
of net interest income.
"ERISA" means the Employee Retirement Income Security Act of 1974, as
amended.
"ERISA Plan" means a pension, profit-sharing, retirement or other employee
benefit plan which is subject to Title I of ERISA.
"Excess Securities" means shares of capital stock representing ownership,
directly or constructively, in excess of 9.8%, in number of shares or value,
of any class of shares of the outstanding capital stock (except as otherwise
waived by the Board of Directors).
"Exchange Act" means the Securities Exchange Act of 1934, as amended.
"Excess Capital Cushion" is a term defined in the Company's Capital
Investment Policy. It represents a portion of the capital the Company is
required to maintain as part of this policy in order to continue to make asset
acquisitions. The Excess Capital Cushion is that part of the required capital
base which is in excess of the Company's haircut requirements.
"face value" means, with respect to Mortgage-Backed Securities, the
outstanding principal balance of Mortgage Loans or Mortgage-Backed Securities
comprising the Mortgage-Backed Securities. In the absence of credit losses,
the face value equals the sum of the principal repayments that will be
received by the Company over the life of the Mortgage-Backed Security.
"Federal Reserve Board" means the Board of Governors of the Federal Reserve
System.
"Fed Funds Rate" means the interest rate charged by banks with excess
reserves at a Federal Reserve System district bank to banks needing overnight
loans to meet reserve requirements.
49
"FHA" means the United States Federal Housing Administration.
"FHA Loans" means Mortgage Loans insured by the FHA.
"FHLMC" means the Federal Home Loan Mortgage Corporation.
"FHLMC ARM Certificates" means adjustable-rate FHLMC Certificates.
"FHLMC Certificates" means mortgage participation certificates issued by
FHLMC, either in certificate or book-entry form.
"FIDAC" means Fixed Income Discount Advisory Company, a Delaware
corporation.
"Floaters" means adjustable-rate CMOs.
"FNMA" means the Federal National Mortgage Association.
"FNMA ARM Certificates" means adjustable-rate FNMA Certificates.
"FNMA Certificates" means mortgage pass-through certificates issued by FNMA,
either in certificated or book-entry form.
"fully-indexed rate" means, with respect to ARMs, the rate that would be
paid by the borrower ("gross") or received by the Company as owner of the
Mortgage Asset ("net") if the coupon rate on the ARM were able to adjust
immediately to a market rate without being subject to adjustment periods,
periodic caps, or life caps. It is equal to the current yield of the ARM index
plus the gross or net margin.
"GAAP" means generally accepted accounting principles.
"GNMA" means the Government National Mortgage Association.
"GNMA ARM Certificates" means adjustable-rate GNMA Certificates.
"GNMA Certificates" means fully modified pass-through mortgage-backed
certificates guaranteed by GNMA and issued either in certificated or book-
entry form.
"gross margin" means, with respect to ARMs, the coupon rate to be paid by
the borrower. The term "gross" is used to differentiate payments made by the
borrower with the lower "net" payments actually received by the Company after
the acquisition of a Mortgage Asset. The difference between the gross margin
and the net margin reflects loan servicing fees and other pre-determined
contractual deductions. The fully-indexed gross coupon rate equals the current
yield on the ARM index (six month LIBOR, one year Treasury, etc.) plus the
gross margin. The actual coupon rate paid by the borrower may be lower than
the fully-indexed gross rate at the initiation of the loan if originated at a
"teaser rate" or during periods of rising interest rates due to the
limitations of the ARM adjustment schedule and the periodic and life caps. If
so, the coupon rate paid by the borrower would move towards the fully-indexed
gross rate over time.
"haircut" means the over-collateralization amount required by a lender in
connection with a collateralized borrowing.
"High Quality" means (i) securities which are rated within one of the two
highest rating categories by at least one of the nationally recognized rating
agencies, (ii) securities that are unrated but are guaranteed by the United
States government or an agency of the United States government, or (iii)
securities that are unrated or whose ratings have not been updated but are
determined to be of comparable quality to rated High Quality Mortgage-Backed
Securities on the basis of credit enhancement features that meet the High
Quality credit criteria approved by the Company's Board of Directors.
50
"Housing Act" means the National Housing Act of 1934, as amended.
"HUD" means the Department of Housing and Urban Development.
"Independent Director" means a director of the Company who is not an officer
or employee of the Company.
"interest-only strip," "interest only security" or "IO" means a type of
Mortgage-Backed Security which receives a portion of the interest payments
from an underlying pool of mortgage loans but will receive little or no
principal payments and hence will have little or no face value. The market
value and yield of an IO are unusually sensitive to the prepayment rates
experienced on and anticipated for the underlying pool of mortgage loans. The
market values and yields of IOs may increase as interest rates increase and,
in certain conditions, IOs may act in a counter-cyclical manner as compared to
other Mortgage-Backed Securities.
"interest rate adjustment indices" means, in the case of Mortgage-Backed
Securities, any of the objective indices based on the market interest rates of
a specified debt instrument (such as United States Treasury Bills in the case
of the Treasury Index and United States dollar deposits in London in the case
of LIBOR) or based on the average interest rate of a combination of debt
instruments (such as the 11th District Cost of Funds Index), used as a
reference base to reset the interest rate for each adjustment period on the
Mortgage Asset, and in the case of borrowings, is used herein to mean the
market interest rates of a specified debt instrument (such as repurchase
agreements for Mortgage-Backed Securities) as well as any of the objective
indices described above that are used as a reference base to reset the
interest rate for each adjustment period under the related borrowing
instrument.
"interest rate adjustment period" means, in the case of Mortgage-Backed
Securities, the period of time set forth in the debt instrument that
determines when the interest rate is adjusted and, with respect to borrowings,
is used to mean the term to maturity of a short-term, fixed-rate debt
instrument (such as a 30-day repurchase agreement) as well as the period of
time set forth in a long-term, adjustable-rate debt instrument that determines
when the interest rate is adjusted.
"interest rate agreement" means an agreement, such as an interest rate swap
cap, collar or floor, entered into for the purpose of hedging risks associated
with changes in interest rates.
"Investment Company Act" means the Investment Company Act of 1940, as
amended.
"IRS" means the United States Internal Revenue Service.
"LIBOR" means the London Interbank Offered Rate as it may be defined, and
for a period of time specified, in a Mortgage-Backed Security or borrowing of
the Company.
"lifetime interest rate cap" or "life cap" means in the case of a Mortgage
Loan that is an ARM, the maximum coupon rate that may accrue during any period
over the term of such Mortgage Loan as stated in the governing instruments
evidencing such Mortgage Loan, and in the case of a Mortgage-Backed Security
evidencing ARMs, the maximum weighted average coupon rate that may accrue
during any period over the term of such Mortgage-Backed Security as stated in
the governing instruments thereof.
"Limited Investment Assets" means assets of the Company, comprising not more
than 25% of total assets, which are unrated or rated less than High Quality.
"Maryland General Corporation Law" means the Corporations and Associations
Article of the Annotated Code of Maryland.
"Mezzanine Securities" means Mortgage-Backed Securities rated below the two
highest levels but no lower than a single "B" level under the S&P rating
system (or comparable level under other rating systems) which are supported by
one or more classes of Subordinated Securities which bear Realized Losses
prior to the classes of Mezzanine Securities.
51
"Mortgage Loans" means Single-Family Mortgage Loans, Multifamily Mortgage
Loans and Commercial Mortgage Loans.
"Mortgage-Backed Securities" means (i) Pass-Through Certificates, and (ii)
CMOs.
"Multifamily Mortgage Loans" means Mortgage Loans secured by multifamily (in
excess of four units) residential property.
"Multifamily Privately-Issued Certificates" means Privately-Issued
Certificates evidencing ownership interests in a pool of Multifamily Mortgage
Loans.
"Multifamily CMOs" means CMOs that are collateralized by Multifamily
Mortgage Loans.
"net margin" is part of the calculation of the coupon rate to be received by
the Company as owner of an ARM. The term "net" is used to differentiate
payments actually received by the Company from a Mortgage Asset from the
higher "gross" payment made by the borrower. The difference between the gross
margin and the net margin reflects loan servicing fees and other pre-
determined contractual deductions. The fully-indexed net rate equals the
current yield on the ARM index (six month LIBOR, one year Treasury, etc.) plus
the net margin. The actual coupon rate received by the Company may be lower
than the fully-indexed net rate at the initiation of the loan if originated at
a "teaser rate" or during periods of rising interest rates due to the
limitations of the ARM adjustment schedule and the periodic and life caps. If
so, the coupon rate received by the Company would move towards the fully-
indexed net coupon rate over time.
The "95% Gross Income Test" means the requirement for each taxable year that
at least 95% of the Company's gross income for each taxable year must be
derived from sources of income qualifying for the 75% Gross Income Test,
dividends, interest, and gains from the sale of stock or other securities
(including certain interest rate swap and cap agreements entered into to hedge
variable rate debt incurred to acquire Qualified REIT Real Estate Assets) not
held for sale in the ordinary course of business.
"Non-ERISA Plan" means a Plan that does not cover common law employees.
"Non-United States Holder" means a purchaser of the Common Stock that, for
United States Federal income tax purposes, is not a "United States person."
"Ownership Limit" means 9.8% of the outstanding shares of capital stock, as
may be increased or reduced by the Board of Directors of the Company.
"Pass-Through Certificates" means securities (or interests therein),
including Agency Certificates and Privately-Issued Certificates, evidencing
undivided ownership interests in a pool of Mortgage Loans, the holders of
which receive a "pass-through" of the principal and interest paid in
connection with the underlying Mortgage Loans in accordance with the holders'
respective, undivided interests in the pool.
"period ended December 31, 1997" means the period from the commencement of
operations by the Company on February 18, 1997 through December 31, 1997.
"periodic interest rate cap" or "periodic cap" means, with respect to ARMs,
the maximum change in the coupon rate permissible under the terms of the loan
at each coupon adjustment date. Periodic caps limit both the speed by which
the coupon rate can adjust upwards in a rising interest rate environment and
the speed by which the coupon rate can adjust downwards in a falling rate
environment.
"Plan" means a pension, profit-sharing, retirement or other employee benefit
plan which is subject to ERISA.
"Plan Asset Regulations" means regulations of the DOL defining "plan
assets."
"Private Placement" means the sale by the Company on February 18, 1997 of
3,600,000 shares of Common Stock in an offering exempt from registration under
the Securities Act and state securities laws.
52
"Private Placement Shares" means the 3,600,000 shares of Common Stock issued
by the Company in the Private Placement.
"Privately-Issued Certificates" means privately-issued Pass-Through
Certificates issued by a third party issuer which is not an Agency
Certificate.
"PTE" means a U.S. Department of Labor Prohibited Transaction Exemption.
"purported transferee" means the intended transferee in connection with any
transfer of shares of capital stock that would result in disqualification of
the Company as a REIT or that would (a) create a direct or constructive
ownership of shares of stock in excess of the Ownership Limit, (b) result in
the shares of stock being beneficially owned (within the meaning section
856(a) of the Code) by fewer than 100 persons (determined without reference to
any rules of attribution), or (c) result in the Company being "closely held"
within the meaning of section 856(h) of the Code.
"Qualified REIT Real Estate Assets" means Pass-Through Certificates,
Mortgage Loans, Agency Certificates, and other assets of the type described in
section 856(c) (6)(B) of the Code.
"Qualified REIT Subsidiary" means a corporation whose stock is entirely
owned by the REIT at all times during such corporation's existence.
"Qualifying Interests" means "mortgages and other liens on and interests in
real estate," as defined in section 3(c)(5)(C) under the Investment Company
Act.
"rating" means (i) the rating assigned to an asset by one or more of the
four nationally recognized rating agencies as adjusted to the rating scale
under the S&P rating system, (ii) in the case of assets rated differently by
such rating agencies, the rating deemed by management to most appropriately
reflect such asset's credit quality or (iii) for unrated assets, the Company's
deemed comparable rating.
"Rating Agency" means S&P or another nationally recognized rating agency.
"Realized Losses" means losses incurred in respect of Mortgage-Backed
Securities upon foreclosure sales and other liquidations of underlying
mortgaged properties that result in failure to recover all amounts due on the
loans secured thereby.
A "REIT" means a Real Estate Investment Trust.
"REIT Provisions of the Code" means sections 856 through 860 of the Code.
"REMIC" means Real Estate Mortgage Investment Conduit.
"repurchase agreement" means a borrowing device evidenced by an agreement to
sell securities or other assets to a third-party and a simultaneous agreement
to repurchase them at a specified future date and price, the price difference
constituting the interest on the borrowing.
"residuals" means the right to receive the remaining or residual cash flows
from a pool of Mortgage Loans or Mortgage-Backed Securities after distributing
required amounts to the holders of interests in or obligations backed by such
loans or securities and after payment of any required pool expenses.
"S&P" means Standard & Poor's Corporation, a New York corporation.
"Securities Act" means the Securities Act of 1933, as amended.
"Senior Securities" means a class of Mortgage-Backed Security that has a
prior right to receive principal and/or interest from the underlying pool of
Mortgage Loans.
53
"Senior-Subordinated Mortgage-Backed Securities" means a series of Pass-
Through Certificates or CMOs in which one or more classes have a prior right
to receive principal and/or interest payments from the underlying pool of
Mortgage Loans.
The "75% Asset Test" at the close of each quarter of each taxable year means
the requirement that at least 75% of the value of the Company's total assets
must consist of Qualified REIT Real Estate Assets, government securities, cash
and cash items.
The "75% Gross Income Test" means the requirement for each taxable year that
at least 75% of the Company's gross income must be derived from certain
specified real estate sources including interest income and gain from the
disposition of Qualified REIT Real Estate Assets or "qualified temporary
investment income" (i.e., income derived from "new capital" within one year of
the receipt of such capital).
"Short-Term Investments" means the short-term bank certificates of deposit,
short-term United States treasury securities, short-term United States
government agency securities, commercial paper, reverse repurchase agreements,
short-term CMOs, short-term asset-backed securities and other similar types of
short-term investment instruments, all of which will have maturities or
average durations of less than one year.
"Single-Family Mortgage Loans" means Mortgage Loans secured by single-family
(one- to four-units) residential property.
"Single-Family Privately-Issued Certificates" means Privately-Issued
Certificates evidencing ownership interests in a pool of Single-Family
Mortgage Loans.
"Single-Family CMOs" means CMOs that are collateralized by Single-Family
Mortgage Loans.
"Subordinated Interests" means a class of Mortgage-Backed Securities that is
subordinated to one or more other classes of Mortgage-Backed Securities, all
of which classes share the same collateral.
"Subordinated Securities" means any class that bears the "first loss" from
Realized Losses or that is rated below a single "B" level (or, if unrated, is
deemed by the Company to be below such level).
"Tax-Exempt Entity" means a qualified pension, profit-sharing or other
employee retirement benefit plan, Keogh plans, bank commingled trust funds for
such plans, individual retirement accounts and other similar entities intended
to be exempt from Federal income taxation.
The "30% Gross Income Test" is the requirement for each taxable year that
less than 30% of the Company's gross income is derived from the sale of
Qualified REIT Real Estate Assets held for less than four years, stock or
securities held for less than one year (including certain interest rate swap
and cap agreements entered into to hedge variable rate debt incurred to
acquire Qualified Real Estate Assets) and certain "dealer" property.
"Treasury Department" means the United States Department of the Treasury.
"Treasury Index" means the weekly average yield of the benchmark U.S.
Treasury securities, as published by the Board of Governors of the Federal
Reserve System.
"UBTI" means "unrelated business taxable income" as defined in section 512
of the Code.
"United States person" means a citizen or resident of the United States; a
corporation, partnership, or other entity created or organized in the United
States or under the laws of the United States or of any political subdivision
thereof; or an estate or trust whose income is includible in gross income for
United States Federal income tax purposes regardless of its source.
"VA" means the United States Department of Veterans Affairs.
"VA Loans" means Mortgage Loans partially guaranteed by the VA under the
Servicemen's Readjustment Act of 1944, as amended.
54
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
ANNALY MORTGAGE MANAGEMENT, INC.
Date: March 25, 1998 /s/ Michael A. J. Farrell
By: _________________________________
Michael A. J. Farrell
Chairman and Chief Executive
Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the date indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ Kevin P. Brady Director March 25, 1998
____________________________________
Kevin P. Brady
/s/ Spencer I. Bowne Director March 25, 1998
____________________________________
Spencer I. Bowne
/s/ Kathryn F. Fagan Chief Financial Officer and March 25, 1998
____________________________________ Treasurer (principal
Kathryn F. Fagan financial and accounting
officer)
/s/ Michael A.J. Farrell Chairman of the Board, Chief March 25, 1998
____________________________________ Executive Officer and
Michael A.J. Farrell Director (principal
executive officer)
/s/ John S. Grace Director March 25, 1998
____________________________________
John S. Grace
/s/ Jonathan D. Green Director March 25, 1998
____________________________________
Jonathan D. Green
/s/ Timothy J. Guba President, Chief Operating March 25, 1998
____________________________________ Officer and Director
Timothy J. Guba
/s/ John A. Lambiase Director March 25, 1998
____________________________________
John A. Lambiase
/s/ Donnell A. Segalas Director March 25, 1998
____________________________________
Donnell A. Segalas
/s/ Wellington J. St. Claire Vice Chairman of the Board March 25, 1998
____________________________________ and Director
Wellington J. St. Claire
55
ANNALY MORTGAGE MANAGEMENT, INC.
FINANCIAL STATEMENTS AND INDEPENDENT AUDITORS' REPORT
FOR INCLUSION IN FORM 10-K
ANNUAL REPORT FILED WITH
SECURITIES AND EXCHANGE COMMISSION
DECEMBER 31, 1997
ANNALY MORTGAGE MANAGEMENT, INC.
INDEX TO FINANCIAL STATEMENTS
PAGE
--------
INDEPENDENT AUDITORS' REPORT.......................................... F-2
FINANCIAL STATEMENTS:
Balance Sheet--December 31, 1997.................................... F-3
Statement of Operations for the period February 18, 1997
(Commencement of Operations) through December 31, 1997............. F-4
Statement of Stockholders' Equity for the period February 18, 1997
(Commencement of Operations) through December 31, 1997............. F-5
Statement of Cash Flows for the period February 18, 1997
(Commencement of Operations) through December 31, 1997............. F-6
Notes to Financial Statements....................................... F-7-F-12
F-1
INDEPENDENT AUDITORS' REPORT
To the Stockholders of
Annaly Mortgage Management, Inc.
We have audited the accompanying balance sheet of Annaly Mortgage
Management, Inc. (the "Company") as of December 31, 1997, and the related
statements of operations, stockholders' equity and cash flows for the period
February 18, 1997 (commencement of operations) through December 31, 1997.
These financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements
based on our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis
for our opinion.
In our opinion, such financial statements present fairly, in all material
respects, the financial position of the Company at December 31, 1997 and the
results of its operations and its cash flows for the period February 18, 1997
(commencement of operations) through December 31, 1997 in conformity with
generally accepted accounting principles.
February 6, 1998
F-2
ANNALY MORTGAGE MANAGEMENT, INC.
BALANCE SHEET
DECEMBER 31, 1997
ASSETS
------
CASH AND CASH EQUIVALENTS....................................... $ 511,172
MORTGAGE-BACKED SECURITIES--At fair value, net of amortized
premium/discount............................................... 1,161,779,192
ACCRUED INTEREST RECEIVABLE..................................... 5,338,861
OTHER ASSETS.................................................... 111,257
--------------
TOTAL ASSETS................................................ $1,167,740,482
==============
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
LIABILITIES:
Repurchase agreements......................................... $ 918,869,000
Payable for Mortgage-Backed Securities purchased.............. 105,793,723
Accrued interest payable...................................... 4,992,447
Dividends payable............................................. 2,797,058
Accounts payable.............................................. 201,976
--------------
Total liabilities........................................... 1,032,654,204
--------------
STOCKHOLDERS' EQUITY:
Common stock: par value $.01 per share; 100,000,000
authorized,
12,713,900 shares issued and outstanding..................... 127,139
Additional paid-in capital.................................... 132,705,765
Net unrealized gains on Mortgage-Backed Securities............ 2,023,751
Retained earnings............................................. 229,623
--------------
Total stockholders' equity.................................. 135,086,278
--------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY.................. $1,167,740,482
==============
See notes to financial statements.
F-3
ANNALY MORTGAGE MANAGEMENT, INC.
STATEMENT OF OPERATIONS
FOR THE PERIOD FEBRUARY 18, 1997 (COMMENCEMENT OF OPERATIONS) THROUGH DECEMBER
31, 1997
INTEREST INCOME:
Mortgage-Backed Securities....................................... $24,682,353
Money market account............................................. 30,782
-----------
Total interest income.......................................... 24,713,135
INTEREST EXPENSE:
Repurchase agreements............................................ 19,676,954
-----------
NET INTEREST INCOME................................................ 5,036,181
GAIN ON SALE OF MORTGAGE-BACKED SECURITIES......................... 735,303
GENERAL AND ADMINISTRATIVE EXPENSES................................ 851,990
-----------
NET INCOME......................................................... $ 4,919,494
===========
NET INCOME PER SHARE:
Basic............................................................ $ 0.83
===========
Dilutive......................................................... $ 0.78
===========
AVERAGE NUMBER OF SHARES OUTSTANDING............................... 5,952,123
===========
See notes to financial statements.
F-4
ANNALY MORTGAGE MANAGEMENT, INC.
STATEMENT OF STOCKHOLDERS' EQUITY
FOR THE PERIOD FEBRUARY 18, 1997 (COMMENCEMENT OF OPERATIONS)
THROUGH DECEMBER 31, 1997
COMMON
STOCK ADDITIONAL NET
PAR PAID-IN UNREALIZED RETAINED
VALUE CAPITAL GAIN EARNINGS TOTAL
-------- ------------ ---------- ----------- ------------
BALANCE, FEBRUARY 18,
1997................... $ 800 $ 11,200 $ -- $ (209) $ 11,791
Issuance of common
stock.................. 126,339 132,694,565 -- -- 132,820,904
Available for sale
securities--Fair value
adjustment............. -- -- 2,023,751 -- 2,023,751
Net income.............. -- -- -- 4,919,494 4,919,494
Dividends declared--
$0.79 per average
share.................. -- -- -- (4,689,662) (4,689,662)
-------- ------------ ---------- ----------- ------------
BALANCE, DECEMBER 31,
1997................... $127,139 $132,705,765 $2,023,751 $ 229,623 $135,086,278
======== ============ ========== =========== ============
See notes to financial statements.
F-5
ANNALY MORTGAGE MANAGEMENT, INC.
STATEMENT OF CASH FLOWS
FOR THE PERIOD FEBRUARY 18, 1997 (COMMENCEMENT OF OPERATIONS)
THROUGH DECEMBER 31, 1997
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income.................................................. $ 4,919,494
Adjustments to reconcile net income to net cash provided by
operating activities:
Amortization of mortgage premiums and discounts, net...... 2,620,729
Gain on sale of Mortgage-Backed Securities................ (735,303)
Increase in accrued interest receivable................... (5,338,861)
Increase in other assets.................................. (111,257)
Increase in accrued interest payable...................... 4,992,447
Increase in accounts payable.............................. 201,976
---------------
Net cash provided by operating activities............... 6,549,225
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of Mortgage-Backed Securities...................... (1,310,362,097)
Proceeds from sale of Mortgage-Backed Securities............ 174,682,533
Principal payments on Mortgage-Backed Securities............ 79,832,420
---------------
Net cash used in investing activities................... (1,055,847,144)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from repurchase agreements......................... 3,498,546,390
Principal payments on repurchase agreements................. (2,579,677,390)
Net proceeds from private placement equity offering......... 32,979,904
Net proceeds from direct offering........................... 878,000
Net proceeds from public offering........................... 98,962,999
Dividends paid.............................................. (1,892,604)
---------------
Net cash provided by financing activities............... 1,049,797,299
---------------
NET INCREASE IN CASH AND CASH EQUIVALENTS..................... 499,380
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD................ 11,792
---------------
CASH AND CASH EQUIVALENTS, END OF PERIOD...................... $ 511,172
===============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Interest paid............................................... $ 14,684,507
===============
NONCASH FINANCING ACTIVITIES:
Net unrealized gains on available-for-sale securities....... $ 2,023,751
===============
Dividends declared, not yet paid............................ $ 2,797,058
===============
See notes to financial statements.
F-6
ANNALY MORTGAGE MANAGEMENT, INC.
NOTES TO FINANCIAL STATEMENTS
FOR THE PERIOD FEBRUARY 18, 1997 (COMMENCEMENT OF OPERATIONS) THROUGH DECEMBER
31, 1997
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Annaly Mortgage Management, Inc. (the "Company") was incorporated in
Maryland on November 25, 1996. The Company commenced its operations of
purchasing and managing an investment portfolio of primarily adjustable-rate
Mortgage-Backed Securities on February 18, 1997, upon receipt of the net
proceeds from the private placement of equity capital. On July 31, 1997, the
Company received additional proceeds from a direct offering to officers and
directors. An initial public offering was completed on October 14, 1997 (see
Note 5).
A summary of the Company's significant accounting policies follows:
CASH AND CASH EQUIVALENTS--Cash and cash equivalents includes cash on hand
and money market funds. The carrying amounts of cash equivalents approximates
their value.
MORTGAGE-BACKED SECURITIES--The Company invests primarily in mortgage pass-
through certificates, collateralized mortgage obligations and other mortgage-
backed securities representing interests in or obligations backed by pools of
mortgage loans (collectively, "Mortgage-Backed Securities").
Statement of Financial Accounting Standards No. 115, Accounting for Certain
Investments in Debt and Equity Securities ("SFAS 115"), requires the Company
to classify its investments as either trading investments, available-for-sale
investments or held-to-maturity investments. Although the Company generally
intends to hold most of its Mortgage-Backed Securities until maturity, it may,
from time to time, sell any of its Mortgage-Backed Securities as part of its
overall management of its balance sheet. Accordingly, this flexibility
requires the Company to classify all of its Mortgage-Backed Securities as
available-for-sale. All assets classified as available-for-sale are reported
at fair value, with unrealized gains and losses excluded from earnings and
reported as a separate component of stockholders' equity.
Unrealized losses on Mortgage-Backed Securities that are considered other
than temporary, as measured by the amount of decline in fair value
attributable to factors other than temporary, are recognized in income and the
cost basis of the Mortgage-Backed Securities is adjusted. There were no such
adjustments for the period ending December 31, 1997.
Interest income is accrued based on the outstanding principal amount of the
Mortgage-Backed Securities and their contractual terms. Premiums and discounts
associated with the purchase of the Mortgage-Backed Securities are amortized
into interest income over the lives of the securities using the effective
yield method.
Mortgage-Backed Securities transactions are recorded on the date the
securities are purchased or sold. Purchases of newly issued securities are
recorded when all significant uncertainties regarding the characteristics of
the securities are removed, generally shortly before settlement date. Realized
gains and losses on Mortgage-Backed Securities transactions are determined on
the specific identification basis.
CREDIT RISK--At December 31, 1997, the Company has limited is exposure to
credit losses on its portfolio of Mortgage-Backed Securities by only
purchasing securities from Federal Home Loan Mortgage Corporation ("FHLMC"),
Federal National Mortgage Association ("FNMA"), or Government National
Mortgage Association ("GNMA"). The payment of principal and interest on the
FHLMC and FNMA Mortgage-Backed Securities are guaranteed by those respective
agencies and the payment of principal and interest on the GNMA Mortgage-Backed
Securities are backed by the full-faith-and-credit of the U.S. government. At
December 31, 1997, all of the Company's Mortgage-Backed Securities have an
implied "AAA" rating.
F-7
ANNALY MORTGAGE MANAGEMENT, INC.
NOTES TO FINANCIAL STATEMENTS--(CONTINUED)
INCOME TAXES--The Company has elected to be taxed as a Real Estate
Investment Trust ("REIT") and intends to comply with the provisions of the
Internal Revenue Code of 1986, as amended (the "Code") with respect thereto.
Accordingly, the Company will not be subjected to Federal income tax to the
extent of its distributions to shareholders and as long as certain asset,
income and stock ownership tests are met.
USE OF ESTIMATES--The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent 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.
2. MORTGAGE-BACKED SECURITIES
The following table pertains to the Company's Mortgage-Backed Securities
classified as available-for-sale as of December 31, 1997, which are carried at
their fair value:
FEDERAL FEDERAL GOVERNMENT
HOME LOAN NATIONAL NATIONAL TOTAL
MORTGAGE MORTGAGE MORTGAGE MORTGAGE
CORPORATION ASSOCIATION ASSOCIATION ASSETS
------------ ------------ ------------ --------------
Mortgage-Backed
Securities, gross...... $273,119,008 $691,081,916 $174,164,513 $1,138,365,437
Unamortized discount.... (3,619) (110,567) -- (114,186)
Unamoritzed premium..... 2,848,376 14,532,363 4,123,451 21,504,190
------------ ------------ ------------ --------------
Amortized cost.......... 275,963,765 705,503,712 178,287,964 1,159,755,441
Gross unrealized gains.. 376,485 1,948,068 928,453 3,253,006
Gross unrealized losses. (115,190) (802,801) (311,264) (1,229,255)
------------ ------------ ------------ --------------
Estimated fair value.... $276,225,060 $706,648,979 $178,905,153 $1,161,779,192
============ ============ ============ ==============
FASB Statement No. 107, Disclosures About Fair Value of Financial
Instruments, defines the fair value of a financial instrument as the amount at
which the instrument could be exchanged in a current transaction between
willing parties, other than in a forced or liquidation sale.
The fair values of the Company's Mortgage-Backed Securities are based on
market prices provided by certain dealers who make markets in these financial
instruments. The fair values reported reflect estimates and may not
necessarily be indicative of the amounts the Company could realize in a
current market exchange. Cash and cash equivalents, interest receivable,
repurchase agreements and other liabilities are reflected in the financial
statements at their amortized cost, which approximates their fair value
because of the short-term nature of these instruments.
The adjustable rate Mortgage-Backed Securities are limited by periodic caps
(generally interest rate adjustments are limited to no more than 1% every six
months) and lifetime caps. At December 31, 1997, the weighted average lifetime
cap was 10.8%.
During the period ended December 31, 1997, the Company realized $735,303 in
gains from sales of Mortgage-Backed Securities. There were no losses on sales
of Mortgage-Backed Securities during the period.
3. REPURCHASE AGREEMENTS
The Company has entered into repurchase agreements to finance most of its
Mortgage-Backed Securities. The repurchase agreements are secured by the
market value of the Company's Mortgage-Backed Securities and bear interest
rates that have historically moved in close relationship to LIBOR.
F-8
ANNALY MORTGAGE MANAGEMENT, INC.
NOTES TO FINANCIAL STATEMENTS--(CONTINUED)
As of December 31, 1997, the Company had outstanding $918,869,000 of
repurchase agreements with a weighted average borrowing rate of 6.16% and a
weighted average remaining maturity of 16 days. At December 31, 1997,
Mortgage-Backed Securities actually pledged had an estimated fair value of
$936,859,658.
At December 31, 1997, the repurchase agreements had the following remaining
maturities:
Within 30 days.............................................. $590,960,000
30 to 59 days............................................... 51,776,000
60 to 89 days............................................... --
90 to 119 days.............................................. 103,391,000
Over 120 days............................................... 172,742,000
------------
$918,869,000
============
4. COMMON STOCK
During the period the Company completed a private placement of equity
capital. The Company received net proceeds of $32,979,905 from an issuance of
3,600,000 shares of common stock. The Company received additional proceeds of
$878,000 from an issuance of 87,800 shares of common stock upon the closing of
a direct offering to certain directors, officers, and employees of the Company
on July 31, 1997. The Company issued 9,006,100 shares of common stock on
October 14, 1997 during an initial public offering. Approximate net proceeds
received in the offering were $98,962,999.
During the Company's period ending December 31, 1997, the Company declared
dividends to shareholders totaling $4,689,662, or $.79 per weighted average
share, of which $1,892,604 was paid during the period and $2,797,058 was paid
on January 20, 1998. For Federal income tax purposes dividends paid for the
period is ordinary income to the Company stockholders.
5. EARNINGS PER SHARE (EPS)
In February 1997, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting No. 128, Earnings Per Share (SFAS No. 128),
which requires dual presentation of Basic EPS and Diluted EPS on the face of
the income statement for all entities with complex capital structures. SFAS
No. 128 also requires a reconciliation of the numerator and denominator of
Basic EPS and Diluted EPS computation. The reconciliation is as follows:
FOR THE PERIOD ENDED
DECEMBER 31, 1997
-----------------------------------
INCOME SHARES PER SHARE
(NUMERATOR) (DENOMINATOR) AMOUNT
----------- ------------- ---------
Net income............................... $4,919,494
----------
Basic EPS................................ 4,919,494 5,952,123 $0.83
=====
Effect of dilutive securities:
Dilutive stock options................. -- 348,500
---------- ---------
Diluted EPS............................ $4,919,494 6,300,623 $0.78
========== ========= =====
Options to purchase 348,500 shares were outstanding during the period (Note
7) and were dilutive as the exercise price (between $4.00 and $10.00) was less
than the average stock price for the period for the Company (between $11.00
and $12.00).
F-9
ANNALY MORTGAGE MANAGEMENT, INC.
NOTES TO FINANCIAL STATEMENTS--(CONTINUED)
6. LONG TERM STOCK INCENTIVE PLAN
The Company has adopted a Long Term Stock Incentive Plan for executive
officers, key employees and nonemployee directors (the "Incentive Plan"). The
Incentive Plan authorizes the Compensation Committee of the Board of Directors
to grant awards, including incentive stock options as defined under section
422 of the Code ("ISOs") and options not so qualified ("NQSOs"). The Incentive
Plan authorizes the granting of options or other awards for an aggregate of
the greater of 500,000 shares or 5% of the outstanding shares of the Company's
common stock.
The Company adopted the disclosure-only provisions of Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation."
Accordingly, no compensation cost for the Incentive Plan has been determined
based on the fair value at the grant date for awards consistent with the
provisions of SFAS No. 123. For the Company's pro forma net earnings, the
compensation cost will be amortized over the four-year vesting period of the
options. The Company's net earnings per share would have been reduced to the
pro forma amounts indicated below:
FOR THE PERIOD ENDING
-----------------------
JUNE 30, DECEMBER 31,
1997 1997
---------- ------------
Net earnings--as reported............................ $1,340,059 $4,919,494
Net earnings--pro forma.............................. 1,249,778 4,738,932
Earnings per share--as reported...................... $ 0.36 $ 0.83
Earnings per share--pro forma........................ $ 0.34 $ 0.80
The fair value of each option grant is estimated on the date of grant using
the Black-Scholes option-pricing model with the following weighted average
assumptions used for grants in the period ended December 31, 1997: dividend
yield of 10%; expected volatility of 25%; risk-free interest rate of 6.07%;
and expected lives of four years.
Information regarding options is as follows:
WEIGHTED
AVERAGE
EXERCISE
SHARES PRICE
------- --------
Granted (311,000 ISOs, 37,500 NQSOs)..................... 348,500 $6.42
Exercised................................................ -- --
Expired.................................................. -- --
------- -----
Outstanding, end of period............................... 348,500 $6.42
======= =====
Weighted average fair value of options granted during the
period (per share)...................................... $ 2.07
=======
The following table summarizes information about stock options outstanding:
OPTIONS OUTSTANDING
--------------------
WEIGHTED
AVERAGE WEIGHTED
REMAINING AVERAGE
RANGE OF OPTIONS CONTRACTUAL EXERCISE
EXERCISE PRICES OUTSTANDING LIFE (YRS.) PRICE
--------------- ----------- ----------- --------
$4.00................................... 208,250 4.0 $ 4.00
$10.00.................................. 140,250 3.8 10.00
-------
$4.00-$10.00............................ 348,500 3.9 $ 6.42
======= === ======
F-10
ANNALY MORTGAGE MANAGEMENT, INC.
NOTES TO FINANCIAL STATEMENTS--(CONTINUED)
The vesting periods for the options are as follows: 7,500 options vested as
of June 26, 1997. The remainder of the options will vest in four equal annual
installments beginning in 1998 and ending in 2001.
7. LEASE COMMITMENTS
The Corporation has a noncancellable lease for office space, which commences
in April 1998 and expires in December 2007.
The Corporation's aggregate future minimum lease payments are as follows:
1998.......................................................... $ 67,787
1999.......................................................... 92,804
2000.......................................................... 95,299
2001.......................................................... 97,868
2002.......................................................... 100,515
2003 and thereafter........................................... 582,406
----------
$1,036,679
==========
8. SUMMARIZED QUARTERLY RESULTS (UNAUDITED)
The following is a presentation of the quarterly results of operations.
QUARTERS ENDING
PERIOD ENDED -------------------------------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
1997 1997 1997 1997
------------ ---------- ------------- ------------
Interest income from
Mortgage-Backed
Securities and cash........ $1,060,692 $5,448,215 $6,123,457 $12,080,771
Interest expense on
repurchase agreements...... 713,120 4,435,697 5,126,089 9,402,048
---------- ---------- ---------- -----------
Net interest income....... 347,572 1,012,518 997,368 2,678,723
Gain on sale of Mortgage-
Backed Securities.......... -- 229,865 429,400 76,038
General and administrative
expenses................... 64,047 185,849 227,245 374,849
---------- ---------- ---------- -----------
Net income.................. $ 283,525 $1,056,534 $1,199,523 $ 2,379,912
========== ========== ========== ===========
Net income per share:
Basic..................... $ 0.08 $ 0.28 $ 0.32 $ 0.21
========== ========== ========== ===========
Dilutive.................. $ 0.07 $ 0.26 $ 0.29 $ 0.20
========== ========== ========== ===========
Average number of shares
outstanding................ 3,680,000 3,680,000 3,739,170 11,449,777
========== ========== ========== ===========
F-11
EXHIBIT INDEX
SEQUENTIALLY
EXHIBIT NUMBERED
NUMBER EXHIBIT DESCRIPTION PAGE
------- ------------------- ------------
3.1 Articles of Incorporation of the Registrant
(incorporated by reference to Exhibit 3.1 to the
Company's Registration Statement on Form S-11
(Registration No. 333-32913)
filed with the Securities and Exchange Commission on
August 5, 1997).
3.2 Articles of Amendment and Restatement of the Articles
of Incorporation of the Registrant (incorporated by
reference to Exhibit 3.2 to the Company's Registration
Statement on Form S-11 (Registration No. 333-32913)
filed with the Securities and Exchange Commission on
August 5, 1997).
3.3 Bylaws of the Registrant, as amended (incorporated by
reference to Exhibit 3.3 to the Company's Registration
Statement on Form S-11 (Registration No. 333-32913)
filed with the Securities and Exchange Commission on
August 5, 1997).
4.1 Specimen Common Stock Certificate (incorporated by
reference to Exhibit 4.1 to Amendment No. 1 to the
Company's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities
and Exchange Commission on September 17, 1997).
10.1 Purchase Agreement, dated February 12, 1997, between
the Registrant and Friedman, Billings, Ramsey & Co.,
Inc. ("FBR") (incorporated by reference to Exhibit
10.1 to the Company's Registration Statement on Form
S-11 (Registration No. 333-32913) filed with the
Securities and Exchange Commission on August 5, 1997).
10.2 Registration Rights Agreement, dated February 12, 1997,
between the Registrant and FBR (incorporated by
reference to Exhibit 10.2 to the Company's
Registration Statement on Form S-11 (Registration No.
333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
10.3 Long-Term Stock Incentive Plan (incorporated by
reference to Exhibit 10.3 to the Company's
Registration Statement on Form S-11 (Registration No.
333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
10.4 Employment Agreement, effective as of January 27, 1997,
between the Company and Michael A.J. Farrell
(incorporated by reference to Exhibit 10.4 to the
Company's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities
and Exchange Commission on August 5, 1997).
10.5 Employment Agreement, effective as of January 27, 1997,
between the Company and Timothy J. Guba (incorporated
by reference to Exhibit 10.5 to the Company's
Registration Statement on Form S-11 (Registration No.
333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
10.6 Employment Agreement, effective as of January 27, 1997,
between the Company and Wellington J. St. Claire
(incorporated by reference to Exhibit 10.6 to the
Company's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities
and Exchange Commission on August 5, 1997).
10.7 Form of Master Repurchase Agreement (incorporated by
reference to Exhibit 10.7 to the Company's
Registration Statement on Form S-11 (Registration No.
333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
10.8 Form of Purchase Agreement between the Company and the
purchasers in the Direct Offering (incorporated by
reference to Exhibit 10.8 to the Company's
Registration Statement on Form S-11 (Registration No.
333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
10.9 Employment Agreement, effective as of November 1, 1997,
between the Company and Katherine F. Fagan.
27 Financial Data Schedule.