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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED: MARCH 31, 2003 OR
| | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM _________________ TO _________________
COMMISSION FILE NUMBER: 001-11914
THORNBURG MORTGAGE, INC.
(Exact name of Registrant as specified in its Charter)
MARYLAND 85-0404134
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification Number)
150 WASHINGTON AVENUE
SANTA FE, NEW MEXICO 87501
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (505) 989-1900
(Former name, former address and former fiscal year,
if changed since last report)
Not applicable
Indicate by check mark whether the Registrant (1) has filed all documents and
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
(1) Yes |X| No | |
(2) Yes |X| No | |
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Securities Exchange Act of 1934).
Yes |X| No | |
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Common Stock ($.01 par value) 59,568,311 as of May 14, 2003
1
THORNBURG MORTGAGE, INC.
FORM 10-Q
INDEX
Page
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets at March 31, 2003 and December 31, 2002................. 3
Consolidated Income Statements for the three months ended
March 31, 2003 and March 31, 2002.................................................. 4
Consolidated Statement of Shareholders' Equity for the three months
ended March 31, 2003 and March 31, 2002............................................ 5
Consolidated Statements of Cash Flows for the three months ended
March 31, 2003 and March 31, 2002.................................................. 6
Notes to Consolidated Financial Statements.......................................... 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations........................................... 21
Item 3. Quantitative and Qualitative Disclosures About Market Risk.............................. 43
Item 4. Controls and Procedures................................................................. 43
PART II. OTHER INFORMATION
Item 1. Legal Proceedings....................................................................... 44
Item 2. Changes in Securities and Use of Proceeds .............................................. 44
Item 3. Defaults Upon Senior Securities ........................................................ 44
Item 4. Submission of Matters to a Vote of Security Holders..................................... 44
Item 5. Other Information....................................................................... 44
Item 6. Exhibits and Reports on Form 8-K........................................................ 44
SIGNATURES .......................................................................................... 45
CERTIFICATIONS....................................................................................... 46
EXHIBIT INDEX ....................................................................................... 49
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
THORNBURG MORTGAGE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands)
March 31, 2003
ASSETS (unaudited) December 31, 2002
-------------- -----------------
Adjustable-rate mortgage ("ARM") assets:
ARM securities $ 10,857,065 $ 9,335,643
Collateral for collateralized notes -- 289,783
ARM loans held for securitization 1,152,372 709,787
------------ ------------
12,009,437 10,335,213
------------ ------------
Cash and cash equivalents 308,639 122,220
Accrued interest receivable 52,986 47,435
Prepaid expenses and other 5,876 8,064
------------ ------------
$ 12,376,938 $ 10,512,932
============ ============
LIABILITIES
Reverse repurchase agreements $ 10,283,647 $ 8,568,260
Collateralized notes -- 255,415
Whole loan financing facilities 1,062,237 589,081
Payable for assets purchased -- 202,844
Accrued interest payable 18,896 17,234
Dividends payable 1,670 32,536
Accrued expenses and other 18,277 14,520
------------ ------------
11,384,727 9,679,890
------------ ------------
COMMITMENTS
SHAREHOLDERS' EQUITY
Preferred stock: par value $.01 per share;
Series A 9.68% Cumulative Convertible shares,
aggregate preference in liquidation $69,000,
2,760 shares authorized, issued and outstanding; 65,805 65,805
Series B Cumulative, 22 shares authorized,
none issued and outstanding -- --
Common stock: par value $.01 per share;
497,218 shares authorized, 59,071 and 52,763 shares
issued and outstanding, respectively 591 528
Additional paid-in-capital 1,001,090 878,929
Accumulated other comprehensive loss (105,813) (105,254)
Notes receivable from stock sales (7,337) (7,437)
Retained earnings 37,875 471
------------ ------------
992,211 833,042
------------ ------------
$ 12,376,938 $ 10,512,932
============ ============
See Notes to Consolidated Financial Statements.
3
THORNBURG MORTGAGE, INC. AND SUBSIDIARIES
CONSOLIDATED INCOME STATEMENTS (UNAUDITED)
(In thousands, except per share data)
Three Months Ended
March 31,
--------------------------
2003 2002
--------- --------
Interest income from ARM assets and cash equivalents $ 123,196 $ 79,427
Interest expense on borrowed funds (71,162) (47,803)
--------- --------
Net interest income 52,034 31,624
--------- --------
Fee income 304 5
Hedging expense (177) (314)
Management fee (2,485) (1,644)
Performance fee (6,187) (3,193)
Long-term incentive awards (1,669) (547)
Other operating expenses (2,746) (1,638)
--------- --------
NET INCOME $ 39,074 $ 24,293
========= ========
Net income $ 39,074 $ 24,293
Dividends on preferred stock (1,670) (1,670)
--------- --------
Net income available to common shareholders $ 37,404 $ 22,623
========= ========
Basic earnings per share:
Net income $ 0.67 $ 0.62
Average number of shares outstanding 55,631 36,417
========= ========
Diluted earnings per share:
Net income $ 0.67 $ 0.62
Average number of shares outstanding 58,391 36,417
========= ========
See Notes to Consolidated Financial Statements.
4
THORNBURG MORTGAGE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (UNAUDITED)
Three months ended March 31, 2003 and 2002
(In thousands, except share data)
Accum.
Other
Compre- Notes Compre-
Additional hensive Receivable Retained hensive
Preferred Common Paid-in Income From Earnings/ Income
Stock Stock Capital (Loss) Stock Sales (Deficit) (Loss) Total
--------- ----- ---------- --------- ----------- --------- --------- ---------
Balance, December 31, 2001 $65,805 $ 333 $ 515,516 $ (36,566) $ (7,904) $ (4,526) $ 532,658
Comprehensive income:
Net income -- -- -- -- -- 24,293 $24,293 24,293
Other comprehensive income:
Available-for-sale assets:
Fair value adjustment -- -- -- (5,319) -- -- (5,319) (5,319)
Swap Agreements and Eurodollar
Transactions:
Fair value adjustment, net of
amortization -- -- -- 26,220 -- -- 26,220 26,220
-------
Comprehensive income $45,194
=======
Issuance of common stock -- 76 140,796 -- -- -- 140,872
Interest and principal payments on
notes receivable from stock sales -- -- 76 -- -- -- 76
Dividends declared on preferred
stock - $0.605 per share -- -- -- -- -- (1,670) (1,670)
------- ----- ---------- --------- -------- -------- ---------
Balance, March 31, 2002 $65,805 $ 409 $ 656,388 $ (15,665) $ (7,904) $ 18,097 $ 717,130
======= ===== ========== ========= ======== ======== =========
Balance, December 31, 2002 $65,805 $ 528 $ 878,929 $(105,254) $ (7,437) $ 471 $ 833,042
Comprehensive income:
Net income -- -- -- -- -- 39,074 $39,074 39,074
Other comprehensive income:
Available-for-sale assets:
Fair value adjustment -- -- -- 3,850 -- -- 3,850 3,850
Swap Agreements and Eurodollar
Transactions:
Fair value adjustment, net of
amortization -- -- -- (4,409) -- -- (4,409) (4,409)
-------
Comprehensive income $38,515
=======
Issuance of common stock -- 63 122,090 -- -- -- 122,153
Interest and principal payments on
notes receivable from stock sales -- -- 71 -- 100 -- 171
Dividends declared on preferred
stock - $0.605 per share -- -- -- -- -- (1,670) (1,670)
------- ----- ---------- --------- -------- -------- ---------
Balance, March 31, 2003 $65,805 $ 591 $1,001,090 $(105,813) $ (7,337) $ 37,875 $ 992,211
======= ===== ========== ========= ======== ======== =========
See Notes to Consolidated Financial Statements.
5
THORNBURG MORTGAGE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)
Three Months Ended
March 31,
--------------------------
2003 2002
----------- -----------
Operating Activities:
Net Income $ 39,074 $ 24,293
Adjustments to reconcile net income to net cash provided
by operating activities:
Amortization 8,167 5,110
Hedging expense 177 314
Change in assets and liabilities:
Accrued interest receivable (5,551) (3,861)
Prepaid expenses and other 2,177 (1,150)
Accrued interest payable 1,662 1,477
Accrued expenses and other 3,757 4,499
----------- -----------
Net cash provided by operating activities 49,463 30,682
----------- -----------
Investing Activities:
Available-for-sale ARM securities:
Purchases (1,848,384) (1,805,247)
Proceeds on sales -- 50,106
Principal payments 1,138,208 871,186
Collateral for collateralized notes:
Principal payments 24,855 70,616
ARM loans:
Purchases (1,204,489) (599,357)
Proceeds on sales -- 3,711
Principal payments 9,403 4,011
----------- -----------
Net cash used in investing activities (1,880,407) (1,404,974)
----------- -----------
Financing Activities:
Net borrowings from reverse repurchase agreements 1,715,413 1,311,248
Repayments of collateralized notes (255,415) (70,268)
Net other borrowings 473,156 96,172
Payments (received) made on Eurodollar contracts (5,579) 102
Proceeds from common stock issued, net 122,153 140,872
Dividends paid (32,536) (19,987)
Payments on notes receivable from stock sales 171 9
----------- -----------
Net cash provided by financing activities 2,017,363 1,458,148
----------- -----------
Net increase in cash and cash equivalents 186,419 83,856
Cash and cash equivalents at beginning of period 122,220 33,884
----------- -----------
Cash and cash equivalents at end of period $ 308,639 $ 117,740
=========== ===========
Supplemental disclosure of cash flow information and non-cash activities is
included in Note 4.
See Notes to Consolidated Financial Statements
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SIGNIFICANT ACCOUNTING POLICIES
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and
Rule 10-01 of Regulation S-X. Therefore, they do not include all of the
information and footnotes required by generally accepted accounting
principles for complete financial statements.
In the opinion of management, all material adjustments, consisting of
normal recurring adjustments, considered necessary for a fair presentation
have been included. The operating results for the quarter ended March 31,
2003 are not necessarily indicative of the results that may be expected
for the calendar year ending December 31, 2003.
BASIS OF PRESENTATION AND PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of
Thornburg Mortgage, Inc. (together with its subsidiaries referred to
hereafter as the "Company") and its wholly owned bankruptcy-remote
special purpose finance subsidiaries, Thornburg Mortgage Funding
Corporation ("TMFC") and Thornburg Mortgage Acceptance Corporation
("TMAC"), its wholly owned mortgage banking subsidiary, Thornburg
Mortgage Home Loans, Inc. ("TMHL"), and TMHL's two wholly owned
special purpose finance subsidiaries, Thornburg Mortgage Funding
Corporation II and Thornburg Mortgage Acceptance Corporation II. All
of the Company's subsidiaries are wholly owned qualified real estate
investment trust ("REIT") subsidiaries and are consolidated with the
Company for financial statement and tax reporting purposes. All
material intercompany accounts and transactions are eliminated in
consolidation.
CASH AND CASH EQUIVALENTS
"Cash and cash equivalents" includes cash on hand and highly liquid
investments with original maturities of three months or less. The
carrying amount of cash equivalents approximates their fair value.
ADJUSTABLE-RATE MORTGAGE ("ARM") ASSETS
The Company's ARM assets are comprised of ARM securities, ARM loans
and collateral for AAA notes payable, which consists of ARM loans.
All of the Company's ARM assets are either traditional ARM
securities and loans, which have interest rates that reprice in a
year or less ("Traditional ARMs"), or hybrid ARM securities and
loans that have a fixed interest rate for an initial period,
generally three to ten years, and then convert to Traditional ARMs
for their remaining terms to maturity ("Hybrid ARMs").
Management has designated all of its ARM securities as
available-for-sale. Therefore, they are reported at fair value, with
unrealized gains and losses reported in "Accumulated other
comprehensive income (loss)" as a separate component of
shareholders' equity.
The Company securitizes the loans it acquires and originates and
retains the resulting securities in its ARM securities portfolio.
Alternatively, the Company may issue the securities it creates to
third party investors, which provides an alternative form of
long-term financing for the Company's assets. The Company does not
sell any of the securities created from its securitizations to
generate gain on sale income. The securitization process benefits
the Company by either creating highly liquid assets that are readily
financeable in the reverse repurchase agreement market or enabling
the Company to enter into long-term secured debt financing
transactions where the Company is not subject to future recourse on
these financing transactions. The securitizations of the Company's
loans are not accounted for as sales and the Company does
7
not capitalize any servicing rights or obligations as a result of
this process. The fair value reflected in the Company's financial
statements for these securities is generally based on market prices
provided by certain dealers who make markets in these financial
instruments.
Management has the intent and ability to hold the Company's ARM
loans for the foreseeable future, and until maturity or payoff.
Therefore, these loans are carried at their unpaid principal
balances, net of unamortized premium or discount and allowance for
loan losses.
The collateral for the AAA notes payable consists of ARM loans,
which are accounted for in the same manner as ARM loans that are not
held as collateral.
Interest income on ARM assets is accrued based on the outstanding
principal amount and contractual terms of the assets. Premiums and
discounts associated with the purchase of the ARM assets are
amortized into interest income over the lives of the assets using
the effective yield method, adjusted for the effects of estimated
prepayments.
ARM asset transactions are recorded on the date the ARM assets are
purchased or sold. Purchases of new issue ARM securities and all ARM
loans are recorded when all significant uncertainties regarding the
characteristics of the assets are removed and, in the case of loans,
underwriting due diligence has been completed, generally shortly
before the settlement date. Realized gains and losses on ARM asset
transactions are determined on the specific identification basis.
CREDIT RISK
The Company limits its exposure to credit losses on its portfolio of
ARM securities by purchasing ARM securities that have an investment
grade rating at the time of purchase and have some form of credit
enhancement, or are guaranteed by an agency of the federal
government ("Ginnie Mae") or a government-sponsored or
federally-chartered corporation ("Fannie Mae" or "Freddie Mac"). An
investment grade security generally has a security rating of BBB or
Baa or better by at least one of two nationally recognized rating
agencies, Standard & Poor's, Inc. or Moody's Investors Service, Inc.
(the "Rating Agencies"). Additionally, the Company purchases and
originates ARM loans or purchases all classes of an ARM loan
securitization (including the classes rated less than Investment
Grade) and limits its exposure to credit losses by restricting its
whole loan purchases and originations to ARM loans generally
originated to "A" quality underwriting standards. The Company
further limits its exposure to credit risk by limiting its
investment in investment grade securities that are rated A or
equivalent, BBB or equivalent, or ARM loans originated to "A"
quality underwriting standards ("Other Investments"), including the
subordinate classes of securities retained as part of the Company's
securitization of loans or purchases of 100% of the classes from
other loan securitizations, to no more than 30% of the portfolio.
The Company, in general, securitizes all of its loans and retains
the resulting securities in its ARM portfolio. The Company may also
purchase an entire securitization backed by "A" quality loans. At
the time of securitization, the Company obtains a credit review of
the loans being securitized by one or more Rating Agency. Based in
part on this review, the Company makes a determination regarding the
expected losses to be realized in the future and adjusts the basis
of the securities to their expected realizable value. In doing so,
the Company establishes a basis adjustment amount to absorb the
expected credit losses. The Company then monitors the delinquencies
and losses on the underlying loans backing its ARM securities. If
the credit performance of the underlying loans is not as good as
expected, the Company records a provision for additional probable
credit losses at a level deemed appropriate by management to provide
for estimated losses inherent in its ARM securities portfolio. The
provision is based on management's assessment of numerous factors
affecting the Company's portfolio of ARM assets including, but not
limited to, current economic conditions, delinquency status, credit
losses to date on underlying loans and remaining credit protection.
The provision for ARM securities is made by reducing the cost basis
of the individual security for the decline in fair value (which is
other than temporary), and the amount of such
8
write-down is recorded as a realized loss, thereby reducing
earnings. Additionally, once a loan within one of these securities
is 90 days or more delinquent, or a borrower declares bankruptcy,
the Company adjusts the value of its accrued interest receivable to
what it believes to be collectible and stops accruing interest on
that portion of the security collateralized by the loan.
Loans that are not yet securitized are also reviewed for probable
losses. The Company's loans are held for securitization until an
appropriate size pool is created, which generally occurs within a
few months of acquisition or origination. As a result, although the
Company reviews its unsecuritized loans for probable losses, it is
unlikely a loan would incur a loss prior to securitization. If a
loss were estimated on an unsecuritized loan in excess of existing
reserves, the Company would record a provision, which would reduce
earnings, and adjust the loan loss reserve.
Provisions for credit losses do not reduce taxable income and thus
do not affect the dividends paid by the Company to shareholders in
the period the provisions are taken. Actual losses realized by the
Company do reduce taxable income in the period the actual loss is
realized and would affect the dividends paid to shareholders for
that tax year.
VALUATION METHODS
The fair values of the Company's ARM securities are generally based
on market prices provided by certain dealers who make markets in
these financial instruments, or by third-party pricing services. If
the fair value of an ARM security is not reasonably available from a
dealer or a third-party pricing service, management estimates the
fair value based on characteristics of the security that the Company
receives from the issuer and on available market information. The
fair values for ARM loans are estimated by the Company by using the
same pricing models employed by the Company in the process of
determining a price to bid for loans in the open market, taking into
consideration the aggregated characteristics of groups of loans such
as, but not limited to, collateral type, index, interest rate,
margin, length of fixed-rate period, life cap, periodic cap,
underwriting standards, age and credit. The fair values of the
Company's collateralized notes payable, interest rate swap
agreements and interest rate cap agreements are based on market
values provided by dealers who are familiar with the terms of the
notes, swap agreements and cap agreements. The fair value of futures
contracts is determined on a daily basis by the closing price on the
Chicago Mercantile Exchange. The fair values reported reflect
estimates and may not necessarily be indicative of the amounts the
Company could realize if these instruments were sold. Cash and cash
equivalents, interest receivable, reverse repurchase agreements,
other borrowings 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.
DERIVATIVE FINANCIAL INSTRUMENTS
All of the Company's derivative financial instruments (interest rate
cap agreements, interest rate swap agreements and Eurodollar futures
contracts) are carried on the balance sheet at their fair value. If
a derivative is designated as a "fair value hedge," the changes in
the fair value of the derivative instrument and the changes in the
fair value of the hedged item are both recognized in earnings. If a
derivative is designated as a "cash flow hedge," the effective
amount of change in the fair value of the derivative instrument is
recorded in "Other comprehensive income" and is transferred from
"Other comprehensive income" to earnings as the hedged item affects
earnings. The ineffective amount of all hedges is recognized in
earnings each quarter.
As the Company enters into hedging transactions, it formally
documents the relationship between the hedging instruments and the
hedged items. The Company has also documented its risk-management
policies, including objectives and strategies, as they relate to its
hedging activities. The Company assesses, both at inception of a
hedging activity and on an on-going basis, whether or not the
hedging activity is highly effective. If it is determined that a
hedge is not highly effective, the Company discontinues hedge
accounting prospectively.
9
INTEREST RATE SWAP AGREEMENTS AND EURODOLLAR FUTURES CONTRACTS
The Company enters into interest rate swap agreements ("Swap
Agreements") and Eurodollar futures contracts ("Eurodollar
Transactions") in order to manage its interest rate exposure when
financing its ARM assets. The Company generally borrows money based
on short-term interest rates, either by entering into borrowings
with maturity terms of less than one year, and frequently one to
three months, or by entering into borrowings with longer maturities
of one to two years that have an interest rate that is reset based
on a frequency that is commonly one to three months. The Company's
Traditional ARM assets generally have interest rates that reprice
based on frequency terms of one to twelve months. The Company's
Hybrid ARM assets have an initial fixed interest rate period of
three to ten years. As a result, the Company's existing and
forecasted borrowings reprice to a new rate on a more frequent basis
than do the Company's ARM assets. When the Company enters into a
Swap Agreement, it generally agrees to pay a fixed rate of interest
and to receive a variable interest rate, generally based on the
London InterBank Offer Rate ("LIBOR"). The Company also enters into
Eurodollar Transactions in order to hedge changes in its forecasted
three-month LIBOR-based liabilities. The notional balances of the
Swap Agreements and the total contract size of the Eurodollar
Transactions generally decline over the life of these instruments.
These Swap Agreements and Eurodollar Transactions have the effect of
converting the Company's variable-rate debt into fixed-rate debt
over the life of the Swap Agreements and Eurodollar Transactions.
These instruments are used as a cost effective way to lengthen the
average repricing period of the Company's variable rate and
short-term borrowings such that the duration of the borrowings
closely matches the duration of the Company's ARM assets.
All Swap Agreements are designated as cash flow hedges against the
benchmark interest rate risk associated with the Company's
borrowings. Although the terms and characteristics of the Company's
Swap Agreements and hedged borrowings are nearly identical, due to
the explicit requirements of Financial Accounting Standards No. 133
("FAS 133"), the Company does not account for these hedges under a
method defined in FAS 133 as the "shortcut" method, but rather the
Company calculates the effectiveness of these hedges on an ongoing
basis, and to date, has calculated effectiveness of approximately
100%. Eurodollar Transactions are also designated as cash flow
hedges and are accounted for in accordance with FAS 133
implementation issue No. G7, Method 1: Change in Variable Cash
Correspondent Method, and application of this method has resulted in
no measured ineffectiveness. All changes in the unrealized gains and
losses on Swap Agreements and the Eurodollar Transactions have been
recorded in "Accumulated other comprehensive income" and are
reclassified to earnings as interest expense is recognized on the
Company's hedged borrowings. If it becomes probable that the
forecasted transaction, which in this case refers to interest
payments to be made under the Company's short-term borrowing
agreements, will not occur by the end of the originally specified
time period, as documented at the inception of the hedging
relationship, or within an additional two-month time period
thereafter, then the related gain or loss in "Accumulated other
comprehensive income" would be reclassified to income. As of March
31, 2003, the net unrealized loss on Swap Agreements, deferred gains
from terminated Swap Agreements and deferred gains and losses on
Eurodollar Transactions recorded in "Accumulated other comprehensive
income" was a net loss of $153.4 million. The Company estimates that
over the next twelve months, $81.5 million of these net unrealized
losses will be reclassified from "Accumulated other comprehensive
income" to interest expense.
The loss on Swap Agreements is the discounted value of the remaining
future net interest payments expected to be made over the remaining
life of the Swap Agreements. Therefore, over time, as the actual
payments are made, the unrealized loss in "Accumulated other
comprehensive income" and the carrying value of the Swap Agreements
adjusts to zero and the Company realizes a fixed cost of money over
the life of the hedging instrument
The Company has terminated and/or replaced Swap Agreements in the
course of managing its liquidity and balance sheet. Since the
Company's adoption of FAS 133, realized gains and losses resulting
from the termination of Swap Agreements are initially recorded in
"Accumulated other comprehensive income" as a separate component of
equity. The gain or loss from the terminated
10
Swap Agreements remains in "Accumulated other comprehensive income"
until the forecasted interest payments affect earnings. If it
becomes probable that the forecasted interest payments will not
occur, then the entire gain or loss would be reclassified to income.
INTEREST RATE CAP AGREEMENTS
The Company purchases interest rate cap agreements ("Cap
Agreements") to manage interest rate risk on a portion of its
assets. In general, ARM assets have a contractual maximum interest
rate ("Life Cap"), which is a component of the fair value of an ARM
asset. Pursuant to the terms of the Cap Agreements, the Company will
receive cash payments if the interest rate index specified in any
such Cap Agreement increases above certain specified levels.
Therefore, such Cap Agreements have the effect of offsetting a
portion of the Company's borrowing costs, above a specified level so
that the net margin on the Company's ARM assets will be protected in
high interest rate environments.
The Company does not currently apply hedge accounting to its Cap
Agreements and, as a result, the Company records the change in fair
value of the Cap Agreements as hedging expense in current earnings.
The Company purchases Cap Agreements by incurring a one-time fee or
premium and carries them at fair value. The carrying value of the
Cap Agreements is included in "Prepaid expenses and other" on the
balance sheet.
ACCUMULATED OTHER COMPREHENSIVE INCOME
The Financial Accounting Standard Board's Statement 130, "Reporting
Comprehensive Income," divides comprehensive income into net income
and other comprehensive income, which includes unrealized gains and
losses on marketable securities defined as available-for-sale and
unrealized gains and losses on derivative financial instruments that
qualify for hedge accounting under FAS 133. Accumulated other
comprehensive income (loss) at March 31, 2003 and December 31, 2002
includes the following (dollar amounts in thousands):
March 31, 2003 December 31, 2002
-------------- -----------------
Net unrealized gain on available-for-sale ARM
assets $ 47,487 $ 43,489
Net unrealized loss on Swap Agreements and
Eurodollar Transactions (153,300) (148,743)
--------- ---------
Accumulated other comprehensive loss $(105,813) $(105,254)
========= =========
INCOME TAXES
The Company elected to be taxed as a REIT and believes it complies
with the provisions of the Internal Revenue Code of 1986, as amended
(the "Code") with respect thereto. Accordingly, the Company will not
be subject to Federal income tax on that portion of its income that
is distributed to shareholders, as long as certain asset, income and
stock ownership tests are met.
NET EARNINGS PER SHARE
Basic EPS amounts are computed by dividing net income (adjusted for
dividends declared on preferred stock) by the weighted average
number of common shares outstanding. Diluted EPS amounts assume the
conversion, exercise or issuance of all potential common stock
instruments, unless the effect is to reduce a loss or increase the
earnings per common share.
Following is information about the computation of the earnings per
share data for the three-month periods ended March 31, 2003 and 2002
(amounts in thousands except per share data):
11
Income Shares Earnings Per Share
-------- ------ ------------------
Three Months Ended March 31, 2003
Net income $ 39,074
Less preferred stock dividends (1,670)
--------
Basic EPS, income available to common shareholders 37,404 55,631 $ 0.67
======
Effect of dilutive securities:
Convertible preferred stock 1,670 2,760
-------- ------
Diluted EPS $ 39,074 58,391 $ 0.67
======== ====== ======
Three Months Ended March 31, 2002
Net income $ 24,293
Less preferred stock dividends (1,670)
--------
Basic EPS, income available to common shareholders 22,623 36,417 $ 0.62
======
Effect of dilutive securities:
Convertible preferred stock -- --
-------- ------
Diluted EPS $ 22,623 36,417 $ 0.62
======== ====== ======
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.
CURRENT ACCOUNTING PRONOUNCEMENTS
In November 2002, the FASB issued Interpretation No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"),
which is an interpretation of SFAS No. 5; "Accounting for
Contingencies," SFAS No. 57; "Related Party Disclosures," and SFAS
No. 107; "Disclosures About Fair Value of Financial Instruments."
FIN 45 clarifies the disclosure and liability recognition
requirements relating to guarantees issued by an entity. FIN 45 is
effective for new guarantees issued or modification of guarantees
made after December 31, 2002. The adoption of FIN 45`s measurement
requirements is not expected to have a significant impact on the
Company's financial position or results of operations. The Company
has no guarantees requiring disclosure under FIN 45.
In January 2003, the FASB issued FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities" ("FIN 46"), which is
an interpretation of Accounting Research Bulletin No. 51,
"Consolidated Financial Statements." FIN 46 requires business
enterprises to consolidate variable interest entities which have one
or more of the following characteristics:
1. The equity investment at risk is not sufficient to permit the
entity to finance its activities without additional
subordinated financial support from other parties.
2. The equity investors lack one or more of the following
essential characteristics of a controlling financial interest:
12
a. The direct or indirect ability to make decisions about
the entity's activities through voting rights or similar
rights
b. The obligation to absorb the expected losses of the
entity if they occur
c. The right to receive expected residual returns of the
entity if they occur.
FIN 46 excludes qualifying special purpose entities subject to the
reporting requirements of SFAS 140. FIN 46 applies upon formation to
variable interest entities created after January 31, 2003, and to
all variable interest entities in the first fiscal year or interim
period beginning after June 15, 2003. The adoption of FIN 46 is not
expected to have an impact on the Company's financial statements.
In April 2003, the FASB issued SFAS 149, "Amendment of Statement 133
on Derivative Instruments and Hedging Activities", which amends SFAS
133 for certain decisions made by the FASB Derivatives
Implementation Group. In particular, SFAS 149 (1) clarifies under
what circumstances a contract with an initial net investment meets
the characteristic of a derivative, (2)clarifies when a derivative
contains a financing component, (3) amends the definition of an
underlying to conform it to language used in FIN 45, and (4) amends
certain other existing pronouncements. This Statement is effective
for contracts entered into or modified after June 30, 2003, and for
hedging relationships designated after June 30, 2003. In addition,
most provisions of SFAS 149 are to be applied prospectively. The
Company does not expect the adoption of SFAS 149 to have a material
impact on its financial position, cash flows or results of
operations.
13
NOTE 2. ADJUSTABLE-RATE MORTGAGE ASSETS
The following tables present the Company's ARM assets as of March
31, 2003 and December 31, 2002. The ARM securities classified as
available-for-sale are carried at their fair value, while the
collateral for collateralized notes and ARM loans are carried at
their amortized cost basis (dollar amounts in thousands):
March 31, 2003:
Available-for-Sale Collateral for
ARM Securities Collateralized Notes ARM Loans Total
------------------ -------------------- ----------- ------------
Principal balance outstanding $ 10,659,982 $ -- $ 1,146,475 $ 11,806,457
Net unamortized premium 131,913 -- 5,997 137,910
Basis adjustments/Allowance for losses (16,525) -- (100) (16,625)
Principal payment receivable 33,163 -- -- 33,163
------------ --------- ----------- ------------
Amortized cost, net 10,808,533 -- 1,152,372 11,960,905
Gross unrealized gains 80,833 -- 6,424 87,257
Gross unrealized losses (32,301) -- (1,245) (33,546)
------------ --------- ----------- ------------
Fair value $ 10,857,065 $ -- $ 1,157,551 $ 12,014,616
============ ========= =========== ============
Carrying value $ 10,857,065 $ -- $ 1,152,372 $ 12,009,437
============ ========= =========== ============
December 31, 2002:
Available-for-Sale Collateral for
ARM Securities Collateralized Notes ARM Loans Total
------------------ -------------------- ----------- ------------
Principal balance outstanding $ 9,162,747 $ 287,409 $ 706,965 $ 10,157,121
Net unamortized premium 108,565 5,613 2,922 117,100
Basis adjustments/Allowance for losses (11,384) (3,239) (100) (14,723)
Principal payment receivable 31,033 -- -- 31,033
------------ --------- ----------- ------------
Amortized cost, net 9,290,961 289,783 709,787 10,290,531
Gross unrealized gains 73,805 2,297 3,505 79,607
Gross unrealized losses (29,123) (120) (160) (29,403)
------------ --------- ----------- ------------
Fair value $ 9,335,643 $ 291,960 $ 713,132 $ 10,340,735
============ ========= =========== ============
Carrying value $ 9,335,643 $ 289,783 $ 709,787 $ 10,335,213
============ ========= =========== ============
The Company did not sell any ARM assets during the quarter ended
March 31, 2003. During the quarter ended March 31, 2002, the Company
sold one ARM security in the amount of $50.1 million for no gain or
loss. The ARM security sold was classified as "available-for-sale."
In addition, the Company sold $3.7 million of loans and realized a
gross gain of $6.0 thousand and a gross loss of $3.0 thousand.
During the quarter ended March 31, 2003, the Company securitized
$774.5 million of its ARM loans into a series of private-label
multi-class ARM securities. In keeping with the Company's portfolio
lending strategy, it retained for its ARM portfolio, all of the
classes of the securities created. The Company did not account for
this securitization as a sale and, therefore, did not record any
gain or loss in connection with the securitization. The Company
carries the securities at fair value, based primarily on market
value prices received from dealers familiar with similar securities.
As of March 31, 2003, $3.5 billion of the Company's ARM assets had
been created from the Company's loan securitization and retention
process.
14
As of March 31, 2003 and December 31, 2002, the Company had reduced
the cost basis of its securitized ARM loans by $15.2 million and
$13.8 million, respectively, due to estimated credit losses (other
than temporary declines in fair value). The reduction in the cost
basis recorded during the first quarter of 2003, in the amount of
$1.5 million, was recorded in connection with the Company's
securitization of $774.5 million of loans.
As of March 31, 2003 and December 31, 2002, the Company had reduced
the cost basis of other ARM securities by $1.3 million and $858.8
thousand, respectively, due to estimated credit losses (other than
temporary declines in fair value) related to ARM securities
purchased at a discount. The Company recorded a reduction in cost
basis of $435.8 thousand related to ARM securities purchased during
the quarter ended March 31, 2003 on which the Company has first loss
credit exposure. These securities were purchased as part of a
transaction in which the Company purchased all of the classes of a
loan securitization in the amount of $299.7 million, including the
subordinated classes. The Company also recorded realized losses on
purchased ARM securities in the amount of $49.1 thousand and
realized recoveries in the amount of $52.6 thousand during the first
quarter of 2003.
The Company has credit exposure on loans it has securitized and
loans held for securitization. All of the loans that were delinquent
as of March 31, 2003 and December 31, 2002 were loans the Company
had securitized. The following tables summarize ARM loan delinquency
information as of March 31, 2003 and December 31, 2002 (dollar
amounts in thousands):
March 31, 2003
Percent of ARM Percent of
Delinquency Status Loan Count Loan Balance Loans (1) Total Assets
---------- ------------ --------- ------------
60 to 89 days 3 $ 807 0.02% 0.01%
90 days or more 1 147 0.00% 0.00%
In foreclosure 6 3,807 0.08% 0.03%
------ ------ ------ ------
10 $4,761 0.10% 0.04%
====== ====== ====== ======
December 31, 2002
Percent of ARM Percent of
Delinquency Status Loan Count Loan Balance Loans (1) Total Assets
---------- ------------ --------- ------------
60 to 89 days 2 $ 270 0.01% 0.00%
90 days or more 1 159 0.00% 0.00%
In foreclosure 5 2,970 0.08% 0.03%
------ ------ ------ ------
8 $3,399 0.09% 0.03%
====== ====== ====== ======
(1) ARM loans include loans held for securitization and loans that
the Company has securitized and retained first loss credit
exposure for total amounts of $4.6 billion and $3.7 billion at
March 31, 2003 and December 31, 2002, respectively.
As of March 31, 2003, the Company has a $100.0 thousand reserve for
estimated losses on loans pending securitization. The Company
believes that its current level of reserves is adequate to cover any
estimated loss, should one occur, on loans pending securitization.
15
As of March 31, 2003, the Company had commitments to purchase or
originate the following amounts of ARM assets (dollar amounts in
thousands):
ARM securities $ 331,210
Whole loans - bulk purchase 202,282
Whole loans - correspondent 449,506
Whole loans - direct originations 119,220
----------
$1,102,218
==========
The Company has entered into transactions whereby the Company
expects to acquire the remaining balance of certain AAA rated Hybrid
ARM securities, at a price of par, between 2004 and 2007, when the
fixed-rate period of the Hybrid ARM securities terminates and the
securities convert into Traditional ARM securities with
characteristics similar to the ARM securities held in the current
portfolio. The Company views these as an alternative source of
Traditional ARM assets. The current balance of the Hybrid ARM
securities is approximately $3.4 billion, but is expected to be less
than 25% of that, and could be zero, at the time they convert into
Traditional ARM securities. If the Company decides not to acquire
the Hybrid ARM securities when they convert into Traditional ARM
securities, then it is committed to pay or receive the difference
between par and the fair value of the Traditional ARM securities at
that time, as determined by an auction of the Traditional ARM
securities. As of March 31, 2003, the Company has delivered $6.9
million of collateral in connection with these transactions.
NOTE 3. INTEREST RATE CAP AGREEMENTS
The fair value of the Cap Agreements at March 31, 2003 and December
31, 2002 amounted to $74.1 thousand and $84.7 thousand,
respectively, and is included in "Prepaid expenses and other" on the
balance sheet. Purchased Cap Agreements had a remaining notional
amount of $1.2 billion and $1.8 billion as of March 31, 2003 and
December 31, 2002, respectively. The notional amount of the Cap
Agreements purchased declines at a rate that is expected to
approximate the amortization of the Traditional ARM securities.
Under these Cap Agreements, the Company will receive cash payments
should the one-month or three-month LIBOR increase above the
contract rates of these hedging instruments, which range from 6.00%
to 12.00% and average 9.73%. The Cap Agreements had an average
maturity of 1.2 years as of March 31, 2003. The initial aggregate
notional amount of the Cap Agreements declines to $1.2 billion over
the period of the agreements, which expire between 2003 and 2005.
During the three-month periods ended March 31, 2003 and 2002, the
Company recognized expenses of $177.1 thousand and $313.6 thousand,
respectively, which is reported as "Hedging expense" in the
Company's Consolidated Income Statements.
NOTE 4. REVERSE REPURCHASE AGREEMENTS, WHOLE LOAN FINANCING FACILITIES,
COLLATERALIZED NOTES AND OTHER BORROWINGS
REVERSE REPURCHASE AGREEMENTS
The Company has arrangements to enter into reverse repurchase
agreements, a form of collateralized short-term borrowing, with 23
different financial institutions, and as of March 31, 2003, had
borrowed funds from 15 of these firms. Because the Company borrows
money under these agreements based on the fair value of its ARM
assets, and because changes in interest rates can negatively impact
the valuation of ARM assets, the Company's borrowing ability under
these agreements could be limited and lenders could initiate margin
calls in the event interest rates change or the value of the
Company's ARM assets declines for other reasons.
As of March 31, 2003, the Company had $10.1 billion of reverse
repurchase agreements outstanding with a weighted average borrowing
rate of 1.45% and a weighted average remaining maturity of 4.5
months. After including the $142.5 million carrying value of Swap
Agreements, the combined reverse repurchase agreements and Swap
Agreements outstanding of $10.3 billion as of March 31, 2003 had a
weighted average borrowing rate of 2.79% and a weighted average
remaining maturity of 1.8 years.
16
As of December 31, 2002, the Company had $8.4 billion of reverse
repurchase agreements outstanding with a weighted average borrowing
rate of 1.59% and a weighted average remaining maturity of 4.6
months. After including the $142.5 million carrying value of Swap
Agreements, the combined reverse repurchase agreements and Swap
Agreements outstanding of $8.6 billion as of December 31, 2002 had a
weighted average borrowing rate of 2.95% and a weighted average
remaining maturity of 1.7 years. As of March 31, 2003, $6.8 billion
of the Company's borrowings were variable-rate term reverse
repurchase agreements with original maturities that range from six
months to twenty-four months. The interest rates of these term
reverse repurchase agreements are indexed to either the one- or
three-month LIBOR rate and reprice accordingly. ARM assets with a
carrying value of $10.7 billion, including accrued interest and cash
totaling $68.9 million, collateralized the reverse repurchase
agreements at March 31, 2003.
At March 31, 2003, the reverse repurchase agreements, which includes
the carrying value of Swap Agreements, had the following remaining
maturities (dollar amounts in thousands):
Within 30 days $ 3,167,365
31 to 89 days 1,421,305
90 to 365 days 5,148,955
Over 365 days 403,517
-----------
10,141,142
Swap Agreements (carrying value) 142,505
-----------
$10,283,647
===========
WHOLE LOAN FINANCING FACILITIES
As of March 31, 2003, the Company had entered into three whole loan
financing facilities. The interest rates on these facilities are
indexed to one-month LIBOR and reprice accordingly. One of the whole
loan financing facilities has a committed borrowing capacity of $600
million and matures in January 2004. The other two financing
facilities have a committed borrowing capacity of $300 million each
and mature in November 2003 and March 2004. As of March 31, 2003,
the Company had $1.1 billion borrowed against these whole loan
financing facilities at an effective cost of 1.99%. As of December
31, 2002, the Company had $589.1 million borrowed against whole loan
financing facilities at an effective cost of 2.11%. The amount
borrowed on the whole loan financing agreements at March 31, 2003
was collateralized by ARM loans with a carrying value of $1.1
billion, including accrued interest.
The whole loan financing facility with a borrowing capacity of $300
million and maturing in March 2004, discussed above, is a
securitization transaction in which the Company transfers groups of
whole loans to a wholly owned bankruptcy-remote special purpose
subsidiary. The subsidiary, in turn, simultaneously transfers its
interest in the loans to a trust, which issues beneficial interests
in the loans in the form of a note and a subordinated certificate.
The note is then used to collateralize borrowings. This whole loan
financing facility works similarly to a secured line of credit
whereby the Company can deliver loans into the facility and take
loans out of the facility at the Company's discretion subject to the
terms and conditions of the facility. This securitization
transaction is accounted for as a secured borrowing.
COLLATERALIZED NOTES
On December 18, 1998, the Company, through a wholly owned
bankruptcy-remote special purpose finance subsidiary, issued $1.1
billion of notes payable ("Notes") collateralized by ARM loans and
ARM securities. As part of this transaction, the Company retained
ownership of a subordinated certificate in the amount of $32.4
million, which represents the Company's maximum exposure to credit
losses on the loans collateralizing the Notes. On January 25, 2003,
the Company called the Notes. The Company re-securitized the loan
collateral securitizing these notes payable in a loan securitization
in April 2003. (See Note 9.)
17
SWAP AGREEMENTS AND EURODOLLAR TRANSACTIONS
As of March 31, 2003, the Company was counterparty to Swap
Agreements and Eurodollar Transactions having an aggregate current
notional balance of $6.4 billion. In addition, the Company entered
into a delayed Swap Agreement with a notional balance of $500
million that becomes effective in August 2003. These Swap Agreements
and Eurodollar Transactions hedge the cost of financing Hybrid ARM
assets during their fixed rate term (generally three to ten years).
As of March 31, 2003, these Swap Agreements and Eurodollar
Transactions had a weighted average maturity of 2.7 years. In
accordance with the Swap Agreements, the Company will pay a fixed
rate of interest during the term of these Swap Agreements and
receive a payment that varies monthly with the one-month LIBOR rate.
The Company hedges the funding of its Hybrid ARM assets such that
the weighted average net duration of borrowed funds, hedges and
Hybrid ARM assets is less than one year. At March 31, 2003, the
financing and hedging of the Company's Hybrid ARM assets resulted in
a net duration of approximately 2 months. The carrying value of the
Swap Agreements, in the amount of $142.5 million as of March 31,
2003, is included in "Reverse repurchase agreements" in the
accompanying balance sheets. As of March 31, 2003, ARM assets with a
carrying value of $113.4 million, including accrued interest, and
cash totaling $11.3 million collateralized the Swap Agreements.
OTHER
The total cash paid for interest was $68.9 million and $45.7 million
during the quarters ended March 31, 2003 and 2002, respectively.
NOTE 5. FAIR VALUE OF FINANCIAL INSTRUMENTS AND OFF-BALANCE SHEET CREDIT RISK
The following table presents the carrying amounts and estimated fair
values of the Company's financial instruments at March 31, 2003 and
December 31, 2002 (dollar amounts in thousands):
March 31, 2003 December 31, 2002
------------------------------ ------------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
----------- ----------- ----------- -----------
Assets:
ARM assets $12,009,437 $12,014,616 $10,335,213 $10,340,735
Cap Agreements 74 74 85 85
Liabilities:
Reverse repurchase agreements 10,141,142 10,142,142 8,425,729 8,425,729
Collateralized notes -- -- 255,415 255,863
Whole loan financing facilities 1,062,237 1,062,237 589,081 589,081
Swap Agreements 142,505 142,505 142,531 142,531
The above Cap Agreements are included in the balance sheet under the
caption "Prepaid expenses and other." The carrying amount for
securities, which are categorized as available-for-sale, is their
fair value, whereas the carrying amount for loans, which are
categorized as held for the foreseeable future, is their amortized
cost.
NOTE 6. COMMON AND PREFERRED STOCK
During February 2003, the Company completed a public offering of
3,473,500 shares of common stock and received net proceeds of $65.9
million under its shelf registration statement on Form S-3 that was
declared effective by the Securities and Exchange Commission ("SEC")
on August 30, 2002. During the quarter ended March 31, 2003, the
Company also issued 1,449,300 shares of common stock in "at-market"
transactions under a controlled equity program under the August 2002
shelf registration statement and received net proceeds of $29.1
million. As of March 31, 2003, $25.1 million and $243.8
18
million of the Company's registered securities remained available
for future issuance and sale under its currently effective July 2001
and August 2002 shelf registration statements, respectively.
During the quarter ended March 31, 2003, the Company issued
1,384,846 shares of common stock under its Dividend Reinvestment and
Stock Purchase Plan (the "DRP") and received net proceeds of $27.2
million.
On December 17, 2002, the Company declared the fourth quarter 2002
dividend of $0.585 per share of common stock, which was paid on
January 24, 2003 to common shareholders of record as of December 31,
2002.
On March 14, 2003, the Company declared a first quarter dividend of
$0.605 per share to the shareholders of the Series A 9.68%
Cumulative Convertible Preferred Stock, which was paid on April 10,
2003 to preferred shareholders of record as of March 31, 2003.
On April 22, 2003, the Company declared the first quarter 2003
dividend of $0.60 per share of common stock, which will be paid on
May 16, 2003 to common shareholders of record as of May 2, 2003.
For federal income tax purposes, all dividends are expected to be
ordinary income to the Company's common and preferred shareholders,
subject to year-end allocations of the common dividend between
ordinary income, capital gain income and non-taxable income as
return of capital, depending on the amount and character of the
Company's full year taxable income.
NOTE 7. LONG-TERM INCENTIVE AWARDS
The Company's Board of Directors adopted the "Amended and Restated
2002 Long-Term Incentive Plan" (the "Plan"), effective September 29,
2002. The Board of Directors further amended the Plan in January
2003 to exclude the authorization of stock options. The amended Plan
authorizes the Company's Compensation Committee to grant Dividend
Equivalent Rights ("DERs"), Stock Appreciation Rights ("SARs") and
Phantom Stock Rights ("PSRs").
During the first quarter of 2003, the policy of the Compensation
Committee and the Board was to grant only PSR and DER awards under
the Plan. The PSRs are granted in lieu of stock options, based on
equivalent values as calculated by a Black Scholes option model. In
March 2003, the Compensation Committee suspended the award of DERs
related to equity issued subsequent to March 31, 2003 for the
remainder of 2003.
The PSRs, when received as a grant, generally vest over a three-year
period. The Company usually issues DERs under a formula at the same
time that other awards under the Plan are granted; however, the
Compensation Committee has suspended the formula-based awards of
DERs subsequent to March 31, 2003 for the remainder of 2003. The DER
and PSR participants may elect to reinvest their PSR and DER cash
dividends into additional PSRs at the price of the Company's common
stock on the related dividend payment date. The PSRs are expensed
over the applicable vesting period. The DERs are fully expensed on
the Company's income statement.
As of March 31, 2003, there were 1,331,758 DERs outstanding, of
which 1,303,597 were vested, and 502,255 PSRs outstanding, of which
303,606 were vested. The Company recorded an expense associated with
DERs and PSRs of $1.7 million and $547.4 thousand for the quarters
ended March 31, 2003 and 2002, respectively. Of the expense recorded
in the first quarter of 2003, $1.0 million was the amount of
dividend equivalents paid on DERs and PSRs, $422.7 thousand was the
amortization of unvested PSRs, and $210.0 thousand was the impact of
the increase in the Company's common stock price on the value of the
PSRs which was recorded as a fair value adjustment. Of the expense
recorded during the first quarter of 2002, $436.9 thousand was the
amount of dividend equivalents paid on DERs and PSRs, $20.3 thousand
was the impact of the increase in the Company's common stock price
on the value of the PSRs which was recorded as a fair value
adjustment, and $90.2 thousand was the
19
amortization of the value of restricted shares (all of which were
subsequently cancelled in April 2002 by the Company's Board of
Directors and replaced with PSRs of equal value), net of the effect
of cancelled restricted shares due to employment termination.
Notes receivable from stock sales arose from the Company financing a
portion of the purchase of shares of common stock by directors,
officers and employees through the exercise of stock options prior
to 2002. The notes mature in 2010 and accrue interest at a rate of
3.91% per annum. In addition, the notes are full recourse promissory
notes and are secured by a pledge of the shares of the common stock
acquired. Interest, which is credited to paid-in-capital, is payable
quarterly, with the balance due at the maturity of the notes. The
payment of the notes will be accelerated only upon the sale of the
shares of common stock pledged for the notes. The notes may be
prepaid at any time at the option of each borrower. As of March 31,
2003, there was $7.3 million of notes receivable outstanding from
stock sales. All of these notes were made prior to the enactment of
the Sarbanes-Oxley Act of 2002 (the "Act"). As a result of the Act,
the notes made to directors and executive officers of the Company
may not be modified and these individuals are not eligible to
participate in any such program in the future. In April 2002, the
Board approved a limited stock repurchase program for the repurchase
of shares of common stock at current market value that were acquired
pursuant to the exercise of stock options under the Company's
previous stock option plan. The Company will first apply the
proceeds from any such repurchases to the repayment of any
outstanding stock option notes receivable due from the holders. As
of March 31, 2003, no shares have been repurchased under this
program.
NOTE 8. TRANSACTIONS WITH AFFILIATES
The Company has no employees and is managed externally by Thornburg
Mortgage Advisory Corporation ("the Manager") a under the terms of a
Management Agreement (the "Agreement") that has been negotiated and
approved by the Board of Directors. Under the terms of this
Agreement, the Manager, subject to the supervision of the Company's
Board of Directors, is responsible for the management of all
operations of the Company and provides certain personnel and office
space. Certain defined expenses of the Manager and affiliates of the
Manager are reimbursed by the Company, principally expenses of TMHL,
the Company's mortgage banking subsidiary, related to mortgage loan
acquisition, selling, servicing and securitization activities,
including the personnel and office space attributed to these
activities. During the quarters ended March 31, 2003 and 2002, the
Company reimbursed the Manager and affiliates of the Manager $1.1
million and $457.4 thousand for expenses, respectively, in
accordance with the terms of the Agreement. As of March 31, 2003 and
2002, $850.0 thousand and $274.9 thousand, respectively, was payable
by the Company to the Manager for reimbursable expenses. The
Agreement has a ten-year term expiring July 15, 2009, and provides
for an annual review of the Manager's performance under the
Agreement by the unaffiliated directors of the Board of Directors.
The Company must pay a substantial cancellation fee if it terminates
the Agreement other than for cause.
The Company pays the Manager an annual base management fee based on
average shareholders' equity, adjusted for liabilities that are not
incurred to finance assets ("Average Shareholders' Equity" or
"Average Net Invested Assets" as defined in the Agreement), payable
monthly in arrears as follows: 1.20% of the first $300 million of
Average Shareholders' Equity, plus 0.88% of Average Shareholders'
Equity above $300 million. The Agreement also has a cost of living
clause that adjusts the base management fee formula by the change in
the Consumer Price Index over the previous twelve-month period,
effective as of each annual review of the Agreement. In addition,
the three wholly owned subsidiaries of the Company and the two
wholly owned subsidiaries of TMHL have entered into separate
Management Agreements with the Manager for additional management
services for a combined amount of $1.2 thousand per month, paid in
arrears.
For the quarters ended March 31, 2003 and 2002, the Company incurred
costs of $2.5 million and $1.6 million, respectively, in base
management fees in accordance with the terms of the Agreement. As of
March 31, 2003 and 2002, $872.1 thousand and $602.3 thousand,
respectively, was payable by the Company to the Manager for the base
management fee.
20
The Manager is also entitled to earn performance-based compensation
in an amount equal to 20% of the Company's annualized net income,
before performance-based compensation, above an annualized return on
equity equal to the ten year U.S. Treasury Rate plus 1%. For
purposes of the performance fee calculation, equity is generally
defined as proceeds from the issuance of common stock before
underwriter's discount and other costs of issuance, plus retained
earnings. For the quarters ended March 31, 2003 and 2002, the
Manager earned performance-based compensation in the amount of $6.2
million and $3.2 million, respectively, in accordance with the terms
of the Agreement. As of March 31, 2003 and 2002, $6.2 million and
$3.2 million, respectively, was payable by the Company to the
Manager for performance-based compensation.
Pursuant to an employee residential mortgage loan program approved
by the Board of Directors as part of the Company's residential
mortgage loan origination activities, certain of the directors,
officers and employees of the Company and of other affiliates of the
Company have obtained residential first lien mortgage loans from the
Company. In general, the terms of the loans and the underwriting
requirements are identical to the loan programs the Company offers
to unaffiliated third parties, except that participants in the
program, who are neither directors nor executive officers of the
Company, qualify for an employee discount on the interest rate. At
the time each participant enters into a loan agreement, such
participant executes an addendum that provides for the discount on
the interest rate that is subject to cancellation at the time such
participant's employment is terminated for any reason. Effective
with the enactment of the Sarbanes-Oxley Act of 2002 on July 30,
2002, any new loans made to directors or executive officers are not
eligible for the employee discount. As of March 31, 2003, the
aggregate balance of mortgage loans outstanding to directors and
officers of the Company, and to employees of the Manager and other
affiliates, amounted to $24.9 million, had a weighted average
interest rate of 4.38%, and maturities ranging between 2016 and
2033.
Pursuant to the terms of a Joint Marketing Agreement with Thornburg
Securities Corporation ("TSC"), a registered broker-dealer, TMHL
shall pay TSC an annual fee of $50.0 thousand in 2003, in quarterly
installments, as compensation for certain marketing, promotional and
advertising services and to provide marketing materials to brokers
and financial advisers. During the quarter ended March 31, 2003,
TMHL paid $12.5 thousand to TSC pursuant to this agreement.
NOTE 9. RECENT DEVELOPMENTS
On April 3, 2003, approximately $1.1 billion of mortgage loans from
our ARM loan portfolio were transferred to Thornburg Mortgage
Securities Trust 2003-2 and were securitized. Approximately $1.0
billion of the securities issued in connection with this
securitization were sold to third-party investors in the form of
AAA-rated floating rate pass-through certificates. This transaction
will be accounted for as a financing of our loans and represents
long-term secured non-marginable financing for our portfolio.
On May 15, 2003, the Company completed an unregistered offering of
$200.0 million in senior unsecured notes at par. The notes bear
interest at 8%, payable each May 15 and November 15, commencing
November 15, 2003, and mature on May 15, 2013. The notes are
redeemable, in whole or in part, beginning May 2008. The notes may
also be redeemed under limited circumstances on or before May 15,
2006.
21
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Certain information contained in this Quarterly Report on Form 10-Q constitutes
"Forward-Looking Statements" within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended. You can identify such forward-looking statements by the presence of
forward-looking terminology such as "may," "will," "expect," "anticipate,"
"estimate," "plan," or "continue," or the negatives thereof, or similar
terminology. You should be aware that all forward-looking statements involve
risks and uncertainties including, but not limited to, risks related to the
future level and relationship of various interest rates, prepayment rates,
availability and cost of acquiring new assets, the timing of new programs and
the performance of third party, private-label relationships involved in the
origination and servicing of loans. The cautionary statements that you will find
in the "Risk Factors" section on pages 14 through 17 of our 2002 Annual Report
on Form 10-K identify important factors, including certain risks and
uncertainties, with respect to such forward-looking statements that could cause
our actual results, performance or achievements to differ materially from those
reflected in such forward-looking statements.
CORPORATE GOVERNANCE
We pride ourselves on maintaining an ethical workplace in which the highest
standards of professional conduct are practiced. Accordingly, we would like to
highlight the following facts relating to corporate governance:
- Our Board of Directors consists of a majority of independent
directors. The Audit, Nominating/Corporate Governance and
Compensation Committees of the Board of Directors are also composed
exclusively of independent directors.
- Our long-term incentive plan does not provide for the granting of
stock options. All long-term incentive awards are fully expensed in
our consolidated income statements and are fully disclosed in our
financial reports.
- We have established a formal internal audit function to further the
effective functioning of our internal controls and procedures. Our
internal audit plan is intended to provide management and the Audit
Committee with an effective tool to identify and address areas of
financial or operational concerns and ensure that appropriate
controls and procedures are in place.
- We have adopted both a Code of Business Conduct and Ethics and
Corporate Governance Guidelines that cover a wide range of business
practices and procedures, that apply to all of our employees,
officers and directors, and that foster the highest standards of
ethics and conduct in all of our business relationships.
- We have an Insider Trading Policy designed to prohibit any of the
directors or officers of the Company or any director, officer or
employee of the Manager from buying or selling our stock on the
basis of material nonpublic information, and to prohibit
communicating material nonpublic information to others.
Our Internet website address is www.thornburgmortgage.com. We make available
free of charge, through our Internet website, our annual report on Form 10-K,
our quarterly reports on Form 10-Q, our current reports on Form 8-K, and any
amendments to those reports that we file or furnish pursuant to Section 13(a) or
15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable
after we electronically file such material with, or furnish it to, the
Securities and Exchange Commission (the "SEC").
You may also find on our website our Code of Business Conduct and Ethics,
Corporate Governance Guidelines and the charters of the Audit Committee,
Nominating/Corporate Governance Committee and Compensation Committee of our
Board of Directors. These documents are also available in print to anyone who
requests them by writing to us at the following address: 150 Washington Avenue,
Suite 302, Santa Fe, New Mexico, 87501, or by phoning us at (505) 989-1900.
22
Please note that the reference to our website address is an inactive textual
reference made only for purposes of complying with SEC rules.
CRITICAL ACCOUNTING POLICIES
Our financial statements are prepared in conformity with generally accepted
accounting principles, many of which require the use of estimates and
assumptions. In accordance with recent SEC guidance, those material accounting
policies that we believe are the most critical to an investor's understanding of
our financial results and condition and require complex management judgment have
been expanded and discussed below.
- - Fair Value. We record our adjustable and variable rate mortgage ("ARM")
securities, interest rate cap agreements ("Cap Agreements"), interest rate
swap agreements ("Swap Agreements") and Eurodollar futures contracts
("Eurodollar Transactions") at fair value. The fair values of our ARM
securities, Cap Agreements, Swap Agreements and Eurodollar Transactions
are generally based on market prices provided by certain dealers who make
markets in these financial instruments or third-party pricing services. If
the fair value of an ARM security or other financial instrument is not
reasonably available from a dealer or a third-party pricing service,
management estimates the fair value. This requires management judgment in
determining how the market would value a particular ARM security based on
characteristics of the security we receive from the issuer and available
market information. The fair values reported reflect estimates and may not
necessarily be indicative of the amounts we could realize in a current
market exchange.
- - Basis Adjustments on ARM Securities. In general, we securitize all of our
loans and retain the resulting securities in our ARM portfolio. At the
time of securitization, we obtain a credit review of the loans being
securitized by one or more of the Rating Agencies. Based on this review, a
determination is made, which requires management judgment regarding the
expected losses to be realized in the future and we adjust the basis of
the securities to their expected realizable value. This is referred to as
a "basis adjustment." In doing so, we establish an account, similar to a
loss reserve, to absorb the expected credit losses. The actual losses
could be more or less than the amount estimated by management at the time
of securitization. Therefore, we monitor the delinquencies and losses on
the underlying mortgage loans backing our ARM securities. If the credit
performance of the underlying mortgage loans is not as expected, we make a
provision for additional probable credit losses at a level deemed
appropriate by management to provide for estimated losses inherent in our
ARM securities portfolio. Any such provision is based on management's
assessment of numerous factors affecting our portfolio of ARM assets
including, but not limited to, current economic conditions, delinquency
status, credit losses to date on underlying mortgages and remaining credit
protection. The basis adjustment for ARM securities is made by reducing
the cost basis of the individual security for the decline in fair value,
which is other than temporary, and the amount of such write-down is
recorded as a realized loss, thereby reducing earnings.
- - Loan Securitization. For financial statement purposes, we do not account
for any of our loan securitizations as sales since we retain the
beneficial and economic interests of the loans. Since the securitizations
of our loans are not accounted for as sales, we do not record any
servicing assets or liabilities as a result of this process.
- - Revenue Recognition. Interest income on ARM assets is a combination of
accruing interest based on the outstanding balance and contractual terms
of the assets and the amortization of yield adjustments using generally
accepted interest methods, principally the amortization of purchase
premiums and discounts. Premiums and discounts associated with the
purchase of ARM assets are amortized into interest income over the lives
of the assets using the effective yield method adjusted for the effects of
estimated prepayments. Estimating prepayments and estimating the remaining
lives of our ARM assets requires management judgment, which involves
consideration of possible future interest rate environments and an
estimate of how borrowers will behave in those environments. The actual
lives could be more or less than the amount estimated by management at the
time of purchase of the ARMs.
For additional information on our significant accounting policies, see Note 1 to
the Consolidated Financial Statements.
23
GENERAL
We are a single-family residential mortgage lender that originates, acquires and
retains investments in ARM assets comprised of traditional ARM securities and
ARM loans and hybrid ARM securities and loans, thereby providing capital to the
single-family residential housing market. Traditional ARM securities and loans
have interest rates that reprice in a year or less ("Traditional ARMs") and
hybrid ARM securities and loans have a fixed interest rate for an initial
period, generally three to ten years, and then convert to Traditional ARMs for
their remaining terms to maturity ("Hybrid ARMs"). ARM securities represent
interests in pools of ARM loans, which are publicly rated and include guarantees
or other credit enhancements against losses from loan defaults.
While we are not a bank or savings and loan institution, our business purpose,
strategy, method of operation and risk profile are best understood in comparison
to such institutions. We finance the purchases and originations of our ARM
assets with equity capital and borrowings such as reverse repurchase agreements,
whole loan financing facilities, long-term secured debt and other secured or
unsecured financings that we may establish with approved institutional lenders.
We consistently operate with an equity-to-asset ratio of greater than 8% based
on historical cost (excluding other comprehensive income) and generally
averaging 9%. Since all of the assets we hold are ARM assets and we pursue a
matched funding strategy, we believe our exposure to changes in interest rates
can be prudently managed. Moreover, we focus on acquiring primarily high quality
assets to ensure our access to financing. Similarly, we maintain strict credit
underwriting standards and have experienced cumulative credit losses of only
$174,000 on our loan portfolio over the last five years. Our lean operating
structure has resulted in operating costs well below those of our peers. We
believe our corporate structure differs from most lending institutions in that
we are organized for tax purposes as a real estate investment trust ("REIT")
and, therefore, substantially all of our earnings are paid in the form of
dividends to shareholders, without paying federal or state income tax at the
corporate level. We have five qualified REIT subsidiaries, all of which are
consolidated in our financial statements and federal and state income tax
returns. Two of these subsidiaries, Thornburg Mortgage Funding Corporation and
Thornburg Mortgage Acceptance Corporation, are involved in financing our
mortgage loan assets. Thornburg Mortgage Home Loans, Inc. ("TMHL"), our wholly
owned mortgage-banking subsidiary, conducts our mortgage loan acquisition,
origination, processing, underwriting, securitization, and servicing activities.
TMHL's two wholly owned special purpose subsidiaries, Thornburg Mortgage Funding
Corporation II and Thornburg Mortgage Acceptance Corporation II, facilitate the
financing of loans by TMHL.
We are an externally advised REIT and are managed under a management agreement
(the "Management Agreement") with Thornburg Mortgage Advisory Corporation (the
"Manager"), which manages our operations, subject to the supervision of our
Board of Directors.
Portfolio Strategies
Our business strategy is to acquire and originate ARM assets to hold in our
portfolio, fund them using equity capital and borrowed funds, and generate
earnings from the difference or spread between the yield on our assets and our
cost of borrowing. We originate ARM loans for our portfolio through our
correspondent lending program, which currently includes approximately 100
approved correspondents, and we originate loans direct to consumers through
TMHL. Currently, TMHL is authorized to lend in 43 states and the District of
Columbia. Additionally, we acquire ARM assets by purchasing ARM securities or
large packages of ARM loans that other mortgage lending institutions have
originated and serviced. We believe that diversifying our sources for ARM loans
and ARM securities will enable us to consistently find attractive opportunities
to acquire or create high quality assets at attractive yields and spreads for
our portfolio.
In addition to our direct origination efforts, we acquire ARM assets from
investment banking firms, broker-dealers and similar financial institutions that
regularly make markets in these assets. We also acquire ARM assets from other
mortgage suppliers, including mortgage bankers, banks, savings and loans,
investment banking firms, home builders and other firms involved in originating,
packaging and selling mortgage loans. We believe we have a competitive advantage
in the acquisition and investment of these mortgage securities and loans due to
the low cost of our operations relative to traditional mortgage investors, such
as banks and savings and loans.
We have a focused portfolio lending investment policy designed to minimize
credit risk and interest rate risk. Our mortgage assets portfolio may consist of
ARM pass-through securities guaranteed by an agency of the federal
24
government ("Ginnie Mae"), a government-sponsored corporation or
federally-chartered corporation ("Fannie Mae" or "Freddie Mac"), or privately
issued (generally publicly registered) ARM pass-through securities, multi-class
pass-through securities, floating rate classes of collateralized mortgage
obligations ("CMOs"), ARM loans, fixed rate mortgage-backed securities ("MBS")
with an expected duration of one year or less or short-term investments that
either mature within one year or have an interest rate that reprices within one
year. Agency securities ("Agency Securities") are MBS for which a U.S.
Government agency or a government-sponsored or federally chartered corporation,
such as Ginnie Mae, Fannie Mae or Freddie Mac, guarantees payments of principal
or interest on the certificates. Agency Securities are not rated, but carry an
implied AAA rating.
Our ARM assets also include investments in Hybrid ARM assets, which are
typically 30-year loans with a fixed rate of interest for an initial period,
generally 3 to 10 years, and then convert to an adjustable rate for the balance
of their term. In April 2003, our Board of Directors increased the limitation on
our ownership of Hybrid ARM assets with fixed rate periods of greater than five
years from 10% to 20% of our total assets. We also have a policy to fund our
Hybrid ARM assets with fixed rate borrowings such that the net duration of
Hybrid ARM assets and the corresponding borrowings and hedges is one year or
less. We use Swap Agreements and Eurodollar Transactions as hedges to fix the
interest rates on our short-term borrowing costs.
Our investment policy requires that we invest at least 70% of total assets in
High Quality ARM assets and short-term investments. High Quality means:
(1) Agency Securities; or
(2) securities which are rated within one of the two highest rating
categories by at least one of either Standard & Poor's Corporation
or Moody's Investors Service, Inc. (the "Rating Agencies"); or
(3) securities that are unrated or whose ratings have not been updated
but are determined to be of comparable quality (by the rating
standards of at least one of the Rating Agencies) to a High Quality
rated mortgage security, as determined by the Manager and approved
by our Board of Directors; or
(4) the portion of ARM loans that have been deposited into a trust and
have received a credit rating of AA or better from at least one
Rating Agency.
The remainder of our ARM portfolio, comprising not more than 30% of total
assets, may consist of Other Investment assets, which may include:
(1) adjustable or variable rate pass-through certificates, multi-class
pass-through certificates or CMOs backed by loans on single-family,
multi-family, commercial or other real estate-related properties so
long as they are rated at least Investment Grade at the time of
purchase. "Investment Grade" generally means a security rating of
BBB or Baa or better by at least one of the Rating Agencies; or
(2) ARM loans collateralized by first liens on single-family residential
properties, generally underwritten to "A" quality standards, and
acquired for the purpose of future securitization; or
(3) fixed rate mortgage loans collateralized by first liens on single
family residential properties originated for sale to third parties;
or
(4) real estate properties acquired as a result of foreclosing on our
ARM loans; or
(5) as authorized by our Board of Directors, ARM securities rated less
than Investment Grade that are created as a result of our loan
acquisition and securitization efforts or are acquired as part of a
loan securitization effected by third parties in which we purchase
all of the classes of the loan securitization and that equal an
amount no greater than 17.5% of shareholders' equity, measured on a
historical cost basis.
To mitigate the adverse effect of an increase in prepayments on our ARM assets,
we emphasize the purchase of ARM assets at prices close to or below par. We
amortize any premiums paid for our assets over their expected lives using the
level yield method of accounting. To the extent that the prepayment rate on our
ARM assets differs from expectations, our net interest income will be affected.
Prepayments generally increase when mortgage interest rates fall below the
interest rates on ARM loans. To the extent there is an increase in prepayment
rates, resulting in a shortening of the expected lives of our ARM assets, our
net income and, therefore, the amount available for dividends could be adversely
affected. Our portfolio of ARM assets is held at a book price, excluding
unrealized gains and losses, of 101.03% of par at March 31, 2003. The book
price, including unrealized gains and losses, was 101.44% at March 31, 2003,
compared to 101.45% at December 31, 2002.
25
We believe that our status as a mortgage REIT makes an investment in our equity
securities attractive for tax-exempt investors, such as pension plans, profit
sharing plans, 401(k) plans, Keogh plans and Individual Retirement Accounts. We
do not invest in real estate mortgage investment conduit ("REMIC") residuals or
other CMO residuals that would result in the creation of excess inclusion income
or unrelated business taxable income.
Acquisition, Securitization and Retention of Traditional ARM and Hybrid ARM
Loans
We acquire and originate High Quality mortgage loans through TMHL from three
sources: (i) correspondent lending, which involves acquiring individual loans
from correspondent lenders or other loan originators who originate the
individual loans using our underwriting criteria and guidelines, or criteria and
guidelines that we have approved, (ii) direct retail loan originations, which
are loans that we originate, and (iii) bulk acquisitions, which involve
acquiring pools of whole loans, which are originated using the seller's
guidelines and underwriting criteria. The loans we acquire or originate are
financed through warehouse borrowing arrangements and securitized for our
portfolio, or, in the case of fixed rate loans, sold to third parties.
The loans acquired or originated by TMHL are first lien, single-family
residential Traditional ARM and Hybrid ARM loans with original terms to maturity
of not more than forty years and are either fully amortizing or are interest
only up to ten years, and fully amortizing thereafter. Interest-only loans
acquired or originated during the first quarter of 2003 represented 90.4% of
total loan production during that period. We believe interest-only loans do not
pose additional credit risk due to original effective loan-to-value ratios
averaging 66.5% and the credit strength of our borrowers.
All ARM loans that we acquire for our portfolio bear an interest rate tied to an
interest rate index. Most loans have periodic and lifetime constraints on how
much the loan interest rate can change on any predetermined interest rate reset
date. In general, the interest rate on each Traditional ARM loan resets monthly,
semi-annually or annually. The Traditional ARM loans generally adjust to a
margin over a U.S. Treasury index or a LIBOR index. The Hybrid ARM loans have a
fixed rate for an initial period, generally 3 to 10 years, and then convert to
Traditional ARM loans for their remaining term to maturity.
We acquire ARM loans for our portfolio with the intention of securitizing them
into pools of High Quality ARM securities and retaining them in our portfolio.
In order to facilitate the securitization of our loans, we generally create
subordinate certificates, which provide a specified amount of credit
enhancement. Upon securitization, we hold the High Quality ARM securities and
the subordinate certificates in our portfolio and then finance them in the
repurchase agreement market or through the issuance of securities in the capital
markets. Our investment policy limits the amount we may hold in our portfolio of
these below Investment Grade subordinate certificates, and subordinate classes
that we purchase in connection with a whole pool securitization effected by
third parties, to 17.5% of shareholders' equity, measured on a historical cost
basis.
We believe the acquisition and origination of ARM loans for securitization
benefits us by providing: (i) greater control over the quality and types of ARM
assets acquired; (ii) the ability to acquire ARM assets at lower prices, so that
the amount of the premium to be amortized will be reduced in the event of
prepayment; (iii) additional sources of new whole-pool ARM assets; and (iv)
generally higher yielding investments in our portfolio.
We offer a loan modification program on all loans we originate and certain loans
we acquire. We believe this program promotes customer retention and reduces loan
prepayments. Under the terms of this program, a borrower may choose to pay a fee
and modify the mortgage loan to any then-available hybrid or adjustable-rate
product that we offer at the offered interest rate plus 1/8%, at any time during
the life of the loan.
Financing Strategies
We finance our purchased or securitized ARM assets using equity capital and
borrowings, such as reverse repurchase agreements, lines of credit, and other
secured or unsecured financings that we may establish with approved
institutional lenders. We have established lines of credit and collateralized
financing agreements with twenty-three different financial institutions. We
generally expect to maintain an equity-to-assets ratio of between 8% and 10%, as
measured on a historical cost basis. This ratio may vary from time to time
within the above stated
26
range depending upon market conditions and other factors that our management
deems relevant, but cannot fall below 8% without the approval of our Board of
Directors.
We borrow primarily at short-term interest rates and in the form of reverse
repurchase agreements using our ARM securities as collateral. Reverse repurchase
agreements involve a simultaneous sale of pledged assets to a lender at an
agreed-upon price in return for the lender's agreement to resell the same assets
back to us at a future date (the maturity of the borrowing) at a higher price.
The price difference is the cost of borrowing under these agreements. We
generally enter into two types of reverse repurchase agreements: variable rate
term reverse repurchase agreements and fixed rate reverse repurchase agreements.
Variable rate term reverse repurchase agreements are financings with original
maturities ranging from six to 24 months. The interest rates on these variable
rate term reverse repurchase agreements are indexed to either the one- or
three-month LIBOR rate, and reprice accordingly. The fixed rate reverse
repurchase agreements have original maturities generally ranging from 30 to 180
days. Generally, upon repayment of each reverse repurchase agreement, we
immediately pledge the ARM assets used to collateralize the financing to secure
a new reverse repurchase agreement.
We have also financed the purchase of ARM assets by issuing long-term secured
debt obligations and collateralized notes in the capital markets, which are
collateralized by securitized pools of our ARM assets that are placed in a
trust. The trust pays the principal and interest payments on the debt out of the
cash flows received on the collateral. Using such a structure enables us to
issue debt that will not be subject to margin calls once the long-term secured
debt obligation has been issued.
We also enter into financing facilities for whole loans. A whole loan is the
actual mortgage loan evidenced by a note and secured by a mortgage or deed of
trust. We use these credit lines to finance our acquisition of whole loans while
we are accumulating loans for securitization.
Hedging Strategies
We attempt to mitigate our interest rate risk by funding our ARM assets with
borrowings whose maturities approximately match the interest rate adjustment
periods on our ARM assets. Accordingly, some of our borrowings have variable
interest rates or short term fixed maturities (one year or less) because, as of
March 31, 2003, 24.9% of our ARM assets were Traditional ARMs, which had
interest rates that adjust within one year. However, for the remaining portion
of our portfolio comprised of Hybrid ARM assets, which generally have fixed
interest rate periods of 3 to 10 years and, as of March 31, 2003, averaged a
4.1-year fixed rate period, we utilize Swap Agreements and Eurodollar
Transactions to, in effect, extend the fixed-rate of interest of our borrowings
such that the net duration of our Hybrid ARM assets and fixed-rate borrowings
and hedges funding our Hybrid ARM assets is no more than one year. By
maintaining a net duration of less than one year, we expect the net market value
change of our Hybrid ARM portfolio and associated fixed-rate liabilities and
hedging instruments to be no more than 1.00% for a 1.00% change in interest
rates. A lower duration indicates a lower expected volatility of earnings given
future changes in interest rates. We generally accomplish this fixed-rate
maturity extension through the use of Swap Agreements and Eurodollar
Transactions. When we enter into a Swap Agreement, we generally agree to pay a
fixed rate of interest and to receive a variable interest rate, generally based
on LIBOR. We enter into Eurodollar Transactions in order to hedge changes in our
forecasted three-month LIBOR based liabilities. These Swap Agreements and
Eurodollar Transactions have the effect of converting our short-term borrowings
into fixed-rate borrowings over the life of the Swap Agreements and Eurodollar
Transactions. As of March 31, 2003, our current Swap Agreements and Eurodollar
Transactions that hedged the financing of Hybrid ARM assets had a remaining
average fixed rate term to maturity of 2.7 years and a duration mismatch of
approximately 2 months, which is in compliance with our hedging policy.
In general, ARM assets have a maximum lifetime interest rate cap, or ceiling,
meaning that each ARM asset contains a contractual maximum interest rate. Since
our borrowings are not subject to equivalent interest rate caps, we have entered
into Cap Agreements, which have the effect of offsetting a portion of our
borrowing costs above a specified level so that the net margin on our ARM assets
will be protected in high interest rate environments. A Cap Agreement is a
contractual agreement for which we pay a fee, which may at times be financed,
typically to either a commercial bank or investment banking firm. Pursuant to
the terms of the Cap Agreements owned as of March 31, 2003, we will receive cash
payments if the applicable index, generally the three- or six-month LIBOR index,
increases above certain specified levels, which range from 6.00% to 12.00% and
average 9.73%. The fair value of
27
these Cap Agreements generally increases when general market interest rates
increase and decreases when market interest rates decrease, helping to partially
offset changes in the fair value of our ARM assets related to the effect of the
lifetime interest rate cap.
In addition, some ARM assets are subject to periodic caps. Periodic caps
generally limit the maximum interest rate coupon change on any interest rate
coupon adjustment date to either a maximum of 1.00% per semiannual adjustment or
2.00% per annual adjustment. The borrowings that we incur do not have similar
periodic caps. We do not hedge against the risk of our borrowing costs rising
above the periodic interest rate cap level on the ARM assets because the
contractual future interest rate adjustments on the ARM assets will cause their
interest rates to increase over time and reestablish the ARM assets' interest
rate to a spread over the then current index rate. As of March 31, 2003, $1.8
billion of our Traditional ARM securities and Traditional ARM loans have
periodic caps, representing 15.0% of total ARM assets.
We may enter into other hedging-type transactions designed to protect our
borrowing costs or portfolio yields from interest rate changes. We may also
purchase "interest only" mortgage derivative assets or other mortgage derivative
products for purposes of mitigating risk from interest rate changes, although we
have not, to date, entered into these types of transactions. We may also use
from time to time futures contracts and options on futures contracts on the
Eurodollar, Federal Funds, Treasury bills and Treasury notes and similar
financial instruments.
The hedging transactions that we currently use generally are designed to protect
our net interest income during periods of changing market interest rates. We do
not hedge for speculative purposes. Further, no hedging strategy can completely
insulate us from risk, and certain of the federal income tax requirements that
we must satisfy to qualify as a REIT may limit our ability to hedge,
particularly with respect to hedging against periodic cap risk. We carefully
monitor and may have to limit our hedging strategies to ensure that we do not
realize excessive hedging income or hold hedging assets having excess value in
relation to total assets.
FINANCIAL CONDITION
At March 31, 2003, we held total assets of $12.4 billion, $12.0 billion of which
consisted of ARM assets, as compared to $10.5 billion of total assets and $10.3
billion of ARM assets at December 31, 2002. Since commencing operations, we have
primarily purchased either ARM securities (backed by agencies of the U.S.
government or federally chartered corporations or privately-issued, generally
publicly registered, mortgage assets, most of which are rated AA or higher by at
least one of the Rating Agencies), or ARM loans generally originated to "A"
quality underwriting standards. At March 31, 2003, 89.4% of our assets,
including cash and cash equivalents, were High Quality assets, far exceeding our
investment policy minimum requirement of investing at least 70% of our total
assets in High Quality ARM assets and cash and cash equivalents. Of the ARM
assets we owned as of March 31, 2003, 96.9% were in the form of adjustable rate
pass-through certificates or ARM loans. The remainder were floating rate classes
of CMOs (2.0%), or investments in floating rate classes of CBOs (1.1%) backed
primarily by ARM MBS.
28
The following table presents a schedule of ARM assets owned at March 31, 2003
and December 31, 2002 classified by High Quality and Other Investment assets and
further classified by type of issuer and by ratings categories:
ARM ASSETS BY ISSUER AND CREDIT RATING
(Dollar amounts in thousands)
March 31, 2003 December 31, 2002
--------------------------------- ---------------------------------
Carrying Portfolio Carrying Portfolio
Value Mix Value Mix
----------- ----------- ----------- -----------
HIGH QUALITY:
Agency Securities $ 2,571,004 21.4% $ 2,682,555 26.0%
Privately Issued:
AAA/Aaa Rating 7,747,637(1) 64.5 6,409,860(1) 62.0
AA/Aa Rating 377,966 3.2 394,096 3.8
----------- ----------- ----------- -----------
Total Privately Issued 8,125,603 67.7 6,803,956 65.8
----------- ----------- ----------- -----------
----------- ----------- ----------- -----------
Total High Quality 10,696,607 89.1 9,486,511 91.8
----------- ----------- ----------- -----------
OTHER INVESTMENT:
Privately Issued:
A Rating 77,861 0.6 63,198 0.6
BBB/Baa Rating 36,416 0.3 31,657 0.3
BB/Ba Rating and Other 46,181(1) 0.4 44,060(1) 0.4
ARM loans pending securitization 1,152,372(2) 9.6 709,787 6.9
----------- ----------- ----------- -----------
Total Other Investment 1,312,830 10.9 848,702 8.2
----------- ----------- ----------- -----------
Total ARM Portfolio $12,009,437 100.0% $10,335,213 100.0%
=========== =========== =========== ===========
- ----------
(1) The AAA Rating category includes $261.3 million of whole loans as of
December 31, 2002 that have been credit enhanced to AAA by a combination
of an insurance policy purchased from a third party and an unrated
subordinated certificate retained in the amount of $31.7 million as of
December 31, 2002. The subordinated certificate is included in the BB/Ba
Rating and Other category. In connection with the AAA collateralized notes
payable called on January 25, 2003, the underlying collateral is not
included in the above table as of March 31, 2003.
(2) On April 3, 2003, approximately $801.0 million of ARM loans pending
securitization were transferred to Thornburg Mortgage Securities Trust
2003-2 and were securitized. Also included in the April 3, 2003
securitization were $259.9 million of ARM loans, which had collateralized
the AAA notes called on January 25, 2003.
As of March 31, 2003 and December 31, 2002, we had reduced the carrying value of
our securitized ARM loans by $15.2 million and $13.8 million, respectively, due
to estimated credit losses (other than temporary declines in fair value). In
addition, we had reduced the cost basis of other ARM securities by $1.3 million
and $858.8 thousand, as of the same dates, respectively, related to Other
Investments that we purchased at a discount that included an estimate of credit
losses.
As of March 31, 2003, 10 of the 11,252 loans in our ARM loan portfolio were
considered seriously delinquent (60 days or more delinquent) and had an
aggregate balance of $4.8 million. At March 31, 2002, the ARM loan portfolio
included no real estate-owned properties that we acquired as the result of
foreclosure procedures. The average original effective loan-to-value ratio on
the delinquent loans was approximately 64%. We believe that our current level of
basis adjustments and allowance for loan losses is more than adequate to cover
estimated losses from these loans and properties.
29
The following table presents a summary of the basis adjustments on our
securitized ARM loans, the basis adjustments on our purchased ARM securities and
the allowance for losses on our ARM loans (dollar amounts in thousands):
Allowance for
Basis Adjustments Losses
---------------------------------------- --------------
Thornburg
Securitized Purchased ARM
ARM Loans Securities ARM Loans Total
----------- -------------- --------- --------------
Balance, December 31, 2002 $13,764 $ 859 $100 $ 14,723
Basis adjustment recorded at
time of loan securitization
or security acquisition 1,462 436 -- 1,898
Charge-offs -- (49) -- (49)
Recoveries -- 53 -- 53
------- ------- ---- --------
Balance, March 31, 2003 $15,226 $ 1,299 $100 $ 16,625
======= ======= ==== ========
The following table classifies our portfolio of ARM and short-term mortgage
assets by type of interest rate index:
ARM AND SHORT-TERM MORTGAGE ASSETS BY INDEX
(Dollar amounts in thousands)
March 31, 2003 December 31, 2002
------------------------------ ------------------------------
Carrying Portfolio Carrying Portfolio
Value Mix Value Mix
----------- ----------- ----------- -----------
TRADITIONAL ARM ASSETS:
INDEX:
One-month LIBOR $ 450,137 3.8% $ 576,837 5.6%
Three-month LIBOR 124,693 1.0 187,624 1.8
Six-month LIBOR 1,067,368 8.9 834,709 8.1
Six-month Certificate of Deposit 84,373 0.7 93,064 0.9
Six-month Constant Maturity Treasury 4,980 0.0 10,752 0.1
One-year Constant Maturity Treasury 1,204,211 10.0 1,095,945 10.6
Cost of Funds 57,845 0.5 68,165 0.6
----------- ----------- ----------- -----------
2,993,607 24.9 2,867,096 27.7
----------- ----------- ----------- -----------
HYBRID ARM ASSETS 9,015,830 75.1 7,468,117 72.3
----------- ----------- ----------- -----------
$12,009,437 $10,335,213
=========== =========== =========== ===========
The ARM portfolio had a current weighted average coupon of 4.81% at March 31,
2003. This consisted of an average coupon of 5.04% on the Hybrid ARM portion of
the portfolio and an average coupon of 3.93% on the Traditional ARM portion of
the portfolio. If the portfolio had been "fully indexed," the weighted average
coupon of the portfolio would have been approximately 4.66%, based upon the
current composition of the portfolio and the applicable indices. Additionally,
if the Traditional ARM portion of the portfolio had been "fully indexed," the
weighted average coupon of that portion of the portfolio would have been
approximately 3.31%, also based upon the current composition of the portfolio
and the applicable indices. The term "fully indexed" refers to an ARM asset that
has an interest rate that is currently equal to its applicable index plus a
margin to the index that is specified by the terms of the ARM asset. The average
interest rate on the total portfolio is expected to decrease during 2003 until
it reaches the "fully indexed" rate.
As of December 31, 2002, the ARM portfolio had a current weighted average coupon
of 4.99%. This consisted of an average coupon of 5.23% on the Hybrid ARM portion
of the portfolio and an average coupon of 4.27% on the rest of the portfolio. If
the Traditional ARM portion of the portfolio had been "fully indexed," the
weighted average coupon of the ARM portfolio would have been approximately
4.82%, based upon the composition of the portfolio and the applicable indices at
that time.
30
At March 31, 2003, the current yield of the ARM assets portfolio was 4.35%,
compared to 4.63% as of December 31, 2002. The decrease in the yield of 0.28% as
of March 31, 2003, compared to December 31, 2002, is due to the decreased
weighted average interest rate coupon discussed above, which decreased by 0.18%
and a higher level of net premium amortization, which had the effect of
decreasing the yield by 0.06%. Additionally, the relative level of non-interest
earning principal payments receivables also decreased the portfolio yield by
0.04%.
The ARM asset portfolio had an average term to the next repricing date of 3.2
years as of March 31, 2003, compared to 2.8 years as of December 31, 2002. The
Traditional ARM asset portion of the portfolio had an average term to the next
repricing date of 71 days and the Hybrid ARM asset portion had an average term
to the next repricing date of 4.1 years at March 31, 2003. As of March 31, 2003,
Hybrid ARM assets comprised 75.1% of the total ARM asset portfolio, compared to
72.3% as of the end of 2002.
31
The following table presents various characteristics of our Traditional ARM and
Hybrid ARM loan portfolio as of March 31, 2003. This information pertains to
loans held for securitization, loans held as collateral for notes payable and
loans securitized for our own portfolio for which we retained credit loss
exposure. The combined amount of the loans included in this information is $4.6
billion.
TRADITIONAL ARM AND HYBRID ARM LOAN PORTFOLIO CHARACTERISTICS
Average High Low
-------- ---------- -------
Original loan balance $419,337 $6,000,000 $31,000
Unpaid principal balance $465,952 $6,000,000 $ 273
Coupon rate on loans 5.01% 9.13% 1.78%
Pass-through rate 4.82% 8.73% 1.76%
Pass-through margin 1.91% 3.48% 0.23%
Lifetime cap 11.11% 18.00% 6.00%
Original term (months) 359 480 168
Remaining term (months) 343 479 40
Geographic distribution (top 5 states): Property type:
California 25.8% Single-family 86.3%
Georgia 14.0 Condominium 8.4
Colorado 7.6 Other residential 5.3
New York 6.5
Florida 5.0
ARM Interest Rate Caps:
Occupancy status: Initial Cap on Hybrid loans:
Owner occupied 85.8% 3.00% or less 5.4%
Second home 11.6 3.01%-4.00% 14.1
Investor 2.6 4.01%-5.00% 35.3
5.01%-6.00% 12.7
Documentation type: Periodic Cap on Traditional ARM
Full/Alternative 93.8% loans:
Other 6.2 None 18.2%
1.00% or less 11.6
Over 1.00% 2.7
Loan purpose:
Purchase 32.1%
Cash out refinance 29.5 Percent of loan balances that
Rate & term refinance 38.4 are interest only: 80.6% (1)
Effective original FICO scores:
loan-to-value: 801 and over 2.6%
90.01% and over (3) 0.7% 751 to 800 40.6
80.01%-90.00% (3) 2.0 701 to 750 34.4
70.01%-80.00% 39.5 651 to 700 18.7
60.01%-70.00% 25.4 601 to 650 3.2
50.01%-60.00% 13.9 600 or less 0.5
50.00% or less 18.5
Average effective original Average FICO score 737 (2) 66.6%
loan-to-value:
(1) The average effective original loan-to-value on interest only loans is
66.5%.
(2) FICO is a credit score, ranging from 300 to 850, based upon the credit
evaluation methodology developed by Fair, Isaac and Company, a consulting
firm specializing in creating credit evaluation models.
(3) All loans with an effective original loan-to-value ratio over 80% have
mortgage insurance.
32
As of March 31, 2003 and December 31, 2002, we serviced $2.6 billion and $2.0
billion of our loans, respectively, and had 6,017 and 4,778 customer
relationships, respectively. We hold all of the loans that we service in our
portfolio in the form of securitized loans or loans to be securitized for our
portfolio. We have not retained or capitalized any servicing rights on loans
sold.
During the quarter ended March 31, 2003, we purchased $1.6 billion of ARM
securities, 99.3% of which were High Quality assets, and $1.2 billion of ARM
loans, generally originated to "A" quality underwriting standards. Of the ARM
assets acquired during the three months ended March 31, 2003, 88.9% were Hybrid
ARM assets, 11.0% were indexed to LIBOR and less than 1% were indexed to U.S.
Treasury bill rates. The following table compares our ARM asset acquisition and
origination activity for the consecutive quarters ended March 31, 2003 and
December 31, 2002 (dollar amounts in thousands):
For the quarters ended:
----------------------------------
March 31, 2003 December 31, 2002
-------------- -----------------
ARM SECURITIES:
Agency Securities $ 193,008 $ 425,668
High Quality, privately issued 1,440,240 1,014,293
Other privately issued 12,292 --
---------- ----------
1,645,540 1,439,961
---------- ----------
LOANS:
Bulk acquisitions 341,423 114,615
Correspondent purchases 762,850 686,195
Direct retail originations 100,216 144,025
---------- ----------
1,204,489 944,835
---------- ----------
Total production $2,850,029 $2,384,796
========== ==========
Since 1997, we have emphasized purchasing Traditional ARM and Hybrid ARM assets,
high quality, floating rate collateralized mortgages and short term, fixed rate
securities at substantially lower prices relative to par in order to reduce the
potential impact of rapid prepayments. In doing so, the average
premium/(discount) that we paid for ARM assets acquired in the first three
months of 2003 and for the year 2002 was 0.92% and 0.86% of par, respectively,
as compared to 3.29% of par in 1997 when we emphasized the purchase of seasoned
ARM assets. In part, as a result of this strategy, the book price of our ARM
assets, excluding unrealized gains and losses, was 101.03% of par as of March
31, 2003, down from 102.77% of par as of the end of 1997. The book price,
including unrealized gains and losses, was 101.44% at March 31, 2003, compared
to 101.45% at December 31, 2002.
During the quarter ended March 31, 2003, we securitized $774.5 million of our
ARM loans into a series of privately issued multi-class ARM securities, all of
the economic classes of which we retained for our ARM portfolio. We securitize
the ARM loans that we acquire into ARM securities for our own portfolio in order
to reduce the cost of financing the portfolio and in order to enhance the high
quality and highly liquid characteristics of our portfolio, thereby improving
our access to mortgage finance markets. In doing so, we retain all of the
economic interest and risk of the loans. Of the loans that we securitized during
the first quarter of 2003, 99.8% were rated at least Investment Grade and 0.2%
were related below Investment Grade and provided credit support to the
Investment Grade securities.
On January 25, 2003, we called the collateralized notes, which had an
outstanding balance of $255.4 million at December 31, 2002. We re-securitized
the mortgage loans collateralizing these notes payable in a new loan
securitization in April 2003 and continue to hold these assets in our portfolio.
As of March 31, 2003, we had commitments to purchase $331.2 million of ARM
securities, $202.3 million of ARM loans through wholesale channels and $568.7
million of ARM loans through retail channels.
33
We sold $50.1 million of ARM securities for no gain or loss during the quarter
ended March 31, 2002. In addition, we sold $3.7 million of loans for a gain of
$3.0 thousand. There were no sales of ARM assets during the quarter ended March
31, 2003.
For the quarter ended March 31, 2003, our mortgage assets paid down at an
approximate average annualized Constant Paydown Rate ("CPR") of 32%, compared to
34% for the quarter ended March 31, 2002 and 37% for the quarter ended December
31, 2002. When prepayment experience increases, we have to amortize our premiums
over a shorter time period, resulting in a reduced yield to maturity on our ARM
assets. Conversely, if actual prepayment experience decreases, we would amortize
the premium over a longer time period, resulting in a higher yield to maturity.
We monitor our prepayment experience on a monthly basis in order to adjust the
amortization of the net premium, as appropriate.
The amount of the adjustment to the fair value on the ARM assets classified as
available-for-sale improved from a positive adjustment of $44.7 million as of
December 31, 2002, to a positive adjustment of $48.5 million as of March 31,
2003. All of our ARM securities are classified as available-for-sale and are
carried at their fair value.
Our ARM assets generally have a maximum lifetime interest rate cap or ceiling,
meaning that each ARM asset contains a contractual maximum interest rate. Since
our borrowings are not subject to equivalent interest rate caps, we have entered
into Cap Agreements that have the effect of offsetting a portion of our
borrowing costs above a specified level so that the net margin on our ARM assets
will be protected in high interest rate environments. As of March 31, 2003, our
ARM assets had an average lifetime interest rate cap of 11.60%, far exceeding
the current level of interest rates. At March 31, 2003, our Cap Agreements had a
remaining notional balance of $1.2 billion with an average final maturity of 1.2
years, compared to a remaining notional balance of $1.8 billion with an average
final maturity of 1.0 year at December 31, 2002. At March 31, 2003, the fair
value of our Cap Agreements was $74.1 thousand compared to a fair value of $84.7
thousand as of December 31, 2002. Pursuant to the terms of the Cap Agreements,
we will receive cash payments if the one month or three month LIBOR indices
increase above certain specified levels, which range from 6.00% to 12.00% and
average approximately 9.73%. Due to the current low level of interest rates, we
have decided not to purchase additional Cap Agreements at this time, but will
reevaluate this policy on an ongoing basis.
We enter into interest rate Swap Agreements and Eurodollar Transactions in order
to manage our interest rate exposure when financing our ARM assets. We generally
borrow money based on short term interest rates, either by entering into short
term fixed-rate borrowings with maturity terms ranging from one month to three
months, or by entering into variable-rate borrowings with longer maturity terms
of six months to two years that reprice based on a frequency ranging from one
month to three months. Our Traditional ARM assets generally have interest rates
that reprice based on frequency terms of one to twelve months. Our Hybrid ARM
assets generally have an initial fixed interest rate period of three to ten
years. As a result, our existing and forecasted borrowings reprice to a new
interest rate on a more frequent basis than these ARM assets. When we enter into
a Swap Agreement, we agree to pay a fixed rate of interest and to receive a
variable interest rate based on LIBOR. We generally enter into Swap Agreements
and Eurodollar transactions that have notional balances that decline over time
in approximate relation to the expected paydown of our Hybrid ARM assets. Both
Swap Agreements and Eurodollar Transactions have the effect of converting our
variable rate debt into fixed rate debt over the life of the Swap Agreements and
Eurodollar Transactions. We use Swap Agreements and Eurodollar Transactions as a
cost effective way to lengthen the average repricing period of our variable rate
and short term borrowings such that the duration of our borrowings more closely
matches the duration of our ARM assets. The relative balances and duration of
our Hybrid ARM assets and our Swap Agreements and Eurodollar Transactions are
monitored on a continual basis in order to manage the duration mismatch within
our policy limits.
As of March 31, 2003, we had entered into Swap Agreements and Eurodollar
Transactions that together had an aggregate current notional balance of $6.4
billion. In addition, we have also entered into a delayed Swap Agreement with a
notional balance of $500.0 million that becomes effective in August 2003. These
Swap Agreements and Eurodollar Transactions hedged our short-term financing
during the fixed interest rate period of the Hybrid ARM assets we held in our
portfolio and had a weighted average maturity of 2.7 years. The combined
weighted average fixed rate payable of the Swap Agreements and Eurodollar
Transactions was 3.46% and 3.74% at March 31, 2003 and December 31, 2002,
respectively. As a result of entering into these Swap Agreements and Eurodollar
Transactions, we have reduced the interest rate variability of our cost to
finance our Hybrid ARM assets. The
34
average remaining fixed rate term of our Hybrid ARM assets as of March 31, 2003
was 4.1 years. Furthermore, the net duration of Hybrid ARM assets and associated
borrowings, Swap Agreements and Eurodollar Transactions funding Hybrid ARM
assets, as of March 31, 2003, was approximately 2 months.
In accordance with Financial Accounting Standards No. 133 ("FAS 133"), we
designate all of these Swap Agreements as cash flow hedges and, as of March 31,
2003, carry them on the balance sheet as a liability with a fair value of $147.7
million including accrued interest. As of March 31, 2003, the fair value
adjustment for Swap Agreements was a decrease to "Accumulated other
comprehensive income" in the amount of $142.5 million. The Swap Agreements and
the short-term borrowings they hedge have nearly identical terms and
characteristics with respect to the applicable index and interest rate repricing
dates, and we have calculated the effectiveness of this cash flow hedge to be
approximately 100%. As a result, we have recorded all changes in the unrealized
gains and losses on Swap Agreements in "Accumulated other comprehensive income"
and we have reclassified all such changes to earnings as interest expense is
recognized on our hedged borrowings.
Also, in accordance with FAS 133, we designate all of the Eurodollar
Transactions as cash flow hedges and, as of March 31, 2003, carry them on the
balance sheet as a liability with a fair value of $11.0 million. The Eurodollar
Transactions hedge the change in the three-month LIBOR interest rate index and
we have also entered into short-term borrowings indexed to three-month LIBOR
with re-pricing dates that correspond to the valuation dates of the Eurodollar
Transactions. As a result, there has not been any measurable ineffectiveness
from this activity and, therefore, the gains and losses from this activity have
been recorded in "Accumulated other comprehensive income" and will be
reclassified to earnings as interest expense is recognized on our hedged
short-term borrowings.
RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 2003
For the quarter ended March 31, 2003, our net income was $39.1 million, or $0.67
per share, Basic and Diluted EPS, based on a weighted average of 55,631,000 and
58,391,000 shares outstanding, respectively. That compares to $24.3 million, or
$0.62 per share (Basic and Diluted EPS) for the quarter ended March 31, 2002,
based on a weighted average of 36,417,000 shares outstanding, an 8% increase in
our earnings per share.
The table below highlights the historical trend, the components of return on
average common equity (annualized) and the 10-year U.S. Treasury average yield
during each respective quarter that is applicable to the computation of the
performance fee of the Manager:
COMPONENTS OF RETURN ON AVERAGE COMMON EQUITY (1)
ROE in
10-Year Excess of
Net Provision Gain G & A Net US 10-Year
For the Interest Hedging For on ARM Expense Perform. Preferred Income/ Treasury US Treas.
Quarter Income/ Expense/ Losses/ Sales/ (2)/ Fee/ Dividend/ Equity Average Average
Ended Equity Equity Equity Equity Equity Equity Equity (ROE) Yield Yield
------- -------- ------- --------- ------ ------- -------- --------- ------- -------- ---------
Mar 31, 2001 17.40% 0.18% 0.22% -- 2.59% 1.12% 2.03% 11.24% 5.04% 6.21%
Jun 30, 2001 18.50% 0.55% 0.18% -- 2.81% 1.26% 1.97% 11.73% 5.28% 6.45%
Sep 30, 2001 21.36% 0.55% 0.25% -- 3.07% 1.76% 1.80% 13.94% 4.99% 8.95%
Dec 31, 2001 25.25% 0.19% 0.08% -- 3.51% 2.70% 1.46% 17.31% 4.76% 12.55%
Mar 31, 2002 23.16% 0.23% -- -- 2.80% 2.34% 1.22% 16.56% 5.08% 11.49%
Jun 30, 2002 22.53% 0.38% -- 0.05% 2.90% 2.27% 1.02% 16.01% 5.11% 10.90%
Sep 30, 2002 23.15% 0.09% -- 0.01% 2.56% 2.75% 0.91% 16.85% 4.27% 12.58%
Dec 31, 2002 23.05% 0.16% -- 0.39% 3.24% 2.74% 0.82% 16.49% 4.00% 12.48%
Mar 31, 2003 22.58% 0.08% -- -- 2.86% 2.68% 0.72% 16.23% 3.92% 12.31%
(1) Average common equity excludes unrealized gain (loss) on
available-for-sale ARM securities.
(1) General and administrative ("G & A") expense excludes performance fees and
is net of loan servicing fees.
Our return on average common equity was 16.23% for the quarter ended March 31,
2003 compared to 16.56% for the quarter ended March 31, 2002.
35
The following table presents the components of our net interest income:
COMPARATIVE NET INTEREST INCOME COMPONENTS
(Dollar amounts in thousands)
For the quarters ended March 31,
--------------------------------
2003 2002
--------- --------
Coupon interest income on ARM assets $ 129,983 $ 84,190
Amortization of net premium (7,187) (5,148)
Cash and cash equivalents 400 385
--------- --------
Interest income 123,196 79,427
--------- --------
Reverse repurchase agreements 35,429 26,530
AAA notes payable 585 2,626
Other borrowings 3,721 1,815
Swap Agreements and Eurodollar
Transactions 31,426 16,832
--------- --------
Interest expense 71,162 47,803
--------- --------
Net interest income $ 52,034 $ 31,624
========= ========
As presented in the table above, our net interest income increased by $20.4
million in the first quarter of 2003 compared to the first quarter of 2002. The
change was attributable to a $43.8 million increase in interest income primarily
due to an increased asset base, partially offset by a $23.4 million increase in
interest expense. Included in this increase in interest expense is a $14.6
million increase resulting from the impact of Swap Agreements and Eurodollar
Transactions which is commensurate with the increase in borrowings financing our
Hybrid ARM assets. Hybrid ARM assets totaled $9.0 billion and $3.8 billion at
March 31, 2003 and 2002, respectively.
The following table presents the average balances for each category of our
interest earning assets as well as our interest bearing liabilities, with the
corresponding annualized effective rate of interest and the related interest
income or expense:
AVERAGE BALANCE, RATE, INTEREST INCOME AND INTEREST EXPENSE TABLE
(Dollar amounts in thousands)
For the quarters ended March 31,
---------------------------------------------------------------------------------
2003 2002
---------------------------------------- -------------------------------------
Interest Interest
Average Effective Income and Average Effective Income and
Balance Rate Expense Balance Rate Expense
----------- ----------- ---------- ---------- ----------- ---------
Interest Earning Assets:
Adjustable-rate mortgage assets $11,013,679 4.46% $ 122,796 $6,326,564 5.00% $79,042
Cash and cash equivalents 132,120 1.21 400 95,158 1.62 385
----------- ----------- ---------- ---------- ----------- -------
11,145,799 4.42 123,196 6,421,722 4.95 79,427
----------- ----------- ---------- ---------- ----------- -------
Interest Bearing Liabilities:
Reverse repurchase agreements 9,330,058 2.87 66,855 5,144,702 3.37 43,362
Collateralized notes payable 68,737 3.41 585 405,069 2.59 2,626
Other borrowings 735,418 2.02 3,721 234,486 3.10 1,815
----------- ----------- ---------- ---------- ----------- -------
10,134,213 2.81 71,162 5,784,257 3.31 47,803
----------- ----------- ---------- ---------- ----------- -------
Net Interest Earning Assets and Spread $ 1,011,586 1.61% $ 52,034 $ 637,465 1.64% $31,624
=========== =========== ========== ========== =========== =======
Yield on Net Interest Earning Assets (1) 1.87% 1.97%
=========== ===========
(1) Yield on Net Interest Earning Assets is computed by dividing annualized
net interest income by the average daily balance of interest earning
assets.
36
The following table presents the total amount of change in interest
income/expense from the table above and presents the amount of change due to
changes in interest rates versus the amount of change due to changes in volume
(dollar amounts in thousands):
Three Months Ended March 31,
2003 versus 2002
-----------------------------------
Rate Volume Total
--------- --------- ---------
Interest Income:
ARM assets $ (8,505) $ 52,259 $ 43,754
Cash and cash equivalents (97) 112 15
--------- --------- ---------
(8,602) 52,371 43,769
--------- --------- ---------
Interest Expense:
Reverse repurchase agreements (6,497) 29,990 23,493
Collateralized notes 821 (2,862) (2,041)
Other borrowings (629) 2,535 1,906
--------- --------- ---------
(6,305) 29,663 23,358
--------- --------- ---------
Net interest income $ (2,297) $ 22,708 $ 20,411
========= ========= =========
As presented in the table above, net interest income increased by $20.4 million.
This increase in net interest income is both a favorable rate variance and a
favorable volume variance. As a result of the yield on our interest-earning
assets decreasing to 4.42% during the first quarter of 2003 from 4.95% during
the same period of 2002, a decrease of 0.53%, while our cost of funds decreased
to 2.81% from 3.31% during the same time period, a decrease of 0.50%, there was
a net unfavorable rate variance of $2.3 million. This was primarily due to an
unfavorable rate variance on our ARM assets portfolio and other interest-earning
assets that decreased net interest income by $8.6 million, partially offset by a
favorable rate variance on our borrowings in the amount of $6.3 million. The
potential volatility in the rate variance is reduced through our use of hedging
instruments and the net improvement in interest income is primarily a result of
the benefits resulting from the issuance of additional common equity and the
investments opportunities we have pursued in our ARM asset portfolio as a result
of this growth. The increased average size of our portfolio during the first
quarter of 2003 compared to the same period in 2002 increased net interest
income in the amount of $22.7 million. The average balance of our
interest-earning assets was $11.1 billion during the first quarter of 2003,
compared to $6.4 billion during the same period of 2002 -- an increase of 73.6%.
37
The following table highlights the components of net interest spread and the
annualized yield on net interest-earning assets as of each applicable quarter
end:
COMPONENTS OF NET INTEREST SPREAD AND YIELD ON NET INTEREST EARNING ASSETS (1)
(Dollar amounts in millions)
Weighted Yield on
Average Average Yield on Net
As of the Interest Fully Weighted Yield Interest Net Interest
Quarter Earning Indexed Average Adjust- Earning Cost of Interest Earning
Ended Assets Coupon Coupon ment (2) Assets Funds Spread Assets
--------- ---------- -------- -------- -------- -------- ------- ------ -----------
Mar 31, 2001 $ 4,260.2 6.64% 7.47% 0.79% 6.68% 5.48% 1.20% 1.34%
Jun 30, 2001 $ 4,394.4 6.06% 6.84% 0.97% 5.87% 4.75% 1.12% 1.43%
Sep 30, 2001 $ 4,641.4 5.63% 6.49% 0.85% 5.64% 3.74% 1.90% 1.71%
Dec 31, 2001 $ 5,522.5 5.16% 5.96% 0.89% 5.07% 3.01% 2.06% 2.10%
Mar 31, 2002 $ 6,421.4 5.05% 5.42% 0.53% 4.89% 3.28% 1.61% 1.97%
Jun 30, 2002 $ 7,846.1 5.06% 5.27% 0.30% 4.97% 3.17% 1.80% 1.88%
Sep 30, 2002 $ 9,237.3 4.92% 5.10% 0.41% 4.69% 3.12% 1.57% 1.84%
Dec 31, 2002 $ 10,104.7 4.82% 4.99% 0.40% 4.59% 2.79% 1.80% 1.85%
Mar 31, 2003 $ 11,145.8 4.66% 4.81% 0.54% 4.27% 2.71% 1.56% 1.87%
(1) Yield on Net Interest Earning Assets is computed by dividing annualized
net interest income for the applicable quarter by the average daily
balance of interest earning assets during the quarter.
(2) Yield adjustments include the impact of amortizing premiums and discounts,
the cost of hedging activities, the amortization of deferred gains from
hedging activities and the impact of principal payment receivables.
The following table presents the components of the yield adjustments for the
dates presented in the table above.
COMPONENTS OF THE YIELD ADJUSTMENTS ON ARM ASSETS
Impact of
As of the Premium/ Principal Hedging Total
Quarter Discount Payments Activity/ Yield
Ended Amortization Receivable Other Adjustment
- ------------ ------------ ---------- --------- ----------
Mar 31, 2001 0.61% 0.14% 0.04% 0.79%
Jun 30, 2001 0.74% 0.20% 0.03% 0.97%
Sep 30, 2001 0.69% 0.14% 0.02% 0.85%
Dec 31, 2001 0.68% 0.20% 0.01% 0.89%
Mar 31, 2002 0.33% 0.16% 0.04% 0.53%
Jun 30, 2002 0.19% 0.11% 0.00% 0.30%
Sep 30, 2002 0.23% 0.16% 0.02% 0.41%
Dec 31, 2002 0.29% 0.07% 0.04% 0.40%
Mar 31, 2003 0.35% 0.11% 0.08% 0.54%
We recorded hedging expense during the first quarter of 2003 of $177.1 thousand.
At March 31, 2003, the fair value of our Cap Agreements was $74.1 thousand
compared to a fair value of $84.7 thousand as of December 31, 2002, a decrease
in fair value of $10.6 thousand. Since we are not currently applying hedge
accounting to our Cap Agreements, we recorded this change in fair value of the
Cap Agreements as hedging expense during the quarter ended March 31, 2003.
Additionally, during the first quarter of 2003, we incurred hedging expenses of
$17.3 thousand related to Eurodollar Transactions and also reclassified to
earnings $149.2 thousand of the transition adjustment recorded in "Accumulated
other comprehensive income" on January 1, 2001, in connection with the
implementation of FAS 133. During the first quarter of 2002, we recorded hedging
expense of $313.6 thousand. At March 31, 2002, the fair value of our Cap
Agreements was $212.0 thousand.
38
Since we began acquiring whole loans in 1997, we have only experienced losses on
three loans, for a total amount of $174.0 thousand. We continue to evaluate our
estimated credit losses on loans prior to their securitization and we may
readjust our current policy if the circumstances warrant. As of March 31, 2003,
our whole loans, including those that we have securitized, but with respect to
which we have retained credit loss exposure, accounted for 39.1% of our
portfolio of ARM assets or $4.6 billion.
For the quarter ended March 31, 2003, our ratio of operating expenses to average
assets was 0.47%, compared to 0.44% for the same period in 2002, and 0.49% for
the quarter ended December 31, 2002. The most significant single increase to our
expenses was the performance-based fee of $6.2 million that the Manager earned
during the first quarter of 2003 as a result of our achieving a return on
shareholders' equity in excess of the threshold as defined in the Management
Agreement with the Manager. Our return on equity prior to the effect of the
performance-based fee was 18.91%, whereas the threshold, the average 10-year
treasury rate plus 1%, was 4.92%. Our other expenses increased by approximately
$3.1 million from the first quarter of 2002 to the first quarter of 2003,
primarily due to the operations of TMHL, expenses associated with our issuance
of Dividend Equivalent Rights ("DERs") and Phantom Stock Rights ("PSRs"), and
other corporate matters. TMHL's operations accounted for $789.2 thousand of this
increase, and our issuance of DERs and PSRs accounted for $1.1 million of the
increase. Our expense ratios are among the lowest of any company originating and
investing in mortgage assets, giving us what we believe to be a significant
competitive advantage over more traditional mortgage portfolio lending
institutions, such as banks and savings and loan institutions. Further, many of
these expenses are performance based, implying that a change in return on equity
will affect these expenses. This competitive advantage enables us to operate
with less credit and interest rate risk, and still generate an attractive
long-term return on equity when compared to more traditional mortgage portfolio
lending institutions.
We pay the Manager an annual base management fee, generally based on average
shareholders' equity as defined in the Management Agreement, payable monthly in
arrears as follows: 1.20% of the first $300 million of average shareholders'
equity, plus 0.88% of average shareholders' equity above $300 million, subject
to an annual inflation adjustment based on changes in the Consumer Price Index.
Since the management fee is based on shareholders' equity and not assets, the
fee increases as we raise additional equity capital and thereby manage a larger
amount of invested capital on behalf of our shareholders. In order for the
Manager to earn a performance fee, the rate of return on the shareholders'
investment, as defined in the Management Agreement, must exceed the average
10-year U.S. Treasury rate during the quarter plus 1%. As presented in the
following table, the performance fee is a variable expense that fluctuates with
our return on shareholders' equity relative to the average 10-year U.S. Treasury
rate.
The following table highlights the quarterly trend of operating expenses as a
percent of average assets:
ANNUALIZED OPERATING EXPENSE RATIOS
Management Fee & Total Operating
For the Other Expenses/ Performance Fee/ Expenses/
Quarter Ended Average Assets Average Assets Average Assets
------------- -------------- -------------- --------------
Mar 31, 2001 0.20% 0.09% 0.29%
Jun 30, 2001 0.21% 0.10% 0.31%
Sep 30, 2001 0.25% 0.14% 0.39%
Dec 31, 2001 0.28% 0.22% 0.50%
Mar 31, 2002 0.24% 0.20% 0.44%
Jun 30, 2002 0.24% 0.19% 0.43%
Sep 30, 2002 0.22% 0.22% 0.44%
Dec 31, 2002 0.27% 0.22% 0.49%
Mar 31, 2003 0.25% 0.22% 0.47%
LIQUIDITY AND CAPITAL RESOURCES
Our primary source of funds for the quarter ended March 31, 2003 consisted of
reverse repurchase agreements totaling $10.1 billion and whole loan financing
facilities of $1.1 billion. Our other significant sources of funds for
39
the quarter ended March 31, 2003 consisted primarily of payments of principal
and interest from our ARM assets of $1.3 billion. In the future, we expect our
primary sources of funds to continue to consist of borrowed funds under reverse
repurchase agreement transactions with one to twelve month maturities, funds
borrowed from whole loan financing facilities, capital market financing
transactions collateralized by Traditional ARM and Hybrid ARM loans, proceeds
from monthly payments of principal and interest on our ARM assets portfolio,
proceeds from sales of new unsecured debt or equity and occasional asset sales.
Our liquid assets generally consist of unpledged ARM assets, cash and cash
equivalents.
Total borrowings outstanding at March 31, 2003 had a weighted average effective
cost of 1.52%. The reverse repurchase agreements had a weighted average
remaining term to maturity of 4.5 months, although we utilize Swap Agreements
and Eurodollar Transactions to extend the re-pricing characteristic of total
borrowings to 1.6 years. In January 2003, we called the AAA collateralized
notes. We re-securitized the loan collateral securitizing these notes in a new
long-term secured debt securitization in April 2003 and continue to hold these
assets in our portfolio. The whole loan financing facilities are committed
facilities that mature in November 2003, January 2004 and March 2004. As of
March 31, 2003, $6.8 billion of our borrowings were variable rate term reverse
repurchase agreements. Term reverse repurchase agreements are committed
financings with original maturities that range from six to 24 months. The
interest rates on these term reverse repurchase agreements are indexed to either
the one- or three-month LIBOR rate, and reprice accordingly. The interest rates
on the whole loan financing facilities are indexed to the one-month LIBOR index
and are subject to either daily or monthly adjustment.
We have arrangements to enter into reverse repurchase agreements with 23
different financial institutions and on March 31, 2003, had borrowed funds with
15 of these firms. Because we borrow money under these agreements based on the
fair value of our ARM assets, and because changes in interest rates can
negatively impact the valuation of ARM assets, our borrowing ability under these
agreements may be limited and lenders may initiate margin calls in the event
interest rates change or the value of our ARM assets decline for other reasons.
External disruptions to credit markets might also impair access to additional
liquidity and, therefore, we might be required to sell certain mortgage assets
in order to maintain liquidity. If required, such sales might be at prices lower
than the carrying value of the assets, which would result in losses. We had
adequate liquidity throughout the quarter ended March 31, 2003. We believe we
will continue to have sufficient liquidity to meet our future cash requirements
from our primary sources of funds for the foreseeable future without needing to
sell assets.
As of March 31, 2003, we had entered into three whole loan financing facilities.
We borrow money under these facilities based on the fair value of the ARM loans
pledged to secure these facilities. Therefore, the amount of money available to
us under these facilities is subject to margin call based on changes in fair
value, which can be negatively affected by changes in interest rates and other
factors, including the delinquency status of individual loans. One of the whole
loan financing facilities has a committed borrowing capacity of $600 million and
matures in January 2004. The other two facilities have a borrowing capacity of
$300 million each and mature in November 2003 and March 2004. We expect to renew
these facilities. As of March 31, 2003, we had $1.1 billion borrowed against
these whole loan financing facilities, at an effective cost of 2.11%.
During February 2003, we completed a public offering of 3,473,500 shares of
common stock and received net proceeds of $65.9 million under our shelf
registration statement on Form S-3 that was declared effective by the SEC on
August 30, 2002. During the quarter ended March 31, 2003, we also issued
1,449,300 shares of common stock through "at-market" transactions under a
controlled equity program under the August 2002 shelf registration statement and
received net proceeds of $29.1 million. As of March 31, 2003, $25.1 million and
$243.8 million of our registered securities remained available for future
issuance and sale under our currently effective July 2001 and August 2002 shelf
registration statements, respectively.
We have a Dividend Reinvestment and Stock Purchase Plan (the "DRP") designed to
provide a convenient and economical way for existing shareholders to
automatically reinvest their dividends in additional shares of our common stock,
and for new and existing shareholders to purchase shares at a discount to the
current market price of the common stock, as defined in the DRP. During the
quarter ended March 31, 2003, we issued 1,384,846 shares of common stock under
the DRP and received net proceeds of $27.2 million.
On April 3, 2003, approximately $1.1 billion of mortgage loans from our ARM loan
portfolio were transferred to Thornburg Mortgage Securities Trust 2003-2 and
were securitized. Approximately $1.0 billion of the securities
40
issued in connection with this securitization were sold to third-party investors
in the form of AAA-rated floating rate pass-through certificates. This
transaction will be accounted for as a financing of our loans and represents
long-term secured non-marginable financing for our portfolio.
On May 15, 2003, we completed an unregistered offering of $200.0 million in
senior unsecured notes at par. The notes bear interest at 8%, payable each May
15 and November 15, commencing November 15, 2003, and mature on May 15, 2013.
The notes are redeemable, in whole or in part, beginning May 2008. The notes may
also be redeemed under limited circumstances on or before May 15, 2006.
MARKET RISKS
The market risk management discussion and the amounts estimated from the
analysis that follows are forward-looking statements that assume that certain
market conditions occur. Actual results may differ materially from these
projected results due to changes in our ARM portfolio and borrowings mix and due
to developments in the domestic and global financial and real estate markets.
Developments in the financial markets include the likelihood of changing
interest rates and the relationship of various interest rates and their impact
on our ARM portfolio yield, cost of funds and cash flows. The analytical methods
that we use to assess and mitigate these market risks should not be considered
projections of future events or operating performance.
As a financial institution that has only invested in U.S.-dollar denominated
instruments, primarily residential mortgage instruments, and has only borrowed
money in the domestic market, we are not subject to foreign currency exchange or
commodity price risk, but rather our market risk exposure is limited solely to
interest rate risk. Interest rate risk is defined as the sensitivity of our
current and future earnings to interest rate volatility, variability of spread
relationships, the difference in repricing intervals between our assets and
liabilities and the effect that interest rates may have on our cash flows,
especially ARM portfolio prepayments. Interest rate risk impacts our interest
income, interest expense and the market value on a large portion of our assets
and liabilities. The management of interest rate risk attempts to maximize
earnings and to preserve capital by minimizing the negative impacts of changing
market rates, asset and liability mix, and prepayment activity.
The table below presents our consolidated interest rate risk using the static
gap methodology. This method reports the difference between interest
rate-sensitive assets and liabilities at specific points in time as of March 31,
2003, based on the earlier of term to repricing or the term to repayment of the
asset or liability. The table does not include assets and liabilities that are
not interest rate-sensitive such as payment receivables, prepaid expenses,
payables and accrued expenses. The table provides a projected repricing or
maturity based on scheduled rate adjustments, scheduled payments, and estimated
prepayments. For many of our assets and certain of our liabilities, the maturity
date is not determinable with certainty. In general, our ARM assets can be
prepaid before contractual amortization and/or maturity. Likewise, our AAA rated
notes payable are paid down as the related ARM asset collateral pays down. The
static gap report reflects our investment policy that allows for only the
acquisition of ARM assets that reprice within one year, short-term fixed rate
assets with an average life of one year or less or Hybrid ARM assets that are
match funded to within a duration mismatch of one year.
The difference between assets and liabilities repricing or maturing in a given
period is one approximate measure of interest rate sensitivity. More assets than
liabilities repricing in a period (a positive gap) implies earnings will rise as
interest rates rise and decline as interest rates decline. More liabilities
repricing than assets (a negative gap) implies declining income as rates rise
and increasing income as rates decline. The static gap analysis does not take
into consideration constraints on the repricing of the interest rate of ARM
assets in a given period resulting from periodic and lifetime cap features nor
the behavior of various indices applicable to our assets and liabilities.
Different interest rate indices exhibit different degrees of volatility in the
same interest rate environment due to other market factors such as, but not
limited to, government fiscal policies, market concern regarding potential
credit losses, changes in spread relationships among different indices and
global market disruptions.
The use of interest rate instruments such as Swaps Agreements, Eurodollar
Transactions and Cap Agreements are integrated into our interest rate risk
management. The notional amounts of these instruments are not reflected in our
balance sheet. The Swap Agreements and Eurodollar Transactions that hedge the
financing of our Hybrid ARM assets are included in the static gap report for
purposes of analyzing interest rate risk because they have the effect of
adjusting the repricing characteristics of our liabilities. The Cap Agreements
that hedge the lifetime cap on our
41
ARM assets are not considered in a static gap report because they do not affect
the timing of the repricing of the instruments they hedge, but rather they, in
effect, remove the limit on the amount of interest rate change that can occur
relative to the applicable hedged asset.
INTEREST RATE SENSITIVITY GAP ANALYSIS
(Dollar amounts in thousands)
March 31, 2003
Over 1 Over 3
1 Year Year to Years to Over
or less 3 Years 5 Years 5 Years Total
----------- ----------- ---------- ---------- -----------
Interest-earning assets:
ARM securities $ 2,666,198 $ -- $ -- $ -- $ 2,666,198
Hybrid ARM securities and loans 3,445,364 4,493,696 1,271,577 50,907 9,261,544
Cash and cash equivalents 308,639 -- -- -- 308,639
----------- ----------- ---------- ---------- -----------
Total interest-earning assets 6,420,201 4,493,696 1,271,577 50,907 12,236,381
----------- ----------- ---------- ---------- -----------
Interest-bearing liabilities:
Reverse repurchase agreements 9,737,625 403,517 -- -- 10,141,142
Whole loan financing facilities 1,062,237 -- -- -- 1,062,237
Swap Agreements and
Eurodollar Transactions (5,489,547) 4,368,317 1,121,230 -- --
----------- ----------- ---------- ---------- -----------
Total interest bearing
liabilities 5,310,315 4,771,834 1,121,230 -- 11,203,379
----------- ----------- ---------- ---------- -----------
Interest rate sensitivity gap $ 1,109,886 $ (278,138) $ 150,347 $ 50,907 $ 1,033,002
=========== =========== ========== ========== ===========
Cumulative interest rate
sensitivity gap $ 1,109,886 $ 831,748 $ 982,095 $1,033,002
=========== =========== ========== ==========
Cumulative interest rate sensitivity
gap as a percentage of total assets
before market value adjustments 9.16% 6.87% 8.11% 8.53%
=========== =========== ========== ==========
Although the static gap methodology is widely accepted in identifying interest
rate risk, it does not take into consideration changes that may occur such as,
but not limited to, changes in investment and financing strategies, changes in
market spreads and relationships among different indices, changes in asset
yields, which can change more quickly than the underlying interest coupon on ARM
assets, changes in hedging strategy, changes in prepayment speeds and changes in
business volumes. Accordingly, we make extensive usage of an earnings simulation
model to analyze our level of interest rate risk. This analytical technique used
to measure and manage interest rate risk includes the impact of all
on-balance-sheet and off-balance-sheet financial instruments.
There are a number of key assumptions made in using our earnings simulation
model. These key assumptions include changes in market conditions that affect
interest rates, the pricing of ARM products, the availability of ARM products,
and the availability and the cost of financing for ARM products. Other key
assumptions made in using the simulation model include prepayment speeds,
management's investment, financing and hedging strategies, and the issuance of
new equity. We typically run the simulation model under a variety of
hypothetical business scenarios that may include different interest rate
scenarios, different investment strategies, different prepayment possibilities
and other scenarios that provide us with a range of possible earnings outcomes
in order to assess potential interest rate risk. The assumptions used represent
our estimate of the likely effect of changes in interest rates and do not
necessarily reflect actual results. The earnings simulation model takes into
account periodic and lifetime caps embedded in our ARM assets in determining the
earnings at risk.
42
At March 31, 2003, based on the earnings simulation model, our potential
earnings increase (decrease) from a parallel 100 and 200 basis point rise in
market interest rates over the next twelve months and a commensurate slow down
in prepayment speeds as interest rates rise, was (2.7%) and (3.6%) of projected
2003 net income, respectively, and (0.8%) and 0.3% of projected 2004 net income,
respectively. The assumptions used in the earnings simulation model are
inherently uncertain and as a result, the analysis cannot precisely predict the
impact of higher interest rates on net income. Actual results would differ from
simulated results due to timing, magnitude and frequency of interest rate
changes, changes in prepayment speed other than what was assumed in the model,
and changes in other market conditions and management strategies to offset our
potential exposure, among other factors. This measure of risk represents our
exposure to higher interest rates at a particular point in time. Our actual risk
is always changing. We continuously monitor our risk profile as it changes and
alter our strategies as appropriate in our view of the likely course of interest
rates and other developments in our business.
EFFECTS OF INTEREST RATE CHANGES
Changes in interest rates impact our earnings in various ways. While we invest
primarily in ARM assets, rising short-term interest rates may temporarily
negatively affect our earnings, and, conversely, falling short-term interest
rates may temporarily increase our earnings. This impact can occur for several
reasons and may be mitigated by portfolio prepayment activity and portfolio
funding strategies as discussed below. First, our borrowings may react to
changes in interest rates sooner than our ARM assets because the weighted
average next repricing dates of the borrowings may be shorter time periods than
that of the ARM assets. Second, interest rates on Traditional ARM assets may be
limited to an increase of either 1% or 2% per adjustment period (commonly
referred to as the periodic cap), and our borrowings do not have similar
limitations. At March 31, 2003, 14.9% of our total ARM assets were Traditional
ARM assets subject to periodic caps. Third, our ARM assets typically lag changes
in the applicable interest rate indices by 45 days, due to the notice period
provided to ARM borrowers when the interest rates on their loans are scheduled
to change.
Interest rates can also affect our net return on Hybrid ARM assets (net of the
cost of financing Hybrid ARMs). We estimate the duration of the fixed rate
period of our Hybrid ARM assets and have a policy to hedge the financing of the
Hybrid ARM assets such that the net duration of our borrowed funds, hedging
instruments and the Hybrid ARM assets is less than one year. During a declining
interest rate environment, the prepayment of hybrid ARM assets may accelerate
causing the amount of fixed rate financing to increase relative to the amount of
Hybrid ARM assets, possibly resulting in a decline in our net return on Hybrid
ARM assets as replacement Hybrid ARM assets may have a lower yield than the ones
paying off. In contrast, during an increasing interest rate environment, Hybrid
ARM assets may prepay slower than expected, requiring us to finance a higher
amount of Hybrid ARM assets than originally anticipated at a time when interest
rates may be higher, resulting in a decline in our net return on Hybrid ARM
assets. In order to manage our exposure to changes in the prepayment speed of
Hybrid ARM assets, we regularly monitor the balance of Hybrid ARM assets and
make adjustments to the amounts anticipated to be outstanding in future periods
and, on a regular basis, make adjustments to the amount of our fixed-rate
borrowing obligations in future periods.
The rate of prepayment on our mortgage assets may increase if interest rates
decline or if the difference between long term and short term interest rates
diminishes. Increased prepayments would cause us to amortize the premiums paid
for our mortgage assets faster, resulting in a reduced yield on our mortgage
assets. Additionally, to the extent proceeds of prepayments cannot be reinvested
at a rate of interest at least equal to the rate previously earned on such
mortgage assets, our earnings may be adversely affected.
Conversely, the rate of prepayment on our mortgage assets may decrease if
interest rates rise or if the difference between long term and short term
interest rates increases. Decreased prepayments would cause us to amortize the
premiums paid for our ARM assets over a longer time period, resulting in an
increased yield on our mortgage assets. Therefore, in rising interest rate
environments where prepayments are declining, not only would the interest rate
on the ARM assets portfolio increase to re-establish a spread over the higher
interest rates, but the yield also would rise due to slower prepayments. The
combined effect could significantly mitigate other negative effects that rising
short-term interest rates might have on earnings.
Lastly, because we invest primarily in ARM assets, and approximately 8% to 10%
of such assets are purchased with shareholders' equity, our earnings, over time,
will tend to increase, after an initial short term decline, following
43
periods when short term interest rates have risen, and decrease after an initial
short term increase, following periods when short term interest rates have
declined. This is because the financed portion of our portfolio of ARM assets
will, over time, reprice to a spread over our cost of funds, while the portion
of our portfolio of ARM assets purchased with shareholders' equity will
generally have a higher yield in a higher interest rate environment and a lower
yield in a lower interest rate environment.
OTHER MATTERS
The Internal Revenue Code of 1986, as amended (the "Code"), requires that at
least 75% of our total assets must be Qualified REIT Assets, as defined by the
Code. The Code also requires that we meet a defined 75% source of income test
and a 90% source of income test. As of March 31, 2003, we calculated that we
were in compliance with all of these requirements. We also met all REIT
requirements regarding the ownership of our common stock and the distributions
of our net income. Therefore, as of March 31, 2003, we believe that we continue
to qualify as a REIT under the provisions of the Code.
We intend to conduct our business so as not to become regulated as an investment
company under the Investment Company Act of 1940, as amended. If we were to
become regulated as an investment company, our 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 SEC, in order to
qualify for this exemption, we must maintain at least 55% of our assets directly
in Qualifying Interests as defined in the Code. 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. We
calculated that we are in compliance with this requirement.
ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information called for by Item 3 is incorporated by reference from the
information in Part I, Item 2 under the caption "Market Risks."
ITEM 4. CONTROLS AND PROCEDURES
Under the supervision, and with the participation of the Chief Executive
Officer, the President and Chief Operating Officer and the Executive Vice
President, Chief Financial Officer and Treasurer, management has evaluated the
effectiveness of the design and operation of the Company's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report pursuant to Exchange Act Rule 13a-14. Based on that evaluation,
the Chief Executive Officer, the President and Chief Operating Officer and the
Executive Vice President, Chief Financial Officer and Treasurer, concluded that
the Company's disclosure controls and procedures were effective. There have been
no significant changes in the Company's internal controls or in other factors
that could significantly affect internal controls subsequent to their
evaluation.
44
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
At March 31, 2003, there were no pending legal proceedings to which
we were a party or of which any of our property was subject.
Item 2. Changes in Securities and Use of Proceeds
Not applicable
Item 3. Defaults Upon Senior Securities
Not applicable
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K:
(a) Exhibits
See "Exhibit Index"
(b) Reports on Form 8-K
The Company filed the following Current Reports on Form 8-K
during the quarter ended March 31, 2003:
(i) Current Report on Form 8-K, filed on January 30, 2003,
attaching the Company's Business Presentation, dated
January 30, 2003, which includes a description of
certain strategic objectives for the years 2003 to 2005.
(ii) Current Report on Form 8-K, filed on February 5, 2003,
attaching the Company's Press Release of January 21,
2003 announcing the Company's earnings for the year and
the quarter ending December 31, 2002.
(iii) Current Report on Form 8-K, filed on February 7, 2003,
regarding the Registrant's sale of 3,200,000 shares in a
public offering and related underwriting agreement.
45
SIGNATURES
Pursuant to the requirements 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.
THORNBURG MORTGAGE, INC.
Dated: May 14, 2003 By: /s/ Garrett Thornburg
----------------------------------------------
Garrett Thornburg
Chairman of the Board and Chief Executive
Officer
(authorized officer of registrant)
Dated: May 14, 2003 By: /s/ Larry A. Goldstone
----------------------------------------------
Larry A. Goldstone
President and Chief Operating Officer
(authorized officer of registrant)
Dated: May 14, 2003 By: /s/ Richard P. Story
----------------------------------------------
Richard P. Story
Executive Vice President, Chief Financial
Officer and Treasurer
(principal accounting officer)
46
CERTIFICATIONS
I, Garrett Thornburg, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Thornburg Mortgage,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: May 14, 2003 By: /s/ Garrett Thornburg
---------------------------------------
Garrett Thornburg
Chief Executive Officer
(authorized officer of registrant)
47
CERTIFICATIONS
I, Larry A. Goldstone, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Thornburg Mortgage,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: May 14, 2003 By: /s/ Larry A. Goldstone
-------------------------------------------
Larry A. Goldstone
President and Chief Operating Officer
(authorized officer of registrant)
48
CERTIFICATIONS
I, Richard P. Story, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Thornburg Mortgage,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Date: May 14, 2003 By: /s/ Richard P. Story
-------------------------------------------------
Richard P. Story
Executive Vice President, Chief Financial Officer
and Treasurer
(authorized officer of registrant)
49
Exhibit Index
Exhibit Number Exhibit Description
- -------------- -------------------
99.1 Certification of Chief Executive Officer pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
99.2 Certification of President and Chief Operating Officer
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
99.3 Certification of Executive Vice President, Chief Financial
Officer and Treasurer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002
50