UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

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

 

For the Quarterly Period Ended March 31, 2003

 

Commission File Number 000-25193

 

CAPITAL CROSSING PREFERRED CORPORATION

(Exact name of registrant as specified in its charter)

 

Massachusetts

(State or other jurisdiction of incorporation or organization)

 

04-3439366

(I.R.S. Employer Identification Number)

 

101 Summer Street, Boston, Massachusetts

(Address of principal executive offices)

 

02110

(Zip Code)

 

(617) 880-1000

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý  No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o  No ý

 

Indicate the number of shares outstanding of the issuer’s common stock, $.01 par value per share, as of May 6, 2003: 100.

No common stock was held by non-affiliates of the issuer.

 

 

Capital Crossing Preferred Corporation

Table of Contents

 

PART I – Financial Information
Item 1.  Financial Statements:
	Balance Sheets
	Statements of Income
	Statements of Changes in Stockholders’ Equity
	Statements of Cash Flows
	Notes to Financial Statements
Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Critical Accounting Policies
	Results of Operations
	Changes in Financial Condition
	Interest Rate Risk
	Significant Concentration of Credit Risk
	Liquidity Risk Management
	Risk Factors and Factors Affecting Future Operating Results
Item 3.  Quantitative and Qualitative Disclosures about Market Risk
Item 4.  Controls and Procedures
PART II – Other Information
Item 1.  Legal Proceedings
	Signatures
	Certifications
	Exhibit Index

 

 

PART I

 

Item 1. Financial Statements

Capital Crossing Preferred Corporation

Balance Sheets

 

		March 31, 2003			December 31, 2002
		(in thousands, except share data)
ASSETS
Cash account with Capital Crossing Bank		$	89		$	88
Interest bearing deposits with Capital Crossing Bank		116,338			92,622
Total cash and cash equivalents		116,427			92,710
Certificate of deposit		100			100
Loans		257,622			277,515
Less discount and net deferred loan income		(30,624		)	(32,196		)
Less allowance for loan losses		(7,354		)	(7,354		)
Loans, net		219,644			237,965
Accrued interest receivable		1,142			1,219
Other assets		16			—
		$	337,329		$	331,994
LIABILITIES AND STOCKHOLDERS’ EQUITY
Accrued expenses and other liabilities		$	426		$	435
Total liabilities		426			435
Stockholders’ equity:
Preferred stock, Series A, 9.75% non-cumulative, exchangeable; $.01 par value; $10 liquidation value per share; 1,449,000 shares authorized, 1,416,130 shares issued and outstanding		14			14
Preferred stock, Series B, 8% cumulative, non-convertible; $.01 par value; $1,000 liquidation value per share plus accrued dividends; 1,000 shares authorized, 941 shares issued and outstanding		—			—
Preferred stock, Series C, 10.25% non-cumulative, exchangeable; $.01 par value; $10 liquidation value per share; 1,840,000 shares authorized, issued and outstanding		18			18
Common stock, $.01 par value, 100 shares authorized, issued and outstanding		—			—
Additional paid-in capital		329,475			329,475
Retained earnings		7,396			2,052
Total stockholders’ equity		336,903			331,559
		$	337,329		$	331,994

 

See accompanying notes to unaudited interim financial statements.

 

1

 

Capital Crossing Preferred Corporation

Statements of Income

 

		Three Months Ended March 31,
		2003			2002
		(in thousands)
Interest income:
Interest and fees on loans		$	5,671		$	4,970
Interest on interest-bearing deposits		719			581
Total interest income		6,390			5,551
Other income:
Gains on sales of loans		—			517
Guarantee fee income		20			20
Total other income		20			537
Operating expenses:
Loan servicing and advisory services		172			104
Other general and administrative		59			17
Total operating expenses		231			121
Net income		6,179			5,967
Preferred stock dividends		835			835
Net income available to common stockholder		$	5,344		$	5,132

 

See accompanying notes to unaudited interim financial statements.

 

2

 

Capital Crossing Preferred Corporation

Statements of Changes in Stockholders’ Equity

 

		Three Months Ended March 31, 2003
		Preferred Stock Series A					Preferred Stock Series B					Preferred Stock Series C					Common Stock					Additional Paid-in			Retained			Total Stockholders’
		Shares		Amount			Shares		Amount			Shares		Amount			Shares		Amount			Capital			Earnings			Equity
		(dollars in thousands)
Balance at December 31, 2002		1,416,130		$	14		941		$	—		1,840,000		$	18		100		$	—		$	329,475		$	2,052		$	331,559
Net income		—		—			—		—			—		—			—		—			—			6,179			6,179
Dividends on preferred stock, Series A		—		—			—		—			—		—			—		—			—			(345		)	(345		)
Cumulative dividends on preferred stock, Series B		—		—			—		—			—		—			—		—			—			(19		)	(19		)
Dividends on preferred stock, Series C		—		—			—		—			—		—			—		—			—			(471		)	(471		)
Balance at March 31, 2003		1,416,130		$	14		941		$	—		1,840,000		$	18		100		$	—		$	329,475		$	7,396		$	336,903

 

		Three Months Ended March 31, 2002
		Preferred Stock Series A					Preferred Stock Series B					Preferred Stock Series C					Common Stock					Additional Paid-in			Retained			Total Stockholders’
		Shares		Amount			Shares		Amount			Shares		Amount			Shares		Amount			Capital			Earnings			Equity
		(dollars in thousands)
Balance at December 31, 2001		1,416,130		$	14		941		$	—		1,840,000		$	18		100		$	—		$	235,742		$	174		$	235,948
Net income		—		—			—		—			—		—			—		—			—			5,967			5,967
Dividends on preferred stock, Series A		—		—			—		—			—		—			—		—			—			(345		)	(345		)
Cumulative dividends on preferred stock, Series B		—		—			—		—			—		—			—		—			—			(19		)	(19		)
Dividends on preferred stock, Series C		—		—			—		—			—		—			—		—			—			(471		)	(471		)
Balance at March 31, 2002		1,416,130		$	14		941		$	—		1,840,000		$	18		100		$	—		$	235,742		$	5,306		$	241,080

 

See accompanying notes to the unaudited interim financial statements.

 

3

 

Capital Crossing Preferred Corporation

Statements of Cash Flows

 

		Three Months Ended March 31,
		2003			2002
		(in thousands)
Cash flows provided by operating activities:
Net income		$	6,179		$	5,967
Adjustments to reconcile net income to net cash provided by operating activities:
Gains on sales of loans		—			(517		)
Other, net		52			(55		)
Net cash provided by operating activities		6,231			5,395
Cash flows provided by (used in) investing activities:
Amortization and payoffs on loans		18,321			11,575
Purchase of loans from Capital Crossing Bank		—			(16,944		)
Proceeds from sales of loans		—			2,686
Net cash provided by (used in) investing activities		18,321			(2,683		)
Cash flows used in financing activities:
Payment of preferred stock dividends		(835		)	(835		)
Net cash used in financing activities		(835		)	(835		)
Net change in cash and cash equivalents		23,717			1,877
Cash and cash equivalents at beginning of period		92,710			87,989
Cash and cash equivalents at end of period		$	116,427		$	89,866

 

See accompanying notes to unaudited interim financial statements.

 

4

 

Capital Crossing Preferred Corporation

Notes to Financial Statements

Three Months Ended March 31, 2003 and 2002

 

Note 1.   Basis of Presentation

 

Capital Crossing Preferred Corporation (“Capital Crossing Preferred), is a Massachusetts corporation organized on March 20, 1998, to acquire and hold real estate assets.  Capital Crossing Bank (“Capital Crossing”), a federally insured Massachusetts trust company, owns all of Capital Crossing Preferred’s outstanding common stock.  Capital Crossing is in compliance with its regulatory capital requirements at March 31, 2003.

 

On March 31, 1998, Capital Crossing Preferred was initially capitalized with the issuance to Capital Crossing of 100 shares of Capital Crossing Preferred’s common stock, $.01 par value, and 1,000 shares of Series B preferred stock, $.01 par value, with Capital Crossing transferring to Capital Crossing Preferred a portfolio of loans at its estimated fair value of $140,740,000.  Such loans were recorded in the accompanying balance sheet at Capital Crossing’s historical cost, which approximated their estimated fair values.

 

In 1999, Capital Crossing Preferred completed the sale of 1,416,130 shares of Series A preferred stock.  In 2001, Capital Crossing Preferred completed the sale 1,840,000 shares of Series C preferred stock.

 

The financial information as of March 31, 2003 and the results of operations, changes in stockholders’ equity and cash flows for the three months ended March 31, 2003 and 2002 are unaudited; however, in the opinion of management, the financial information reflects all adjustments (consisting solely of normal recurring accruals) necessary for a fair presentation in accordance with accounting principles generally accepted in the United States of America.  Interim results are not necessarily indicative of results to be expected for the entire year.  These interim statements are intended to be read in conjunction with the financial statements presented in Capital Crossing Preferred’s Annual Report on Form 10-K as of and for the year ended December 31, 2002.

 

In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.  Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for losses on loans, the allocation of purchase discount between amortizing and non-amortizing portions, and the rate at which the discount is accreted into interest income.

 

Note 2.   Commitments and Contingencies

 

Guarantees

 

Capital Crossing Preferred has guaranteed all of the obligations of Capital Crossing under advances Capital Crossing may receive from time to time from the Federal Home Loan Bank of Boston (“FHLBB”), and Capital Crossing Preferred has agreed to pledge a significant amount of its assets in connection with those advances. This guarantee would rank senior to the preferred shares upon liquidation. Capital Crossing Preferred’s obligations under this agreement are limited by applicable laws pertaining to fraudulent conveyance and fraudulent transfer. The assets pledged to the FHLBB will vary from time to time, however the potential exists for Capital Crossing Preferred to pledge all of its assets to the FHLBB to secure advances to Capital Crossing. In addition, Capital Crossing has pledged to the FHLBB all of the shares of Capital Crossing Preferred’s capital stock it owns as collateral for its FHLBB borrowings.  Under the terms of the pledge, if Capital Crossing becomes undercapitalized, the FHLBB may require Capital Crossing to dissolve Capital Crossing Preferred such that the assets of Capital Crossing Preferred are distributed to Capital Crossing. In such circumstance, holders of the Series A and Series C preferred stock would receive their liquidation preference only to the extent there are available assets of Capital Crossing Preferred following satisfaction of its outstanding obligations, including its guarantee of Capital Crossing’s FHLBB borrowings.  At March 31, 2003, approximately $39.6 million, or 11.9%, of Capital Crossing Preferred’s assets had been pledged to and accepted by the FHLBB to secure advances to Capital Crossing.  Capital Crossing has also agreed that it will not request or accept advances from the FHLBB in excess of Capital Crossing Preferred’s total stockholder’s equity, less the stockholder’s equity attributable to the Series A and Series C preferred shares. As of March 31, 2003, this restriction would limit Capital Crossing’s ability to receive advances in excess of approximately $304.3 million. As of March 31, 2003, Capital Crossing had $129.0 million in outstanding FHLBB borrowings.

 

5

 

Tax assessment

 

The Massachusetts Department of Revenue (“DOR”) has issued tax assessments to Capital Crossing and numerous other financial institutions in Massachusetts that reported a deduction for dividends received from a REIT on their Massachusetts financial institution excise tax returns.

 

On March 5, 2003, the Governor of Massachusetts signed a bill which includes an amendment to existing law to expressly deny a dividends received deduction for dividends from a REIT. This amendment applies retroactively to tax years ending on or after December 31, 1999. Capital Crossing intends to challenge this legislation, especially the retroactive application to prior years, on constitutional and other grounds and to vigorously defend its position.

 

Capital Crossing Preferred has also received a Notice of Assessment (“Notice”) for additional taxes from the DOR. This Notice indicates that, if the dividend received deduction is held to be available to Capital Crossing, the DOR believes the dividend paid deduction is not available to Capital Crossing Preferred. The Notice received relates to 1999 and is in the amount of $2.7 million, including interest. Capital Crossing Preferred’s total exposure through March 31, 2003 is approximately $9.6 million.

 

6

 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

This Form 10-Q contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Capital Crossing Preferred may also make written or oral forward-looking statements in other documents filed with the Securities and Exchange Commission (“SEC”), in press releases and other written materials, and in oral statements made by its officers or directors. Forward-looking statements can be identified by the use of the words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “assume,” “will,” “should,” and other expressions which predict or indicate future events and trends and which do not relate to historical matters. Forward-looking statements should not be unduly relied upon because they involve known and unknown risks, uncertainties and other factors, some of which are beyond the control of Capital Crossing Preferred. These risks, uncertainties and other factors may cause the actual results, performance or achievements of Capital Crossing Preferred to be materially different from the anticipated future results, performance or achievements that are expressed or implied by the forward-looking statements.

 

Capital Crossing Preferred’s actual results could differ materially from those projected in the forward-looking statements as a result, among other factors, of the factors discussed in the section entitled “Risk Factors and Factors Affecting Future Operating Results” of this Form 10-Q.

 

All of these factors should be carefully reviewed, and the reader of this Form 10-Q should be aware that there may be other factors that could cause these differences. These forward-looking statements were based on information, plans and estimates at the date of this report, and Capital Crossing Preferred does not promise to update any forward-looking statements to reflect changes in underlying assumptions or factors, new information, future events or other changes.

 

Critical Accounting Policies

 

In December 2001, the SEC requested that all registrants discuss their most “critical accounting policies” in management’s discussion and analysis of financial condition and results of operations. The SEC indicated that a “critical accounting policy” is one which is both important to the portrayal of the company’s financial condition and results and requires management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. While Capital Crossing Preferred’s significant accounting policies are more fully described in Note 1 to the Financial Statements included in its Annual Report on Form 10-K, management believes the following accounting policies to be most critical in their potential effect on Capital Crossing Preferred’s financial position or results of operations:

 

Allowance for Loan Losses.  Arriving at an appropriate level of allowance for loan losses requires a high degree of judgment. Capital Crossing Preferred maintains an allowance for probable loan losses that are inherent in its loan portfolio. The initial allowance for loan losses was transferred from Capital Crossing at the time of the initial transfer of loans to Capital Crossing Preferred and additional transfers are made in connection with each transfer of loans from Capital Crossing. Subsequent to the date of transfer, the allowance for loan losses will be increased or decreased through a provision or credit for loan losses included in earnings. Additionally, the allowance for loan losses is increased upon allocation of purchase discount upon acquisition of loans. Loan losses are charged against the allowance when management believes the loan balance, or a portion thereof, is uncollectible. Subsequent recoveries, if any, are credited to the allowance when cash payments are received.

 

Management makes significant judgments in determining the adequacy of the allowance for loan losses. Management initially considers the loan loss allowances specifically allocated to individual impaired loans. Next, management considers the level of general loan loss allowances deemed appropriate for the balance of the portfolio. Factors considered include known and inherent risks in the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, historical loss ranges, the estimated value of any underlying collateral and prevailing economic conditions. An additional allowance for loan losses is maintained based on a judgmental process whereby management considers qualitative and quantitative assessments of other factors including regional credit concentration, industry concentration, results of regulatory examinations, historical loss ranges, portfolio composition, economic conditions such as interest rates and energy costs and other changes in the portfolio. The allowance for loan losses is management’s estimate of the probable loan losses incurred as of the balance sheet date. There can be no assurance that Capital Crossing Preferred’s actual losses with respect to loans will not exceed its allowance for loan losses.

 

7

 

Discounts on Acquired Loans.  At the time of acquisition of purchased pools of loans, the excess of the contractual balances over the amount of reasonably estimable and probable discounted future cash collections for each loan is recorded as non-amortizing discount. The remaining discount, which represented the excess of the amount of reasonably estimable and probable discounted future cash collections over the acquisition amount is accreted into interest income using the interest method over the term of the loans and is not accreted on non-performing loans. There is a high degree of judgment involved in estimating the amount of future cash flows. The amount and timing of actual cash flows could differ materially from management’s estimates, which could materially affect financial condition and results of operations.

 

The non-amortizing discount is not accreted into income until it is determined that the amount and timing of the related cash flows are reasonably estimable and collection is probable. If cash flows cannot be reasonably estimated for any loan, and collection is not probable, the cost recovery method of accounting is used. Under the cost recovery method, any amounts received are applied against the recorded amount of the loan. Non-amortizing discount is generally offset against the related principal balance when the amount at which a loan is resolved or restructured is determined.

 

Subsequent to acquisition, if cash flow projections improve, and it is determined that the amount and timing of the cash flows related to the non-amortizing discount are reasonably estimable and collection is probable, the corresponding decrease in the non-amortizing discount is transferred to the amortizing portion and is accreted into interest income over the remaining life of the loan on the interest method. If cash flow projections deteriorate subsequent to acquisition, the decline is accounted for through the allowance for loan losses.

 

When a loan is paid-off, the excess of any cash received over the net investment is recorded as interest income. In addition to the amount of purchase discount that is recognized at that time, income may also include interest owed by the borrower prior to Capital Crossing’s acquisition of the loan, interest collected if on non-performing status, prepayment fees and other loan fees.

 

Changes in interest rates also can affect the value of Capital Crossing Preferred’s loans (and other interest-earning assets) and its ability to realize gains on the resolution of assets. A significant portion of Capital Crossing Preferred’s earnings results from accelerated interest income resulting from loan prepayments. This type of income can vary significantly from quarter to quarter and year to year based on a number of different factors, including the interest rate environment. An increase in interest rates that adversely affects the ability of borrowers to pay the principal or interest on Capital Crossing Preferred’s loans may lead to a reduction of discount accreted into income, which could have a material adverse effect on its results of operations.

 

Results of Operations

 

Three Months Ended March 31, 2003 and 2002

 

Net income available to common stockholder increased $212,000, or 4.1%, to $5.3 million for the three months ended March 31, 2003, compared to $5.1 million for the three months ended March 31, 2002.  This increase was primarily attributable to an increase in total interest income; offset by: (1) a decrease in total other income as there were no gains on sales of loans for the three months ended March 31, 2003 and (2) an increase in operating expenses.  Total interest income for the three months ended March 31, 2003 increased $839,000, or 15.1%, to $6.4 million, compared to $5.6 million for the three months ended March 31, 2002.

 

The following table sets forth the yields on Capital Crossing Preferred’s earning assets for the periods indicated:

 

		Three Months Ended March 31,
		2003								2002
		Average Balance			Interest Income			Yield		Average Balance			Interest Income			Yield
		(dollars in thousands)
Loans, net (1)		$	235,135		$	5,671		9.78	%	$	151,214		$	4,970		13.33	%
Interest-bearing deposits		103,820			719			2.81		90,477			581			2.60
		$	338,955		$	6,390		7.65	%	$	241,691		$	5,551		9.31	%

 

(1) Non-performing loans are excluded from average balance calculations.

 

8

 

The decline in yield on interest-earning assets from 2002 to 2003 is a result of a decline in yield on the loan portfolio, partially offset by an increase in the yield on interest-bearing deposits. The yield on the loan portfolio declined as a result of: (1) a decrease in yield attributable to regularly scheduled interest income as a result of the declining interest rate environment, (2) a decline, relative to the overall yield on loans, in interest income recognized at the time of individual loan pay-offs and (3) as a result of the purchase or contribution in 2002 of loans from Capital Crossing that were acquired from the Small Business Administration which generate lower regularly scheduled interest and accretion. Average loans, net for the three months ended March 31, 2003 totaled $235.1 million compared to $151.2 million for the same period in 2002. This increase is due primarily to purchases of loans from or contribution of loans by Capital Crossing totaling $167.2 million, which was partially offset by payoffs, sales, and amortization related to loans, since the first quarter of 2002.

 

Income on loans includes the portion of the purchase discount that is accreted into income over the remaining lives of the related loans using the interest method. Because the carrying value of the loan portfolio is net of purchase discount, the related yield on this portfolio generally is higher than the aggregate contractual rate paid on the loans. The total yield includes the excess of a loan’s expected discounted future cash flows over its net investment, recognized using the interest method.

 

When a loan is paid-off, the excess of any cash received over the net investment is recorded as interest income. In addition to the amount of purchase discount that is recognized at that time, income may also include interest owed by the borrower prior to Capital Crossing’s acquisition of the loan, interest collected if on non-performing status and other loan fees (“other interest and fee income”). The following table sets forth, for the years indicated, the components of interest and fees on loans. There can be no assurance regarding future interest income, including the yields and related level of such income, or the relative portion attributable to loan pay-offs as compared to other sources.

 

		Three Months Ended March 31,
		2003					2002
		Interest Income			Yield		Interest Income			Yield
		(dollars in thousands)
Regularly scheduled interest and accretion income		$	4,472		7.71	%	$	3,299		8.85	%
Interest and fee income recognized on loan pay-offs:
Non-amortizing discount		560			0.97		653			1.75
Amortizing discount		634			1.09		984			2.64
Other interest and fee income		5			0.01		34			0.09
		1,199			2.07		1,671			4.48
		$	5,671		9.78	%	$	4,970		13.33	%

 

The amount of loan pay-offs and related discount income is influenced by several factors, including the interest rate environment, the real estate market in particular areas, the timing of transactions, and circumstances related to individual borrowers and loans.

 

The average balance of interest-bearing deposits increased $13.3 million to $103.8 million for the three months ended March 31, 2003, compared to $90.5 million for 2002, as a result of cash flows from loan repayments, offset by loan purchases and periodic dividend payments. The yield on interest-bearing deposits increased because the rate paid by Capital Crossing on the money market account held by Capital Crossing Preferred increased in 2003 compared to 2002.

 

During the three months ended March 31, 2003 there were no sales of loans to unaffiliated third parties compared to a gain on a sale of one loan to an unaffiliated third party of $517,000 during the three months ended March 31, 2002.

 

Loan servicing and advisory services expenses for the three months ended March 31, 2003 increased $68,000, or 65.4%, to $172,000 compared to $104,000 for the three months ended March 31, 2002. This increase was due to the increase in the average balance of the loan portfolio.

 

Other general and administrative expenses increased $42,000, or 247.1%, to $59,000 for the three months ended March 31, 2003 compared to $17,000 for the three months ended March 31, 2002. This increase is primarily attributable to an increase in professional fees, consisting of legal, audit and tax preparation services.

 

Capital Crossing Preferred intends to pay dividends on its preferred stock and common stock in amounts necessary to continue to preserve its status as a REIT under the Internal Revenue Code.

 

9

 

Changes in Financial Condition

 

Interest-bearing Deposits with Capital Crossing Bank

 

Interest-bearing deposits with Capital Crossing Bank consist entirely of a money market account at March 31, 2003.

 

Loan Portfolio

 

To date, all of Capital Crossing Preferred’s loans have been acquired from Capital Crossing.  The following table sets forth information regarding the composition of the loan portfolio at the dates indicated:

 

 

Included in net loans, at March 31, 2003 and December 31, 2002, are approximately $26.3 million and $32.9 million (of which $180,000 at December 31, 2002 are non-performing), respectively, for which the net recorded investment represents the amortized cost of these loans, where at acquisition, the amounts of reasonably estimable and probable discounted future cash collections were less than the contractual balances owed. These loans were purchased at a price to yield a market rate of interest after considering the credit quality of the loans at acquisition and the aforementioned expected future cash collections. The excess of the contractual balances over the amount of reasonably estimable and probable discounted future cash collections represents the predominant portion of the $7.3 million and $8.2 million of non-amortizing discount at March 31, 2003 and December 31, 2002, respectively.

 

Capital Crossing Preferred intends that each loan acquired from Capital Crossing in the future will be a whole loan, and will be originated or acquired by Capital Crossing in the ordinary course of its business. Capital Crossing Preferred also intends that all loans held by it will be serviced pursuant to its master service agreement with Capital Crossing.

 

From time to time, returns of capital may be made to Capital Crossing. This would have the effect of reducing the asset size of Capital Crossing Preferred.

 

Non-performing loans, net of discount, totaled $1.4 million and $1.8 million at March 31, 2003 and December 31, 2002, respectively.

 

Loans generally are placed on non-performing status and the accrual of interest and accretion of discount are generally discontinued when the collectibility of principal and interest is not probable or estimable. Unpaid interest income previously accrued on such loans is reversed against current period interest income. A loan is returned to accrual status when it is brought current in accordance with management’s anticipated cash flows at the time of acquisition.

 

10

 

Non-Amortizing Discount.  At the time of acquisition, the excess of the contractual loan balances over the amount of reasonably estimable and probable future cash collections is recorded as non-amortizing discount. The non-amortizing discount is not transferred to amortizing discount and accreted into income until it is determined that the amount and timing of the cash flows related to the non-amortizing discount are reasonably estimable and collection is probable. Non-amortizing discount generally is reduced and offset against the related principal balance when the amount at which a loan is resolved or restructured is determined. There is no effect on the income statement as a result of these reductions.  If cash flow projections deteriorate subsequent to acquisition, the decline is accounted for through the allowance for loan losses.

 

The following table sets forth certain information relating to the activity in the non-amortizing discount for the periods indicated:

 

 

Allowance for Loan Losses. Capital Crossing Preferred maintains an allowance for probable loan losses that are inherent in its loan portfolio. The allowance for probable loan losses is increased or decreased by provisions or credits for loan losses included in earnings. Additionally, the allowance for loan losses is increased upon allocations of discounts on purchased loans and reduced by net loan charge-offs. Loans are charged-off when they are deemed to be uncollectible, or partially charged-off when a portion of a loan is deemed uncollectible. Recoveries are generally recorded only when cash payments are received. The loan loss allowance policy requires the maintenance of allowances sufficient to satisfy estimated probable losses arising from impaired real estate or other secured commercial loans.

 

Capital Crossing Preferred performs periodic reviews of its loan portfolio to identify loans for which specific allocations are considered prudent. Specific allocations include the results of measuring impaired loans under Statement of Financial Accounting Standards No. 114. General risk allocations are determined by a formula whereby the loan portfolio is stratified by loan type and by internal risk rating categories. Loss factors are then applied to each strata based on various considerations including historic loss experience, delinquency trends, current economic conditions, industry standards and regulatory guidelines. An additional allowance is maintained based on a judgment by management after consideration of qualitative and quantitative assessments of certain factors including regional credit concentration, industry concentration, results of regulatory examinations, historical loss ranges, portfolio composition, economic conditions such as interest rates and energy costs and other changes in the portfolio. The allowance for loan losses is management’s estimate of the probable loan losses incurred as of the balance sheet date.

 

Additional factors influencing the calculation of the allowance for loan losses are particular concentrations within the portfolio, including the geographic concentration of loans in California, which accounted for approximately 43.4% of the portfolio at March 31, 2003, and concentrations of loans to individual borrowers.

 

Capital Crossing Preferred’s allowance for loan losses at March 31, 2003 was $7.4 million. The determination of this allowance requires the use of estimates and assumptions regarding the risks inherent in individual loans and the loan portfolio in its entirety. In addition, regulatory agencies periodically review the adequacy of the allowance for loan losses and may require Capital Crossing Preferred to make additions to its allowance for loan losses. While management believes its estimates and assumptions are reasonable, there can be no assurance that they will be proven to be correct in the future. The actual amount of future provisions that may be required cannot be determined, and such provisions may exceed the amounts of past provisions. Management believes that the allowance for loan losses is adequate to absorb the known and inherent risks in Capital Crossing Preferred’s loan portfolio at each date based on the facts known to management as of such date. Management continues to monitor and modify the allowances for general and specific loan losses as economic conditions dictate.

 

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The following table sets forth certain information relating to the activity in the allowance for loan losses for the periods indicated:

 

 

Interest Rate Risk

 

Capital Crossing Preferred’s income consists primarily of interest income. If there is a decline in market interest rates, Capital Crossing Preferred may experience a reduction in interest income and a corresponding decrease in funds available to be distributed to its shareholders. The reduction in interest income may result from downward adjustments of the indices upon which the interest rates on loans are based and from prepayments of mortgage loans with fixed interest rates, resulting in reinvestment of the proceeds in lower yielding mortgage loans. Capital Crossing Preferred does not intend to use any derivative products to manage its interest rate risk.

 

Significant Concentration of Credit Risk

 

Concentration of credit risk generally arises with respect to Capital Crossing Preferred’s loan portfolio when a number of borrowers engage in similar business activities, or activities in the same geographical region. Concentration of credit risk indicates the relative sensitivity of Capital Crossing Preferred’s performance to both positive and negative developments affecting a particular industry. Capital Crossing Preferred’s balance sheet exposure to geographic concentrations directly affects the credit risk of the loans within its loan portfolio.

 

At March 31, 2003, 43.4% and 13.4% of Capital Crossing Preferred’s total loan portfolio consisted of loans in California and New England, respectively. At December 31, 2002, 43.7% and 14.1% of Capital Crossing Preferred’s total real estate loan portfolio consisted of loans located in California and New England, respectively. Consequently, the portfolio may experience a higher default rate in the event of adverse economic, political or business developments or natural hazards in California or New England that may affect the ability of property owners to make payments of principal and interest on the underlying mortgages.

 

Liquidity Risk Management

 

The objective of liquidity management is to ensure the availability of sufficient cash flows to meet all of Capital Crossing Preferred’s financial commitments. In managing liquidity risk, Capital Crossing Preferred takes into account various legal limitations placed on a REIT. Capital Crossing Preferred’s principal liquidity need is to pay dividends on the preferred shares and common shares.

 

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The acquisition of additional mortgage assets is intended to be funded primarily through repayment of principal balances of mortgage assets by individual borrowers. Capital Crossing Preferred does not have and does not anticipate having any material capital expenditures. To the extent that the Board of Directors determines that additional funding is required, Capital Crossing Preferred may raise such funds through additional equity offerings, debt financing or retention of cash flow (after consideration of provisions of the Internal Revenue Code requiring the distribution by a REIT of at least 90% of its REIT taxable income and taking into account taxes that would be imposed on undistributed income), or a combination of these methods. Except for its obligation to guarantee certain borrowings of Capital Crossing, Capital Crossing Preferred does not currently intend to incur any indebtedness. The organizational documents of Capital Crossing Preferred limit the amount of indebtedness which it is permitted to incur without the approval of the Series A and the Series C preferred stockholders to no more than 100% of the total stockholders’ equity of Capital Crossing Preferred. Any such debt may include intercompany advances made by Capital Crossing to Capital Crossing Preferred.

 

RISK FACTORS AND FACTORS AFFECTING FUTURE OPERATING RESULTS

 

Set forth below are a number of risk factors that investors should carefully consider in making an investment in Capital Crossing Preferred’s preferred stock. These factors may cause Capital Crossing Preferred’s actual results to differ materially from anticipated future results, performance or achievements expressed or implied by the forward-looking statements.

 

All of these factors should be carefully reviewed, and the reader of this Form 10-Q should be aware that there may be other factors that could cause these differences.

 

A decline in Capital Crossing’s capital levels may result in the Series A and Series C preferred shares being subject to automatic exchange into preferred shares of Capital Crossing

 

The returns from an investment in the Series A or Series C preferred shares will depend to a significant extent on the performance and capital of Capital Crossing. A significant decline in the performance and capital levels of Capital Crossing or the placement of Capital Crossing into bankruptcy, reorganization, conservatorship or receivership could result in the automatic exchange of the Series A and Series C preferred shares for preferred shares of Capital Crossing, which would represent an investment in Capital Crossing and not in Capital Crossing Preferred. Under these circumstances:

 

•                  a holder of Series A or Series C preferred shares would be a preferred stockholder of Capital Crossing at a time when Capital Crossing’s financial condition was deteriorating or when Capital Crossing had been placed into bankruptcy, reorganization, conservatorship or receivership and, accordingly, it is unlikely that Capital Crossing would be in a financial position to pay any dividends on the preferred shares of Capital Crossing. An investment in Capital Crossing is also subject to risks that are distinct from the risks associated with an investment in Capital Crossing Preferred. For example, an investment in Capital Crossing would involve risks relating to the capital levels of, and other federal and state regulatory requirements applicable to, Capital Crossing, and the performance of Capital Crossing’s overall loan portfolio and other business lines. Capital Crossing also has significantly greater liabilities and significantly less stockholders’ equity than does Capital Crossing Preferred;

 

•                  if a liquidation of Capital Crossing occurs, the claims of depositors and creditors of Capital Crossing and of the FDIC would have priority over the claims of holders of the preferred shares of Capital Crossing, and therefore, a holder of Series A and Series C preferred shares likely would receive substantially less than such holder would receive had the Series A and Series C preferred shares not been exchanged for preferred shares of Capital Crossing; and

 

•                  the exchange of the Series A or Series C preferred shares for preferred shares of Capital Crossing would be a taxable event to a holder of Series A or Series C preferred shares under the Internal Revenue Code, and such holder would incur a gain or a loss, as the case may be, measured by the difference between such holder’s basis in the Series A or Series C preferred shares and the fair market value of Capital Crossing preferred shares received in the exchange.

 

Because of Capital Crossing Preferred’s obligations to creditors, it may not be able to make dividend or liquidation payments to holders of the Series A and Series C preferred shares

 

The Series A and Series C preferred shares rank:

 

•                  junior to borrowings of Capital Crossing Preferred, including claims of the FHLBB for amounts due or which may become due under Capital Crossing Preferred’s guarantee of Capital Crossing’s obligations to the FHLBB, and any other obligations to Capital Crossing Preferred’s creditors upon its liquidation; and

 

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•                  senior to Capital Crossing Preferred’s common stock and its Series B preferred stock with regard to payment of dividends and amounts upon liquidation.

 

If Capital Crossing Preferred incurs significant indebtedness, it may not have sufficient funds to make dividend or liquidation payments on the Series A or Series C preferred shares. Upon Capital Crossing Preferred’s liquidation, its obligations to its creditors would rank senior to the Series A and Series C preferred shares. At March 31, 2003, Capital Crossing Preferred had approximately $139,000 in accounts payable and other liabilities which, upon its liquidation, would be required to be paid before any payments could be made to holders of the Series A or Series C preferred shares. In addition, upon Capital Crossing Preferred’s liquidation, dissolution or winding up, if it does not have sufficient funds to pay the full liquidation amount to the holders of the Series A and Series C preferred shares, such holders may receive less than the $10.00 per share liquidation amount.

 

The terms of the Series A and Series C preferred shares limit Capital Crossing Preferred’s ability to incur debt in excess of 100% of its stockholders’ equity without the approval of the holders of all of the outstanding Series A and Series C preferred shares but do not require that Capital Crossing Preferred obtain the approval of the holders of the Series A and Series C preferred shares to issue additional series of preferred shares which rank equal to the Series A and Series C preferred shares as to payment of dividends or amount upon liquidation. As a result, subject to these limitations, Capital Crossing Preferred may incur obligations which may further limit its ability to make dividend or liquidation payments in the future.

 

Bank regulators may limit the ability of Capital Crossing Preferred to implement its business plan and may restrict its ability to pay dividends

 

Because Capital Crossing Preferred is a subsidiary of Capital Crossing, federal and state regulatory authorities will have the right to examine it and its activities and under certain circumstances, to impose restrictions on Capital Crossing or Capital Crossing Preferred which could impact Capital Crossing Preferred’s ability to conduct its business according to its business plan, which could materially adversely affect the financial condition and results of operations of Capital Crossing Preferred:

 

•                  if Capital Crossing’s regulators determine that Capital Crossing’s relationship to Capital Crossing Preferred results in an unsafe and unsound banking practice, the regulators could restrict Capital Crossing Preferred’s ability to transfer assets, to make distributions to its stockholders, including dividends on its Series A and Series C preferred shares, or to redeem shares of Series A and Series C preferred stock or even require Capital Crossing to sever its relationship with or divest its ownership interest in Capital Crossing Preferred. Such actions could potentially result in Capital Crossing Preferred’s failure to qualify as a REIT.

 

•                  payment of dividends on the Series A and Series C preferred shares could also be subject to regulatory limitations if Capital Crossing becomes undercapitalized. Capital Crossing will be deemed undercapitalized if its total risk-based capital ratio is less than 8.0%, its Tier 1 risk-based capital ratio is less than 4.0% or its Tier 1 leverage ratio is less than 4.0%. At March 31, 2003, Capital Crossing had a total risk-based capital ratio of 12.76%, a Tier 1 risk-based capital ratio of 11.49% and a Tier 1 leverage ratio of 9.12%, which is sufficient for Capital Crossing to be considered well-capitalized. As part of its common stock repurchase program, Capital Crossing has also agreed with the FDIC to maintain, for so long as the repurchase program continues, its Tier 1 leverage ratio at least 8.00%. Capital Crossing Preferred makes no assurance that Capital Crossing will be well-capitalized under applicable regulations as of any future date. For purposes of calculating these capital ratios as a percentage of Capital Crossing’s risk-weighted assets, as opposed to its total assets, Capital Crossing’s assets are assigned to risk categories based on the relative credit risk of the asset in question. These risk weights consist of 0% for assets deemed least risky such as cash, claims backed by the full faith and credit of the U.S. government, and balances due from Federal Reserve banks; 20% for assets deemed slightly more risky such as portions of obligations conditionally guaranteed by the U.S. government or federal funds sold; 50% for assets deemed still more risky such as government issued-revenue bonds, one-to-four family residential first mortgage loans and well-collateralized multi-family residential first mortgage loans; and 100% for all other assets, including private sector loans such as commercial mortgage loans as well as bank-owned real estate.

 

•                  while Capital Crossing Preferred believes that dividends on the Series A and Series C preferred shares should not be considered distributions by Capital Crossing, the FDIC may not agree with this position. Under FDIC regulations on capital distributions, the ability of Capital Crossing to make a capital distribution varies depending primarily on Capital Crossing’s earnings and regulatory capital levels. Capital distributions are defined to include payment of dividends, stock repurchases, cash-out mergers and other distributions charged against the capital accounts of an institution. The FDIC could limit or prohibit the payment of dividends on the Series A and Series C preferred shares if it determines that the payment of those dividends is a capital distribution by Capital Crossing and that Capital Crossing’s earnings and regulatory capital levels are below specified levels.

 

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Capital Crossing Preferred does not have insurance to cover its exposure to borrower defaults and bankruptcies and special hazard losses that are not covered by its standard hazard insurance policies

 

Capital Crossing Preferred does not generally obtain general credit enhancements such as mortgagor bankruptcy insurance or obtain special hazard insurance for its mortgage assets, other than standard hazard insurance, which will in each case only relate to individual mortgage loans. Accordingly, Capital Crossing Preferred will be subject to risks of borrower defaults and bankruptcies and special hazard losses, such as losses occurring from floods that are not covered by standard hazard insurance. A significant number of loans acquired in recent years are loans that were originated under the Small Business Administration’s disaster relief program. These loans are typically loans made to small businesses and individuals for the purpose of assisting those who have been the victim of a disaster and may be located in an area prone to such disasters. In the event of a default on any mortgage loan held by Capital Crossing Preferred resulting from declining property values or worsening economic conditions, among other factors, it would bear the risk of loss of principal to the extent of any deficiency between (1) the value of the related mortgaged property, plus any payments from an insurer or guarantor in the case of commercial mortgage loans, and (2) the amount owing on the mortgage loan.

 

Capital Crossing Preferred’s results will be affected by factors beyond its control

 

Capital Crossing Preferred’s mortgage loan portfolio is subject to local economic conditions which could affect the value of the real estate assets underlying its loans and therefore, its results of operations will be affected by various conditions in the real estate market, all of which are beyond its control, such as:

 

•                  local and other economic conditions affecting real estate values;

 

•                  the continued financial stability of a borrower and the borrower’s ability to make mortgage payments;

 

•                  the ability of tenants to make lease payments;

 

•                  the ability of a property to attract and retain tenants, which may in turn be affected by local conditions, such as oversupply of space or a reduction in demand for rental space in the area;

 

•                  interest rate levels and the availability of credit to refinance mortgage loans at or prior to maturity; and

 

•                  increased operating costs, including energy costs, real estate taxes and costs of compliance with environmental controls and regulations.

 

Capital Crossing Preferred’s loans are concentrated in California and New England and adverse conditions in those markets could adversely affect its operations

 

Properties underlying Capital Crossing Preferred’s current mortgage assets are concentrated primarily in California, particularly Southern California, and New England. As of March 31, 2003, approximately 43.4% of its mortgage assets were secured by properties located in California and 13.4% in New England. Adverse economic, political or business developments or natural hazards may affect these areas and the ability of property owners in these areas to make payments of principal and interest on the underlying mortgages. If either region experienced adverse economic, political or business conditions, Capital Crossing Preferred would likely experience higher rates of loss and delinquency on its mortgage loans than if its loans were more geographically diverse.

 

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A substantial majority of Capital Crossing Preferred’s loans were originated by other parties whose level of due diligence may be different than Capital Crossing’s level of due diligence

 

At March 31, 2003, approximately 93.8% of Capital Crossing Preferred’s loan portfolio consisted of loans originated by third parties that were purchased by Capital Crossing and subsequently acquired by Capital Crossing Preferred from Capital Crossing. Because these loans were originated by third parties, Capital Crossing generally is not able to conduct the same level of due diligence on these loans that it would have conducted had it originated them. Generally, while Capital Crossing conducts an acquisition review, it relies on the underwriting standards of the parties originating the loans it acquires. The standards of these loan originators may be substantially different than those of Capital Crossing. These differences may include less rigorous appraisal requirements and debt service coverage ratios, and less rigorous analysis of property location and environmental factors, building condition and age, tenant quality, compliance with zoning regulations, any use restrictions, easements or right of ways that may impact the value and the borrower’s ability to manage the property. Other disadvantages of purchased loans versus originated loans may include the lack of current financial information, incomplete legal documentation and outdated appraisals.

 

More than half of Capital Crossing Preferred’s loan portfolio is made up of commercial mortgage loans which are generally riskier than other types of loans

 

Commercial mortgage loans constituted approximately 69.5% of the total gross loans in Capital Crossing Preferred’s loan portfolio at March 31, 2003 and commercial mortgage loans are generally subject it to greater risks than other types of loans. Capital Crossing Preferred’s commercial mortgage loans, like most commercial mortgage loans, generally lack standardized terms, tend to have shorter maturities than residential mortgage loans and may not be fully amortizing, meaning that they have a principal balance or “balloon” payment due on maturity. The commercial real estate properties underlying Capital Crossing Preferred’s commercial mortgage loans also tend to be unique and are more difficult to value than residential real estate properties. They are also subject to relatively greater environmental risks than other types of loans and to the corresponding burdens and costs of compliance with environmental laws and regulations. Because of these risks related to commercial mortgage loans, Capital Crossing Preferred may experience higher rates of default on its mortgage loans than it would if its loan portfolio was more diversified and included a greater number of residential and other mortgage loans.

 

Capital Crossing Preferred may not be able to purchase loans at the same volumes or with the same yields as it has historically purchased

 

To date Capital Crossing Preferred has purchased all of the loans in its portfolio from Capital Crossing. Historically, Capital Crossing has acquired such loans (1) from institutions which sought to eliminate certain loans or categories of loans from their portfolios, (2) from institutions participating in securitization programs, (3) from failed or consolidating financial institutions and (4) from government agencies, specifically the Small Business Administration. Future loan purchases will depend on the availability of pools of loans offered for sale and Capital Crossing’s ability to submit successful bids or negotiate satisfactory purchase prices. The acquisition of whole loans is highly competitive. In fact, the Small Business Administration has recently announced that all future assets sales are on hold, pending the outcome of an internal review of its loan sale program. Consequently, Capital Crossing Preferred cannot provide assurance that Capital Crossing will be able to purchase loans at the same volumes or with the same yields as it has historically purchased. This may interfere with Capital Crossing Preferred’s ability to maintain the requisite level of mortgage assets to maintain its qualification as a REIT. If volumes of loans purchased decline or the yields on these loans decline further, Capital Crossing Preferred would experience a material adverse effect on its business, financial condition and results of operations.

 

Capital Crossing Preferred could be held responsible for environmental liabilities of properties it acquires through foreclosure

 

If Capital Crossing Preferred chooses to foreclose on a defaulted mortgage loan to recover its investment it may be subject to environmental liabilities related to the underlying real property. Approximately 69.5% of the loans in Capital Crossing Preferred’s portfolio at March 31, 2003 were commercial mortgage loans, which generally are subject to relatively greater environmental risks than other types of loans. Hazardous substances or wastes, contaminants, pollutants or sources thereof may be discovered on properties during Capital Crossing Preferred’s ownership or after a sale to a third party. The amount of environmental liability could exceed the value of the real property. There can be no assurance that Capital Crossing Preferred would not be fully liable for the entire cost of any removal and clean-up on an acquired property, that the cost of removal and clean-up would not exceed the value of the property or that Capital Crossing Preferred could recoup any of the costs from any third party. In addition, Capital Crossing Preferred may find it difficult or impossible to sell the property prior to or following any such remediation.

 

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Capital Crossing Preferred is dependent in virtually every phase of its operations on the diligence and skill of the management of Capital Crossing

 

Capital Crossing, which holds all of Capital Crossing Preferred’s common stock, is involved in virtually every aspect of Capital Crossing Preferred’s existence. Capital Crossing Preferred has five officers and no other employees and does not have any independent corporate infrastructure. Capital Crossing Preferred does not have any employees because it has retained Capital Crossing to perform all necessary functions pursuant to the advisory agreement and the master service agreement. All of Capital Crossing Preferred’s officers are also officers of Capital Crossing. Under an advisory agreement between Capital Crossing Preferred and Capital Crossing, Capital Crossing administers day-to-day activities, including monitoring of Capital Crossing Preferred’s credit quality and advising it with respect to the acquisition, management, financing and disposition of mortgage assets and its operations generally. Under a master service agreement between Capital Crossing Preferred and Capital Crossing, Capital Crossing services Capital Crossing Preferred’s loan portfolio. The advisory agreement has an initial term of five years with an automatic renewal feature and the master service agreement has a one-year term with an automatic renewal feature. Both the master service agreement and the advisory agreement are subject to earlier termination upon provision of 30 days and 90 days notice, respectively. Capital Crossing may subcontract all or a portion of its obligations under the advisory agreement to its affiliates or, with the approval of a majority of the Board of Directors as well as a majority of the independent directors, subcontract its obligations under the advisory agreement to unrelated third parties. Capital Crossing will not, in connection with the subcontracting of any of its obligations under the advisory agreement, be discharged or relieved from its obligations under the advisory agreement. The loss of the services of Capital Crossing, or the inability of Capital Crossing to effectively provide such services whether as a result of the loss of key members of Capital Crossing’s management, early termination of the agreements or otherwise, and Capital Crossing Preferred’s inability to replace such services on favorable terms, or at all, could adversely affect Capital Crossing Preferred’s ability to conduct its operations.

 

Capital Crossing Preferred’s relationship with Capital Crossing may create conflicts of interest

 

Capital Crossing and its affiliates may have interests which are not identical to Capital Crossing Preferred’s and therefore conflicts of interest have arisen and may arise in the future with respect to transactions between Capital Crossing Preferred and Capital Crossing such as:

 

Acquisition of mortgage assets.  Capital Crossing Preferred anticipates that it will from time to time continue to purchase additional mortgage assets. Capital Crossing Preferred intends to acquire all or substantially all of such mortgage assets from Capital Crossing, on terms that are comparable to those that could be obtained by Capital Crossing Preferred if such mortgage assets were purchased from unrelated third parties. Neither Capital Crossing Preferred nor Capital Crossing currently have specific policies with respect to the purchase by Capital Crossing Preferred from Capital Crossing of particular loans or pools of loans, other than that such assets must be eligible to be held by a REIT. Although these purchases are structured to take advantage of the underwriting procedures of Capital Crossing, and while Capital Crossing Preferred believes that any agreements and transactions between it, on the one hand, and Capital Crossing and/or its affiliates on the other hand, are fair to all parties and consistent with market terms, neither Capital Crossing Preferred nor Capital Crossing have obtained any third-party valuation to confirm whether Capital Crossing Preferred will be paying fair market value for these loans, nor does Capital Crossing Preferred anticipate doing so in the future. Additionally, through limiting Capital Crossing Preferred’s source of purchased mortgage assets solely to those originated or purchased by Capital Crossing, Capital Crossing Preferred’s portfolio will generally reflect the nature, scope and risk of Capital Crossing’s portfolio rather than a more diverse portfolio composed of mortgage loans also purchased from other lenders.

 

Servicing of Capital Crossing Preferred mortgage assets by Capital Crossing.  Capital Crossing Preferred’s loans are serviced by Capital Crossing pursuant to the terms of the master service agreement. Capital Crossing in its role as servicer under the terms of the master service agreement receives a fee equal to 0.20% per annum, payable monthly, on the gross outstanding principal balances of loans serviced. The master service agreement requires Capital Crossing to service the loan portfolio in a manner substantially the same as for similar work performed by Capital Crossing for transactions on its own behalf. This will become especially important as Capital Crossing services any loans which become classified or are placed on non-performing status, or are renegotiated due to the financial deterioration of the borrower. While Capital Crossing Preferred believes that Capital Crossing will diligently pursue collection of any non-performing loans, Capital Crossing Preferred cannot provide assurance that this will be the case. Capital Crossing Preferred’s ability to make timely payments of dividends will depend in part upon Capital Crossing’s prompt collection efforts on behalf of Capital Crossing Preferred.

 

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Future dispositions by Capital Crossing Preferred of mortgage assets to Capital Crossing or its affiliates.  The master service agreement provides that foreclosures and dispositions of the mortgage assets are to be performed with a view toward maximizing Capital Crossing Preferred’s recovery as owner of the mortgage assets, and Capital Crossing shall service the mortgage assets solely with a view toward Capital Crossing Preferred’s interests, and without regard to the interests of Capital Crossing or any of its affiliates. However, Capital Crossing Preferred cannot provide assurance that any such agreement or transaction will be on terms as favorable to it as would have been obtained from unaffiliated third parties. Capital Crossing may seek to exercise its influence over Capital Crossing Preferred’s affairs so as to cause the sale of the mortgage assets owned by Capital Crossing Preferred and their replacement by lesser quality loans purchased from Capital Crossing or elsewhere which could adversely affect Capital Crossing Preferred’s business and its ability to make timely payments of dividends.

 

Future modifications of the advisory agreement or master service agreement.  Should Capital Crossing Preferred seek to modify either the advisory agreement or the master service agreement, it would rely upon its officers, all of whom are also officers of Capital Crossing, and/or its directors, three of whom are also officers of Capital Crossing. Thus, Capital Crossing Preferred’s officers and/or directors would be responsible for taking positions with respect to such agreements that, while in Capital Crossing Preferred’s best interests, would not be in the best interests of Capital Crossing. Although the termination, modification or decision not to renew the advisory agreement and/or the master service agreement requires the approval of a majority of Capital Crossing Preferred’s independent directors, Capital Crossing, as holder of all of Capital Crossing Preferred’s outstanding common stock, controls the election of all Capital Crossing Preferred directors, including the independent directors. Capital Crossing Preferred cannot provide assurance that such modifications will be on terms as favorable to it as those that could have been obtained from unaffiliated third parties.

 

The terms of Capital Crossing Preferred’s guarantee of obligations of Capital Crossing.  Capital Crossing Preferred has guaranteed all of the obligations of Capital Crossing under advances Capital Crossing may receive from time to time from the FHLBB, and has agreed to pledge a significant amount of it’s assets in connection with those advances. The assets Capital Crossing Preferred pledges to the FHLBB will vary from time to time; however, the potential exists for Capital Crossing Preferred to pledge all of its assets to the FHLBB to secure advances to Capital Crossing. In addition, Capital Crossing has pledged to the FHLBB all of the shares of Capital Crossing Preferred’s capital stock it owns as collateral for its FHLBB borrowings. Under the terms of the pledge, if Capital Crossing becomes undercapitalized the FHLBB may require Capital Crossing to dissolve Capital Crossing Preferred such that the assets of Capital Crossing Preferred are distributed to Capital Crossing. In this circumstance the holders of Series A and Series C Preferred shares would receive their liquidation preference only to the extent there are available assets of Capital Crossing Preferred following satisfaction of its outstanding obligations, including its guarantee of Capital Crossing’s FHLBB borrowings. At March 31, 2003, approximately $39.6 million, or 11.9%, of Capital Crossing Preferred assets have been pledged to and accepted by the FHLBB to secure advances to Capital Crossing. Capital Crossing has also agreed with the FHLBB that it will not request or accept advances from the FHLBB in excess of Capital Crossing Preferred’s total stockholders equity, less the stockholders equity attributable to the Series A and Series C preferred shares. As of March 31, 2003, this restriction would limit Capital Crossing’s ability to receive advances in excess of approximately $304.3 million. As of March 31, 2003, Capital Crossing had $129.0 million in outstanding FHLBB borrowings. The guarantee and pledge were approved by Capital Crossing Preferred’s independent directors, subject to certain requirements and limitations, including the requirement that Capital Crossing pay Capital Crossing Preferred a guarantee fee. Any default by Capital Crossing on its obligations which would require Capital Crossing Preferred to satisfy its guarantee could adversely affect its business and its ability to make timely payments of dividends.

 

The master loan purchase agreement was not the result of arm’s-length negotiations.  Capital Crossing Preferred acquires loans pursuant to the master mortgage loan purchase agreement between Capital Crossing Preferred and Capital Crossing, at an amount equal to Capital Crossing’s net carrying value for those mortgage assets. While Capital Crossing Preferred believes that the master mortgage loan purchase agreement was fair to all parties and consistent with market terms, all of it’s officers and three of its directors are also officers and/or directors of Capital Crossing and/or affiliates of Capital Crossing. Capital Crossing, as holder of all of Capital Crossing Preferred’s outstanding common stock, controls the election of all Capital Crossing Preferred directors, including the independent directors. Capital Crossing Preferred cannot provide assurance that the master mortgage loan purchase agreement was entered into on terms as favorable to Capital Crossing Preferred as those that could have been obtained from unaffiliated third parties.

 

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Neither Capital Crossing Preferred nor Capital Crossing have specific policies with respect to the purchase by Capital Crossing Preferred from Capital Crossing of particular loans or pools of loans

 

The lack of specific policies with respect to the purchase by Capital Crossing Preferred of loans from Capital Crossing could result in Capital Crossing Preferred acquiring lower quality mortgage assets from Capital Crossing than if such policies were otherwise in place. Neither Capital Crossing Preferred nor Capital Crossing currently have specific policies with respect to the purchase by Capital Crossing Preferred from Capital Crossing of particular loans or pools of loans, other than that such assets must be eligible to be held by a REIT. Capital Crossing Preferred’s Board of Directors has adopted certain policies to guide the acquisition and disposition of assets but these policies may be revised from time to time at the discretion of the Board of Directors without a vote of Capital Crossing Preferred’s stockholders. Capital Crossing Preferred intends to acquire all or substantially all of the additional mortgage assets it may acquire in the future from Capital Crossing on terms that are comparable to those that could be obtained by Capital Crossing Preferred if such mortgage assets were purchased from unrelated third parties, but Capital Crossing Preferred cannot provide assurance that this will always be the case.

 

Capital Crossing Preferred’s Board of Directors has broad discretion to revise Capital Crossing Preferred’s strategies

 

Capital Crossing Preferred’s Board of Directors has established Capital Crossing Preferred’s investment and operating strategies. These strategies may be revised from time to time at the discretion of the Board of Directors without a vote of Capital Crossing Preferred’s stockholders. Changes in Capital Crossing Preferred’s strategies could have a negative effect on shareholders.

 

Capital Crossing Preferred does not obtain third-party valuations and therefore it may pay more or receive less than fair market value for its mortgage assets

 

To date, Capital Crossing Preferred has not obtained third-party valuations as part of its loan acquisitions or dispositions and does not anticipate obtaining third-party valuations for future acquisitions and dispositions of mortgage assets. Capital Crossing Preferred does not intend to obtain third-party valuations even where it is acquiring mortgage assets from, or disposing mortgage assets to, one of its affiliates, including Capital Crossing. Accordingly, Capital Crossing Preferred may pay its affiliates, including Capital Crossing, more than the fair market value of mortgage assets it acquires and may receive less than the fair market value of the mortgage assets it sells based on a third-party valuation.

 

Capital Crossing Preferred may pay more than fair market value for mortgages it purchases from Capital Crossing because it does not engage in arm’s- length negotiations with Capital Crossing

 

Capital Crossing Preferred acquires mortgage assets from Capital Crossing under a master mortgage loan purchase agreement between it and Capital Crossing, at an amount equal to Capital Crossing’s net carrying value for those mortgage assets. Because Capital Crossing is an affiliate of Capital Crossing Preferred’s, Capital Crossing Preferred does not engage in any arm’s-length negotiations regarding the consideration to be paid. Accordingly, if Capital Crossing’s net carrying value exceeds the fair market value of the mortgage assets, Capital Crossing Preferred would pay Capital Crossing more than the fair market value for those mortgaged assets.

 

A decline in interest rates could reduce Capital Crossing Preferred earnings and affect its ability to pay dividends

 

Capital Crossing Preferred’s income consists primarily of interest earned on its mortgage assets and short-term investments. A significant portion of Capital Crossing Preferred’s mortgage assets bear interest at adjustable rates. If there is a decline in interest rates, then Capital Crossing Preferred will experience a decrease in income available to be distributed to its stockholders. If interest rates decline, Capital Crossing Preferred may also experience an increase in prepayments on its mortgage assets and may find it difficult to purchase additional mortgage assets bearing rates sufficient to support payment of dividends on the Series A and Series C preferred shares. Because the dividend rates on the Series A and Series C preferred shares are fixed, a significant decline in interest rates could materially adversely affect Capital Crossing Preferred’s ability to pay dividends on the Series A and Series C preferred shares.

 

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Tax Risks Related to REITs

 

If Capital Crossing Preferred fails to qualify as a REIT, it will be subject to federal income tax at regular corporate rates.  If Capital Crossing Preferred fails to qualify as a REIT for any taxable year, it would be subject to federal income tax, including any applicable alternative minimum tax, on its taxable income at regular corporate rates. As a result, the amount available for distribution to Capital Crossing Preferred’s stockholders would be reduced for the year or years involved. In addition, unless entitled to relief under statutory provisions, Capital Crossing Preferred would be disqualified from treatment as a REIT for the four taxable years following the year which qualification was lost. The failure to qualify as a REIT would reduce Capital Crossing Preferred’s net earnings available for distribution to its stockholders because of the additional tax liability for the year or years involved. Capital Crossing Preferred’s failure to qualify as a REIT would not by itself give it the right to redeem the Series A or Series C preferred shares, nor would it give the holders of the Series A or Series C preferred shares the right to have their shares redeemed.

 

Although Capital Crossing Preferred currently intends to operate in a manner designed to qualify as a REIT, future economic, market, legal, tax or other considerations may cause it to determine that it is in its best interest and in the best interest of holders of its common stock and preferred stock to revoke its REIT election. The tax law prohibits Capital Crossing Preferred from electing treatment as a REIT for the four taxable years following the year of any such revocation.

 

If Capital Crossing Preferred does not distribute 90% of its net taxable income, it may not qualify as a REIT.  In order to qualify as a REIT, Capital Crossing Preferred generally is required each year to distribute to its stockholders at least 90% of its net taxable income, excluding net capital gains. Capital Crossing Preferred may retain the remainder of REIT taxable income or all or part of its net capital gain, but will be subject to tax at regular corporate rates on such income. In addition, Capital Crossing Preferred is subject to a 4% nondeductible excise tax on the amount, if any, by which certain distributions considered as paid by Capital Crossing Preferred with respect to any calendar year are less than the sum of (1) 85% of its ordinary income for the calendar year, (2) 95% of its capital gains net income for the calendar year and (3) 100% of any undistributed income from prior periods. Under certain circumstances, federal or state regulatory authorities may restrict Capital Crossing Preferred’s ability, as a subsidiary of Capital Crossing, to make distributions to its stockholders in an amount necessary to retain its REIT qualification. Such a restriction could result in Capital Crossing Preferred failing to qualify as a REIT. To the extent Capital Crossing Preferred’s REIT taxable income may exceed the actual cash received for a particular period, Capital Crossing Preferred may not have sufficient liquidity to make distributions necessary to retain its REIT qualification.

 

Capital Crossing Preferred may redeem the Series A and Series C preferred shares at any time upon the occurrence of a tax event.  At any time following the occurrence of certain changes in the tax laws or regulations concerning REITs, Capital Crossing Preferred will have the right to redeem the Series A and Series C preferred shares in whole, subject to the prior written approval of the FDIC. Capital Crossing Preferred would have the right to redeem the Series A and Series C preferred shares if it received an opinion of counsel to the effect that, as a result of changes to the tax laws or regulations:

 

(1)          dividends paid by Capital Crossing Preferred with respect to its capital stock are not fully deductible by it for income tax purposes; or

 

(2)          Capital Crossing Preferred are otherwise unable to qualify as a REIT.

 

The occurrence of such changes in the tax laws or regulations will not, however, give the holders of the Series A or Series C preferred shares any right to have their shares redeemed.

 

Capital Crossing Preferred has imposed ownership limitations to protect its ability to qualify as a REIT, however, if ownership of the common stock of Capital Crossing becomes concentrated in a small number of individuals Capital Crossing Preferred may fail to qualify as a REIT.  To maintain Capital Crossing Preferred’s status as a REIT, not more than 50% in value of Capital Crossing Preferred’s outstanding shares may be owned, directly or indirectly, by five or fewer individuals, as defined in the Internal Revenue Code, or the Code, to include certain entities, during the last half of each taxable year. Capital Crossing Preferred currently satisfies this requirement because for this purpose Capital Crossing Preferred’s common stock held by Capital Crossing is treated as held by Capital Crossing’s stockholders. However, it is possible that the ownership of Capital Crossing might become sufficiently concentrated in the future such that five or fewer individuals would be treated as having constructive ownership of more than 50% of the value of Capital Crossing Preferred’s stock. Capital Crossing Preferred may have difficulty monitoring the daily ownership and constructive ownership of its outstanding shares and, therefore, Capital Crossing Preferred cannot provide assurance that it will continue to meet the share ownership requirement. This risk may be increased in the future as Capital Crossing implements common stock repurchase programs because repurchases may cause ownership in Capital Crossing to become more concentrated. In addition, while the fact that the Series A and the Series C preferred shares may be redeemed or exchanged will not affect Capital Crossing Preferred’s REIT status prior to any such redemption or exchange, the redemption or exchange of all or a part of the Series A and Series C preferred shares could adversely affect Capital Crossing Preferred’s ability to satisfy the share ownership requirements in the future.

 

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

Market risk is the risk of loss from adverse changes in market prices and interest rates. It is the objective of Capital Crossing Preferred to attempt to control risks associated with interest rate movements. Capital Crossing Preferred’s market risk arises primarily from interest rate risk inherent in holding loans. To that end, management actively monitors and manages the interest rate risk exposure of Capital Crossing Preferred.

 

Capital Crossing Preferred’s management reviews, among other things, the sensitivity of Capital Crossing Preferred’s assets to interest rate changes, the book and market values of assets, purchase and sale activity, and anticipated loan pay-offs. Capital Crossing’s senior management also approves and establishes pricing and funding decisions with respect to Capital Crossing Preferred’s overall asset and liability composition.

 

Capital Crossing Preferred’s methods for evaluating interest rate risk include an analysis of its interest-earning assets maturing or repricing within a given time period. Since Capital Crossing Preferred has no interest-bearing liabilities, a period of rising interest rates would tend to result in an increase in interest income. A period of falling interest rates would tend to adversely affect interest income.

 

The following table sets forth Capital Crossing Preferred’s interest-rate-sensitive assets categorized by repricing dates and weighted average yields at March 31, 2003. For fixed rate instruments, the repricing date is the maturity date. For adjustable-rate instruments, the repricing date is deemed to be the earliest possible interest rate adjustment date. Assets that are subject to immediate repricing are placed in the overnight column.

 

		Overnight			Within One Year			One to Two Years			Two to Three Years			Three to Four Years			Four to Five Years			Over Five Years			Total
		(dollars in thousands)
Interest-bearing deposits in banks		$	116,338		$	100		$	—		$	—		$	—		$	—		$	—		$	116,438
Average interest rate		2.66		%	2.00		%
Fixed-rate loans (1)		—			40,820			27,643			21,621			14,055			11,447			19,752			135,338
Average interest rate					8.33		%	8.23		%	8.31		%	7.90		%	7.82		%	7.00		%
Adjustable-rate loans (1)		27,696			56,949			5,346			248			—			—			—			90,239
Average interest rate		7.60		%	6.59		%	8.88		%	8.96		%
Total rate-sensitive assets		$	144,034		$	97,869		$	32,989		$	21,869		$	14,055		$	11,447		$	19,752		$	342,015

 

(1) Loans are presented at net amounts before deducting the allowance for loan losses and exclude non-performing loans.

 

Based on Capital Crossing Preferred’s experience, management applies the assumption that, on average, approximately 14% of the outstanding fixed and adjustable rate loans will prepay annually.

 

At March 31, 2003, the fair value of net loans was $239.0 million as compared to the net carrying value of net loans of $219.6 million. The fair value of interest-bearing deposits in banks approximates carrying value.

 

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Item 4. Controls and Procedures

 

(a)           Evaluation of disclosure controls and procedures.

 

As required by Rule 13a-15 under the Exchange Act, within the 90 days prior to the date of this report, Capital Crossing Preferred carried out an evaluation under the supervision and with the participation of its management, including its Principal Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of Capital Crossing Preferred’s disclosure controls and procedures. In designing and evaluating Capital Crossing Preferred’s disclosure controls and procedures, Capital Crossing Preferred and its management recognize that any controls and procedures, no matter how well designed and operated, can provide only a reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating and implementing possible controls and procedures. Based upon that evaluation, the Principal Executive Officer and Principal Financial Officer concluded that they believe Capital Crossing Preferred’s disclosure controls and procedures are reasonably effective to ensure that information required to be disclosed by Capital Crossing Preferred in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. In connection with the rules regarding disclosure controls and procedures, we intend to continue to review and document our disclosure controls and procedures, including our internal controls and procedures for financial reporting, and may from time to time make changes aimed at enhancing their effectiveness and to ensure that our systems evolve with our business.

 

(b)           Changes in internal controls.

 

None.

 

Part II

 

Item 1.  Legal Proceedings

 

From time to time, Capital Crossing Preferred may be involved in routine litigation incidental to its business, including a variety of legal proceedings with borrowers, which would contribute to Capital Crossing Preferred’s expenses, including the costs of carrying non-performing assets. Capital Crossing Preferred is not currently a party to any material proceedings.

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, Capital Crossing Preferred Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

CAPITAL CROSSING PREFERRED CORPORATION

 

 

Date: May 13, 2003	By:	/s/ Richard Wayne
	Richard Wayne
	President (Principal Executive Officer)
Date: May 13, 2003	By:	/s/ Edward F. Mehm
	Edward F. Mehm
	Treasurer (Principal Financial Officer)

 

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CERTIFICATIONS

 

I, Richard Wayne, certify that:

 

1.                                       I have reviewed this quarterly report on Form 10-Q of Capital Crossing Preferred Corporation;

 

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 officer 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 have:

 

a)                                      Designed such disclosure controls and procedures to ensure that material information relating to the registrant, 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 officer 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 officer 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 13, 2003	By:	/s/ Richard Wayne
	Richard Wayne
	President  (Principal Executive Officer)

 

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I, Edward F. Mehm, certify that:

 

1.                                       I have reviewed this quarterly report on Form 10-Q of Capital Crossing Preferred Corporation;

 

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 officer 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 have:

 

a)                                      Designed such disclosure controls and procedures to ensure that material information relating to the registrant, 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 officer 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 officer 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 13, 2003	By:	/s/ Edward F. Mehm
	Edward F. Mehm
	Treasurer (Principal Financial Officer)

 

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EXHIBIT INDEX

 

Exhibit		Item		Page Number
99.1		Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 signed by Richard Wayne, President (Prinicipal Executive Officer).		27
99.2		Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 signed by Edward F. Mehm, Treasurer (Principal Financial Officer).		28

 

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