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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the year ended December 31, 2002
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______________ to ______________
Commission File Number: 1-13991
MFA MORTGAGE INVESTMENTS, INC.
(Exact name of registrant as specified in its charter)
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Maryland 13-3974868
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
350 Park Avenue, 21st Floor, New York, New York 10022
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (212) 207-6400
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Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on Which Registered
Common Stock, $0.01 par value New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K (229.405 of the chapter) is not contained herein, and will
not be contained, to the best of the registrant's knowledge, in definitive proxy
or information statements incorporated by reference in Part III of this Form
10-K or any amendment to this Form 10-K. |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes |X| No |_|
The aggregate market value of the voting common stock held by
non-affiliates of the registrant based on the final closing price of the
Company's common stock on the New York Stock Exchange on February 5, 2003 was
$384,937,254.
The number of shares of the registrant's common stock outstanding on
February 5, 2003, was 46,279,605.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's proxy statement for the 2003 Annual Meeting of
Stockholders scheduled to be held on May 20, 2003 are incorporated by reference
into Part III of this Annual Report on Form 10-K.
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TABLE OF CONTENTS
PART I
Item 1. Business......................................................... 1
Item 2. Properties....................................................... 14
Item 3. Legal Proceedings................................................ 14
Item 4. Submission of Matters to a Vote of Security Holders.............. 14
Item 4A. Executive Officers of the Company................................ 14
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters.......................................................... 16
Item 6. Selected Financial Data.......................................... 17
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................ 18
Item 7A. Quantitative and Qualitative Disclosures About Market Risk....... 26
Item 8. Financial Statements and Supplementary Data...................... 29
Item 9. Changes in and Disagreements With Accountants on Accounting and
Financial Disclosure............................................. 51
PART III
Item 10. Directors and Executive Officers of the Registrant............... 51
Item 11. Executive Compensation........................................... 51
Item 12. Security Ownership of Certain Beneficial Owners and Management... 51
Item 13. Certain Relationships and Related Transactions................... 51
Item 14. Controls and Procedures.......................................... 51
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K.. 51
SIGNATURES................................................................. 54
CERTIFICATIONS ............................................................ 55
PART I
Item 1. Business.
THE COMPANY
MFA Mortgage Investments, Inc. (the "Company") is a self-advised mortgage
real estate investment trust ("REIT"), which is primarily engaged in the
business of investing in adjustable rate mortgage-backed securities and hybrid
mortgage-backed securities (collectively, "ARM-MBS"). The Company's investment
portfolio consists primarily of ARM-MBS issued or guaranteed by an agency of the
U.S. Government, such as Ginnie Mae, Fannie Mae or Freddie Mac (collectively
referred to as "Agency MBS"), and, to a lesser extent, high quality ARM-MBS,
rated in one of the two highest rating categories by at least one nationally
recognized rating agency, which include, Moody's Investors Services, Inc.,
Standard & Poor's Corporation or Fitch, Inc. (collectively, the "Rating
Agencies"). The Company's principal business objective is to generate net income
for distribution to its stockholders resulting from the spread between the
interest and other income it earns on its investments and the cost of financing
such investments.
As of December 31, 2002, the Company held total assets on its balance
sheet valued at $3.604 billion, of which 98.5% consisted of Agency MBS, other
high quality mortgage-backed securities ("MBS") and cash. The Company also held
controlling and non-controlling interests in corporate and partnership entities
that own six apartment properties, containing a total of 1,473 rental units.
Four of these apartment properties are located in Georgia, one in North Carolina
and one in Nebraska.
The Company has elected to be taxed as a REIT for federal income tax
purposes. Pursuant to the current federal tax regulations, one of the
requirements of maintaining its status as a REIT is that the Company must
distribute at least 90% of its annual taxable net income to its stockholders,
subject to certain adjustments. For additional information, see "Certain Federal
Income Tax Considerations."
The Company was incorporated in Maryland on July 24, 1997, and began its
business operations on April 10, 1998, when the Company consummated a merger
transaction (the "1998 Merger") with America First Participating/Preferred
Equity Mortgage Fund Limited Partnership ("PREP Fund 1" or the "Predecessor"),
America First PREP Fund 2 Limited Partnership ("PREP Fund 2") and America First
PREP Fund 2 Pension Series Limited Partnership ("Pension Fund" and, together
with PREP Fund 1 and PREP Fund 2, the "PREP Funds"). As a result of the 1998
Merger, PREP Fund 1 and PREP Fund 2 were merged directly into the Company and
Pension Fund became a partnership subsidiary of the Company. In December 1999,
Pension Fund was liquidated and dissolved, and, as a result, the Company
acquired 99% of the assets of Pension Fund. The remaining assets, consisting
solely of cash, were distributed to the holders of Pension Fund securities who
elected to remain in place following the 1998 Merger. As a result of the 1998
Merger, the Company issued a total of 9,035,084 shares of its $.01 par value
common stock ("Common Stock") to the former partners of the PREP Funds.
Following the completion of the 1998 Merger through December 31, 2001, the
Company was an externally advised and managed REIT. As such, the Company had no
employees and relied entirely on America First Mortgage Advisory Corporation
(the "Advisor") to perform all of the duties that are generally performed by
internal management. Pursuant to an agreement between the Company and the
Advisor (the "Advisory Agreement"), the Advisor provided the day-to-day
management of the Company's operations for a fee, which was calculated on a
quarterly basis. The Advisor was a subsidiary of America First Companies L.L.C.
("AFC").
On December 12, 2001, the Company's stockholders approved the terms of an
Agreement and Plan of Merger, dated September 24, 2001, among the Company, the
Advisor, AFC and the stockholders of the Advisor (the "Advisor Merger
Agreement"), which provided for the merger of the Advisor into the Company (the
"Advisor Merger"). Subsequent to the Advisor Merger, effective January 1, 2002,
the Company became a self-advised REIT. As a self-advised REIT, the Company no
longer pays a fee to the Advisor under the Advisory Agreement, but instead
directly incurs all of the costs of operating the Company. Accordingly, the
employees of the Advisor became employees of the Company. The Company also
acquired all of the tangible and intangible business assets of the Advisor. (For
additional information regarding the Advisor and the Advisor Merger, see Note 3a
to the accompanying consolidated financial statements included under Item 8.)
On August 13, 2002, the Company changed its name from America First
Mortgage Investments, Inc. to MFA Mortgage Investments, Inc.
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BUSINESS AND INVESTMENT STRATEGY
The Company is primarily engaged in the business of investing in
high-grade ARM-MBS, which are secured by pools of adjustable rate and hybrid
mortgage loans ("ARMs") primarily on single family residences. The Company's
investment strategy also provides for the acquisition and ownership of
multifamily housing properties. The Company does not currently originate
mortgage loans or provide other types of financing to the owners of real estate.
The Company's investment policy requires that at least 50% of its
investment portfolio consist of ARM-MBS that are either (i) Agency MBS or (ii)
rated in one of the two highest rating categories by one of the Rating Agencies.
The remainder of the Company's assets may consist of (a) direct investments
(mezzanine or equity) in multifamily apartment properties, (b) investments in
limited partnerships or REITs or (c) other fixed-income instruments. At December
31, 2002, 98.5% of the Company's assets consisted of Agency MBS, high quality
"AAA" rated MBS and cash. The Company's other investments, primarily consisting
of direct and indirect investments in limited partnerships owning real estate,
comprised less than 1.0% of its remaining assets at December 31, 2002.
The Company's ARM-MBS are generally indexed to the one-year constant
maturity treasury ("CMT") rate with interest rates that adjust on an interim
basis, generally annually, however, the hybrid MBS have an initial fixed rate
period, which does not exceed 36 months and thereafter reprice on an interim
basis. Other ARM-MBS are indexed to the London Interbank Offered Rate ("LIBOR")
or the 11th District Cost of Funds Index. ARM-MBS are generally subject to a
limitation on the amount of the interim interest rate change, which is usually
100 to 200 basis points (i.e. one basis point is equal to 1/100 of 1%) per
annum. ARMs also have lifetime caps on interest rate changes from the initial
interest rate, which typically do not exceed 600 basis points from the initial
interest rate.
FINANCING STRATEGY
The Company utilizes repurchase agreements to finance the acquisition of
ARM-MBS and other assets by borrowing against its portfolio of assets. In
addition, the Company may also finance the acquisition of additional assets with
the proceeds from capital market transactions. When fully invested, the
Company's policy is to maintain an assets-to-equity ratio of less than 11:1. As
of December 31, 2002, the Company's assets-to-equity ratio was 9.7:1 and its
debt-to-equity ratio was 8.6:1.
A repurchase agreement, although structured as a sale and repurchase
obligation, operates as a financing (i.e., borrowing) under which the Company
pledges its investment securities as collateral to secure a short-term loan with
a counterparty. The borrowed amount is limited to a specified percentage,
generally not more than 97%, of the estimated market value of the pledged
collateral. Repurchase agreements take the form of a sale of the pledged
collateral to a lender at an agreed upon price in return for such lender's
simultaneous agreement to resell the same securities back to the borrower at a
future date (i.e., the maturity of the borrowing) at a higher price. The
difference between the sale and repurchase price is the cost, or interest
expense, of borrowing under the repurchase agreements. The Company retains
beneficial ownership of the pledged collateral, including the right to
distributions, while the counterparty maintains custody of the collateral
securities. At the maturity of a repurchase agreement, the Company is required
to repay the loan and concurrently receive back its pledged collateral from the
lender or, may rollover (i.e., extend) such agreement at the then prevailing
financing rate. The repurchase agreements may require the Company to pledge
additional assets to the lender in the event the market value of existing
pledged collateral declines below a specified percentage. The pledged collateral
may fluctuate in value due to, among other things, principal repayments, market
changes in interest rates and credit quality. As of December 31, 2002, the
Company did not have any margin calls on its repurchase agreements that it was
not able to satisfy with either cash or additional pledged collateral.
The Company's repurchase agreements generally have maturities ranging from
one to 18 months at inception of the loan; however, the Company may decide to
enter into repurchase agreements with longer maturities in the future. Should
the counterparty to a repurchase agreement decide not to renew the agreement at
maturity, the Company would be required to either refinance elsewhere or be in a
position to retire the obligation. If, during the term of a repurchase
agreement, a lender should file for bankruptcy, the Company might experience
difficulty recovering its pledged assets and may have an unsecured claim against
the lender's assets for the difference between
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the amount loaned to the Company and the fair value of the security pledged by
the Company as collateral.
To reduce its exposure, the Company enters into repurchase agreements only
with financially sound institutions whose holding or parent company's long-term
debt rating is "A" or better as determined by at least one of the Rating
Agencies, where applicable. If this minimum criterion is not met, the Company
will not enter into repurchase agreements with that lender without the specific
approval of its Board of Directors. The Company generally seeks to diversify its
exposure by entering into repurchase agreements with at least four separate
lenders with a maximum loan from any lender of no more than three times the
Company's stockholders' equity. As of December 31, 2002, the Company had
repurchase agreements with 12 separate lenders, all of which were rated "A" or
better, with a maximum exposure (the difference between the amount loaned to the
Company and the fair value of the security pledged by the Company as collateral)
to a single lender of $54.3 million.
The Company may use derivatives and other hedging strategies to help
mitigate its prepayment and interest rate risks if it is determined that the
cost of these transactions is justified by their potential benefit. Through
December 31, 2002, the Company's use of hedge instruments has been limited to
purchased interest rate caps ("Cap Agreements"). A Cap Agreement is a contract,
whereby the purchaser pays a fee in exchange for the right to receive payments
equal to the principal (i.e., notional amount) times the difference between a
specified interest rate and a future interest rate during a defined "active"
period of time. As of December 31, 2002, the Company had 11 Cap Agreements, with
a total notional amount of $310.0 million. The Cap Agreements, which had an
amortized cost of $4.0 million were carried at their estimated fair value of
$1.1 million, with unrealized losses of $2.9 million reflected in accumulated
other comprehensive income. Management expects to enter into additional Cap
Agreements to hedge against increases in interest rates on its anticipated
future LIBOR-based repurchase agreements. However, the timing and amount of
future hedging transactions, if any, will depend on numerous market conditions,
including, but not limited to, the interest rate environment, management's
assessment of the future changes in interest rates and the market availability
and cost of entering into such hedge transactions.
Each of the multifamily apartment properties in which the Company holds an
interest is financed with a long-term fixed rate mortgage loan. The borrowers on
these mortgage loans are separate corporations, limited partnerships or limited
liability companies. Each of these mortgage loans is made to the applicable
ownership entity, generally on a nonrecourse basis, which means that the
lender's source of payment in the event of a default is generally foreclosure of
the underlying property securing the mortgage loan. As of December 31, 2002, the
aggregate mortgage indebtedness secured by the six multifamily apartment
properties in which the Company owns an interest was $47.7 million.
RISK FACTORS
The results of the Company's operations are affected by various factors,
many of which are beyond the control of the Company. The results of the
Company's operations primarily depend on, among other things, the level of its
net interest income, the market value of its assets and the supply of and demand
for such assets. The Company's net interest income varies primarily as a result
of changes in short-term interest rates, borrowing costs and prepayment rates,
the behavior of which involves various risks and uncertainties as set forth
below. Prepayment rates and interest rates vary according to the type of
investment, conditions in financial markets, competition and other factors, none
of which can be predicted with any certainty. In addition to these factors,
borrowing costs are further affected by the creditworthiness of the borrower.
Since changes in interest rates may significantly affect the Company's
activities, the operating results of the Company depend, in large part, upon the
ability of the Company to effectively manage its interest rate and prepayment
risks while maintaining its status as a REIT. The Company also has risks
inherent with its investments in real estate and hedging instruments. Because
these investments represented less than 1.0% of its total assets at December 31,
2002, the Company's risk relating to these assets is limited, but nonetheless
these investment have the potential of causing a material impact on the
Company's operating results. These risks, the Company's strategies to mitigate
the risks and the limitations of such strategies are discussed in further detail
below.
Interest Rate Risks
While management believes that there is no strategy that would completely
insulate the Company from interest rate changes and related prepayments on
investments, while achieving targeted profitability, the Company undertakes
certain strategies aimed at mitigating the potential negative effects of
interest rate changes. In order to limit interest rate risk on its assets, the
Company invests predominantly in ARM-MBS, which include hybrid MBS
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with generally less than 36 months to reprice at the time of acquisition, and
enters into interest rate Cap Agreements on the cash flows of anticipated
LIBOR-based repurchase agreements. The Company's hybrid MBS have a fixed rate
for an initial number of years, typically not greater than three years, and
thereafter convert to an adjustable rate coupon, which typically resets
annually. These strategies and related assets carry certain inherent risks other
than interest rate risk and/or costs. The Company finances the acquisition of
MBS through borrowings under repurchase agreements, which subjects the Company
to interest rate risk in relationship to the corresponding assets.
The cost of the Company's borrowings under its repurchase agreements is
based on the prevailing short-term market rates. The term of the Company's
repurchase agreements range from one to 18 months at inception of the loan;
however, the Company may decide to enter into repurchase agreements with longer
maturities in the future. The Company's ARM-MBS have interest rates that reset
every 12 months, after an initial fixed rate period for the hybrid MBS. At
December 31, 2002, the weighted average term to repricing for the ARM-MBS
portfolio was 19.6 months, while the weighted average term to repricing for the
Company's repurchase agreements was 5.8 months. The Company's policy is to
maintain an asset/borrowings repricing gap (i.e., the weighted average time
period for ARM-MBS to reprice, less the weighted average time period for
liabilities to reprice) of less than 18 months. At December 31, 2002, the
Company had a repricing gap of 13.8 months. However, it should be noted that a
significant portion, 31.9%, of the Company's repurchase agreements were
scheduled to mature in the first quarter of 2003.
The market determines the interest rates that the Company pays on its
borrowings (i.e., its repurchase agreements) to finance its MBS assets. The
Company has control over the cost of borrowings only to the extent of the
Company's credit standing and competitive bargaining ability. However, the level
of increase in rates on the Company's interest earning assets is limited. At
December 31, 2002, ARM-MBS comprised 96.5% of the Company's total assets and
99.8% of total MBS. The amount by which the interest rate on ARM-MBS can adjust
is limited by the interim and lifetime caps on the underlying ARMs. Generally,
interest rates on ARM-MBS can adjust by a maximum of 100 to 200 basis points per
annum (i.e., an interim cap) and 600 basis points from the initial interest rate
over the term of the ARMs (i.e., a lifetime cap). Lifetime and interim interest
rate caps on ARM-MBS could limit the change in the coupon (i.e., the stated
interest rated) on such assets. At December 31, 2002, $656.9 million, or 18.9%
of the Company's ARM-MBS (18.2% of the total assets), had a 1% interim cap and
the remainder had a 2% interim cap. As of December 31, 2002, the ARM-MBS had a
weighted average term to repricing of 19.6 months.
The cost of the Company's borrowings is generally LIBOR-based while
interest rates on ARM-MBS are primarily based on one-year CMT rates. Therefore,
any increase in the LIBOR relative to the CMT rates will generally result in an
increase in the Company's borrowing cost that is not matched by a corresponding
increase in the interest earnings on its ARM-MBS portfolio. At December 31,
2002, the one-year LIBOR was 1.44% and the one-year CMT was 1.32%. At December
31, 2002, the Company had 71.8% of its ARM-MBS portfolio repricing from the
one-year CMT index; 26.1% repricing from the one-year LIBOR index and 2.1%
repricing from the 11th District Cost of Funds Index (i.e., COFI).
In order to mitigate its interest rate risks, the Company intends to
continue to keep a substantial majority of its assets invested in ARM-MBS,
rather than fixed rate securities. These assets allow the Company's interest
income to generally move with changes in corresponding interest rates. However,
given the lag in interest rate resets along with the interim and lifetime
interest rate limitations on adjustments on its ARM-MBS portfolio, relative to
changes in the interest rates it pays on its liabilities, net interest income
could be negatively affected over the short term in a rising interest rate
environment. The ability of ARM-MBS to adjust based on changes in interest rates
helps to mitigate interest rate risk more effectively over a longer time period
than over the short term; however, interest rate risk is not eliminated under
either scenario. The general trend of declining interest rates experienced
during 2002 significantly reduced the Company's average cost of borrowings, to
2.32% for 2002 from 3.96% for 2001, which benefited the Company. However, as
interest rates declined, the prepayment speeds on the Company's MBS portfolio
increased, causing an increase in principal prepayments and corresponding
acceleration of amortization of premiums paid on the ARM-MBS portfolio.
Consequently, the increased amortization of purchase premiums decreased the
yield on the portfolio. In addition, coupons on ARM-MBS scheduled to reset
declined to lower interest rates and principal repayments were reinvested at the
lower prevailing market rates. For 2002, the weighted average coupon (i.e., the
weighted average stated rate) on the Company's MBS portfolio was 5.44%, while
the net yield on the MBS portfolio was 4.25%. The differential between the
coupon and net yield on the Company's MBS portfolio reflect the cost of premium
amortization, the cost of delay and difference between the coupon and gross
yield. The Company's cost of delay reflects the cost associated with the delay
in receiving the cash for principal
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repayments, during which time such receivable is non-interest bearing. The gross
yield reflects the coupon interest income divided by the amortized cost, which
includes purchase premiums, of the MBS, and thus is lower than the coupon.
In accordance with the Company's investment guidelines, it may enter into
Cap Agreements to hedge against anticipated future increases in interest rates
on the Company's anticipated repurchase agreements. The Company only enters into
interest rate Cap Agreements with financial institutions which have a debt
rating of "A" or better by one of the Rating Agencies, thereby securing, to the
greatest extent possible, receipt of payments under the Cap Agreements. In the
unlikely event that a counterparty is unable to make required payments pursuant
to a Cap Agreement, the Company's loss would be limited to any remaining
unamortized premium paid for the specific Cap Agreement. Management monitors the
ratings of all of its counterparties on a regular basis; however, no assurance
can be given that the Company can eliminate risks related to third parties. As
of December 31, 2002, the Company had (i) ten interest rate Cap Agreements, with
a total notional amount of $260.0 million, that will become active during the
next 18 months, with strike prices ranging from 3.00% to 5.00% and (ii) a $50.0
million notional amount Cap Agreement which became active during the fourth
quarter of 2002, with a strike price of 5.75% that will run through October
2004. The Company's active Cap Agreement did not result in the Company receiving
any payments during 2002, as the 30-day LIBOR did not exceed the strike rate of
5.75% during the active period. Cap Agreements are extremely sensitive to
changes in interest rates and therefore their values are quite volatile;
however, the Company's maximum exposure is limited to the premium paid to
purchase the Cap Agreement. Because the Company utilizes Cap Agreements solely
to mitigate interest rate risk, in the form of a liability hedge, changes in the
market value are reflected in other comprehensive income and the premium is
amortized over the active period of the Cap Agreement, provided that the hedge
remains effective. As of December 31, 2002, the Company had unrealized losses of
$2.9 million on its Cap Agreements.
As a part of its hedging strategy, the Company may engage in limited
amounts of the buying and/or selling of mortgage derivative securities or other
derivative products, including interest rate swap agreements, financial futures
contracts and options. Although the Company has not historically used such
instruments, it is not precluded by its operating policies from doing so. In the
future, management may use such instruments as hedges against interest rate
risk. Management does not anticipate entering into derivatives for speculative
or trading purposes. Any use of derivatives and contemplated derivative
strategies are addressed with the investment committee of the Board of Directors
of the Company. It should be noted that no cost beneficial hedging strategy can
completely insulate the Company against interest rate risks. In addition, there
can be no assurance that any such hedging activities will have the desired
impact on the Company's results of operations or financial condition. Hedging
typically involves transaction costs, which increase dramatically as the period
covered by the hedge increases and which also increase during periods of rising
or volatile interest rates. Such hedging costs may cause the Company to conclude
that a particular hedging transaction is not appropriate for the Company,
thereby affecting the Company's ability to mitigate interest rate risk. As of
December 31, 2002, the Company's only hedge instruments were comprised of the
Cap Agreements previously discussed.
Increases in short-term interest rates may cause the Company's financing
costs to increase faster than rates increase on its ARM-MBS. As a result, the
Company's net interest spread and net interest margin could decline during such
periods, the severity of which would depend on the asset/liability structure at
the time as well as the magnitude and duration of the interest rate increase. In
the case of a sudden and sustained increase in interest rates, the net interest
income could become negative. Accordingly, in such a period, the Company could
incur a net loss from operations. In addition, such an interest rate environment
could decrease the market value of the ARM-MBS, to a level that additional
collateral could be required to secure the borrowings under the Company's
repurchase agreements. If such additional collateral were not available, the
lender could liquidate the securities collateralizing the repurchase agreements,
resulting in a loss to the Company. Further, such a decrease in the Company's
net interest income could negatively impact dividend distributions made by the
Company, which, in turn could reduce the market price of the Company's Common
Stock. The Company could also react to such a scenario by reducing borrowings
and assets, by selling assets or not replacing securities as they amortize
and/or prepay, thereby "shrinking the balance sheet." Such an action would
likely reduce interest income, interest expense and net income, the extent of
which would be dependent on the level of reduction in assets and liabilities as
well as the sale price of the assets sold.
Prepayment Risks
In general, residential borrowers of the mortgage loans securing the MBS
in the Company's portfolio may prepay such mortgage loans at any time without
penalty. Prepayments result when a homeowner sells his home or
5
decides to either satisfy or refinance his existing mortgage loan. In addition,
defaults and foreclosures have the same effect as prepayments. Prepayments
usually can be expected to increase when mortgage interest rates decrease
significantly, as was the case in 2001 and 2002, and decrease when mortgage
interest rates increase, although such effects are not entirely predictable.
Prepayment experience also may be affected by the conditions in the housing and
financial markets, general economic conditions and the relative interest rates
on fixed rate and adjustable rate mortgage loans. During 2002, prepayments rates
increased, particularly in the last quarter of 2002. During 2002, the constant
prepayment rate ("CPR"), which is a measure of prepayment speeds, ranged from a
low of 23% to high of 38%; during 2001, the CPR ranged from a low of 17% to a
high of 31%.
Prepayments are the primary feature of MBS that distinguishes them from
other types of bonds. While a certain percentage of the pool of mortgage loans
underlying MBS are expected to prepay during a given period of time, the
prepayment rate can, and often does, vary significantly from the anticipated
rate of prepayment. Prepayments generally have a negative impact on the
Company's financial results, the effects of which depends on, among other
things, the amount of unamortized premium on the securities, the reinvestment
lag and the reinvestment opportunities.
The Company limits its exposure to the impact of accelerated premium
amortization caused by prepayments, by limiting the premium paid on its MBS
portfolio. MBS securities can trade at significantly different prices depending
on, among other things, seasoning (i.e., age of the security) and the interest
rate. According to the Company's current policy, the average purchase price of
the MBS portfolio must be less than 103.5% of the securities par value. The
Company's gross premium as a percentage of current par value of the total MBS
portfolio was 2.26% and 1.99% at December 31, 2002 and 2001, respectively. In
addition, the Company maintains a diversified MBS portfolio with a variety of
prepayment characteristics and may reduce leverage in less advantageous market
environments. While these strategies may not maximize earnings potential in the
short term, the Company's objective is aimed at obtaining more predictable
earnings with less potential risk to capital.
Risks Associated with Leverage
The Company's financing strategy is designed to increase the size of its
mortgage investment portfolio by borrowing against a substantial portion of the
market value of its MBS. If interest income on the MBS purchased with borrowed
funds fails to cover the cost of the borrowings, the Company will experience net
interest losses and may experience net losses from operations. Such losses could
be significant as a result of the Company's leveraged structure.
The ability of the Company to achieve its investment objectives depends on
its ability to borrow money in sufficient amounts and on favorable terms
compared to the assets that the borrowings fund. Currently, the Company's direct
borrowings are comprised of collateralized borrowings in the form of repurchase
agreements. The ability of the Company to enter into repurchase agreements in
the future will depend on the market value of the MBS pledged to secure the
specific borrowings, the availability of financing and other conditions existing
in the lending market at that time. The cost of borrowings under repurchase
agreements generally corresponds to LIBOR plus or minus a margin, although such
agreements may not expressly incorporate a LIBOR index. Future increases in
haircuts (i.e., the about by which the collateral value exceeds the repurchase
agreement loan amount), decreases in the market value of the Company's MBS,
increases in interest rate volatility, and changes in the availability of
financing in the market, could cause the Company to be unable to achieve the
degree of leverage it believes to be optimal. As a result, the Company may be
less profitable than it would be otherwise.
In the future, the Company may also use other sources of funding, that
generally bear interest rates that correspond to a short-term benchmark, such as
other types of collateralized borrowings, loan agreements, lines of credit,
dollar-roll agreements or through the issuance of debt securities.
The Company's wholly-owned subsidiary, Retirement Centers Corporation
("RCC"), has non-recourse mortgage loans secured by two real estate properties,
which had an aggregate balance of $16.3 million and a weighted average interest
rate of 7.3%. In addition, the Company had investments in four limited
partnerships, which had an aggregate of $31.4 million of non-recourse mortgage
loans secured by the underlying properties, with a weighted average interest
rate of 7.7%.
Risks of Decline in Market Value
The value of interest-bearing obligations such as mortgages and MBS
typically move inversely with interest rates. Accordingly, in a rising interest
rate environment, the value of such instruments may decline. Because the
interest earned on ARM-MBS may increase as interest rates increase subject to a
delay until each such security's
6
next reset date, the values of these assets are generally less sensitive to
changes in interest rates than are fixed rate instruments. Therefore, in order
to mitigate this risk, the Company intends to maintain a substantial majority of
its portfolio in ARM-MBS. At December 31, 2002, ARM-MBS constituted 96.5% of
total assets and 99.8% of the Company's total MBS.
A decline in the market value of the Company's MBS assets may limit the
Company's ability to borrow or result in lenders initiating margin calls, which
require a pledge of additional collateral or cash to re-establish the required
ratio of borrowing to collateral value. The Company could be required to sell
some of its MBS under adverse market conditions in order to maintain liquidity.
If such sales were to be made at prices lower than the amortized cost (i.e., the
carrying value) of the securities, the Company would incur losses. A default by
the Company under its collateralized borrowings could also result in a
liquidation of the collateral, and a resulting loss of the difference between
the value of the collateral and the amount borrowed.
Credit Risks Associated with Investments
The holder of a mortgage or MBS assumes a risk that the borrowers may
default on their obligations to make full and timely payments of principal and
interest. The Company significantly mitigates this credit risk by requiring that
at least 50% of its investment portfolio consist of ARM-MBS that are either (i)
Agency MBS or (ii) rated in one of the two highest rating categories by one of
the Rating Agencies. The remainder of the Company's assets may be either (a)
direct investment (mezzanine or equity) in multifamily apartment properties, (b)
investments in limited partnerships or REITs or (c) other fixed-income
instruments. As of December 31, 2002, 93.2% of the Company's assets consisted of
Agency MBS, 3.5% were high quality MBS rated "AAA" and 1.8% were of cash and
cash equivalents; combined these assets comprised 98.5% of the Company's total
assets. During 2002, the Company sold all of its remaining investments in
corporate debt and equity securities. (See Notes 5 and 6 to the accompanying
consolidated financial statements, included under Item 8.)
Investment Company Act
The Company at all times intends to conduct its business so as to not
become regulated as an investment company under the Investment Company Act of
1940 (the "Investment Company Act"). If the Company were to become regulated as
an investment company, then, among other things, the Company's ability to use
leverage would be substantially reduced. The Investment Company Act exempts
entities that are "primarily engaged in the business of purchasing or otherwise
acquiring mortgages and other liens on and interests in real estate" (i.e.,
"Qualifying Interests"). Under the current interpretation of the staff of the
Securities and Exchange Commission, in order to qualify for this exemption, the
Company must maintain at least 55% of its assets directly in Qualifying
Interests. In addition, unless certain MBS represent an undivided interest in
the entire pool backing such MBS (i.e., whole pools), such MBS may be treated as
securities separate from the underlying mortgage loan, thus, may not be
considered Qualifying Interests for purposes of the 55% exemption requirement.
Accordingly, the Company monitors its compliance with this requirement in order
to maintain its exempt status. As of December 31, 2002, the Company determined
that it was in and has maintained compliance with this requirement.
CERTAIN FEDERAL INCOME TAX CONSIDERATIONS
The following is a description of certain U.S. federal income tax
consequences relating to the Company's taxation as a REIT.
The information in this section is based on the Internal Revenue Code of
1986, as amended (the "Code"), current, temporary and proposed regulations
promulgated under the Code, the legislative history of the Code, current
administrative interpretations and practices of the Internal Revenue Service
(the "IRS") and court decisions, all as of the date hereof. The administrative
interpretations and practices of the IRS upon which this summary is based
include its practices and policies as expressed in private letter rulings which
are not binding on the IRS, except with respect to the taxpayers who requested
and received such rulings. In each case, these sources are relied upon as of the
date hereof. No assurance can be given that future legislation, regulations
administrative interpretations and practices and court decisions will not
significantly change current law, or adversely affect certain existing
interpretations of existing law, on which the information in this section is
based. Even if there is no change in applicable law, no assurance can be
provided that the statements made in the following discussion will not be
challenged by the IRS or will be sustained by a court if so challenged.
7
General
The Company has elected to be taxed as a REIT under Sections 856 through
860 of the Code, commencing with the Company's taxable year ended December 31,
1998. Management believes that the Company is organized and has operated in a
manner so as to qualify as a REIT under the Code and intends to continue to
operate in such a manner. No assurance, however, can be given that the Company
in fact has qualified or will remain qualified as a REIT.
The sections of the Code that relate to the qualification and taxation of
REITs are highly technical and complex. The following describes the material
aspects of the sections of the Code that govern the federal income tax treatment
of a REIT. This summary is qualified in its entirety by the applicable Code
provisions, rules and regulations promulgated under the Code, and administrative
and judicial interpretations of the Code.
Qualification and taxation as a REIT depend upon the Company's ability to
meet on a continuing basis, through actual annual operating results, the various
requirements under the Code and, as described in this Form 10-K, with regard to,
among other things, the Company's; (i) source of gross income, (ii) composition
of assets, (iii) distribution levels and (iv) diversity of stock ownership.
While the Company intends to operate so that the Company qualifies as a REIT,
given the highly complex nature of the rules governing REITs, the ongoing
importance of factual determinations and the possibility of future changes in
the Company's circumstances or in the law, no assurance can be given that the
Company so qualifies or will continue to so qualify.
Provided the Company qualifies for taxation as a REIT, it generally will
not be subject to federal corporate income tax on net income that is currently
distributed to the Company's stockholders. This treatment substantially
eliminates the "double taxation" that generally results from an investment in a
corporation. Double taxation means taxation once at the corporate level, when
income is earned, and once again at the stockholder level when such income is
distributed through dividends. However, even as a REIT, the Company will be
subject to federal income taxation under the following circumstances:
o The Company will be required to pay tax at regular corporate
rates on any undistributed REIT taxable income, including
undistributed net capital gains;
o The Company may be subject to the "alternative minimum tax"
on items of tax preference, if any;
o If the Company has (i) net income from the sale or other
disposition of "foreclosure property" which is held primarily for
sale to customers in the ordinary course of business or (ii) other
nonqualifying income from foreclosure property, the Company will be
required to pay tax at the highest corporate rate on this income. In
general, foreclosure property is property acquired through
foreclosure after a default on a loan secured by the property or on
a lease of the property;
o The Company will be required to pay a 100% tax on any net
income from prohibited transactions. In general, prohibited
transactions are sales or other taxable dispositions of assets,
other than foreclosure property, held for sale to customers in the
ordinary course of business;
o If the Company fails to satisfy the 75% or 95% gross income
tests, as described below, but has, nevertheless, maintained its
qualification as a REIT, the Company will be subject to a tax equal
to the gross income attributable to the greater of either (i) the
amount by which 75% of the Company's gross income exceeds the amount
qualifying under the 75% test for the taxable year or (ii) the
amount by which 90% of the Company's gross income exceeds the amount
of its income qualifying under the 95% test for the taxable year
multiplied in either case by a fraction intended to reflect the
Company's profitability;
o The Company will be required to pay a 4% excise tax on the
amount by which its annual distributions to stockholders is less
than the sum of (i) 85% of the Company's ordinary income for the
year, (ii) 95% of the Company's REIT capital gain net income for the
year, and (iii) any undistributed taxable income from prior periods;
o If the Company acquires an asset from a corporation which is
not a REIT in a transaction in which the basis of the asset in the
Company's hands is determined by reference to the basis of the asset
in the hands of the transferor corporation and the Company
subsequently sells or otherwise disposes of the asset within ten
years, then under existing treasury regulations, the Company would
be required to pay tax at the highest regular corporate tax rate on
this gain to the extent the fair market value of the asset exceeds
the Company's adjusted tax basis in the asset, in each case,
determined as of the date on which the
8
Company acquired the asset. The results described in this paragraph
assume that the Company will not elect in lieu of this treatment to
be subject to an immediate tax when the asset is acquired; and
o The Company will generally be subject to tax on the portion
of any "excess inclusion income" derived from an investment in
residual interests in real estate mortgage investment conduits to
the extent the Company's stock is held by specified tax exempt
organizations not subject to tax on unrelated business taxable
income.
Requirements for Qualification as a REIT
General. The Code defines a REIT as a corporation, trust or association:
(1) that is managed by one or more trustees or directors;
(2) that issues transferable shares or transferable
certificates to its owners;
(3) that would be taxable as a regular corporation, but for
its election to be taxed as a REIT;
(4) that is not a financial institution or an insurance
company under the Code;
(5) that is owned by 100 or more persons;
(6) that has not more than 50% of the value of its outstanding
stock that is owned, actually or constructively, by five or fewer
individuals (as defined in the Code to include certain entities)
during the last half of each year (the "5/50 Rule"); and
(7) that meets other tests, described below, regarding the
nature of its income and assets, and the amount of its
distributions.
The Code provides that conditions (1) through (4) must be met during the
entire year and that condition (5) must be met during at least 335 days of a
year of twelve months or during a proportionate part of a shorter taxable year.
Conditions (5) and (6) do not apply to the first taxable year for which an
election is made to be taxed as a REIT.
The Company's amended and restated articles of incorporation provide for
restrictions regarding ownership and transfer of the Company's stock. These
restrictions are intended to assist the Company in satisfying the share
ownership requirements described in conditions (5) and (6) above. These
restrictions, however, may not ensure that the Company will, in all cases, be
able to satisfy the share ownership requirements described in conditions (5) and
(6) above. If the Company fails to satisfy these share ownership requirements,
the Company's status as a REIT may terminate. If, however, the Company complied
with the rules contained in applicable regulations that require a REIT to
determine the actual ownership of its shares and the Company does not know, or
would not have known through the exercise of reasonable diligence, that the
Company failed to meet the requirement described in condition (6) above, the
Company would not be disqualified as a REIT.
In addition, a corporation may not qualify as a REIT unless its taxable
year is the calendar year. The Company has a calendar taxable year.
Qualified REIT Subsidiaries. A "qualified REIT subsidiary" is a
corporation, all of the stock of which is owned by a REIT. Under the Code, a
qualified REIT subsidiary is not treated as a separate corporation from the
REIT. Rather, all of the assets, liabilities and items of income, deduction and
credit of the qualified REIT subsidiary are treated as the assets, liabilities
and items of income, deduction and credit of the REIT for purposes of the REIT
income and asset tests described below.
Taxable REIT Subsidiaries. A "taxable REIT subsidiary" is a corporation
which, together with a REIT, which owns an interest in such corporation, makes
an election to be treated as a taxable REIT subsidiary. A taxable REIT
subsidiary may earn income that would be nonqualifying income if earned directly
by a REIT and is generally subject to full corporate level tax. A REIT may own
up to 100% of the stock of a taxable REIT subsidiary.
Certain restrictions imposed on taxable REIT subsidiaries are intended to
ensure that such entities will be subject to appropriate levels of federal
income taxation. First, a taxable REIT subsidiary may not deduct interest
payments made in any year to an affiliated REIT to the extent that such payments
exceed, generally, 50% of the taxable REIT subsidiary's adjusted taxable income
for that year (although the taxable REIT subsidiary may carry forward to, and
deduct in, a succeeding year the disallowed interest amount if the 50% test is
satisfied in that year). In addition, if a taxable REIT subsidiary pays
interest, rent or another amount to a REIT that exceeds the amount that would be
paid to an unrelated party in an arm's length transaction, the REIT generally
will be subject to an
9
excise tax equal to 100% of such excess. The Company, together with RCC, had
made a taxable REIT subsidiary election with respect to its ownership interest
in RCC, which election was effective, for federal income tax purposes, as of
March 30, 2002; however, the Company and RCC revoked this election in January of
2003. As a result, effective January 2003, RCC became a qualified REIT
subsidiary of the Company. During its time as a TRS, RCC made interest and other
payments to the Company.
Income Tests. The Company must meet two annual gross income requirements
to qualify as a REIT. First, each year the Company must derive, directly or
indirectly, at least 75% of its gross income, excluding gross income from
prohibited transactions, from investments relating to real property or mortgages
on real property, including "rents from real property" and mortgage interest, or
from specified temporary investments. Second, each year the Company must derive
at least 95% of its gross income, excluding gross income from prohibited
transactions, from investments meeting the 75% test described above, or from
dividends, interest and gain from the sale or disposition of stock or
securities. For these purposes, the term "interest" generally does not include
any interest of which the amount received depends on the income or profits of
any person. An amount will generally not be excluded from the term "interest;"
however, if such amount is based on a fixed percentage of gross receipts or
sales.
Any amount includable in the Company's gross income with respect to a
regular or residual interest in a real estate mortgage investment conduit is
generally treated as interest on an obligation secured by a mortgage on real
property for purposes of the 75% gross income test. If, however, less than 95%
of the assets of a real estate mortgage investment conduit consist of real
estate assets, the Company will be treated as receiving directly its
proportionate share of the income of the real estate mortgage investment
conduit, which would generally include non-qualifying income for purposes of the
75% gross income test. In addition, if the Company receives interest income with
respect to a mortgage loan that is secured by both real property and other
property and the principal amount of the loan exceeds the fair market value of
the real property on the date the mortgage loan was made by the Company,
interest income on the loan will be apportioned between the real property and
the other property, which apportionment would cause the Company to recognize
income that is not qualifying income for purposes of the 75% gross income test.
To the extent interest on a loan is based on the cash proceeds from the
sale or value of property, such income would be treated as gain from the sale of
the secured property, which generally should qualify for purposes of the 75% and
95% gross income tests.
The Company inevitably may have some gross income from various sources
that fails to constitute qualifying income for purposes of one or both of the
gross income tests, such as qualified hedging income, which would constitute
qualifying income for purposes of the 95% gross income test, but not the 75%
gross income test. However, the Company intends to maintain its status as a REIT
by carefully monitoring any such potential nonqualifying income.
If the Company fails to satisfy one or both of the 75% or 95% gross income
tests for any year, the Company may still qualify as a REIT if it is entitled to
relief under the Code. Generally, the Company may be entitled to relief if:
o the failure to meet the gross income tests was due to
reasonable cause and not due to willful neglect;
o a schedule of the sources of the Company's income is
attached to its federal income tax return; and
o any incorrect information on the schedule was not due to
fraud with the intent to evade tax.
It is not possible to state whether in all circumstances the Company would
be entitled to rely on these relief provisions. If these relief provisions do
not apply to a particular set of circumstances, the Company would fail to
qualify as a REIT. As discussed above in "General," even if these relief
provisions apply and the Company retains its status as a REIT, a tax would be
imposed with respect to the Company's income that does not meet the gross income
tests. The Company may not always be able to maintain compliance with the gross
income tests for REIT qualification despite periodically monitoring the
Company's income.
Foreclosure Property. Net income realized by the Company from foreclosure
property would generally be subject to tax at the maximum federal corporate tax
rate (currently 35%). Foreclosure property means real property and related
personal property that is acquired through foreclosure following a default on a
lease of such property or a default on indebtedness that is secured by the
property and for which an election is made to treat the property as foreclosure
property.
10
Prohibited Transaction Income. Any gain realized by the Company on the
sale of any asset other than foreclosure property, held as inventory or
otherwise held primarily for sale to customers in the ordinary course of
business will be prohibited transaction income and subject to a 100% penalty
tax. Prohibited transaction income may also adversely affect the Company's
ability to satisfy the gross income tests for qualification as a REIT. Whether
an asset is held as inventory or primarily for sale to customers in the ordinary
course of a trade or business depends on all the facts and circumstances
surrounding the particular transaction. While the regulations provide standards
which, if met, would not cause a sale of an asset to result in prohibited
transaction income, the Company may not be able to meet these standards in all
circumstances.
Asset Tests. At the close of each calendar quarter, the Company also must
satisfy four tests relating to the nature of its assets. First, at least 75% of
the value of the Company's total assets must be real estate assets, cash, cash
items and government securities. For purposes of this test, real estate assets
include real estate mortgages, real property, interests in other REITs and stock
or debt instruments held for one year or less that are purchased with the
proceeds of a stock offering or a long-term public debt offering. Second, not
more than 25% of the Company's total assets may be represented by securities,
other than those securities includable in the 75% asset class. Third, not more
than 20% of the value of the Company's total assets may be represented by
securities in one or more taxable REIT subsidiaries. Fourth, of the investments
included in the 25% asset class, the value of any one issuer's securities may
not exceed 5% of the value of the Company's total assets, and the Company may
not own more than 10% of the total vote or value of the outstanding securities
of any one issuer (other than securities of a qualified REIT subsidiary, a
taxable REIT subsidiary and, with respect to the 10% value test, certain
"straight debt" securities).
The Company currently owns 100% of RCC. RCC elected to be taxed as a REIT
for its taxable year ended December 31, 2001 and jointly elected, together with
the Company, to be treated as a taxable REIT subsidiary effective as of March
30, 2002. The Company believes that RCC met all of the requirements for taxation
as a REIT with respect to its taxable year ended December 31, 2001 and as a
taxable REIT subsidiary commencing as of March 30, 2002; however, the sections
of the Code that relate to qualification as a REIT are highly technical and
complex and there are certain requirements that must be met in order for RCC to
have qualified as a taxable REIT subsidiary effective March 30, 2002. Since RCC
has been subject to taxation as a REIT or a taxable REIT subsidiary, as the case
may be, at the close of each quarter of the Company's taxable years beginning
with the year ended December 31, 2001, the Company believes that its ownership
interest in RCC has not caused the Company to fail to satisfy the 10% value
test. In addition, the Company believes that it has, at all times prior to
October 1, 2002, owned less than 10% of the voting securities of RCC. No
assurance, however, can be given that RCC in fact qualified as a REIT for its
taxable year ended December 31, 2001 or as a taxable REIT subsidiary as of March
30, 2002, that the nonvoting preferred stock of RCC owned by the Company would
not be deemed to be "voting stock" for purposes of the asset tests or, as a
result of any of the foregoing, that the Company has qualified or will continue
to qualify as a REIT. Effective January 2003, the Company and RCC revoked their
election to treat RCC as a taxable REIT subsidiary. As a result, effective as of
such date, RCC became a qualified REIT subsidiary of the Company.
After meeting the asset tests at the close of any quarter, the Company
will not lose its status as a REIT if it fails to satisfy the asset tests at the
end of a later quarter solely by reason of changes in asset values. In addition,
if the Company fails to satisfy the asset tests because it acquires assets
during a quarter, the Company can cure this failure by disposing of sufficient
nonqualifying assets within 30 days after the close of that quarter.
The Company intends to monitor the status of the assets that the Company
owns for purposes of the various asset tests and manage its portfolio in order
to comply with such tests.
Annual Distribution Requirements. To qualify as a REIT, the Company is
required to distribute dividends, other than capital gain dividends, to its
stockholders in an amount at least equal to the sum of (i) 90% of the Company's
"REIT taxable income" and (ii) 90% of the Company's after-tax net income, if
any, from foreclosure property, minus (iii) the sum of certain items of non-cash
income. In general, "REIT taxable income" means taxable ordinary income without
regard to the dividends paid deduction.
The Company is generally required to distribute income in the taxable year
in which it is earned, or in the following taxable year before the Company
timely files its tax return if such dividend distributions are declared and paid
on or before the Company's first regular dividend payment. Generally, these
distributions are taxable to holders of common stock in the year in which paid,
even though these distributions relate to the prior year for purposes of the
Company's 90% distribution requirement. To the extent that the Company does not
distribute all of
11
its net capital gain or distribute at least 90% of its "REIT taxable income,"
the Company will be subject to tax at regular corporate tax rates on such
under-distributed amount.
From time to time, the Company may not have sufficient cash or other
liquid assets to meet the above distribution requirement due to timing
differences between the actual receipt of cash and payment of expenses and the
inclusion of income and deduction of expenses in arriving at the Company's
taxable income. If these timing differences occur, in order to meet the REIT
distribution requirements, the Company may need to arrange for short-term, or
possibly long-term, borrowings, or to pay dividends in the form of taxable stock
dividends.
Under certain circumstances, the Company may be able to rectify a failure
to meet a distribution requirement for a year by paying "deficiency dividends"
to its stockholders in a later year, which may be included in the Company's
deduction for dividends paid for the earlier year. Thus, the Company may be able
to avoid being subject to tax on amounts distributed as deficiency dividends.
The Company will be required, however, to pay interest based upon the amount of
any deduction claimed for deficiency dividends. In addition, the Company will be
subject to a 4% excise tax on the excess of the required distribution over the
amounts actually distributed if the Company should fail to distribute each year
at least the sum of 85% of its ordinary income for the year, 90% of its capital
gain income for the year and any undistributed taxable income from prior
periods.
Recordkeeping Requirements. The Company is required to maintain records
and request on an annual basis information from specified stockholders. This
requirement is designed to disclose the actual ownership of the Company's
outstanding stock.
Excess Inclusion Income. If the Company is deemed to have issued debt
obligations having two or more maturities, the payments on which correspond to
payments on mortgage loans owned by the Company, such arrangement will be
treated as a "taxable mortgage pool" for federal income tax purposes. If all or
a portion of the Company is considered a taxable mortgage pool, its status as a
REIT generally should not be impaired; however, a portion of its taxable income
may be characterized as "excess inclusion income" and allocated to its
stockholders. Any excess inclusion income:
o could not be offset by unrelated net operating losses of a
stockholder;
o would be subject to tax as "unrelated business taxable
income" to a tax-exempt stockholder;
o would be subject to the application of federal income tax
withholding (without reduction pursuant to any otherwise applicable
income tax treaty) with respect to amounts allocable to foreign
stockholders; and
o would be taxable (at the highest corporate tax rate) to the
Company, rather than its stockholders, to the extent allocable to
the Company's stock held by disqualified organizations (generally,
tax-exempt entities not subject to unrelated business income tax,
including governmental organizations).
Failure to Qualify. If the Company fails to qualify for taxation as a REIT
in any taxable year and the relief provisions of the Code described above do not
apply, the Company will be subject to tax, including any applicable alternative
minimum tax, and possibly increased state and local taxes, on its taxable income
at regular corporate rates. Such taxation would reduce the cash available for
distribution by the Company to its stockholders. Distributions to the Company's
stockholders in any year in which the Company fails to qualify as a REIT will
not be deductible by the Company and the Company will not be required to
distribute any amounts to its stockholders. Additionally, if the Company fails
to qualify as a REIT, distributions to its stockholders will be subject to tax
as ordinary income to the extent of the Company's current and accumulated
earnings and profits and, subject to certain limitations of the Code, corporate
stockholders may be eligible for the dividends received deduction. Unless
entitled to relief under specific statutory provisions, the Company would also
be disqualified from taxation as a REIT for the four taxable years following the
year during which the Company lost its qualification. It is not possible to
state whether in all circumstances the Company would be entitled to statutory
relief.
State, Local and Foreign Taxation
The Company may be required to pay state, local and foreign taxes in
various state, local and foreign jurisdictions, including those in which the
Company transacts business or make investments, and its stockholders may be
required to pay state, local and foreign taxes in various state, local and
foreign jurisdictions, including those in which they reside. The Company's
state, local and foreign tax treatment may not conform to the federal income tax
consequences summarized above.
12
Proposed Legislative or Other Actions Affecting REITs
On January 7, 2003, the Bush Administration released a proposal intended
to eliminate one level of the federal "double taxation" that is currently
imposed on corporate income for regular C corporations. Under this proposal,
dividends from a regular C corporation will be excluded from a stockholder's
federal taxable income to the extent that corporate income tax has been paid on
the earnings from which the dividends are paid. If a REIT receives a dividend
from a regular C corporation that has been subject to corporate income tax, the
REIT could distribute or retain the dividend amount without any additional
federal income tax being imposed on the REIT or its stockholders.
REITs currently are tax-advantaged relative to regular C corporations
because they are not subject to corporate-level federal income tax on income
that they distribute to stockholders. The Bush Administration's proposal, if
enacted, could decrease the tax advantage of a REIT relative to a regular C
corporation, because part or all of the dividends received by a stockholder from
the regular C corporation would be exempt from federal income tax. It is not
possible to predict whether the Bush Administration's proposal ultimately will
be enacted, the form which it might take, and, if enacted, the effects it may
have on the value of REIT shares.
The rules dealing with federal income taxation are constantly under review
by persons involved in the legislative process and by the IRS and the U.S.
Treasury Department. Changes to the tax law, which may have retroactive
application, could adversely affect the Company and its stockholders. It cannot
be predicted whether, when, in what forms or with what effective dates, the tax
law applicable to the Company or its stockholders will be changed.
COMPETITION
The Company believes that its principal competitors in the business of
acquiring and holding MBS of the types in which it invests are financial
institutions, such as banks, savings and loan institutions, life insurance
companies, institutional investors, including mutual funds and pension funds and
other mortgage REITs. Such investors may not be subject to similar regulatory
constraints (i.e., REIT tax compliance or maintaining an exemption under the
Investment Company Act). In addition, many of the other entities purchasing
mortgages and MBS have greater financial resources and access to capital than
the Company. The existence of these competitive entities, as well as the
possibility of additional entities forming in the future, may increase the
competition for the acquisition of MBS and other REIT qualifying investments
that the Company may invest in, resulting in higher prices and lower yields on
such assets.
AVAILABLE INFORMATION
The Company maintains a website on the World Wide Web at www.mfa-reit.com.
The Company makes available, free of charge, on its website its annual report on
the Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and
amendments to those reports filed or furnished pursuant to Section 13(a) or
15(d) of the Securities Exchange Act of 1934, as amended (the "1934 Act"), as
soon as reasonable practicable after such reports are electronically filed with,
or furnished to, the SEC. The Company's reports filed with, or furnished to, the
SEC are also available at the SEC's website at www.sec.gov.
13
Item 2. Properties.
Executive Office
During the second quarter of 2002, the Company entered into a lease
through 2012 for its corporate headquarters, located at 350 Park Avenue, New
York, New York. The lease provides for, among other things, annual rent of (i)
$338,000 though July 31 2005; (ii) $348,000 from August 1, 2005 through November
30, 2008 and (iii) $357,000 from December 1, 2008 through August 31, 2012. The
Company believes that the leased space is adequate to meet the Company's
foreseeable operating needs.
Property Owned Through Subsidiary Corporation
On October 1, 2002, the Company acquired 100% of the voting common stock
of RCC Corporation, representing 5% economic interest, for $260,000. (See Note 3
to the consolidated financial statements, included under Item 8). As a result of
the purchase of RCC common shares, the Company indirectly owns the controlling
interest the properties known as "The Greenhouse" and "Lealand Place". The
Greenhouse is a 127-unit high-rise rental apartment building located at 900
Farnam on the Mall in Omaha, Nebraska. Lealand Place is a 192-unit three and
four-story garden-style apartment rental complex located at 2945 Cruse Road,
Lawrenceville, Georgia.
Item 3. Legal Proceedings.
There are no material pending legal proceedings to which the Company is a
party or any of its assets are subject.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
Item 4A Executive Officers of the Company.
The following table sets forth certain information with respect to each
executive officer of the Company. The Board of Directors appoints or annually
reaffirms the appointment of all of the Company's executive officers.
Name Age* Position held with the Company
- ------------------- ---- ----------------------------------------------------
Stewart Zimmerman 58 President and Chief Executive Officer and Director
William S. Gorin 44 Executive Vice President and Chief Financial Officer
Ronald A. Freydberg 42 Executive Vice President and Secretary
Teresa D. Covello 37 Senior Vice President and Controller
* As of December 31, 2002
Stewart Zimmerman has served as President and Chief Executive Officer of
the Company since 1997. From 1989 through 1997, he initially served as a
consultant to The America First Companies and then became Executive Vice of
America First Companies, L.L.C. During this time he held a number of positions:
President and Chief Operating Officer of America First REIT, Inc., and President
of several America First Mortgage funds, including America First
Participating/Preferred Equity Mortgage Fund, America First PREP Fund 2, America
First PREP Fund II Pension Series Limited Partnership, Capital Source L.P.,
Capital Source II L.P.-A, America First Tax Exempt Mortgage Fund Limited
Partnership and America First Tax Exempt Fund 2-Limited Partnership. From 1986
through 1989, Mr. Zimmerman served as a Managing Director and Director of
Security Pacific Merchant Bank. From 1982 through 1986 Mr. Zimmerman served as
First Vice President of EF Hutton & Company, Inc. From 1980 through 1982, Mr.
Zimmerman was employed by First Pennco Securities and Cralin & Company. From
1977 to 1980, he served as Vice President of Lehmann Brothers. Prior to that
time, Mr. Zimmerman was an officer of Bankers Trust Company as well as Vice
President of Zenith Mortgage Company. Mr. Zimmerman holds a Bachelors of Arts
degree from Michigan State University.
14
William S. Gorin serves as Executive Vice President, Chief Financial
Officer and Treasurer of the Company. He has served as Executive Vice President
since 1997 and was appointed Chief Financial Officer and Treasurer in 2001. From
1998 to 2001, Mr. Gorin served as Executive Vice President and Secretary of the
Company. From 1989 to 1997, Mr. Gorin held various positions with PaineWebber
Incorporated/Kidder, Peabody & Co. Incorporated, New York, New York, serving as
a First Vice President in the Research Department. Prior to that position, Mr.
Gorin was Senior Vice President in the Special Products Group. From 1982 to
1988, Mr. Gorin was employed by Shearson Lehman Hutton, Inc./E.F. Hutton &
Company, Inc., New York, New York, in various positions in corporate finance and
direct investments. Mr. Gorin has a Masters of Business Administration degree
from Stanford University and a Bachelor of Arts in Economics from Brandeis
University.
Ronald A. Freydberg serves as Executive Vice President and Secretary of
the Company, which positions he was appointed to in 2001. From 1998 to 2001, he
served as Senior Vice President of the Company. From 1995 to 1997, Mr. Freydberg
served as a Vice President of Pentalpha Capital, in Greenwich, Connecticut,
where he was a fixed-income quantitative analysis and structuring specialist. In
addition, he worked with various financial institutions on the acquisition and
sale of residential, commercial and asset-backed securities. From 1988 to 1995,
Mr. Freydberg held various positions with J.P. Morgan & Co. in New York, New
York. From 1994 to 1995, he was with the Global Markets Group. In that position,
he was involved in all aspects of commercial mortgage-backed securitization and
sale of distressed commercial real estate, including structuring, due diligence
and marketing. From 1985 to 1988, Mr. Freydberg was employed by Citicorp in New
York, New York. Mr. Freydberg holds a Masters of Business Administration degree
in Finance from George Washington University and a Bachelor of Arts degree from
Muhlenberg College.
Teresa D. Covello has served as Senior Vice President and Controller of
the Company since October 2001. From 2000 up to joining the Company, Ms. Covello
was a self-employed financial consultant, concentrating in investment banking
within the financial services sector. From 1990 to 2000, she held progressive
positions, was the Director of Financial Reporting and served on the Strategic
Planning Team for JSB Financial, Inc., where her key responsibilities included;
Securities and Exchange Commission ("SEC") reporting, implementing accounting
standards, establishing policies and procedures, managing asset/liability and
interest rate risk policy and reporting, and investor and regulatory
communications. Ms. Covello began her career in public accounting in 1987 with
KPMG Peat Marwick (predecessor to KPMG LLP), participating in and supervising
financial statement audits, compliance examinations, public debt and equity
offerings. Ms. Covello is a Certified Public Accountant and has a Bachelor of
Science degree in Public Accounting from Hofstra University.
15
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
(a) Market Information The Company's Common Stock began trading on the New
York Stock Exchange on April 10, 1998, under the symbol "MFA." As of February 5,
2003, the last sales price for the Company's Common Stock on the New York Stock
Exchange was $8.55. The following table sets forth the high and low sale prices
per share for the Company's Common Stock during the 12 months ending December
31, 2002 and 2001.
2002 2001
-------------------- -------------------
Quarter Ended High Low High Low
------------------- ------- ------ ------ ------
March 31 $9.590 $8.200 $7.500 $5.063
June 30 $10.740 $8.300 $8.250 $6.750
September 30 $10.180 $7.210 $8.850 $7.250
December 31 $9.160 $7.100 $9.400 $7.650
(b) Investors
The approximate number of record holders of the Company's Common Stock as
of December 31, 2002 was 492; the total number of beneficial owners was
estimated at 16,500.
(c) Dividends
The Company currently pays cash dividends on a quarterly basis. Total cash
dividends declared by the Company to stockholders during the years ended
December 31, 2002 and 2001, were $54.8 million ($1.24 per share) and $17.0
million ($0.845 per share), respectively. In general, consistent with the
Company's underlying operational strategy, the Company's dividends will for the
most part be characterized as ordinary income to its stockholders for federal
tax purposes. However, a portion of the Company's dividends may be characterized
as capital gains or return of capital. All of the Company's dividends for 2002
and 2001 were characterized as ordinary income. (For additional dividend
information, see Note 11 to the accompanying consolidated financial statements,
included under Item 8.)
The Company elected to be treated as a REIT for federal income tax
purposes beginning with its 1998 taxable year and, as such, has distributed and
anticipates distributing annually at least 90% (95% prior to January 1, 2001) of
its taxable income, subject to certain adjustments. Although the Company may
borrow funds to make distributions; cash for such distributions has generally
been and is expected to continue to be largely generated from the Company's
results of operations.
The Company declared the following dividends during the years ended
December 31, 2002 and 2001:
Dividend
Declaration Date Record Date Payment Date per Share
- ------------------ ------------------ ---------------- -----------
2002
- ----
March 12, 2002 March 28, 2002 April 30, 2002 $ 0.30 (1)
June 12, 2002 June 28, 2002 July 30, 2002 0.30 (1)
September 12, 2002 September 30, 2002 October 30, 2002 0.32 (2)
December 19, 2002 December 30, 2002 January 24, 2003 0.32 (2)
2001
- ----
February 12, 2001 April 16, 2001 April 30, 2001 $ 0.165
April 9, 2001 June 30, 2001 July 16, 2001 0.175
September 19, 2001 October 2, 2001 October 18, 2001 0.225
December 12, 2001 December 28, 2001 January 30, 2002 0.280
(1) Included a special dividend of $0.02 per share.
(2) Included a special dividend of $0.04 per share.
Note: For tax purposes, a portion of each of the dividends declared on
December 19, 2002 and December 12, 2001 were treated as a dividend for
stockholders in the subsequent year.
Dividends are declared by the Company's Board of Directors after
considering the Company's available cash for distribution, financial condition,
ability to maintain its REIT status, and such other factors that may be deemed
relevant. See Item 7, Management's Discussion and Analysis of Financial
Conditions and Results of Operations, for information regarding the sources of
funds used for dividends and for a discussion of factors, if any, which may
adversely affect the Company's ability to pay dividends at the same levels in
2003 and thereafter.
16
Item 6. Selected Financial Data.
Set forth below is selected financial data for the Company (for periods
after April 9, 1998) and the Predecessor (for periods up to April 9, 1998). The
information set forth below should be read in conjunction with the consolidated
financial statements and notes to the consolidated financial statements.
For the Year Ended December 31, Company Predecessor
------------------------------------------------ --------- -----------
2002 2001 2000 1999 1998 (1)
--------- --------- --------- --------- ----------------------
Operating Data:
(In Thousands, Except per Share Amounts)
Mortgage securities income $ 126,238 $ 53,387 $ 33,391 $ 24,302 7,627 $ 614
Corporate debt securities income 791 1,610 1,336 675 165 --
Dividend income 39 666 928 331 -- --
Interest income on temporary cash investments 926 842 645 366 440 149
Interest expense on repurchase agreements (63,491) (35,073) (30,103) (18,466) (4,620) --
Income from equity interests in real estate (2) 80 3,137 3,670 3,013 582 145
Revenue from operations of real estate held (3) 685 -- -- -- -- --
Net gain (loss) on sale of securities 205 (438) 456 55 415 --
Other-than-temporary impairment on securities (3,474) (2,453) -- -- -- --
Operating and other expenses (4) (5,905) (5,355) (2,457) (2,672) (1,674) (421)
Cost incurred in acquiring Advisor (5) -- (12,539) -- -- -- --
Minority interest N/A N/A N/A (4) (4) N/A
--------- --------- --------- --------- --------- ---------
Net income $ 56,094 $ 3,784 $ 7,866 $ 7,600 $ 2,931 $ 487
========= ========= ========= ========= ========= =========
Net income, per share - basic $ 1.35 $ 0.25 $ 0.89 $ 0.84 $ 0.32 N/A
========= ========= ========= ========= ========= =========
Net income, per share - diluted $ 1.35 $ 0.25 $ 0.89 $ 0.84 $ 0.32 N/A
========= ========= ========= ========= ========= =========
Net income per exchangeable unit - basic N/A N/A N/A N/A N/A $ 0.08
========= ========= ========= ========= ========= =========
Net income per exchangeable unit - diluted N/A N/A N/A N/A N/A $ 0.08
========= ========= ========= ========= ========= =========
Dividends declared per common share or cash
distributions paid/accrued per
exchangeable unit $ 1.24 $ 0.85 $ 0.59 $ 0.67 $ 0.80 $ 0.26
========= ========= ========= ========= ========= =========
Balance Sheet Data:
At the Period Ended December 31,
--------------------------------------------------------------
2002 2001 2000 1999 1998
---------- ---------- ---------- ---------- ----------
(In Thousands)
MBS $3,485,319 $1,926,900 $ 470,576 $ 475,720 $ 241,895
Corporate debt securities -- 9,774 15,666 8,020 4,673
Corporate equity securities -- 4,088 9,011 3,131 1,154
Total assets 3,603,859 2,068,933 522,490 524,384 264,669
Repurchase agreements 3,185,910 1,845,598 448,583 452,102 190,250
Total stockholders' equity 371,200 203,624 69,912 67,614 70,933
(1) The column labeled "Company" reflects the results of the Company from April
10, 1998 through December 31, 1998; the column labeled "Predecessor" reflects
the results of the Predecessor from January 1, 1998 through April 9, 1998. PREP
Fund 1 was considered the sole predecessor to the Company and, accordingly, the
historical operating results presented in this report as those of PREP Fund 1.
The 1998 Merger was accounted for as a purchase by PREP Fund 1 of 100% of the
assigned limited partnership interests (known as "BUCs") of PREP Fund 2 and 99%
of the BUCs of Pension Fund. As a result of this treatment, the Company, as the
successor to PREP Fund 1, recorded all of the assets and liabilities of PREP
Fund 1 at their book value, but was required to record the assets of PREP Fund 2
and Pension Fund at their fair value. The amount by which the fair value of the
Company's Common Stock issued to the BUC holders of PREP Fund 2 and Pension Fund
exceeded the fair value of the net assets of PREP Fund 2 and Pension Fund was
recorded as goodwill by the Company.
(2) Includes gains of $2.6 million, $2.6 million and $2.2 million resulting from
the sale of the underlying real estate of unconsolidated real estate limited
partnerships for the years ended December 31, 2001, 2000 and 1999, respectively.
(See Note 7 to the accompanying consolidated financial statements, included
under Item 8.)
(3) On October 1, 2002, the Company acquired the voting common shares of RCC.
RCC's results of operations have been consolidated with the Company for the
three months ended December 31, 2002. (See Notes 3c and 7 to the accompanying
consolidated financial statements, included under Item 8.)
(4) Includes an incentive fees of $511,000, $519,000 and $433,000 earned by the
Advisor in connection with the sales described in (2) above for the years ended
December 31, 2001, 2000 and 1999, respectively.
(5) Reflects the cost of acquiring the Advisor, of which, $11.3 million was
non-cash. (See Note 3 to the accompanying consolidated financial statements,
included in Item 8.)
17
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
GENERAL
MFA Mortgage Investments, Inc. is a self-advised mortgage REIT, which is
primarily engaged in the business of investing in ARM-MBS. The Company's
investment portfolio consists primarily of Agency MBS and, to a lesser extent,
high quality MBS, rated in one of the two highest rating categories by at least
one Rating Agency. The Company's investment strategy also provides for the
acquisition of multi-family housing properties, investments in REIT securities
and other securities. The Company's principal business objective is to generate
net income for distribution to its stockholders, resulting from the spread
between the interest and other income it earns on its investments and the cost
of financing such investments.
The Company has elected to be taxed as a REIT for federal income tax
purposes. Pursuant to the current federal tax regulations, one of the
requirements of maintaining its status as a REIT is that the Company must
distribute at least 90% of its annual taxable net income to its stockholders,
subject to certain adjustments.
The Company was incorporated in Maryland on July 24, 1997 and began
operations on April 10, 1998 upon consummating the 1998 Merger. As a result of
the 1998 Merger, PREP Fund 1 and PREP Fund 2 were merged directly into the
Company and Pension Fund became a partnership subsidiary of the Company. In
December 1999, Pension Fund was liquidated and dissolved and, as a result, the
Company acquired 99% of the assets of Pension Fund. The remaining assets,
consisting solely of cash, were distributed to the holders of Pension Fund
securities who elected to remain in place following the 1998 Merger. As a result
of the 1998 Merger, the Company issued a total of 9,035,084 shares of its Common
Stock to the former partners of the PREP Funds.
Following the completion of the 1998 Merger through December 31, 2001, the
Company was externally advised and managed by the Advisor. As such, the Company
had no employees and relied entirely on the Advisor to perform all of the duties
that are typically performed by internal management, as well as perform all back
office operations. Pursuant the Advisory Agreement, the Advisor provided the
day-to-day management and administrative functions for the Company for a fee,
which was calculated on a quarterly basis. The Advisor was a subsidiary of AFC.
On December 12, 2001, the Company's stockholders approved the terms of the
Advisor Merger Agreement, dated September 24, 2001, among the Company, the
Advisor, AFC and the stockholders of the Advisor which provided for the Advisor
Merger. The Advisor Merger became effective on January 1, 2002. As a result of
the Advisor Merger, the Company became a self-advised REIT and, as such, was no
longer be required to pay a fee to the Advisor under the Advisory Agreement, but
rather directly incur all of the costs of operating the Company. In connection
with the Advisor Merger, the employees of the Advisor became employees of the
Company. The Company also acquired all of the tangible and intangible business
assets of the Advisor.
On August 13, 2002, the Company changed its name from America First
Mortgage Investments, Inc. to MFA Mortgage Investments, Inc.
The Company's core business strategy is to invest on a leveraged basis in
a portfolio of high-grade ARM-MBS, which primarily consist of Agency MBS.
Beginning in September 2001, the Company began to significantly increase its
asset base by leveraging equity raised through additional public offerings of
the Company's Common Stock. As a result, the Company has experienced significant
growth in assets and earnings. The Company's total assets grew to $3.603 billion
at December 31, 2002, from $2.069 billion at December 31, 2001. As of December
31, 2002, 98.5% of the Company's assets consisted of Agency MBS, AAA rated MBS
and cash. The Company also has indirect interests in four apartment properties
and a controlling indirect interest in two apartment properties, these six
properties contain a total of 1,473 rental units. Four of these apartment
properties are located in Georgia, one is located in North Carolina and one is
located in Nebraska.
The results of the Company's operations are affected by various factors,
many of which are beyond the control of the Company. The results of the
Company's operations primarily depend on, among other things, the level of its
net interest income, the market value of its assets and the supply of and demand
for such assets. The Company's net interest income, which reflects the
amortization of purchase premiums, varies primarily as a result of changes in
short-term interest rates, borrowing costs and prepayment rates, the behavior of
which involves various risks and uncertainties. Prepayment rates, as reflected
by the CPR, and interest rates vary according to the type of investment,
conditions in financial markets, competition and other factors, none of which
can be predicted with any certainty. The CPR on the Company's MBS portfolio
averaged 30.9% and 23.5% for the years ended December 3, 2002 and
18
2001, respectively. In addition to these factors, borrowing costs are further
affected by the creditworthiness of the borrower. Since changes in interest
rates may significantly affect the Company's activities, the operating results
of the Company depend, in large part, upon the ability of the Company to
effectively manage its interest rate and prepayment risks while maintaining its
status as a REIT. During 2002, the Company sold all of its remaining investments
in corporate debt securities, realizing an aggregate net loss of $637,000. The
Company also has risks inherent in its other investments, comprised of interests
in multi-family real estate properties and hedging instruments. Because these
investments represented less than 1.0% of the Company's total assets at December
31, 2002, the risk related to these assets is limited; nonetheless, these
investments have the potential of causing a material impact on the Company's
operating performance in future periods.
RESULTS OF OPERATIONS
Year Ended December 31, 2002, Compared to Year Ended December 31, 2001
In comparing the results of operations for 2002 with 2001, the results of
each year are marked by significant charges and/or gains as well as substantial
growth in assets funded by investment and leveraging of the additional equity
capital raised during the year. During 2002 and 2001, the Company recognized
charges of $3.5 million and $2.5 million, respectively, against certain of its
debt securities due to other-than-temporary declines in their market values.
Other non-recurring items for 2001 included a gain of $2.6 million on the sale
of an assisted living center and the $12.5 million one-time expense incurred in
connection with the Advisor Merger, of which $11.3 million was non-cash, stock
based consideration. Further, prior to 2002, the Company's operating expenses
were primarily comprised of a formula driven fee paid to the Advisor; subsequent
to the Advisor Merger, which became effective January 1, 2002, the Company
incurred its own direct operating costs.
The Board of Directors sets the Company's dividend rates based on, among
other things, the Company's taxable income. The capital losses realized on the
sale of the Company's investments in corporate debt securities during 2002 and
2001 cannot be used to offset operating income. The tax losses will be carried
forward and used to offset future long-term capital gains, if any. The gain
realized on the sale of the assisted living center during 2001 was deferred for
tax purposes and therefore did not impact the Company's taxable income.
Total interest and dividend income earned in 2002 increased by $71.5
million, or 126.5%, to $128.0 million compared to $56.5 million earned in 2001.
During 2002, the average amortized cost basis of the MBS portfolio increased by
$2.1 billion to $2.964 billion from $909.8 million for 2001. The growth in the
portfolio during 2002 is attributable to the investment of proceeds, on a
leveraged basis, of $147.0 million from the sale of 17.8 million shares of the
Company's Common Stock. The MBS portfolio generated income, after premium
amortization, of $126.2 million in 2002, an increase of $72.9 million, or
136.5%, from $53.4 million for 2001. The overall increase in income related to
the growth in MBS investments was partially offset by a decrease in the net
yield on the MBS portfolio to 4.25% for 2002 from 5.87% for 2001, reflecting the
impact of the decline in market interest rates that continued during 2002.
Further, the increase in prepayments caused additional amounts to be reinvested
at lower prevailing market interest rates and an acceleration of the premium
amortization on the portfolio. The CPR, which is a measure of the prepayment
speed, increased to a weighted average of 30.1% for 2002 from 23.5% for 2001.
During 2002, the Company recorded premium amortization of $28.1 million, which
reduced the net yield on the MBS portfolio by 99 basis points for 2002, while
net premium amortization for 2001 was $5.6 million, which reduced the yield on
the portfolio by 61 basis points. Management carefully monitors the premiums
paid for MBS to mitigate the impact of spikes in prepayment activity, such as
those experienced during 2002. As of December 31, 2002, the Company had net
purchase premiums of $76.3 million, reflecting an aggregate portfolio premium of
2.26% to par value, compared to $37.5 million of premiums, or 1.99% of par
value, at December 31, 2001.
Lifetime and interim interest rate caps on ARM-MBS could limit the change
in the coupon on such assets. At December 31, 2002, $656.9 million, or 19.9% of
the Company's ARM-MBS (18.2% of the Company's total assets) had a 1% interim cap
with the remainder having a 2% interim cap.
Income recognized on short-term investments in cash and cash equivalents
increased by $84,000, or 10.0%, to $926,000 for 2002 from $842,000 in 2001.
While the yield on the Company's cash decreased to 1.49% for 2002, from 3.21%
for 2001, the average balance of cash and cash equivalents increased by $35.9
million, or 136.9% , to $62.1 million for 2002 compared to $26.2 million for
2001. In general, as the portfolio of MBS continues to grow, balances of cash
and cash equivalents also tend to increase, reflecting the reinvestment lag on
larger monthly scheduled amortization and pre-payments received on the MBS
portfolio. Further, as reflected by the increase in the
19
CPR, greater prepayments increased cash inflows, increasing the Company's
temporary investments in money market accounts until ultimately reinvested in
MBS.
Income from corporate debt and equity securities decreased by an aggregate
of $1.4 million in 2002, or 63.5%, resulting from the sale of the entire
corporate debt and equity portfolio during 2002.
The Company's interest expense increased by $28.4 million, or 81.0%, for
2002, compared to 2001. This increase is related to the significant increase in
average borrowings under repurchase agreements. The Company's increase in
borrowings through repurchase agreements reflects the leveraging of $147.0
million of equity capital raised during 2002. The average balance of repurchase
agreements increased to $2.738 billion for 2002, compared to $885.0 million for
2001, while the cost of such borrowings decreased to 2.32% for 2002, from 3.96%
for 2001.
Net interest income increased by $43.1 million, or 201.0%, to $64.5
million from $21.4 million for the years ended December 31, 2002 and 2001,
respectively. The Company's net interest margin narrowed slightly to 2.13% for
2002, from 2.24% for 2001. The interest rate spread also decreased slightly to
1.90% for 2002, compared to 1.95% for 2001. This slight decrease reflects the
decrease in the yield on interest earning assets to 4.22% for 2002, from 5.91%
for 2001 and the decrease in the cost of interest bearing liabilities to 2.32%
for 2002, from 3.96% for 2001. During 2002, interest rates continued to
generally decline from 2001. Management believes that it is unlikely that
interest rates will continue to decline significantly in 2003.
Total other income decreased by $2.8 million to a loss of $2.5 million in
2002, from income of $246,000 for 2001. The components of the net total other
income/(loss) include: (i) income from equity interests in real estate; (ii)
income from operations of real estate held, which was comprised of the
consolidated income of RCC for the fourth quarter of 2002; (iii) net gain/(loss)
on the sale of securities and (iv) other-than-temporary impairment charges taken
against investments in corporate debt securities during both 2002 and 2001.
Prior to October 1, 2002, the Company accounted for its non-controlling
interest in the preferred stock of RCC under the equity method, whereby results
of operations were reported net, relative the Company's equity interest. On
October 1, 2002, the Company acquired 100% of the voting common stock in RCC,
and commenced accounting for such subsidiary on a consolidated basis,
prospectively. (See Note 3 to the accompanying consolidated financial
statements, included under Item 8.) This change in ownership and resulting
change in accounting for RCC caused certain line items of the Company's 2002
statement of operations to be non-comparable to the 2001 presentation. While
income from equity interests in real estate was $80,000 for 2002, compared to
$3.1 million for 2001, had RCC continued to be accounted for under the equity
method for 2002 in its entirety, the Company would have reported income from
equity interests in real estate of $276,000 for 2002, compared to $3.1 million
for 2001, primarily reflecting the impact of a $2.6 million non-recurring gain
on the sale of an assisted living center realized during 2001. Excluding the
2001 gain, income from equity interest in real estate investments would have
decreased by $276,000 for 2002 compared to 2001, had the Company continued to
account for RCC under the equity method for 2002 in its entirety. As of December
31, 2002, the Company had indirect interests in six multi-family properties
consisting of a total of 1,473 rental units, through investments in four limited
partnerships and one corporation as a common stockholder. In the aggregate, real
estate equity interests and real estate held, which is owned through a
consolidated subsidiary, comprised less than 1.0% of the Company's total assets
at December 31, 2002.
The Company reported a net gain of $205,000 on the sale of securities
during 2002, comprised of gross gains of $2.0 million and gross losses of $1.8
million. Included in gross gains were gains of $937,000, $569,000 and $515,000
from sales of corporate debt securities, corporate equity securities and MBS,
respectively. Included in gross losses were losses of $1.6 million and $241,000
on sales of corporate debt securities and MBS, respectively. In addition, during
2002, the Company recognized a $3.5 million other-than-temporary impairment
charge on corporate debt securities. This loss was entirely attributable to an
investment in the corporate debt securities of Level 3 Corporation ("Level 3").
The corporate debt securities portfolio accounted for an aggregate net losses of
$4.1 million during 2002, which includes the $3.5 million impairment charge and
net gains and losses from sales, which decreased earnings by $.10 per basic and
diluted share. The Company liquidated all of the corporate debt and equity
portfolios during 2002, and has no future plans to resume investing in such
instruments.
During 2001, the Company recognized gross losses of $3.6 million, on its
investments in corporate debt securities, of which $3.3 million was attributable
to the RCN Corporation ("RCN") debt securities. Losses recognized on the RCN
securities during 2001 were comprised of (i) a $2.5 million impairment charge
made against the investment for an other-than-temporary decline in the market
value and (ii) losses of $885,000 realized on sales and redemptions.
20
Operating and other expenses for the year ended December 31, 2002 are not
readily comparable to operating costs incurred during 2001. During 2001, the
Company was externally managed, and as such had no employees or the typical
costs associated with being internally managed. Prior to January 1, 2002, the
Company's general and administrative expenses were primarily comprised of
formula driven fees payable to the Advisor. During 2001, the Company incurred
cost of $12.5 million to acquire the Advisor, of which $11.3 million was
non-cash, comprised of 1,287,501 shares of the Company's Common Stock. The
Company and the Advisor merged effective 12:01a.m. on January 1, 2002. As a
result, the Company became self-advised commencing January 1, 2002 and, has
thereafter directly incurred the cost of all overhead necessary to operate the
Company. For 2001, Company paid the Advisor total fees of $4.3 million, which
included an incentive fee of $2.9 million. During 2002, the Company incurred
$5.9 million of operating expenses, or 0.19% of average assets on an annualized
basis, of which, employee compensation and benefits were $2.9 million, or 47.3%,
operating expenses from real estate held and mortgage interest for the fourth
quarter were $185,000 and $304,000, respectively, or 12.6%, and other general
and administrative expenses were $2.5 million, or 40.1%. Other general and
administrative expenses were comprised primarily of fees for professional
services, including legal and accounting, corporate insurance, office rent and
director fees. The Company relocated to new headquarters during the third
quarter of 2002, as additional space was needed to accommodate the Company's
post-Advisor Merger operations. In addition, commencing October 1, 2002, when
the Company acquired the voting common stock of RCC, the Company consolidated
RCC's results of operations, resulting in RCC's indirect mortgages and related
interest expense being reported on the Company's consolidated financial
statements. (See Note 3 to the accompanying consolidated financial statements,
included under Item 8.) These mortgage loans, which had an aggregate balance of
$16.3 million, had an average interest rate of 7.3%. Prior to the Company
acquiring the voting common stock of RCC, the preferred stock interest in RCC
was accounted for under the equity method, with the Company's percentage
interest in RCC's income or loss reflected net as a component of income from
equity interests in real estate.
During 2002, the Sarbanes-Oxley Act ("SOX Act") was enacted. The SOX Act,
among other things, places additional responsibilities on management and the
boards of directors of public companies. The Company expects to incur
incremental costs associated with complying with the provisions of the SOX Act
and other related changes to federal securities and corporate governance laws.
The Company expects to experience an increase in the cost of its professional
fees, including, but not limited to, accounting and compliance. The incremental
increase in costs to be incurred to comply with the provisions of the SOX Act
and related changes to federal securities and corporate governance laws, as well
as other associated increases, such as director and officer liability insurance,
is uncertain at the present time.
Year Ended December 31, 2001, Compared to Year Ended December 31, 2000
In comparing the results of operations for 2001 with 2000, the 2001
results are marked by two significant charges and a substantial growth in assets
funded by leveraging of the additional equity capital raised during the year.
During 2001, the Company incurred a one-time expense of $12.5 million, of which
$11.3 million was non-cash, in connection with the Advisor Merger. In addition,
the Company incurred a charge of $2.5 million taken against the corporate debt
securities portfolio for an other-than-temporary impairment against an
investment in corporate debt securities.
Total interest and dividend income increased by $20.2 million, or 55.7%,
to $56.5 million compared to $36.3 million earned in 2000. The 2001 increase is
directly attributable to the growth in assets as a result of the investing, on a
leveraged basis, the proceeds from the sale of 18.3 million shares of the
Company's Common Stock. The Company's "core assets" which consist of MBS,
generated $53.4 million of income, reflecting $20.0 million, or 59.9%, increase
from $33.4 million for 2000. The increase in MBS income reflects the growth in
the Company's MBS portfolio of $1.456 billion, or 309.5%, from $470.6 million as
of December 31, 2000 to $1.927 billion as of December 31, 2001.
Lifetime interest rate caps on ARM-MBS could limit earnings on the
Company's assets. At December 31, 2001, 19.9% of the Company's ARM-MBS had a 1%
interim cap with the remainder having a 2% interim cap.
Income recognized on short-term investments in cash and cash equivalents
increased by $197,000, as funds generated through the sale of the Company's
common shares remain in interest earning cash investments until fully invested.
Further, significant growth in investments will, in general, due to the
reinvestment lag, result in an increase in temporary cash investments. Income
from corporate debt securities increased $274,000; however losses on sales of
such securities and losses recognized for other-than-temporary impairment on one
of the Company's corporate debt investments far exceeded the growth in income.
Slightly offsetting increases in interest income was a
21
decrease in dividend income on equity securities of $262,000 reflecting sales of
equity securities. The yield on the equity security portfolio decreased to 8.6%
for 2001 from 15.0% in 2000.
The Company's interest expense increased by $5.0 million, or 16.5%, for
the year ended December 31, 2001. The average borrowings under repurchase
agreements increased by $434.7 million, or 96.5% from $450.3 million during 2000
to $885.0 million during 2001, while the average cost of borrowings decreased
from 6.68% to 3.96% for the years ended December 31, 2000 and 2001,
respectively.
Net interest and dividend income increased by $15.2 million, or 245.8%,
from $6.2 million to $21.4 million for the years ended December 31, 2000 and
2001, respectively. The Company's net interest margin improved by 102 basis
points to 2.24% for 2001 from 1.22% for 2000. Overall, the significant increase
in the Company's net interest income can be attributed to the significant
balance sheet growth and the increase in the interest rate spread and net
interest margin during 2001. During 2001, interest rates generally declined,
resulting in an expansion (i.e., increase) in interest rate spreads and margins.
Income from equity interests in real estate decreased $533,000, to $3.1
million from $3.7 million for 2000. During both 2001 and 2000, the Company
recognized gains of $2.6 million related to sales of real estate properties
through the Company's non-consolidated real estate investments. Excluding the
gains on sales of the underlying equity interests, the decrease reflects a
decline in the performance of the underlying properties held through equity
interests. As of December 31, 2001, the Company had indirect interests in six
multi-family properties consisting of a total of 1,473 rental units, through
investments in four limited partnerships and one corporation as a preferred
stockholder. These investments, which had a net carrying value of $9.8 million
at December 31, 2001, comprised less than 1.0% of the Company's total assets.
The Company reported a net loss of $438,000 on the sale of securities
during 2001. This net loss was comprised of gross sale gains of $1.2 million on
corporate equity securities and $81,000 on corporate debt securities and MBS,
net of gross losses from sales of $1.2 million on corporate debt securities and
$588,000 on equity securities. This compares to a net gain of $456,000
recognized during the year ended December 31, 2000 resulting from the sale of
corporate debt, equity and mortgage-backed securities.
During 2001, the Company recognized an other-than-temporary impairment
loss of $2.5 million on its investment in RCN debt securities. At December 31,
2001, the Company held RCN debt securities, which were carried at their
estimated fair value of $2.1 million. In addition to RCN debt securities, the
corporate debt portfolio included other debt securities designated as
held-to-maturity that were carried at their amortized cost of $7.6 million which
had estimated gross unrealized losses of $3.4 million. The investment in the
corporate debt securities of Level 3 accounted for $3.1 million of the $3.4
million of unrealized losses.
General and administrative expenses for the Company for the year ended
December 31, 2001, increased $2.9 million as compared to 2000. Such increase is
primarily attributable to higher base management and incentive compensation fees
earned by the Advisor resulting from an increase in the Company's stockholders'
equity and an increase in income generated by the Company.
The Company incurred costs in acquiring the Advisor of $12.5 million, of
which $11.3 million was a non-cash equity issuance, representing the fair value
of the Company's Common Stock issued in the Advisor Merger. The Company and the
Advisor merged effective 12:01a.m. on January 1, 2002. As a result, the Company
became self-advised and thereafter, has directly incurred the cost of all
overhead necessary to operate the Company.
CRITICAL ACCOUNTING POLICIES
Management has the obligation to insure that its policies and
methodologies are in accordance with generally accepted accounting principles.
During 2002, management reviewed and evaluated its critical accounting policies
and believes them to be appropriate.
The Company's consolidated financial statements include the accounts of
the Company and all majority owned and controlled subsidiaries. The preparation
of consolidated financial statements in accordance with generally accepted
accounting principles requires management to makes estimates and assumptions in
certain circumstances that affect amounts reported in the accompanying
consolidated financial statements. In preparing these consolidated financial
statements, management has made its best estimates and judgements of certain
amounts included in the consolidated financial statements, giving due
consideration to materiality. The Company does not believe that there is a great
likelihood that materially different amounts would be reported related to
accounting policies described
22
below. However, application of these accounting policies involves the exercise
of judgement and use of assumptions as to future uncertainties and, as a result,
actual results could differ from these estimates.
The Company's accounting policies are described in Note 2 to the Company's
consolidated financial statements, included in Item 8. Management believes the
more significant of these to be as follows:
Revenue Recognition
The most significant source of the Company's revenue is derived from its
investments in MBS. The Company reflects income using the effective yield
method, which recognizes periodic income over the term of the investment on a
constant yield basis, as adjusted for actual prepayment activity. Management
believes the Company's revenue recognition policies are appropriate to reflect
the substance of the underlying transactions.
Other-than-temporary Impairment
The Company's accounting policies require that management review its
investment portfolio for potential "other-than-temporary" declines in value on
an investment-by-investment basis. The majority of the Company's investments are
in ARM-MBS which are issued or guaranteed by an agency of the U.S. Government,
such that management considers it unlikely that these securities will experience
substantial declines in value that are due to other-than-temporary market
fluctuations. For the Company's other non-real estate investments, management
assesses on a quarterly basis significant declines in value which may be
considered other-than-temporary and, if necessary, recognizes an accounting
charge to write-down the carrying value of such investments. In making this
assessment, management considers a wide range of objective and subjective
information, including, but not limited to, the following: the magnitude and
duration of historical decline in market prices, credit rating activity,
assessments of liquidity and public filings and statements made by the issuer,
if applicable. Actual losses, if any, could ultimately differ from these
estimates.
Impairment of Long-Lived Assets
Real estate investments held directly or through joint ventures represent
"long-lived" assets for accounting purposes. The Company periodically reviews
long-lived assets to be held and used in operations for impairment in value
whenever any events or changes in circumstances indicate that the carrying
amount of the assets may not be recoverable. In management's opinion, based on
this analysis, real estate held and investments in joint ventures are considered
to be held for investment and are not carried at amounts in excess of their
estimated fair value.
Income Taxes
The Company's financial results generally do no reflect provisions for
current or deferred income taxes. Management believes that the Company has and
intends to continue to operate in a manner that will continue to allow it to be
taxed as a REIT and as a result does not expect to pay substantial corporate
level taxes. Many of these requirements, however, are highly technical and
complex. If the Company were to fail to meet these requirements, the Company
would be subject to federal income tax.
New Accounting Pronouncements
In December 2002, the Financial Accounting Standards Board ("FASB") issued
Financial Accounting Standards ("FAS") No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure" ("FAS 148"). FAS 148, amends FAS No.
123, "Accounting for Stock-Based Compensation," ("FAS 123") by providing
alternative methods of transition for a voluntary change to the fair value based
method of accounting for stock-based employee compensation. In addition, FAS 148
amends the disclosure requirements of FAS 123 to require prominent disclosures
in both annual and interim financial statements about the method of accounting
for stock-based employee compensation and the effect of the method used on
reported results. The Company plans to record option expense for options granted
subsequent to January 1, 2003, in accordance with FAS 123, as amended by FAS
148; such change is not expected to have a significant impact on the Company.
23
Liquidity and Capital Resources
The Company's principal sources of liquidity consist of borrowings under
repurchase agreements, principal payments received on its portfolio of MBS, cash
flows generated by operations and proceeds from capital market transactions. The
Company's principal uses of cash include purchases of MBS and, to a lesser
extent, may include hedge instruments, payments for operating expenses and the
payment of dividends on the Company's Common Stock.
Repurchase agreements provided an additional $1.340 billion to finance
asset growth during 2002, this increase in leverage was facilitated by the
increase in the Company's capital as a result of the public stock offerings
completed in 2002. At December 31, 2002, borrowings under repurchase agreements
were $3.186 billion, compared to $1.846 billion at December 31, 2001. At
December 31, 2002, repurchase agreements had a weighted average borrowing rate
of 2.02%, on loan balances of between $560,000 and $88.4 million. These
agreements generally have original terms to maturity ranging from one to 18
months and interest rates that are typically based off of LIBOR. To date, the
Company has not had any margin calls on its repurchase agreements that it was
unable to satisfy with either cash or additional pledged collateral.
During the year ended December 31, 2002, the Company completed two public
offerings, as detailed below, of its Common Stock, in which it issued 17.8
million shares, and raised net proceeds of $147.0 million. The Company's 2002
equity offerings were as follows:
Price Gross Offering Net
Settlement Date Number of Shares Per Share Proceeds Expenses(1) Proceeds
--------------- ---------------- --------- -------- ----------- --------
(In Thousands, Except Price per Share)
January 18, 2002 7,475 $8.25 $61,669 $ 3,508 $58,161
June 5, 2002 10,350 $9.10 $94,185 $ 5,378 $88,807
(1) Includes commissions, discounts and other offering exenses.
On September 25, 2001, the Company filed a registration statement with the
SEC relating to $300 million of its Common Stock and preferred stock that the
Company may offer from time to time for cash in a variety of transactions,
including underwritten public offerings (the "Shelf Registration"). The Common
Stock offerings completed by the Company during 2002 utilized the securities
registered pursuant to this registration statement. As of December 31, 2002, the
Company had approximately $80.1 million of securities remaining on the Shelf
Registration.
To the extent the Company raises additional equity capital from future
sales of common and/or preferred stock pursuant to the Shelf Registration, the
Company anticipates using the net proceeds primarily to acquire additional
ARM-MBS. Management may also consider additional interests in multifamily
apartment properties and other investments consistent with its operating
policies. There can be no assurance, however, that the Company will be able to
raise additional equity capital at any particular time or on any particular
terms.
During 2002, principal payments on MBS generated cash of $1.302 billion
and operations provided a net cash of $83.3 million. In addition, the Company
received proceeds of $3.9 million, $5.7 million and $93.1 million from the sale
of investments in corporate debt securities, corporate equity securities and
MBS, respectively, during 2002.
As part of its core investing activities, during 2002, the Company
acquired $2.959 billion of ARM-MBS. Other uses of funds during the year ended
December 31, 2002 included $47.6 million for dividend payments on the Company's
Common Stock.
In order to reduce interest rate risk exposure on a portion of the
Company's LIBOR-based repurchase agreements, the Company has entered into
interest rate Cap Agreements, costing an aggregate of $3.7 million. (See
"Quantitative and Qualitative Disclosures About Market Risk"). Additional
purchases of Cap Agreements may be made during 2003. The Cap Agreements will
generate future cash if interest rates increase beyond the rate specified in the
individual agreement.
The Company's restricted cash balance represents cash held on deposit with
certain counterparties (i.e., lenders) to satisfy margin calls on repurchase
agreements. The margin calls result from the decline in the value of the MBS
securing repurchase agreements, generally due to principal reduction in the MBS
from scheduled amortization and prepayments. At December 31, 2002, the Company
had 31.9% of the balance of its repurchase agreements scheduled to roll (i.e.,
is contractually mature and payable to the counterparty) within the first three
months of 2003.
24
The significant amount of repurchase agreements scheduled to roll within the
first three months of 2003 reflects the Company's strategy to avoid having a
significant amount of repurchase agreements from rolling at or near calendar
year end. At the time a repurchase agreement rolls, the Company will apply the
restricted cash against the repurchase agreement balance, thereby reducing the
borrowed balance.
Effective January 1, 2002, the Company became a self-advised REIT and has
since directly incurred all costs associated with conducting its business. The
Company believes it has adequate financial resources to meet its obligations as
they come due and to fund committed dividends as well as to actively pursue its
investment policies.
INFLATION
Virtually all of the Company's assets and liabilities are financial in
nature. As a result, interest rates and other factors drive the Company's
performance far more than does inflation. Changes in interest rates do not
necessarily correlate with inflation rates and changes in inflation rates. The
Company's consolidated financial statements are prepared in accordance with
Generally Accepted Accounting Principles while dividends are based upon net
income as calculated for tax purposes; in each case, the Company's activities
and balance sheet are measured with reference to historical cost or fair market
value without considering inflation.
OTHER MATTERS
The Company at all times intends to conduct its business so as to not
become regulated as an investment company under the Investment Company Act. If
the Company were to become regulated as an investment company, then, among other
things, the Company's ability to use leverage would be substantially reduced.
The Investment Company Act exempts entities that are "primarily engaged in the
business of purchasing or otherwise acquiring Qualifying Interests. Under the
current interpretation of the staff of the SEC, in order to qualify for this
exemption, the Company must maintain at least 55% of its assets directly in
Qualifying Interests. In addition, unless certain MBS represent an undivided
interest in the entire pool backing such MBS (i.e., whole pool MBS), such MBS
may be treated as securities separate from the underlying mortgage loan and,
thus, may not be considered Qualifying Interests for purposes of the 55%
exemption requirement. Accordingly, the Company monitors its compliance with
this requirement in order to maintain its exempt status. As of December 31,
2002, the Company determined that it is in and has maintained compliance with
this requirement.
FORWARD LOOKING STATEMENTS
When used in this Annual Report on Form 10-K, in future SEC filings, or in
press releases or other written or oral communications, the words or phrases
"will likely result," "are expected to," "will continue," "is anticipated,"
"estimate," "project" or similar expressions are intended to identify
"forward-looking statements" for purposes of Section 27A if the Securities Act
of 1933, as amended, and Section 21E of the 1934 Act, as amended, and as such
may involve know and unknown risks, uncertainties and assumptions.
These forward-looking statements are subject to various risks and
uncertainties, including, but not limited to, those relating to: increases in
the prepayment rates on the mortgage loans securing the Company's MBS; changes
in short-term interest rates; the Company's ability to use borrowings to finance
its assets; risks associated with investing in real estate, including changes in
business conditions and the general economy; changes in government regulations
affecting the Company's business; and the Company's ability to maintain its
qualification as a REIT for federal income tax purposes. These risks,
uncertainties and factors could cause the Company's actual results to differ
materially from those projected in any forward-looking statements it makes.
All forward-looking statements speak only as the date they are made and
the Company does not undertake, and specifically disclaims, any obligation to
update any forward-looking statement to reflect events or circumstances after
the date of such statements. Readers are cautioned that the Company's actual
results could differ materially from those set forth in such forward-looking
statements.
25
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
The Company seeks to manage the interest rate, market value, liquidity,
prepayment and credit risks inherent in all financial institutions in a prudent
manner designed to insure the longevity of the Company while, at the same time,
seeking to provide an opportunity to stockholders to realize attractive total
rates of return through stock ownership of the Company. While the Company does
not seek to avoid risk, it does seek, to the best of its ability, to assume risk
that can be quantified from historical experience, to actively manage such risk,
to achieve returns that justify the taking of such risks and to maintain capital
levels consistent with its risk posture.
INTEREST RATE RISK
The Company primarily invests in ARM-MBS, which include hybrid-MBS that
have fixed rate coupons for a specified period, generally not greater than three
years at the time of purchase, and thereafter convert to variable rate coupons.
Most of the Company's adjustable rate assets are dependent on the one-year CMT
rate while the Company's repurchase agreements are generally priced off of
LIBOR. These indexes generally move in parallel, but there can be no assurance
that this will continue to occur. At December 31, 2002, the Company had 71.8% of
its ARM-MBS portfolio repricing from the one-year CMT index, 26.1% repricing
from the one-year LIBOR index and 2.1% repricing from the 11th District Cost of
Funds Index (i.e., COFI).
The Company's adjustable rate investment assets and repurchase agreements
reset on different dates for the specific asset or obligation. In general, the
repricing of the Company's repurchase obligations occurs more quickly than the
repricing of assets. Therefore, the Company's cost of funds would likely rise or
fall more quickly than would its earnings rate on assets.
The following table presents the Company's interest rate risk using the
static gap methodology. The table presents the difference between the carrying
value of the Company's interest rate sensitive assets and liabilities at
December 31, 2002, based on the earlier of term to repricing or the term to
repayment of the asset or liability, scheduled principal amortization is not
reflected in the table. Further, the ARM-MBS can be prepaid before contractual
amortization and/or maturity, which is also not reflected in the table. The
table does not include assets and liabilities that are not interest rate
sensitive.
As of December 31, 2002, the Company's investment assets and debt
obligations will contractually reprice based on the following time frames:
As of December 31, 2002
------------------------------------------------------------------------------------
(In Thousands) Less than Three Months One Year to Two Years to Beyond
Three Months to One Year Two Years Year Three Three Years Total
------------ ----------- --------- ---------- ----------- -----------
Interest Earning Assets:
ARM-MBS $ 244,021 $ 1,051,460 $ 448,966 $ 1,734,091 $ -- $ 3,478,538
Fixed-Rate - MBS -- -- -- -- 6,781 6,781
Debt Securities -- -- -- -- -- --
Equity Securities -- -- -- -- -- --
----------- ----------- ----------- ----------- ----------- -----------
Total interest-earning assets 244,021 1,051,460 448,966 1,734,091 6,781 3,485,319
Interest Bearing Liabilities:
Repurchase agreements 1,016,430 1,976,980 192,500 -- -- 3,185,910
----------- ----------- ----------- ----------- ----------- -----------
Total interest-bearing liabilities 1,016,430 1,976,980 192,500 -- -- 3,185,910
Interest sensitivity gap (772,409) (925,520) 256,466 1,734,091 6,781 $ 299,409
Cumulative interest sensitivity gap $ (772,409) $(1,697,929) $(1,441,463) $ 292,628 $ 299,409
The difference between assets and liabilities repricing or maturing in a
given period is one approximate measure of interest rate sensitivity. When more
assets than liabilities reprice during a period, the gap is considered positive
and it is anticipated that earnings will increase as interest rates rise and
earnings will decrease as interest rates decline. When more liabilities reprice
than assets during a given period, as is the case with respect to the Company
for periods less than one year, the gap is considered negative. With a negative
gap it is anticipated that income will decline as interest rates increase and
income will increase as interest rates decline. The static gap analysis does not
reflect the constraints on the repricing of ARM-MBS in a given period resulting
from periodic and
26
life time cap features on these securities, nor the behavior of various indexes
applicable to the Company's assets and liabilities. The actual repricing can and
will likely be affected by prepayments on the Company's MBS portfolio.
To a limited extent, the Company uses interest rate Cap Agreements as part
of its interest rate risk management. The notional amounts of these instruments
are not reflected in the Company's balance sheet. The Cap Agreements that hedge
against increases in interest rates on the Company's LIBOR-based repurchase
agreements are not considered in the static gap analysis, as they do not effect
the timing of the repricing of the instruments they hedge, but rather to the
extent of the notional amount, cap the limit on the amount of interest rate
change that can occur relative to the applicable of the hedged liability.
MARKET VALUE RISK
Substantially all of the Company's investments are designated as
"available-for-sale" assets. As such, they are reflected at their estimated fair
value, with the difference between amortized cost and fair value reflected in
accumulated other comprehensive income, a component of stockholders' equity.
(See Note 13 to the accompanying consolidated financial statements, included
under Item 8.) The market value of the Company's MBS assets fluctuate primarily
due to changes in interest rates and other factors; however, given that 93.2% of
the Company's assets are issued or guaranteed by an agency of the U.S.
Government, such fluctuations are generally not based on the underlying
creditworthiness. During 2002, the Company liquidated its portfolio of corporate
debt and equity securities, eliminating the market risks associated with such
investments. (See "Risk Factors - Risks of Decline in Market Value")
LIQUIDITY RISK
The primary liquidity risk for the Company arises from financing
long-maturity assets, which have interim and life time interest rate adjustment
caps, with short-term debt in the form of repurchase agreements. Although the
interest rate adjustments of assets and liabilities are managed through the
Company's operating policies, maturities are not matched.
The Company's assets which are pledged to secure short-term borrowings are
high-quality, liquid assets. As a result, the Company has not had difficulty
rolling over (i.e., renewing) its short-term debt as it matures. However, the
Company cannot give assurances that it will always be able to roll over its
short-term debt. At December 31, 2002, the Company had cash and cash equivalents
of $64.1 million available to meet margin calls on repurchase agreements and for
other corporate purposes. The Company had no long-term debt at December 31,
2002.
PREPAYMENT AND REINVESTMENT RISK
The Company typically pays a premium over the par value of its MBS upon
acquisition. As the Company receives repayments of principal on its MBS,
premiums are amortized, thereby reducing interest income. Discounts, to the
extent the Company owns MBS with a discount to par value, are accreted to
interest income. Premiums arise when the Company acquires MBS at a price in
excess of the principal value of the mortgages or par value if purchased at the
original issue. Conversely, discounts arise when the Company acquires MBS at a
price below the principal value of the mortgages, or par, if purchased at
original issue. For financial accounting purposes, the premium is amortized
using the effective yield method, which reflects the effect of prepayments on
amortization of premium and accretion of discounts. Greater than anticipated
prepayments will accelerate the amortization of premiums, thereby reducing
interest income.
For tax accounting purposes, premiums are amortized based on the asset
yield at the purchase date. Therefore, on a tax basis, amortization of premiums
will differ from those reported for financial purposes. At December 31, 2002,
the gross unamortized premium for the MBS in the Company's portfolio for
financial accounting purposes was $76.3 million (2.26% of the MBS portfolio)
compared with $72.9 million for federal tax purposes.
In general, the Company believes it will be able to reinvest proceeds from
scheduled principal payments and prepayments at acceptable yields; however, no
assurances can be given that, should significant prepayments occur, market
conditions would be such that acceptable investments could be identified and the
proceeds reinvested.
27
TABULAR PRESENTATION
The information presented in the following table, projects the potential
impact of sudden changes in interest rates on 2003 projected net income and net
assets based on the investments in the Company's portfolio on December 31, 2002,
and includes the Company's interest-rate sensitive assets and liabilities. The
Company acquires interest-rate sensitive assets and funds them with
interest-rate sensitive liabilities. The Company generally plans to retain such
assets and the associated interest rate risk to maturity.
Change in Percentage Change Percentage Change
Interest Rates in Net Income in Net Assets
-------------- ------------- -------------
+2.00% (4.62)% (17.20)%
+1.00% (2.31)% (9.03)%
-- -- --
-0.50% (1.54)% 1.81 %
-1.00% (6.15)% 8.93 %
Many assumptions are made to present the information in the above table,
as such, there can be no assurance that assumed events will occur or that other
events will not occur that would affect the outcomes; therefore, the above table
and all related disclosure constitutes forward-looking statements. The analysis
presented utilizes assumptions and estimates based on management's judgment and
experience. Furthermore, future sales, acquisitions and restructuring could
materially change the Company's interest rate risk profile.
The table quantifies the potential changes in net income and net asset
value should interest rates immediately change ("Shock"). The results of
interest rate Shocks of plus 100 and 200 basis points are presented; while rate
Shock declines are limited to 50 and 100 basis points, as a greater decline
would result in negative interest rates for certain of the interest rate indexes
that drive the repricing of some of the Company's assets and liabilities. The
cash flows associated with the portfolio of ARM-MBS for each rate Shock are
calculated based on a variety of assumptions, including prepayment speeds, time
until coupon reset, yield on future acquisitions, slope of the yield curve and
size of the portfolio. Assumptions made on the interest rate sensitive
liabilities, which are repurchase agreements, include anticipated interest
rates, collateral requirements as a percent of the repurchase agreement and
amount of borrowing. Assumptions made in calculating the impact on net asset
value of interest rate Shocks include interest rates, prepayment rates and the
yield spread of ARM-MBS relative to prevailing interest rates.
The Company's asset/liability structure is generally such that a decrease
in interest rates would be expected to result in an increase to net interest
income, as the Company's cost of funds are generally shorter term than the
Company's interest earning assets. However, given the impact of prepayment
assumptions and other assumptions coupled with the low level of interest rates
at December 31, 2002, the interest rate Shocks presented in the above table
would cause net income to decrease under each of the interest rate Shock
scenarios presented. When interest rates are Shocked, prepayment assumptions are
adjusted based on management's best estimate of the effects of changes in
interest rates on prepayment speeds. For example, under current market
conditions, a 100 basis point decline in interest rates is estimated to result
in a 22% increase in the prepayment rate of the ARM-MBS portfolio. The base
interest rate scenario assumes interest rates at December 31, 2002. Actual
results could differ significantly from those estimated in the table.
28
Item 8. Financial Statements and Supplementary Data.
Index to Financial Statements
Page
Report of Independent Accountants .......................................... 30
Financial Statements:
Consolidated Statements of Financial Condition of the Company as of
December 31, 2002 and December 31, 2001............................... 31
Consolidated Statements of Income of the Company for the years ended
December 31, 2002, 2001 and 2000...................................... 32
Consolidated Statements of Changes in Stockholders' Equity of the
Company for the years ended December 31, 2002, 2001 and 2000.......... 33
Consolidated Statements of Cash Flows of the Company for the years ended
December 31, 2002, 2001 and 2000...................................... 34
Consolidated Statements of Comprehensive Income for the years ended
December 31, 2002, 2001 and 2000...................................... 35
Notes to the Consolidated Financial Statements of Company................... 36
All financial statement schedules are omitted because they are not
applicable or the required information is shown in the consolidated financial
statements or notes thereto.
Financial statements of four real estate limited partnerships, in which
the Company owns between 50% and 99% limited partnership interests, have been
omitted because the Company's proportionate share of the income from continuing
operations before income taxes of each entity on an individual and aggregate
basis is less than 20% of the Company's respective amount, and the investment
in, and advances to, each entity on an individual and aggregate basis is less
than 20% of total assets.
29
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
MFA Mortgage Investments, Inc.
In our opinion, the accompanying consolidated statements of financial condition
and the related consolidated statements of income, changes in stockholders'
equity, cash flows and comprehensive income present fairly, in all material
respects, the financial position of MFA Mortgage Investments, Inc. and its
subsidiaries (the "Company") at December 31, 2002 and 2001, and the results of
their operations and their cash flows for the each of the three years in the
period ended December 31, 2002 in conformity with accounting principles
generally accepted in the United States of America. These financial statements
are the responsibility of the Company's management; our responsibility is to
express an opinion on these financial statements based on our audits. We
conducted our audits of these statements in accordance with auditing standards
generally accepted in the United States of America, which require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
PricewaterhouseCoopers LLP
New York, New York
February 3, 2003
30
MFA MORTGAGE INVESTMENTS, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(In Thousands, Except Share and per Share Amounts) At December 31,
--------------------------
2002 2001
----------- -----------
Assets
Mortgage backed securities ("MBS") (Note 4) $ 3,485,319 $ 1,926,900
Cash and cash equivalents 64,087 58,533
Restricted cash 39 39,499
Corporate debt securities (Note 5) -- 9,774
Corporate equity securities (Note 6) -- 4,088
Accrued interest and dividends receivable 19,472 12,340
Interest rate cap agreements (Note 8) 1,108 513
Equity interests in real estate investments (Note 7) 3,806 9,800
Real estate held (Note 7) 21,986 --
Goodwill, net 7,189 7,189
Prepaid and other assets 853 297
----------- -----------
$ 3,603,859 $ 2,068,933
=========== ===========
Liabilities
Repurchase agreements (Note 9) $ 3,185,910 $ 1,845,598
Accrued interest payable 14,299 11,387
Mortgages payable on real estate held 16,337 --
Dividends payable 14,952 7,718
Accrued expenses and other liabilities 1,161 606
----------- -----------
3,232,659 1,865,309
----------- -----------
Commitments and contingencies (Note 10) -- --
Stockholders' Equity
Common stock, $.01 par value; 375,000,000 shares authorized;
46,270,855 and 28,348,601 issued and outstanding in
2002 and 2001, respectively (Note 11) 463 283
Additional paid-in capital 359,359 212,001
Accumulated deficit (12,417) (13,704)
Accumulated other comprehensive income (Note 13) 23,795 5,044
----------- -----------
371,200 203,624
----------- -----------
$ 3,603,859 $ 2,068,933
=========== ===========
The accompanying notes are an integral part of the
consolidated financial statements.
31
MFA MORTGAGE INVESTMENTS, INC.
CONSOLIDATED STATEMENTS OF INCOME
For the Year Ended December 31,
-----------------------------------
2002 2001 2000
--------- --------- ---------
(In Thousands, Except Per Share Amounts)
Interest and Dividend Income:
Mortgage securities income $ 126,238 $ 53,387 $ 33,391
Corporate debt securities income 791 1,610 1,336
Dividend income 39 666 928
Interest income on temporary cash investments 926 842 645
--------- --------- ---------
Total Interest and Dividend Income 127,994 56,505 36,300
--------- --------- ---------
Interest Expense on Repurchase Agreements 63,491 35,073 30,103
--------- --------- ---------
Net Interest and Dividend Income 64,503 21,432 6,197
--------- --------- ---------
Other Income (Loss):
Income from equity interests in real estate 80 3,137 3,670
Revenue from operations of real estate held 685 -- --
Net gain (loss) on sale of securities 205 (438) 456
Other-than-temporary impairment of securities (3,474) (2,453) --
--------- --------- ---------
Total Other Income/(Loss) (2,504) 246 4,126
--------- --------- ---------
Operating and Other Expense:
Compensation and benefits 2,929 -- --
Real estate held operating expense 185 -- --
Mortgage interest on real estate held 304 -- --
Other general and administrative 2,487 1,017 920
Advisor fees (Note 3) -- 4,338 1,537
Costs incurred in acquiring external advisor (Note 3) -- 12,539 --
--------- --------- ---------
Total Operating and Other Expense 5,905 17,894 2,457
--------- --------- ---------
Net Income $ 56,094 $ 3,784 $ 7,866
========= ========= =========
Net Income Per Share:
Net income per share - basic $ 1.35 $ 0.25 $ 0.89
Weighted average shares outstanding - basic 41,432 15,229 8,869
Net income per share - diluted $ 1.35 $ 0.25 $ 0.89
Weighted average shares outstanding - diluted 41,534 15,330 8,887
The accompanying notes are an integral part of the
consolidated financial statements.
32
MFA MORTGAGE INVESTMENTS, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
For the Year Ended December 31,
-----------------------------------
2002 2001 2000
--------- --------- ---------
(In Thousands, Except Share and per Share Amounts)
Common Stock - Par value: $.01
Balance at beginning of year $ 283 $ 87 $ 90
Retirement of treasury shares -- -- (3)
Issuance of 1,287,501 shares pursuant to Advisor Merger (Note 3) -- 13 --
Issuance of common shares, net of offering expenses 179 183 --
Issuance of common shares for option exercises and stock based compensation 1 -- --
--------- --------- ---------
Balance at end of year 463 283 87
--------- --------- ---------
Additional Paid-in Capital
Balance at beginning of year 212,001 73,828 75,296
Issuance of common shares to directors 67 50 40
Retirement of treasury stock -- -- (1,508)
Exercise of common stock options 438 128 --
Compensation expense for stock options 64 142 --
Issuance of 1,287,501 shares pursuant to Advisor Merger (Note 3) -- 11,253 --
Issuance of common shares, net of offering expenses 146,789 126,600 --
--------- --------- ---------
Balance end of year 359,359 212,001 73,828
--------- --------- ---------
Common Stock Held in Treasury, at Cost
Balance at beginning of year -- -- --
Common stock reacquired, at cost -- -- (1,512)
Common stock reissued for options exercised -- -- 1,512
--------- --------- ---------
Balance at end of year -- -- --
--------- --------- ---------
Accumulated Deficit
Balance at beginning of year (13,704) (440) (2,878)
Net income 56,094 3,784 7,866
Cash dividends declared ($1.24, $.845, $.59 per share, respectively) (54,807) (17,048) (5,428)
--------- --------- ---------
Balance at end of year (12,417) (13,704) (440)
--------- --------- ---------
Accumulated Other Comprehensive Income (Loss)
Balance at beginning of year 5,044 (3,563) (4,894)
Unrealized gain on available for sale securities, net 21,851 8,444 1,331
Unrealized (loss)/gain on interest rate cap agreements (3,100) 163 --
--------- --------- ---------
Balance at end of year 23,795 5,044 (3,563)
--------- --------- ---------
Total Stockholders' Equity $ 371,200 $ 203,624 $ 69,912
========= ========= =========
The accompanying notes are an integral part of the
consolidated financial statements.
33
MFA MORTGAGE INVESTMENTS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended December 31,
-----------------------------------------
(In Thousands) 2002 2001 2000
----------- ----------- -----------
Cash Flows From Operating Activities:
Net income $ 56,094 $ 3,784 $ 7,866
Adjustments to reconcile net income
to net cash provided by operating activities:
Net (gain) loss on sale of portfolio investments (205) 438 (456)
Unrealized impairment recognized on debt securities 3,474 2,453 --
Net gain on sale of real estate equity interests -- (2,574) (2,565)
Amortization of premium on investments 28,094 5,355 1,485
Amortization of goodwill -- 200 199
Stock issued in consideration of termination of advisor agreement -- 11,266 --
Increase in interest receivable (7,132) (8,907) (578)
Decrease (increase) in other assets and other (425) 251 (243)
Increase (decrease) in accrued expenses and other liabilities 555 56 (46)
Increase (decrease) in accrued interest payable 2,912 9,348 (740)
----------- ----------- -----------
Net cash provided by operating activities 83,367 21,670 4,922
----------- ----------- -----------
Cash Flows From Investing Activities:
Principal payments on mortgage securities 1,301,856 293,619 105,991
Proceeds from sale of corporate equity securities 3,947 6,705 1,169
Proceeds from sale of corporate debt securities 5,664 2,516 373
Proceeds from sale of mortgage securities 93,075 5,544 5,019
Proceeds from sale of equity interests in real estate -- 19 2,565
Purchases of mortgage-backed securities (2,958,608) (1,753,323) (106,414)
Purchases of corporate debt securities -- -- (7,719)
Purchases of corporate equity securities -- (392) (6,943)
Income from equity interests in real estate in excess of
(less than) distributions 186 (66) (3,320)
Purchase of controlling interest in consolidated subsidiary (260) -- --
Cash increase from consolidation of subsidiary 419 -- --
----------- ----------- -----------
Net cash used by investing activities (1,553,721) (1,445,378) (9,279)
----------- ----------- -----------
Cash Flows From Financing Activities:
Decrease (increase) in restricted cash 39,460 (39,000) 3,211
Purchase of interest rate cap agreements (3,697) (350) --
Net increase (decrease) in repurchase agreements 1,340,312 1,397,015 (3,518)
Net proceeds from issuance of common stock 146,968 126,783 --
Dividends paid (47,573) (10,736) (5,319)
Proceeds from exercise of stock options 438 128 --
Stock purchased for retirement -- -- (1,512)
----------- ----------- -----------
Net cash provided by (used in) financing activities 1,475,908 1,473,840 (7,138)
----------- ----------- -----------
Net increase (decrease) in cash and cash equivalents 5,554 50,132 (11,495)
Cash and cash equivalents at beginning of period 58,533 8,401 19,896
----------- ----------- -----------
Cash and cash equivalents at end of period $ 64,087 $ 58,533 $ 8,401
=========== =========== ===========
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for interest $ 60,883 $ 25,726 $ 30,843
The accompanying notes are an integral part of the
consolidated financial statements.
34
MFA MORTGAGE INVESTMENTS, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
For the Year Ended December 31,
-------------------------------
2002 2001 2000
-------- -------- --------
(In Thousands, Except Share and per Share Amounts)
Net Income $ 56,094 $ 3,784 $ 7,866
Other Comprehensive Income:
Unrealized holding gains arising during the year, net 21,851 8,444 1,331
Unrealized holding gains (losses) on interest rate cap
agreements arising during the year, net (3,100) 163 --
-------- -------- --------
Comprehensive Income $ 74,845 $ 12,391 $ 9,197
======== ======== ========
The accompanying notes are an integral part of the
consolidated financial statements
35
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
1. Organization
MFA Mortgage Investments, Inc. (the "Company") was incorporated in
Maryland on July 24, 1997 and began operations on April 10, 1998.
On April 10, 1998, the Company and three partnerships; America First
Participating/Preferred Equity Mortgage Fund Limited Partnership ("PREP Fund
1"), America First PREP Fund 2 Limited Partnership ("PREP Fund 2"), and America
First PREP Fund 2 Pension Series Limited Partnership ("Pension Fund"),
consummated a merger transaction whereby the pre-existing net assets and
operations of PREP Fund 1 and PREP Fund 2 and a majority interest in the Pension
Fund were contributed to the Company in exchange for 9,035,084 shares of the
Company's common stock (the "1998 Merger"). The 1998 Merger was accounted for
using the purchase method of accounting in accordance with generally accepted
accounting principles. PREP Fund 1 was deemed to be the acquirer of PREP Fund 2
and Pension Fund under the purchase method. Accordingly, the 1998 Merger
resulted, for financial accounting purposes, in the effective purchase by PREP
Fund 1 of all the Beneficial Unit Certificates ("BUCs") of PREP Fund 2 and 99%
of the BUCs of Pension Fund. In December 1999, Pension Fund was liquidated and
dissolved and, as a result, the Company directly acquired 99% of the assets of
Pension Fund. The remaining assets, consisting solely of cash, were distributed
to the holders of Pension Fund BUCs who elected to remain in place following the
1998 Merger. As the surviving entity for financial accounting purposes, the
assets and liabilities of PREP Fund 1 were recorded by the Company at their
historical cost and the assets and liabilities of PREP Fund 2 and Pension Fund
were adjusted to fair value. The excess of the fair value of the common stock
issued over the fair value of net assets acquired was recorded as goodwill.
From the time of its inception, the Company was externally managed by
America First Mortgage Advisory Corporation (the "Advisor"), pursuant to an
agreement between the parties. As an externally managed company, the Company had
no employees of its own and relied on the Advisor to conduct its business and
operations.
Pursuant to consummation of the stockholder approved merger between the
Company and the Advisor (the "Advisor Merger"), the Company and the Advisor
merged effective 12:01 a.m. on January 1, 2002. As a result, the Company became
self-advised and commencing January 1, 2002 and thereafter will directly incur
the cost of all overhead necessary to operate the Company. For accounting
purposes, the Advisor Merger is not considered the acquisition of a "business"
for purposes of applying Accounting Principles Board ("APB") Opinion No. 16,
"Business Combinations" as superceded by FAS 141, "Business Combinations" and,
therefore, the market value of the common stock issued, valued as of the
consummation of the Advisor Merger, in excess of the fair value of the net
tangible assets acquired was charged to operating income rather than capitalized
as goodwill for the year ended December 31, 2001. (See Note 3a.)
On August 13, 2002, the Company changed its name from America First
Mortgage Investments, Inc. to MFA Mortgage Investments, Inc. The name change was
made in order to clearly define MFA's status as a self-advised mortgage REIT.
2. Summary of Significant Accounting Policies
(a) Basis of Presentation
The accompanying consolidated financial statements are prepared on the
accrual basis of accounting in accordance with generally accepted accounting
principles utilized in the United States.
The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the consolidated
financial statements and the reported amounts of revenues and expenses during
the reporting period. Actual results could differ from those estimates.
(b) MBS, Corporate Debt Securities and Corporate Equity Securities
Statement of Financial Accounting Standards ("FAS") No. 115, "Accounting
for Certain Investments in Debt and Equity Securities", requires that
investments in securities be designated as either held-to-maturity,
available-for-sale or trading at the time of acquisition. Securities that are
designated as held-to-maturity are carried at their amortized cost. Securities
designated as available-for-sale are carried at fair value with unrealized gains
and losses excluded from earnings and reported in other comprehensive income.
36
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
Although the Company generally intends to hold most of its MBS until
maturity, it may, from time to time, sell any of its MBS as part of its overall
management of its business. The available-for-sale designation provides the
flexibility to sell its MBS in order to appropriately act on potential future
market opportunities, changes in economic conditions and ensure future
liquidity.
Other-than-temporary losses on investment securities, whether designated
as available-for-sale or held-to-maturity, as measured by the amount of decline
in fair value attributable to factors other-than-temporary, are charged against
income resulting in an adjustment of the cost basis of such securities.
Other-than-temporary losses are determined based on management's assessment of
various factors affecting the security. The following are among, but not all,
the factors considered in determining whether and to what extent an
other-than-temporary impairment exists (i) the expected cash flow from the
investments; (ii) whether an other-than-temporary deterioration of the credit
quality of the underlying mortgages, debtor, or the company in which equity
interests are held; (iii) the credit protection available to the related
mortgage pool for MBS; (iv) any other market information available, including
analysts assessments and statements, public statements and filings made by the
debtor, counterparty or other relevant party issuing or otherwise securing the
particular security; (v) management's internal analysis of the security
considering all known relevant information at the time of assessment; and (vi)
the magnitude and duration of historical decline in market prices Because
management's assessments are based on factual information as well as subjective
information available at the time of assessment, the determination as to whether
an other-than-temporary decline exists and, if so, the amount considered
impaired is also subjective and, therefore, constitutes material estimates, that
are susceptible to a significant change. (See Note 5.)
Gains or losses on the sale of investment securities are based on the
specific identification method.
The Company's adjustable rate assets are comprised primarily of MBS that
are comprised of adjustable rate MBS ("ARM-MBS") issued or guaranteed by Ginnie
Mae, Fannie Mae or Freddie Mac. Included in these ARM-MBS are hybrid MBS that
have a fixed interest rate for an initial period, generally three years for
those purchased by the Company, then convert to an adjustable rate for their
remaining term to maturity.
Interest income is accrued based on the outstanding principal amount of
the investment securities and their contractual terms. Premiums and discounts
associated with the purchase of the investment securities are amortized into
interest income over the lives of the securities using the effective yield
method, adjusted for actual prepayment activity.
(c) Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and highly liquid
investments with original maturities of three months or less. The carrying
amount of cash equivalents approximates their fair value.
(d) Restricted Cash
Restricted cash represents amounts held with certain lending institutions
with which the Company has repurchase agreements. Such amounts may be used to
make principal and interest payments on the related repurchase agreements.
(e) Credit Risk
The Company limits its exposure to credit losses on its investment
portfolio by requiring that at least 50% of its investment portfolio consist of
MBS that are issued or guaranteed by an agency of the U.S. Government, such as
Ginnie Mae, Fannie Mae and Freddie Mac ("Agency MBS"). The remainder of the
Company's assets may be either: (i) investments in multifamily apartment
properties; (ii) investments in limited partnerships, real estate investment
trusts or a preferred stock of a real estate related corporation or (iii) other
fixed-income instruments. Adjustable rate Agency MBS comprised 93% and 80% of
the Company's total assets at December 31, 2002 and 2001, respectively. The
Company did not have an allowance for credit losses at December 31, 2002 or
2001.
A decline in the value of any of its investments, if any, that is
considered by management to be other-than-temporary would result in the Company
reducing the cost basis of the specific security and recognizing the write down
as a charge against earnings. In monitoring asset quality, management evaluates
its investment securities portfolios on a regular basis, not less than
quarterly, to determine whether impairment, if any, is considered
other-than-temporary. Among the factors considered are: the market price of the
securities over time; the anticipated performance of the security over the next
six to twelve months; the carrying value compared to the market value. Charges
are made and the carrying value of the security adjusted if management
determines that the security's impairment is considered other-than-temporary.
This determination, which to a significant extent is subjective, is based on the
information available at the time of assessment and considers debtors' financial
condition, expectations
37
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
about the debtors' future performance and other pertinent market information
available. Further, if management were to decide to sell any security,
held-for-investment or held for sale, and any unrealized losses at that time the
decision to sell is made would be charged against earnings in the period the
decision to sell is made. However, gains would be deferred until realized.
(f) Equity Interests in Real Estate
Equity interest in real estate consists of certain non-consolidated
investments accounted for under the equity method, which are comprised of
investments in limited partnerships owning real estate. The Company acquired
these investments as part of the 1998 Merger. Certain of the properties
underlying the equity interests in the limited partnerships that the Company
received in the 1998 Merger were subsequently exchanged for other properties
through non-taxable exchanges, known for tax purposes as a "Section 1031
exchange".
Certain of the investments have a zero carrying value and are generating
operating losses after depreciation. On these investments, earnings are recorded
only to the extent distributions are received. Such investments have not been
reduced below zero through recognition of allocated investment losses since the
Company has no legal obligation to provide additional cash support to the
underlying property partnerships as it is not the general partner, nor has it
indicated any commitment to provide this support. As of December 31, 2002, the
Company had investments in four such limited partnerships, which had mortgage
loans secured by the underlying investment properties; however, the Company has
no liability for the mortgage loans, since (1) the Company's investment is as a
limited partner and (2) the mortgages have non-recourse provisions, such that
they are secured only to the extent of the collateral which is comprised of the
mortgaged property.
(g) Real Estate Held
Real estate held is comprised of the two multi-family real estate
properties owned by the Company's wholly-owned subsidiary Retirement Centers
Corporation ("RCC"). On October 1, 2002, the Company purchased 100% of the
voting common stock of RCC. (See Note 3c.) Prior to the Company's October 1,
2002 purchase of RCC's voting common stock, the Company held only the preferred
stock of RCC and accounted for its investment in RCC under the equity method of
accounting. Subsequent to October 1, 2002, RCC became a wholly-owned subsidiary
of the Company and, as such, was consolidated on a prospective basis. RCC is
consolidated with its subsidiaries, which hold properties known as "The
Greenhouse" and "Lealand Place". The Greenhouse is a 127-unit muti-family
apartment building located in Omaha, Nebraska; Lealand Place is a 192-unit
garden-style apartment complex located in Lawrenceville, Georgia.
The properties, capital improvements and other assets held in connection
with the properties are carried at cost, net of accumulated depreciation and
amortization, not to exceed fair value. Depreciation and amortization are
computed using the straight line method over the useful life of the related
asset. Maintenance, repairs and minor improvements are charged to expense in the
period incurred, while capital improvements are capitalized.
(h) Repurchase Agreements
The Company finances the acquisition of its MBS at short-term borrowing
rates through the use of repurchase agreements. Under a repurchase agreement,
the Company sells securities to a lender and agrees to repurchase those
securities in the future for a price that is higher than the original sales
price. The difference between the sale price the Company receives and the
repurchase price the Company pays represents interest paid to the lender.
Although structured as a sale and repurchase obligation, a repurchase agreement
operates as a financing under which the Company effectively pledges its
securities as collateral to secure a short-term loan which is equal in value to
a specified percentage of the market value of the pledged collateral. The
Company retains beneficial ownership of the pledged collateral, including the
right to distributions. At the maturity of a repurchase agreement, the Company
is required to repay the loan and concurrently receives back its pledged
collateral from the lender or, upon mutual consent with the lender, the Company
may renew such agreement at the then prevailing financing rate. The repurchase
agreements may require the Company to pledge additional assets to the lender in
the event the market value of the existing pledged collateral declines. Through
December 31, 2002, the Company did not have any margin calls on its repurchase
agreements that it was not able to satisfy with either cash or additional
pledged collateral.
The Company's repurchase agreements generally range from one month to 18
months; however, future repurchase agreements may have longer maturities. Should
the providers of the repurchase agreements decide not to renew them at maturity,
the Company must either refinance elsewhere or be in a position to satisfy the
obligation. If, during the term of a repurchase agreement, a lender should file
for bankruptcy, the Company might experience difficulty recovering its pledged
assets and may have an unsecured claim against the lender's assets. To reduce
its
38
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
exposure, the Company enters into repurchase agreements only with financially
sound institutions whose holding or parent company's long-term debt rating is
"A" or better as determined by two of the Rating Agencies, where applicable. The
Company will not enter into repurchase agreements with a lender without the
specific approval of the Company's Board of Directors, if the minimum criterion
is not met. In the event an existing lender is downgraded below "A", the Company
will seek board approval before entering into additional repurchase agreements
with that lender. The Company generally aims to diversify its exposure by
entering into repurchase agreements with at least four separate lenders with a
maximum loan from any lender of no more than three times the Company's
stockholders' equity. As of December 31, 2002, the Company had repurchase
agreements with 12 separate lenders with a maximum net exposure (the difference
between the amount loaned to the Company and the fair value of the security
pledged by the Company as collateral) to a single lender of $54.3 million. (See
Note 9.)
(i) Earnings per Common Share ("EPS")
Basic EPS is computed by dividing net income by the weighted average
number of shares of common stock outstanding during the period. Diluted EPS is
computed by dividing net income by the weighted-average common shares and common
equivalent shares outstanding during the period. For the diluted EPS
calculation, the weighted average common shares and common equivalent shares
outstanding include the average number of shares of common stock outstanding
adjusted for the dilutive effect of unexercised stock options using the treasury
stock method. Under the treasury stock method, common equivalent shares are
calculated assuming that all dilutive common stock equivalents are exercised and
the proceeds are used to buy back shares of the Company's outstanding common
stock at the average market price during the reported period. No common share
equivalents are included in the computation of any diluted per share amount for
a period in which a net operating loss is reported. (See Note 11.)
(j) Comprehensive Income
Statement of FAS No. 130, "Reporting Comprehensive Income" requires the
Company to display and report comprehensive income, which includes all changes
in Stockholders' Equity with the exception of additional investments by or
dividends to stockholders. Comprehensive income for the Company includes net
income and the change in net unrealized holding gains (losses) on investments
and certain derivative instruments. (See Note 13.)
(k) Federal Income Taxes
The Company has elected to be taxed as a real estate investment trust
("REIT") under the provisions of the Internal Revenue Code of 1986, as amended
(the "Code"), and the corresponding provisions of state law. The Company expects
to operate in a manner that will enable it to continue to be taxed as a REIT. As
such, no provision for current or deferred income taxes has been made in the
accompanying consolidated financial statements.
(l) Adoption of New Accounting Standards
In July 2001, the Financial Accounting Standards Board ("FASB") issued FAS
No. 141, "Business Combinations" ("FAS 141") and FAS No. 142, "Goodwill and
Other Intangible Assets" ("FAS 142") which provide guidance on how entities are
to account for business combinations and for the goodwill and other intangible
assets that arise from those combinations or are acquired otherwise. FAS 142
requires that goodwill is no longer amortized, but instead be tested for
impairment at least annually. As of the date of adoption, the Company had
unamortized goodwill in the amount of $7,189,000. There was no amortization
expense related to goodwill in 2002. Had FAS 142 been adopted for calendar years
2001 and 2000, net income for each of those years would have increased by
$200,000. The Company's adoption of FAS 141 and FAS 142 on January 1, 2002 did
not have a material effect on the Company's consolidated financial statements.
In October 2001, the FASB issued FAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets" ("FAS 144"). FAS 144 provides new
guidance on the recognition of impairment losses on long-lived assets to be held
and used or to be disposed of and also broadens the definition of what
constitutes a discontinued operation and how the results of a discontinued
operation are to be measured and presented. The adoption of FAS 144 on January
1, 2002 did not have a significant impact on the Company.
(m) New Accounting Pronouncements
In December 2002, the FASB issued FAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure" ("FAS 148"). FAS 148, amends FAS No.
123, "Accounting for Stock-Based Compensation," ("FAS 123") by providing
alternative methods of transition for a voluntary change to the fair value based
method of accounting for stock-based employee compensation. In addition, FAS 148
amends the disclosure requirements of Statement 123 to require prominent
disclosures in both annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect of the method
used on reported results. The
39
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
Company plans to record option expense for options granted subsequent to January
1, 2003, in accordance with FAS 123, as amended by FAS 148; such change is not
expected to have a significant impact on the Company.
(n) Derivative Financial Instruments - Interest Rate Cap Agreements
On January 1, 2001, the Company adopted FAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities," ("FAS 133") as amended by FAS
No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging
Activities" ("FAS 138"). Since the Company had no derivative instruments nor any
embedded derivatives that required bifurcation and separate accounting; there
was no cumulative effect of an accounting change upon the adoption of FAS 133,
as amended.
In accordance with FAS 133, a derivative which is designated as a hedge is
recognized as an asset/liability and measured at fair value. To qualify for
hedge accounting, at inception of the Cap, the Company must anticipate that the
hedge will be highly effective in limiting the Company's cost beyond the Cap
threshold on its matching (on an aggregate basis) anticipated repurchase
agreements during the active period of the Cap. As long as the hedge remains
effective, changes in fair value are included in the accumulated other
comprehensive income portion of stockholders' equity. Upon the Cap Agreement
active period commencing, the premium paid to enter into the Cap Agreement is
amortized and reflected in interest expense. The periodic amortization of the
premium expense is based on an estimated allocation of the premium, determined
at inception of the hedge, for the monthly components on a fair value basis.
Payments received in connection with the Cap Agreement will be reported a
reduction to interest expense, net of the amortization recognized for the
premium. If it is determined that a Cap Agreement is not effective, the premium
would be reduced and a corresponding charge made to interest expense, for the
ineffective portion of the Cap Agreement. The maximum cost related to the
Company's Caps is limited to the original purchase price of the derivative. In
order to limit credit risk associated with purchased Caps, the Company only
purchases caps from financial institutions rated "A" or better by one of the
Rating Agencies. Income generated by purchased caps, if any, would be presented
as an off-set to interest expense on the hedged liabilities.
In order to continue to qualify for and to apply hedge accounting, Caps
are monitored on a quarterly basis to determine whether they continue to be
effective or, if prior to the commencement of the active period, whether the Cap
expects to continue to be effective. If during the term of the Cap agreement the
Company determines that a Cap is not effective or that a Cap is not expected to
be effective, the ineffective portion of the Cap will no longer qualify for
hedge accounting and, accordingly subsequent changes in its fair value will be
reflected in earnings.
During 2001, the Company entered into its first interest rate cap
agreement ("Cap Agreement" or "Cap"), which is a derivative instrument, as
defined by FAS 133 and FAS 138. At December 31, 2002, the Company had 11
interest rate cap agreements, with an aggregate notional amount of $310.0
million. The Company utilizes Caps for the purpose of managing interest rate
risk and does not anticipate entering into derivative transactions for
speculative or trading purposes. There were unrealized losses of $2.9 million on
the Company's Caps. (See Note 8.)
(o) Stock Based Compensation
The Company's policy is to apply the intrinsic method of Accounting
Principles Bulletin No. 25 ("APB 25") for its direct employees and independent
directors. Under the intrinsic method, no compensation expense is recorded when
options are issued with an exercise price equal to the market price of the
underlying security. The Company has only granted options with a strike price
equal to the market price at the time of grant.
(p) Reclassifications
Certain prior period amounts have been reclassified to conform to the
current period presentation.
40
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
3. Advisor Merger/Related Parties and Other Related Party Transactions
(a) Advisor Fees and Advisor Merger
From the time of the 1998 Merger through December 31, 2001, the Advisor
managed the operations and investments of the Company and performed
administrative services for the Company. Prior to the Advisor Merger (as defined
below), the Advisor was owned directly and indirectly by certain of the
Company's directors and executive officers (see discussion below). For the
services and functions provided to the Company, the Advisor received a monthly
management fee in an amount equal to 1.10% per annum of the first $300 million
of Stockholders' Equity of the Company, plus 0.80% per annum of the portion of
Stockholders' Equity of the Company above $300 million. The Company also paid
the Advisor, as incentive compensation for each calendar quarter, an amount
equal to 20% of the dollar amount by which the annualized Return on Equity for
such quarter exceeded the amount necessary to provide an annualized Return on
Equity equal to the Ten-Year U.S. Treasury Rate plus 1%. For the years ended
December 31, 2001 and 2000, the Advisor earned a base management fee of
$1,424,000, and $740,000, respectively, and incentive compensation of
$2,914,000, and $797,000, respectively. $511,000 and $519,000 of the incentive
fee earned in 2001, and 2000, respectively, was attributable to the gains on
sale described in Note 7.
The Company entered into an Agreement and Plan of Merger, dated September
24, 2001 (the "Advisor Merger Agreement"), with the Advisor, America First
Companies L.L.C. ("AFC") and the stockholders of the Advisor. In December 2001,
the Company's stockholders approved the terms of the Advisor Merger Agreement,
which provided for the merger of the Advisor into the Company effective 12:01
a.m. on January 1, 2002. Pursuant to the Advisor Merger Agreement, the Company
issued 1,287,501 shares of its $.01 par value common stock ("Common Stock") to
the stockholders of the Advisor effective January 1, 2002. As a result, the
Company became self-advised commencing January 1, 2002 and directly incurs the
cost of all overhead necessary for its operation and administration. The market
value of the Common Stock issued in the Advisor Merger, valued as of the
consummation of the Advisor Merger in excess of the fair value of the net
tangible assets acquired, was charged to operating income of the Company for the
year ended December 31, 2001.
Certain of the Company's directors and executive officers who were
involved in discussions and negotiations relating to the Advisor Merger had, and
continue to have, interests that would be affected by the Advisor Merger. At the
time of the Advisor Merger, AFC owned 80% of the outstanding capital stock of
the Advisor. At that time, Michael Yanney, the Chairman of the Company's Board
of Directors, and George H. Krauss, one of the Company's directors, beneficially
owned 57% and 17%, respectively, of AFC. In addition, Stewart Zimmerman, the
Company's President and Chief Executive Officer, and William S. Gorin, the
Company's Executive Vice President, Chief Financial Officer and Treasurer,
collectively owned 3% of AFC. At the time of the Advisor Merger, Messrs.
Zimmerman, Gorin and Ronald A. Freydberg, the Company's Executive Vice President
and Secretary, also owned, in the aggregate, the remaining 20% of the Advisor.
Accordingly, the Advisor Merger resulted in these individuals receiving, in the
aggregate, beneficial ownership of an additional 1,287,501 shares of the
Company's Common Stock valued at $11.3 million at the time of the Advisor
Merger.
Because the Advisor Merger was between affiliated parties and may not be
considered to have been negotiated in a completely arm's-length manner, the
Company's Board of Directors established a special committee of the Board which
consisted of three of the Company's independent directors who had no personal
interest in the Advisor Merger, to direct the negotiations relating to the
Advisor Merger on the Company's behalf and to consider and make recommendations
to the Board relating to the Advisor Merger.
(b) Property Management
America First Properties Management Company L.L.C. (the "Property
Manager") provides property management services for certain of the multifamily
properties in which the Company has an interest. The Property Manager also
provided property management services to certain properties which were acquired
in the 1998 Merger. The Property Manager receives a management fee equal to a
stated percentage of the gross revenues generated by the Company's properties
under management, ranging from 3.5% to 4% of gross revenues. The Property
Manager received $412,000, $432,000 and $375,000, respectively, for the years
ended December 31, 2002, 2001 and 2000 for property management services provided
at the Company's properties. The Property Manager is a wholly-owned subsidiary
of AFC.
(c) Investment in Retirement Centers Corporation
From 1998 thorough September 30, 2002, the Company held all of the
non-voting preferred stock, representing 95% of the ownership and economic
interest, in RCC, an entity formed following the 1998 Merger, which indirectly
holds two rental income properties. (See Note 7.) Through September 30, 2002,
Mr. Gorin, the Company's
41
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
Executive Vice President, Chief Financial Officer and Treasurer, held all of the
voting common stock of RCC, representing 5% of the ownership and economic
interest in RCC.
On October 1, 2002, the Company entered into an agreement to purchase 100%
of the voting common stock held by Mr. Gorin, representing a 5% economic
interest and 100% controlling interest in RCC, for $260,000. The purchase price
was based on the estimated value of the underlying properties, as determined by
independent appraisers, net of the related mortgage indebtedness. As a result of
the purchase of common shares, the Company now holds all of the outstanding
securities of RCC, resulting in RCC becoming a wholly-owned subsidiary of the
Company. (See Note 7.)
(d) Investments in Certain Corporate Debt Securities
Prior to the Company liquidating its corporate debt securities portfolio
during 2002, the Company held the corporate debt securities of RCN Corporation
("RCN"), which were purchased between February 1999 and August 2000 and Level 3
Corporation ("Level 3"), which were purchased between August 1998 and August
2000. At December 31, 2001, the Company's investment in (i) the RCN debt
securities had a carrying value of $2,147,000 and (ii) the Level 3 debt
securities had a carrying value of $6,553,000 and an estimated fair value of
$3,360,000. Mr. Yanney, the Chairman of the Company's Board of Directors, is
currently on the board of directors of both RCN and Level 3. One of the
Company's Directors, W. David Scott, is the son of the Chairman of both Level 3
and RCN. (See Note 5.)
4. Mortgage Backed Securities
As of December 31, 2002 and 2001, all of the Company's MBS were classified
as available-for-sale, and as such, were carried at their fair value. The
following table presents the carrying value of the Company's MBS as of December
31, 2002 and 2001.
2002 2001
---------- ----------
(In Thousands)
Agency MBS:
Fannie Mae Certificates $1,901,621 $1,228,095
Ginnie Mae Certificates 5,577 12,266
Freddie Mac Certificates 1,450,675 472,908
Non-agency AAA 127,446 213,631
---------- ----------
$3,485,319 $1,926,900
========== ==========
At December 31, 2002 and 2001, the Company's portfolio of MBS consisted of
pools of ARM-MBS with carrying values of $3,478,538,000 and $1,915,380,000,
respectively, and fixed rate MBS with carrying values of $6,781,000 and
$11,520,000, respectively.
Agency MBS: Although not rated, Agency MBS carry an implied "AAA" rating.
Agency MBS are guaranteed as to principal or interest by a government agency or
federally chartered corporation, such as Fannie Mae, Ginnie Mae or Freddie Mac.
Non-Agency "AAA": Non-Agency "AAA" MBS are privately issued certificates
that are backed by pools of single-family and multi family mortgage loans.
Non-Agency "AAA" MBS are rated as such by one of the Rating Agencies. "AAA" is
the highest rating given by bond rating agencies and indicates the relative
security of the investment. These securities are not guaranteed by the U.S.
Government or any of its agencies.
The following table presents the components of the carrying value of the
MBS portfolio as of December 31, 2002 and 2001:
2002 2001
----------- -----------
(In Thousands)
Current principal balance $ 3,382,275 $ 1,885,869
Premium 76,333 37,544
Discount (20) (79)
Gross unrealized gains 27,154 8,339
Gross unrealized losses (423) (4,773)
----------- -----------
Carrying value/fair value $ 3,485,319 $ 1,926,900
=========== ===========
42
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
5. Corporate Debt Securities
During 2002, the Company liquidated its remaining portfolio of corporate
debt securities, realizing gains of $937,000 and losses of $1,575,000. These
securities were comprised of "non-investment grade," "high yield bonds". The
Company had taken impairment charges of $3,474,000 and $2,453,000 on certain of
its corporate debt securities during 2002 and 2001, respectively. The following
tables presents the amortized cost, gross unrealized gains, gross unrealized
losses and fair value of the Company's corporate debt securities as of December
31, 2002 and 2001:
2002 2001
--------- -------
(In Thousands)
Held-to-maturity securities:
Amortized cost/carrying value $ -- $ 7,627
Gross unrealized gains -- --
Gross unrealized losses -- (3,439)
--------- -------
Fair value $ -- $ 4,188
========= =======
Available-for-sale securities:
Amortized cost, as adjusted (1) $ -- $ 2,147 (1)
Gross unrealized gains -- --
Gross unrealized losses -- --
--------- -------
Fair value/carrying value $ -- $ 2,147
========= =======
Corporate debt securities -carrying value:
Held-to-maturity securities $ -- $ 7,627
Available-for-sale securities -- 2,147
--------- -------
$ -- $ 9,774
========= =======
(1) Reflects the impact of a $2,453,000 write down of the cost basis of the RCN
debt securities for other-than-temporary impairment.
6. Corporate Equity Securities
During 2002, the Company liquidated its remaining portfolio of corporate
equity securities, realizing gains of $569,000. Corporate equity securities were
classified as available-for-sale. The following table presents the cost, gross
unrealized gains, gross unrealized losses and fair value of the Company's
corporate equity securities as of December 31, 2002 and 2001:
2002 2001
------ ------
(In Thousands)
Cost $ -- $3,378
Gross unrealized gains -- 710
Gross unrealized losses -- --
------ ------
Fair value $ -- $4,088
====== ======
7. Equity Interests in Real Estate Investments and Real Estate Held
Equity interests in real estate investments and real estate held consisted
of the following as of December 31, 2002 and 2001:
2002 2001
------- -------
(In Thousands)
Real estate held $21,986 $ --
Investment in RCC -- (1) 5,572
Investments in and advances to real estate
limited partnerships 3,806 4,228
------- -------
$25,792 $ 9,800
======= =======
(1) On October 1, 2002, the Company purchased the voting common stock of RCC.
Prior to this purchase, the Company held the non-voting preferred stock and
accounted for its investment in RCC under the equity method. Upon acquiring the
controlling interest in RCC, the Company changed from the equity method of
accounting for this investment to consolidating RCC, reflecting the assets and
liabilities and results of operations of RCC on a prospective basis.
43
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
a. Real Estate Held/Retirement Center Corporation
RCC was formed as a separate taxable corporation to hold certain
properties acquired in the 1998 Merger, primarily retirement/assisted living
properties, the operations of which, if held directly would be incompatible with
the Company's maintaining compliance with the REIT provisions of the Code. Such
assets have since been sold and the proceeds reinvested in the properties
currently held by RCC. As noted above, on October 1, 2002, the Company acquired
100% of the voting common stock of RCC, resulting in a change in the accounting
for RCC from that of an equity interest to a wholly-owned consolidated
subsidiary.
As of December 31, 2002, RCC owned (i) The Greenhouse, which was acquired
on January 12, 2000, and (ii) an 88.3% undivided interest in a 192-unit
apartment property located in Lawrenceville, Georgia, which was acquired on
January 18, 2001. The Company also acquired the remaining 11.7% undivided
interest in the Georgia property on January 18, 2001. In December 2000, the
Company loaned Greenhouse Holding LLC (which holds The Greenhouse) $437,000 to
fund building renovations.
The summary results of real estate held, reflects the operations of RCC as
consolidated with its two apartment properties for the period from October 1,
2002 through December 31, 2002 were as follows:
(In Thousands)
Revenue from operations of real estate held $ 685
Interest expense for mortgages on real estate held (304)
Other real estate operations expense (185)
-----
$ 196
=====
b. Equity Interests in Real Estate
As of December 31, 2002, the Company had investments in four limited
partnerships, which had an aggregate of $31.4 million of non-recourse mortgage
loans secured by the underlying investment properties. These mortgages have
non-recourse provisions, such that they are generally secured to the extent of
the collateral, which is comprised of the mortgaged property. Prior to October
1, 2002, the Company held 100% of the non-voting preferred stock of RCC which
represented a 95% economic interest, as such the net assets of RCC were included
in equity interests in real estate. On October 1, 2002, the Company acquired
100% of RCC's voting common stock, thereby gaining full ownership of RCC.
Therefore, the Company changed its accounting for RCC from that of an equity
investment to a consolidated subsidiary effective October 1, 2002.
Income from the Company's equity interests in real estate, which includes
the results of operations for RCC prior to October 1, 2002, was as follows for
the years ended December 31, 2002, 2001 and 2000:
(In Thousands) 2002 2001 2000
------ ------ ------
Gains on sale of underlying properties $ -- $2,574 (1) $2,565 (2)
Equity earnings (loss), net 80 (3) 563 1,105
------ ------ ------
$ 80 $3,137 $3,670
====== ====== ======
(1) During 2001, RCC sold its undivided interest in the net assets of an
assisted living center. Such sale contributed $2,063,000 ($2,574,000
less a related incentive fee of $511,000 reflected in other general
and administrative expense) to the Company's net income for the year
ended December 31, 2001. The proceeds of such sale were utilized to
acquire the limited partnership interest in Lealand Place LLC, which
purchased Lealand Place, a 192-unit apartment property located in
Lawrenceville, Georgia, on January 18, 2001. For tax purposes, the
gain on sale was not recognized, as the purchase and sale were
structured as Section 1031 exchange.
(2) During 2000, Owings Chase Limited Partnership, in which the Company
had a 99% limited partnership interest sold a multifamily apartment
property. Such sale contributed $2,046,000; $2,565,000 less a
related incentive fee to the Advisor of $519,000 reflected in other
general and administrative expense. The proceeds of such sale were
utilized to acquire a 202 unit garden apartment complex known as
Cameron at Hickory Grove, located in Charlotte, North Carolina. For
tax purposes, the gain on sale was not recognized, as the purchase
and sale were structured as Section 1031 exchange.
(3) Does not include the results for RCC from October 1, 2002 though
December 31, 2002.
8. Interest Rate Cap Agreements
As of December 31, 2002, the Company had 11 interest rate Caps with an
aggregate notional amount of $310.0 purchased to hedge against increases in
interest rates on $310.0 million of its anticipated future 30-day term
repurchase agreements. The Caps had an amortized cost of $4,044,000 and a fair
value of $1,108,000 at December
44
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
31, 2002, resulting in an unrealized loss of $2,936,000, which is included as a
component of accumulated other comprehensive income. If the 30-day London
Interbank Offered Rate ("LIBOR") were to increase above the rate specified in
the Cap Agreement during the effective term of the Cap, the Company would
receive monthly payments from its counterparty.
The Company's counterparties for the Cap Agreements are financial
institutions whose holding or parent company's long-term debt rating is "A" or
better, as determined by two of the Rating Agencies, where applicable. In the
unlikely event of a default by the counterparty, the Company would not receive
payments provided for under the terms of the Cap Agreement and could incur a
loss for the initial cost of entering into the Cap Agreement.
Weighted
Average Weighted Estimated Fair Gross
Remaining Average LIBOR Notional Unamortized Value/Carrying Unrealized
Active Period Strike Rate (1) Amount Premium Value Loss
------------- --------------- ------ ------- ----- ----
(Dollars in Thousands)
Months until active:
Currently active 22 Months 5.750% $ 50,000 $ 347 $ 28 $ (319)
Within six months -- -- -- -- -- --
Six to nine months 18 Months 4.750 100,000 1,486 149 (1,337)
Nine to 12 months 18 Months 4.500 100,000 1,386 301 (1,085)
12 to 24 months 18 Months 3.250 60,000 825 630 (195)
--------- ------- ------- --------
Weighted Average/Total 19 Months 4.540% $ 310,000 $ 4,044 $ 1,108 $ (2,936)
========= ======= ======= ========
(1) The 30-day LIBOR strike rate at which payments would become due to the
Company under the terms of the Cap Agreement. At December 31, 2002, the
30-day LIBOR was 1.38%.
9. Repurchase Agreements
As of December 31, 2002, the Company had outstanding balances of $3.2
billion under 182 repurchase agreements with a weighted average borrowing rate
of 2.02% and a weighted average remaining maturity of 5.8 months. As of December
31, 2002, all of the Company's borrowings were fixed rate term repurchase
agreements with original maturities that range from one-to-18 months. As of
December 31, 2001, the Company had outstanding balances of $1.8 million under
116 repurchase agreements with a weighted average borrowing rate of 2.91%. As of
December 31, 2002 and 2001, the repurchase agreements had the following
remaining maturities:
2002 2001
---------- ----------
(In Thousands)
Within 30 days $ 457,606 $ 557,167
31 to 60 days 467,105 274,599
61 to 90 days 91,719 80,594
3 to 6 months 1,076,804 622,608
6 to 9 months 481,776 272,630
9 to 12 months 418,400 38,000
12 to 18 months 192,500 --
---------- ----------
$3,185,910 $1,845,598
========== ==========
The repurchase agreements are collateralized by the Company's MBS
securities with an aggregate current face value of $3.5 billion. The Company's
repurchase agreements generally bear interest at rates that are LIBOR-based.
10. Commitments and Contingencies
Securities purchase commitments
At December 31, 2002, there were commitments to purchase two hybrid MBS
with a par value of $43.8 million with coupons ranging from 4.09% to 4.59%, with
purchases prices ranging from of 102.2% to 102.3% of par.
45
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
11. Stockholders' Equity
(a) Dividends/Distributions
The Company declared the following distributions during 2002, 2001 and
2000:
Dividend
Declaration Date Record Date Payment Date per Share
---------------- ----------- ------------ ---------
2002
March 12, 2002 March 28, 2002 April 30, 2002 $ 0.300 (1)
June 12, 2002 June 28, 2002 July 30, 2002 0.300 (1)
September 12, 2002 September 30, 2002 October 30, 2002 0.320 (2)
December 19, 2002 December 30, 2002 January 24, 2003 0.320 (2)
2001
February 12, 2001 April 16, 2001 April 30, 2001 $ 0.165
April 9, 2001 June 30, 2001 July 16, 2001 0.175
September 19, 2001 October 2, 2001 October 18, 2001 0.225
December 12, 2001 December 28, 2001 January 30, 2002 0.280
2000
March 17, 2000 April 14, 2000 May 17, 2000 $ 0.140
June 14, 2000 June 30, 2000 August 17, 2000 0.140
September 18, 2000 October 16, 2000 November 17, 2000 0.155
December 14, 2000 January 15, 2001 January 30, 2001 0.155
(1) Includes a special dividend of $0.02 per share.
(2) Includes a special dividend of $0.04 per share.
For tax purposes, a portion of each of the dividends declared in December
of 2002, 2001 and 2000 were treated as a dividend for stockholders in the
subsequent year.
In general, consistent with the Company's underlying operational strategy,
the Company's dividends will generally be characterized as ordinary income to
its stockholders for federal tax purposes. However, a portion of the Company's
dividends may be characterized as capital gains or return of capital. All of the
dividends for 2002 and 2001 were characterized as ordinary income and $0.02 of
the Company's dividends for the year ended December 31, 2000 was characterized
as capital gains.
(b) Common Stock Offerings
On January 18, 2002, the Company issued 7,475,000 shares of its $0.01 par
value Common Stock at $8.25 per share, raising net proceeds of $58.2 million,
and, on June 5, 2002, the Company issued 10,350,000 shares of its Common Stock
at $9.10 per share, raising net proceeds of $88.8 million.
On June 27, 2001, the Company issued 10,335,214 shares of its Common Stock
at $7.00 per share, raising net proceeds of $67.1 million. On November 7, 2001,
the Company issued 8,000,000 shares of its Common Stock at $8.00 per share,
raising net proceeds of $59.7 million.
(c) Shelf Registration
On September 25, 2001, the Company filed a registration statement on Form
S-3 with the SEC under the Securities Act of 1933, as amended, (the "Act"), with
respect to an aggregate of $300,000,000 of Common Stock and/or preferred stock
that may be sold by the Company from time to time pursuant to Rule 415 under the
Act. On October 5, 2001, the Commission declared the registration statement
effective. As of December 31, 2002, the Company had $80.1 million remaining
under this shelf registration statement.
(d) Stock Repurchase Plan
The Company did not repurchase any of its Common Stock during the years
ended December 31, 2002 or 2001. Since implementing the stock repurchase program
during the fourth quarter of 1999, through December 31, 2002, the Company had
repurchased and retired 378,221 shares at an aggregate cost of $1,924,000.
46
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
12. EPS Calculation
The following table presents the reconciliation between basic and diluted shares
outstanding used in calculating basic and diluted EPS for the years ended
December 31, 2002, 2001 and 2000:
2002 2001 2000
------ ------ ------
(In Thousands)
Weighted average shares outstanding -basic 41,432 15,229 8,869
Add effect of assumed shares issued under treasury
stock method for stock options 102 101 18
------ ------ ------
Weighted average shares outstanding - diluted 41,534 15,330 8,887
====== ====== ======
13. Accumulated Other Comprehensive Income
Accumulated other comprehensive income at December 31, 2002 and 2001 was
as follows:
2002 2001
-------- --------
(In Thousands)
Unrealized gains on available-for-sale:
MBS $ 27,155 $ 8,409
Corporate equity securities -- 710
Unrealized losses on available for sale:
MBS (423) (4,238)
-------- --------
26,732 4,881
-------- --------
Hedging Instruments:
Unrealized (depreciation) appreciation on interest rate
cap agreement (2,937) 163
-------- --------
Accumulated other comprehensive income $ 23,795 $ 5,044
======== ========
14. 1997 Stock Option Plan and Employment Agreements
(a) 1997 Stock Option Plan
The Company's Second Amended and Restated 1997 Stock Option Plan (the
"1997 Plan") authorizes the granting of options to purchase an aggregate of up
to 1,000,000 shares of the Company's Common Stock, but not more than 10% of the
total outstanding shares of the Company's Common Stock. The 1997 Plan authorizes
the Board of Directors, or a committee of the Board of Directors, to grant
Incentive Stock Options ("ISOs"), as defined under section 422 of the Code,
non-qualified stock options ("NQSOs") and dividend equivalent rights ("DERs") to
eligible persons. The exercise price for any options granted to eligible persons
under the 1997 Plan shall not be less than the fair market value of the Common
Stock on the day of the grant. The options expire if not exercised ten years
from the date of grant.
Activity in the 1997 Plan is summarized as follows for the years ended
December 31, 2002, 2001 and 2000:
2002 2001 2000
---------------------- ---------------------- ---------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Options Price Options Price Options Price
------- ----- ------- ----- ------- -----
Outstanding at beginning of year: 793,750 $6.44 820,000 $6.52 820,000 $6.52
Granted -- -- -- -- -- --
Cancelled (60,000) -- -- -- -- --
Exercised (90,000) 4.88 (26,250) 4.88 -- --
-------- -------- --------
Outstanding at end of year 643,750 8.09 793,750 6.44 820,000 6.52
======== ======== ========
Options exercisable at end of year 643,750 $8.09 793,750 $6.12 545,000 $6.11
DERs on the ISOs vest on the same basis as the options and DERs on NQSOs
become fully vested one year following the date of grant. Dividends are paid on
vested DERs only to the extent of ordinary income. DERs are not entitled to
distributions representing a return of capital. Dividends paid on ISOs are
charged to stockholders' equity when declared and dividends paid on NQSOs are
charged to earnings when declared. For the years ended
47
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002, 2001 and 2000, the Company recorded charges of $573,000,
$423,000 and $221,000, respectively, to stockholders' equity (included in
dividends paid or accrued) associated with the DERs on ISOs and charges of
$3,500, $4,000 and $4,000, respectively, to earnings associated with DERs on
NQSOs. All DERs granted in 1998 were outstanding and fully vested at December
31, 2002.
Because the Company was externally managed from the time of its formation
through January 1, 2002, it had no direct employees. The individuals who
received the ISO grants and related DERs were employees of the Advisor. The
Company was therefore required to account for the ISO grants applying the fair
value method as described under Statement of FAS No. 123 resulting in option
related expenses recognized over the vesting period. Management used the
Black-Scholes valuation model to determine the option expense. Because the
Company commenced operations in 1998, management used assumptions consistent
with activity of a comparable peer group of companies including an estimated
option life, a volatility rate, a risk free rate and a current dividend yield
for the 1998 and 1999 grants (or 0% if the related DERs are issued). For the
years ended December 31, 2002, 2001 and 2000, the Company reflected expenses of
$65,000, $129,000 and $113,000, respectively, representing the value of
ISOs/DERs granted over their vesting period.
NQSOs were granted to the Company's directors as consideration for the
performance of their duties as directors. The Company treated the directors as
employees for purposes of applying FAS 123 and, in accordance with its policy,
accounted for the NQSOs under APB 25, as described earlier, with no expense
recognized for the NQSOs, as the exercise price at the time of grant was equal
to the market value of the stock.
(b) Employment Agreements
On March 12, 2002, the Board of Directors adopted a compensation plan for
Messrs. Zimmerman, Gorin and Freydberg that took effect on August 1, 2002. Under
the new agreements, salaries to be paid to Messrs. Zimmerman, Gorin, and
Freydberg will be equal to 0.25%, 0.20% and 0.20%, respectively, of the
Company's tangible net worth, which will be calculated on a semi-annual basis on
each June 30 and December 31. In the event that the Company's annualized return
on equity for any given six-month period were to fall below 10%, the salaries to
be paid to Messrs. Zimmerman, Gorin and Freydberg with respect to the following
six-month period would be adjusted downward to equal (i) 0.2375%, 0.19% and
0.19%, respectively, of the Company's tangible net worth if its annualized
return on equity was between 10% and 5% and (ii) 0.225%, 0.18% and 0.18%,
respectively, of the Company's tangible net worth if its annualized return on
equity was less than 5%. Notwithstanding the foregoing, the annual base salaries
payable to Messrs. Zimmerman, Gorin and Freydberg pursuant to the new
compensation plan will in no event exceed $1,000,000, $750,000 and $750,000,
respectively. On October 1, 2002, the Company entered into an employment
agreement with Ms. Teresa Covello, the Company's Senior Vice
President/Controller, that provides for, among other things, a base salary of
$140,000.
(c) Deferred Compensation Plans
On December 19, 2002, the Company's Board of Directors adopted the MFA
Mortgage Investments, Inc. 2003 Nonemployee Directors' Deferred Compensation
Plan and the MFA Mortgage Investments, Inc. Senior Officers Deferred Bonus Plan
(collectively, the "Deferred Plans"). Directors and senior officers of the
Company may elect to defer a percentage of their compensation under the Deferred
Plans for compensation earned subsequent to December 31, 2002. The Deferred
Plans are intended to provide non-employee Directors and Senior Officers of the
Company with an opportunity to defer up to 100% of certain compensation, as
defined in the Deferred Plans, while at the same time aligning their interests
with the interests of the stockholders. Amounts deferred are considered to be
converted into "stock units" of the Company, which do not represent stock of the
Company, but rather the right to receive a cash payment equal to the fair market
value of an equivalent number of shares of the Common Stock. Deferred accounts
increase or decrease in value as would equivalent shares of the Common Stock and
are settled in cash at the termination of the deferral period, based on the
value of the stock units at that time. The Deferred Plans are non-qualified
plans under the Employee Retirement Income Security Act ("ERISA") and are not
funded. Prior to the time that the deferred accounts are settled, participants
are unsecured creditors of the Company.
The Deferred Plans are intended to be non-qualified deferred compensation
plans under the provisions of the Code. At the time a participant's deferral of
compensation is made, it is intended that such participant will not recognize
income for federal income tax purposes, nor will the Company receive a deduction
until such time that the compensation is actually distributed to the
participant.
48
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
15. Fair Value of Financial Instruments
FAS No. 107 "Disclosures about Fair Value of Financial Instruments"
defines the fair value of a financial instrument as the amount at which the
instrument could be exchanged in a current transaction between willing parties.
The relevance and reliability of the estimates of fair values presented are
limited, given the dynamic nature of market conditions, including changes in
interest rates, the real estate market, debtors' financial condition and
numerous other factors over time. The following table presents the carrying
value and estimated fair value of financial instruments at December 31, 2002 and
2001:
2002 2001
----------------------- -----------------------
Carrying Estimated Carrying Estimated
Value Fair Value Value Fair Value
---------- ---------- ---------- ----------
(In Thousands)
Financial Assets:
Cash and cash equivalents $ 64,087 $ 64,087 $ 58,533 $ 58,533
Restricted cash 39 39 39,499 39,499
Investment in mortgage securities 3,485,319 3,485,319 1,926,900 1,926,900
Investment in corporate debt securities -- -- 9,774 6,335
Investment in corporate equity securities -- -- 4,088 4,088
Hedge instruments 1,108 1,108 513 513
Financial Liabilities:
Repurchase agreements 3,185,910 3,195,823 1,845,598 1,851,133
The following methods and assumptions were used by the Company in
estimating the fair value of its financial instruments:
Investments in MBS, corporate debt securities and corporate equity
securities: Fair values are based on broker quotes or amounts obtained from
independent pricing sources.
Cash and cash equivalents and restricted cash: Fair value approximates the
carrying value of such assets.
Repurchase agreements: Fair value reflects the present value of the
contractual cash flow (i.e., future value). The discount rate used to present
value the contractual future value was LIBOR rate quoted at the valuation date
that is closest to the weighted average term to maturity of the aggregate
repurchase agreements.
Commitments: Commitments to purchase securities are derived by applying
the fees currently charged to enter into similar agreements, taking into account
remaining terms of the agreements and the present creditworthiness of the
counterparties. The commitments existing at December 31, 2002 and 2001, would
have been offered at substantially the same rates and under substantially the
same terms that would have been offered at December 31, 2002 and 2001;
respectively, therefore, the estimated fair value of the commitments was zero at
those dates and are not included in the table above.
49
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
16. Summary of Quarterly Results of Operations (Unaudited)
2002 Quarter Ended
---------------------------------------------------
March 31 June 30 September 30 December 31
-------- ------- ------------ -----------
(In Thousands, Except per Share Amounts)
Interest and dividend income $27,253 $30,710 $37,031 $33,000
Interest expense 13,483 15,247 17,830 16,931
------- ------- ------- -------
Net interest/dividend income 13,770 15,463 19,201 16,069
Other income (loss) (3,001)(1) (34) (415) 946 (2)
Operating and other expenses 1,212 (1) 1,272 1,446 1,975 (2)
------- ------- ------- -------
Net income $ 9,557 $14,157 $17,340 $15,040
======= ======= ======= =======
Net income per share - basic $ 0.28 (1) $ 0.37 $ 0.37 $ 0.33
======= ======= ======= =======
Net income per share - diluted $ 0.28 (1) $ 0.37 $ 0.37 $ 0.32
======= ======= ======= =======
2001 Quarter Ended
---------------------------------------------------
March 31 June 30 September 30 December 31
-------- ------- ------------ -----------
(In Thousands, Except per Share Amounts)
Interest and dividend income $ 8,897 $ 8,956 $16,688 $21,964
Interest expense 6,536 5,814 10,276 12,447
------- ------- ------- -------
Net interest/dividend income 2,361 3,142 6,412 9,517
Other income (loss) 2,874 (3) (180) 105 (2,553)(4)
Operating and other expenses 1,167 (3) 739 1,430 14,558 (5)
------- ------- ------- -------
Net income $ 4,068 $ 2,223 $ 5,087 $(7,594)
======= ======= ======= =======
Net income per share - basic $ 0.47 (3) $ 0.24 $ 0.27 $ (0.32)
======= ======= ======= =======
Net income per share - diluted $ 0.46 (3) $ 0.24 $ 0.27 $ (0.32)
======= ======= ======= =======
(1) Includes an "other-than-temporary" impairment charge of $3.4 million
related to a corporate debt security, which reduced net income by $0.10
per basic and diluted share.
(2) Reflects the income and expenses of a consolidated subsidiary commencing
October 1, 2002, when the Company acquired the voting common stock of RCC,
in which the Company previously held a non-controlling interest.
(3) Other income includes $2.6 million of gains on sale of a property;
operating and other expense include an incentive fee of $511,000 paid to
the Advisor related to this gain; on a net basis this gain increased per
share income by $0.24.
(4) Includes an "other-than-temporary" impairment charge of $2.5 million
related to a debt security, which reduced net income by $0.10 per basic
and diluted share.
(5) Includes the $12.5 million of costs, of which $11.3 million was a non-cash
equity distribution, incurred to acquire the Advisor, which reduced net
income by $0.53 per basic and diluted share.
50
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
There were no changes in, nor any disagreements with the Company's
independent accountants on accounting principles and practices or financial
disclosure, during the years ended December 31, 2002, 2001 and 2000.
PART III
Item 10. Directors and Executive Officers of Registrant.
Information regarding the Company's directors appears under the heading
"Election of Directors" in the Company's proxy statement relating to its 2003
Annual Meeting of Stockholders to be held on May 20, 2003 (the "Proxy
Statement") and is incorporated herein by reference.
Information regarding the Company's executive officers appears under Item
4A of Part I of this Annual Report on Form 10-K.
Information regarding compliance with Section 16(a) of the 1934 Act, as
amended, appears under the heading "Compliance with Section 16(a) of the
Exchange Act" in the Proxy Statement and is incorporated herein by reference.
Item 11. Executive Compensation.
Information regarding executive compensation appears under the heading
"Executive Compensation" in the Proxy Statement and is incorporated herein by
reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
The table of beneficial ownership of the Company appears under the heading
"Security Ownership of Certain Beneficial Owners and Management" in the Proxy
Statement and is incorporated herein by reference.
Item 13. Certain Relationships and Related Transactions.
Information regarding certain relationships and related transactions
appears under the heading "Certain Relationships and Related Transactions" in
the Proxy Statement and is incorporated herein by reference.
Item 14. Controls and Procedures
A review and evaluation was performed by the Company's management,
including the Company's Chief Executive Officer (the "CEO") and Chief Financial
Officer (the "CFO"), of the effectiveness of the design and operation of the
Company's disclosure controls and procedures as of a date within 90 days prior
to the filing of this Annual Report on Form 10-K. Based on that review and
evaluation, the CEO and CFO have concluded that the Company's current disclosure
controls and procedures, as designed and implemented, were effective. There have
been no significant changes in the Company's internal controls or in other
factors that could significantly affect the Company's internal controls
subsequent to the date of their evaluation. There were no significant material
weaknesses identified in the course of such review and evaluation and,
therefore, no corrective measures were taken by the Company.
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K.
(a) The following documents are filed as part of this report:
1. Financial Statements. The consolidated financial statements of the
Company, together with the Independent Accountants' Report thereon, are
set forth on pages 30 through 51 of this Form 10-K and are incorporated
herein by reference.
2. Financial Statement Schedules. Financial Statement Schedules have been
omitted because they are not applicable or the required information is
shown in the consolidated financial statements and/or in the notes to
consolidated financial statements filed in response to Item 8 hereof.
51
3. Exhibits.
2.1 Agreement and Plan of Merger by and among the Registrant,
America First Participating/Preferred Equity Mortgage Fund
Limited Partnership, America First Prep Fund 2 Limited
Partnership, America First Prep Fund 2 Pension Series Limited
Partnership and certain other parties, dated as of July 29,
1997 (incorporated herein by reference to Exhibit 2.1 of the
Registration Statement on Form S-4, dated February 12, 1998,
filed by the Registrant pursuant to the Securities Act of 1933
(Commission File No. 333-46179)).
2.2 Agreement and Plan of Merger by and among the Registrant,
America First Mortgage Advisory Corporation ("AFMAC") and the
shareholders of AFMAC, dated September 24, 2001 (incorporated
herein by reference to Exhibit A of the definitive Proxy
Statement, dated November 12, 2001, filed by the Registrant
pursuant to the 1934 Act (Commission File No. 1-13991)).
3.1 Amended and Restated Articles of Incorporation of the
Registrant (incorporated herein by reference to Form 8-K,
dated April 10, 1998, filed by the Registrant pursuant to the
1934 Act (Commission File No. 1-13991)).
3.2 Articles of Amendment to the Amended and Restated Articles of
Incorporation of the Registrant, dated August 6, 2002
(incorporated herein by reference to Form 8-K, dated August
13, 2002, filed by the Registrant pursuant to the 1934 Act
(Commission File No. 1-13991)).
3.3 Articles of Amendment to the Amended and Restated Articles of
Incorporation of the Registrant, dated August 16, 2002
(incorporated herein by reference to Exhibit 3.3 of the Form
10-Q, dated September 30, 2002, filed by the Registrant
pursuant to the 1934 Act (Commission File No. 1-13991)).
3.4 Amended and Restated Bylaws of the Registrant (incorporated
herein by reference to the Form 8-K, dated August 13, 2002,
filed by the Registrant pursuant to the 1934 Act (Commission
File No. 1-13991)).
4.1 Specimen of Common Stock Certificate of the Registrant
(incorporated herein by reference to Exhibit 4.1 of the
Registration Statement on Form S-4, dated February 12, 1998,
filed by the Registrant pursuant to the Securities Act of 1933
(Commission File No. 333-46179)).
10.1 Employment Agreement of Stewart Zimmerman, dated August 1,
2002 (incorporated herein by reference to Exhibit 10.1 of the
Form 10-Q, dated September 30, 2002, filed by the Registrant
pursuant to the 1934 Act (Commission File No. 1-13991)).
10.2 Employment Agreement of William S. Gorin, dated August 1, 2002
(incorporated herein by reference to Exhibit 10.2 of the Form
10-Q, dated September 30, 2002, filed by the Registrant
pursuant to the 1934 Act (Commission File No. 1-13991)).
10.3 Employment Agreement of Ronald A. Freydberg, dated August 1,
2002 (incorporated herein by reference to Exhibit 10.3 of the
Form 10-Q dated September 30, 2002, filed by the Registrant
pursuant to the 1934 Act (Commission File No. 1-13991)).
10.4 Employment Agreement of Teresa D. Covello, dated October 1,
2002.
10.5 Amended and Restated 1997 Stock Option Plan of the Registrant
(incorporated herein by reference to Form 10-K, dated December
31, 1999, filed with the Securities and Exchange Commission
pursuant to the 1934 Act (Commission File No. 1-13991)).
10.6 Second Amended and Restated 1997 Stock Option Plan of the
Registrant (incorporated herein by reference to the Form 10-Q,
dated August 10, 2001, filed with the Securities and Exchange
Commission pursuant to the 1934 Act (Commission File No.
1-13991)).
10.7 MFA Mortgage Investments, Inc. Senior Officers Deferred
Compensation Plan, adopted December 19, 2002.
10.8 MFA Mortgage Investments, Inc. 2003 Non-Employee Directors
Deferred Compensation Plan, adopted December 19, 2002.
21 Subsidiaries of the Registrant.
23 Consent of PricewaterhouseCoopers LLP.
99.1 Certification of the Chief Executive Officer
99.2 Certification of the Chief Financial Officer
52
Reports on Form
8-K The Registrant filed the following on Form 8-K during the fourth
quarter of 2002:
Item Reported Financial Statements Filed Date of Report
- ------------- -------------------------- --------------
9. Regulation FD Disclosure No October 28, 2002
53
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities
Exchange Act of 1934, the Company has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
MFA Mortgage Investments, Inc.
Date: February 6, 2003 By /s/ Stewart Zimmerman
------------------------------------
Stewart Zimmerman
Chief Executive Officer
Date: February 6, 2003 By /s/ William S. Gorin
------------------------------------
William S. Gorin
Executive Vice President
Chief Financial Officer/Treasurer
(Principal Accounting Officer)
Pursuant to the requirements of the Securities Act of 1934, this report
has been signed below by the following persons on behalf of the Company and in
the capacities and on the dates indicated.
Date: February 6, 2003 By /s/ Michael B. Yanney
------------------------------------
Michael B. Yanney
Chairman of the Board
Date: February 6, 2003 By /s/ Stewart Zimmerman
------------------------------------
Stewart Zimmerman
Chief Executive Officer and Director
Date: February 6, 2003 By /s/ Alan Gosule
------------------------------------
Alan Gosule
Director
Date: February 6, 2003 By /s/ George H. Krauss
------------------------------------
George H. Krauss
Director
Date: February 6, 2003 By /s/ Michael L. Dahir
------------------------------------
Michael L. Dahir
Director
Date: February 6, 2003 By /s/ W. David Scott
------------------------------------
W. David Scott
Director
Date: February 6, 2003 By /s/ Stephen R. Blank
------------------------------------
Stephen R. Blank
Director
54
CERTIFICATIONS
I, Stewart Zimmerman, certify that:
1. I have reviewed this annual report on Form 10-K of MFA Mortgage
Investments, Inc. (the "Registrant");
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary in
order 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 annual report;
3. Based on my knowledge, the consolidated financial statements, and other
financial information included in this annual 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
annual 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 we
have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the Registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this annual
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 annual report (the "Evaluation Date"); and
c) presented in this annual 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 the Registrant's board of directors:
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
annual 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: February 6, 2003
/s/ Stewart Zimmerman
---------------------
Name: Stewart Zimmerman
Title: President and Chief Executive Officer
55
I, William S. Gorin, certify that:
1. I have reviewed this annual report on Form 10-K of MFA Mortgage
Investments, Inc. (the "Registrant");
2. Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary in
order 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 annual report;
3. Based on my knowledge, the consolidated financial statements, and other
financial information included in this annual 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
annual 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 we
have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the Registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this annual
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 annual report (the "Evaluation Date"); and
c) presented in this annual 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 the Registrant's board of directors:
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
annual 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: February 6, 2003
/s/ William S. Gorin
--------------------
Name: William S. Gorin
Title: Executive Vice President and Chief Financial Officer
56