Attached files
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EX-32.1 - EXHIBIT 32.1 - CreXus Investment Corp. | a6194397ex32_1.htm |
EX-21.1 - EXHIBIT 21.1 - CreXus Investment Corp. | a6194397ex21_1.htm |
EX-32.2 - EXHIBIT 32.2 - CreXus Investment Corp. | a6194397ex32_2.htm |
EX-31.2 - EXHIBIT 31.2 - CreXus Investment Corp. | a6194397ex31_2.htm |
EX-23.1 - EXHIBIT 23.1 - CreXus Investment Corp. | a6194397ex23_1.htm |
EX-31.1 - EXHIBIT 31.1 - CreXus Investment Corp. | a6194397ex31_1.htm |
UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
WASHINGTON,
D.C. 20549
FORM
10-K
[X] ANNUAL
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE
ACT OF 1934
FOR THE
FISCAL YEAR ENDED: DECEMBER 31, 2009
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: 1-34451
CREXUS
INVESTMENT CORP.
(Exact
name of Registrant as specified in its Charter)
MARYLAND
|
26-2652391
|
(State
or other jurisdiction of incorporation or organization)
|
(IRS
Employer Identification No.)
|
1211
AVENUE OF THE AMERICAS, SUITE 2902
NEW YORK,
NEW YORK
(Address
of principal executive offices)
10036
(Zip
Code)
(646)
829-0160
(Registrant’s
telephone number, including area code)
Securities
registered pursuant to Section 12(b) of the Act:
Title
of Each Class
|
Name
of Each Exchange on Which Registered
|
|
Common
Stock, par value $.01 per share
|
New
York Stock Exchange
|
Securities registered pursuant to Section 12(g) of the Act:
None.
Indicate
by check mark whether the Registrant is a well-known seasoned issuer, as defined
in Rule 405 of the Securities Act. Yes o No x
Indicate
by check mark if the Registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act. Yes o No x
Indicate
by check mark whether the Registrant (1) has filed all documents and reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days: Yes þ No o
Indicate
by check mark whether the Registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of
this chapter) during the preceding 12 months (or for such shorter period that
the registrant was required to submit and post such files). Yes o No o
Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. o
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, non-accelerated filer, or a smaller reporting company. See definition of “accelerated filer,” “large accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large
accelerated filer o
|
Accelerated
filer o
|
Non-accelerated
filer þ
|
Smaller
reporting company o
|
Indicate
by check mark whether the Registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yes o No þ
At
September 17, 2009 (the day that trading in the registrant's common stock
commenced on the New York Stock Exchange), the aggregate market value of the
voting stock held by non-affiliates of the Registrant was $195,066,676 based on
the closing sale price on the New York Stock Exchange on that date.
APPLICABLE
ONLY TO CORPORATE ISSUERS:
Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of the last practicable date:
Class
|
Outstanding
at February 25, 2010
|
Common
Stock, $.01 par value
|
18,120,112
|
DOCUMENTS
INCORPORATED BY REFERENCE
The
registrant intends to file a definitive proxy statement pursuant to Regulation
14A within 120 days of the end of the fiscal year ended December 31, 2009.
Portions of such proxy statement are incorporated by reference into Part III of
this Form 10-K.
CREXUS
INVESTMENT CORP.
2009
FORM 10-K ANNUAL REPORT
TABLE
OF CONTENTS
PAGE
PART
I
|
||
ITEM
1.
|
2
|
|
ITEM
1A.
|
10
|
|
ITEM
1B.
|
46
|
|
ITEM
2.
|
46
|
|
ITEM
3.
|
46
|
|
ITEM
4.
|
46
|
|
PART
II
|
||
ITEM
5.
|
47 | |
ITEM
6.
|
49
|
|
ITEM 7. |
51
|
|
ITEM
7A.
|
73
|
|
ITEM
8.
|
78
|
|
ITEM 9. |
78
|
|
ITEM
9A.
|
78
|
|
ITEM
9B.
|
78
|
|
PART
III
|
||
ITEM
10.
|
78
|
|
ITEM
11.
|
79
|
|
ITEM 12. |
79
|
|
ITEM
13.
|
79
|
|
ITEM
14.
|
79
|
|
PART
IV
|
||
ITEM
15.
|
79
|
|
F-1 | ||
S-1 | ||
EXHIBITS
|
iii
Special
Note Regarding Forward-Looking Statements
We make
forward-looking statements in this report that are subject to risks and
uncertainties. These forward-looking statements include information about
possible or assumed future results of our business, financial condition,
liquidity, results of operations, plans and objectives. When we use the words
‘‘believe,’’ ‘‘expect,’’ ‘‘anticipate,’’ ‘‘estimate,’’ ‘‘plan,’’ ‘‘continue,’’
‘‘intend,’’ ‘‘should,’’ ‘‘may,’’ ‘‘would,’’ “will,” or similar expressions, we
intend to identify forward-looking statements. Statements regarding
the following subjects, among others, are forward-looking by their
nature:
·
|
our
business and strategy; our projected financial and operating
results;
|
·
|
our
ability to obtain and maintain financing arrangements and the terms of
such arrangements;
|
·
|
general
volatility of the markets in which we acquire
assets;
|
·
|
the
implementation, timing and impact of, and changes to, various government
programs, including the Treasury’s plan to buy U.S. government agency
residential mortgage-backed securities, the Term Asset-Backed Securities
Loan Facility and the Public-Private Investment
Program;
|
·
|
our
expected assets;
|
·
|
changes
in the value of our assets;
|
·
|
interest
rate mismatches between our assets and our borrowings used to fund such
purchases;
|
·
|
changes
in interest rates and mortgage prepayment rates; effects of interest rate
caps on our adjustable-rate assets;
|
·
|
rates
of default or decreased recovery rates on our
assets;
|
·
|
prepayments
of the mortgage and other loans underlying our mortgage-backed or other
asset-backed securities;
|
·
|
the
degree to which our hedging strategies may or may not protect us from
interest rate volatility;
|
·
|
changes
in governmental regulations, tax law and rates, accounting guidance, and
similar matters;
|
·
|
availability
of opportunities in real estate-related and other securities; availability
of qualified personnel;
|
·
|
estimates
relating to our ability to make distributions to our stockholders in the
future;
|
·
|
our
understanding of our competition;
|
·
|
market
trends in our industry, interest rates, the debt securities markets or the
general economy;
|
·
|
our
ability to maintain our exemption from registration under the Investment
Company Act of 1940, as amended;
and
|
·
|
our
ability to maintain our qualification as a Real Estate Investment Trust,
or REIT for federal income tax
purposes.
|
The
forward-looking statements are based on our beliefs, assumptions and
expectations of our future performance, taking into account all information
currently available to us. You should not place undue reliance on these
forward-looking statements. These beliefs, assumptions and expectations can
change as a result of many possible events or factors, not all of which are
known to us. Some of these factors are described under the caption ‘‘Risk
Factors’’ in this annual report. If a change occurs, our business,
financial condition, liquidity and results of operations may vary materially
from those expressed in our forward-looking statements. Any
forward-looking statement speaks only as of the date on which it is made. New
risks and uncertainties arise from time to time, and it is impossible for us to
predict those events or how they may affect us. Except as required by law, we
are not obligated to, and do not intend to, update or revise any forward-looking
statements, whether as a result of new information, future events or
otherwise.
1
PART
I. Business
The
Company
We are a
specialty finance company that acquires, manages, and finances, directly or
through our subsidiaries, commercial mortgage loans and other commercial real
estate debt, commercial mortgage-backed securities, or CMBS, and other
commercial real estate-related assets. We expect that the commercial
real estate loans we acquire will be high quality fixed and floating rate first
mortgage loans secured by commercial properties. We may also acquire
subordinated commercial mortgage loans and mezzanine loans. We intend
to acquire CMBS which are rated AAA through BBB as well as CMBS that are below
investment grade or are non-rated. Other commercial real
estate-related securities and other commercial real estate asset classes will
consist of debt and equity tranches of commercial real estate collateralized
debt obligations, or CRE CDOs, loans to real estate companies including real
estate investment trusts, or REITs, and real estate operating companies, or
REOCs, commercial real estate securities and commercial real
property. In addition, to maintain our exemption from registration
under the Investment Company Act of 1940, as amended, or the 1940 Act, we expect
to acquire residential mortgage-backed securities, or RMBS, for which a U.S.
Government agency such as the Government National Mortgage Association, or
Ginnie Mae, or a federally chartered corporation such as the Federal National
Mortgage Association, or Fannie Mae, or the Federal Home Loan Mortgage
Corporation, or Freddie Mac, guarantees payments of principal and interest on
the securities. We refer to these securities as Agency
RMBS. We refer to Ginnie Mae, Fannie Mae, and Freddie Mac
collectively as the Agencies.
We are
externally managed by Fixed Income Discount Advisory Company, which we refer to
as our manager or FIDAC. FIDAC is a wholly-owned subsidiary of Annaly
Capital Management, Inc., or Annaly, a New York Stock Exchange-listed
REIT. Annaly owns approximately 25% of our outstanding shares of
common stock. We intend to elect and qualify to be taxed as a REIT,
for U.S. federal income tax purposes.
Our
objective is to provide attractive risk-adjusted returns to our investors over
the long-term, primarily through dividends and secondarily through capital
appreciation. We intend to achieve this objective by acquiring a
broad range of commercial real estate-related assets to construct a portfolio
that is designed to achieve attractive risk-adjusted returns and that is
structured to comply with the various U.S. federal income tax requirements for
REIT status. We also intend to operate our business in a manner that
will permit us to maintain our exemption from registration under the 1940
Act.
Our
Manager
We are
externally managed and advised by FIDAC, an investment advisor registered with
the Securities and Exchange Commission. Our Manager is a fixed-income
investment management company specializing in managing fixed income investments
in (i) Agency RMBS, (ii) non-Agency RMBS, including investment grade and
non-investment grade classes, which are typically pass-through certificates
created by a securitization of a pool of mortgage loans that are collateralized
by residential real properties and (iii) collateralized debt obligations, or
CDOs. Our Manager also has experience in managing and structuring
debt financing associated with these asset classes. Our Manager is
also a leading liquidation agent of CDOs. Our Manager commenced
active investment management operations in 1994. At December 31,
2009, our Manager was the adviser or sub-adviser for investment vehicles and
separate accounts with approximately $6.0 billion in net assets and $13.6
billion in gross assets, which includes the assets of Chimera Investment
Corporation, or Chimera, a publicly traded REIT whose shares are traded on the
NYSE under the symbol “CIM” and is externally managed by our
Manager.
2
Our
Manager is responsible for administering our business activities and day-to-day
operations pursuant to a management agreement with us. All of our
officers are employees of our Manager or its affiliates. Our Chief
Executive Officer, President and Director, Kevin Riordan, is a Managing Director
of Annaly and FIDAC and has over 25 years of experience in evaluating, acquiring
and managing a wide range of commercial real estate-related assets, including
CMBS and commercial real estate loans, and managing third-party origination and
servicing programs, including as a Group Managing Director at Teachers Insurance
and Annuity Association-College Retirement Equities Fund, or
TIAA-CREF. Our Manager has well-respected and established portfolio
management resources for each of our targeted asset classes and a sophisticated
infrastructure supporting those resources, including professionals focusing on
residential and commercial mortgage loans, Agency and non-Agency RMBS, CMBS and
other asset-backed securities. We also benefit from our Manager’s
finance and administration functions, which address legal, compliance, investor
relations, and operational matters, including portfolio management, trade
allocation and execution, securities valuation, risk management and information
technology in connection with the performance of its duties.
Our
Investment Strategy
We rely
on our Manager’s expertise in identifying assets within our targeted asset
classes. Our Manager makes decisions based on various factors,
including expected cash yield, relative value, risk-adjusted returns, current
and projected credit fundamentals, current and projected macroeconomic
considerations, current and projected supply and demand, credit and market risk
concentration limits, liquidity, cost of financing and financing availability,
as well as maintaining our REIT qualification and our exemption from
registration under the 1940 Act.
We
recognize that making acquisitions in our targeted asset classes is highly
competitive, and that our Manager will compete with many other investment
managers for profitable opportunities in these areas. Annaly and our
Manager have close relationships with a diverse group of financial
intermediaries, including life insurance companies, commercial mortgage brokers,
primary dealers, commercial and investment banks and brokerage firms, specialty
investment dealers and financial sponsors. In addition, we benefit
from our Manager’s analytical and portfolio management expertise and
technology.
To
facilitate our acquisition of commercial real estate loans, we have entered into
a Mortgage Origination and Servicing Agreement, or MOSA and expect to enter into
additional MOSAs with third parties to originate, underwrite, conduct due
diligence, close and service commercial real estate loans. Under the
terms of our MOSAs, we expect that borrowers will pay our MOSA counterparties
any origination, commitment and closing fees for the loans originated under our
MOSAs. Our Manager oversees the diligence, credit evaluation,
underwriting, and financial reporting with respect to our potential loan
acquisitions. We expect to have representations and warranties from
our MOSA counterparties with respect to the counterparty themselves as well as
the loans originated pursuant to our MOSAs. Our MOSAs may or may not
require us to pay termination fees with respect to the termination of a MOSA or
the transfer of loans serviced under such MOSA. In addition, we
expect to make loan acquisitions from our own direct relationships with
commercial mortgage brokers and borrowers. We believe that the
combined and complementary strengths of Annaly and our Manager, as well as the
capabilities of our MOSA counterparties, give us a competitive advantage over
REITs with a similar focus to ours. On August 28, 2009, we entered
into a MOSA with Principal Real Estate Investors, LLC, or Principal whereby
Principal will originate, underwrite, conduct due diligence, close and service
commercial real estate loans for us on the terms set forth above. Our
MOSA with Principal has no fixed termination date but is terminable by us with
or without cause upon 30 days prior written notice and is terminable by
Principal with or without cause upon 180 days prior written notice provided that
Principal shall continue to serve as the servicer until a successor servicer is
appointed.
Over
time, we will continually adjust our allocation strategy as market conditions
change to seek to maximize the returns from our portfolio. We believe
this strategy, combined with our Manager’s experience, will enable us to pay
dividends and achieve capital appreciation throughout changing interest rate and
credit cycles and provide attractive long-term returns to
investors.
3
Our
targeted asset classes and the principal assets we expect to acquire are as
follows:
Asset Class
|
Principal Assets
|
Commercial
Real Estate Loans
|
First
mortgage loans that are secured by commercial properties
Subordinated
mortgage loans or “B-Notes”
Mezzanine
loans
Construction
loans
|
Commercial
Mortgage-Backed Securities, or
CMBS
|
CMBS
rated AAA through BBB
CMBS
that are rated below investment grade or are non-rated
|
Other
Commercial Real Estate Assets
|
Debt
and equity tranches of CRE CDOs
Loans
to real estate companies including REITs and REOCs
Commercial
real estate securities
Commercial
real property
|
Agency
RMBS
|
Single-family
residential mortgage pass-through certificates representing interests in
“pools” of mortgage loans secured by residential real property where
payments of both interest and principal are guaranteed by a U.S.
Government agency or federally chartered
corporation
|
As the
diligence and acquisition lead times for commercial real estate loans are longer
than for CMBS and Agency RMBS, we expect at the outset that a majority of our
portfolio will consist of CMBS, Agency RMBS and cash and cash equivalents,
subject to maintaining our REIT qualification and our 1940 Act
exemption. However, we expect our portfolio to become weighted toward
commercial real estate loans over the next 12 months. Based on prevailing market
conditions, our current expectation is that over the next 12 months, our
portfolio will consist of between 50% to 70% commercial mortgage loans, 30% to
50% CMBS, up to 5% other commercial real estate-related assets and up to 5%
Agency RMBS. Our allocation decisions will depend on prevailing market
conditions and may change over time in response to opportunities available in
different interest rate, economic and credit environments. Furthermore, there is
no assurance that we will not allocate our portfolio in a different manner among
our targeted assets from time to time. We may change our strategy and policies
without a vote of our stockholders.
We intend
to elect and qualify to be taxed as a REIT and to operate our business so as to
be exempt from registration under the 1940 Act, and therefore will be required
to acquire a substantial majority of our assets in loans secured by mortgages on
real estate and real estate-related assets. Subject to maintaining
our REIT qualification and our 1940 Act exemption, we do not have any
limitations on the amounts we may acquire of any of our targeted asset
classes.
Portfolio
Commercial
Mortgage-Backed Securities
CMBS are
bonds that evidence interests in, or are secured by, a single commercial
mortgage or a pool of commercial mortgage loans. CMBS are typically
issued in multiple tranches or split into different levels of risk thereby
allowing an investor to select a credit level that suits its risk profile.
Principal payments are applied sequentially to the most senior tranche of the
structure until the most senior class has been repaid. Losses and other
shortfalls are borne by the most subordinate class which receives principal
payments only after the more senior classes are repaid.
4
Commercial
Real Estate Loans
First Mortgage Loans – First
mortgage loans are generally three-to-ten year term loans that are primarily for
fully constructed real estate located in the United States that are current pay
and are either fixed or floating rate. Some of these loans may be syndicated in
either a pari passu or in a senior /subordinated structure. First mortgages
generally provide for a higher recovery rate due to their senior
position.
Subordinated Mortgage Loans or
“B-Notes” – These instruments include structurally subordinated first
mortgage loans and junior participations in first mortgage loans or
participations in these types of assets. A B Note is typically a
privately negotiated loan that is secured by a first mortgage on a single large
commercial property or group of related properties and subordinated to an A Note
secured by the same first mortgage property or group. The
subordination of a B Note typically is evidenced by an intercreditor agreement
with the holder of the A Note. B notes are subject to more credit
risk with respect to the underlying mortgage collateral than the corresponding A
Note. We may create subordinated mortgage loans by tranching our
purchased first mortgage loans through syndication of our senior first
mortgages, or buy such assets directly from third party
originators. Due to balance sheet constraints arising from the
current credit disruption, we believe opportunities to acquire these
subordinated, first mortgage positions will be readily available at attractive
prices on an adjusted risk/return basis.
Purchasers
of subordinated mortgage loans and B notes are compensated for the increased
risk of such assets but still benefit from a lien on the related property.
Investors’ rights are generally governed through participations and other
agreements that, subject to certain limitations, provide the holders of
subordinated positions of the mortgage loan with the ability to cure certain
defaults and control certain decisions of holders of senior debt secured by the
same property or properties.
Mezzanine Loans – These loans
are secured by a pledge of the borrower’s equity ownership in the property.
Unlike a mortgage, this loan does not represent a lien on the
property. Therefore it is always junior and subject to any first-lien
as well as second liens, if applicable, on the property. These loans
are senior to any preferred equity or common equity
interests. Purchasers of mezzanine loans benefit from a right to
foreclose on the ownership equity in a more efficient means than senior mortgage
debt. Also, investor rights are usually governed by intercreditor
agreements that provide holders with the rights to cure defaults and exercise
control on certain decisions of any senior debt secured by the same
property. Mezzanine loans may also be syndicated in either a pari
passu or senior/subordinated structure.
Construction Loans – We may
acquire participations in construction or rehabilitation loans on commercial
properties. These loans will generally provide 40% to 60% of
financing on the total cost of the construction or rehabilitation project and
will be secured by first mortgage liens on the property under construction or
rehabilitation. Purchases of construction and rehabilitation loans
would generally allow us to earn origination fees and may also entitle us to a
percentage of the underlying property’s net operating income (subject to our
qualification as a REIT) or gross revenues, payable on an ongoing basis, as well
a percentage of any increase in value of the property, payable upon maturity or
refinancing of the loan.
Other
Real Estate-Related Securities and Assets
Commercial Real Estate
Collateralized Debt Obligations – CRE CDOs are multiple class securities,
or bonds, secured by pools of assets such as CMBS, B-Notes, mezzanine loans and
REIT debt. In a CRE CDO, the assets are pledged to a trustee for the benefit of
the bond certificate holders. Generally, principal payments are applied
sequentially to the most senior tranche of the structure until the most senior
class has been repaid. Losses and other shortfalls are borne by the most
subordinate class which receives principal payments only after the more senior
classes are repaid. However, these structures are also subject to further
compliance tests pursuant to their respective indentures, the failure of which
can also result in the redirection of cash flow to the most senior
securities.
Loans to REITS and REOCs –
These assets generally are publicly registered, unsecured corporate obligations
made to companies whose primary business is the ownership and operation of
commercial real estate including office, retail, multifamily and industrial
properties. These investments generally pay semi-annually versus monthly for
mortgage instruments. Credit protections include both operating and maintenance
covenants.
5
Commercial Real Property – We
may make a limited number of acquisitions in commercial real property to take
advantage of attractive opportunities. In certain circumstances, our real estate
debt investments may result in us owning commercial real property as a result of
a loan workout and the exercise of our remedies under the mortgage
documents.
Agency
RMBS
We may
acquire Agency RMBS to the extent necessary to maintain our exemption from
registration under the 1940 Act. These are investments in pools of
mortgage-backed securities which, although not rated, carry an implied “AAA”
rating. Agency mortgage-backed securities are mortgage-backed securities for
which a government agency or federally chartered corporation, such as Freddie
Mac, Fannie Mae, or Ginnie Mae, guarantees payments of principal or interest on
the securities.
Asset
Guidelines
Our board
of directors has adopted a set of asset guidelines that set out the asset
classes, risk tolerance levels, diversification requirements and other criteria
used to evaluate the merits of specific assets as well as the overall portfolio
composition. Our Manager’s Investment Committee will review our
compliance with the asset guidelines at least quarterly and our board of
directors will receive an investment report at each quarter-end in conjunction
with its review of our quarterly results. Our board of directors will
also review our portfolio and related compliance with our policies and
procedures and asset guidelines at each regularly scheduled board of directors
meeting.
Our board
of directors and our Manager’s Investment Committee have adopted the following
asset guidelines for our assets:
·
|
No
investment shall be made that would cause us to fail to qualify as a REIT
for U.S. federal income tax
purposes;
|
·
|
No
investment shall be made that would cause us to be regulated as an
investment company under the 1940
Act;
|
·
|
Any
assets we purchase will be in our targeted assets;
and
|
·
|
Until
appropriate assets can be identified, our Manager may deploy the proceeds
of this and any future offerings in interest-bearing, short-term
investments, including money market accounts and/or funds, that are
consistent with our intention to qualify as a
REIT.
|
These
asset guidelines may be changed by a majority of our board of directors without
the approval of our stockholders.
Our board
of directors has also adopted a separate set of asset guidelines and procedures
to govern our relationships with FIDAC. We have also adopted detailed
compliance policies to govern our interaction with FIDAC, including when FIDAC
is in receipt of material nonpublic information.
Our
Financing Strategy
To the
extent available, we have financed and may seek to finance our CMBS portfolio
with non-recourse financings under the Term Asset-Backed Securities Loan
Facility, or TALF, and based on market conditions we intend to utilize
structural leverage through securitizations of CMBS. With regard to leverage
available under the TALF, the maximum level of allowable leverage under
currently announced CMBS programs is 6.7:1. If we are unable to obtain financing
through U.S. Government programs and unable to invest in the asset classes
expected to be financed through these programs, then we will consider using
other non-recourse or recourse financing sources, invest in these assets on an
unlevered basis or not invest in these asset classes. With regard to
securitizations, the leverage will depend on the market conditions for
structuring such transactions. We will seek to finance the
acquisition of Agency RMBS using repurchase agreements with counterparties,
which are recourse obligations. We anticipate that leverage for
Agency RMBS would be available to us, which would provide for a debt-to-equity
ratio in the range of 2:1 to 4:1 but would likely not exceed
6:1. Based on current market conditions, we expect to operate within
the leverage levels described above in the near and long term. We are
not required to maintain any specific debt-to-equity ratio, as we believe the
level of leverage will vary based on the particular asset class, the
characteristics of the portfolio and market conditions. We can
provide no assurance that we will be able to obtain financing as described
herein.
6
The
Term Asset-Backed Securities Loan Facility (TALF)
In
response to the severe dislocation in the credit markets, the U.S. Treasury and
the Federal Reserve jointly announced the establishment of the TALF on November
25, 2008. The TALF is designed to increase credit availability and
support economic activity by facilitating renewed securitization
activities.
Credit
extensions under the TALF are non-recourse as between the borrower and the
Federal Reserve Bank of New York, or FRBNY, unless the borrower breaches certain
of its representations, warranties or covenants, and are exempt from margin
calls related to a decrease in the underlying collateral value. The loans are
pre-payable in whole or in part at the option of the borrower, subject to the
restrictions on permitted repayment dates set forth in the Master Loan and
Security Agreement and the satisfaction of certain conditions. Under
the TALF, as announced, the FRBNY will lend to each borrower an amount equal to
the lesser of the par or market value of the pledged collateral minus a
“haircut,” which varies based on the type and expected life of the collateral,
except that the loan amount of each legacy CMBS will be the lesser of the dollar
purchase price on the applicable trade date or the market price on the
subscription date of the CMBS less, in either case, the applicable haircut (from
par). Unless otherwise provided in the Master Loan and Security
Agreement that a primary dealer must enter into with the FRBNY as part of its
relationship with a TALF borrower, any remittance of principal on eligible
collateral must be used immediately to reduce the principal amount of the loan
in proportion to the loan’s haircut. However, if certain events of
default, credit support depletion events or early amortization events occur and
are continuing as of any determination date with respect to the collateral, all
interest and principal received from such collateral will be applied on the
related payment date to repay the TALF loan before any amounts are distributed
to the borrower. In addition, except for legacy CMBS, if the pledged collateral
is priced at a premium to par, the borrower will make an additional principal
payment calculated to adjust for the average reversion of market value toward
par value as the collateral matures. Further, for five-year TALF
loans, the excess of collateral interest distributions over the TALF loan
interest payable will be remitted to the borrower only until such excess equals
25% per annum of the haircut amount in the first three loan years, 10% in the
fourth loan year, and 5% in the fifth loan year, and the remainder of such
excess will be applied to TALF loan principal. For three-year TALF
loans related to legacy CMBS, such excess distributions will be remitted to the
borrower only until it equals 30% of the original haircut amount in any loan
year, and the remainder of such excess will be applied to TALF loan
principal.
The TALF
is expected to run through June 30, 2010, for newly issued CMBS, and through
March 31, 2010, for Legacy CMBS, but either date may be extended by the
FRBNY. To be considered eligible collateral under the TALF, both
newly issued CMBS and legacy CMBS must have at least two AAA ratings from DBRS,
Inc., Fitch Ratings, Moody’s Investors Service, Realpoint LLC or Standard &
Poor’s and must not have a rating below AAA from any of these rating agencies or
be under watch or review for a downgrade (unless, in the case of legacy CMBS,
such watch or review occurs after the subscription date for a loan with regard
to such CMBS). As many legacy CMBS have had their ratings downgraded
and at least one rating agency, S&P, has announced that further downgrades
are likely in the future, these downgrades may significantly reduce the quantity
of legacy CMBS available.
Even if
newly issued or legacy CMBS meets all the criteria for eligibility under the
TALF, the FRBNY may, in its sole discretion, reject the CMBS as collateral based
on its own risk assessment. There can be no assurance, however, that
we will be able to utilize CMBS financing under the TALF successfully or at
all. If we are not able to obtain financing through the TALF, we will
continue to invest in commercial mortgage loans and CMBS.
The
Public-Private Investment Program (PPIP)
On March
23, 2009, the U.S. Treasury, in conjunction with the FDIC and the Federal
Reserve, announced the establishment of the Public-Private Investment Program,
or PPIP. The PPIP is designed to encourage the transfer of certain
illiquid legacy real estate-related assets off of the balance sheets of
financial institutions, restarting the market for these assets and supporting
the flow of credit and other capital into the broader economy. The
PPIP as announced has two primary components: the Legacy Securities Program and
the Legacy Loans Program. Under the Legacy Securities Program, Legacy
Securities PPIFs are to be established to purchase from financial institutions
certain non-Agency RMBS and CMBS that were originally rated in the highest
rating category by one or more of the nationally recognized statistical rating
agencies. Under the Legacy Loans Program, Legacy Loan PPIFs are to be
established to purchase troubled loans (including residential and commercial
mortgage loans) from insured depository institutions. To the extent
available to us, we may participate as an equity investor in one or more Legacy
Loan or Legacy Securities PPIFs.
7
Securitizations
We intend
to seek to enhance the returns on our commercial mortgage loan investments,
especially loan acquisitions, through securitizations. If available, we intend
to securitize the senior portion, expected to be equivalent to AAA-rated CMBS,
while retaining the subordinate securities in our portfolio.
Other
Sources of Financing
We expect
to use repurchase agreements to finance acquisitions of Agency RMBS with a
number of counterparties. In the future, we may also use other sources of
financing to fund the acquisition of our targeted assets, including warehouse
facilities and other secured and unsecured forms of borrowing. We may also seek
to raise further equity capital or issue debt securities in order to fund our
future asset acquisitions.
Our
Interest Rate Hedging and Risk Management Strategy
Subject
to maintaining our qualification as a REIT, we may, from time to time, utilize
derivative financial instruments to hedge all or a portion of the interest rate
risk associated with our investments.
We intend
to engage in a variety of interest rate management techniques that seek to
mitigate changes in interest rates or other potential influences on the values
of our assets. The U.S. federal income tax rules applicable to REITs
may require us to implement certain of these techniques through a domestic
Taxable REIT Subsidiary, or TRS, that is fully subject to corporate income
taxation. Our interest rate management techniques may
include:
·
|
puts
and calls on securities or indices of
securities;
|
·
|
Eurodollar
futures contracts and options on such
contracts;
|
·
|
interest
rate caps, swaps and swaptions;
|
·
|
U.S.
treasury securities and options on U.S. treasury securities;
and
|
·
|
other
similar transactions.
|
We expect
to attempt to reduce interest rate risks and to minimize exposure to interest
rate fluctuations through the use of match funded financing structures, when
appropriate, whereby we seek (i) to match the maturities of our debt obligations
with the maturities of our assets and (ii) to match the interest rates on our
investments with like-kind debt (i.e., floating rate assets are financed with
floating rate debt and fixed-rate assets are financed with fixed-rate debt),
directly or through the use of interest rate swaps, caps or other financial
instruments, or through a combination of these strategies. We expect
this to allow us to minimize the risk that we have to refinance our liabilities
before the maturities of our assets and to reduce the impact of changing
interest rates on our earnings.
Compliance
with REIT and Investment Company Requirements
We
monitor our investments and the income from our investments and, to the extent
we enter into hedging transactions, we monitor income from our hedging
transactions as well, so as to ensure at all times that we maintain our qualification
as a REIT and our exempt status under the 1940 Act.
Staffing
We are
externally managed and advised by our Manager pursuant to a management
agreement. We have no employees other than our officers, each of whom is
also an employee of our Manager or one of its affiliates. Our Manager is
not obligated to dedicate certain of its employees exclusively to us, nor is it
or its employees obligated to dedicate any specific portion of its time to our
business. Our Manager uses the proceeds from its management fee in part to
pay compensation to its officers and employees who, notwithstanding that certain
of them also are our officers, receive no cash compensation directly from
us.
8
Management
Agreement
We have
entered into a management agreement with FIDAC, which provides for an initial
term through December 31, 2013, with automatic one-year extension options and
subject to certain termination rights. Under the management agreement, we are
obligated to pay FIDAC a management fee quarterly in arrears in an amount equal
to 0.50% per annum until September 23, 2010, 1.00% per annum from September 23,
2010 through March 22, 2011, and 1.50% per annum after March 22, 2011,
calculated quarterly, of our stockholders’ equity. For purposes of calculating
the management fee, our stockholders’ equity means the sum of the net proceeds
from any issuances of our equity securities since inception (allocated on a pro
rata daily basis for such issuances during the fiscal quarter of any such
issuance), plus our retained earnings at the end of such quarter (without taking
into account any non-cash equity compensation expense incurred in current or
prior periods), less any amount that we pay for repurchases of our common stock,
and less any unrealized gains, losses or other items that do not affect realized
net income (regardless of whether such items are included in other comprehensive
income or loss, or in net income). This amount will be adjusted to exclude
one-time events pursuant to changes in GAAP and certain non-cash charges after
discussions between FIDAC and our independent directors and approved by a
majority of our independent directors. The management fee will be reduced, but
not below zero, by our proportionate share of any management fees FIDAC receives
from any investment vehicle in which we invest, based on the percentage of
equity we hold in such vehicle.
We are obligated to reimburse FIDAC for
its costs incurred under the management agreement. In addition, we
are required to pay our pro rata portion of rent, telephone, utilities, office
furniture, equipment, machinery and other office, internal and overhead expenses
of FIDAC required for our operations. These expenses will be
allocated between FIDAC and us based on the ratio of our proportion of gross
assets compared to all remaining gross assets managed by FIDAC as calculated at
each quarter end. We and FIDAC will modify this allocation
methodology, subject to our board of directors’ approval if the allocation
becomes inequitable (i.e., if we become very highly leveraged compared to
FIDAC’s other funds and accounts). FIDAC has waived its right to
request reimbursement from us of these expenses until such time as it determines
to rescind that waiver.
For the
period beginning September 22, 2009 to December 31, 2009, our Manager
earned management fees of $354,000 and received expense reimbursement of
$300,000. Currently, our Manager has waived its right to require us to pay
our pro rata portion of rent, telephone, utilities, office furniture, equipment,
machinery and other office, internal and overhead expenses of our Manager and
its affiliates required for our operations.
Competition
A number
of entities will compete with us to purchase the types of assets we plan to
acquire. Our net income will depend, in large part, on our ability to
acquire assets at favorable spreads. In acquiring real estate-related assets, we
will compete with other REITs, public and private funds, including PPIFs,
commercial and investment banks, commercial finance companies and other
entities. In addition, there are numerous mortgage REITs with similar
asset acquisition objectives, including a number that have been recently formed,
and others may be organized in the future. These other REITs will increase
competition for the available supply of real estate-related assets suitable for
purchase. Many of our anticipated competitors are substantially larger than we
are, have considerably greater financial, technical, marketing and other
resources and may have other advantages over us. Several other REITs have
recently raised, or are expected to raise, significant amounts of capital, and
may have objectives that overlap with ours, which may create competition for
asset acquisition opportunities. Some competitors may have a lower
cost of funds and access to funding sources that are not available to
us. In addition, some of our competitors may have higher risk
tolerances or different risk assessments, which could allow them to consider a
wider variety of investments and establish more relationships than
us.
In the
face of this competition, we expect to have access to our Manager’s and MOSA
counterparties’, including Principal, professionals and their industry
expertise, which may provide us with a competitive advantage and help us assess
investment risks and determine appropriate pricing for certain potential
investments. We expect that these relationships will enable us to compete more
effectively for attractive investment opportunities. In addition, we believe
that current market conditions may have adversely affected the financial
condition of certain competitors. Thus, not having a legacy portfolio
may also enable us to compete more effectively for attractive investment
opportunities. However, we may not be able to achieve our business goals or
expectations due to the competitive risks that we face. For additional
information concerning these competitive risks, see “Risk Factors—Risks Related
To Our Business.”
9
Available
Information
Our
investor relations website is www.crexusinvestment.com.
We make available on the website under "Financial Information/SEC filings," free
of charge, our annual report on Form 10-K and any other reports as soon as
reasonably practicable after we electronically file or furnish such materials to
the SEC. Information on our website, however, is not part of this Annual Report
on Form 10-K. All reports filed with the Securities and Exchange
Commission may also be read and copied at the SEC’s public reference room at 100
F Street, N.E., Washington, D.C. 20549. Further information regarding the
operation of the public reference room may be obtained by calling
1-800-SEC-0330. In addition, all of our filed reports can be obtained at
the SEC’s website at www.sec.gov.
An
investment in our stock involves a number of risks. Before making an
investment decision, you should carefully consider all of the risks described in
this Form 10-K. If any of the risks discussed in this Form 10-K
actually occur, our business, financial condition and results of operations
could be materially adversely affected. If this were to occur, the
trading price of our stock could decline significantly and you may lose all or
part of your investment.
If any of
the following risks occur, our business, financial condition or results of
operations could be materially and adversely affected. In that case, the trading
price of our common stock could decline, and stockholders may lose some or all
of their investment.
Risks
Associated With Our Management and Relationship With Our Manager
We
are dependent on our Manager and its key personnel, and we may not find a
suitable replacement if any of them becomes unavailable to us.
We have
no separate facilities and are completely reliant on our Manager. We
have no employees. Our officers are also employees of our Manager,
who has significant discretion as to the implementation of our asset and
operating policies and strategies. Accordingly, we depend on the
diligence, skill and network of business contacts of the senior management of
our Manager. The senior management of our Manager evaluates,
negotiates, structures, closes and monitors our assets; therefore, our success
depends on their continued service. The departure of any of the
senior managers of our Manager or our MOSA counterparties could have a material
adverse effect on our performance. In addition, we can offer no
assurance that our Manager will remain our manager or that we will continue to
have access to our Manager’s principals and professionals. Our
management agreement with our Manager only extends until December 31,
2013. If the management agreement is terminated and no suitable
replacement is found to manage us, we may not be able to execute our business
plan. Moreover, our Manager is not obligated to dedicate certain of
its employees exclusively to us nor is it obligated to dedicate any specific
portion of its time to our business, and none of our Manager’s employees are
contractually dedicated to us under our management agreement with our
Manager. Each of Kevin Riordan, our Chief Executive Officer,
President and Director, Jeffrey Conti, our Head of Commercial Underwriting, and
Robert Karner, our Head of Investments, currently devotes all of their time to
our business, and Daniel Wickey, our Chief Financial Officer, currently devotes
a substantial portion of his time to our business.
We
are dependent on third parties and their key personnel for our success, and we
may not find a suitable replacement if any of them becomes unavailable to
us.
We rely
on third parties. To facilitate our acquisition of commercial real
estate loans, we have entered into a MOSA and expect to enter into additional
MOSAs with third parties to originate, underwrite, conduct due diligence, close
and service commercial real estate loans. The departure of any of the
key personnel of our MOSA counterparties could have a material adverse effect on
our performance. In addition, we can offer no assurance that we will
be able to enter into additional MOSAs with suitable counterparties or maintain
commercial relationships with our MOSA counterparties. Furthermore,
none of our third parties will be obligated to dedicate any specific portion of
their time to our business. If any of our MOSAs is terminated and no
suitable replacement is found to provide us with similar services, we may not be
able to successfully execute our business plan.
10
There
are conflicts of interest in our relationships with third parties, which could
hinder our ability to successfully execute our business plan.
There are
also potential conflicts of interest that could arise out of our relationships
with certain third parties, with which we will enter into MOSAs. Our
MOSA counterparties may manage assets for themselves or other clients that
participate in some or all of our targeted asset classes, and therefore our MOSA
counterparties may compete directly with us for opportunities or may have other
clients that do so. As a result, we may compete with our MOSA
counterparties or their other clients for opportunities and, as a result, we may
either not be presented with certain opportunities or have to compete with such
other clients to acquire these assets. Further, at times when there
are turbulent conditions in the mortgage markets or distress in the credit
markets or other times when we will need focused support from our MOSA
counterparties, other clients of our MOSA counterparties will likewise require
greater focus and attention, placing our MOSA counterparties’ resources in high
demand. Employees of such MOSA counterparties may have conflicts
between their duties to us through our Manager and their employer. It
is not expected that our MOSA counterparties will be required to devote a
specific amount of time to our operations. In such situations, we may
not receive the level of support and assistance that we may need to successfully
execute our business plan.
There
are conflicts of interest in our relationship with our Manager and Annaly, which
could result in decisions that are not in the best interest of our
stockholders.
We are
subject to potential conflicts of interest arising out of our relationship with
Annaly and our Manager. An Annaly executive officer is our Manager’s
sole director; two of Annaly’s employees are our directors; and several of
Annaly’s employees are officers of our Manager and us. Specifically,
each of our officers also serves as an employee of our Manager or
Annaly. As a result, our Manager and our executives may have
conflicts between their duties to us and their duties to, and interests in,
Annaly or our Manager. There may also be conflicts in allocating
assets which are suitable both for us and Annaly as well as other FIDAC managed
funds. Annaly may compete with us with respect to certain assets
which we may want to acquire, and as a result, we may either not be presented
with the opportunity or have to compete with Annaly or other FIDAC-managed funds
to acquire these assets. Our Manager and our executive officers may
choose to allocate favorable assets to Annaly or other FIDAC-managed funds
instead of to us. The ability of our Manager and its officers and
employees to engage in other business activities may reduce the time our Manager
spends managing us. Further, during turbulent conditions in the
mortgage industry, distress in the credit markets or other times when we will
need focused support and assistance from our Manager, other entities for which
our Manager also acts as a manager will likewise require greater focus and
attention, placing our Manager’s resources in high demand. In such
situations, we may not receive the necessary support and assistance we require
or would otherwise receive if we were internally managed or if our Manager did
not act as a manager for other entities. There is no assurance that
the allocation policy that addresses some of the conflicts relating to our
assets, will be adequate to address all of the conflicts that may
arise.
Annaly
and our executive officers and directors as a group own approximately 25% and
0.3%, respectively, of our common stock, which entitles them to receive
quarterly distributions based on financial performance. In evaluating
assets and other management strategies, this may lead our Manager to place
emphasis on the maximization of revenues at the expense of other criteria, such
as preservation of capital. Assets with higher yield potential are
generally riskier or more speculative. This could result in increased
risk to the value of our portfolio. Annaly and each our Manager’s
officers and employees who is an existing stockholder may sell shares in us at
any time following the lock-up period. The lock-up period expires on
the earlier of (i) September 16, 2012 or (ii) the termination of the management
agreement. To the extent Annaly or our Manager’s officers and
employees sell some of their shares, their interests may be less aligned with
our interests.
Our
Manager has limited management experience with CMBS, commercial real estate
loans and securities or other commercial real estate assets, and there can be no
assurance that our Manager will be able to replicate its historical
performance.
11
Our
Manager has limited management experience with CMBS, commercial real estate
loans and securities or other commercial real estate assets, which we may pursue
as part of our strategy. Our targeted asset classes are different
from that of other entities that are or have been managed by our
Manager. In particular, entities managed by our Manager have not
purchased commercial mortgage loans or structured commercial loan
securitizations. Accordingly, our Manager’s historical returns will
not be indicative of its performance for our strategy, and we can offer no
assurance that our Manager will replicate the historical performance of the
Manager’s professionals in their previous endeavors. Our returns
could be substantially lower than the returns achieved by our Manager’s
professionals’ previous endeavors.
Our
Manager’s management fee is payable regardless of our performance, which may
reduce our Manager’s incentive to devote its time and effort to seeking
attractive assets for our portfolio.
We will
pay our Manager a management fee regardless of our performance, which may reduce
our Manager’s incentive to devote its time and effort to seeking assets that
provide attractive risk-adjusted returns for our portfolio. This in
turn could hurt both our ability to make distributions to our stockholders and
the market price of our common stock. In addition, in calculating the
management fee, unrealized gains and losses are excluded, which could
incentivize our manager to sell appreciated assets and keep non-performing
assets, even though it may not be in our best interest to do so.
The
management agreement with our Manager was not negotiated on an arm’s-length
basis and may not be as favorable to us as if it had been negotiated with an
unaffiliated third party and may be costly and difficult to
terminate.
Our Chief
Executive Officer, President, Chief Financial Officer, Head of Commercial
Underwriting, Head of Investments, Treasurer, Controller and Secretary also
serve as employees of our Manager. In addition, certain of our
directors are employees of our Manager. Our management agreement with
our Manager was negotiated between related parties, and its terms, including
fees payable, may not be as favorable to us as if it had been negotiated with an
unaffiliated third party.
Termination
of the management agreement with our Manager without cause is difficult and
costly. Our independent directors will review our Manager’s
performance and the management fees annually. During the initial
three-year term of the management agreement, we may not terminate the management
agreement except for cause. Following the initial term, the
management agreement may be terminated annually by us without cause upon the
affirmative vote of at least two-thirds of our independent directors, or by a
vote of the holders of at least a majority of the outstanding shares of our
common stock (other than those shares held by Annaly or its affiliates), based
upon: (i) our Manager’s unsatisfactory performance that is materially
detrimental to us, or (ii) a determination that the management fees payable to
our Manager are not fair, subject to our Manager’s right to prevent termination
based on unfair fees by accepting a reduction of management fees agreed to by at
least two-thirds of our independent directors. Our Manager will be
provided 180-days’ prior notice of any such
termination. Additionally, upon such termination, the management
agreement provides that we will pay our Manager a termination fee equal to three
times the average annual management fee (or if the period is less than 24 months
annualized) earned by our Manager during the prior 24-month period before such
termination, calculated as of the end of the most recently completed fiscal
quarter. These provisions may adversely affect our ability to
terminate our Manager without cause.
Our
Manager is only contractually committed to serve us until December 31,
2013. Thereafter, the management agreement is renewable on an annual
basis; provided, however, that our Manager may terminate the management
agreement annually upon 180-days’ prior notice. If the management
agreement is terminated and no suitable replacement is found to manage us, we
may not be able to execute our business plan.
Our
board of directors has approved very broad asset guidelines for our Manager and
will not approve each decision made by our Manager.
Our
Manager is authorized to follow very broad asset guidelines. Our
board of directors reviews our asset guidelines and our portfolio at least
quarterly, but will not, and will not be required to, review all of our proposed
asset acquisitions or any type or category of asset, except that an asset in a
security structured or managed by our Manager must be approved by a majority of
our independent directors. In addition, in conducting periodic
reviews, our board of directors may rely primarily on information provided to
them by our Manager. Furthermore, our Manager may use complex
strategies, and transactions entered into by our Manager may be costly,
difficult or impossible to unwind by the time they are reviewed by our board of
directors. Our Manager will have great latitude within broad asset
guidelines in determining the types of assets it may decide are proper for us,
which could result in returns that are substantially below expectations or that
result in losses, which would materially and adversely affect our business
operations and results. Furthermore, decisions made by our Manager
may not be in your best interest.
12
We
may change our strategy or asset guidelines, asset allocation, financing
strategy or leverage policies without stockholder consent, which may result in
riskier asset purchases.
We may
change our strategy or asset guidelines, asset allocation, financing strategy or
leverage policies at any time without the consent of our stockholders, which
could result in our purchasing assets that are different from, and possibly
riskier than, the assets described in this annual report. A change in
our strategy may increase our exposure to default risk, real estate market
fluctuations and interest rate risk. These changes could adversely
affect the market price of our common stock and our ability to make
distributions to our stockholders.
Our
Manager has an incentive to deploy our funds in investment vehicles managed by
our Manager, which may reduce other opportunities available to us.
While
purchasing interests in investment vehicles managed by our Manager requires
approval by a majority of our independent directors, our Manager has an
incentive to deploy our funds in investment vehicles managed by our
Manager. In addition, we cannot assure you that purchasing interests
in investment vehicles managed by our Manager will prove beneficial to
us.
We
compete with investment vehicles of our Manager for access to our Manager’s
resources and asset acquisition opportunities.
Our
Manager provides investment and financial advice to a number of investment
vehicles and some of our Manager’s personnel are also employees of Annaly and in
that capacity are involved in Annaly’s asset acquisition
process. Accordingly, we will compete with our Manager’s other
investment vehicles and with Annaly for our Manager’s resources and asset
acquisition opportunities. In the future, our Manager may sponsor and
manage other investment vehicles with a focus that overlaps with ours, which
could result in us competing for access to the benefits that we expect our
relationship with our Manager to provide to us.
Risks
Related To Our Assets
A
prolonged economic slowdown or continued declining real estate values could
impair our assets and harm our operating results.
Many of
our assets may be susceptible to economic slowdowns or recessions, which could
lead to financial losses in our assets and a decrease in revenues, net income
and asset values. Unfavorable economic conditions also could increase
our funding costs, limit our access to the capital markets or result in a
decision by lenders not to extend credit to us. These events could
result in significant diminution in the value of our assets, prevent us from
increasing our assets and have an adverse effect on our operating
results.
Difficult
conditions in the mortgage and commercial real estate markets may cause us to
experience market losses related to our holdings, and we do not expect these
conditions to improve in the near future.
Our
results of operations are materially affected by conditions in the mortgage and
commercial real estate markets, the financial markets and the economy
generally. Continuing concerns about the declining real estate
market, as well as inflation, energy costs, geopolitical issues and the
availability and cost of credit, have contributed to increased volatility and
diminished expectations for the economy and markets going
forward. The mortgage market has been severely affected by changes in
the lending landscape and there is no assurance that these conditions have
stabilized or that they will not worsen. The disruption in the
mortgage market has an impact on new demand for homes, which will compress the
home ownership rates and weigh heavily on future home price performance. There
is a strong correlation between home price growth rates and mortgage loan
delinquencies. In addition, the commercial mortgage market has also
begun to come under significant pressure, which has dramatically impacted the
valuation of CMBS and commercial loans. The further deterioration of
the real estate market after we deploy the proceeds from this offering may cause
us to experience losses related to our assets and we could sell assets at a
loss. Declines in the market values of our assets may adversely
affect our results of operations and credit availability, which may reduce
earnings and, in turn, cash available for distribution to our
stockholders.
13
In
addition, declines in the real estate markets, including falling home prices and
increasing foreclosures and unemployment, have resulted in significant asset
write-downs by financial institutions, which have caused many financial
institutions to seek additional capital, to merge with other institutions and,
in some cases, to fail. We may rely on the availability of financing to acquire
real estate-related securities and commercial mortgage loans on a levered basis.
Institutions from which we will seek to obtain financing may have owned or
financed real estate-related securities and commercial real estate loans, which
have declined in value and caused them to suffer losses as a result of the
downturn in the real estate markets. Many lenders and institutional investors
have reduced and, in some cases, ceased to provide funding to borrowers,
including other financial institutions. If these conditions persist, these
institutions may become insolvent or tighten their lending standards, which
could make it more difficult for us to obtain financing on favorable terms or at
all. Our profitability may be adversely affected if we are unable to obtain
cost-effective financing for our assets.
Continued
adverse developments in the broader residential and commercial mortgage market
may adversely affect the value of the assets in which we invest.
In 2008,
2009 and so far in 2010, the residential and commercial mortgage market in the
United States has experienced a variety of difficulties and changed economic
conditions, including defaults, credit losses and liquidity
concerns. Certain commercial banks, investment banks and insurance
companies have announced extensive losses from exposure to the residential and
commercial mortgage market. These losses have reduced financial
industry capital, leading to reduced liquidity for some
institutions. These factors have impacted investor perception of the
risk associated with CMBS and commercial mortgage loans which we may
acquire. As a result, values for CMBS and commercial mortgage loans
in which we intend to invest have experienced volatility. Further
increased volatility and deterioration in the broader residential and commercial
mortgage and MBS markets may adversely affect the performance and market value
of our assets.
Any
decline in the value of our assets, or perceived market uncertainty about their
value, would likely continue to make it difficult for us to obtain financing on
favorable terms or at all, or maintain our compliance with terms of any
financing arrangements already in place. The CMBS in which we invest
is classified for accounting purposes as available-for-sale. All
assets classified as available-for-sale will be reported at fair value with
unrealized gains and losses excluded from earnings and reported as a separate
component of stockholders’ equity. As a result, a decline in fair
values may reduce the book value of our assets. Moreover, if the
decline in fair value of an available-for-sale security is
other-than-temporarily impaired, such decline will reduce
earnings. If market conditions result in a decline in the fair value
of our CMBS, our financial position and results of operations could be adversely
affected.
The
commercial mortgage loans we expect to acquire and the mortgage loans underlying
our CMBS assets will depend on the ability of the commercial property owner to
generate net income from operating the property. Failure to do so may
result in delinquency and/or foreclosure.
Commercial
mortgage loans are secured by multifamily or commercial property and are subject
to risks of delinquency and foreclosure, and risks of loss that may be greater
than similar risks associated with loans made on the security of single-family
residential property. The ability of a borrower to repay a loan secured by an
income-producing property typically is dependent primarily upon the successful
operation of such property rather than upon the existence of independent income
or assets of the borrower. If the net operating income of the property is
reduced, the borrower’s ability to repay the loan may be impaired. Net operating
income of an income-producing property can be adversely affected by, among other
things,
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tenant
mix;
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success
of tenant businesses;
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property
management decisions;
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·
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property
location, condition and design;
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14
·
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competition
from comparable types of
properties;
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·
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changes
in laws that increase operating expenses or limit rents that may be
charged;
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·
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changes
in national, regional or local economic conditions or specific industry
segments, including the credit and securitization
markets;
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·
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declines
in regional or local real estate
values;
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·
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declines
in regional or local rental or occupancy
rates;
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·
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increases
in interest rates, real estate tax rates and other operating
expenses;
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·
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costs
of remediation and liabilities associated with environmental
conditions;
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·
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the
potential for uninsured or underinsured property
losses;
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·
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changes
in governmental laws and regulations, including fiscal policies, zoning
ordinances and environmental legislation and the related costs of
compliance; and
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·
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acts
of God, terrorist attacks, social unrest and civil
disturbances.
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In the
event of any default under a mortgage loan held directly by us, we will bear a
risk of loss of principal to the extent of any deficiency between the value of
the collateral and the principal and accrued interest of the mortgage loan,
which could have a material adverse effect on our cash flow from operations and
limit amounts available for distribution to our stockholders. In the
event of the bankruptcy of a mortgage loan borrower, the mortgage loan to such
borrower will be deemed to be secured only to the extent of the value of the
underlying collateral at the time of bankruptcy (as determined by the bankruptcy
court), and the lien securing the mortgage loan will be subject to the avoidance
powers of the bankruptcy trustee or debtor-in-possession to the extent the lien
is unenforceable under state law. Foreclosure of a mortgage loan can
be an expensive and lengthy process, which could have a substantial negative
effect on our anticipated return on the foreclosed mortgage loan.
We
may not realize income or gains from our assets which could cause the value of
our common stock to decline.
We seek
to generate both current income and capital appreciation. The assets
we invest in may, however, not appreciate in value and, in fact, may decline in
value, and the loans and debt securities we purchase may default on interest or
principal payments. Accordingly, we may not be able to realize income
or gains from our assets. Any gains that we do realize may not be
sufficient to offset any other losses we experience. Any income that
we realize may not be sufficient to offset our expenses.
Because
assets we expect to acquire may experience periods of illiquidity, we may lose
profits or be prevented from earning capital gains if we cannot sell
mortgage-related assets at an opportune time.
We bear
the risk of being unable to dispose of our targeted assets at advantageous times
or in a timely manner because mortgage-related assets generally experience
periods of illiquidity, including the recent period of delinquencies and
defaults with respect to commercial mortgage loans. The lack of
liquidity may result from the absence of a willing buyer or an established
market for these assets, as well as legal or contractual restrictions on resale
or the unavailability of financing for these assets. As a result, our
ability to vary our portfolio in response to changes in economic and other
conditions may be relatively limited, which may cause us to incur
losses.
The lack of liquidity in our assets may
adversely affect our business.
The
illiquidity of our assets in real estate loans and CMBS, may make it difficult
for us to sell such assets if the need or desire arises. Many of the
securities we purchase are not be registered under the relevant securities laws,
resulting in a prohibition against their transfer, sale, pledge or their
disposition except in a transaction that is exempt from the registration
requirements of, or otherwise in accordance with, those laws. In addition,
certain assets such as B Notes, mezzanine loans and bridge and other loans are
also particularly illiquid assets due to their short life, their potential
unsuitability for securitization and the greater difficulty of recovery in the
event of a borrower’s default. Moreover, turbulent market conditions,
such as those recently in effect, could significantly and negatively impact the
liquidity of our assets. It may be difficult or impossible to obtain third party
pricing on the assets we purchase. Illiquid assets typically experience greater
price volatility, as a ready market does not exist, and can be more difficult to
value. In addition, validating third party pricing for illiquid
assets may be more subjective than more liquid assets. As a result,
we expect many of our assets will be illiquid and if we are required to
liquidate all or a portion of our portfolio quickly, we may realize
significantly less than the value at which we have previously recorded our
assets. Further, we may face other restrictions on our ability to
liquidate an asset in a business entity to the extent that we or our Manager has
or could be attributed with material, nonpublic information regarding such
business entity. As a result, our ability to vary our portfolio in
response to changes in economic and other conditions may be relatively limited,
which could adversely affect our results of operations and financial
condition.
15
Our
assets may be concentrated and will be subject to risk of default.
We are
not required to observe specific diversification criteria. To the
extent that our portfolio is concentrated in any one region or type of asset,
downturns relating generally to such region or type of asset may result in
defaults on a number of our assets within a short time period, which may reduce
our net income and the value of our shares and accordingly may reduce our
ability to pay dividends to our stockholders.
Our
CMBS assets are subject to losses.
We have
acquired and expect to continue to acquire CMBS. In general, losses on a
mortgaged property securing a mortgage loan included in a securitization will be
borne first by the equity holder of the property, then by a cash reserve fund or
letter of credit, if any, then by the holder of a mezzanine loan or B Note, if
any, then by the “first loss” subordinated security holder generally, the
“B-Piece” buyer, and then by the holder of a higher-rated
security. In the event of default and the exhaustion of any equity
support, reserve fund, letter of credit, mezzanine loans or B Notes, and any
classes of securities junior to those which we acquire, we will not be able to
recover all of our capital in the securities we purchase. In
addition, if the underlying mortgage portfolio has been overvalued by the
originator, or if the values subsequently decline and, as a result, less
collateral is available to satisfy interest and principal payments due on the
related mortgage-backed securities. The prices of lower credit
quality CMBS are generally less sensitive to interest rate changes than more
highly rated CMBS, but more sensitive to adverse economic downturns or
individual issuer developments. The projection of an economic
downturn, for example, could cause a decline in the price of lower credit
quality CMBS because the ability of obligors of mortgages underlying CMBS to
make principal and interest payments may be impaired. In such event, existing
credit support in the securitization structure may be insufficient to protect us
against loss of our principal on these securities.
We
may not control the special servicing of the mortgage loans included in the CMBS
in which we invest and, in such cases, the special servicer may take actions
that could adversely affect our interests.
With
respect to the CMBS in which we invest, overall control over the special
servicing of the related underlying mortgage loans will be held by a “directing
certificateholder” or a “controlling class representative,” which is appointed
by the holders of the most subordinate class of CMBS in such series (except in
the case of TALF-financed CMBS, where TALF rules prohibit control by investors
in a subordinate class once the principal balance of that class is reduced to
less than 25% of its initial principal balance as a result of both actual
realized losses and “appraisal reduction amounts”). To the extent
that we focus on acquiring classes of existing series of CMBS originally rated
AAA, we will not have the right to appoint the directing
certificateholder. In connection with the servicing of the specially
serviced mortgage loans, the related special servicer may, at the direction of
the directing certificateholder, take actions with respect to the specially
serviced mortgage loans that could adversely affect our interests.
If
our Manager overestimates the yields or incorrectly prices the risks of our
assets, we may experience losses.
Our
Manager values our potential assets based on yields and risks, taking into
account estimated future losses on the mortgage loans and the underlying
collateral included in the securitization’s pools, and the estimated impact of
these losses on expected future cash flows and returns. Our Manager’s
loss estimates may not prove accurate, as actual results may vary from
estimates. In the event that our Manager underestimates the asset level losses
relative to the price we pay for a particular asset, we may experience losses
with respect to such asset.
16
Purchases
of non-conforming and non-investment grade rated loans or securities involve
increased risk of loss.
It is
possible that some of the loans we acquire will not conform to conventional loan
standards applied by traditional lenders and either will not be rated or will be
rated as non-investment grade by the rating agencies. The
non-investment grade ratings for these assets typically result from the overall
leverage of the loans, the lack of a strong operating history for the properties
underlying the loans, the borrowers’ credit history, the properties’ underlying
cash flow or other factors. As a result, these loans will have a
higher risk of default and loss than investment grade rated assets. Any loss we
incur may be significant and may reduce distributions to our stockholders and
adversely affect the market value of our common shares. There are no
limits on the percentage of unrated or non-investment grade rated assets we may
hold in our portfolio.
Any
credit ratings assigned to our assets will be subject to ongoing evaluations and
revisions, and we cannot assure you that those ratings will not be
downgraded.
Some of
our assets may be rated by Moody’s Investors Service, Fitch Ratings, S&P,
DBRS, Inc. or Realpoint LLC. Any credit ratings on our assets are
subject to ongoing evaluation by credit rating agencies, and we cannot assure
you that any such ratings will not be changed or withdrawn by a rating agency in
the future if, in its judgment, circumstances warrant. If rating
agencies assign a lower-than-expected rating or reduce or withdraw, or indicate
that they may reduce or withdraw, their ratings of our assets in the future, the
value of these assets could significantly decline, which would adversely affect
the value of our portfolio and could result in losses upon disposition or the
failure of borrowers to satisfy their debt service obligations to
us. Further, if rating agencies reduce the ratings on assets that we
intended to finance through the TALF or put such assets on watch or review for a
downgrade, such assets (with limited exceptions) would no longer be eligible
collateral that could be financed through the TALF.
The
B Notes that we may acquire may be subject to additional risks related to the
privately negotiated structure and terms of the transaction, which may result in
losses to us.
We may
acquire B Notes. A B Note is a mortgage loan typically (1) secured by a first
mortgage on a single large commercial property or group of related properties
and (2) subordinated to an A Note secured by the same first mortgage on the same
collateral. As a result, if a borrower defaults, there may not be
sufficient funds remaining for B Note holders after payment to the A Note
holders. However, because each transaction is privately negotiated, B Notes can
vary in their structural characteristics and risks. For example, the rights of
holders of B Notes to control the process following a borrower default may vary
from transaction to transaction. Further, B Notes typically are
secured by a single property and so reflect the risks associated with
significant concentration. Significant losses related to our B Notes
would result in operating losses for us and may limit our ability to make
distributions to our stockholders.
Our
mezzanine loan assets will involve greater risks of loss than senior loans
secured by income-producing properties.
We have
acquired and may continue to acquire mezzanine loans, which take the form of
subordinated loans secured by second mortgages on the underlying property or
loans secured by a pledge of the ownership interests of either the entity owning
the property or a pledge of the ownership interests of the entity that owns the
interest in the entity owning the property. These types of assets
involve a higher degree of risk than long-term senior mortgage lending secured
by income-producing real property, because the loan may become unsecured as a
result of foreclosure by the senior lender. In the event of a bankruptcy of the
entity providing the pledge of its ownership interests as security, we may not
have full recourse to the assets of such entity, or the assets of the entity may
not be sufficient to satisfy our mezzanine loan. If a borrower
defaults on our mezzanine loan or debt senior to our loan, or in the event of a
borrower bankruptcy, our mezzanine loan will be satisfied only after the senior
debt. As a result, we may not recover some or all of our initial
expenditure. In addition, mezzanine loans may have higher
loan-to-value ratios than conventional mortgage loans, resulting in less equity
in the property and increasing the risk of loss of
principal. Significant losses related to our mezzanine loans would
result in operating losses for us and may limit our ability to make
distributions to our stockholders.
17
We
may be required to repurchase mortgage loans or indemnify investors if we breach
representations and warranties, which could harm our earnings.
When we
sell loans, we will be required to make customary representations and warranties
about such loans to the loan purchaser. Our commercial mortgage loan
sale agreements will require us to repurchase or substitute loans in the event
we breach a representation or warranty given to the loan
purchaser. In addition, we may be required to repurchase loans as a
result of borrower fraud or in the event of early payment default on a mortgage
loan. Likewise, we may be required to repurchase or substitute loans
if we breach a representation or warranty in connection with our
securitizations. The remedies available to a purchaser of mortgage
loans are generally broader than those available to us against the originating
broker or correspondent. Further, if a purchaser enforces its
remedies against us, we may not be able to enforce the remedies we have against
the sellers. The repurchased loans typically can only be financed at
a steep discount to their repurchase price, if at all. They are also
typically sold at a significant discount to the unpaid principal
balance. Significant repurchase activity could harm our cash flow,
results of operations, financial condition and business prospects.
Our
Manager’s and our third party loan originators and servicers’ due diligence of
potential assets may not reveal all of the liabilities associated with such
assets and may not reveal other weaknesses in such assets, which could lead to
losses.
Before
making an asset acquisition, our Manager will assess the strengths and
weaknesses of the originator or issuer of the asset as well as other factors and
characteristics that are material to the performance of the asset. In
making the assessment and otherwise conducting customary due diligence, our
Manager will rely on resources available to it, including our third party loan
originators and servicers. This process is particularly important
with respect to newly formed originators or issuers because there may be little
or no information publicly available about these entities and
assets. There can be no assurance that our Manager’s due diligence
process will uncover all relevant facts or that any asset acquisition will be
successful.
Our
real estate assets are subject to risks particular to real property, which may
adversely affect our returns from certain assets and our ability to make
distributions to our stockholders.
We own
assets secured by real estate and may own real estate directly in the future,
either through direct purchases or upon a default of mortgage
loans. Real estate assets are subject to various risks,
including:
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acts
of God, including earthquakes, floods and other natural disasters, which
may result in uninsured losses;
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·
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acts
of war or terrorism, including the consequences of terrorist attacks, such
as those that occurred on September 11,
2001;
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·
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adverse
changes in national and local economic and market
conditions;
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·
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changes
in governmental laws and regulations, fiscal policies and zoning
ordinances and the related costs of compliance with laws and regulations,
fiscal policies and ordinances;
|
·
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costs
of remediation and liabilities associated with environmental conditions
such as indoor mold; and
|
·
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the
potential for uninsured or under-insured property
losses.
|
If any of
these or similar events occurs, it may reduce our return from an affected
property or investment and reduce or eliminate our ability to make distributions
to stockholders.
Construction
loans involve an increased risk of loss.
We may
acquire construction loans. If we fail to fund our entire commitment
on a construction loan or if a borrower otherwise fails to complete the
construction of a project, there could be adverse consequences associated with
the loan, including: a loss of the value of the property securing the loan,
especially if the borrower is unable to raise funds to complete it from other
sources; a borrower claim against us for failure to perform under the loan
documents; increased costs to the borrower that the borrower is unable to pay; a
bankruptcy filing by the borrower; and abandonment by the borrower of the
collateral for the loan.
18
Risks of
cost overruns and noncompletion of renovation of the properties underlying
rehabilitation loans may result in significant losses. The
renovation, refurbishment or expansion by a borrower under a mortgaged property
involves risks of cost overruns and noncompletion. Estimates of the costs of
improvements to bring an acquired property up to standards established for the
market position intended for that property may prove
inaccurate. Other risks may include rehabilitation costs exceeding
original estimates, possibly making a project uneconomical, environmental risks
and rehabilitation and subsequent leasing of the property not being completed on
schedule. If such renovation is not completed in a timely manner, or
if it costs more than expected, the borrower may experience a prolonged
impairment of net operating income and may not be able to make payments on our
investment, which could result in significant losses.
Our
Manager uses analytical models and data in connection with the valuation of our
assets, and any incorrect, misleading or incomplete information used in
connection therewith would subject us to potential risks.
Given the
complexity of our assets and strategies, our Manager must rely heavily on
analytical models (both proprietary models developed by our Manager and those
supplied by third parties) and information and data supplied by our third party
loan originators and servicers, or models and data. Models and data
are used to value assets or potential asset purchases and also in connection
with hedging our assets. When models and data prove to be incorrect,
misleading or incomplete, any decisions made in reliance thereon expose us to
potential risks. For example, by relying on models and data, especially
valuation models, our Manager may be induced to buy certain assets at prices
that are too high, to sell certain other assets at prices that are too low or to
miss favorable opportunities altogether. Similarly, any hedging based
on faulty models and data may prove to be unsuccessful. Furthermore,
any valuations of our assets that are based on valuation models may prove to be
incorrect.
Some of
the risks of relying on analytical models and third-party data are particular to
analyzing tranches from securitizations, such as MBS. These risks include, but
are not limited to, the following: (i) collateral cash flows and/or liability
structures may be incorrectly modeled in all or only certain scenarios, or may
be modeled based on simplifying assumptions that lead to errors; (ii)
information about collateral may be incorrect, incomplete, or misleading; (iii)
collateral or bond historical performance (such as historical prepayments,
defaults, cash flows, etc.) may be incorrectly reported, or subject to
interpretation (e.g., different issuers may report delinquency statistics based
on different definitions of what constitutes a delinquent loan); or (iv)
collateral or bond information may be outdated, in which case the models may
contain incorrect assumptions as to what has occurred since the date information
was last updated.
Some of
the analytical models used by our Manager, such as mortgage prepayment models or
mortgage default models, are predictive in nature. The use of
predictive models has inherent risks. For example, such models may
incorrectly forecast future behavior, leading to potential losses on a cash flow
and/or a mark-to-market basis. In addition, the predictive models used by our
Manager may differ substantially from those models used by other market
participants, with the result that valuations based on these predictive models
may be substantially higher or lower for certain assets than actual market
prices. Furthermore, since predictive models are usually constructed
based on historical data supplied by third parties, the success of relying on
such models may depend heavily on the accuracy and reliability of the supplied
historical data and the ability of these historical models to accurately reflect
future periods.
All
valuation models rely on correct market data inputs. If incorrect market data is
entered into even a well-founded valuation model, the resulting valuations will
be incorrect. However, even if market data is inputted correctly, “model prices”
will often differ substantially from market prices, especially for securities
with complex characteristics, such as derivative securities.
Interest
rate mismatches between our assets and our borrowings used to fund our purchases
of these assets may reduce our income during periods of changing interest
rates.
We intend
to fund some of our acquisitions of commercial real estate loans and real
estate-related securities with borrowings that have interest rates based on
indices and repricing terms with shorter maturities than the interest rate
indices and repricing terms of our adjustable-rate assets. Accordingly, if
short-term interest rates increase, this may harm our
profitability.
19
Some of
the commercial real estate loans and real estate-related securities we acquire
will be fixed-rate securities. This means that their interest rates will not
vary over time based upon changes in a short-term interest rate index.
Therefore, the interest rate indices and repricing terms of the assets that we
acquire and their funding sources will create an interest rate mismatch between
our assets and liabilities. During periods of changing interest rates, these
mismatches could reduce our net income, dividend yield and the market price of
our stock.
Accordingly,
in a period of rising interest rates, we could experience a decrease in net
income or a net loss because the interest rates on our borrowings will adjust
whereas the interest rates on our fixed-rate assets will remain
unchanged.
Interest
rate caps on our adjustable-rate MBS may adversely affect our
profitability.
Adjustable-rate
MBS are typically subject to periodic and lifetime interest rate caps. Periodic
interest rate caps limit the amount an interest rate can increase during any
given period. Lifetime interest rate caps limit the amount an interest rate can
increase over the life of the security. Our borrowings typically will not be
subject to similar restrictions. Accordingly, in a period of rapidly increasing
interest rates, the interest rates paid on our borrowings could increase without
limitation while caps could limit the interest rates on our adjustable-rate MBS.
This problem is magnified for hybrid adjustable-rate and adjustable-rate MBS
that are not fully indexed. Further, some hybrid adjustable-rate and
adjustable-rate MBS may be subject to periodic payment caps that result in a
portion of the interest being deferred and added to the principal outstanding.
As a result, we may receive less cash income on hybrid adjustable-rate and
adjustable-rate MBS than we need to pay interest on our related borrowings.
These factors could reduce our net interest income and cause us to suffer a
loss.
We may experience a decline in the fair
value of our assets.
A decline
in the fair market value of our assets may require us to recognize an
“other-than-temporary” impairment against such assets under GAAP if we were to
determine that, with respect to any assets in unrealized loss positions, we do
not have the ability and intent to hold such assets to maturity or for a period
of time sufficient to allow for recovery to the amortized cost of such
assets. If such a determination were to be made, we would recognize
unrealized losses through earnings and write down the amortized cost of such
assets to a new cost basis, based on the fair value of such assets on the date
they are considered to be other-than-temporarily impaired. Such impairment
charges reflect non-cash losses at the time of recognition; subsequent
disposition or sale of such assets could further affect our future losses or
gains, as they are based on the difference between the sale price received and
adjusted amortized cost of such assets at the time of sale.
Some of
our portfolio assets are recorded at fair value and, as a result, there will be
uncertainty as to the value of these assets. Some of our portfolio
assets are in the form of positions or securities that are not publicly
traded. The fair value of securities and other investments that are
not publicly traded may not be readily determinable. We value these
assets quarterly at fair value. Because such valuations are subjective, the fair
value of certain of our assets may fluctuate over short periods of time and our
determinations of fair value may differ materially from the values that would
have been used if a ready market for these securities existed. The
value of our common stock could be adversely affected if our determinations
regarding the fair value of these investments were materially higher than the
values that we ultimately realize upon their disposal.
An
increase in prepayment rates could adversely affect yields on our
assets.
The value
of our assets may be affected by prepayment rates on mortgage
loans. Prepayment rates on mortgage loans are influenced by changes
in interest rates and a variety of economic, geographic and other factors beyond
our control, and consequently, prepayment rates cannot be predicted with
certainty. In periods of declining mortgage interest rates,
prepayments on mortgage loans generally increase. If general interest rates
decline as well, we are likely to reinvest the proceeds of prepayments received
during these periods in assets yielding less than the mortgage loans that were
prepaid. In addition, the market value of the mortgage loan assets may, because
of the risk of prepayment, benefit less than other fixed-income securities from
declining interest rates. Conversely, in periods of rising interest
rates, prepayments on mortgage loans generally decrease, in which case we would
not have the prepayment proceeds available to acquire assets with higher
yields. Under certain interest rate and prepayment scenarios, we may
fail to recoup fully our cost of certain assets purchased at a premium to face
value. In addition, other factors such as the credit rating of the
borrower, the rate of home price appreciation or depreciation and the
availability of public or private loan modification programs, none of which can
be predicted with any certainty, may affect prepayment speeds on mortgage
loans.
20
Liability
relating to environmental matters may impact the value of properties that we may
acquire upon foreclosure of the properties underlying our assets.
If we
foreclose on properties with respect to which we have extended mortgage loans,
we may be subject to environmental liabilities arising from such foreclosed
properties. Under various U.S. federal, state and local laws, an
owner or operator of real property may become liable for the costs of removal of
certain hazardous substances released on its property. These laws often impose
liability without regard to whether the owner or operator knew of, or was
responsible for, the release of such hazardous substances.
The
presence of hazardous substances may adversely affect an owner’s ability to sell
real estate or borrow using real estate as collateral. To the extent that an
owner of a property underlying one of our debt investments becomes liable for
removal costs, the ability of the owner to make payments to us may be reduced,
which in turn may adversely affect the value of the relevant mortgage asset held
by us and our ability to make distributions to our stockholders. If we acquire
any properties, the presence of hazardous substances on a property may adversely
affect our ability to sell the property and we may incur substantial remediation
costs, thus harming our financial condition. The discovery of material
environmental liabilities attached to such properties could have a material
adverse effect on our results of operations and financial condition and our
ability to make distributions to our stockholders.
The
conservatorship of Fannie Mae and Freddie Mac and related efforts, along with
any changes in laws and regulations affecting the relationship between Fannie
Mae and Freddie Mac and the U.S. Government, may adversely affect our
business.
On
September 7, 2008, the Federal Housing Finance Agency, or FHFA, placed Fannie
Mae and Freddie Mac into conservatorship and, together with the Treasury,
established a program designed to boost investor confidence in Fannie Mae’s and
Freddie Mac’s debt and mortgage-backed securities. In addition to
FHFA becoming the conservator of Fannie Mae and Freddie Mac, the Treasury and
Fannie Mae and Freddie Mac pursuant to which the Treasury will ensure that each
of the Fannie Mae and Freddie Mac maintains a positive net worth. On
December 24, 2009, the U.S. Treasury’s amended the terms of the of the U.S.
Treasury’s PSPAs with Fannie Mae and Freddie Mac to remove the $200 billion per
institution limit established under the PSPAs until the end of
2012. The U.S. Treasury also amended the PSPAs with respect to the
requirements for Fannie Mae and Freddie Mac to reduce their
portfolios. Although the Treasury has committed capital to Fannie Mae
and Freddie Mac, there can be no assurance that its actions will be adequate for
their needs. If these actions are inadequate, Fannie Mae and Freddie Mac could
continue to suffer losses and could fail to honor their guarantees and other
obligations. The future roles of Fannie Mae and Freddie Mac could be
significantly reduced and the nature of their guarantees could be considerably
diminished. Any changes to the nature of the guarantees provided by Fannie Mae
and Freddie Mac could redefine what constitutes MBS and could have broad adverse
market implications.
On
November 25, 2008, the Federal Reserve announced that it will initiate a program
to purchase $100 billion in direct obligations of Fannie Mae, Freddie Mac and
the FHLBs and $500 billion in agency MBS backed by Fannie Mae, Freddie Mac and
Ginnie Mae. On March 18, 2009, the Federal Reserve increased the size of this
program to $200 billion and $1.25 trillion respectively. The Federal
Reserve has announced that it intends to wind up this program on March 31,
2010. It is possible that a change in the Treasury’s and the Federal
Reserve’s commitment to purchase MBS in the future could negatively affect the
pricing of MBS that we seek to acquire. Given the highly fluid and
evolving nature of events, it is unclear how our business may be
impacted. Further activity of the U.S. Government or market response
to developments at Fannie Mae and Freddie Mac could adversely impact our
business. Any changes to the nature of their guarantee obligations
could redefine what constitutes a MBS and could have broad adverse implications
for the market and our business, operations and financial
condition. Moreover, if Fannie Mae or Freddie Mac were eliminated, or
their structures were to change radically (i.e., limitation or removal of the
guarantee obligation), we may be unable to acquire additional MBS and our
existing MBS could be materially and adversely impacted.
Future
legislation could further change the relationship between Fannie Mae and Freddie
Mac and the U.S. Government, and could also nationalize or eliminate such
entities entirely. Any law affecting these GSEs may create market
uncertainty and have the effect of reducing the actual or perceived credit
quality of securities issued or guaranteed by Fannie Mae or Freddie
Mac. As a result, such laws could increase the risk of loss on
investments in MBS guaranteed by Fannie Mae and/or Freddie Mac. It
also is possible that such laws could adversely impact the market for such
securities and spreads at which they trade. All of the foregoing
could materially and adversely affect our business, operations and financial
condition.
21
Risks
Related To Our Business
We
have a limited operating history and may not be able to operate successfully or
generate sufficient revenue to make or sustain distributions to our
stockholders.
We were
organized in January 2008 and have limited operating history. We
cannot assure you that we will be able to operate our business successfully or
implement our operating policies and strategies. The results of our
operations depend on many factors, including the availability of opportunities
for the acquisition of assets, the valuation of assets acquired, the level and
volatility of interest rates, the availability of adequate short and long-term
financing and the terms of the financing, conditions in the financial markets
and economic conditions.
We
operate in a highly competitive market for asset acquisition opportunities and
more established competitors may be able to compete more effectively for asset
acquisition opportunities than we can.
A number
of entities compete with us to purchase the types of assets that we
acquire. We compete with other REITs, public and private funds,
including PPIFs, commercial and investment banks and commercial finance
companies, including some of the third parties with which we expect to have
relationships. Many of our competitors are substantially larger and
have considerably greater financial, technical and marketing resources than we
do. Several other REITs have recently raised, or are expected to
raise, significant amounts of capital, and may have objectives that overlap with
ours, which may create competition for asset acquisition
opportunities. Some competitors may have a lower cost of funds and
access to funding sources that are not available to us. In addition,
some of our competitors may have higher risk tolerances or different risk
assessments, which could allow them to consider a wider variety of asset
acquisitions and establish more relationships than us. We cannot
assure you that the competitive pressures we face will not have a material
adverse effect on our business, financial condition and results of
operations. Also, as a result of this competition, we may not be able
to take advantage of attractive asset acquisition opportunities from time to
time, and we can offer no assurance that we will be able to identify and
purchase assets that are consistent with our objectives.
Maintenance
of our exemption from registration under the 1940 Act imposes significant limits
on our operations.
We
conduct our operations so that neither we nor any of our subsidiaries are
required to register as an investment company under the 1940 Act. Because we are
a holding company that will conduct its businesses primarily through
wholly-owned subsidiaries, the securities issued by these subsidiaries that are
excepted from the definition of “investment company” under Section 3(c)(1) or
Section 3(c)(7) of the 1940 Act, together with any other investment securities
we may own, may not have a combined value in excess of 40% of the value of our
adjusted total assets on an unconsolidated basis. This requirement limits the
types of businesses in which we may engage through our subsidiaries. In
addition, the assets we and our subsidiaries may acquire are limited by the
provisions of the 1940 Act and the rules and regulations promulgated under the
1940 Act, which may adversely affect our performance.
If the
value of securities issued by our subsidiaries that are excepted from the
definition of “investment company” by Section 3(c)(1) or 3(c)(7) of the 1940
Act, together with any other investment securities we own, exceeds 40% of our
adjusted total assets on an unconsolidated basis, or if one or more of such
subsidiaries fail to maintain an exception or exemption from the 1940 Act, we
could, among other things, be required either (a) to substantially change the
manner in which we conduct our operations to avoid being required to register as
an investment company or (b) to register as an investment company under the 1940
Act, either of which could have an adverse effect on us and the market price of
our securities. If we were required to register as an investment company under
the 1940 Act, we would become subject to substantial regulation with respect to
our capital structure (including our ability to use leverage), management,
operations, transactions with affiliated persons (as defined in the 1940 Act),
portfolio composition, including restrictions with respect to diversification
and industry concentration, and other matters.
22
We expect
CreXus S Holdings LLC and certain subsidiaries that we may form in the future to
rely upon the exemption from registration as an investment company under the
1940 Act pursuant to Section 3(c)(5)(C) of the 1940 Act, which is available for
entities “primarily engaged in the business of purchasing or otherwise acquiring
mortgages and other liens on and interests in real estate.” This exemption
generally requires that at least 55% of these subsidiaries’ assets must be
comprised of qualifying real estate assets and at least 80% of each of their
portfolios must be comprised of qualifying real estate assets and real
estate-related assets under the 1940 Act. We expect each of our subsidiaries
relying on Section 3(c)(5)(C) to rely on guidance published by the SEC staff or
on our analyses of guidance published with respect to other types of assets to
determine which assets are qualifying real estate assets and real estate-related
assets. If the SEC staff publishes new or different guidance with respect to
these matters, we may be required to adjust our strategy accordingly. In
addition, we may be limited in our ability to make certain investments and these
limitations could result in the subsidiary holding assets we might wish to sell
or selling assets we might wish to hold.
Certain
of our subsidiaries may rely on the exemption provided by Section 3(c)(6) to the
extent that they hold mortgage assets through majority owned subsidiaries that
rely on Section 3(c)(5)(C). The SEC staff has issued little interpretive
guidance with respect to Section 3(c)(6) and any guidance published by the staff
could require us to adjust our strategy accordingly.
We expect
CreXus F Asset Holdings LLC and CreXus TALF Holdings, LLC, a subsidiary we
formed for the purpose of borrowing under TALF, to rely on Section 3(c)(7) for
their 1940 Act exemption and, therefore our interest in each of these
subsidiaries would constitute an “investment security” for purposes of
determining whether we pass the 40% test.
Additionally,
we may in the future organize one or more subsidiaries, that seek to rely on the
1940 Act exemption provided to certain structured financing vehicles by Rule
3a-7. In general, Rule 3a-7 exempts from the 1940 Act issuers that
limit their activities as follows:
·
|
the
issuer issues securities the payment of which depends primarily on the
cash flow from “eligible assets” that by their terms convert into cash
within a finite time period;
|
·
|
the securities sold are fixed income securities
rated investment grade by at least one rating agency (fixed income
securities which are unrated or rated below investment grade may be sold
to institutional accredited investors and any securities may be sold to
“qualified institutional buyers” and to persons involved in the
organization or operation of the
issuer);
|
·
|
the
issuer acquires and disposes of eligible assets (1) only in accordance
with the agreements pursuant to which the securities are issued and (2) so
that the acquisition or disposition does not result in a downgrading of
the issuer’s fixed income securities and (3) the eligible assets are not
acquired or disposed of for the primary purpose of recognizing gains or
decreasing losses resulting from market value changes;
and
|
·
|
unless the issuer is issuing only commercial
paper, the issuer appoints an independent trustee, takes reasonable steps
to transfer to the trustee an ownership or perfected security interest in
the eligible assets, and meets rating agency requirements for commingling
of cash flows.
|
Any
subsidiary also would need to be structured to comply with any guidance that may
be issued by the Division of Investment Management of the SEC on how the
subsidiary must be organized to comply with the restrictions contained in Rule
3a-7. Compliance with Rule 3a-7 may require that the indenture governing the
subsidiary include additional limitations on the types of assets the subsidiary
may sell or acquire out of the proceeds of assets that mature, are refinanced or
otherwise sold, on the period of time during which such transactions may occur,
and on the level of transactions that may occur. In light of the requirements of
Rule 3a-7, our ability to manage assets held in a special purpose subsidiary
that complies with Rule 3a-7 will be limited and we may not be able to purchase
or sell assets owned by that subsidiary when we would otherwise desire to do so,
which could lead to losses. Initially, we will limit the aggregate value of our
interests in our subsidiaries that may in the future seek to rely on Rule 3a-7
to 20% or less of our total assets on an unconsolidated basis, as we continue to
discuss with the SEC staff the use of subsidiaries that rely on Rule 3a-7 to
finance our operations.
23
The
determination of whether an entity is a majority-owned subsidiary of our company
is made by us. The 1940 Act defines a majority-owned subsidiary of a person as a
company 50% or more of the outstanding voting securities of which are owned by
such person, or by another company which is a majority-owned subsidiary of such
person. The 1940 Act further defines voting securities as any security presently
entitling the owner or holder thereof to vote for the election of directors of a
company. We treat companies in which we own at least a majority of the
outstanding voting securities as majority-owned subsidiaries for purposes of the
40% test. We have not requested the SEC to approve our treatment of any company
as a majority-owned subsidiary and the SEC has not done so. If the SEC were to
disagree with our treatment of one or more companies as majority-owned
subsidiaries, we would need to adjust our strategy and our assets in order to
continue to pass the 40% test. Any such adjustment in our strategy could have a
material adverse effect on us.
There can
be no assurance that the laws and regulations governing the 1940 Act status of
REITs, including the Division of Investment Management of the SEC providing more
specific or different guidance regarding these exemptions, will not change in a
manner that adversely affects our operations. If we or our subsidiaries fail to
maintain an exception or exemption from the 1940 Act, we could, among other
things, be required either to (a) change the manner in which we conduct our
operations to avoid being required to register as an investment company, (b)
effect sales of our assets in a manner that, or at a time when, we would not
otherwise choose to do so, or (c) register as an investment company, any of
which could negatively affect the value of our common stock, the sustainability
of our business model, and our ability to make distributions which could have an
adverse effect on our business and the market price for our shares of common
stock.
Rapid
changes in the values of our CMBS, commercial mortgage loans and other real
estate-related assets may make it more difficult for us to maintain our
qualification as a REIT or exemption from the 1940 Act.
If the
market value or income potential of our CMBS, commercial mortgage loans and
other real estate-related assets declines as a result of market deterioration,
ratings downgrades, increased interest rates, prepayment rates or other factors,
we may need to increase our real estate assets and income and/or liquidate our
non-qualifying assets in order to maintain our REIT qualification or exemption
from the 1940 Act. If the decline in real estate asset values and/or income
occurs quickly, this may be especially difficult to accomplish. This difficulty
may be exacerbated by the illiquid nature of any non-qualifying assets that we
may own. We may have to make decisions that we otherwise would not make absent
the REIT and 1940 Act considerations.
We
are highly dependent on information systems and third parties, and systems
failures could significantly disrupt our business, which may, in turn,
negatively affect the market price of our common stock and our ability to pay
dividends to our stockholders.
Our
business is highly dependent on communications and information
systems. Any failure or interruption of our systems could cause
delays or other problems in our operations, including CMBS purchases and sales,
which could have a material adverse effect on our operating results and
negatively affect the market price of our common stock and our ability to pay
dividends to our stockholders.
The
increasing number of proposed federal, state and local laws may increase our
risk of liability with respect to certain mortgage loans and could increase our
cost of doing business.
The
United States Congress and various state and local legislatures are considering
legislation, which, among other provisions, would permit limited assignee
liability for certain violations in the mortgage loan origination process and
“credit risk” retention by originators or securitizers of mortgage
loans. We cannot predict whether or in what form Congress or the
various state and local legislatures may enact legislation affecting our
business. We are evaluating the potential impact of these
initiatives, if enacted, on our practices and results of
operations. As a result of these and other initiatives, we are unable
to predict whether federal, state or local authorities will require changes in
our practices in the future. These changes, if required, could
adversely affect our profitability, particularly if we make such changes in
response to new or amended laws, regulations or ordinances in any state where we
acquire a significant portion of our mortgage loans, or if such changes result
in us being held responsible for any violations in the mortgage loan origination
process.
24
Accounting
rules for certain of our transactions are highly complex and involve significant
judgment and assumptions, and changes in accounting treatment may adversely
affect our profitability and impact our financial results.
Accounting
rules for mortgage loan sales and securitizations, valuations of financial
instruments, investment consolidations and other aspects of our anticipated
operations are highly complex and involve significant judgment and assumptions.
These complexities could lead to a delay in preparation of financial information
and the delivery of this information to our shareholders. Changes in accounting
interpretations or assumptions could impact our financial statements and our
ability to timely prepare our financial statements in a timely fashion. Our
inability to timely prepare our financial statements in a timely fashion in the
future would likely adversely affect our share price significantly.
The fair
value at which our assets may be recorded may not be an indication of their
realizable value. Ultimate realization of the value of an asset depends to a
great extent on economic and other conditions that are beyond our control.
Further, fair value is only an estimate based on good faith judgment of the
price at which an investment can be sold since market prices of investments can
only be determined by negotiation between a willing buyer and seller. If we were
to liquidate a particular asset, the realized value may be more than or less
than the amount at which such asset is valued. Accordingly, the value of our
common shares could be adversely affected by our determinations regarding the
fair value of our investments, whether in the applicable period or in the
future. Additionally, such valuations may fluctuate over short periods of
time.
Risks
Related to U.S. Government Programs
There
can be no assurance that the actions of the U.S. Congress, the Federal Reserve,
U.S. Treasury and other governmental and regulatory bodies for the purpose of
stabilizing the financial markets and increasing credit availability, including
the establishment of the TALF and the PPIP, or market response to those actions,
will achieve the intended effect, or that our business will benefit from these
actions, and further government or market developments may materially and
adversely impact us.
In
response to the financial issues affecting the banking system and the financial
markets and going concern threats to investment banks and other financial
institutions, the U.S. Congress, the Federal Reserve, the U.S. Treasury and
other governmental and regulatory bodies have taken action to attempt to
stabilize the financial markets and increase credit
availability. Significant measures include the enactment of the
Economic Stabilization Act of 2008, or the EESA, to, among other things,
establish the Troubled Asset Relief Program, or the TARP; the enactment of the
Housing and Economic Recovery Act of 2008, or the HERA, which established a new
regulator for Fannie Mae and Freddie Mac; the establishment of the TALF; and the
establishment of the PPIP. There can be no assurance that the EESA,
HERA, TALF, PPIP or other recent U.S. Government actions will have a beneficial
impact on the financial markets. To the extent the market does not
respond favorably to these initiatives or these initiatives do not function as
intended, our business may not benefit from the legislation or other U.S.
Government actions. There can also be no assurance that we will be
eligible to participate in any programs established by the U.S. Government, such
as the TALF or the PPIP, or, if we are eligible, that we will be able to utilize
them successfully or at all. In addition, because the programs are designed, in
part, to restart the market for certain of our targeted assets, the
establishment of these programs may result in increased competition for
attractive opportunities in our targeted assets. It is also possible that our
competitors may utilize the programs which would provide them with attractive
debt and equity capital funding from the U.S. Government. In addition, the
Federal Reserve, the U.S. Treasury and other governmental and regulatory bodies
have taken or are considering taking other actions to address the financial
crisis. We cannot predict whether or when such actions may occur, and
such actions could have an adverse impact on our business, results of operations
and financial condition.
25
We
may use U.S. Government equity and debt financing to acquire a portion of our
CMBS and commercial mortgage loan portfolio.
We have
acquired CMBS with financings from the FRBNY, under the TALF. To
become eligible collateral under the TALF, legacy CMBS must have been issued
before January 1, 2009, and must be senior in payment priority to all other
interests in the underlying pool of commercial mortgages in addition to meeting
other specified criteria designed to protect the Federal Reserve and the U.S.
Treasury from credit risk. The TALF programs for newly-issued CMBS
are available until June 30, 2010. The TALF programs for all other
TALF-eligible collateral are available until March 31, 2010. To
be considered eligible collateral under the TALF, both newly issued CMBS and
legacy CMBS must have at least two AAA ratings from DBRS, Inc., Fitch Ratings,
Moody’s Investors Service, Realpoint LLC or S&P and must not have a rating
below AAA from any of these rating agencies or be under watch or review for a
downgrade (unless, in the case of legacy CMBS, such watch or review occurs after
the subscription date for a loan with regard to such CMBS). As many
legacy CMBS have had their ratings downgraded and at least one rating agency,
S&P, has announced that further downgrades are likely in the future, these
downgrades may significantly reduce the quantity of legacy CMBS
available. Many legacy CMBS, however, have had their ratings
downgraded, and at least one rating agency, S&P, has announced that further
downgrades are likely in the future as property values have
declined. These downgrades and reviews for downgrade may
significantly reduce the quantity of legacy CMBS that are TALF
eligible. Even if newly issued or legacy CMBS meets all the criteria
for eligibility under the TALF, the FRBNY may, in its sole discretion, reject
the CMBS as collateral based on its own risk assessment. There can be
no assurance that we will be able to utilize this program successfully or at
all.
We may
also acquire CMBS with financing under the PPIP by investing in one or more
public-private investment funds, or PPIFs, managed by unaffiliated parties
established under the Legacy Securities Program to purchase legacy
securities.
The
terms and conditions of the TALF may change, which could adversely affect our
investments.
The terms
and conditions of the TALF, including asset and borrower eligibility, could be
changed at any time. Any such modifications may have an adverse
effect on the market value of any of our assets that are eligible for financing
through the TALF and on our ability to obtain TALF financing. If the
TALF is prematurely discontinued or reduced while our assets financed through
the TALF are still outstanding, there may be no market for these assets and the
market value of these assets would be adversely affected.
There is no assurance that we will be able to obtain any TALF
loans.
The TALF
is operated by the FRBNY. TALF loans are available only on one or two
specified days per month. The TALF runs to June 30, 2010, for
newly-issued CMBS, and to March 31, 2010, for all other TALF-eligible
collateral. The FRBNY has complete discretion regarding the extension
of credit under the TALF and is under no obligation to make any loans to us even
if we meet all of the applicable criteria. We have previously
submitted applications for extensions of credit under the TALF for multiple
legacy CMBS assets and have had one request for a TALF loan rejected by the
FRBNY related to a legacy CMBS asset. Requests for TALF loans may
surpass the amount of funding authorized by the Federal Reserve and the U.S.
Treasury, resulting in an early termination of the TALF. Depending on
the demand for TALF loans and the general state of the credit markets, the
Federal Reserve and the U.S. Treasury may decide to modify the terms and
conditions of the TALF. Such actions may adversely affect our ability
to obtain TALF loans and use the loan leverage to enhance returns, and may
otherwise affect expected returns on our investments. If we do obtain
TALF loans, we may be subject to refinancing risk to the extent the maturity of
the CMBS securing a TALF loan is longer than the term of the related TALF
loan. The FRBNY will offer TALF loans with maturities of three or
five years while the CMBS securing the TALF loan may have an average life of up
to ten years.
26
We
could lose our eligibility as a TALF borrower, which would adversely affect our
ability to fulfill our investment objectives.
Any U.S.
company is eligible to apply to participate in the TALF, provided that it
maintains an account relationship with a primary dealer. An entity is
a U.S. company for purposes of the TALF if it is (1) a business entity or
institution that is organized under the laws of the United States or a political
subdivision or territory thereof (U.S.-organized) and conducts significant
operations or activities in the United States, including any U.S.-organized
subsidiary of such an entity; (2) a U.S. branch or agency of a non-U.S. bank
(other than a foreign central bank) that maintains reserves with a Federal
Reserve Bank; (3) a U.S. insured depository institution; or (4) an investment
fund that is U.S.-organized and managed by an investment manager that has its
principal place of business in the United States. An entity that
satisfies any one of the requirements above is a U.S. company regardless of
whether it is controlled by, or managed by, a company that is not
U.S.-organized. Notwithstanding the foregoing, a U.S. company
excludes any entity, other than those described in clauses (2) and (3) above,
that is controlled by a foreign government or is managed by an investment
manager controlled by a foreign government, other than those described in
clauses (2) and (3) above. For these purposes, an entity controls a
company if, among other things, such entity owns, controls, or holds with power
to vote 25% or more of a class of voting securities of, or the total equity of,
the company. If for any reason we are deemed not to be eligible to
participate in the TALF, all of our outstanding TALF loans will become
immediately due and payable, the FRBNY will have full recourse against us for
repayment of our TALF loans, and we will not be eligible to obtain future TALF
loans.
There
is no assurance that we will be able to participate in the PPIP or, if we are
able to participate, that funding will be available.
Investors
in the Legacy Loans Program must be pre-qualified by the FDIC. The
FDIC has complete discretion regarding the qualification of investors in the
Legacy Loans Program and is under no obligation to approve our participation
even if we meet all of the applicable criteria. Under the terms of
the Legacy Securities Program, the U.S. Treasury has the right to cease funding
of committed but undrawn equity capital and debt financing to a specific fund
participating in the Legacy Securities Program.
Downgrades
of legacy CMBS and/or changes in the rating methodology and assumptions for
future CMBS issuances, may decrease the availability of the TALF to finance
CMBS.
On May
26, 2009, Standard & Poor’s Investors Service, Inc., or S&P, which rates
a substantial majority of CMBS issuances, issued a request for comment regarding
its proposed changes to its methodology and assumptions for rating CMBS, and in
so doing indicated that the proposed changes would result in downgrades of a
considerable amount of CMBS (including super-senior
tranches). Specifically, S&P indicated that “it is likely that
the proposed changes, which represent a significant change to the criteria for
rating high investment-grade classes, will prompt a considerable amount of
downgrades in recently issued (2005-2008 vintage) CMBS.” S&P
noted that its preliminary findings indicate that approximately 25%, 60%, and
90% of the most senior tranches (by count) within the 2005, 2006, and 2007
vintages, respectively, may be downgraded. The current TALF
guidelines issued by the FRBNY indicate that in order to be eligible for the
TALF, legacy CMBS must not have a rating below the highest investment-grade
rating category or be under watch or review for a downgrade from any TALF
CMBS-eligible rating agency, which includes S&P. Other rating
agencies may take similar actions with regard to their ratings of
CMBS. As a result, downgrades of legacy CMBS may limit substantially
the availability of the TALF for legacy CMBS. Further, changes to the
methodology and assumptions in rating CMBS by rating agencies, including
S&P’s proposed changes, may decrease the amount or availability of new issue
CMBS rated in the highest investment-grade rating category.
27
The
FRBNY has discretion to reject any legacy CMBS as TALF loan collateral and may
limit the volume of TALF loans secured by legacy CMBS.
The FRBNY
has the right to reject any legacy CMBS as TALF loan collateral based on its
risk assessment. The FRBNY may reject a legacy CMBS based on factors
including, but not limited to, unacceptable performance of the mortgage loans in
the loan pool backing such legacy CMBS, taking into account whether such pool
may have high cumulative losses or a high percentage of delinquent loans, and
unacceptable concentrations of mortgage loans with respect to borrower
sponsorship, property type and geographic region. We have previously
submitted applications for extensions of credit under the TALF for multiple
legacy CMBS assets and have had one request for a TALF loan rejected by the
FRBNY related to a legacy CMBS asset. The FRBNY may also limit the
volume of TALF loans secured by legacy CMBS.
We
may not be able to acquire sufficient amounts of eligible assets to utilize the
TALF or the PPIP in a material way consistent with our investment
strategy.
Assets to
be used as collateral for TALF and PPIP loans must meet strict eligibility
criteria with respect to characteristics such as issuance date, maturity and
credit rating and with respect to the origination date of the underlying
collateral. With regard to the TALF, these restrictions may limit the
availability of eligible assets, and we may be unable to acquire sufficient
amounts of assets to obtain financing under TALF in a material way consistent
with our investment strategy. With regard to the PPIP, even if Legacy
Loans PPIFs and Legacy Securities PPIFs are successful in raising capital to
fund the purchase of legacy assets, it is unclear whether PPIFs will be
successful in deploying such capital to acquire sufficient amounts of assets in
a material way consistent with their investment strategies.
Our
ability to transfer any assets we may purchase using TALF funding, to the extent
available to us, is restricted.
Our
assets purchased using TALF funding will be pledged to the FRBNY as collateral
for the TALF loans. If we sell or transfer any of these assets, we
must either repay the related TALF loan or obtain the consent of the FRBNY to
assign our obligations under the related TALF loan to the assignee, and the
assignee must satisfy the criteria as an eligible borrower under
TALF. The FRBNY in its discretion may restrict or prevent us from
assigning our loan obligations to a third-party, including a third-party that
meets the criteria of an eligible borrower. In addition, the FRBNY will not
consent to any assignments after the termination date for making new
loans. The FRBNY TALF programs runs to June 30, 2010, for
newly-issued CMBS, and to March 31, 2010, for all other TALF-eligible
collateral.
We
may need to surrender eligible TALF assets to repay TALF loans at
maturity.
Each TALF
loan must be repaid by its maturity, either three or five years. We
intend to invest in CMBS that do not mature within the term of the TALF
loan. If we do not have sufficient funds to repay interest and
principal on the related TALF loan at maturity and if these assets cannot be
sold for an amount equal to or greater than the amount owed on such loan, we
must surrender the assets to the FRBNY in lieu of repayment. If we
are forced to sell any assets to repay a TALF loan, we may not be able to obtain
a favorable price. If we default on our obligation to pay a TALF loan
and the FRBNY elects to liquidate the assets used as collateral to secure such
TALF loan, the proceeds from that sale will be applied, first, to any
enforcement costs, second, to unpaid principal and, finally, to unpaid
interest. Under the terms of the TALF, if assets are surrendered to
the FRBNY in lieu of repayment, all assets that collateralize that loan must be
surrendered. In these situations, we would forfeit any equity that we held in
these assets.
FRBNY
consent is required to exercise our voting rights on CMBS and while a collateral
enforcement event is continuing.
As a
requirement of the TALF, we must agree not to exercise and must refrain from
exercising any voting, consent or waiver rights under TALF collateral without
the consent of the FRBNY. During the continuance of a collateral
enforcement event with respect to any TALF loan, the FRBNY will have the right
to exercise voting rights in the related collateral.
28
We
are dependent on the activities of our primary dealers.
To obtain
TALF loans, we have executed a customer agreement with a primary dealer, which
acts on our behalf under the agreement with the FRBNY. The primary
dealer will submit aggregate loan request amounts on behalf of its customers in
the form and manner specified by the FRBNY. Each primary dealer is
required to apply its internal customer identification program and due diligence
procedures to each borrower and represent that each borrower is an eligible
borrower for purposes of the TALF, and to provide the FRBNY with information
sufficient to describe the dealer’s customer risk assessment
methodology. These customer agreements may impose additional
requirements that could affect our ability to obtain TALF loans or that impose
liability on us to the primary dealer for certain breaches. Each
primary dealer is expected to have relationships with other TALF borrowers, and
a primary dealer may allocate more resources toward assisting other borrowers
with whom it has other business dealings. Primary dealers are also
responsible for distributing principal and interest after receipt thereof from
The Bank of New York Mellon, as custodian for the TALF. Once funds or
collateral are transferred to a primary dealer or at the direction of a primary
dealer, neither the custodian nor the FRBNY has any obligation to account for
whether the funds or collateral are transferred to the borrower. We
will therefore be exposed to bankruptcy risk of our primary
dealers.
We
will be subject to interest rate risk, which can adversely affect our net
income.
We expect
interest rates on fixed-rate TALF loans secured by CMBS will be set at a premium
over the then-current three-year or five-year LIBOR swap rate. As a
result, we may be exposed to (1) timing risk between the dates on which payments
are received on assets financed through the TALF and the dates on which interest
payments are due on the TALF loans and (2) asset/liability repricing risk, due
to differences in the dates and indices on which floating rates on the financed
assets and on the related TALF loans are reset.
Our
ability to receive the interest earnings may be limited.
We make
interest payments on any TALF loan from the interest paid to us on the assets
used as collateral for the TALF loan. To the extent that we receive
distributions from pledged assets in excess of our required interest payments on
a TALF loan during any loan year, the amount of excess interest we may retain
will be limited.
Interest
payments that are received from the assets that are used as collateral for a
TALF loan must be applied to pay interest on the related TALF loan before any
interest payments can be distributed to us. To the extent there are
interest payments from the collateral in excess of the required interest payment
on the related TALF Loan, the amount of such excess interest that will be
distributed to us will be limited. For example, for a five-year TALF
loan, the excess of interest distributions from the collateral over the TALF
loan interest payable will be remitted to us only until such excess equals 25%
per annum of the haircut amount in the first three loan years, 10% in the fourth
loan year, and 5% in the fifth loan year, and the remainder of such excess will
be applied to the related TALF loan principal.
We may be
required to use our earnings to keep the TALF loans current. If the
interest on the collateral pledged to support a TALF loan is not sufficient to
cover the interest payment on such loan, we will have a grace period of 30 days
to make the interest payment. If the loan remains delinquent after
the grace period, the FRBNY will enforce its rights to the
collateral.
To the
extent that proceeds from our TALF assets are received by the custodian prior to
the monthly date on which they are distributed to us, such proceeds will be held
by the custodian and all interest earned on such proceeds will be retained by
the FRBNY. If such proceeds were immediately distributed to us, we
would be able to invest such proceeds in short-term investments and the income
from such investments would be available to distribute to our
stockholders.
Under
certain conditions, we may be required to provide full recourse for TALF loans
or to make indemnification payments.
To
participate in the TALF, we have executed a customer agreement with a primary
dealer authorizing it, among other things, to act as our agent under TALF and to
act on our behalf under the agreement with the FRBNY and with The Bank of New
York Mellon as administrator and as the FRBNY’s custodian of the
collateral. Under this agreement, we are required to represent to the
primary dealer and to the FRBNY that, among other things, we are an eligible
borrower, that all of our investors are eligible borrowers and that, based on
our review of the disclosure documents relating to the collateral, the
collateral that we pledge meets the TALF eligibility criteria. We
also must make representations relating to the arms-length nature of our
purchase of legacy CMBS and secondary market nature of the
transaction. The FRBNY has full recourse to us for repayment of the
loan for any breach of these representations. In addition, we may be
required to pay to our primary dealer fees under the customer agreement, and we
will be required to indemnify our primary dealers for certain breaches under the
customer agreements and to indemnify the FRBNY and its custodian for certain
breaches under the agreement with the FRBNY. Payments made to satisfy
such full recourse requirements and indemnities could have a material adverse
effect on our net income and our distributions to our stockholders, including
any proceeds of this offering that we have not yet invested in targeted assets
or distributed to our stockholders.
29
Risks
Related to Private Sources of Financing
Our
access to private sources of financing may be limited and thus our ability to
maximize our returns may be adversely affected.
If and to
the extent available in the future, our financing sources may include borrowings
in the form of bank credit facilities (including term loans and revolving
facilities), repurchase agreements, warehouse facilities, structured financing
arrangements, public and private equity and debt issuances and derivative
instruments, in addition to transaction or asset specific funding arrangements.
Our access to private sources of financing will depend upon a number of factors
over which we have little or no control, including:
·
|
general
market conditions;
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·
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the
market’s view of the quality of our
assets;
|
·
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the
market’s perception of our growth
potential;
|
·
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our
eligibility to participate in and access capital from programs established
by the U.S. Government;
|
·
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our
current and potential future earnings and cash distributions;
and
|
·
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the
market price of the shares of our capital
stock.
|
The
current dislocation and weakness in the capital and credit markets could
adversely affect one or more private lenders and could cause one or more of our
private lenders to be unwilling or unable to provide us with financing or to
increase the costs of that financing. In addition, if regulatory
capital requirements imposed on our private lenders change, they may be required
to limit, or increase the cost of, financing they provide to us. In
general, this could potentially increase our financing costs and reduce our
liquidity or require us to sell assets at an inopportune time or
price.
Under
current market conditions, many forms of structured financing arrangements are
generally unavailable, which has also limited borrowings under warehouse and
repurchase agreements that are intended to be refinanced by such
financings. Consequently, the execution of our strategy may be
dictated by the cost and availability of financing. Depending on
market conditions at the relevant time, we may have to rely more heavily on
additional equity issuances, which may be dilutive to our shareholders, or on
less efficient forms of debt financing that require a larger portion of our cash
flow from operations, thereby reducing funds available for our operations,
future business opportunities, cash distributions to our shareholders and other
purposes. Furthermore, we could be forced to sell our assets at an
inopportune time when prices are depressed. In addition, as a REIT, we are
required to distribute annually at least 90% of our REIT taxable income,
determined without regard to the deduction for dividends paid and excluding net
capital gain, to our shareholders and are therefore not able to retain
significant amounts of our earnings for new acquisitions. We cannot
assure you that we will have access to such equity or debt capital on favorable
terms (including, without limitation, cost and term) at the desired times, or at
all, which may cause us to curtail our asset acquisition activities and/or
dispose of assets, which could negatively affect our results of
operations.
30
We
may incur significant debt, which will subject us to increased risk of loss and
may reduce cash available for distributions to our shareholders.
Subject
to market conditions and availability, we may incur significant debt through
bank credit facilities (including term loans and revolving facilities),
repurchase agreements, warehouse facilities and structured financing
arrangements, public and private debt issuances and derivative instruments, in
addition to transaction or asset specific funding arrangements. The
percentage of leverage we employ will vary depending on our available capital,
our ability to obtain and access financing arrangements with lenders and the
lenders’ and rating agencies’ estimate of the stability of our investment
portfolio’s cash flow. Our governing documents contain no limitation on the
amount of debt we may incur. Initially, we anticipate utilizing
moderate leverage. However, we may significantly increase the amount
of leverage we utilize at any time without approval of our board of
directors. In addition, we may leverage individual assets at
substantially higher levels. Incurring substantial debt could subject us to many
risks that, if realized, would materially and adversely affect us, including the
risk that:
·
|
our
cash flow from operations may be insufficient to make required payments of
principal of and interest on the debt or we may fail to comply with all of
the other covenants contained in the debt, which is likely to result in
(i) acceleration of such debt (and any other debt containing a
cross-default or cross-acceleration provision) that we may be unable to
repay from internal funds or to refinance on favorable terms, or at all,
(ii) our inability to borrow unused amounts under our financing
arrangements, even if we are current in payments on borrowings under those
arrangements or (iii) the loss of some or all of our assets to foreclosure
or sale;
|
·
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our
debt may increase our vulnerability to adverse economic and industry
conditions with no assurance that investment yields will increase with
higher financing costs;
|
·
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we
may be required to dedicate a substantial portion of our cash flow from
operations to payments on our debt, thereby reducing funds available for
operations, future business opportunities, shareholder distributions or
other purposes; and
|
·
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we
are not able to refinance debt that matures prior to the investment it was
used to finance on favorable terms, or at
all.
|
Interest
rate fluctuations could significantly decrease our results of operations and
cash flows and the market value of our assets.
Our
primary interest rate exposures relate to the yield on our assets and the
financing cost of our debt, as well as our interest rate swaps that we utilize
for hedging purposes. Changes in interest rates will affect our net
interest income, which is the difference between the interest income we earn on
our interest-earning assets and the interest expense we incur in financing these
assets. Interest rate fluctuations resulting in our interest expense
exceeding interest income would result in operating losses for
us. Changes in the level of interest rates also may affect our
ability to originate and acquire assets, the value of our assets and our ability
to realize gains from the disposition of assets. Changes in interest
rates may also affect borrower default rates. Our operating results
depend in large part on differences between the income from our assets, net of
credit losses, and our financing costs. To the extent that our
financing costs will be determined by reference to floating rates, such as LIBOR
or a U.S. Treasury index, plus a margin, the amount of which will depend on a
variety of factors, including, without limitation, (i) for collateralized debt,
the value and liquidity of the collateral, and for non-collateralized debt, our
credit, (ii) the level and movement of interest rates and (iii) general market
conditions and liquidity. In a period of rising interest rates, our
interest expense on floating rate debt would increase, while any additional
interest income we earn on our floating rate assets may not compensate for such
increase in interest expense, the interest income we earn on our fixed rate
assets would not change, the duration and weighted average life of our fixed
rate assets would increase and the market value of our fixed rate assets would
decrease. Similarly, in a period of declining interest rates, our
interest income on floating rate assets would decrease, while any decrease in
the interest we are charged on our floating rate debt may not compensate for
such decrease in interest income and interest we are charged on our fixed rate
debt would not change. We anticipate that for any period during which
our assets are not match-funded, the income from such assets will respond more
slowly to interest rate fluctuations than the cost of our borrowings.
Consequently, changes in interest rates may significantly influence our net
income. Increases in these rates will tend to decrease our net income and the
market value of our fixed rate assets. Interest rate fluctuations resulting in
our interest expense exceeding interest income would result in operating losses
for us. Any such scenario could materially and adversely affect
us. Our operating results will depend, in part, on differences
between the income earned on our assets, net of credit losses, and our financing
costs.
31
If
we utilize non-recourse long-term securitizations, such structures may expose us
to risks which could result in losses to us.
We may
utilize non-recourse long-term securitizations of our assets in mortgage loans,
especially loan originations, if and when they become available. Prior to any
such financing, we may seek to finance assets with relatively short-term
facilities until a sufficient portfolio is accumulated. As a result, we would be
subject to the risk that we would not be able to acquire, during the period that
any short-term facilities are available, sufficient eligible assets to maximize
the efficiency of a securitization. We also would bear the risk that we would
not be able to obtain new short-term facilities or would not be able to renew
any short-term facilities after they expire should we need more time to seek and
acquire sufficient eligible assets for a securitization. In addition,
conditions in the capital markets, including the recent unprecedented volatility
and disruption in the capital and credit markets, may not permit a non-recourse
securitization at any particular time or may make the issuance of any such
securitization less attractive to us even when we do have sufficient eligible
assets. While we would intend to retain the unrated equity component
of securitizations and, therefore, still have exposure to any assets included in
such securitizations, our inability to enter into such securitizations would
increase our overall exposure to risks associated with direct ownership of such
assets, including the risk of default. Our inability to refinance any
short-term facilities would also increase our risk because borrowings thereunder
would likely be recourse to us as an entity. If we are unable to obtain and
renew short-term facilities or to consummate securitizations to finance our
assets on a long-term basis, we may be required to seek other forms of
potentially less attractive financing or to liquidate assets at an inopportune
time or price.
Any
warehouse facilities that we may obtain in the future may limit our ability to
acquire assets, and we may incur losses if the collateral is
liquidated.
If
securitization financings become available, we may utilize, if available,
warehouse facilities pursuant to which we would accumulate commercial mortgage
loans in anticipation of a securitization financing, which assets would be
pledged as collateral for such facilities until the securitization transaction
is consummated. To borrow funds to acquire assets under any future
warehouse facilities, we expect that our lenders thereunder would have the right
to review the potential assets for which we are seeking financing. We
may be unable to obtain the consent of a lender to acquire assets that we
believe would be beneficial to us and we may be unable to obtain alternate
financing for such assets. In addition, no assurance can be given
that a securitization structure would be consummated with respect to the assets
being warehoused. If the securitization is not consummated, the
lender could liquidate the warehoused collateral, and we would then have to pay
any amount by which the original purchase price of the collateral assets exceeds
its sale price, subject to negotiated caps, if any, on our
exposure. In addition, regardless of whether the securitization is
consummated, if any of the warehoused collateral is sold before the
consummation, we would have to bear any resulting loss on the
sale. Currently, we have no warehouse facilities in place, and no
assurance can be given that we will be able to obtain one or more warehouse
facilities on favorable terms, or at all.
Any
repurchase agreements and bank credit facilities that we may use in the future
to finance our assets may require us to provide additional collateral or pay
down debt.
In the
event we utilize such financing arrangements, they would involve the risk that
the market value of the loans pledged or sold by us to the repurchase agreement
counterparty or provider of the bank credit facility may decline in value, in
which case the lender may require us to provide additional collateral or to
repay all or a portion of the funds advanced. We may not have the funds
available to repay our debt at that time, which would likely result in defaults
unless we are able to raise the funds from alternative sources, which we may not
be able to achieve on favorable terms or at all. Posting additional
collateral would reduce our liquidity and limit our ability to leverage our
assets. If we cannot meet these requirements, the lender could
accelerate our indebtedness, increase the interest rate on advanced funds and
terminate our ability to borrow funds from them, which could materially and
adversely affect our financial condition and ability to implement our business
plan. In addition, in the event that the lender files for bankruptcy or becomes
insolvent, our loans may become subject to bankruptcy or insolvency proceedings,
thus depriving us, at least temporarily, of the benefit of these
assets. Such an event could restrict our access to bank credit
facilities and increase our cost of capital. The providers of
repurchase agreement financing and bank credit facilities may also require us to
maintain a certain amount of cash or set aside assets sufficient to maintain a
specified liquidity position that would allow us to satisfy our collateral
obligations. As a result, we may not be able to leverage our assets
as fully as we would choose, which could reduce our return on assets. In the
event that we are unable to meet these collateral obligations, our financial
condition and prospects could deteriorate rapidly.
32
If
the counterparty to a repurchase transaction defaults on its obligation to
resell the underlying security back to us at the end of the transaction term, or
if the value of the underlying security has declined as of the end of that term
or if we default on our obligations under a repurchase agreement, we will lose
money on that repurchase transaction.
If we
engage in a repurchase transaction, we generally would sell securities to the
transaction counterparty and receive cash from the counterparty. The
counterparty would be obligated to resell the securities back to us at the end
of the term of the transaction, which is typically 30 to 90 days. Because the
cash we would receive from the counterparty when we initially sold the
securities to the counterparty will be less than the value of those securities
(this difference is referred to as the haircut), if the counterparty defaults on
its obligation to resell the securities back to us we would incur a loss on the
transaction equal to the amount of the haircut (assuming there was no change in
the value of the securities).
We would
also lose money on a repurchase transaction if the value of the underlying
securities has declined as of the end of the transaction term, as we would have
to repurchase the securities for their initial value but would receive
securities worth less than that amount. Any losses we incur on our repurchase
transactions could adversely affect our earnings, and thus our cash available
for distribution to you. If we default on one of our obligations under a
repurchase transaction, the counterparty can terminate the transaction and cease
entering into any other repurchase transactions with us. In that case, we would
likely need to establish a replacement repurchase facility with another
repurchase dealer in order to continue to leverage our portfolio and carry out
our strategy. There is no assurance we would be able to establish a suitable
replacement facility.
Our
rights under repurchase agreements will be subject to the effects of the
bankruptcy laws in the event of our or our lenders’ bankruptcy or insolvency
under the repurchase agreements, which may allow our lenders to repudiate our
repurchase agreements.
In the
event of our insolvency or bankruptcy, certain repurchase agreements may qualify
for special treatment under the U.S. Bankruptcy Code, the effect of which, among
other things, would be to allow the lender under the applicable repurchase
agreement to avoid the automatic stay provisions of the U.S. Bankruptcy Code and
to foreclose on the collateral agreement without delay. In the event of the
insolvency or bankruptcy of a lender during the term of a repurchase agreement,
the lender may be permitted, under applicable insolvency laws, to repudiate the
contract, and our claim against the lender for damages may be treated simply as
an unsecured creditor. In addition, if the lender is a broker or dealer subject
to the Securities Investor Protection Act of 1970, or an insured depository
institution subject to the Federal Deposit Insurance Act, our ability to
exercise our rights to recover our securities under a repurchase agreement or to
be compensated for any damages resulting from the lender’s insolvency may be
further limited by those statutes. These claims would be subject to significant
delay and, if and when received, may be substantially less than the damages we
actually incur.
An
increase in our borrowing costs relative to the interest we will receive on our
assets may adversely affect our profitability, and thus our cash available for
distribution to you.
As
repurchase agreements and other short-term borrowings that we may enter mature,
we would be required either to enter into new borrowings or to sell certain of
our assets. An increase in short-term interest rates at the time that we seek to
enter into new borrowings would reduce the spread between our returns on our
assets and the cost of our borrowings. This would adversely affect our returns
on our assets that are subject to prepayment risk, including our mortgage-backed
securities, which might reduce earnings and, in turn, cash available for
distribution to you.
If
we issue senior securities we will be exposed to additional risks, which may
restrict our operating flexibility.
If we
decide to issue senior securities in the future, it is likely that they will be
governed by an indenture or other instrument containing covenants restricting
our operating flexibility. Additionally, any convertible or exchangeable
securities that we issue in the future may have rights, preferences and
privileges more favorable than those of our common stock and may result in
dilution to owners of our common stock. We and, indirectly, you, will bear the
cost of issuing and servicing such securities.
33
Securitizations
would expose us to additional risks.
In the
most likely securitization structure, we would convey a pool of assets to a
special purpose vehicle, the issuing entity, and the issuing entity would issue
one or more classes of non-recourse notes pursuant to the terms of an indenture.
The notes would be secured by the pool of assets. In exchange for the transfer
of assets to the issuing entity, we would receive the cash proceeds of the sale
of non-recourse notes and a 100% interest in the equity of the issuing entity.
The securitization of our portfolio might magnify our exposure to losses because
any equity interest we retain in the issuing entity would be subordinate to the
notes issued to investors and we would, therefore, absorb all of the losses
sustained with respect to a securitized pool of assets before the owners of the
notes experience any losses. Moreover, we cannot be assured that we will be able
to continue to access the securitization market or be able to do so at favorable
rates. The inability to securitize our portfolio could hurt our performance and
our ability to grow our business.
Lenders
may require us to enter into restrictive covenants relating to our operations
that may inhibit our ability to grow our business and increase
revenues.
If or
when we obtain debt financing, lenders (especially in the case of bank credit
facilities) may impose restrictions on us that would affect our ability to incur
additional debt, make certain allocations or acquisitions, reduce liquidity
below certain levels, make distributions to our shareholders, redeem debt or
equity securities and impact our flexibility to determine our operating policies
and strategies. For example, our loan documents may contain negative
covenants that limit, among other things, our ability to repurchase our common
shares, distribute more than a certain amount of our net income or funds from
operations to our shareholders, employ leverage beyond certain amounts, sell
assets, engage in mergers or consolidations, grant liens, and enter into
transactions with affiliates. If we fail to meet or satisfy any of
these covenants, we would be in default under these agreements, and our lenders
could elect to declare outstanding amounts due and payable, terminate their
commitments, require the posting of additional collateral and enforce their
interests against existing collateral. We may also be subject to
cross-default and acceleration rights and, with respect to collateralized debt,
the posting of additional collateral and foreclosure rights upon
default. Furthermore, this could also make it difficult for us to
satisfy the qualification requirements necessary to maintain our status as a
REIT for U.S. federal income tax purposes. A default and resulting
repayment acceleration could significantly reduce our liquidity, which could
require us to sell our assets to repay amounts due and outstanding. This could
also significantly harm our business, financial condition, results of operations
and ability to make distributions, which could cause the value of our capital
stock to decline. A default could also significantly limit our financing
alternatives such that we would be unable to pursue our leverage strategy, which
could adversely affect our returns.
If
one or more of our Manager’s executive officers are no longer employed by our
Manager, financial institutions providing any financing arrangements we may have
may not provide future financing to us, which could materially and adversely
affect us.
If
financial institutions that we seek to finance our assets require that one or
more of our Manager’s executives continue to serve in such capacity and if one
or more of our Manager’s executives are no longer employed by our Manager, it
may constitute an event of default and the financial institution providing the
arrangement may have acceleration rights with respect to outstanding borrowings
and termination rights with respect to our ability to finance our future assets
with that institution. If we are unable to obtain financing for our accelerated
borrowings and for our future assets under such circumstances, we could be
materially and adversely affected.
Risks
Related to Hedging
We
may enter into economic hedging transactions that could expose us to contingent
liabilities in the future and adversely affect our financial
condition.
Subject
to maintaining our qualification as a REIT, part of our strategy will involve
entering into hedging transactions that could require us to fund cash payments
in certain circumstances (such as the early termination of the hedging
instrument caused by an event of default or other early termination event, or
the decision by a counterparty to request margin securities it is contractually
owed under the terms of the hedging instrument). These potential payments will
be contingent liabilities and therefore may not appear in our financial
statements. The amount due would be equal to the unrealized loss of
the open swap positions with the respective counterparty and could also include
other fees and charges. These economic losses will be reflected in our results
of operations, and our ability to fund these obligations will depend on the
liquidity of our assets and access to capital at the time, and the need to fund
these obligations could adversely impact our financial condition.
34
Hedging
against interest rate exposure may adversely affect our earnings, which could
reduce our cash available for distribution to our stockholders.
Subject
to maintaining our qualification as a REIT, we may pursue various hedging
strategies to seek to reduce our exposure to adverse changes in interest rates.
Our hedging activity will vary in scope based on the level and volatility of
interest rates, the type of assets held and liabilities incurred and other
changing market conditions. Interest rate hedging may fail to protect or could
adversely affect us because, among other things:
·
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interest
rate hedging can be expensive, particularly during periods of rising and
volatile interest rates;
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·
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available
interest rate hedges may not correspond directly with the interest rate
risk for which protection is
sought;
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·
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due
to a credit loss, the duration of the hedge may not match the duration of
the related liability;
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·
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the
amount of income that a REIT may earn from hedging transactions (other
than hedging transactions that satisfy certain requirements of the
Internal Revenue Code or that are done through a TRS) to offset interest
rate losses is limited by U.S. federal tax provisions governing
REITs;
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·
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the
credit quality of the hedging counterparty owing money on the hedge may be
downgraded to such an extent that it impairs our ability to sell or assign
our side of the hedging transaction;
and
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·
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the
hedging counterparty owing money in the hedging transaction may default on
its obligation to pay.
|
Hedging
transactions, which are intended to limit losses, may actually limit gains and
increase our exposure to losses. As a result, hedging activity may adversely
affect our earnings, which could reduce our cash available for distribution to
you. In addition, hedging instruments involve risk since they often are not
traded on regulated exchanges, guaranteed by an exchange or its clearing house,
or regulated by any U.S. or foreign governmental authorities. Consequently,
there are no requirements with respect to record keeping, financial
responsibility or segregation of customer funds and positions. Furthermore, the
enforceability of agreements underlying derivative transactions may depend on
compliance with applicable statutory and commodity and other regulatory
requirements and, depending on the identity of the counterparty, applicable
international requirements. The business failure of a hedging counterparty with
whom we enter into a hedging transaction will most likely result in its default.
Default by a party with whom we enter into a hedging transaction may result in
the loss of unrealized profits and force us to cover our commitments, if any, at
the then current market price. Although generally we will seek to reserve the
right to terminate our hedging positions, it may not always be possible to
dispose of or close out a hedging position without the consent of the hedging
counterparty, and we may not be able to enter into an offsetting contract in
order to cover our risk. We cannot assure you that a liquid secondary market
will exist for hedging instruments purchased or sold, and we may be required to
maintain a position until exercise or expiration, which could result in
losses.
In
addition, we may fail to recalculate, readjust and execute hedges in an
efficient manner.
Any
hedging activity in which we engage may materially and adversely affect our
results of operations and cash flows. Therefore, while we may enter
into such transactions seeking to reduce interest rate risks, unanticipated
changes in interest rates may result in poorer overall performance than if we
had not engaged in any such hedging transactions. In addition, the degree of
correlation between price movements of the instruments used in a hedging
strategy and price movements in the portfolio positions or liabilities being
hedged may vary materially. Moreover, for a variety of reasons, we
may not seek to establish a perfect correlation between such hedging instruments
and the portfolio positions or liabilities being hedged. Any such imperfect
correlation may prevent us from achieving the intended hedge and expose us to
risk of loss.
35
Hedging
instruments often are not traded on regulated exchanges, guaranteed by an
exchange or its clearing house, or regulated by any U.S. or foreign governmental
authorities and involves risks and costs that could result in material
losses.
The cost
of using hedging instruments increases as the period covered by the instrument
increases and during periods of rising and volatile interest rates, we may
increase our hedging activity and thus increase our hedging costs during periods
when interest rates are volatile or rising and hedging costs have increased. In
addition, hedging instruments involve risk since they often are not traded on
regulated exchanges, guaranteed by an exchange or its clearing house, or
regulated by any U.S. or foreign governmental authorities. Consequently, there
are no requirements with respect to record keeping, financial responsibility or
segregation of customer funds and positions. Furthermore, the enforceability of
agreements underlying hedging transactions may depend on compliance with
applicable statutory and commodity and other regulatory requirements and,
depending on the identity of the counterparty, applicable international
requirements. The business failure of a hedging counterparty with
whom we enter into a hedging transaction will most likely result in its default.
Default by a party with whom we enter into a hedging transaction may result in
the loss of unrealized profits and force us to cover our commitments, if any, at
the then current market price. Although generally we will seek to
reserve the right to terminate our hedging positions, it may not always be
possible to dispose of or close out a hedging position without the consent of
the hedging counterparty, and we may not be able to enter into an offsetting
contract in order to cover our risk. We cannot assure you that a
liquid secondary market will exist for hedging instruments purchased or sold,
and we may be required to maintain a position until exercise or expiration,
which could result in significant losses.
Risks
Related To Our Common Stock
Annaly
owns a significant percentage of our common stock, which could result in
significant influence over the outcome of matters submitted to the vote of our
stockholders.
Annaly
owns approximately 25% of our outstanding shares of common stock. As
a result, Annaly may have significant influence over the outcome of matters
submitted to a vote of our stockholders, including the election of our directors
or transactions involving a change in control. The interests of Annaly may
conflict with, or differ from, the interests of other holders of our capital
stock. So long as Annaly continues to own a significant percentage of shares of
our common stock, it will significantly influence all our corporate decisions
submitted to our stockholders for approval, regardless of whether or not we
terminate the management agreement with our Manager.
The
market price of our common stock may be highly volatile and could be subject to
wide fluctuations.
The
market price of our common stock may be highly volatile and could be subject to
wide fluctuations. Some of the factors that could negatively affect
our share price include:
·
|
our
actual or projected operating results, financial condition, cash flows and
liquidity, or changes in business strategy or
prospects;
|
·
|
actual
or perceived conflicts of interest with our Manager and individuals,
including our executives;
|
·
|
equity
issuances by us, or share resales by our stockholders, or the perception
that such issuances or resales may
occur;
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·
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actual
or anticipated accounting problems;
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·
|
publication
of research reports about us or the real estate
industry;
|
·
|
changes
in market valuations of similar
companies;
|
·
|
adverse
market reaction to any increased indebtedness we incur in the
future;
|
·
|
additions
to or departures of our Manager’s or Annaly’s key
personnel;
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·
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actions
by stockholders;
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·
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speculation
in the press or investment
community;
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36
·
|
our
failure to meet, or the lowering of, our earnings’ estimates or those of
any securities analysts;
|
·
|
increases
in market interest rates, which may lead investors to demand a higher
distribution yield for our common stock, if we have begun to make
distributions to our stockholders, and would result in increased interest
expenses on our debt;
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·
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failure
to maintain our REIT qualification or exemption from the 1940
Act;
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·
|
price
and volume fluctuations in the stock market generally;
and
|
·
|
general
market and economic conditions, including the current state of the credit
and capital markets.
|
Market
factors unrelated to our performance could also negatively impact the market
price of our common stock. One of the factors that investors may consider in
deciding whether to buy or sell our common stock is our distribution rate as a
percentage of our stock price relative to market interest rates. If market
interest rates increase, prospective investors may demand a higher distribution
rate or seek alternative investments paying higher dividends or interest. As a
result, interest rate fluctuations and conditions in the capital markets can
affect the market value of our common stock. For instance, if interest rates
rise, it is likely that the market price of our common stock will decrease as
market rates on interest-bearing securities increase.
Common
stock eligible for future sale may have adverse effects on our share
price.
We cannot
predict the effect, if any, of future sales of our common stock, or the
availability of shares for future sales, on the market price of the common
stock. If an active trading market develops for our common stock, the
market price of our common stock may decline significantly when the restrictions
on re-sale (or lock-up agreement) by certain of our stockholders
lapse. Sales of substantial amounts of common stock, or the
perception that such sales could occur, may adversely affect the prevailing
market price for our common stock.
Also, we
may issue additional shares of our common stock in subsequent public offerings
or private placements to acquire new assets or for other purposes. We
are not required to offer any such shares to our current stockholders on a
preemptive basis. Therefore, it may not be possible for existing
stockholders to participate in such future share issuances which may dilute
their interests in us.
There
is a risk that you may not receive distributions or that distributions may not
grow over time.
We intend
to make distributions on a quarterly basis out of assets legally available
therefore to our stockholders in amounts such that all or substantially all of
our REIT taxable income in each year is distributed. We have not
established a minimum distribution payment level and our ability to pay
distributions may be adversely affected by a number of factors, including the
risk factors described in this annual report. All distributions will
be made at the discretion of our board of directors and will depend on our
earnings, our financial condition, maintenance of our REIT status and other
factors as our board of directors may deem relevant from time to
time. Among the factors that could adversely affect our results of
operations and impair our ability to pay distributions to our stockholders
are:
·
|
the
profitability of the assets we purchase with the net proceeds of this
offering:
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·
|
our
ability to make profitable asset
acquisitions;
|
·
|
margin
calls or other expenses that reduce our cash
flow;
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·
|
defaults
in our asset portfolio or decreases in the value of our portfolio;
and
|
·
|
the
fact that anticipated operating expense levels may not provide accurate,
as actual results may vary from
estimates.
|
A change
in any one of these factors could affect our ability to make
distributions. We cannot assure you that we will achieve results that
will allow us to make a specified level of cash distributions or year-to-year
increases in cash distributions.
37
Market
interest rates may have an effect on the trading value of our
shares.
One of
the factors that investors may consider in deciding whether to buy or sell our
shares is our distribution rate as a percentage of our share price relative to
market interest rates. If market interest rates increase, prospective
investors may demand a higher distribution rate or seek alternative investments
paying higher dividends or interest. As a result, interest rate
fluctuations and capital market conditions can affect the market value of our
shares. For instance, if interest rates rise, it is likely that the
market price of our shares will decrease as market rates on interest-bearing
securities, such as bonds, increase.
Investing
in our shares may involve a high degree of risk and may result in a loss of
principal.
The
assets we purchase in accordance with our objectives may result in a high amount
of risk when compared to alternative asset acquisition options and volatility or
loss of principal. Our investments may be highly speculative and
aggressive, are subject to credit, interest and market value risks, among other
things, and therefore an investment in our shares may not be suitable for
someone with lower risk tolerance.
Broad
market fluctuations could negatively impact the market price of our common
stock.
The stock
market has experienced extreme price and volume fluctuations that have affected
the market price of many companies in industries similar or related to ours and
that have been unrelated to these companies’ operating
performances. These broad market fluctuations could reduce the market
price of our common stock. Furthermore, our operating results and
prospects may be below the expectations of public market analysts and investors
or may be lower than those of companies with comparable market capitalizations,
which could lead to a material decline in the market price of our common
stock.
Future
sales of shares may have adverse consequences for investors.
We may
issue additional shares in public offerings or private placements to make new
asset purchases or for other purposes. We are not required to offer
any such shares to existing stockholders on a pre-emptive
basis. Therefore, it may not be possible for existing stockholders to
participate in such future share issues, which may dilute the existing
stockholders’ interests in us. Additional shares may be issued
pursuant to the terms of the underwriters’ option, which, if issued, would
dilute stockholders’ percentage ownership in us. If the underwriters
exercise their option to purchase additional shares to cover overallotments, the
issuance of additional shares by us, or the possibility of such issue, may cause
the market price of the shares to decline. Annaly executive officers
and directors as a group own approximately 25% and 0.3%, respectively, of our
outstanding shares of common stock.
Risks
Related to Our Organization and Structure
Our
charter and bylaws contain provisions that may inhibit potential acquisition
bids that you and other stockholders may consider favorable, and the market
price of our common stock may be lower as a result.
Our
charter and bylaws contain provisions that may have an anti-takeover effect and
inhibit a change in our board of directors. These provisions include
the following:
·
|
There are ownership limits and
restrictions on transferability and ownership in our
charter. To qualify as a REIT for each taxable year
after 2009, not more than 50% of the value of our outstanding stock may be
owned, directly or constructively, by five or fewer individuals during the
second half of any taxable year. In addition, our shares must
be beneficially owned by 100 or more persons during at least 335 days of a
taxable year of 12 months or during a proportionate part of a shorter
taxable year for each taxable year after 2009. To assist us in
satisfying these tests, our charter generally prohibits any person from
beneficially or constructively owning more than 9.8% in value or number of
shares, whichever is more restrictive, of any class or series of our
outstanding capital stock. These restrictions may discourage a
tender offer or other transactions or a change in the composition of our
board of directors or control that might involve a premium price for our
shares or otherwise be in the best interests of our stockholders and any
shares issued or transferred in violation of such restrictions being
automatically transferred to a trust for a charitable beneficiary, thereby
resulting in a forfeiture of the additional
shares.
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38
·
|
Our charter permits our board
of directors to issue stock with terms that may discourage a third party
from acquiring us. Our charter permits our board of
directors to amend the charter without stockholder approval to increase
the total number of authorized shares of stock or the number of shares of
any class or series and to issue common or preferred stock, having
preferences, conversion or other rights, voting powers, restrictions,
limitations as to dividends or other distributions, qualifications, or
terms or conditions of redemption as determined by our board of
directors. Thus, our board of directors could authorize the
issuance of stock with terms and conditions that could have the effect of
discouraging a takeover or other transaction in which holders of some or a
majority of our shares might receive a premium for their shares over the
then-prevailing market price of our
shares.
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·
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Maryland Control Share
Acquisition Act. Maryland law provides that “control
shares” of a corporation acquired in a “control share acquisition” will
have no voting rights except to the extent approved by a vote of
two-thirds of the votes eligible to be cast on the matter under the
Maryland Control Share Acquisition
Act.
|
If voting
rights or control shares acquired in a control share acquisition are not
approved at a stockholders’ meeting, or if the acquiring person does not deliver
an acquiring person statement as required by the Maryland Control Share
Acquisition Act, then, subject to certain conditions and limitations, the issuer
may redeem any or all of the control shares for fair value. If voting
rights of such control shares are approved at a stockholders’ meeting and the
acquiror becomes entitled to vote a majority of the shares of stock entitled to
vote, all other stockholders may exercise appraisal rights. Our
bylaws contain a provision exempting acquisitions of our shares from the
Maryland Control Share Acquisition Act. However, our board of
directors may amend our bylaws in the future to repeal or modify this exemption,
in which case any control shares of our company acquired in a control share
acquisition will be subject to the Maryland Control Share Acquisition
Act.
·
|
Business
Combinations. Under Maryland law, “business
combinations” between a Maryland corporation and an interested stockholder
or an affiliate of an interested stockholder are prohibited for five years
after the most recent date on which the interested stockholder becomes an
interested stockholder. These business combinations include a
merger, consolidation, share exchange or, in circumstances specified in
the statute, an asset transfer or issuance or reclassification of equity
securities. An interested stockholder is defined
as:
|
·
|
any
person who beneficially owns 10% or more of the voting power of the
corporation’s shares; or
|
·
|
an
affiliate or associate of the corporation who, at any time within the
two-year period before the date in question, was the beneficial owner of
10% or more of the voting power of the then outstanding voting stock of
the corporation.
|
A person
is not an interested stockholder under the statute if the board of directors
approved in advance the transaction by which such person otherwise would have
become an interested stockholder. However, in approving a
transaction, the board of directors may provide that its approval is subject to
compliance, at or after the time of approval, with any terms and conditions
determined by the board of directors.
After the
five-year prohibition, any business combination between the Maryland corporation
and an interested stockholder generally must be recommended by the board of
directors of the corporation and approved by the affirmative vote of at
least:
·
|
80%
of the votes entitled to be cast by holders of outstanding shares of
voting stock of the corporation;
and
|
·
|
two-thirds
of the votes entitled to be cast by holders of voting stock of the
corporation, other than shares held by the interested stockholder with
whom or with whose affiliate the business combination is to be effected or
held by an affiliate or associate of the interested
stockholder.
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39
These
super-majority vote requirements do not apply if the corporation’s common
stockholders receive a minimum price, as defined under Maryland law, for their
shares in the form of cash or other consideration in the same form as previously
paid by the interested stockholder for its shares.
The
statute permits various exemptions from its provisions, including business
combinations that are exempted by the board of directors before the time that
the interested stockholder becomes an interested stockholder. Our
board of directors has adopted a resolution which provides that any business
combination between us and any other person is exempted from the provisions of
the Maryland Control Share Acquisition Act, provided that the business
combination is first approved by the board of directors. This
resolution, however, may be altered or repealed in whole or in part at any
time. If this resolution is repealed, or the board of directors does
not otherwise approve a business combination, this statute may discourage others
from trying to acquire control of us and increase the difficulty of consummating
any offer.
·
|
Staggered board of
directors. Our board of directors is divided into three
classes of directors. The current terms of the directors expire
in 2010, 2011 and 2012, respectively. Directors of each class
are chosen for three-year terms upon the expiration of their current
terms, and each year one class of directors is elected by the
stockholders. The staggered terms of our directors may reduce
the possibility of a tender offer or an attempt at a change in control,
even though a tender offer or change in control might be in the best
interests of our stockholders.
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·
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Our charter and bylaws contain
other possible anti-takeover provisions. Upon completion
of this offering, our charter and bylaws will contain other provisions
that may have the effect of delaying, deferring or preventing a change in
control of us or the removal of existing directors and, as a result, could
prevent our stockholders from being paid a premium for their common stock
over the then-prevailing market
price.
|
Our
rights and the rights of our stockholders to take action against our directors
and officers are limited, which could limit your recourse in the event of
actions not in your best interests.
Under
Maryland law generally, a director’s actions will be upheld if he or she
performs his or her duties in good faith, in a manner he or she reasonably
believes to be in our best interests and with the care that an ordinarily
prudent person in a like position would use under similar circumstances. In
addition, our charter limits the liability of our directors and officers to us
and our stockholders for money damages, except for liability resulting
from:
·
|
actual
receipt of an improper benefit or profit in money, property or services;
or
|
·
|
a
final judgment based upon a finding of active and deliberate dishonesty by
the director or officer that was material to the cause of action
adjudicated
|
for which
Maryland law prohibits such exemption from liability.
In
addition, our charter authorizes us to obligate our company to indemnify our
present and former directors and officers for actions taken by them in those
capacities to the maximum extent permitted by Maryland law. Our
bylaws require us to indemnify each present or former director or officer, to
the maximum extent permitted by Maryland law, in the defense of any proceeding
to which he or she is made, or threatened to be made, a party because of his or
her service to us. In addition, we may be obligated to fund the
defense costs incurred by our directors and officers.
Our
charter contains provisions that make removal of our directors difficult, which
could make it difficult for our stockholders to effect changes to our
management.
Our
charter provides that a director may only be removed for cause upon the
affirmative vote of holders of two-thirds of the votes entitled to be cast in
the election of directors. Vacancies may be filled only by a majority of the
remaining directors in office, even if less than a quorum. These requirements
make it more difficult to change our management by removing and replacing
directors and may prevent a change in control of our company that is in the best
interests of our stockholders.
40
Tax
Risks
Your
investment has various tax risks.
This
summary of certain tax risks is limited to the U.S. federal tax risks addressed
below. Additional risks or issues may exist that are not addressed in
this annual report and that could affect the U.S. federal tax treatment of us or
our stockholders.
This
annual report is not intended to be used and cannot be used by any stockholder
to avoid penalties that may be imposed on stockholders under the Internal
Revenue Code.
We
strongly urge you to seek advice based on your particular circumstances from an
independent tax advisor concerning the effects of U.S. federal, state and local
income tax law on an investment in our common stock and on your individual tax
situation.
Complying
with REIT requirements may cause us to forego otherwise attractive
opportunities.
To
qualify as a REIT for U.S. federal income tax purposes, we must continually
satisfy various tests regarding the sources of our income, the nature and
diversification of our assets, the amounts we distribute to our stockholders and
the ownership of our stock. To meet these tests, we may be required
to forego investments we might otherwise make. We may be required to
make distributions to stockholders at disadvantageous times or when we do not
have funds readily available for distribution. Thus, compliance with
the REIT requirements may hinder our investment performance.
Complying
with REIT requirements may force us to liquidate otherwise attractive
investments.
To
qualify as a REIT, we generally must ensure that at the end of each calendar
quarter at least 75% of the value of our total assets consists of cash, cash
items, government securities and qualified REIT real estate assets, including
certain mortgage loans and MBS. The remainder of our investment in
securities (other than government securities and qualifying real estate assets)
generally cannot include more than 10% of the outstanding voting securities of
any one issuer or more than 10% of the total value of the outstanding securities
of any one issuer. In addition, in general, no more than 5% of the
value of our assets (other than government securities and qualifying real estate
assets) can consist of the securities of any one issuer, and no more than 25% of
the value of our total securities can be represented by securities of one or
more TRSs. If we fail to comply with these requirements at the end of
any calendar quarter, we must correct the failure within 30 days after the end
of such calendar quarter or qualify for certain statutory relief provisions to
avoid losing our REIT status and suffering adverse tax
consequences. As a result, we may be required to liquidate from our
portfolio otherwise attractive investments. These actions could have
the effect of reducing our income and amounts available for distribution to our
stockholders.
Potential
characterization of distributions or gain on sale may be treated as unrelated
business taxable income to tax-exempt investors.
If (1)
all or a portion of our assets are subject to the rules relating to taxable
mortgage pools, (2) we are a “pension-held REIT,” (3) a tax-exempt stockholder
has incurred debt to purchase or hold our common stock, or (4) the residual
REMIC interests we buy generate “excess inclusion income,” then a portion of the
distributions to and, in the case of a stockholder described in clause (3),
gains realized on the sale of common stock by such tax-exempt stockholder may be
subject to U.S. federal income tax as unrelated business taxable income under
the Internal Revenue Code
Classification
of a securitization or financing arrangement we enter into as a taxable mortgage
pool could subject us or certain of our stockholders to increased
taxation.
If we
have borrowings with two or more maturities and, (1) those borrowings are
secured by mortgages or MBS and (2) the payments made on the borrowings are
related to the payments received on the underlying assets, then the borrowings
and the pool of mortgages or MBS to which such borrowings relate may be
classified as a taxable mortgage pool under the Internal Revenue
Code. If any part of our investments were to be treated as a taxable
mortgage pool, then our REIT status would not be impaired, but a portion of the
taxable income we recognize may, under regulations to be issued by the Treasury
Department, be characterized as “excess inclusion” income and allocated among
our stockholders to the extent of and generally in proportion to the
distributions we make to each stockholder. Any excess inclusion income
would:
·
|
not
be allowed to be offset by a stockholder’s net operating
losses;
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·
|
be
subject to a tax as unrelated business income if a stockholder were a
tax-exempt stockholder;
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41
·
|
be
subject to the application of U.S. federal income tax withholding at the
maximum rate (without reduction for any otherwise applicable income tax
treaty) with respect to amounts allocable to foreign stockholders;
and
|
·
|
be
taxable (at the highest corporate tax rate) to us, rather than to our
stockholders, to the extent the excess inclusion income relates to stock
held by disqualified organizations (generally, tax-exempt companies not
subject to tax on unrelated business income, including governmental
organizations).
|
Failure
to qualify as a REIT would subject us to U.S. federal income tax, which would
reduce the cash available for distribution to our stockholders.
We intend
to operate in a manner that will cause us to qualify as a REIT for U.S. federal
income tax purposes. However, the U.S. federal income tax laws
governing REITs are extremely complex, and interpretations of the U.S. federal
income tax laws governing qualification as a REIT are
limited. Qualifying as a REIT requires us to meet various tests
regarding the nature of our assets and our income, the ownership of our
outstanding stock, and the amount of our distributions on an ongoing
basis. While we intend to operate so that we will qualify as a REIT,
given the highly complex nature of the rules governing REITs, the ongoing
importance of factual determinations, including the tax treatment of certain
investments we may make, and the possibility of future changes in our
circumstances, no assurance can be given that we will so qualify for any
particular year.
If we
fail to qualify as a REIT in any calendar year and we do not qualify for certain
statutory relief provisions, we would be required to pay U.S. federal income tax
on our taxable income. We might need to borrow money or sell assets
to pay that tax. Our payment of income tax would decrease the amount
of our income available for distribution to our
stockholders. Furthermore, if we fail to maintain our qualification
as a REIT and we do not qualify for certain statutory relief provisions, we no
longer would be required to distribute substantially all of our REIT taxable
income to our stockholders. Unless our failure to qualify as a REIT
were excused under federal tax laws, we would be disqualified from taxation as a
REIT for the four taxable years following the year during which qualification
was lost.
Failure
to make required distributions would subject us to tax, which would reduce the
cash available for distribution to our stockholders.
To
qualify as a REIT, we must distribute to our stockholders each calendar year at
least 90% of our REIT taxable income (including certain items of non-cash
income), determined without regard to the deduction for dividends paid and
excluding net capital gain. To the extent that we satisfy the 90%
distribution requirement, but distribute less than 100% of our taxable income,
we will be subject to federal corporate income tax on our undistributed
income. In addition, we will incur a 4% nondeductible excise tax on
the amount, if any, by which our distributions in any calendar year are less
than the sum of:
·
|
85%
of our REIT ordinary income for that
year;
|
·
|
95%
of our REIT capital gain net income for that year;
and
|
·
|
any
undistributed taxable income from prior
years.
|
We intend
to distribute our REIT taxable income to our stockholders in a manner that will
satisfy the 90% distribution requirement and to avoid both corporate income tax
and the 4% nondeductible excise tax. However, there is no requirement
that taxable REIT subsidiaries distribute their after-tax net income to their
parent REIT or their stockholders.
Our
taxable income may substantially exceed our net income as determined based on
generally accepted accounting principles, or GAAP, because, for example,
realized capital losses will be deducted in determining our GAAP net income, but
may not be deductible in computing our taxable income. In addition,
we may acquire assets that generate taxable income in excess of economic income
or in advance of the corresponding cash flow from the assets. To the
extent that we generate such non-cash taxable income in a taxable year, we may
incur corporate income tax and the 4% nondeductible excise tax on that income if
we do not distribute such income to stockholders in that year. As a
result of the foregoing, we may generate less cash flow than taxable income in a
particular year. In that event, we may be required to use cash
reserves, incur debt, or liquidate non-cash assets at rates or at times that we
regard as unfavorable to satisfy the distribution requirement and to avoid
corporate income tax and the 4% nondeductible excise tax in that
year. Moreover, our ability to distribute cash may be limited by the
financing agreements we enter into.
42
Ownership
limitations may restrict change of control or business combination opportunities
in which our stockholders might receive a premium for their shares.
In order
for us to qualify as a REIT for each taxable year after 2009, no more than 50%
in value of our outstanding capital stock may be owned, directly or indirectly,
by five or fewer individuals during the last half of any calendar
year. “Individuals” for this purpose include natural persons, private
foundations, some employee benefit plans and trusts, and some charitable
trusts. To preserve our REIT qualification, our charter generally
prohibits any person from directly or indirectly owning more than 9.8% in value
or in number of shares, whichever is more restrictive, of any class or series of
the outstanding shares of our capital stock.
This
ownership limitation could have the effect of discouraging a takeover or other
transaction in which holders of our common stock might receive a premium for
their shares over the then prevailing market price or which holders might
believe to be otherwise in their best interests.
Our
ownership of and relationship with any TRS which we may form or acquire
following the completion of this offering will be limited, and a failure to
comply with the limits would jeopardize our REIT status and may result in the
application of a 100% excise tax.
A REIT
may own up to 100% of the stock of one or more TRSs. A TRS may earn
income that would not be qualifying income if earned directly by the parent
REIT. Both the subsidiary and the REIT must jointly elect to treat
the subsidiary as a TRS. Overall, no more than 25% of the value of a
REIT’s assets may consist of stock or securities of one or more
TRSs. A domestic TRS will pay federal, state and local income tax at
regular corporate rates on any income that it earns. In addition, the
TRS rules impose a 100% excise tax on certain transactions between a TRS and its
parent REIT that are not conducted on an arm’s-length basis.
The
domestic TRS that we may form following the completion of this offering would
pay federal, state and local income tax on its taxable income, and its after-tax
net income would be available for distribution to us but would not be required
to be distributed to us. We anticipate that the aggregate value of
the TRS stock and securities owned by us will be less than 25% of the value of
our total assets (including the TRS stock and
securities). Furthermore, we will monitor the value of our
investments in our TRSs to ensure compliance with the rule that no more than 25%
of the value of our assets may consist of TRS stock and securities (which is
applied at the end of each calendar quarter). In addition, we will
scrutinize all of our transactions with taxable REIT subsidiaries to ensure that
they are entered into on arm’s-length terms to avoid incurring the 100% excise
tax described above. There can be no assurance, however, that we will
be able to comply with the 25% limitation discussed above or to avoid
application of the 100% excise tax discussed above.
We
could fail to qualify as a REIT or we could become subject to a penalty tax if
income we recognize from certain investments that are treated or could be
treated as equity interests in a foreign corporation exceeds 5% of our gross
income in a taxable year.
We may
acquire securities, such as subordinated interests in certain CRE CDO offerings,
that are treated or could be treated for federal (and applicable state and
local) corporate income tax purposes as equity interests in foreign
corporations. Categories of income that qualify for the 95% gross
income test include dividends, interest and certain other enumerated classes of
passive income. Under certain circumstances, the U.S. federal income
tax rules concerning controlled foreign corporations and passive foreign
investment companies require that the owner of an equity interest in a foreign
corporation include amounts in income without regard to the owner’s receipt of
any distributions from the foreign corporation. Amounts required to
be included in income under those rules are technically neither actual dividends
nor any of the other enumerated categories of passive income specified in the
95% gross income test. Furthermore, there is no clear precedent with
respect to the qualification of such income under the 95% gross income
test. Due to this uncertainty, we intend to limit our direct
investment in securities that are or could be treated as equity interests in a
foreign corporation such that the sum of the amounts we are required to include
in income with respect to such securities and other amounts of non-qualifying
income do not exceed 5% of our gross income. We cannot assure you
that we will be successful in this regard. To avoid any risk of
failing the 95% gross income test, we may be required to invest only indirectly,
through a domestic TRS, in any securities that are or could be considered to be
equity interests in a foreign corporation. This, of course, will
result in any income recognized from any such investment to be subject to U.S.
federal income tax in the hands of the domestic TRS, which may, in turn, reduce
our yield on the investment.
43
Liquidation
of our assets may jeopardize our REIT qualification.
To
qualify as a REIT, we must comply with requirements regarding our assets and our
sources of income. If we are compelled to liquidate our investments
to repay obligations to our lenders, we may be unable to comply with these
requirements, ultimately jeopardizing our qualification as a REIT, or we may be
subject to a 100% tax on any resultant gain if we sell assets in transactions
that are considered to be prohibited transactions.
The
tax on prohibited transactions will limit our ability to engage in transactions,
including certain methods of securitizing mortgage loans that would be treated
as sales for U.S. federal income tax purposes.
A REIT’s
net income from prohibited transactions is subject to a 100% tax. In general,
prohibited transactions are sales or other dispositions of property, other than
foreclosure property, but including mortgage loans, held primarily for sale to
customers in the ordinary course of business. We might be subject to this tax if
we sold or securitized our assets in a manner that was treated as a sale for
U.S. federal income tax purposes. Therefore, to avoid the prohibited
transactions tax, we may choose not to engage in certain sales of assets at the
REIT level and may securitize assets only in transactions that are treated as
financing transactions and not as sales for tax purposes even though such
transactions may not be the optimal execution on a pre-tax basis.
We could
avoid any prohibited transactions tax concerns by engaging in securitization
transactions through a TRS, subject to certain limitations as described
above. To the extent that we engage in such activities through
domestic TRSs, the income associated with such activities will be subject to
federal (and applicable state and local) corporate income tax.
Characterization
of the repurchase agreements we enter into to finance our investments as sales
for tax purposes rather than as secured lending transactions would adversely
affect our ability to qualify as a REIT.
We
anticipate entering into several repurchase agreements with a number of
counterparties to achieve our desired amount of leverage for the assets in which
we invest. When we enter into a repurchase agreement, we generally
sell assets to our counterparty to the agreement and receive cash from the
counterparty. The counterparty is obligated to resell the assets back
to us at the end of the term of the transaction, which is typically 30-90
days. We believe that for U.S. federal income tax purposes we will be
treated as the owner of the assets that are the subject of repurchase agreements
and that the repurchase agreements will be treated as secured lending
transactions notwithstanding that such agreements may transfer record ownership
of the assets to the counterparty during the term of the agreement. It is
possible, however, that the IRS could successfully assert that we did not own
these assets during the term of the repurchase agreements, in which case we
could fail to qualify as a REIT.
Complying
with REIT requirements may limit our ability to hedge effectively.
The REIT
provisions of the Internal Revenue Code substantially limit our ability to hedge
our assets and related borrowings. Our aggregate gross income from
non-qualifying hedges, fees, and certain other non-qualifying sources cannot
exceed 5% of our annual gross income. As a result, we might have to
limit our use of advantageous hedging techniques or implement those hedges
through a TRS, which we may form following the completion of this
offering. This could increase the cost of our hedging activities or
expose us to greater risks associated with changes in interest rates than we
would otherwise want to bear.
The
failure of a mezzanine loan to qualify as a real estate asset could adversely
affect our ability to qualify as a REIT or cause us to be subject to a penalty
tax.
We may
acquire mezzanine loans, for which the IRS has provided a safe harbor but not
rules of substantive law. Pursuant to the safe harbor, if a mezzanine
loan meets certain requirements, it will be treated by the IRS as a real estate
asset for purposes of the REIT asset tests, and interest derived from the
mezzanine loan will be treated as qualifying mortgage interest for purposes of
the REIT 75% income test. We may acquire mezzanine loans that do not
meet all of the requirements of this safe harbor. In the event we own a
mezzanine loan that does not meet the safe harbor, the IRS could challenge such
loan’s treatment as a real estate asset for purposes of the REIT asset and
income tests and, if such a challenge were sustained, we could be subject to a
penalty tax or could fail to qualify as a REIT.
Our
investments in construction loans will require us to make estimates about the
fair market value of land improvements that may be challenged by the
IRS.
We may
invest in construction loans, the interest from which will be qualifying income
for purposes of the REIT income tests, provided that the loan value of the real
property securing the construction loan is equal to or greater than the highest
outstanding principal amount of the construction loan during any taxable
year. For purposes of construction loans, the loan value of the real
property is the fair market value of the land plus the reasonably estimated cost
of the improvements or developments (other than personal property) which will
secure the loan and which are to be constructed from the proceeds of the
loan. There can be no assurance that the IRS would not challenge our
estimate of the loan value of the real property.
44
Dividends
payable by REITs do not qualify for the reduced tax rates available for certain
dividends.
Legislation
enacted in 2003 generally reduces the maximum tax rate for dividends payable to
domestic stockholders that are individuals, trusts and estates from 38.6% to 15%
(through 2010). Dividends payable by REITs, however, are generally not eligible
for the reduced rates. Although this legislation does not adversely affect the
taxation of REITs or dividends paid by REITs, the more favorable rates
applicable to regular corporate dividends could cause investors who are
individuals, trusts and estates to perceive investments in REITs to be
relatively less attractive than investments in stock of non-REIT corporations
that pay dividends, which could adversely affect the value of the stock of
REITs, including our common stock.
We
may be required to report taxable income for certain investments in excess of
the economic income we ultimately realize from them.
We may
acquire MBS in the secondary market for less than their face amount. The
discount at which such debt instruments are acquired may reflect doubts about
their ultimate collectibility rather than current market interest rates. The
amount of such discount will nevertheless generally be treated as “market
discount” for U.S. federal income tax purposes. Accrued market discount is
reported as income when, and to the extent that, any payment of principal of the
debt instrument is made. Payments on MBS are ordinarily made monthly, and
consequently accrued market discount generally will have to be included in
income each month as if the debt instrument were assured of ultimately being
collected in full. If we collect less on the debt instrument than our purchase
price plus the market discount we had previously reported as income, we may not
be able to benefit from any offsetting loss deductions.
Similarly,
some of the MBS that we acquire may have been issued with original issue
discount. We will be required to report such original issue discount based on a
constant yield method and will be taxed based on the assumption that all future
projected payments due on such MBS will be made. If such MBS turns out not to be
fully collectible, an offsetting loss deduction will become available only in
the later year that uncollectibility is probable and we may not be able to
benefit from any such loss deduction.
Finally,
if any debt instruments or MBS acquired by us are delinquent as to mandatory
principal and interest payments, or if payments with respect to a particular
debt instrument are not made when due, we may nonetheless be required to
continue to recognize the unpaid interest as taxable income as it accrues,
despite doubt as to its ultimate collectibility. Similarly, we may be required
to accrue interest income with respect to subordinate MBS at its stated rate
regardless of whether corresponding cash payments are received or are ultimately
collectible. In each case, while we would in general ultimately have an
offsetting loss deduction available to us when such interest was determined to
be uncollectible, the utility of that deduction could depend on our having
taxable income in that later year or thereafter.
If
we have significant amounts of non-cash taxable income, we may have to declare
taxable stock dividends or make other non-cash distributions.
We
currently intend to pay dividends in cash only, and not in common
stock. However, if for any taxable year, we have significant amounts
of taxable income in excess of available cash flow, we may have to declare
dividends in-kind. We may distribute a portion of our dividends in
the form of our common stock or in the form of our debt
instruments. In either event, you will be required to report dividend
income as a result of such distributions even though we distributed no cash or
only nominal amounts of cash to you.
Alternatively,
we may distribute taxable dividends that are payable in cash and shares of our
common stock at the election of each stockholder. Under IRS Revenue
Procedure 2009-15, up to 90% of any such taxable dividend for 2009 could be
payable in our stock. Taxable U.S. stockholders receiving such
dividends will be required to include the full amount of the dividend as
ordinary income to the extent of our current and accumulated earnings and
profits for U.S. federal income tax purposes. As a result, a U.S.
stockholder may be required to pay income taxes with respect to such dividends
in excess of the cash dividends received. If a U.S. stockholder sells
the stock that it receives as a dividend in order to pay this tax, the sales
proceeds may be less than the amount included in income with respect to the
dividend, depending on the market price of our stock at the time of the
sale. Furthermore, with respect to non-U.S. stockholders, we may be
required to withhold U.S. tax with respect to such dividends, including in
respect of all or a portion of such dividend that is payable in stock, and we
may have to withhold or dispose of part of the shares in such distribution and
use such withheld shares or the proceeds of such disposition to satisfy any
withholding tax imposed. In addition, if a significant number of our
stockholders determine to sell shares of our common stock in order to pay taxes
owed on dividends, it may put downward pressure on the trading price of our
common stock.
45
Further,
because Revenue Procedure 2009-15 applies only to taxable dividends payable in
cash or stock in 2008 and 2009, it is unclear whether and to what extent we will
be able to pay taxable dividends in cash and stock in later
years. Moreover, various tax aspects of such a taxable cash/stock
dividend are uncertain and have not yet been addressed by the IRS. No
assurance can be given that the IRS will not impose additional requirements in
the future with respect to taxable cash/stock dividends, including on a
retroactive basis, or assert that the requirements for such taxable cash/stock
dividends have not been met.
We
may be subject to adverse legislative or regulatory tax changes that could
reduce the market price of our common stock.
At any
time, the U.S. federal income tax laws or regulations governing REITs or the
administrative interpretations of those laws or regulations may be
amended. We cannot predict when or if any new U.S. federal income tax
law, regulation or administrative interpretation, or any amendment to any
existing U.S. federal income tax law, regulation or administrative
interpretation, will be adopted, promulgated or become effective and any such
law, regulation or interpretation may take effect retroactively. We
and our stockholders could be adversely affected by any such change in, or any
new, U.S. federal income tax law, regulation or administrative
interpretation.
None.
We do not
own any property. Our executive and administrative office is located at 1211
Avenue of the Americas, Suite 2902, New York, New York 10036, telephone (646)
454-3759. We share this office space with Annaly and FIDAC.
We are
not party to any material litigation or legal proceedings, or to the best of our
knowledge, any threatened litigation or legal proceedings, which, in our
opinion, individually or in the aggregate, would have a material adverse effect
on our results of operations or financial condition.
None.
46
PART
II
Item 5. Market for Registrant's Common Equity, Related
Stockholder Matters and Issuer Purchases of Equity Securities
Our
common stock began trading publicly on the New York Stock Exchange under the
trading symbol "CXS" on September 17, 2009. As of February 18, 2010, we had
18,120,112 shares of common stock issued and outstanding which were held by
approximately 2,155 beneficial holders. The following table sets forth, for the
periods indicated, the high, low, and closing sales prices per share of our
common stock as reported on the New York Stock Exchange composite tape for the
year ended December 31, 2009 and the period commencing September 17, 2009 and
ending December 31, 2009.
Stock
Prices
|
||||||
|
High
|
Low
|
Close
|
|||
Quarter
Ended December 31, 2009
|
$14.51
|
$13.13
|
$13.96
|
|||
For
the period of September 17, 2009 through September 30,
2009
|
$14.63
|
$14.26
|
$14.30
|
We intend
to pay regular quarterly dividends to our stockholders. We have not yet
declared or paid any dividends.
Use
of Proceeds
We invested the net proceeds of our
initial public offering and our private offering as described in this report
under the caption “Management’s Discussion and Analysis of Financial
Condition and Results of Operations-Investment Activities.”
47
Share
Performance Graph
The following graph and table set forth
certain information comparing the yearly percentage change in cumulative total
return on our common stock to the cumulative total return of the Standard &
Poor’s Composite 500 Stock Index or S&P 500 Index, and the Bloomberg REIT
Mortgage Index, or BBG REIT Index, an industry index of mortgage
REITs. The comparison is for the period from September 16, 2009 to
December 31, 2009 and assumes the reinvestment of dividends. The
graph and table assume that $100 invested in our common stock and the two other
indicies on September 16, 2009. Upon written request we will provide
stockholders with a list of the REITs included in the BBG REIT
Index.
|
9/22/2009
|
12/31/2009
|
|||
CreXus
|
100.0
|
93.1
|
|||
S&P
500 Index
|
100.0
|
104.9
|
|||
BBG REIT Index | 100.0 | 98.5 |
The
information in the share performance graph and table has been obtained from
sources believed to be reliable, but neither its accuracy nor its completeness
can be guaranteed. The historical information set forth above is not
necessarily indicative of future performance. Accordingly, we do not
make or endorse any predictions as to future share performance.
48
Equity
Compensation Plan Information
We have
adopted a long term stock incentive plan, or Incentive Plan, to provide
incentives to our independent directors, employees of our Manager and its
affiliates to stimulate their efforts towards our continued success long-term
growth and profitability and to attract, reward and retain personnel and other
service providers. The Incentive Plan authorizes the Compensation
Committee of the board of directors to grant awards, including incentive stock
options as defined under Section 422 of the Code, or ISOs, non-qualified stock
options, or NQSOs, restricted shares and other types of incentive
awards. Our Incentive Plan provides for grants of restricted common
stock and other equity-based awards up to an aggregate amount, at the time of
the award, of (i) 2.5% of the issued and outstanding shares of our common stock
(on a fully diluted basis) at the time of the award less (ii) 250,000 shares,
subject to an aggregate ceiling of 25,000,000 shares available for issuance
under the Incentive Plan. For a description of our Incentive
Plan, see Note 7 to the Consolidated Financial Statements.
The
following table provides information as of December 31, 2009 concerning shares
of our common stock authorized for issuance under our existing Incentive
Plan.
Number of Securities | ||||||||||||
to be Issued upon | Weighted Average | Number of Securities | ||||||||||
Exercise of | Exercise Price of | Remaining for Future | ||||||||||
Outstanding Options, | Outstanding Options, | Issuance Under | ||||||||||
Warrants and | Warrants and | Equity Compensation | ||||||||||
Rights (1) | Rights (1) | Plans (1) | ||||||||||
Plan
Category
|
|
|
|
|||||||||
Equity
Compensation Plans
|
- | $ | - | 194,002 | ||||||||
Approved by Stockholders | ||||||||||||
Equity
Compensation Plans Not
|
- | $ | - | - | ||||||||
Approved by Stockholders | ||||||||||||
Total | - | $ | - | 194,002 |
__________
(1)
|
Other
than the 9,000 shares of common stock issued to our independent directors
under our equity incentive plan, no awards will be made under our equity
incentive plan until September 23,
2010.
|
The
following selected financial data are derived from our audited financial
statements for the year ended December 31, 2009 and the period from September
22, 2009 (commencement of operations) through December 31, 2009. The selected
financial data should be read in conjunction with the more detailed information
contained in the financial statements and notes thereto and "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
included elsewhere in this Form 10-K.
Consolidated
Statement of Financial Condition Highlights
(dollars
in thousands, except per share data)
For the
period from September 22, 2009 through December 31, 2009
Commercial
mortgage backed securities
|
$ | 30,913 | ||
Loans
held for investment
|
39,998 | |||
Total
assets
|
284,307 | |||
Secured
financing agreements
|
25,579 | |||
Total
liabilities
|
28,480 | |||
Shareholders'
equity
|
255,827 | |||
Book
value per share
|
$ | 14.12 | ||
Number
of shares outstanding
|
18,120,112 |
49
Consolidated Statement of Operations Highlights
(dollars in thousands, except per share data)
For
the period of September 22, 2009
through
December 31, 2009
|
||||
(dollars in thousands) | ||||
Net
interest income
|
$ | 299 | ||
Net
loss
|
(1,009 | ) | ||
Loss
per share - basic and diluted
|
(0.06 | ) | ||
Average
shares - basic and diluted
|
18,120,112 | |||
Dividends
declared per share (1)
|
- |
(1) For
applicable period as reported in our earnings announcement.
Other
Data
|
||||
For
the period of September 22, 2009
through
December 31, 2009
|
||||
(dollars in thousands, except percentages) | ||||
Average
total assets
|
$ | 271,978 | ||
Average
investment securities
|
63,441 | |||
Average
borrowings
|
25,579 | |||
Average
equity
|
256,745 | |||
Annualized
yield on average interest earning
assets
|
10.16 | % | ||
Annualized
cost of funds on average interest
bearing
liabilities
|
3.60 | % | ||
Annualized
interest rate spread
|
6.56 | % | ||
Annualized
net interest margin (net interest income/average
interest
earning assets)
|
8.71 | % | ||
Annualized
G&A and management fee expense
as percentage of average
total assets
|
1.74 | % | ||
Annualized
G&A and management fee expense
as percentage of average
total equity
|
1.84 | % | ||
Return
on average interest earning assets
|
(5.74 | %) | ||
Return
on average equity
|
(1.42 | %) |
50
The
following discussion of our financial condition and results of operations should
be read in conjunction with the financial statements and notes to those
statements included in Item 8 of this Form 10-K. The discussion may contain
certain forward-looking statements that involve risks and
uncertainties. Forward-looking statements are those that are not
historical in nature. As a result of many factors, such as those set forth under
"Risk Factors" in this Form 10-K, our actual results may differ materially from
those anticipated in such forward-looking statements.
Executive
Summary
We are a
specialty finance company that acquires, manages, and finances, directly or
through our subsidiaries, commercial mortgage loans and other commercial real
estate debt, commercial mortgage-backed securities, or CMBS, and other
commercial real estate-related assets. We expect that the commercial
real estate loans we acquire will be high quality fixed and floating rate first
mortgage loans secured by commercial properties. We may also acquire
subordinated commercial mortgage loans and mezzanine loans. We intend
to acquire CMBS which are rated AAA through BBB as well as CMBS that are below
investment grade or are non-rated. The other commercial real
estate-related securities and other commercial real estate asset classes will
consist of debt and equity tranches of commercial real estate collateralized
debt obligations, or CRE CDOs, loans to real estate companies including real
estate investment trusts, or REITs, and real estate operating companies, or
REOCs, commercial real estate securities and commercial real
property. In addition, to maintain our exemption from registration
under the Investment Company Act of 1940, as amended, or the 1940 Act, we expect
to acquire residential mortgage-backed securities, or RMBS, for which a U.S.
Government agency such as the Government National Mortgage Association, or
Ginnie Mae, or a federally chartered corporation such as the Federal National
Mortgage Association, or Fannie Mae, or the Federal Home Loan Mortgage
Corporation, or Freddie Mac, guarantees payments of principal and interest on
the securities. We refer to these securities as Agency
RMBS. We refer to Ginnie Mae, Fannie Mae, and Freddie Mac
collectively as the Agencies.
We are
externally managed by Fixed Income Discount Advisory Company, which we refer to
as FIDAC.
We intend
to qualify to be taxed as a REIT for federal income tax purposes commencing with
our taxable year ending on December 31, 2009. Our targeted asset
classes and the principal investments we expect to make in each are as
follows:
·
|
Commercial
real estate loans, consisting of:
|
o
|
First
mortgage loans that are secured by commercial
properties
|
o
|
Subordinated
mortgage loans or “B-Notes”
|
o
|
Mezzanine
loans
|
o
|
Construction
loans
|
·
|
Commercial
Mortgage-Backed Securities, or CMBS, consisting
of:
|
o
|
CMBS
rated AAA through BBB
|
o
|
CMBS
that are rated below investment grade or are
non-rated
|
·
|
Other
Commercial Real Estate Assets, consisting
of:
|
o
|
Debt
and equity tranches of CRE CDOs
|
o
|
Loans
to real estate companies including REIT’s and
REOC’s
|
o
|
Commercial
real estate securities
|
o
|
Commercial
property
|
·
|
Agency
RMBS:
|
o
|
Single-family
residential mortgage pass-through certificates representing interests in
“pools” of mortgage loans secured by residential real property where
payments of both interest and principal are guaranteed by a U.S.
Government agency or federally chartered
corporation
|
51
We
completed our initial public offering on September 22, 2009. In that
offering and in a concurrent private offering we raised net proceeds of
approximately $257.3 million.
Our
objective is to provide attractive risk-adjusted returns to our investors over
the long-term, primarily through dividends and secondarily through capital
appreciation. We intend to achieve this objective by investing in a
broad range of commercial real estate-related assets to construct a portfolio
that is designed to achieve attractive risk-adjusted returns and that is
structured to comply with the various federal income tax requirements for REIT
status and to maintain our exemption from the 1940 Act.
Since we
commenced operations in September 2009, we have focused our investment
activities on acquiring CMBS and on purchasing commercial mortgage loans that
have been originated by select high-quality originators. We expect that over the
near term our investment portfolio will be weighted toward CMBS and commercial
real estate loans, subject to maintaining our REIT qualification and our 1940
Act exemption.
Our
investment strategy is intended to take advantage of opportunities in the
current interest rate and credit environment. We will adjust our
strategy to changing market conditions by shifting our asset allocations across
these various asset classes as interest rate and credit cycles change over
time. We believe that our strategy, combined with FIDAC’s experience,
will enable us to pay dividends and achieve capital appreciation throughout
changing market cycles. We expect to take a long-term view of assets
and liabilities, and our reported earnings and mark-to-market valuations at the
end of a financial reporting period will not significantly impact our objective
of providing attractive risk-adjusted returns to our stockholders over the
long-term.
To the
extent available, we may seek to finance our CMBS portfolio with non-recourse
financings under the Term Asset-Backed Securities Loan Facility, or the TALF,
and based on market conditions we intend to utilize structural leverage through
securitizations of commercial real estate loans or CMBS. With regard to leverage
available under the TALF, the maximum level of allowable leverage under
currently announced CMBS programs would be 6.7:1. If we are unable to obtain
financing through U.S. Government programs and unable to invest in the asset
classes expected to be financed through these programs at attractive rates of
return on an unlevered basis, then we will consider using other non-recourse
financing sources, receive financing or we will not invest in these asset
classes. With regard to securitizations, the leverage will depend on the market
conditions for structuring such transactions. We will seek to finance the
acquisition of Agency RMBS using repurchase agreements with counterparties,
which are recourse. We anticipate that leverage for Agency RMBS would be
available to us, which would provide for a debt-to-equity ratio in the range of
2:1 to 4:1 but would likely not exceed 6:1. Based on current market conditions,
we expect to operate within the leverage levels described above in the near and
long term. We are not required to maintain any specific debt-to-equity ratio, as
we believe the level of leverage will vary based on the particular asset class,
the characteristics of the portfolio and market conditions. We can provide no
assurance that we will be able to obtain financing as described
herein.
If we
finance all or a portion of our portfolio, subject to maintaining our
qualification as a REIT, we may utilize derivative financial instruments,
including, among others, interest rate swaps, interest rate caps, and interest
rate floors to hedge all or a portion of the interest rate risk. Specifically,
we may seek to hedge our exposure to potential interest rate mismatches between
the interest we earn on our assets and our borrowing costs caused by
fluctuations in short-term interest rates. In utilizing leverage and interest
rate hedges, our objectives will be to improve risk-adjusted returns and, where
possible, to lock in, on a long-term basis, a spread between the yield on our
assets and the cost of our financing.
Current
Environment
We
commenced operations in September 2009. Beginning in the summer
of 2007, challenging market conditions adversely affected financial
market conditions which resulted in a deleveraging of the entire global
financial system. As part of this process, residential and commercial mortgage
markets in the United States experienced a variety of difficulties including
loan defaults, credit losses and reduced liquidity. As a result, many
lenders tightened their lending standards, reduced lending capacity, liquidated
significant portfolios or exited the market altogether, and therefore, financing
with attractive terms is generally unavailable.
52
In
response to these unprecedented events, the U.S. Government has taken a number
of actions to improve stability in the financial markets and encourage
lending. These programs include the
Troubled Assets Relief Program (TARP), the TALF and the Public-Private
Investment Program (PPIP), among others. These programs are ongoing, and
each focuses on particular problems in the credit markets, including bank
capital adequacy, securitization and liquidity. There has been some improvement
in each of these areas as a result of these government programs, as well as
accommodative monetary policy, however financial market conditions remain
uncertain.
Factors
Impacting our Operating Results
In
addition to the prevailing market conditions, we expect that the results of our
operations will be affected by a number of factors and will primarily depend on,
among other things, the level of our net interest income, the market value of
our assets and the supply of, and demand for, commercial real estate debt
including commercial mortgage loans, CMBS and other real estate related
financial assets in the marketplace. Our net interest income includes the actual
payments we receive and is also impacted by the amortization of purchase
premiums and accretion of purchase discounts. Our net interest income may vary
over time primarily as a result of changes in interest rates. Interest rates and
prepayment rates vary according to the type of asset, conditions in the
financial markets, credit worthiness of our borrowers, competition and other
factors, none of which can be predicted with any certainty. Our operating
results may also be impacted by credit losses in excess of levels initially
anticipated or unanticipated credit events experienced by borrowers whose
mortgage loans are held directly by us or are included in our CMBS.
Change in Fair Value of our
Assets. It is our business strategy to hold our targeted assets as
long-term investments. As such, we expect that the majority of our MBS will be
carried at their fair value, as available-for-sale securities, with changes in fair value
recorded through accumulated other comprehensive income/(loss), a component of
stockholders’ equity, rather than through earnings. As a result, we do not
expect that changes in the fair value of the assets will normally impact our
operating results. At least on a quarterly basis, however, we will assess both
our ability and intent to continue to hold such assets as long-term investments.
As part of this process, we will monitor our targeted assets for
other-than-temporary impairment. A change in our ability or intent to continue
to hold any of our investment securities could result in our recognizing an
impairment charge or realizing losses upon the sale of such
securities.
Credit Risk. We may be
exposed to various levels of credit risk depending on the nature of our
underlying assets and the nature and level of credit enhancements, if any,
supporting our assets. FIDAC and FIDAC’s Investment Committee will review and
monitor credit risk and other risks associated with each investment. We will
seek to manage this risk through our pre-acquisition due diligence processes
including, but not limited to, analysis of the sponsor/borrower, the structure
of the investment, property information including tenant composition, the
property’s historical operating performance and evaluation of the market in
which the property is located.
Size of Portfolio. The size
of our portfolio, as measured by the aggregate unpaid principal balance of our
mortgage loans and aggregate principal balance of our mortgage related
securities and the other assets we own is also a key revenue driver. Generally,
as the size of our portfolio grows, the amount of interest income we receive
increases. The larger portfolio, however, may drive increased expenses as we may
incur additional interest expense to finance the purchase of our
assets.
Changes in Market Interest
Rates. With respect to our proposed business operations, increases in
interest rates, in general, may over time cause:
·
|
the
interest expense associated with our borrowings to
increase;
|
·
|
the
value of our mortgage loans and mortgage-backed securities or MBS, to
decline;
|
·
|
coupons
on our mortgage loans to reset, although on a delayed basis, to higher
interest rates;
|
·
|
to
the extent we enter into interest rate swap agreements as part of our
hedging strategy, the value of these agreements to
increase.
|
53
Conversely,
decreases in interest rates, in general, may over time cause:
·
|
to
the extent applicable under the terms of our investments, prepayments or
repayments on our mortgage loan and MBS portfolio to increase, thereby
accelerating the amortization of our purchase premiums and the accretion
of our purchase discounts;
|
·
|
the
interest expense associated with our borrowings to
decrease;
|
·
|
the
value of our mortgage loan and MBS portfolio to
increase;
|
·
|
to
the extent we enter into interest rate swap agreements as part of our
hedging strategy, the value of these agreements to decrease;
and
|
·
|
coupons
on our adjustable-rate mortgage loans and MBS to reset, although on a
delayed basis, to lower interest
rates
|
Since
changes in interest rates may significantly affect our activities, our operating
results depend, in large part, upon our ability to effectively manage interest
rate risks, credit risks and prepayment risks while maintaining our status as a
REIT.
Critical
Accounting Policies
Our
financial statements are prepared in accordance with Generally Accepted
Accounting Principals accepted in the U.S., or GAAP. These accounting
principles may require us to make some complex and subjective decisions and
assessments. Our most critical accounting policies will involve
decisions and assessments that could affect our reported assets and liabilities,
as well as our reported revenues and expenses. We believe that all of
the decisions and assessments upon which our consolidated financial statements
are based will be reasonable at the time made and based upon information
available to us at that time. The following are or will be our most
critical accounting policies:
Loans
and Securities Held for Investment
We
purchase CMBS, commercial real estate loans, and commercial real estate-related
securities, a portion of which may be held for investment. Loans or
securities held for investment are intended to be held to maturity and,
accordingly, will be reported at amortized cost less an allowance for loan
losses.
Securities
Held as Available-for-Sale
A portion
of our CMBS and commercial real estate-related securities may be held as
available-for-sale. In accordance with ASC 320, Investments – Debt and Equity
Securities, all assets classified as available-for-sale are reported at
fair value, and unrealized gains and losses included in other comprehensive
income. Assets are analyzed for impairment and any credit impairment is
reflected in the income statement.
Valuation
of Financial Instruments
ASC 820,
Fair value Measurements and
Disclosure, establishes a framework for measuring fair value, and expands
related disclosures. This guidance establishes a hierarchy of
valuation techniques based on the observability of inputs utilized in measuring
financial instruments at fair values. It also establishes
market based or observable inputs as the preferred source of values, followed by
valuation models using management assumptions in the absence of market
inputs. The three levels of the hierarchy are described
below:
Level 1 –
Quoted prices in active markets for identical assets or
liabilities.
Level 2
– Prices are determined using other significant observable inputs.
Observable inputs are inputs that other market participants would use in pricing
a security. These may include quoted prices for similar securities, interest
rates, prepayment speeds, credit risk and others.
Level 3 –
Prices are determined using significant unobservable inputs. In situations where
quoted prices or observable inputs are unavailable (for example, when there is
little or no market activity for an investment at the end of the period),
unobservable inputs may be used.
54
Unobservable
inputs reflect our own assumptions about the factors that market participants
would use in pricing an asset or liability, and would be based on the best
information available. We anticipate that a portion of our assets will fall in
Level 3 in the valuation hierarchy.
FASB has
provided guidance for the valuation of assets when the market is not active and
when the volume and level of activity have significantly decreased, along with
guidance on identifying transactions that are not orderly. This guidance allows
the use of management’s internal cash flow and discount rate assumptions when
relevant observable data does not exist and clarifies how observable market
information and market quotes should be considered when measuring fair value in
an inactive market. Additionally, FASB provided guidance on
determining fair value when the volume and level of activity for the asset or
liability have significantly decreased when compared with normal market activity
for the asset or liability (or similar assets or liabilities). This guidance
provides factors to evaluate if there has been a decrease in normal market
activity and if so, provides a methodology to analyze transactions or quoted
prices and make necessary adjustments to fair value. The objective is to
determine the point within a range of fair value estimates that is most
representative of fair value under current market conditions.
We rely
on independent pricing of our assets at each quarter’s end to arrive at what we
believe to be reasonable estimates of fair market value. FIDAC will evaluate the
pricing of our assets estimates by conducting its own analysis at least on a
quarterly basis, and more frequently when economic or market conditions warrant
such evaluation. Any changes to the valuation methodology will be reviewed by
management to ensure the changes are appropriate. As markets and products
develop and the pricing for certain products becomes more transparent, we will
continue to refine our valuation methodologies. The methods used by us may
produce a fair value calculation that may not be indicative of net realizable
value or reflective of future fair values. Furthermore, while we anticipate that
our valuation methods will be appropriate and consistent with other market
participants, the use of different methodologies, or assumptions, to determine
the fair value of certain financial instruments could result in a different
estimate of fair value at the reporting date. We will use inputs that are
current as of the measurement date, which may include periods of market
dislocation, during which price transparency may be reduced.
Loan
Impairment
Loans held for investment will be
valued quarterly to determine if an impairment exists. Impairment occurs when it
is deemed probable that we will not be able to collect all amounts due according
to the contractual terms of the loan. If upon completion of the valuation, the
fair value of the underlying collateral securing the impaired loan is less than
the net carrying value of the loan, an allowance will be created with a
corresponding charge to the provision for losses. An allowance for
each loan would be maintained at a level believed adequate by management to
absorb probable losses. We may elect to sell a loan held for investment due to
adverse changes in credit fundamentals. Once the determination has been made by
us that we will no longer hold the loan for investment, we will account for the
loan at the lower of amortized cost or estimated fair value. The
reclassification of the loan/security and recognition of impairments could
adversely affect our reported earnings.
Impairment
of Debt Securities
Securities are
valued quarterly to determine if an other-than-temporary impairment,
or OTTI, exists. Impairment occurs when the fair value of the investment is
less than its amortized cost basis. Securities will be analyzed for credit loss
(the difference between the present value of cash flows expected to be collected
and the amortized cost and the cash flows expected to be collected are
discounted at the effective yield at inception (ASC 320-10) or the current
accretable yield (ASC 310-30)). Further the securities will be
evaluated based on the intent to sell the security or if it is more likely than
not that we will be required to sell the debt security before its anticipated
recovery. If the intention is not to sell (nor are we required to sell) the
credit loss, if any, will be recognized in the statement of earnings and the
balance of impairment related to other factors recognized in Other Comprehensive
Income, or OCI. If the intention is to sell the security, (or we are
required to sell) before its anticipated recovery, the full OTTI will be
recognized in the statement of earnings. The recognition of impairments could
adversely affect our reported earnings.
55
Classifications
of Investment Securities
Our MBS
assets consist primarily of commercial real estate debt instruments and CMBS
that we will classify as either available-for-sale or held-to-maturity. As such,
we expect that our MBS classified as available-for-sale will be carried at their
fair value in accordance with ASC 320, with changes in fair value recorded
through accumulated other comprehensive income/(loss), a component of
stockholders’ equity, rather than through earnings. We do not intend to hold any
of our investment securities for trading purposes; however, if our securities
were classified as trading securities, there could be substantially greater
volatility in our earnings, as changes in the fair value of securities
classified as trading are recorded through earnings. MBS assets held for
investment will be stated at their amortized cost, net of deferred fees and
costs with income recognized using the effective interest
method. When the estimated fair value of an available-for-sale
security is less than amortized cost, we will consider whether there is an
other-than-temporary impairment in the value of the security. Unrealized losses
on securities considered to be other-than-temporary will be recognized in
earnings. The determination of whether a security is other-than-temporarily
impaired will involve judgments and assumptions based on subjective and
objective factors. Consideration will be given to (i) the length of
time and the extent to which the fair value has been less than cost, (ii) the
financial condition and near-term prospects of recovery in fair value of the
security and (iii) our intent to sell our investment in the security, or whether
it is more likely than not we will be required to sell the security before its
anticipated recovery in fair value. Investments with unrealized losses will not
be considered other-than-temporarily impaired if we have the ability and intent
to hold the investments for a period of time, to maturity if necessary,
sufficient for a forecasted market price recovery up to or beyond the amortized
cost of the investments.
Investment
Consolidation
When
acquiring assets, we will evaluate the underlying entity that issued the
securities we intend to acquire, or to which we will make a loan to determine
the appropriate accounting. We refer, initially, to guidance in ASC 860-Transfers and Servicing and
ASC 810-Consolidation,
in performing our analysis. ASC 810 addresses consolidation of certain entities
in which voting rights are not effective in identifying an investor with a
controlling financial interest. An entity is subject to consolidation under this
guidance if it is determined that the entity is a Variable Interest Entity,
or VIE. In a VIE, the investors either do not have sufficient
equity at risk for the entity to finance its activities without additional
subordinated financial support, are unable to direct the entity’s activities, or
are not exposed to the entity’s losses or entitled to its residual returns
proportional to their ownership. Variable interest entities within the scope of
this guidance are required to be consolidated by their primary beneficiary. The
primary beneficiary of a VIE is determined to be the party that absorbs a
majority of the entity’s expected losses, its expected returns, or
both. This guidance has been materially updated effective
January 1, 2010. The update which eliminates the exemption for a
Qualifying Special Purpose Entity, or QSPE, and requires ongoing analysis
of the primary beneficiary in a VIE. This update will have no
material effect on the Company’s financial statements based on the current asset
holdings as the Company has no interest in any QSPE’s or VIE’s at this
time.
Valuations
of Available-for-Sale Securities
Our
available-for-sale securities have fair values as determined by FIDAC with
reference to price estimates provided by independent pricing services and
dealers in the securities. FIDAC will evaluate available-for-sale securities
estimates by conducting its own analysis at least on a quarterly basis, and more
frequently when economic or market conditions warrant such evaluation. The
pricing is subject to various assumptions which could result in different
presentations of value.
When the
fair value of an available-for-sale security is less than its amortized cost for
an extended period, we will consider whether there is an other-than-temporary
impairment in the value of the security. If, based on our analysis, a credit
portion of OTTI exists, the cost basis of the security is written down to
the then-current fair value, and the unrealized loss is transferred from
accumulated other comprehensive loss as an immediate reduction of current
earnings as if the loss had been realized in the period of OTTI . The
determination of other-than-temporary impairment is a subjective process, and
different judgments and assumptions could affect the timing of loss realization.
56
We will
consider the following factors when determining an other-than-temporary
impairment for a security or investment:
·
|
The
length of time and the extent to which the market value has been less than
the amortized cost;
|
·
|
Whether
the security has been downgraded by a rating agency;
and
|
·
|
Whether
we have the intent to sell the security or will be required to sell the
security before any anticipated recovery in market value to amortized
cost.
|
The
determination of other-than-temporary impairment is made at least quarterly. If
we determine an impairment to be other than temporary we will need to realize a
loss that would have an impact on future income.
Interest
Income Recognition
Interest
income on available-for-sale securities and loans held for investment will be
recognized over the life of the investment using the effective interest method.
Interest income on mortgage-backed securities is recognized using the effective
interest method. Interest income on loans held for investment is
recognized based on the contractual terms of the loan instruments. Income
recognition will be suspended for loans when, in the opinion of management, a
full recovery of income and principal becomes doubtful. Income
recognition will be resumed when the loan becomes contractually current and
performance is demonstrated to be resumed. Any loan fees or acquisition costs on
originated loans or securities will be capitalized and recognized as a component
of interest income over the life of the investment using the effective interest
method.
Management
estimates, at the time of purchase, the future expected cash flows and determine
the effective interest rate based on these estimated cash flows and our purchase
price. As needed, these estimated cash flows will be updated and a revised yield
computed based on the current amortized cost of the investment. In estimating
these cash flows, there will be a number of assumptions that will be subject to
uncertainties and contingencies. These include the rate and timing of principal
payments (including prepayments, repurchases, defaults and liquidations), the
pass-through or coupon rate and interest rate fluctuations. In addition,
interest payment shortfalls due to delinquencies on the underlying mortgage
loans, and the timing of the magnitude of credit losses on the mortgage loans
underlying the securities have to be judgmentally estimated. These uncertainties
and contingencies are difficult to predict and are subject to future events that
may impact management’s estimates and our interest income.
Security
transactions will be recorded on the trade date. Realized gains and losses from
security transactions will be determined based upon the specific identification
method and recorded as gain (loss) on sale of available for sale securities and
loans held for investment in the statement of income.
We will
account for accretion of discounts or amortization of premiums on
available-for-sale securities and real estate loans using the effective interest
yield method. Such amounts will be included as a component of
interest income in the income statement.
Accounting
For Derivative Financial Instruments
Our
policies permit us to enter into derivative contracts, including interest rate
swaps and interest rate caps, as a means of mitigating our interest rate risk.
We intend to use interest rate derivative instruments to mitigate interest rate
risk rather than to enhance returns.
We
account for derivative financial instruments in accordance with ASC 815,
“Derivatives and Hedging”. ASC 815 requires an entity to recognize all
derivatives as either assets or liabilities in the balance sheets and to measure
those instruments at fair value. Additionally, the fair value adjustments will
affect either other comprehensive income in stockholders’ equity until the
hedged item is recognized in earnings or net income depending on whether the
derivative instrument qualifies as a hedge for accounting purposes and, if so,
the nature of the hedging activity.
In the
normal course of business, we may use a variety of derivative financial
instruments to manage, or hedge, interest rate risk. When the terms of an
underlying transaction are modified, or when the underlying hedged item ceases
to exist, all changes in the fair value of the instrument are marked-to-market
with changes in value included in net income for each period until the
derivative instrument matures or is settled. Any derivative instrument used for
risk management that does not meet the hedging criteria is marked-to-market with
the changes in value included in net income. Qualitative
disclosures about objectives and strategies for using derivatives, quantitative
disclosures about fair value amounts of gains and losses on derivative
instruments, and disclosures about credit-risk-related contingent features in
derivative agreements shall be included in future financial
reporting.
57
Derivatives
will be used for hedging purposes rather than speculation. We will rely on
quotations from a third party to determine these fair values. FIDAC will
evaluate the quotation estimates by conducting its own analysis at least on a
quarterly basis, and more frequently when economic or market conditions warrant
such evaluation. If our hedging activities do not achieve our desired results,
our reported earnings may be adversely affected.
Reserve
for Probable Credit Losses
The
expense for probable credit losses in connection with debt investments is the
charge to earnings to increase the allowance for probable credit losses to the
level that management estimates to be adequate considering delinquencies, loss
experience and collateral quality. Other factors considered relate to geographic
trends and product diversification, the size of the portfolio and current
economic conditions. Based upon these factors, we will establish the provision
for probable credit losses by category of asset. When it is probable that we
will be unable to collect all amounts contractually due, the account is
considered impaired.
Where
impairment is indicated, a valuation write-down or write-off is measured based
upon the excess of the recorded investment amount over the net fair value of the
collateral, as reduced by selling costs. Any deficiency between the carrying
amount of an asset and the net sales price of repossessed collateral is charged
to the allowance for credit losses.
Income
Taxes
We intend
to elect and qualify to be taxed as a REIT for our taxable year ending on
December 31, 2009. Accordingly, we will generally not be subject to U.S. federal
income tax (or applicable state or local taxes) to the extent that we make
qualifying distributions to our stockholders, and provided we satisfy on a
continuing basis, through actual investment and operating results, the REIT
requirements including certain asset, income, distribution and stock ownership
tests. If we fail to qualify as a REIT, and do not qualify for certain statutory
relief provisions, we will be subject to U.S. federal income tax (and applicable
state and local taxes) and may be precluded from qualifying as a REIT for the
subsequent four taxable years following the year in which we lost our REIT
qualification. Accordingly, our failure to qualify as a REIT could have a
material adverse impact on our results of operations and amounts available for
distribution to our stockholders.
The
dividends paid deduction of a REIT for qualifying dividends to its stockholders
is computed using our taxable income as opposed to net income reported on the
financial statements. Taxable income, generally, will differ from net income
reported on the financial statements because the determination of taxable income
is based on tax provisions and not financial accounting principles.
We may
elect to treat certain of our subsidiaries as TRSs. In general, a TRS of ours
may hold assets and engage in activities that we cannot hold or engage in
directly and generally may engage in any real estate or non-real estate-related
business. A domestic TRS is subject to U.S. federal income tax (and applicable
state and local taxes). We presently have not elected TRS status for any of our
subsidiaries.
Should we
establish a TRS, as such entity generated net income, it could declare dividends
to us which would be included in our taxable income and necessitate a
distribution to our stockholders. Conversely, to avoid a distribution
requirement, the TRS could retain its earnings and we would increase book equity
of the consolidated entity by the amount of the retained earnings.
58
Recent
Accounting Pronouncements
General
Principles
Generally Accepted
Accounting Principles (ASC 105)
In June
2009, the Financial Accounting Standards Board (FASB) issued The Accounting Standards Codification
and the Hierarchy of Generally Accepted Accounting Principles (Codification) which revises
the framework for selecting the accounting principles to be used in the
preparation of financial statements that are presented in conformity with
Generally Accepted Accounting Principles (GAAP). The objective of the
Codification is to establish the FASB Accounting Standards Codification (ASC) as
the source of authoritative accounting principles recognized by the
FASB. The Codification was effective for us for this Form
10-K. In adopting the Codification, all non-grandfathered, non-SEC
accounting literature not included in the Codification is superseded and deemed
non-authoritative. The Codification requires any references within
our consolidated financial statements be modified from FASB issues to
ASC. However, in accordance with the FASB Accounting Standards
Codification Notice to Constituents (v 2.0), we will not reference specific
sections of the ASC but will use broad topic references.
Our
accounting pronouncements section has been formatted to reflect the same
organizational structure as the ASC. Broad topic references will be
updated with pending content as it is released.
Assets
Receivables (ASC
310)
Investments in Debt and
Equity Securities (ASC 320)
New
guidance was provided to make impairment guidance more operational and to
improve the presentation and disclosure of other-than-temporary impairments on
debt and equity securities, as well as beneficial interests in securitized
financial assets, in financial statements. This was as a result of
the SEC mark-to-market study mandated under the EESA. The SEC’s
recommendation was to “evaluate the need for modifications (or the elimination)
of current OTTI guidance to provide for a more uniform system of impairment
testing standards for financial instruments.” The guidance revises
the OTTI evaluation methodology. Previously the analytical focus was
on whether the entity had the “intent and ability to retain its investment in
the debt security for a period of time sufficient to allow for any anticipated
recovery in fair value.” Now the focus is on whether the entity
has the “intent to sell the debt security or, more likely than not, will be
required to sell the debt security before its anticipated
recovery.” Further, the security is analyzed for credit loss (the
difference between the present value of cash flows expected to be collected and
the amortized cost basis). If the entity does not intend to sell the
debt security, nor will be required to sell the debt security prior to its
anticipated recovery, the credit loss, if any, will be recognized in the
statement of operations, while the balance of impairment related to other
factors will be recognized in Other Comprehensive Income/(Loss). If
the entity intends to sell the security, or will be required to sell the
security before its anticipated recovery, the full OTTI will be recognized in
the statement of operations.
Other-than-temporary
impairment has occurred if there has been an adverse change in future estimated
cash flows and its impact reflected in current earnings. The
determination cannot be overcome by management judgment of the probability of
collecting all cash flows previously projected. The objective
of other-than-temporary impairment analysis is to determine whether it is
probable that the holder will realize some portion of the unrealized loss on an
impaired security. Factors to consider when making
other-than-temporary impairment decision include information about past events,
current conditions, reasonable and supportable forecasts, remaining payment
terms, financial condition of the issuer, expected defaults, value of underlying
collateral, industry analysis, sector credit rating, credit enhancement, and
financial condition of guarantor. Our CMBS and Agency RMBS
investments would fall under this guidance and as such, we will assess each
security for other-than-temporary impairments based on estimated future cash
flows.
59
For the
year ended December 31, 2009, we did not have unrealized losses in Investment
Securities that were deemed other-than-temporary.
Broad
Transactions
Consolidation (ASC
810)
On
January 1, 2009, FASB amended the guidance concerning, noncontrolling interests
in consolidated financial statements, which changes the presentation of
financial statements. This guidance requires us to classify noncontrolling
interests (previously referred to as “minority interest”) as part of
consolidated net income and to include the accumulated amount of noncontrolling
interests as part of stockholders’ equity. Similarly, in the presentation of
stockholders’ equity, we must distinguish between equity amounts attributable to
controlling interest and amounts attributable to the noncontrolling interests –
previously classified as minority interest outside of stockholders’
equity. In addition to these financial reporting changes, this guidance
provides for significant changes in accounting related to noncontrolling
interests; specifically, increases and decreases in our controlling financial
interests in consolidated subsidiaries will be reported in equity similar to
treasury stock transactions. If a change in ownership of a consolidated
subsidiary results in loss of control and deconsolidation, any retained
ownership interests are re-measured with the gain or loss reported in net
earnings. For the year ended December 31, 2009, we do not have any
non-controlling interests.
Effective
January 1, 2010, the consolidation standards have been amended by ASU
2009-17. This amendment updates the existing standard and eliminate
the exemption from consolidation of a Qualified Special Purpose Entity. The
update requires an enterprise to perform an analysis to determine whether the
enterprise’s variable interest or interests give it a controlling financial
interest in a variable interest entity (VIE). The analysis identifies the
primary beneficiary of a VIE as the enterprise that has both: a) the power to
direct the activities that most significantly impact the entity’s economic
performance and b) the obligation to absorb losses of the entity or the right to
receive benefits from the entity which could potentially be significant to the
VIE. The update requires enhanced disclosures t o provide users of
financial statements with more transparent information about an enterprises
involvement in a VIE. Further, ongoing assessments of whether an
enterprise is the primary beneficiary on a VIE are required. We are
currently not affected by this update but will analyze and assess the effect the
update will have on future financial reporting.
On
December 4, 2009, the FASB issued a proposed an (ASU) that would indefinitely
defer the effective date of ASU 2009-17 for a reporting enterprises
interest in entities for which it is industry practice to issue financial
statements in accordance with investment company standards (ASC
946). This deferral is expected to most significantly affect
reporting entities in the investment management industry and therefore, as it
stands, has no material effect on our financial statements. On January 27, 2010,
the FASB voted to indefinitely defer the effective date of ASU 2009-17 for
a reporting enterprises interest in entities for which it is industry practice
to issue financial statements in accordance with investment company standards
(ASC 946). This deferral is expected to most significantly affect reporting
entities in the investment management industry and therefore, as it stands, has
no material impact on our consolidated financial statements.
Derivatives and Hedging (ASC
815)
Effective
January 1, 2009, the FASB issued guidance attempting to improve the transparency
of financial reporting by mandating the provision of additional information
about how derivative and hedging activities affect an entity’s financial
position, financial performance and cash flows. This guidance changed
the disclosure requirements for derivative instruments and hedging activities by
requiring enhanced disclosure about (1) how and why an entity uses derivative
instruments, (2) how derivative instruments and related hedged items are
accounted for, and (3) how derivative instruments and related hedged items
affect an entity’s financial position, financial performance, and cash
flows. To adhere to this guidance, qualitative disclosures about
objectives and strategies for using derivatives, quantitative disclosures about
fair value amounts, gains and losses on derivative instruments, and disclosures
about credit-risk-related contingent features in derivative agreements must be
made. This disclosure framework is intended to better convey the
purpose of derivative use in terms of the risks that an entity is intending to
manage. At this time, we continue to evaluate the effect of this
update on future financial reporting.
60
Fair Value Measurements and
Disclosures (ASC 820)
In
response to the deterioration of the credit markets, FASB issued guidance
clarifying how Fair Value Measurements should be applied when valuing securities
in markets that are not active. The guidance provides an illustrative example,
utilizing management’s internal cash flow and discount rate assumptions when
relevant observable data do not exist. It further clarifies how
observable market information and market quotes should be considered when
measuring fair value in an inactive market. It reaffirms the
notion of fair value as an exit price as of the measurement date and that fair
value analysis is a transactional process and should not be broadly applied to a
group of assets. The guidance was effective upon issuance including
prior periods for which financial statements had not been issued.
In
October 2008 the EESA was signed into law. Section 133 of the
EESA mandated that the SEC conduct a study on mark-to-market accounting
standards. The SEC provided its study to the U.S. Congress on
December 30, 2008. Part of the recommendations within the study
indicated that “fair value requirements should be improved through development
of application and best practices guidance for determining fair value in
illiquid or inactive markets”. As a result of this study and the
recommendations therein, on April 9, 2009, the FASB issued additional guidance
for determining fair value when the volume and level of activity for the asset
or liability have significantly decreased when compared with normal market
activity for the asset or liability (or similar assets or
liabilities). The guidance gives specific factors to evaluate if
there has been a decrease in normal market activity and if so, provides a
methodology to analyze transactions or quoted prices and make necessary
adjustments to fair value. The objective is to determine the point
within a range of fair value estimates that is most representative of fair value
under current market conditions.
In August
2009, FASB provided further guidance (ASU 2009-05) regarding the fair
value measurement of liabilities. The guidance states that a quoted
price for the identical liability when traded as an asset in an active market is
a Level 1 fair value measurement. If the value must be adjusted for
factors specific to the liability, then the adjustment to the quoted price of
the asset shall render the fair value measurement of the liability a lower level
measurement. This guidance was effective for us on October 1,
2009. This guidance has no material effect on the fair valuation of
our liabilities.
In
September 2009, FASB issued guidance (ASU 2009-12) on measuring the fair value
of certain alternative investments. This guidance offers investors a
practical expedient for measuring the fair value of investments in certain
entities that calculate net asset value (NAV) per share. If an
investment falls within the scope of the ASU, the reporting entity is permitted,
but not required to use the investment’s NAV to estimate its fair
value. This guidance has no material effect on the fair valuation of
our assets, as we do not hold any assets qualifying under this
guidance.
In
January 2010, FASB issued guidance (ASU 2010-06) which increases disclosure
regarding the fair value of assets. The key provisions of this
guidance include the requirement to disclose separately the amounts of
significant transfers in and out of Level 1 and Level 2 including a description
of the reason for the transfers. Previously this was only required of
transfers between Level 2 and Level 3 assets. Further, reporting
entities are required to provide fair value measurement disclosures for each
class of assets and liabilities; a class is potentially a subset of the assets
or liabilities within a line item in the statement of financial
position. Additionally, disclosures about the valuation techniques
and inputs used to measure fair value for both recurring and nonrecurring fair
value measurements are required for either Level 2 or Level 3
assets. This portion of the guidance is effective for us for all
interim and annual reporting periods after December 15, 2009. The guidance also
requires that the disclosure on any Level 3 assets presents separately
information about purchases, sales, issuances and settlements. In
other words, Level 3 assets are presented on a gross basis rather than as one
net number. However, this last portion of the guidance is not
effective until December 15, 2010. Adoption of this guidance will
result in increased footnote disclosure for us.
61
Financial Instruments (ASC
825)
On April
9, 2009, the FASB issued guidance which requires disclosures about fair value of
financial instruments for interim reporting periods as well as in annual
financial statements.
Subsequent Events (ASC
855)
General
standards governing accounting for and disclosure of events that occur after the
balance sheet date but before the financial statements are issued or are
available to be issued were established in May 2009. ASC 855 also provides
guidance on the period after the balance sheet date during which management of a
reporting entity should evaluate events or transactions that may occur for
potential recognition or disclosure in the financial statements, the
circumstances under which an entity should recognize events or transactions
occurring after the balance sheet date in its financial statements and the
disclosures that an entity should make about events or transactions occurring
after the balance sheet date. We evaluate subsequent events through
the date of issuance of this Annual Report 10-K.
Transfers and Servicing (ASC
860)
On June
12, 2009, the FASB issued ASU 2009-16 an amendment update to the accounting
standards governing the transfer and servicing of financial assets. This
amendment updates the existing standard and eliminates the
concept of a Qualified Special Purpose Entity; clarifies the surrendering of
control to effect sale treatment; and modifies the financial components approach
– limiting the circumstances in which a financial asset or portion thereof
should be derecognized when the transferor maintains continuing
involvement. It defines the term “Participating
Interest”. Under this standard update, the transferor must recognize
and initially measure at fair value all assets obtained and liabilities incurred
as a result of a transfer, including any retained beneficial interest.
Additionally, the amendment requires enhanced disclosures regarding the
transferors risk associated with continuing involvement in any transferred
assets. The amendment is effective beginning January 1,
2010. We have determined the amendment has no material effect
on the financial statements.
Investment
Activities
At
December 31, 2009, our investment portfolio consisted of $70.9 million of
securities and loans. The
following table summarizes certain characteristics of our portfolio at December
31, 2009:
For
the period commencing
September
22, 2009 through
December
31, 2009
|
||||
(dollars in thousands)
|
||||
Investment
portfolio at period-end
|
$ | 70,911 | ||
Interest
bearing liabilities at period-end
|
25,579 | |||
Leverage
at period-end (Debt:Equity)
|
0.1:1
|
|||
Fixed-rate
investments as percentage of portfolio
|
100.0 | % | ||
Fixed-rate
investments
|
||||
Commercial
mortgage-backed securities as percentage of fixed-rate
assets
|
44.7 | % | ||
Commercial
mortgage loans as percentage of fixed-rate assets
|
55.3 | % | ||
Weighted
average yield on assets at period-end
|
9.67 | % | ||
Weighted
average cost of funds at period-end
|
(3.62 | %) |
62
Commercial
Mortgage-Backed Securities
The table
below summarizes our CMBS investments at December 31, 2009:
For
the period September 22, 2009
through
December 31, 2009
|
||||
(dollars in thousands) | ||||
Amortized
Cost
|
$ | 31,286 | ||
Unrealized
gains
|
- | |||
Unrealized
losses
|
(373 | ) | ||
Fair
value
|
$ | 30,913 |
As of
December 31, 2009 the CMBS in our portfolio was purchased at a net discount to
their par value and our CMBS had a weighted average amortized cost of
96.8.
The
overall statistics for our CMBS investments calculated on a weighted average
basis assuming no early prepayments or defaults as of December 31, 2009 are
as follows:
For
the period September 22, 2009
through
December 31, 2009
|
|||
Credit
Ratings (A)
|
AAA
|
||
Coupon
|
5.81
|
% | |
Yield
|
6.50
|
% |
The
rating, vintage, property type, and location of the collateral securing our CMBS
investments calculated on a weighted average basis as of December 31, 2009
are as follows:
For
the period September 22, 2009
through
December 31, 2009
|
|||
Credit
Ratings (A)
|
AAA
|
||
Coupon
|
5.81
|
% | |
Yield
|
6.50
|
% | |
Weighted
Average Life
|
6.3
years
|
(A) Ratings per Fitch, Moody's or S&P.
Geographic
Break Down 5% or Greater
Property
Type
|
Percentage | State | Percentage | Vintage | Percentage | ||||||||||
Office
|
35.1
|
%
|
District of Columbia | 14.2 | % | 2006 | 100 | % | |||||||
Retail
|
20.1
|
%
|
California | 7.3 | % | ||||||||||
Multifamily
|
10.4
|
%
|
New York | 6.3 | % | ||||||||||
Industrial
|
14.2
|
%
|
Wisconsin | 5.7 | % | ||||||||||
Other
|
20.2
|
%
|
Other | 66.5 | % | ||||||||||
Total
|
100.0
|
%
|
Total | 100.0 | % |
63
Commercial
Mortgage Loans
The
following tables present certain characteristics of our whole mortgage loan
portfolio as of December 31, 2009.
December
31, 2009
|
||||
(dollars
in thousands)
|
||||
Original
loan balance
|
$ | 40,000 | ||
Unpaid
principal balance
|
40,000 | |||
Weighted
average coupon rate on loans
|
12% | |||
Weighted
average original term (years)
|
10 | |||
Weighted
average remaining term (years)
|
10 |
Geographic
Distribution
|
Remaining
Balance
|
Property
|
||||||||||
Top 5 States
|
(dollars in thousands)
|
% of Loan
|
Count
|
|||||||||
California
|
$ | 8,600 | 13.1% | 4 | ||||||||
Texas
|
7,296 | 12.1% | 3 | |||||||||
South Carolina | 2,815 | 7.5% | 6 | |||||||||
Arizona
|
2,464 | 7.0% | 2 | |||||||||
Pennslyvania
|
1,670 | 5.8% | 3 |
Secured
Financing Facilities
On
December 22, 2009, the Company received a loan under the Federal Reserve
Bank of New York Term Asset-backed securities Loan Facilities (“TALF”). The TALF
loan is non-recourse, bears a fixed interest rate and matures five years from
the loan closing date. The loan is collateralized by the Company’s CMBS
investment, which is held in a Master TALF Collateral Account and is under the
control of the lender until the loan is satisfied. As of December 31, 2009,
the amounts outstanding under the TALF facility were approximately
$25.6 million.
Debt
|
Collateral
|
|||||||
Book
Value
|
Book
Value
|
|||||||
(dollars in thousands)
|
||||||||
December 22,
2009, TALF loans, fixed rate 3.62%, mature
December 2014
|
$ 25,605 | $ 31,298 |
Principal
repayments are due on the TALF financing when principal is collected on the
underlying CMBS securities, which can be paid off earlier or later than expected
based on certain market factors including asset sales or loan defaults. As of
December 31, 2009, the Manager has no anticipation of early principal repayments
or loan defaults of the underlying CMBS. The following table represents
our five-year principal repayments schedule for the TALF secured financing
assuming no early prepayments or defaults of the underlying CMBS
assets.
Debt
|
||||
Book
Value
|
||||
(dollars in thousands)
|
||||
2009
|
$ | - | ||
2010
|
- | |||
2011
|
- | |||
2012
|
- | |||
2013
and thereafter
|
25,579 | |||
Total
|
$ | 25,579 |
64
Results
of Operations
Net
Loss Summary
Our net
loss for the period ended December 31, 2009 was $1.0 million, or $0.06 per
share. The table below presents the net loss summary for the year ended December
31, 2009:
Net
Loss Summary
(dollars
in thousands, except share and per share data)
For
the Period
September
22, 2009
through
December
31, 2009
|
||||
Net
Interest Income:
|
||||
Interest
income
|
$ | 325 | ||
Interest
expense
|
26 | |||
Net
interest income
|
299 | |||
Other
expenses:
|
||||
Management
fee
|
354 | |||
Provision
for loan losses
|
2 | |||
General
and administrative expenses
|
951 | |||
Total
other expenses
|
1,307 | |||
Loss
before income taxes
|
(1,008 | ) | ||
Income
tax
|
1 | |||
Net
loss
|
$ | (1,009 | ) | |
Net
loss per share-basic and diluted
|
$ | (0.06 | ) | |
Weighted
average number of shares outstanding-basic and diluted
|
18,120,112 | |||
Other
comprehensive loss:
|
||||
Net loss | (1,009 | ) | ||
Unrealized
loss on securities held for investment
|
(373 | ) | ||
Comprehensive
loss:
|
$ | (1,382 | ) |
See notes to consolidated
financial statements.
65
Interest
Income and Average Earning Asset Yield
We had
average earning assets of $63.4 million for the period September 22, 2009 to
December 31, 2009. Our interest income was $279,000 for the period September 22,
2009 to December 31, 2009. The yield on our portfolio was 10.16% for the period
September 22, 2009 to December 31, 2009.
Interest
Expense and the Cost of Funds
We had
average borrowed funds of $25.6 million and total interest expense of $26,000
for the period September 22, 2009 to December 31, 2009. Our average cost of
funds was 3.62% the period September 22, 2009 to December 31, 2009.
Net
Interest Income
Our net
interest income, which equals interest income less interest expense, totaled
$299,000 for the period commencing September 22, 2009, and ending December 31,
2009. Our net interest spread, which equals the yield on our average assets for
the period less the average cost of funds for the period, was 6.05% for the
period commencing September 22, 2009, and ending December 31, 2009.
The table
below shows our average assets held, total interest income, weighted average
yield on average interest earning assets at period end, average balance of
repurchase agreements, interest expense, weighted average cost of
funds at period end, net interest income, and net interest rate spread for the
period commencing September 22, 2009, and ending December 31, 2009.
Net Interest
Income
(Ratios have been
annualized, dollars in thousands)
Yield
on
|
|||||||||||||||||||||||||
Average
|
|||||||||||||||||||||||||
Average |
Interest
|
Interest
|
Average
|
||||||||||||||||||||||
Earning |
Earned
on
|
Earning
|
Debt
|
Interest
|
Average
|
Net
Interest
|
Net
Interest
|
||||||||||||||||||
Assets Held | Assets | Assets | Balance | Expense | Cost of Funds | Income | Rate Spread | ||||||||||||||||||
For
the period September 22, 2009
|
|||||||||||||||||||||||||
to
December 31, 2009
|
$ | 63,441 |
$
|
279
|
9.67
|
% |
$
|
25,579
|
$
|
26
|
(3.62
|
%) |
$
|
253
|
6.05
|
% |
Management
Fee and General and Administrative Expenses
We paid
FIDAC a management fee of $354,000 for the period commencing September 22, 2009,
and ending December 31, 2009.
General
and administrative, or G&A, expenses were $951,000 for the period commencing
September 22, 2009, and ending December 31, 2009.
Total
expenses as a percentage of average total assets were 1.81% for the period
commencing September 22, 2009, and ending December 31, 2009.
Currently,
FIDAC has waived its right to require us to pay our pro rata portion of rent,
telephone, utilities, office furniture, equipment, machinery and other office,
internal and overhead expenses of FIDAC and its affiliates required for our
operations.
The table
below shows our total management fee and G&A expenses as compared to average
total assets and average equity for the period commencing September 22, 2009,
and ending December 31, 2009.
66
Management
Fees and G&A Expenses and Operating Expense Ratios
(Ratios have been annualized, dollars in thousands)
(Ratios have been annualized, dollars in thousands)
Total
Management
|
Total
Management
|
Total
Management
|
||||||||||
Management
Fee
|
Fee
and G&A
|
Fee
and G&A
|
||||||||||
and
G&A
|
Expenses/Average
|
Expenses/Average
|
||||||||||
Expenses
|
Total
Assets
|
Equity
|
||||||||||
For the period commencing September 22, 2009, | ||||||||||||
and
ending December 31, 2009
|
$ | 1,307 | (1.74 | %) | (1.84 | %) |
Net Loss and Return on Average Equity
Our net
loss was $1.0 million for the period commencing September 22, 2009, and ending
December 31, 2009. The table below shows our net interest income, total
expenses, each as a percentage of average equity, and the return on average
equity for the period commencing September 22, 2009, and ending December 31,
2009.
Components
of Return on Average Equity
(Ratios
have been annualized)
Net
|
||||||||||
Interest
|
Total
|
Return
|
||||||||
Income/
|
Expenses/
|
on
|
||||||||
Average
|
Average
|
Average
|
||||||||
Equity
|
Equity
|
Equity
|
||||||||
For the period commencing September 22, 2009, | ||||||||||
and
ending December 31, 2009
|
0.42
|
% |
(1.84
|
%) |
(1.42
|
%) |
Liquidity
and Capital Resources
Liquidity
measures our ability to meet potential cash requirements, including ongoing
commitments to repay borrowings, fund and maintain our assets and operations,
make distributions to our stockholders and other general business
needs. We will use significant cash to purchase our targeted assets,
repay principal and interest on our borrowings, make distributions to our
stockholders and fund our operations. Our primary sources of cash
will generally consist of the net proceeds equity offerings, payments of
principal and interest we receive on our portfolio of assets, cash generated
from our operating results and unused borrowing capacity under our financing
sources.
We have
financed our CMBS portfolio with non-recourse financings under the TALF, and
based on market conditions we intend to utilize structural leverage through
securitizations of commercial real estate loans or CMBS. We will, however, also
seek to finance the acquisition of Agency RMBS using repurchase agreements with
counterparties, which are recourse. With regard to leverage available
under the TALF, the maximum level of allowable leverage under currently
announced CMBS programs would be 6.7:1. If we are unable to obtain financing
through U.S. Government programs, then we will either utilize other
non-recourse or recourse financing sources, invest in these asset classes
on an unlevered basis or we will not invest in these asset classes. With
regard to securitizations, the leverage will depend on the market conditions for
structuring such transactions. We anticipate that leverage for Agency
RMBS would be available to us, which would provide for a debt-to-equity ratio in
the range of 2:1 to 4:1 but would likely not exceed 6:1. Based on
current market conditions, we expect to operate within the leverage levels
described above in the near and long term. We can provide no
assurance that we will be able to obtain financing as described
herein.
67
The
sources of financing for our targeted assets are described below.
The
Term Asset-Backed Securities Loan Facility (TALF)
In response to the severe dislocation
in the credit markets, the U.S. Treasury and the Federal Reserve jointly
announced the establishment of the TALF on November 25, 2008. The
TALF is designed to increase credit availability and support economic activity
by facilitating renewed securitization activities.
Even if newly issued or legacy CMBS
meets all the criteria for eligibility under the TALF, the FRBNY may, in its
sole discretion, reject the CMBS as collateral based on its own risk
assessment. We have previously submitted applications for extensions
of credit under the TALF for multiple legacy CMBS assets and have had one
request for a TALF loan rejected by the FRBNY related to a legacy CMBS
asset. The FRBNY has also announced that it is extending TALF to June
30, 2010, for newly-issued CMBS, and to March 31, 2010, for all other
TALF-eligible collateral. To be considered eligible collateral
under the TALF, both newly issued CMBS and legacy CMBS must have at least two
AAA ratings from DBRS, Inc., Fitch Ratings, Moody’s Investors Service, Realpoint
LLC or S&P and must not have a rating below AAA from any of these rating
agencies or be under watch or review for a downgrade (unless, in the case of
legacy CMBS, such watch or review occurs after the subscription date for a loan
with regard to such CMBS). As many legacy CMBS have had their ratings
downgraded and at least one rating agency, S&P, has announced that further
downgrades are likely in the future, these downgrades may significantly reduce
the quantity of legacy CMBS available.
We believe that the expansion of the
TALF to include highly rated CMBS, to the extent available to us, may provide us
with attractively priced non-recourse term borrowings that we could use to
purchase CMBS that are eligible for funding under this program. There
can be no assurance, however, that we will be able to utilize it successfully or
at all.
The
Public-Private Investment Program (PPIP)
On March 23, 2009, the U.S. Treasury,
in conjunction with the FDIC and the Federal Reserve, announced the
establishment of the PPIP. The PPIP is designed to encourage the
transfer of certain illiquid legacy real estate-related assets off of the
balance sheets of financial institutions, restarting the market for these assets
and supporting the flow of credit and other capital into the broader
economy. The PPIP has two primary components: the Legacy Securities
Program and the Legacy Loans Program. Under the Legacy Securities
Program, Legacy Securities PPIFs will be established to purchase from financial
institutions certain non-Agency RMBS and CMBS that were originally rated in the
highest rating category by one or more of the nationally recognized statistical
rating agencies. Under the Legacy Loans Program, Legacy Loan PPIFs
will be established to purchase troubled loans (including residential and
commercial mortgage loans) from insured depository institutions.
We may
acquire commercial mortgage loans with financing under the Legacy Loans Program
if the program becomes available. To the extent available to us, we
may participate as an equity investor in one or more Legacy Loan or Legacy
Securities PPIFs.
Securitizations
We intend
to seek to enhance the returns on our commercial mortgage loan investments,
especially loan acquisitions, through securitization. If available, we intend to
securitize the senior portion, expected to be equivalent to AAA-rated CMBS,
while retaining the subordinate securities in our portfolio. To facilitate the
securitization market, TALF may provide financing to buyers of AAA-rated
CMBS.
Other
Sources of Financing
We expect
to use repurchase agreements to finance acquisitions of Agency RMBS with a
number of counterparties. In the future, we may also use other sources of
financing to fund the acquisition of our targeted assets, including warehouse
facilities and other secured and unsecured forms of borrowing. We may also seek
to raise further equity capital or issue debt securities in order to fund our
future asset acquisitions.
68
For our
short-term (one year or less) and long-term liquidity, which include investing
and compliance with collateralization requirements under our repurchase
agreements (if the pledged collateral decreases in value or in the event of
margin calls created by prepayments of the pledged collateral), we also rely on
the cash flow from investments, primarily monthly principal and interest
payments to be received on our CMBS and mortgage loans, cash flow from the sale
of securities as well as any primary securities offerings authorized by our
board of directors.
Based
on our current portfolio, leverage ratio and available borrowing arrangements,
we believe our assets will be sufficient to enable us to meet anticipated
short-term (one year or less) liquidity requirements such as to fund our
investment activities, pay fees under our management agreement, fund our
distributions to stockholders and pay general corporate expenses. However, a
decline in the value of our collateral or an increase in prepayment rates
substantially above our expectations could cause a temporary liquidity shortfall
due to the timing of the necessary margin calls on the financing arrangements
and the actual receipt of the cash related to principal paydowns. If our cash
resources are at any time insufficient to satisfy our liquidity requirements, we
may have to sell debt or additional equity securities in a common stock
offering. If required, the sale of CMBS or mortgage loans at prices lower than
their carrying value would result in losses and reduced income.
Our
ability to meet our long-term (greater than one year) liquidity and capital
resource requirements will be subject to obtaining additional debt financing and
equity capital. Subject to our maintaining our qualification as a REIT, we
expect to use a number of sources to finance our investments, including
repurchase agreements, warehouse facilities, securitization, commercial paper
and term financing CDOs. Such financing will depend on market conditions for
capital raises and for the investment of any proceeds. If we are unable to
renew, replace or expand our sources of financing on substantially similar
terms, it may have an adverse effect on our business and results of operations.
Upon liquidation, holders of our debt securities and shares of preferred stock
and lenders with respect to other borrowings will receive a distribution of our
available assets prior to the holders of our common stock.
We held
cash and cash equivalents of approximately $212.1 million at December 31,
2009.
Our
operating activities used net cash of approximately $766,000 for the period
September 22, 2009, to December 31, 2009.
Our
financing activities as of December 31, 2009 consisted of net proceeds from our
September 2009 initial offering in which we raised approximately $257.3 million
and secured financing agreement with the FRBNY. We currently have established
uncommitted repurchase agreements for MBS with 2 counterparties.
At
December 31, 2009, the secured financing agreements for CMBS had the following
remaining maturities:
December
31, 2009
|
||||
(dollars
in thousands)
|
||||
Overnight
|
$ | |||
1-30
days
|
- | |||
30
to 59 days
|
- | |||
60
to 89 days
|
- | |||
90
to 119 days
|
- | |||
Greater
than or equal to 120 days
|
25,579 | |||
Total
|
$ | 25,579 |
We are
not required to maintain any specific debt-to-equity ratio as we believe the
appropriate leverage for the particular assets we are financing depends on the
credit quality and risk of those assets. At December 31, 2009 our total debt was
approximately $25.6 million which represented a debt-to-equity ratio of
approximately 0.1:1.
69
Stockholders'
Equity
Our
charter provides that we may issue up to 1,100,000,000 shares of stock,
consisting of up to 1,000,000,000 shares of common stock having a par value of
$0.01 per share and up to 100,000,000 shares of preferred stock having a par
value of $0.01 per share.
On
September 16, 2009, we announced the sale of 13,333,334 shares of common stock
at $15.00 per share for estimated proceeds, less the underwriters’ discount and
offering expenses, of $189.1 million. Concurrently with the sale of
these shares Annaly purchased 4,527,778 shares at the same price per share as
the public offering, for proceeds of approximately $67.9
million. These sales were completed on September 22,
2009. In all, we raised net proceeds of approximately $257.8 million
in these offerings.
On
September 30, 2009, we issued 9,000 shares of restricted common stock in
accordance to the equity incentive plan to our independent directors, which
vested immediately.
There was
no preferred stock issued or outstanding as of December 31, 2009.
Related
Party Transactions
Management
Agreement
On August
31, 2009, we entered into a management agreement with FIDAC and subsequently
amended on September 16, 2009, pursuant to which FIDAC is entitled to receive a
management fee and, in certain circumstances, a termination fee and
reimbursement of certain expenses as described in the management
agreement. Such fees and expenses do not have fixed and determinable
payments. The management fee is payable quarterly in arrears in an
amount equal to 0.50% per annum for the first twelve months of operations, 1.00%
per annum for the period after the first twelve months through the eighteenth
month of operations, and 1.50% per annum after the first eighteen months of
operations, calculated quarterly, of our stockholders’ equity (as defined in the
management agreement). FIDAC uses the proceeds from its management
fee in part to pay compensation to its officers and employees who,
notwithstanding that certain of them also are our officers, receive no cash
compensation directly from us.
Upon
termination without cause, we will pay FIDAC a termination fee. We may
also terminate the management agreement with 30-days’ prior notice from our
board of directors, without payment of a termination fee, for cause or upon a
change of control of Annaly or FIDAC, each as defined in the management
agreement. FIDAC may terminate the management agreement if we or any of
our subsidiaries become required to register as an investment company under the
1940 Act, with such termination deemed to occur immediately before such event,
in which case we would not be required to pay a termination fee. FIDAC may
also decline to renew the management agreement by providing us with 180-days’
written notice, in which case we would not be required to pay a termination
fee.
We are
obligated to reimburse FIDAC for its costs incurred under the management
agreement. In addition, the management agreement permits FIDAC to require
us to pay for our pro rata portion of rent, telephone, utilities, office
furniture, equipment, machinery and other office, internal and overhead expenses
of FIDAC incurred in our operation. These expenses are allocated between
FIDAC and us based on the ratio of our proportion of gross assets compared to
all remaining gross assets managed by FIDAC as calculated at each quarter
end. We and FIDAC will modify this allocation methodology, subject to our
board of directors’ approval if the allocation becomes inequitable (i.e., if we
become very highly leveraged compared to FIDAC’s other funds and
accounts). FIDAC has waived its right to request reimbursement from us of
these expenses until such time as it determines to rescind that
waiver.
Purchases
of Common Stock by Affiliates
We sold
Annaly 4,527,778 shares at the same price per share paid by other investors in
our public offering and Annaly owns 25% of our outstanding shares of common
stock.
70
On May
21, 2008, we issued 1,000,000 shares of our common stock to certain of FIDAC’s
officers and employees for an aggregate purchase price of $50,000. On September
15, 2009, we repurchased 750,000 shares of common stock from those holders on a
pro rata basis at the initial per share purchase price.
Restricted
Stock Grants
During
the period from September 22, 2009 through December 31, 2009, we awarded
9,000 shares of restricted stock pursuant to our incentive plan to the
independent members of our Board of Directors. These shares vested on
the date of the grant.
Clearing
Fees
We may
use RCap Securities Inc., or RCap, a SEC registered broker-dealer and a
wholly-owned subsidiary of Annaly, to clear CMBS trades for us and RCap would be
entitled to customary market-based fees and charges arising from such
services.
Contractual
Obligations and Commitments
We have
not entered into any lease, operating or purchase obligations as of
yet.
As of
December 31, 2009 we financed our CMBS portfolio with non-recourse financings
under the TALF. Pursuant to our non-recourse financing under the
TALF, we have entered into a long term debt obligation with the
FRBNY. Please see table below to summarize our contractual obligation
at December 31, 2009.
|
Within
One
Year
|
One
to
Three
Years
|
Three
to
Five
Years
|
Greater
Than
Five
Years
|
Total
|
|||||||||||||||
Contractual Obligations | (dollars in thousands) | |||||||||||||||||||
|
||||||||||||||||||||
Secured
financing
|
$ | - | $ | - | $ | 25,579 | $ | - | $ | 25,579 | ||||||||||
Interest
expense on secured financing
|
876 | 1,862 | 1,771 | - | 4,509 | |||||||||||||||
Total
|
$ | 876 | $ | 1,862 | $ | 27,350 | $ | - | $ | 30,088 |
We have
agreed to pay the underwriters of our initial public offering $0.15 per share
for each share sold in the in the initial public offering if during any full
four calendar quarter period during the 24 full calendar quarters after the
consummation of this offering our Core Earnings (as described below) for any
such four-quarter period exceeds an 8% performance hurdle rate (as described
below). The performance hurdle rate will be met if during any full four
calendar quarter period during the 24 full calendar quarters after the
consummation of our initial public offering our Core Earnings for any such
four-quarter period exceeds the product of (x) the weighted average of the issue
price per share of all public offerings of our common stock, multiplied by the
weighted average number of shares outstanding (including any restricted stock
units, any restricted shares of common stock and any other shares of common
stock underlying awards granted under our equity incentive plans) in such
four-quarter period and (y) 8%. Core Earnings is a non-GAAP measure and is
defined as GAAP net income (loss) excluding non-cash equity compensation
expense, depreciation and amortization (to the extent that we foreclose on any
properties underlying our target assets), any unrealized gains, losses or other
non-cash items recorded for the period, regardless of whether such items are
included in other comprehensive income or loss, or in net income. The amount
will be adjusted to exclude one-time events pursuant to changes in GAAP and
certain other non-cash charges after discussions between FIDAC and our
independent directors and after approval by a majority of our independent
directors.
Off-Balance
Sheet Arrangements
We do not
have any relationships with unconsolidated entities or financial partnerships,
such as entities often referred to as structured finance or special purpose
entities, which would have been established for the purpose of facilitating
off-balance sheet arrangements or other contractually narrow or limited
purposes. Further, we have not guaranteed any obligations of
unconsolidated entities nor do we have any commitment or intent to provide
funding to any such entities. As such, we are not materially exposed
to any market, credit, liquidity or financing risk that could arise if we had
engaged in such relationships.
71
Dividends
To
qualify as a REIT, we must pay annual dividends to our stockholders of at least
90% of our taxable income, determined without regard to the deduction for
dividends paid and excluding any net capital gains. We intend to pay regular
quarterly dividends to our stockholders. Before we pay any dividend, whether for
U.S. federal income tax purposes or otherwise, which would only be paid out of
available cash to the extent permitted under our warehouse and repurchase
facilities, we must first meet both our operating requirements and scheduled
debt service on our warehouse lines and other debt payable.
Capital
Resources
At December 31, 2009, we had no
material commitments for capital expenditures.
Inflation
Virtually
all of our assets and liabilities will be interest rate sensitive in nature. As
a result, interest rates and other factors will influence our performance far
more so than does inflation. Changes in interest rates do not necessarily
correlate with inflation rates or changes in inflation rates. Our consolidated
financial statements are prepared in accordance with GAAP and our distributions
will be determined by our board of directors consistent with our obligation to
distribute to our stockholders at least 90% of our REIT taxable income on an
annual basis in order to maintain our REIT qualification; in each case, our
activities and balance sheet are measured with reference to historical cost
and/or fair market value without considering inflation.
72
The
primary components of our market risk are related to credit risk, interest rate
risk, prepayment and market value risk. While we do not seek to avoid risk
completely, we believe the risk can be quantified from historical experience and
seek to actively manage that risk, to earn sufficient compensation to justify
taking those risks and to maintain capital levels consistent with the risks we
undertake.
Credit
Risk
We will
be subject to credit risk, which is the risk of loss due to a borrower’s failure
to repay principal or interest on a loan, a security or otherwise fail to meet a
contractual obligation, in connection with our assets and will face more credit
risk on assets we own which are rated below “AAA”. The credit risk related to
these assets pertains to the ability and willingness of the borrowers to pay,
which is assessed before credit is granted or renewed and periodically reviewed
throughout the loan or security term. We believe that residual loan credit
quality is primarily determined by the borrowers’ credit profiles and loan
characteristics.
FIDAC
will use a comprehensive credit review process. FIDAC’s analysis of loans
includes borrower profiles, as well as valuation and appraisal data. We expect
that FIDAC’s resources include a proprietary portfolio management system, as
well as third party software systems. FIDAC will utilize a third party to
perform an independent underwriting review to insure compliance with existing
guidelines. FIDAC will select loans for review predicated on risk-based criteria
such as loan-to-value, a property’s operating history and loan size. FIDAC will
reject loans that fail to conform to our standards. FIDAC will accept only those
loans which meet our underwriting criteria. Once we own a loan, FIDAC’s
surveillance process includes ongoing analysis and oversight by our third-party
servicer and us. Additionally, the MBS and other commercial real estate-related
securities which we will acquire for our portfolio will be reviewed by
FIDAC to ensure that we acquire MBS and other commercial real estate-related
securities which satisfy our risk based criteria. FIDAC’s review of MBS and
other commercial real estate-related securities will include utilizing its
proprietary portfolio management system. FIDAC’s review of MBS and other
commercial real estate-related securities will be based on quantitative and
qualitative analysis of the risk-adjusted returns MBS and other commercial real
estate-related securities present.
Interest
Rate Risk
Interest
rates are highly sensitive to many factors, including fiscal and monetary
policies and domestic and international economic and political considerations,
as well as other factors beyond our control. We will be subject to interest rate
risk in connection with our assets and any related financing obligations. In
general, we may finance the acquisition of our targeted assets through
financings in the form of borrowings under programs established by the U.S.
government, warehouse facilities, bank credit facilities (including term loans
and revolving facilities), resecuritizations, securitizations and repurchase
agreements. We may mitigate interest rate risk through utilization of hedging
instruments, primarily interest rate swap agreements. Interest rate swap
agreements are intended to serve as a hedge against future interest rate
increases on our borrowings. Another component of interest rate risk is the
effect changes in interest rates will have on the market value of the assets we
acquire. We will face the risk that the market value of our assets will increase
or decrease at different rates than that of our liabilities, including our
hedging instruments. We may acquire floating rate mortgage assets. These are
assets in which the mortgages are typically subject to periodic and lifetime
interest rate caps and floors, which limit the amount by which the asset’s
interest yield may change during any given period. Our borrowing costs pursuant
to our financing agreements, however, will not be subject to similar
restrictions. Therefore, in a period of increasing interest rates, interest rate
costs on our borrowings could increase without limitation by caps, while the
interest-rate yields on our floating rate mortgage assets would effectively be
limited. In addition, floating rate mortgage assets may be subject to periodic
payment caps that result in some portion of the interest being deferred and
added to the principal outstanding. This could result in our receipt of less
cash income on such assets than we would need to pay the interest cost on our
related borrowings. These factors could lower our net interest income or cause a
net loss during periods of rising interest rates, which would harm our financial
condition, cash flows and results of operations.
Our
analysis of interest rate risk is based on FIDAC’s experience, estimates, models
and assumptions. These analyses rely on models which utilize estimates of fair
value and interest rate sensitivity. Actual economic conditions or
implementation of asset allocation decisions by our management may produce
results that differ significantly from the estimates and assumptions used in our
models and the projected results shown in this Form 10-K.
73
Interest
Rate Effect on Net Interest Income
Our
operating results depend, in part, on differences between the income from our
investments and our borrowing costs. Most of our warehouse facilities and
repurchase agreements would provide financing based on a floating rate of
interest calculated on a fixed spread over LIBOR. Our structured
financing through the Term Asset-Backed Securities Loan Facility
(TALF) is at a fixed rate for the life of the loan based on Swap rates at the
submission date of the loan. The fixed spread varies depending on the
type of underlying asset which collateralizes the financing. Accordingly, if a
portion of our portfolio consisted of floating interest rate assets would be
match-funded utilizing our expected sources of short-term financing, while our
fixed interest rate assets will not be match-funded. During periods of rising
interest rates, the borrowing costs associated with our investments tend to
increase while the income earned on our fixed interest rate investments may
remain substantially unchanged, excluding the fixed rate borrowing with the
TALF. This will result in a narrowing of the net interest spread
between the related assets and borrowings and may even result in losses.
Further, during this portion of the interest rate and credit cycles, defaults
could increase and result in credit losses to us, which could adversely affect
our liquidity and operating results. Such delinquencies or defaults could also
have an adverse effect on the spread between interest-earning assets and
interest-bearing liabilities. Hedging techniques are partly based on assumed
levels of prepayments of fixed-rate and hybrid adjustable-rate mortgage loans
and CMBS. If prepayments are slower or faster than assumed, the life of the
mortgage loans and CMBS will be longer or shorter, which would reduce the
effectiveness of any hedging strategies we may use and may cause losses on such
transactions. Hedging strategies involving the use of derivative securities are
highly complex and may produce volatile returns.
Interest
Rate Effects on Fair Value
Another
component of interest rate risk is the effect changes in interest rates will
have on the fair value of the assets we acquire. We face the risk that the fair
value of our assets will increase or decrease at different rates than that of
our liabilities, including our hedging instruments. We primarily assess our
interest rate risk by estimating the duration of our assets and the duration of
our liabilities. Duration essentially measures the market price volatility of
financial instruments as interest rates change. We generally calculate duration
using various financial models and empirical data. Different models and
methodologies can produce different duration numbers for the same
securities.
It is
important to note that the impact of changing interest rates on fair value can
change significantly when interest rates change beyond 100 basis points from
current levels. Therefore, the volatility in the fair value of our assets could
increase significantly when interest rates change beyond 100 basis points. In
addition, other factors impact the fair value of our interest rate-sensitive
investments and hedging instruments, such as the shape of the yield curve,
market expectations as to future interest rate changes and other market
conditions. Accordingly, in the event of changes in actual interest rates, the
change in the fair value of our assets would likely differ from that shown above
and such difference might be material and adverse to our
stockholders.
Interest
Rate Cap Risk
We may
invest in adjustable-rate mortgage loans and CMBS. These are mortgages or CMBS
in which the underlying mortgages are typically subject to periodic and lifetime
interest rate caps and floors, which limit the amount by which the security's
interest yield may change during any given period. However, our borrowing costs
pursuant to our financing agreements will not be subject to similar
restrictions. Therefore, in a period of increasing interest rates, interest rate
costs on our borrowings could increase without limitation by caps, while the
interest-rate yields on our adjustable-rate mortgage loans and CMBS would
effectively be limited. This problem will be magnified to the extent we acquire
adjustable-rate CMBS that are not based on mortgages which are fully indexed. In
addition, the mortgages or the underlying mortgages in an CMBS may be subject to
periodic payment caps that result in some portion of the interest being deferred
and added to the principal outstanding. This could result in our receipt of less
cash income on our adjustable-rate mortgages or CMBS than we need in order to
pay the interest cost on our related borrowings. These factors could lower our
net interest income or cause a net loss during periods of rising interest rates,
which would harm our financial condition, cash flows and results of
operations.
74
Interest
Rate Mismatch Risk
We may
fund a portion of our acquisitions of hybrid adjustable-rate mortgages and RMBS
and CMBS with borrowings that, after the effect of hedging, have interest rates
based on indices and repricing terms similar to, but of somewhat shorter
maturities than, the interest rate indices and repricing terms of the mortgages
and MBS. Thus, we anticipate that in most cases the interest rate indices and
repricing terms of our mortgage assets and our funding sources will not be
identical, thereby creating an interest rate mismatch between assets and
liabilities. Therefore, our cost of funds would likely rise or fall more quickly
than would our earnings rate on assets. During periods of changing interest
rates, such interest rate mismatches could negatively impact our financial
condition, cash flows and results of operations. To mitigate interest rate
mismatches, we may utilize the hedging strategies discussed above. Our analysis
of risks is based on our Manager's experience, estimates, models and
assumptions. These analyses rely on models which utilize estimates of fair value
and interest rate sensitivity. Actual economic conditions or implementation of
investment decisions by our management may produce results that differ
significantly from the estimates and assumptions used in our models and the
projected results shown in this Form 10-K.
Our
profitability and the value of our portfolio (including interest rate swaps) may
be adversely affected during any period as a result of changing interest rates.
The following table quantifies the potential changes in net interest income,
portfolio value should interest rates go up or down 25, 50, and 75 basis points,
assuming the yield curves of the rate shocks will be parallel to each other and
the current yield curve. All changes in income and value are measured as
percentage changes from the projected net interest income and portfolio value at
the base interest rate scenario. The base interest rate scenario assumes
interest rates at December 31, 2009 and various estimates regarding prepayment
and all activities are made at each level of rate shock. Actual results could
differ significantly from these estimates.
Projected
Percentage Change in
|
Projected
Percentage Change in
|
|
Change
in Interest Rate
|
Net
Interest Income
|
Portfolio
Value
|
-75
Basis Points
|
0.40%
|
2.19%
|
-50
Basis Points
|
0.30%
|
1.54%
|
-25
Basis Points
|
0.20%
|
0.20%
|
Base
Interest Rate
|
0%
|
0%
|
+25
Basis Points
|
(0.06%)
|
(0.89%)
|
+50
Basis Points
|
(0.10%)
|
(1.85%)
|
+75
Basis Points
|
(0.14%)
|
(2.89%)
|
Prepayment
Risk
As we
receive prepayments of principal on our assets, premiums paid on such assets
will be amortized against interest income. In general, an increase in prepayment
rates will accelerate the amortization of purchase premiums, thereby reducing
the interest income earned on the assets. Conversely, discounts on such
investments are accreted into interest income. In general, an increase in
prepayment rates will accelerate the accretion of purchase discounts, thereby
increasing the interest income earned on our assets. For commercial real estate
loans, the risk of prepayment is mitigated by call protection, which includes
defeasance, yield maintenance premiums and prepayment charges.
Extension
Risk
For CMBS
and Agency RMBS, FIDAC will compute the projected weighted-average life of our
assets based on assumptions regarding the rate at which the borrowers will
prepay the underlying mortgages. In general, when a fixed-rate or hybrid
adjustable-rate asset is acquired with borrowings, we may, but are not required
to, enter into an interest rate swap agreement or other hedging instrument that
effectively fixes our borrowing costs for a period close to the anticipated
average life of the fixed-rate portion of the related assets. This strategy is
designed to protect us from rising interest rates because the borrowing costs
are fixed for the duration of the fixed-rate portion of the related
mortgage-backed security.
75
If
prepayment rates decrease in a rising interest rate environment, however, the
life of the fixed-rate portion of the related assets could extend beyond the
term of the swap agreement or other hedging instrument. This could have a
negative impact on our results from operations, as borrowing costs would no
longer be fixed after the end of the hedging instrument while the income earned
on the hybrid adjustable-rate assets would remain fixed. This situation may also
cause the market value of our hybrid adjustable-rate assets to decline, with
little or no offsetting gain from the related hedging transactions. In extreme
situations, we may be forced to sell assets to maintain adequate liquidity,
which could cause us to incur losses.
Market
Risk
Market Value
Risk
Our
available-for-sale securities will be reflected at their estimated fair value
with unrealized gains and losses excluded from earnings and reported in other
comprehensive income. The estimated fair value of these securities fluctuates
primarily due to changes in interest rates and other factors. Generally, in a
rising interest rate environment, the estimated fair value of these securities
would be expected to decrease; conversely, in a decreasing interest rate
environment, the estimated fair value of these securities would be expected to
increase. As market volatility increases or liquidity decreases, the fair value
of our assets may be adversely impacted. If we are unable to readily obtain
independent pricing to validate our estimated fair value of the securities in
our portfolio, the fair value gains or losses recorded in other comprehensive
income may be adversely affected.
Real
Estate Risk
Commercial
property values are subject to volatility and may be affected adversely by a
number of factors, including, but not limited to, national, regional and local
economic conditions (which may be adversely affected by industry slowdowns and
other factors); local real estate conditions (such as an oversupply of housing);
changes or continued weakness in specific industry segments; construction
quality, age and design; demographic factors; and retroactive changes to
building or similar codes. In addition, decreases in property values reduce the
value of the collateral and the potential proceeds available to a borrower to
repay our loans, which could also cause us to suffer losses.
Risk
Management
To the
extent consistent with maintaining our REIT status, we will seek to manage risk
exposure to protect our portfolio of commercial mortgage loans, CMBS, and
commercial mortgage securities and related debt against the credit and interest
rate risks. We generally seek to manage our risk by:
·
|
analyzing
the borrower profiles, as well as valuation and appraisal data, of the
loans we acquire. We expect that FIDAC’s resources include a proprietary
portfolio management system, as well as third party software
systems;
|
·
|
using
FIDAC’s proprietary portfolio management system to review our MBS and
other commercial real estate-related
securities;
|
·
|
monitoring
and adjusting, if necessary, the reset index and interest rate related to
our targeted assets and our
financings;
|
·
|
attempting
to structure our financings agreements to have a range of different
maturities, terms, amortizations and interest rate adjustment
periods;
|
·
|
using
derivatives, financial futures, swaps, options, caps, floors and forward
sales to adjust the interest rate sensitivity of our targeted assets and
our borrowings;
|
76
·
|
using
securitization financing to lower average cost of funds relative to
short-term financing vehicles further allowing us to receive the benefit
of attractive terms for an extended period of time in contrast to short
term financing and maturity dates of the assets included in the
securitization; and
|
·
|
actively
managing, on an aggregate basis, the interest rate indices, interest rate
adjustment periods, and gross reset margins of our targeted assets and the
interest rate indices and adjustment periods of our
financings.
|
Our analysis of risks will be based on FIDAC’s
experience, estimates, models and assumptions. These analyses rely on
models which utilize estimates of fair value and interest rate
sensitivity. Actual economic conditions or implementation of
investment decisions by FIDAC may produce results that differ significantly from
the estimates and assumptions used in our models and the projected results shown
in the above tables and in this report. These analyses contain
certain forward-looking statements and are subject to the safe harbor statement
set forth under the heading, “Special Note Regarding Forward-Looking
Statements.”
Our
efforts to manage our assets and liabilities are concerned with the timing and
magnitude of the repricing of assets and liabilities. We attempt to control
risks associated with interest rate movements. Methods for evaluating interest
rate risk include an analysis of our interest rate sensitivity "gap", which is
the difference between interest-earning assets and interest-bearing liabilities
maturing or repricing within a given time period. A gap is considered positive
when the amount of interest-rate sensitive assets exceeds the amount of
interest-rate sensitive liabilities. A gap is considered negative when the
amount of interest-rate sensitive liabilities exceeds interest-rate sensitive
assets. During a period of rising interest rates, a negative gap would tend to
adversely affect net interest income, while a positive gap would tend to result
in an increase in net interest income. During a period of falling interest
rates, a negative gap would tend to result in an increase in net interest
income, while a positive gap would tend to affect net interest income adversely.
Because different types of assets and liabilities with the same or similar
maturities may react differently to changes in overall market rates or
conditions, changes in interest rates may affect net interest income positively
or negatively even if an institution were perfectly matched in each maturity
category.
The
following table sets forth the estimated maturity or repricing of our
interest-earning assets and interest-bearing liabilities at December 31, 2009.
The amounts of assets and liabilities shown within a particular period were
determined in accordance with the contractual terms of the assets and
liabilities, except adjustable-rate loans, and securities are included in the
period in which their interest rates are first scheduled to adjust and not in
the period in which they mature and does include the effect of the interest rate
swaps. The interest rate sensitivity of our assets and liabilities in the
table could vary substantially if based on actual prepayment
experience.
Within
3
|
3-12 |
1
Year to
|
Greater
than
|
|||||||||||||||||
Months
|
Months
|
3
Years
|
3
Years
|
Total
|
||||||||||||||||
Rate
sensitive assets
|
$ | - | $ | - | $ | - | $ | 72,330 | $ | 72,330 | ||||||||||
Cash
equivalents
|
212,133 | - | - | - | 212,133 | |||||||||||||||
Total
rate sensitive assets
|
212,133 | - | - | 72,330 | 284,463 | |||||||||||||||
Rate
sensitive liabilities
|
- | - | - | 25,579 | 25,579 | |||||||||||||||
Interest
rate sensitivity gap
|
$ | 212,133 | $ | - | $ | - | $ | 46,751 | $ | 258,884 | ||||||||||
Cumulative
rate sensitivity gap
|
$ | 212,133 | $ | 212,133 | $ | 212,133 | $ | 258,884 | ||||||||||||
Cumulative
interest rate sensitivity
|
||||||||||||||||||||
gap as a percentage or total rate sensitive assets
|
74.57 | % | 74.57 | % | 74.57 | % | 91.01 | % |
Our
analysis of risks is based on our manager's experience, estimates, models and
assumptions. These analyses rely on models which utilize estimates of fair value
and interest rate sensitivity. Actual economic conditions or implementation of
investment decisions by our manager may produce results that differ
significantly from the estimates and assumptions used in our models and the
projected results shown in the above tables and in this Form 10-K. These
analyses contain certain forward-looking statements and are subject to the safe
harbor statement set forth under the heading, "Special Note Regarding
Forward-Looking Statements."
77
Our
financial statements and the related notes, together with the Report of
Independent Registered Public Accounting Firm thereon, are set forth on pages
F-1 through F-20 of this Form 10-K.
None.
The management
of the Company including its Chief Executive Officer and Chief Financial
Officer, have conducted an evaluation of the effectiveness of the
Company disclosure controls and procedures (as such term is defined in
Rules 13a-15(e) and 15(d)-15(e) under the Securities Exchange Act of 1934, as
amended, (the “Exchange Act”) as of the end of the period covered by this
report. Based on that evaluation, the Chief Executive Officer and Chief
Financial Officer concluded as of December 31, 2009 that the disclosure controls
and procedures are effective in ensuring that the information required to be
disclosed by the Company in reports that it files or submits under the Exchange
Act is (i) recorded, processed, summarized and reported within the time
periods specified in the Commission's rules and forms and (ii) that such
information is accumulated and communicated to the Company’s management,
including its Chief Executive Officer and Chief Financial Officer as appropriate
to allow timely decisions regarding required disclosure.
Management's
Annual Report on Internal Control over Financial Reporting
This
Annual Report on Form 10-K does not include a report of management's assessment
regarding internal control over financial reporting due to a transition period
established by rules of the Securities and Exchange Commissionfor newly public
companies.
Attestation
Report of Registered Public Accounting Firm
This
Annual Report on Form 10-K does not include an attestation report of the
company's registered public accounting firm due to a transition period
established by rules of the Securities and Exchange Commission for newly public
companies.
Changes
in Internal Controls
There
were no changes in our internal control over financial reporting identified in
connection with management’s evaluation that occurred during the during the
fourth quarter and our Fiscal Year, ended December 31, 2009 that has materially
affected, or is reasonably likely to materially affect our internal control over
financial reporting.
None.
PART
III.
The
information required by Item 10 as to our directors is incorporated herein by
reference to the proxy statement to be filed with the SEC within 120 days after
December 31, 2009.
78
The
information regarding our executive officers required by Item 10 is incorporated
by reference to the proxy statement to be filed with the SEC within 120 days
after December 31, 2009.
The
information required by Item 10 as to our compliance with Section 16(a) of the
Securities Exchange Act of 1934 is incorporated by reference to the proxy
statement to be filed with the SEC within 120 days after December 31,
2009.
We have
adopted a Code of Business Conduct and Ethics within the meaning of Item 406 of
Regulation S-K. This Code of Business Conduct and Ethics applies to our
principal executive officer, principal financial officer and principal
accounting officer. This Code of Business Conduct and Ethics is publicly
available on our website at www.crexusinvestment.com. If we make substantive
amendments to this Code of Business Conduct and Ethics or grant any waiver,
including any implicit waiver, we intend to disclose these events on our
website.
The
information regarding certain matters pertaining to our corporate governance
required by Item 407(c)(3), (d)(4) and (d)(5) of Regulation S-K is incorporated
by reference to the Proxy Statement to be filed with the SEC within 120 days
after December 31, 2009.
The
information required by Item 11 is incorporated herein by reference to the proxy
statement to be filed with the SEC within 120 days after December 31,
2009.
Item 12. Security Ownership of Certain Beneficial Owners
and Management and Related Stockholder Matters
The
information required by Item 12 is incorporated herein by reference to the proxy
statement to be filed with the SEC within 120 days after December 31,
2009.
The
information required by Item 13 is incorporated herein by reference to the proxy
statement to be filed with the SEC within 120 days after December 31,
2009.
The
information required by Item 14 is incorporated herein by reference to the proxy
statement to be filed with the SEC within 120 days after December 31,
2009.
PART
IV.
(a)
Documents filed as part of this report:
1.
Financial Statements.
2.
Schedules to Financial Statements.
All
financial statement schedules have been omitted because they are either
inapplicable or the information required is provided in our Financial Statements
and Notes thereto, included in Part II, Item 8, of this Annual Report on Form
10-K.
79
EXHIBIT
INDEX
Exhibit
Number
|
Description
|
3.1
|
Articles
of Amendment and Restatement of CreXus Investment Corp. (filed as Exhibit
3.1 to the Company’s Registration Statement on Amendment No. 5 to Form
S-11 (File No. 333-160254) filed on September 14, 2009 and incorporated
herein by reference).
|
3.2
|
Amended
and Restated Bylaws of CreXus Investment Corp. (filed as Exhibit 3.2 to
the Company’s Registrant's Form 10-Q (filed with the Securities and
Exchange Commission on November 6, 2009) and incorporated herein by
reference).
|
4.1
|
Specimen
Common Stock Certificate of CreXus Investment Corp. (filed as Exhibit 4.1
to the Company’s Registration Statement on Amendment No. 3 to Form S-11
(File No. 333-160254) filed on August 31, 2009 and incorporated herein by
reference).
|
10.1
|
Management
Agreement (filed as Exhibit 10.1 to the Company’s Registration Statement
on Amendment No. 3 to Form S-11 (File No. 333-160254) filed on August 31,
2009 and incorporated herein by reference).
|
10.2
|
Amendment
No. 1 to Management Agreement (filed as Exhibit 10.6 to the Company’s
Registration Statement on Amendment No. 6 to Form S-11 (File No.
333-160254) filed on September 16, 2009 and incorporated herein by
reference).
|
10.3
|
Mortgage
Origination and Servicing Agreement between CreXus Investment Corp. and
Principal Real Estate Investors, LLC (filed as Exhibit 10.2 to the
Company’s Registration Statement on Amendment No. 5 to Form S-11 (File No.
333-160254) filed on September 14, 2009 and incorporated herein by
reference).
|
10.4
|
Equity
Incentive Plan (filed as Exhibit 10.3 to the Company’s Registration
Statement on Form S-8 (File No. 333-162223) filed on September 30, 2009
and incorporated herein by reference).
|
10.5
|
Form
of Common Stock Award (filed as Exhibit 10.4 to the Company’s Registration
Statement on Amendment No. 3 to Form S-11 (File No. 333-160254) filed on
August 31, 2009 and incorporated herein by reference).
|
10.9
|
Form
of Stock Option Grant (filed as Exhibit 10.5 to the Company’s Registration
Statement on Amendment No. 3 to Form S-11 (File No. 333-160254) filed on
August 31, 2009 and incorporated herein by reference).
|
10.10
|
Stock
Purchase Agreement between CreXus Investment Corp. and Annaly Capital
Management, Inc. (filed as Exhibit 10.10 to the Company’s Registrant's
Form 10-Q (filed with the Securities and Exchange Commission on November
6, 2009) and incorporated herein by reference).
|
21.1
|
Subsidiaries
of Registrant.
|
23.1
|
Consent
of Independent Registered Public accounting Firm
|
31.1
|
Certification
of Kevin Riordan, Chief Executive Officer and President of the Registrant,
pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.
|
31.2
|
Certification
of Daniel Wickey, Chief Financial Officer of the Registrant, pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
|
32.1
|
Certification
of Kevin Riordan, Chief Executive Officer and President of the
Registrant, pursuant to 18 U.S.C. Section 1350 as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
|
32.2
|
Certification
of Daniel Wickey, Chief Financial Officer of the Registrant, pursuant to
18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
|
80
CREXUS
INVESTMENT CORP.
Report
of Independent Registered Public Accounting Firm
|
F-2
|
Consolidated
Financial Statements for the period
|
|
commencing
September 22, 2009 through December 31, 2009
|
|
Consolidated
Statements of Financial Condition
|
F-3
|
Consolidated
Statements of Operations and Comprehensive Loss
|
F-4
|
Consolidated
Statements of Stockholders' Equity
|
F-5
|
Consolidated
Statements of Cash Flows
|
F-6
|
Notes
to Consolidated Financial Statements
|
F-7
|
F-1
REPORT OF
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the
Board of Directors and Stockholders of
CreXus
Investment Corporation
New York,
New York
We have
audited the accompanying consolidated statement of financial condition of CreXus
Investment Corporation and subsidiaries (the "Company") as of December 31, 2009
and the related consolidated statement of operations and comprehensive loss,
stockholders' equity, and cash flows for the period from September 22, 2009
(date operations commenced) to December 31, 2009. These financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on the financial statements based on our audit.
We
conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The Company is not required to
have, nor were we engaged to perform, an audit of its internal control over
financial reporting. Our audit included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly, we express no such opinion. An audit also 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, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our
opinion, such consolidated financial statements present fairly, in all material
respects, the financial position of CreXus Investment Corporation and
subsidiaries as of December 31, 2009, and the results of their operations and
their cash flows for the period from September 22, 2009 (date operations
commenced) to December 31, 2009, in conformity with accounting principles
generally accepted in the United States of America.
/s/DELOITTE
& TOUCHE LLP
New York,
New York
February
25, 2010
F-2
CREXUS INVESTMENT
CORP.
|
||||
CONSOLIDATED
STATEMENT OF FINANCIAL CONDITION
|
||||
(dollars
in thousands, except per share data)
|
||||
Assets:
|
December
31, 2009
|
|||
Cash
and cash equivalents
|
$ | 212,133 | ||
Commercial
mortgage-backed securities, at fair value
|
30,913 | |||
Mortgage
loans held for investment,
net
of allowance for loan losses ($2)
|
39,998 | |||
Accrued
interest receivable
|
578 | |||
Other
assets
|
685 | |||
Total
assets
|
$ | 284,307 | ||
Liabilities:
|
||||
Secured
financing agreements
|
$ | 25,579 | ||
Accrued
interest payable
|
26 | |||
Accounts
payable and other liabilities
|
2,521 | |||
Investment
management fees payable to affiliate
|
354 | |||
Total
liabilites
|
28,480 | |||
Commitments and Contingencies (Note 11) | - | |||
Stockholders'
Equity:
|
||||
Common
stock, par value $0.01 per share, 1,000,000,000
|
||||
shares
authorized, 18,120,112 shares
|
||||
issued
and outstanding
|
181 | |||
Additional
paid-in-capital
|
257,029 | |||
Accumulated
other comprehensive loss
|
(373 | ) | ||
Accumulated
deficit
|
(1,010 | ) | ||
Total
stockholders' equity
|
255,827 | |||
Total
liabilities and stockholders' equity
|
$ | 284,307 |
See notes to
consolidated financial statements.
F-3
CREXUS INVESTMENT
CORP.
|
||||
CONSOLIDATED
STATEMENT OF OPERATIONS AND COMPREHENSIVE LOSS
|
||||
(dollars
in thousands, except share and per share data)
|
||||
For
the period commencing September 22, 2009 through
December
31, 2009
|
||||
Net
interest income:
|
||||
Interest
income
|
$ | 325 | ||
Interest
expense
|
26 | |||
Net
interest income
|
299 | |||
Other
expenses:
|
||||
Management
fee
|
354 | |||
Provision
for loan losses
|
2 | |||
General
and administrative expenses
|
951 | |||
Total
other expenses
|
1,307 | |||
Loss
before income taxes
|
(1,008 | ) | ||
Income
tax
|
1 | |||
Net
loss
|
$ | (1,009 | ) | |
Net
loss per share-basic and diluted
|
$ | (0.06 | ) | |
Weighted
average number of shares outstanding-
basic
and diluted
|
18,120,112 | |||
Comprehensive
loss:
|
||||
Net
loss
|
$ | (1,009 | ) | |
Other
comprehensive loss:
|
||||
Unrealized
loss on securities available-for-sale
|
(373 | ) | ||
Comprehensive
loss:
|
$ | (1,382 | ) |
See notes to
consolidated financial statements.
F-4
CREXUS INVESTMENT
CORP.
|
||||||||||||||||||||
CONSOLIDATED
STATEMENT OF STOCKHOLDERS' EQUITY
|
||||||||||||||||||||
(dollars
in thousands, except per share data)
|
||||||||||||||||||||
Accumulated
|
||||||||||||||||||||
Common
|
Additional
|
Other
|
||||||||||||||||||
Stock
Par
|
Paid-in
|
Comprehensive
|
Accumulated
|
|||||||||||||||||
Value
|
Capital
|
Loss
|
Deficit
|
Total
|
||||||||||||||||
Balance,
September 22, 2009
|
$ | 2 | $ | 10 | $ | - | $ | (1 | ) | $ | 11 | |||||||||
Net
loss
|
- | - | (1,009 | ) | (1,009 | ) | ||||||||||||||
Other
comprehensive loss
|
- | - | (373 | ) | - | (373 | ) | |||||||||||||
Net
proceeds from common stock
|
||||||||||||||||||||
offering
|
134 | 189,013 | - | - | 189,147 | |||||||||||||||
Net
proceeds from common stock
|
||||||||||||||||||||
offering,
with affiliates
|
45 | 67,871 | - | - | 67,916 | |||||||||||||||
Proceeds
from restricted stock
|
||||||||||||||||||||
grants
|
- | 135 | - | - | 135 | |||||||||||||||
Balance,
December 31, 2009
|
$ | 181 | $ | 257,029 | $ | (373 | ) | $ | (1,010 | ) | $ | 255,827 | ||||||||
See
notes to consolidated financial statements.
|
F-5
CREXUS INVESTMENT
CORP.
|
||||
CONSOLIDATED
STATEMENT OF CASH FLOWS
|
||||
(dollars
in thousands)
|
||||
For
the Period commencing September 22, 2009 through
December 31,
2009
|
||||
Cash
Flows From Operating Activites:
|
||||
Net
loss
|
$ | (1,009 | ) | |
Allowance
for loan loss provision
|
2 | |||
Restricted
stock grants
|
135 | |||
Changes
in operating assets:
|
||||
Increase
in accrued interest receivable
|
(578 | ) | ||
Increase
in other assets
|
(685 | ) | ||
Changes
in operating liabilities:
|
||||
Increase
in accounts payable and other liabilities
|
2,520 | |||
Increase
in investment management fee payable to affiliate
|
355 | |||
Increase
in accrued interest payable
|
26 | |||
Net
cash provided by operating activities
|
$ | 766 | ||
Cash
Flows From Investing Activities
|
||||
Mortgage-backed
securities portfolio:
|
||||
Purchases
|
$ | (31,286 | ) | |
Loans
held for investment portfolio:
|
||||
Purchases
|
(40,000 | ) | ||
Net
cash used in investing activities
|
$ | (71,286 | ) | |
Cash
Flows From Financing Activities:
|
||||
Net
proceeds from common stock offerings
|
$ | 189,146 | ||
Net
proceeds from common stock offering with affiliates
|
67,917 | |||
Net
proceeds from secured financing
|
25,579 | |||
Net
cash provided by financing activities
|
$ | 282,642 | ||
Net
increase in cash and cash equivalents
|
212,122 | |||
Cash
and cash equivalents at beginning of period
|
11 | |||
Cash
and cash equivalents at end of period
|
$ | 212,133 | ||
Supplemental
disclosure of cash flow information:
|
||||
Interest
paid
|
$ | - | ||
Taxes
paid
|
$ | - |
See notes to consolidated
financial statements.
F-6
CREXUS
INVESTMENT CORP.
NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
FOR
THE PERIOD ENDED DECEMBER 31, 2009
1. Organization
and Significant Accounting Policies
CreXus
Investment Corp. (the “Company”) was organized in Maryland on January 23,
2008. The Company commenced operations on September 22, 2009 when it
completed its initial public offering. The Company intends to acquire
an investment portfolio of commercial real estate loans and commercial mortgage
backed securities (“CMBS”) and will elect to be taxed as a real estate
investment trust (“REIT”), under the Internal Revenue Code of 1986, as
amended. As a REIT, the Company will generally not be subject to U.S.
federal or state corporate taxes on its income to the extent that qualifying
distributions are made to stockholders and the REIT requirements, including
certain asset, income, distribution and stock ownership tests are met. The
Company’s wholly-owned subsidiaries, CreXus S Holdings, LLC, CreXus F Asset
Holdings LLC and CreXus TALF Holdings, LLC, are qualified REIT subsidiaries (the
“subsidiaries”). Annaly Capital Management, Inc. (“Annaly”) owns
approximately 25.0% of the Company’s common shares. The Company is
managed by Fixed Income Discount Advisory Company (“FIDAC”), an investment
advisor registered with the Securities and Exchange Commission
(“SEC”). FIDAC is a wholly-owned subsidiary of Annaly.
Summary
of the Company’s significant accounting policies follows:
Basis
of Presentation
The
consolidated financial statements include the accounts of the Company and its
wholly owned subsidiaries. All intercompany balances and transactions
have been eliminated.
Cash
and Cash Equivalents
Cash and
cash equivalents include cash on hand and in money market accounts with original
maturities less than 90 days.
Commercial
Mortgage-Backed Securities
The
Company invests in CMBS representing interests in obligations backed by pools of
commercial mortgage loans and carries those securities at fair value estimated
using a pricing model. Management reviews the fair values generated by this
model to determine that prices are reflective of the current market. Management
performs a validation of the fair value calculated by this model by the pricing
model by comparing its results to independent prices provided by dealers in the
securities and/or third party pricing services. If dealers or independent
pricing services are unable to provide a price for an asset or if the Company
deems the price provided by such dealers or independent pricing services to be
unreliable, then the Company will determine the fair value of the asset in good
faith. In the current market, it may be difficult or impossible
to obtain third party pricing on certain of the investments the Company
purchases. In addition, validating third party pricing for the Company's
investments may be more subjective as fewer participants may be willing to
provide this service to the Company. Moreover, the current market is
more illiquid than in recent history for some of the investments the Company
purchases. Illiquid investments typically experience greater price volatility as
a ready market does not exist. As volatility increases or liquidity decreases,
the Company may have greater difficulty financing its investments which may
negatively impact its
earnings and the execution of its investment strategy.
The
Company classifies its investment securities as either trading investments,
available-for-sale investments or held-to-maturity investments. The Company
intends to hold its CMBS as available-for-sale and as such may sell any of its
CMBS as part of its overall management of its portfolio. All assets classified
as available-for-sale are reported at estimated fair value, with unrealized
gains and losses included in other comprehensive loss.
If the
fair value of an investment security is less than its amortized cost at the date
of the consolidated statement of financial condition, the Company analyzes the
investment security for other-than-temporary impairment
(“OTTI”). Management evaluates the Company’s CMBS for OTTI at least
on a quarterly basis, and more frequently when economic or market concerns
warrant such evaluation. Consideration is given to (1) the length of
time and the extent to which the fair value has been lower than carrying value,
(2) the intent of the Company to sell the investment prior to recovery in fair
value (3) whether the Company will be more likely than not required to sell the
investment before the expected recovery in fair value, (4) and the expected
future cash flows of the investment in relation to its amortized
cost. Unrealized losses on assets that are considered
other-than-temporary credit impairments are recognized in income and the cost
basis of the asset is adjusted.
F-7
CMBS
transactions are recorded on the trade date. Realized gains and losses from CMBS
transactions are determined based on the specific identification method and
recorded as a gain (loss) on sale of available for sale securities in the
consolidated statement of operations. Accretion of discounts or amortization of
premiums on available-for-sale securities and mortgage loans is computed using
the effective interest yield method and is included as a component of interest
income in the consolidated statement of operations.
Loans
Held for Investment
The
Company's commercial mortgage loans are comprised of fixed-rate loans. The
Company purchases pools of commercial mortgage loans through a select group of
originators. Mortgage loans are designated as held for investment, recorded on
trade date, and are carried at their principal balance outstanding, plus any
premiums or discounts which are amortized or accreted over the estimated life of
the loan, less allowances for loan losses.
Allowance
for Loan Losses
The
Company has established an allowance for loan losses at a level that management
believes is adequate based on an evaluation of known and inherent risks related
to the Company's loan portfolio. The estimate is based on a variety of factors
including, but not limited to, current economic conditions, industry loss
experience, credit quality trends, loan portfolio composition, delinquency
trends, national and local economic trends, national unemployment data, and
whether specific geographic areas where the Company has significant loan
concentrations are experiencing adverse economic conditions and events such as
natural disasters that may affect the local economy or property values. While
the Company has little history of its own to establish loan trends, delinquency
trends of the originators and the current market conditions aided in determining
the allowance for loan losses. The Company also performed due diligence
procedures on a sample of loans that met its criteria during the purchase
process. The Company has created an unallocated provision for probable loan
losses estimated as a percentage of the remaining principal on the loans.
Management's estimate is based on historical experience of similar underwritten
pools.
When it
is probable that contractually due specific amounts are deemed uncollectible,
the account is considered impaired. Where impairment is indicated, a valuation
write-off is measured based upon the excess of the recorded investment over the
net fair value of the collateral. Any deficiency between the carrying amount of
an asset and the net sales price of repossessed collateral is charged to the
allowance for loan losses. There were no losses specifically allocated to loans
as of December 31, 2009.
Reserve
for Probable Credit Losses
The
expense for probable credit losses in connection with mortgage loans is the
charge to earnings to increase the allowance for probable credit losses to the
level that management estimates to be adequate considering delinquencies, loss
experience and collateral quality. Other factors considered relate to geographic
trends and product diversification, the size of the portfolio and current
economic conditions. Based upon these factors, the Company will establish the
provision for probable credit losses by category of asset. When it is probable
that the Company will be unable to collect all amounts contractually due, the
account is considered impaired.
Where
impairment is indicated, a valuation write-down or write-off will be measured
based upon the excess of the recorded investment amount over the net fair value
of the collateral, as reduced by selling costs. Any deficiency between the
carrying amount of an asset and the net sales price of repossessed collateral
will be charged to the allowance for loan losses.
Income
Taxes
The
Company intends to qualify to be taxed as a REIT, and therefore it generally
will not be subject to corporate federal or state income tax to the extent that
qualifying distributions are made to stockholders and the REIT requirements,
including certain asset, income, distribution and stock ownership tests are
met. If the Company failed to qualify as a REIT and did not qualify
for certain statutory relief provisions, the Company would be subject to
federal, state and local income taxes and may be precluded from qualifying as a
REIT for the subsequent four taxable years following the year in which the REIT
qualification was lost. Further the Company conducts continuing
analysis on a quarterly basis in an effort to identify any tax positions taken
by the Company that are not “more-likely-than-not” to be upheld under review by
the Internal Revenue Service.
F-8
Net
Loss per Share
The
Company calculates basic net loss per share by dividing net loss for the period
by the weighted-average shares of its common stock outstanding for that
period. Diluted net loss per share takes into account the effect of
dilutive instruments, such as stock options, but uses the average share price
for the period in determining the number of incremental shares that are to be
added to the weighted average number of shares outstanding. The
Company had no potentially dilutive securities outstanding during the period
presented.
Stock-Based
Compensation
The
Company accounts for stock-based compensation using fair value based methods
which require the Company to measure the fair value of the equity instrument
using the stock prices and other measurement assumptions as of the earlier of
either the date at which a performance commitment by the counterparty is reached
or the date at which the counterparty's performance is
complete. Compensation expense related to grants of stock and stock
options will be recognized over the vesting period of such grants based on the
estimated fair value on the grant date.
Use of Estimates
The
preparation of the financial statements in conformity with Generally Accepted
Accounting Principles (“GAAP”) requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities in reporting period. Actual
results could differ from those estimates.
Recent
Accounting Pronouncements
In June
2009, the Financial Accounting Standards Board (“FASB”) issued The Accounting Standards Codification
and the Hierarchy of Generally Accepted Accounting Principles (“Codification”) which
revises the framework for selecting the accounting principles to be used in the
preparation of financial statements that are presented in conformity with
GAAP. The objective of the Codification is to establish the FASB
Accounting Standards Codification (“ASC”) as the source of authoritative
accounting principles recognized by the FASB. Codification is
effective for the Company for this Form 10-K. In adopting the
Codification, all non-grandfathered, non-SEC accounting literature not included
in the Codification is superseded and deemed
non-authoritative. Codification requires any references within the
Company’s consolidated financial statements be modified from FASB issues to
ASC. However, in accordance with the FASB Accounting Standards
Codification Notice to Constituents (v 2.0), the Company will not
reference specific sections of the ASC but will use broad topic
references.
The
Company’s recent accounting pronouncements section has been formatted to reflect
the same organizational structure as the ASC. Broad topic references
will be updated with pending content as it is released.
New
guidance was issued to make impairment guidance more operational and to improve
the presentation and disclosure of other-than-temporary impairments (“OTTI”) on
debt and equity securities, as well as beneficial interests in securitized
financial assets, in financial statements. This guidance was the
result of the Securities and Exchange Commission (“SEC”) mark-to-market study
mandated under the Emergency Economic Stabilization Act of 2008
(“EESA”). The SEC’s recommendation was to “evaluate the need for
modifications (or the elimination) of current OTTI guidance to provide for a
more uniform system of impairment testing standards for financial
instruments.” The guidance revises the OTTI evaluation
methodology. The focus is on whether the company (1) has the intent
to sell the investment securities, (2) is more likely than not that it will be
required to sell the investment securities before recovery, or (3) does not
expect to recover the entire amortized cost basis of the investment
securities. Further, the security is analyzed for credit loss, (the
difference between the present value of cash flows expected to be collected and
the amortized cost basis). The credit loss, if any, is then be
recognized in the statement of operations, while the balance of impairment
related to other factors will be recognized in Other Comprehensive Loss
(“OCI”). If the entity intends to sell the security, or will be
required to sell the security before its anticipated recovery, the full OTTI
will be recognized in the statement of operations.
F-9
OTTI has
occurred if there has been an adverse change in future estimated cash flows and
its impact reflected in current earnings. The determination cannot be
overcome by management judgment of the probability of collecting all cash flows
previously projected. The objective of OTTI analysis is to
determine whether it is probable that the holder will realize some portion of
the unrealized loss on an impaired security. Factors to consider when
making OTTI decision include information about past events, current conditions,
reasonable and supportable forecasts, remaining payment terms, financial
condition of the issuer, expected defaults, value of underlying collateral,
industry analysis, sector credit rating, credit enhancement, and financial
condition of guarantor. The Company’s CMBS and Agency residential
mortgage-backed securities (“RMBS”) investments fall under this guidance and as
such, the Company will assess each security for other-than-temporary impairments
based on estimated future cash flows.
For the
year ended December 31, 2009, the Company did not have unrealized losses in
Investment Securities that were deemed other-than-temporary.
On
January 1, 2009, FASB amended the guidance concerning, non-controlling interests
in consolidated financial statements. This guidance requires the Company to
classify non-controlling interests (previously referred to as “minority
interest”) as part of consolidated net income and to include the accumulated
amount of non-controlling interests as part of stockholders’ equity. Similarly,
in its presentation of stockholders’ equity, the Company distinguishes between
equity amounts attributable to controlling interest and amounts attributable to
the non-controlling interests – previously classified as minority interest
outside of stockholders’ equity. In addition to these financial reporting
changes, this guidance provides for significant changes in accounting related to
non-controlling interests; specifically, increases and decreases in its
controlling financial interests in consolidated subsidiaries will be reported in
equity similar to treasury stock transactions. If a change in ownership of a
consolidated subsidiary, results in loss of control and deconsolidation, any
retained ownership interests are re-measured with the gain or loss reported in
net earnings. For the year ended December 31, 2009, the Company does not have
any consolidated non-controlling interests.
Effective
January 1, 2010, the consolidation standards have been amended to update the
existing standard and eliminates the exemption from consolidation of a Qualified
Special Purpose Entity (“QSPE”). The update requires an
enterprise to perform an analysis to determine whether the enterprise’s variable
interest or interests give it a controlling financial interest in a variable
interest entity (“VIE”). The analysis identifies the primary beneficiary of a
VIE as the enterprise that has both: a) the power to direct the activities that
most significantly impact the entity’s economic performance and b) the
obligation to absorb losses of the entity or the right to receive benefits from
the entity which could potentially be significant to the VIE. The
update requires enhanced disclosures to provide users of financial statements
with more transparent information about an enterprises involvement in a
VIE. Further, ongoing assessments of whether an enterprise is the
primary beneficiary of the VIE are required. The Company is currently
not affected by this update but will analyze and assess the effect the update
will have on future financial reporting.
On
January 27, 2010, the FASB voted to indefinitely defer the effective date of ASU
2009-17 for a reporting enterprises interest in entities for which it is
industry practice to issue financial statements in accordance with investment
company standards (ASC 946). This deferral is expected to most
significantly affect reporting entities in the investment management industry
and therefore, as it stands, has no material impact on the Company’s
consolidated financial statements.
Effective
January 1, 2009, the FASB issued guidance attempting to improve the transparency
of financial reporting by mandating the provision of additional information
about how derivative and hedging activities affect an entity’s financial
position, financial performance and cash flows. This guidance changed
the disclosure requirements for derivative instruments and hedging activities by
requiring enhanced disclosure about (1) how and why an entity uses derivative
instruments, (2) how derivative instruments and related hedged items are
accounted for, and (3) how derivative instruments and related hedged items
affect an entity’s financial position, financial performance, and cash
flows. To adhere to this guidance, qualitative disclosures about
objectives and strategies for using derivatives, quantitative disclosures about
fair value amounts, gains and losses on derivative instruments, and disclosures
about credit-risk-related contingent features in derivative agreements must be
made. This disclosure framework is intended to better convey the
purpose of derivative use in terms of the risks that an entity is intending to
manage. The Company is currently not engaged in any derivative or
hedging activity and does not intend to elect hedge accounting at this time;
however, it will comply with all disclosure requirements set forth by the FASB
concerning derivatives and hedging when applicable.
F-10
In
response to the deterioration of the credit markets, FASB issued guidance
clarifying how Fair Value Measurements should be applied when valuing securities
in markets that are not active. The guidance provides an illustrative example,
utilizing management’s internal cash flow and discount rate assumptions when
relevant observable data do not exist. It further clarifies how
observable market information and market quotes should be considered when
measuring fair value in an inactive market. It reaffirms the
notion of fair value as an exit price as of the measurement date and that fair
value analysis is a transactional process and should not be broadly applied to a
group of assets. The guidance was effective upon issuance including
prior periods for which financial statements had not been issued
In
October 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was
signed into law. Section 133 of the EESA mandated that the SEC
conduct a study on mark-to-market accounting standards. The SEC
provided its study to the U.S. Congress on December 30, 2008. Part of
the recommendations within the study indicated that “fair value requirements
should be improved through development of application and best practices
guidance for determining fair value in illiquid or inactive
markets”. As a result of this study and the recommendations therein,
on April 9, 2009, the FASB issued additional guidance for determining fair value
when the volume and level of activity for the asset or liability have
significantly decreased when compared with normal market activity for the asset
or liability (or similar assets or liabilities). The guidance gives
specific factors to evaluate if there has been a decrease in normal market
activity and if so, provides a methodology to analyze transactions or quoted
prices and make necessary adjustments to fair value. The objective is
to determine the point within a range of fair value estimates that is most
representative of fair value under current market conditions.
In August
2009, FASB provided further guidance regarding the fair value measurement of
liabilities. The guidance states that a quoted price for the
identical liability when traded as an asset in an active market is a Level 1
fair value measurement. If the value must be adjusted for factors
specific to the liability, then the adjustment to the quoted price of the asset
shall render the fair value measurement of the liability a lower level
measurement. This guidance was effective for the Company on October
1, 2009. This guidance has no material effect on the fair valuation
of the Company’s liabilities.
In
September 2009, FASB issued guidance on measuring the fair value of certain
alternative investments. This guidance offers investors a practical
expedient for measuring the fair value of investments in certain entities that
calculate net asset value (“NAV”) per share. If an investment falls
within the scope of the ASU, the reporting entity is permitted, but not required
to use the investment’s NAV to estimate its fair value. This guidance
has no material effect on the fair valuation of the Company’s assets, as the
Company does not hold any assets qualifying under this guidance.
In
January 2010, FASB issued guidance which increases disclosure regarding the fair
value of assets. The key provisions of this guidance include the
requirement to disclose separately the amounts of significant transfers in and
out of Level 1 and Level 2 including a description of the reason for the
transfers. Previously this was only required of transfers between
Level 2 and Level 3 assets. Further, reporting entities are required
to provide fair value measurement disclosures for each class of assets and
liabilities; a class is potentially a subset of the assets or liabilities within
a line item in the statement of financial position. Additionally,
disclosures about the valuation techniques and inputs used to measure fair value
for both recurring and nonrecurring fair value measurements are required for
either Level 2 or Level 3 assets. This portion of the guidance is
effective for the Company on June 1, 2010. The guidance also requires that the
disclosure on any Level 3 assets presents separately information about
purchases, sales, issuances and settlements. In other words, Level 3
assets are presented on a gross basis rather than as one net
number. However, this last portion of the guidance is not effective
until January 1, 2011. Adoption of this guidance will result in
increased footnote disclosure for the Company.
In April
2009, the FASB issued guidance which requires disclosures about fair value of
financial instruments for interim reporting periods as well as in annual
financial statements. Adoption of this guidance results in increased
footnote disclosure for the Company.
F-11
General
standards governing accounting for and disclosure of events that occur after the
balance sheet date but before the financial statements are issued or are
available to be issued were established provides guidance on the period after
the balance sheet date during which management of a reporting entity should
evaluate events or transactions that may occur for potential recognition or
disclosure in the financial statements, the circumstances under which an entity
should recognize events or transactions occurring after the balance sheet date
in its financial statements and the disclosures that an entity should make about
events or transactions occurring after the balance sheet date. The
Company evaluated subsequent events through February 25, 2010 which is the date
of issuance of this Annual Report on Form 10-K.
In June
2009, the FASB issued an amendment update to the accounting standards governing
the transfer and servicing of financial assets. This
amendment updates the existing standard and eliminates the
concept of a Qualified Special Purpose Entity (“QSPE”); clarifies the
surrendering of control to effect sale treatment; and modifies the financial
components approach – limiting the circumstances in which a financial asset or
portion thereof should be derecognized when the transferor maintains continuing
involvement. It defines the term “Participating
Interest”. Under this standard update, the transferor must recognize
and initially measure at fair value all assets obtained and liabilities incurred
as a result of a transfer, including any retained beneficial interest.
Additionally, the amendment requires enhanced disclosures regarding the
transferors risk associated with continuing involvement in any transferred
assets. The amendment is effective for the Company beginning
January 1, 2010. The company has determined the amendment has
no material effect on the financial statements.
2. Commercial
Mortgage Backed Securities
The
following table represents the Company's available for sale CMBS portfolio as of
December 31, 2009 at fair value.
For
the period
September
22, 2009
through
December 31, 2009
(dollars in
thousands)
|
||||
Amortized
Cost
|
$ | 31,286 | ||
Unrealized
gains
|
- | |||
Unrealized
losses
|
(373 | ) | ||
Fair
value
|
$ | 30,913 |
The
Company did not sell any CMBS during the period from September 22, 2009 to
December 31, 2009.
The
following table presents the gross unrealized losses, and estimated fair value
of the Company's CMBS by length of time that such securities have been in a
continuous unrealized loss position at December 31, 2009.
Unrealized
Loss Position For:
|
||||||||||||||||||||||||
Less than 12 Months |
12
Months or More
|
Total | ||||||||||||||||||||||
Estimated | Unrealized | Estimated | Unrealized | Estimated | Unrealized | |||||||||||||||||||
Fair
Value
|
Losses
|
Fair
Value
|
Losses
|
Fair
Value
|
Losses
|
|||||||||||||||||||
(dollars in thousands) | ||||||||||||||||||||||||
Non-Agency
CMBS
|
$ | 30,913 | (373 | ) | $ | - | $ | - | $ | 30,913 | $ | (373 | ) | |||||||||||
Total
December 31, 2009
|
$ | 30,913 | (373 | ) | $ | - | $ | - | $ | 30,913 | $ | (373 | ) |
The
decline in value of these securities is due to market conditions and not the
credit performance of the assets. The investments are not considered
other-than-temporarily impaired because the Company currently has no intent
to sell and has the ability to hold investments to maturity or for a period
of time sufficient for a forecasted market price recovery up to or beyond the
cost of the investments.
F-12
Actual
maturities of mortgage-backed securities are generally shorter than stated
contractual maturities. Actual maturities of the Company's mortgage-backed
securities are affected by the contractual lives of the underlying mortgages,
periodic payments of principal and prepayments of principal.
The
following table summarizes the Company's mortgage-backed securities at December
31, 2009 according to their weighted-average life classifications:
(dollars
in thousands)
|
||||||||||||
Weighted
Average Life
|
Fair
Value
|
Amortized
Cost
|
Weighted
Average
Coupon
|
|||||||||
Less
than one year
|
$ | - | $ | - | - | % | ||||||
Greater
than one year
|
||||||||||||
less
than five years
|
- | - | - | |||||||||
Greater
than five years
|
30,913 | 31,286 | 5.81 | |||||||||
Total
|
$ | 30,913 | $ | 31,286 | 5.81 | % |
The
weighted-average lives of the mortgage-backed securities as of December 31, 2009
in the tables above are based on data provided through dealer quotes, assuming
constant prepayment rates to the balloon or reset date for
each security. The prepayment model considers current yield, forward
yield, steepness of the curve, current mortgage rates, mortgage rate of the
outstanding loan, loan age, margin and volatility.
3. Loans
Held for Investment
The
following table represents the Company's commercial mortgage loans classified as
held for investment at December 31, 2009, which are carried at their principal
balance outstanding less an allowance for loan losses:
December
31, 2009
|
||||
(dollars
in thousands)
|
||||
|
||||
Mortgage
loans, at principal balance outstanding
|
$ | 40,000 | ||
Less:
allowance for loan losses
|
(2 | ) | ||
Mortgage
loans held for investment
|
$ | 39,998 |
The
following table summarizes the changes in the allowance for loan losses for the
mortgage loan portfolio during the period ended December 31, 2009:
December
31, 2009
|
||||
(dollars in thousands)
|
||||
Balance,
beginning of period
|
$ | - | ||
Provision
for loan loss
|
2 | |||
Charge-offs
|
- | |||
Balance,
end of period
|
$ | 2 |
On a
quarterly basis, the Company evaluates the adequacy of its allowance for loan
losses. Based on this analysis, the Company recorded a general
provision for loan losses of $2,280 for the period ended December 31, 2009,
representing 1.5% of the Company's mortgage loan portfolio over the life of the
loan. At December 31, 2009, there were no loans 90 days or more past due and all
loans were accruing interest.
F-13
4. Fair
Value Measurements
GAAP
defines fair value, establishes a framework for measuring fair value,
establishes a three-level valuation hierarchy for disclosure of fair value
measurement and enhances disclosure requirements for fair value
measurements. The valuation hierarchy is based upon the transparency
of inputs to the valuation of an asset or liability as of the measurement
date. The three levels are defined as follows:
Level 1 –
inputs to the valuation methodology are quoted prices (unadjusted) for identical
assets and liabilities in active markets.
Level 2 –
inputs to the valuation methodology include quoted prices for similar assets and
liabilities in active markets, and inputs that are observable for the asset or
liability, either directly or indirectly, for substantially the full term of the
financial instrument.
Level 3 –
inputs to the valuation methodology are unobservable and significant to fair
value.
The
following discussion describes the methodologies to be utilized by the Company
to fair value its financial instruments by instrument class.
Short-term
Instruments
The
carrying value of cash and cash equivalents, accrued interest receivable,
dividends payable, accounts payable, and accrued interest payable generally
approximates estimated fair value due to the short term nature of these
financial instruments.
CMBS
and RMBS
The
Company will determine the fair value of its investment securities utilizing a
pricing model that incorporates such factors as coupon, prepayment speeds,
weighted average life, collateral composition, borrower characteristics,
expected interest rates, life caps, periodic caps, reset dates, collateral
seasoning, expected losses, expected default severity, credit enhancement, and
other pertinent factors. Management will review the fair values
generated by the model to determine whether prices are reflective of the current
market. Management will perform a validation of the fair value
calculated by the pricing model by comparing its results to independent prices
provided by dealers in the securities and/or third party pricing
services.
During
times of market dislocation, as has been experienced for some time, the
observability of prices and inputs can be reduced for certain
instruments. If dealers or independent pricing services are unable to
provide a price for an asset or if the Company deems the price provided by such
dealers or independent pricing services to be unreliable, then the Company will
determine the fair value of the asset in good faith. In addition,
validating third party pricing for the Company’s investments may be more
subjective as fewer participants may be willing to provide this service to the
Company. Illiquid investments typically experience greater price
volatility as a ready market does not exist. As fair value is not an
entity specific measure and is a market based approach which considers the value
of an asset or liability from the perspective of a market participant,
observability of prices and inputs can vary significantly from period to
period. A condition such as this can cause instruments to be
reclassified from Level 1 to Level 2 or Level 2 to Level 3 when the Company is
unable to obtain third party pricing verification.
If at the
valuation date, the fair value of an investment security is less than its
amortized cost at the date of the consolidated statement of financial condition,
the Company will analyze the investment security for other-than-temporary
impairment. Management will evaluate the Company’s CMBS and RMBS for
OTTI at least on a quarterly basis, and more frequently when economic or market
concerns warrant such evaluation. Consideration will be given to (1)
the length of time and the extent to which the fair value has been lower than
carrying value, (2) the intent of the Company to sell the investment prior to
recovery in fair value (3) whether the Company will be more likely than not
required to sell the investment before the expected recovery, (4) and the
expected future cash flows of the investment in relation to its amortized
cost.
If a
credit portion of OTTI exists, the cost basis of the security is written
down to the then-current fair value, and the unrealized loss is transferred from
accumulated other comprehensive loss as an immediate reduction of current
earnings.
F-14
Repurchase
Agreements
The
Company will record repurchase agreements at their contractual amounts including
accrued interest payable. Repurchase agreements are collateralized
financing transactions the Company could use to acquire investment
securities. Due to the short term nature of these financial
instruments the Company will estimate the fair value of these repurchase
agreements to be the contractual obligation plus accrued interest payable at
maturity.
Securitized
Debt
The
Company will record securitized debt for certificates or notes sold in
securitization or re-securitization transactions treated as
“financings”. The Company will carry securitized debt at the
principal balance outstanding on non-retained notes associated with its
securitized loans held for investment plus premiums or discounts recorded with
the sale of the notes to third parties. The premiums or discounts
associated with the sale of the notes or certificates will be amortized over the
life of the instrument. The Company fair values the securitized debt
by estimating the future cash flows associated with underlying assets
collateralizing the secured debt outstanding. The Company will model
each underlying asset by considering, among other items, the structure of the
underlying security, coupon, servicer, actual and expected defaults, actual and
expected default severities, reset indices, and prepayment speeds in conjunction
with market research for similar collateral performance and management’s
expectations of general economic conditions in the sector and greater
economy.
Any
changes to the valuation methodology will be reviewed by management to ensure
the changes are appropriate. As markets and products develop and the pricing for
certain products becomes more transparent the Company will continue to refine
its valuation methodologies. The methods used may produce a fair value
calculation that may not be indicative of net realizable value or reflective of
future fair values. Furthermore, while the Company believes its valuation
methods will be appropriate and consistent with other market participants, the
use of different methodologies, or assumptions, to determine the fair value of
certain financial instruments could result in a different estimate of fair value
at the reporting date. The Company will use inputs that are current
as of the measurement date, which may include periods of market dislocation,
during which price transparency may be reduced.
As of
December 31, 2009, the Company has classified its CMBS as "Level
2".
The
Company's financial assets and liabilities carried at fair value on a recurring
basis are valued at December 31, 2009 as follows:
Level
1
|
Level
2
|
Level
3
|
||||||||||
(dollars in thousands) | ||||||||||||
Assets:
|
||||||||||||
|
||||||||||||
Cash
and cash equivalents
|
$ | 212,133 | $ | - | $ | - | ||||||
Mortgage-backed
securities
|
- | 30,913 | - | |||||||||
F-15
Mortgage
loan assets totaled $39,998,000 at December 31, 2009. These loans
are held for investment and are valued at amortized cost less allowance for loan
losses. Secured financing liabilities totaled of $25,579,000 which approximates
fair value at December 31, 2009.
As fair
value is not an entity specific measure and is a market based approach which
considers the value of an asset or liability from the perspective of a market
participant, observability of prices and inputs can vary significantly from
period to period. During times of market dislocation, as has been experienced
during the recent months, the observability of prices and inputs can be reduced
for certain instruments. A condition such as this can cause instruments to be
reclassified from level 1 to level 2 to level 3 when the Company is unable to
obtain third party pricing verification.
5. Secured
Financing Agreements
Commercial
Mortgage-Backed Securities
The
Company had outstanding $25.6 million of CMBS structured financing agreements
with weighted average borrowing rate of 3.62% and weighted average remaining
maturities of 5 years as of December 31, 2009. Investment securities pledged as
collateral under these secured financing agreements had an estimated fair value
of $30.91 million at December 31, 2009. The interest rates of these
structured financing agreements are fixed to the 5 year swap curve and 100 basis
points.
At
December 31, 2009, the structured financing agreements all had the following
remaining maturities:
Debt
|
||||
Book
Value
|
||||
(dollars in thousands)
|
||||
2009
|
$ | - | ||
2010
|
- | |||
2011
|
- | |||
2012
|
- | |||
2013
and thereafter
|
25,579 | |||
Total
|
$ | 25,579 |
At
December 31, 2009 the Company did not have an amount at risk of greater than 10%
of the equity of the Company with any counterparty.
F-16
6. Common
Stock
On
September 17, 2009, the Company announced the sale of 13,333,334 shares of
common stock at $15.00 per share for estimated proceeds, less the underwriters’
discount and offering expenses, of $189.4 million. Concurrently with
the sale of these shares Annaly purchased 4,527,778 shares at the same price per
share as the public offering, for proceeds of approximately $67.9
million. These sales were completed on September 22,
2009. In all, the Company raised net proceeds of approximately $257.3
million in these offerings.
On
September 30, 2009, the Company issued 9,000 shares of restricted common stock
in accordance to the equity incentive plan.
There was
no preferred stock issued or outstanding as of December 31, 2009.
During
the year ended December 31, 2009, the Company did not declare dividends to
common shareholders.
7. Equity
Incentive Plan
The
Company has adopted an equity incentive plan to provide incentives to our
independent directors, employees of FIDAC and its affiliates, including Annaly,
and other service providers to stimulate their efforts toward our continued
success, long-term growth and profitability and to attract, reward and retain
personnel. The equity incentive plan is administered by the
compensation committee of our board of directors. Unless terminated
earlier, our equity incentive plan will terminate in 2019, but will continue to
govern unexpired awards. Our equity incentive plan provides for
grants of restricted common stock and other equity-based awards up to an
aggregate amount, at the time of the award, of (i) 2.5% of the issued and
outstanding shares of our common stock on a fully diluted basis and including
shares sold to Annaly concurrently with our initial public offering at the time
of the award less (ii) 250,000 shares, subject to an aggregate ceiling of
25,000,000 shares available for issuance under the plan. The Company
has issued 9,000 shares of restricted stock under the equity incentive plan to
its independent directors, which vested immediately.
8. Income
Taxes
As a
REIT, the Company will generally not be subject to U.S. federal or state
corporate taxes on its income to the extent that qualifying distributions are
made to stockholders and the REIT requirements, including certain asset, income,
distribution and stock ownership tests are met. During the period
ended December 31, 2009, the Company recorded an income tax expense related to
state taxes of $1,000 and no income tax expense related to federal tax
liabilities on undistributed income.
In
general, common stock cash dividends declared by the Company will be considered
ordinary income to stockholders for income tax purposes. From time to
time, a portion of the Company’s dividends may be characterized as capital gains
or return of capital.
9. Credit
Risk and Interest Rate Risk
The
Company's primary risk will be credit risk and interest rate
risk. The Company will be subject to credit risk in connection with
its investments in commercial mortgage loans and credit sensitive
mortgage-backed securities. When the Company assumes credit risk, it
will attempt to minimize interest rate risk through asset selection, hedging and
matching the income earned on mortgage assets with the cost of related
liabilities. The Company will be subject to interest rate risk,
primarily in connection with its investments in CMBS, commercial mortgage loans,
RMBS and borrowings under repurchase agreements. The Company will
attempt to manage credit risk through pre-acquisition due diligence processes
including, but not limited to, analysis of the sponsor/borrower, the structure
of the investment, property information including tenant composition, the
property’s historical operating performance and evaluation of the market in
which the property is located. These factors are considered to be
important indicators of credit risk.
F-17
10. Management
Agreement and Related Party Transactions
The
Company has entered into a management agreement with FIDAC, a wholly owned
subsidiary of Annaly, which provides for an initial term through December 31,
2013 with an automatic one-year extension option and subject to certain
termination rights. The Company pays FIDAC a quarterly management fee
equal to 0.50% per annum for the first twelve months following the commencement
of operations, 1.00% per annum for the period after the first twelve months
through the eighteenth month following the commencement of operations, and 1.50%
per annum after the first eighteen months following the commencement of
operations, calculated quarterly, of our stockholders’ equity (as defined in the
management agreement) of the Company. Management fees accrued and
subsequently paid to FIDAC for the period of September 22, 2009 through December
31, 2009 were $354,000.
Upon
termination without cause, the Company will pay FIDAC a termination fee.
The Company may also terminate the management agreement with 30-days’ prior
notice from the Company’s board of directors, without payment of a termination
fee, for cause or upon a change of control of Annaly or FIDAC, each as defined
in the management agreement. FIDAC may terminate the management agreement
if the Company or any of its subsidiaries become required to register as an
investment company under the Investment Company Act of 1940, as amended, or the
1940 Act, with such termination deemed to occur immediately before such event,
in which case the Company would not be required to pay a termination fee.
FIDAC may also decline to renew the management agreement by providing the
Company with 180-days written notice, in which case the Company would not be
required to pay a termination fee.
The
Company is obligated to reimburse FIDAC for its costs incurred under the
management agreement. In addition, the management agreement permits
FIDAC to require the Company to pay for its pro rata portion of rent, telephone,
utilities, office furniture, equipment, machinery and other office, internal and
overhead expenses of FIDAC incurred in the operation of the
Company. These expenses are allocated between FIDAC and the Company
based on the ratio of the Company’s proportion of gross assets compared to all
remaining gross assets managed by FIDAC as calculated at each quarter
end. FIDAC and the Company will modify this allocation
methodology, subject to the Company’s board of directors’ approval if the
allocation becomes inequitable (i.e., if the Company becomes very highly
leveraged compared to FIDAC’s other funds and accounts). FIDAC has
waived its right to request reimbursement from the Company of these expenses
until such time as it determines to rescind that waiver.
Annaly
purchased 4,527,778 shares of stock at the same price per share paid by other
investors in the Company’s public offering and owns 25% of the Company’s
outstanding shares as an equity investment.
On May
21, 2008, the Company issued 1,000,000 shares of its common stock to certain
FIDAC’s officers and employees for an aggregate purchase price of $50,000. On
September 15, 2009, the Company repurchased 750,000 shares of common stock from
existing holders on a pro rata basis at the initial per share purchase price.
Each of these officers and employees has agreed to a three year lock-up with the
Company, subject to termination upon the termination of the management
agreement, with respect to those shares of our common stock.
11. Commitments
and Contingencies
From time
to time, the Company may become involved in various claims and legal actions
arising in the ordinary course of business. Management is not aware
of any reported or unreported contingencies at December 31, 2009.
F-18
The
Company has agreed to pay the underwriters of its initial public offering $0.15
per share for each share sold in the in the initial public offering if during
any full four calendar quarter period during the 24 full calendar quarters after
the consummation of this offering our Core Earnings (as described below) for any
such four-quarter period exceeds an 8% performance hurdle rate (as described
below). The performance hurdle rate will be met if during any full four
calendar quarter period during the 24 full calendar quarters after the
consummation of the Company’s initial public offering its Core Earnings for any
such four-quarter period exceeds the product of (x) the weighted average of the
issue price per share of all public offerings of its common stock, multiplied by
the weighted average number of shares outstanding (including any restricted
stock units, any restricted shares of common stock and any other shares of
common stock underlying awards granted under our equity incentive plans) in such
four-quarter period and (y) 8%. Core Earnings is a non-GAAP measure and is
defined as GAAP net income (loss) excluding non-cash equity compensation
expense, depreciation and amortization (to the extent that we foreclose on any
properties underlying our target assets), any unrealized gains, losses or other
non-cash items recorded for the period, regardless of whether such items are
included in other comprehensive income or loss, or in net income. The amount
will be adjusted to exclude one-time events pursuant to changes in GAAP and
certain other non-cash charges after discussions between FIDAC and the Company’s
independent directors and after approval by a majority of the Company’s
independent directors.
F-19
12. Summarized
Initial Period Results
The
following is a presentation of the results of operations for the period
September 22, 2009 (commencement of operations) to December 31,
2009.
For
the Period
commencing
September
22, 2009
through
December
31, 2009
|
||||
Net
Interest Income:
|
||||
Interest
income
|
$ | 325 | ||
Interest
expense
|
26 | |||
Net
interest income
|
299 | |||
Other
expenses:
|
||||
Management
fee
|
354 | |||
Provision
for loan losses
|
2 | |||
General
and administrative expenses
|
951 | |||
Total
other expenses
|
1,307 | |||
Loss
before income taxes
|
(1,008 | ) | ||
Income
tax
|
1 | |||
Net
loss
|
$ | (1,009 | ) | |
Net
loss per share-basic and diluted
|
$ | (0.06 | ) | |
Weighted
average number of shares outstanding-basic and diluted
|
18,120,112 | |||
Comprehensive loss: | ||||
Net loss | $ | (1,009 | ) | |
Other
comprehensive loss:
|
||||
Unrealized
loss on securities held for investment
|
(373 | ) | ||
Comprehensive
loss:
|
$ | (1,382 | ) |
F-20
Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized, in the city of New York, State of
New York.
CREXUS
INVESTMENT CORP.
|
||
Date:
February 25, 2010
|
By:
|
/s/ Kevin Riordan
|
Kevin
Riordan
|
||
Chairman,
Chief Executive Officer, and
President
|
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.
Signature
|
Title
|
Date
|
|
/s/ Kevin
Riordan
|
Chief
Executive Officer, President and Director
|
February
25, 2010
|
|
Kevin Riordan | (principal executive officer) | ||
/s/ Daniel
Wickey
|
Chief
Financial Officer (principal financial and
|
February
25, 2010
|
|
Daniel Wickey | accounting officer) | ||
/s/ Ronald
Kazel
|
Director
|
February
25, 2010
|
|
Ronald Kazel | |||
/s/ Robert
Eastep
|
Director
|
February
25, 2010
|
|
Robert Eastep | |||
/s/ Nancy J.
Kuenstner
|
Director
|
February
25, 2010
|
|
Nancy J. Kuenstner | |||
/s/ Patrick
Corcoran
|
Director
|
February
25, 2010
|
|
Patrick Corcoran |
S-1