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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark one)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998
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 No. 1-14043
OCWEN ASSET INVESTMENT CORP.
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(Exact name of Registrant as specified in its charter)
VIRGINIA 65-0736120
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
The Forum, Suite1000 33401
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1675 PALM BEACH LAKES BOULEVARD (Zip Code)
WEST PALM BEACH, FLORIDA
(Address of principal executive office)
(561) 682-8000
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(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
COMMON STOCK, $.01 PAR VALUE NEW YORK STOCK EXCHANGE (NYSE)
(Title of each class) (Name of each exchange on which registered)
Securities registered pursuant to Section 12 (g) of the Act: Not applicable.
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No[ ]
Indicate by check mark if disclosure of delinquent filers pursuant to item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Aggregate market value of the common stock, $.01 par value, held by
nonaffiliates of the registrant, computed by reference to the closing price as
reported on the NYSE as of the close of business on March 9, 1999: $72,121,312.
Number of shares of common stock, $.01 par value, outstanding as of March 9,
1999: 18,965,000 shares.
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OCWEN ASSET INVESTMENT CORP.
1998 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PAGE
PART I
Item 1. Business........................................................ 4
General....................................................... 4
Structure of the Company...................................... 4
Discontinuance of Investment Activities
and Proposed Change in REIT Status.......................... 4
The Manager................................................... 5
Management Fees............................................... 6
Investment Guidelines......................................... 7
Federal Income Tax Considerations............................. 12
Competition................................................... 19
Item 2. Properties...................................................... 19
Item 3. Legal Proceedings............................................... 19
Item 4. Submission of Matters to a Vote of Security Holders............. 19
PART II
Item 5. Market for the Registrant's Common Equity
and Related Stockholder Matters............................. 20
Item 6. Selected Consolidated Financial Data............................ 20
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations......................... 22
Item 7A. Quantitative and Qualitative Disclosures About Market Risk...... 48
Item 8. Financial Statements............................................ 51
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 76
PART III
Item 10. Directors and Executive Officers of the Registrant.............. 76
Item 11. Executive Compensation.......................................... 78
Item 12. Security Ownership of Certain Beneficial Owners and Management.. 79
Item 13. Certain Relationships and Related Transactions.................. 80
PART IV
Item 14. Exhibits, Financial Statement Schedules, and
Reports on Form 8-K ........................................ 82
SIGNATURES...................................................... 85
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FORWARD-LOOKING STATEMENTS
CERTAIN STATEMENTS CONTAINED HEREIN ARE NOT, AND CERTAIN STATEMENTS
CONTAINED IN FUTURE FILINGS BY THE COMPANY WITH THE SECURITIES AND EXCHANGE
COMMISSION (THE "COMMISSION"), IN THE COMPANY'S PRESS RELEASES OR IN THE
COMPANY'S OTHER PUBLIC OR SHAREHOLDER COMMUNICATIONS MAY NOT BE, BASED ON
HISTORICAL FACTS AND ARE "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING OF
SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE
SECURITIES ACT OF 1934, AS AMENDED. THESE FORWARD-LOOKING STATEMENTS, WHICH ARE
BASED ON VARIOUS ASSUMPTIONS (SOME OF WHICH ARE BEYOND THE COMPANY'S CONTROL),
MAY BE IDENTIFIED BY REFERENCE TO A FUTURE PERIOD(S) OR BY THE USE OF
FORWARD-LOOKING TERMINOLOGY SUCH AS "ANTICIPATE," "BELIEVE," "COMMITMENT,"
"CONSIDER," "CONTINUE," "COULD," "ENCOURAGE," "ESTIMATE," "EXPECT," "FORESEE,"
"INTEND," "IN THE EVENT OF," "MAY," "PLAN," "PRESENT," "PROPOSE," "PROSPECT,"
"UPDATE," "WHETHER," "WILL," "WOULD," FUTURE OR CONDITIONAL VERB TENSES, SIMILAR
TERMS, VARIATIONS ON SUCH TERMS OR NEGATIVES OF SUCH TERMS. ALTHOUGH THE COMPANY
BELIEVES THE ANTICIPATED RESULTS OR OTHER EXPECTATIONS REFLECTED IN SUCH
FORWARD-LOOKING STATEMENTS ARE BASED ON REASONABLE ASSUMPTIONS, IT CAN GIVE NO
ASSURANCE THAT THOSE RESULTS OR EXPECTATIONS WILL BE ATTAINED. ACTUAL RESULTS
COULD DIFFER MATERIALLY FROM THOSE INDICATED IN SUCH STATEMENTS DUE TO RISKS,
UNCERTAINTIES AND CHANGES WITH RESPECT TO A VARIETY OF FACTORS, INCLUDING, BUT
NOT LIMITED TO, INTERNATIONAL, NATIONAL, REGIONAL OR LOCAL ECONOMIC ENVIRONMENTS
(PARTICULARLY IN THE MARKET AREAS WHERE THE COMPANY OPERATES), GOVERNMENT FISCAL
AND MONETARY POLICIES (PARTICULARLY IN THE MARKET AREAS WHERE THE COMPANY
OPERATES), PREVAILING INTEREST OR CURRENCY EXCHANGE RATES, EFFECTIVENESS OF
INTEREST RATE, CURRENCY AND OTHER HEDGING STRATEGIES, LAWS AND REGULATIONS
AFFECTING FINANCIAL INSTITUTIONS, REAL ESTATE INVESTMENT TRUSTS, INVESTMENT
COMPANIES AND REAL ESTATE (INCLUDING REGULATORY FEES, CAPITAL REQUIREMENTS,
INCOME AND PROPERTY TAXATION, ACCESS FOR DISABLED PERSONS AND ENVIRONMENTAL
COMPLIANCE), UNCERTAINTY OF FOREIGN LAWS, COMPETITIVE PRODUCTS, PRICING AND
CONDITIONS (INCLUDING FROM COMPETITORS THAT HAVE SIGNIFICANTLY GREATER RESOURCES
THAN THE COMPANY), CREDIT, PREPAYMENT, BASIS, DEFAULT, SUBORDINATION AND
ASSET/LIABILITY RISKS, LOAN SERVICING EFFECTIVENESS, ABILITY TO IDENTIFY
ACQUISITIONS AND INVESTMENT OPPORTUNITIES MEETING THE COMPANY'S INVESTMENT
STRATEGY, COURSE OF NEGOTIATIONS AND ABILITY TO REACH AGREEMENT WITH RESPECT TO
MATERIAL TERMS OF ANY PARTICULAR TRANSACTION, SATISFACTORY DUE DILIGENCE
RESULTS, SATISFACTION OR FULFILLMENT OF AGREED UPON TERMS AND CONDITIONS OF
CLOSING OR PERFORMANCE, TIMING OF TRANSACTION CLOSINGS, THE RECENT DECISION TO
CURTAIL EACH BUSINESS LINE AND DISCONTINUE INVESTMENT ACTIVITIES, ACQUISITIONS
AND INTEGRATION OF ACQUIRED BUSINESSES, SOFTWARE INTEGRATION, DEVELOPMENT AND
LICENSING, AVAILABILITY OF AND COSTS ASSOCIATED WITH OBTAINING ADEQUATE AND
TIMELY SOURCES OF LIQUIDITY, DEPENDENCE ON EXISTING SOURCES OF FUNDING, ABILITY
TO REPAY OR REFINANCE INDEBTEDNESS (AT MATURITY OR UPON ACCELERATION), TO MEET
COLLATERAL CALLS BY LENDERS (UPON RE-VALUATION OF THE UNDERLYING ASSETS OR
OTHERWISE), TO GENERATE REVENUES SUFFICIENT TO MEET DEBT SERVICE PAYMENTS AND
OTHER OPERATING EXPENSES AND TO SECURITIZE WHOLE LOANS, TAXABLE INCOME EXCEEDING
CASH FLOW, AVAILABILITY OF DISCOUNT LOANS FOR PURCHASE, SIZE OF, NATURE OF AND
YIELDS AVAILABLE WITH RESPECT TO THE SECONDARY MARKET FOR MORTGAGE LOANS AND
FINANCIAL, SECURITIES AND SECURITIZATION MARKETS IN GENERAL, ALLOWANCES FOR LOAN
LOSSES, GEOGRAPHIC CONCENTRATIONS OF ASSETS (TEMPORARY OR OTHERWISE), TIMELY
LEASING OF UNOCCUPIED SQUARE FOOTAGE (GENERALLY AND UPON LEASE EXPIRATION),
CHANGES IN REAL ESTATE CONDITIONS (INCLUDING LIQUIDITY, VALUATION, REVENUES,
RENTAL RATES, OCCUPANCY LEVELS AND COMPETING PROPERTIES), ADEQUACY OF INSURANCE
COVERAGE IN THE EVENT OF A LOSS, KNOWN OR UNKNOWN ENVIRONMENTAL CONDITIONS,
EXTERNAL MANAGEMENT, CONFLICTS OF INTEREST, YEAR 2000 COMPLIANCE, OTHER FACTORS
GENERALLY UNDERSTOOD TO AFFECT THE REAL ESTATE ACQUISITION, MORTGAGE AND LEASING
MARKETS, SECURITIES INVESTMENTS AND RAPID GROWTH COMPANIES, AND OTHER RISKS
DETAILED FROM TIME TO TIME IN THE COMPANY'S REPORTS AND FILINGS WITH THE
COMMISSION, INCLUDING ITS REGISTRATION STATEMENTS ON FORMS S-3, S-4 AND S-11 AND
PERIODIC REPORTS ON FORMS 10-Q, 8-K AND 10-K. GIVEN THESE UNCERTAINTIES, READERS
ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON SUCH STATEMENTS. THE COMPANY DOES
NOT UNDERTAKE, AND SPECIFICALLY DISCLAIMS ANY OBLIGATION, TO PUBLICLY RELEASE
THE RESULT OF ANY REVISIONS WHICH MAY BE MADE TO ANY FORWARD-LOOKING STATEMENTS
TO REFLECT THE OCCURRENCE OF ANTICIPATED OR UNANTICIPATED EVENTS OR
CIRCUMSTANCES AFTER THE DATE OF SUCH STATEMENTS.
PLEASE REFER TO EXHIBIT 99.2, RISK FACTORS, FOR A DESCRIPTION OF
MATERIAL RISKS FACED BY THE COMPANY AND ITS SECURITIES HOLDERS.
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PART I
ITEM 1. BUSINESS
GENERAL
Ocwen Asset Investment Corp. ("OAC" or the "Company") was incorporated
in the Commonwealth of Virginia on January 22, 1997, and, through December 31,
1998, has elected to be taxed as a Real Estate Investment Trust ("REIT") under
Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the
"Code"). As such, OAC will generally not be subject to federal income taxation
on that portion of its income that it distributes to its shareholders if it
distributes at least 95% of its taxable income to its shareholders annually and
meets certain other income and asset tests.
The Company's business and investment affairs are managed by Ocwen
Capital Corporation ("OCC" or the "Manager"), a Florida corporation wholly-owned
by Ocwen Financial Corporation ("OCN"), a diversified financial services company
that is primarily engaged in the acquisition, servicing and resolution of
subperforming and nonperforming residential and commercial mortgage loans
through Ocwen Federal Bank, FSB (the "Bank") and other subsidiaries.
The Company has sought to capitalize on inefficiencies in the real
estate and mortgage markets by investing in several categories of real estate
and real estate related assets. Such investments consist primarily of: (i)
subordinate and residual interests in commercial and residential mortgage-backed
securities; and (ii) distressed commercial and multi-family real property,
including properties acquired by a mortgage lender at foreclosure (or
deed-in-lieu of foreclosure). The Company believes that these investment
activities complement each other, from both a cash flow and a tax planning
perspective. In the early years after an acquisition real property tends to
generate more cash flow than taxable income as a result of depreciation
deductions, while subordinate and residual securities during the same period
tend to generate more taxable income than cash flow. The relationship between
taxable income and cash flow will, with respect to each type of investment,
generally reverse in later years.
The Company also has invested, by way of purchase and origination, in:
(i) commercial, multi-family and single family residential mortgage loans,
including construction and rehabilitation loans and mezzanine loans; (ii)
interest-only and inverse interest-only mortgage-related securities supported by
residential and commercial mortgage loans; and (iii) mortgage loans that are in
default or for which default is likely or imminent or for which the borrower is
currently making monthly payments in accordance with a forbearance plan
(collectively, "discount loans").
STRUCTURE OF THE COMPANY
The Company conducts its business primarily through Ocwen Partnership,
L.P. ("the Operating Partnership"), a Virginia limited partnership. Ocwen
General, Inc. (the "General Partner"), a Virginia corporation and a wholly-owned
qualified REIT subsidiary of the Company, holds an 0.9% interest in the
Operating Partnership and is the general partner of and controls the Operating
Partnership. In addition, Ocwen Limited, Inc. (the "Limited Partner"), a
Virginia corporation and a wholly-owned qualified REIT subsidiary of the
Company, currently owns a 90.4% limited partnership interest in the Operating
Partnership. The remaining 8.7% partnership interests in the Operating
Partnership are limited partnership interests held by OCN through Investors
Mortgage Insurance Holding Company ("IMIHC"), a wholly-owned subsidiary.
The relationship among the Company, the Operating Partnership, the
General Partner and the Limited Partner is commonly referred to as an umbrella
partnership REIT (or "UPREIT") structure. In this structure, the Company holds
the same number of units in the Operating Partnership (through the General
Partner and the Limited Partner) as the number of shares of common stock, par
value $0.01 per share (the "Common Stock"), which the Company has issued and
outstanding. As a result, any additional units issued by the Operating
Partnership share ratably with the Common Stock of the Company in any
distributions made by the Operating Partnership. The benefit of this structure
is that owners of real estate assets may transfer them to the UPREIT while
deferring the recognition of the built-in gain for tax purposes.
DISCONTINUANCE OF INVESTMENT ACTIVITIES AND PROPOSED CHANGE IN REIT STATUS
DISCONTINUANCE OF INVESTMENT ACTIVITIES. As discussed under Item 7
below, on October 26, 1998, the Company announced that, for the foreseeable
future, it does not plan to acquire any additional assets or fund any additional
loans (beyond those which are currently committed), and it will work to
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accelerate the stabilization of its existing assets and increase its overall
liquidity position. As a result, the Company has curtailed each of its business
lines, which include the acquisition of subordinate and residual interests in
residential and commercial mortgage-related securities, underperforming real
estate and residential and commercial real estate loans, including construction
and renovation loans.
PROPOSED CHANGE IN REIT STATUS. As discussed in Item 7 below, on
December 21, 1998, the Company announced that its Board of Directors has
approved a proposal to terminate the Company's status as a REIT effective for
calendar year 1999. The proposal, which requires amendment of the Company's
Articles of Incorporation, is subject to shareholder approval. The Board
currently anticipates that this proposal will be considered at the Annual
Meeting of Shareholders of the Company which is scheduled to be held in May
1999. If approved, the Company will be treated as a general corporation for
federal, state, and local tax purposes and will be subject to federal, state and
local income tax on its taxable income. In addition, the Company would not be
eligible to re-elect REIT status until 2004.
THE MANAGER
GENERAL. The Manager is a wholly-owned subsidiary of OCN. OCN is a
financial services company that is primarily engaged in the acquisition,
servicing and resolution of subperforming and nonperforming residential and
commercial mortgage loans. At December 31, 1998, OCN had $3.3 billion of total
assets and shareholders' equity of $436.4 million.
The Company has entered into a management agreement with the Manager
(the "Management Agreement") for an initial term expiring on May 19, 1999, the
second anniversary of the closing date of the initial public offering of the
Common Stock (the "Initial Public Offering"). Thereafter, successive extensions,
each for a period not to exceed one year, may be made by agreement between the
Company and the Manager, subject to the affirmative vote of a majority of the
Company's Independent Directors, as defined in the Company's Articles of
Incorporation. The Company may terminate, or decline to extend the term of, the
Management Agreement without cause at any time after the first two years upon 60
days written notice by a majority vote of the Independent Directors or by a vote
of the holders of a majority of the outstanding shares of Common Stock;
provided, that a termination fee, equal to the sum of the base management fee
and incentive management fee earned during the twelve months preceding such
termination, will be due. In addition, the Company has the right to terminate
the Management Agreement upon the occurrence of certain specified events,
including a material breach by the Manager of any provision contained in the
Management Agreement, without the payment of any termination fee. If the
Management Agreement is terminated for any reason, OCN will have certain
registration rights with respect to the Common Stock held by it.
The Manager at all times is subject to the supervision of the Company's
Board of Directors and has only such functions and authority as the Company
delegates to it. The Manager is responsible for the day-to-day operations of the
Company and performs (or causes to be performed) such services and activities
relating to the assets and operations of the Company as may be appropriate,
including: (i) serving as the Company's consultant with respect to formulation
of investment criteria and preparation of policy guidelines by the Board of
Directors (the "Guidelines"); (ii) representing the Company in connection with
the purchase and commitment to purchase assets, the sale and commitment to sell
assets, and the maintenance and administration of its portfolio of assets; (iii)
furnishing reports and statistical and economic research to the Company
regarding the Company's activities and the services performed for the Company by
the Manager; (iv) monitoring and providing to the Board of Directors on an
ongoing basis price information and other data obtained from certain nationally
recognized dealers that maintain markets in assets identified by the Board of
Directors from time to time, and providing data and advice to the Board of
Directors in connection with the identification of such dealers; (v) providing
executive and administrative personnel, office space and office services
required in rendering services to the Company; (vi) administering the day-to-day
operations of the Company and performing and supervising the performance of such
other administrative functions necessary in the management of the Company as may
be agreed upon by the Manager and the Board of Directors, including the
collection of revenues and the payment of the Company's debts and obligations
and maintenance of appropriate computer services to perform such administrative
functions; (vii) communicating on behalf of the Company with the holders of any
equity or debt securities of the Company as required to satisfy the reporting
and other requirements of any governmental bodies or agencies or trading markets
and to maintain effective relations with such holders; (viii) to the extent not
otherwise subject to an agreement executed by the Company, designating a
servicer for mortgage loans sold to the Company and arranging for the monitoring
and administering of such servicers; (ix) counseling the Company in connection
with policy decisions to be made by the Board of Directors; (x) engaging in
hedging activities on behalf of the Company, consistent with the Company's
status as a REIT and with the Guidelines; (xi) upon request by and in accordance
with the directions of the Board of Directors, investing or reinvesting any
money of the Company; and (xii) counseling the Company regarding the maintenance
of its status as a REIT and monitoring compliance with the various REIT
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qualification tests and other rules set out under the Code by the U.S. Treasury
(the "Treasury Regulations"). See "Federal Income Tax Considerations" below.
PORTFOLIO MANAGEMENT. The Manager performs portfolio management
services on behalf of the Company and the Operating Partnership pursuant to the
Management Agreement. Such services include, but are not limited to, consulting
with the Company on purchase and sale opportunities, collection of information
and submission of reports pertaining to the Company's assets, interest rates and
general economic conditions, periodic review and evaluation of the performance
of the Company's portfolio of assets, acting as a liaison between the Company
and banking, mortgage banking, investment banking and other parties with respect
to the purchase, financing and disposition of assets, and other customary
functions related to portfolio management. The Manager may enter into
subcontracts with other parties, including its affiliates, to provide any such
services to the Company, but has not done so to date.
MONITORING SERVICING. The Manager performs monitoring services on
behalf of the Company pursuant to the Management Agreement with respect to the
Company's portfolio of mortgage loans. Such monitoring services include, but are
not limited to, the following activities: negotiating servicing agreements;
serving as the Company's consultant with respect to the servicing of mortgage
loans; collection of information and submission of reports pertaining to the
mortgage loans and to moneys remitted to the Manager or the Company; acting as a
liaison between the servicers of the mortgage loans and the Company and working
with servicers to the extent necessary to improve their servicing performance;
with respect to mortgage loans for which the Company is servicer, periodic
review and evaluation of the performance of each servicer to determine its
compliance with the terms and conditions of the related servicing agreement;
review of and recommendations as to fire losses, easement problems and
condemnation, delinquency and foreclosure procedures with regard to mortgage
loans; review of servicers' delinquency, foreclosures and other reports on
mortgage loans; supervising claims filed under any mortgage insurance policies;
and enforcing the obligation of any servicer to repurchase mortgage loans. The
Manager may enter into subcontracts with other parties, including its
affiliates, to provide any such services to the Company, but has not done so to
date. For a description of servicing agreements entered in to by the Company
with the Bank, see "Certain Transactions" under Item 13.
MANAGEMENT FEES
BASE AND INCENTIVE FEES. The Manager receives a base management fee,
calculated and paid quarterly, in an amount equal to 0.25% per quarter (1% per
annum), based upon the Average Invested Assets of the Company for such quarter.
The term "Average Invested Assets" for any period means the average of the
aggregate book value of the assets of the Company, including the assets of all
of its direct and indirect subsidiaries, before reserves for depreciation or bad
debts or other similar noncash reserves, computed by taking the daily average of
such values during such period; provided, however, effective January 1, 1998,
with respect to residential loans, the phase means average net equity invested.
The Manager is entitled to receive incentive compensation for each
fiscal quarter in an amount equal to the product of (A) 25% of the dollar amount
by which (1)(a) Funds From Operations ("FFO") (before the incentive fee) of the
Company per share of Common Stock (based on the weighted average number of
shares outstanding) plus (b) gains (or minus losses) from debt restructuring and
sales of property per share of Common Stock (based on the weighted average
number of shares outstanding), exceed (2) an amount equal to (a) the weighted
average of the price per share at the initial offering and the prices per share
at any secondary offerings by the Company multiplied by (b) the ten-year U.S.
Treasury rate plus five percent per annum multiplied by (B) the weighted average
number of shares of Common Stock outstanding during such period. FFO, as defined
by National Association of Real Estate Investment Trusts ("NAREIT"), means net
income, computed in accordance with generally accepted accounting principles
("GAAP"), excluding gains (losses) from debt restructuring and sales of
property, plus depreciation and amortization on real estate assets, and after
adjustments for unconsolidated partnerships and joint ventures, as discussed
under Item 7. FFO does not represent cash generated from operating activities in
accordance with GAAP and should not be considered as an alternative to net
income as an indication of the Company's performance or to cash flows as a
measure of liquidity or ability to make distributions. As used in calculating
the Manager's compensation, the term "Ten Year U.S. Treasury Rate" means the
arithmetic average of the weekly average yield to maturity for actively traded
current coupon U.S. Treasury fixed interest rate securities (adjusted to
constant maturities of ten years) published by the Federal Reserve Board during
a quarter, or, if such rate is not published by the Federal Reserve Board, any
Federal Reserve Bank or agency or department of the federal government selected
by the Company. If the Company determines in good faith that the Ten Year U.S.
Treasury Rate cannot be calculated as provided above, then the rate shall be the
arithmetic average of the per annum average yields to maturities, based upon
closing asked prices on each business day during a quarter, for each actively
traded marketable U.S. Treasury fixed interest rate security with a final
maturity date not less than eight nor more than twelve years from the date of
the closing asked prices, as chosen and quoted for each business day in each
such quarter in New York City by at least three recognized dealers in U.S.
Government securities selected by the Company.
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When the Manager's employees perform certain due diligence tasks that
purchasers of real estate (including managers of REITs) typically hire outside
consultants to perform, the Manager is reimbursed for (or charges the Company
directly for) the Manager's out-of-pocket costs in performing such due diligence
on assets purchased or considered for purchase by the Company. Moreover, the
Manager tracks the time its employees spend in performing such due diligence
tasks and is entitled to reimbursement for the allocated portion of the salary
and benefits of such employees.
EXPENSES. The Company does not, and does not expect to, maintain an
office or employ full-time personnel. Instead it relies on the facilities and
resources of the Manager to conduct its operations, and it is required to pay
out-of-pocket expenses and an allocated portion of salary and benefits of the
Manager attributable to the operations of the Company. Expense reimbursement is
made quarterly.
PAYMENT OF FEES AND EXPENSES. The management fees are payable in
arrears. The Manager's base and incentive fees and due diligence and other
expenses are calculated by the Manager within 45 days after the end of each
quarter, and such calculation is promptly delivered to the Company. The Company
is obligated to pay such fees and expenses within 60 days after the end of each
fiscal quarter.
During 1998, the Manager earned $5.9 million in base management fees
and no incentive compensation from the Company. In addition, for such period,
the Manager was reimbursed $1.8 million for out-of-pocket costs and salary
allocations for due diligence tasks.
INVESTMENT GUIDELINES
GENERAL
The Company invests primarily in (i) subordinate and residual interests
in mortgage-related securities and (ii) distressed commercial and multi-family
residential real estate, including real estate acquired in connection with
foreclosure on non-performing loans or by deed-in-lieu thereof. Although the
Company's primary emphasis is on the acquisition of subordinate and residual
interests and distressed real properties, the Company has acquired and will
continue to acquire other real estate-related assets.
The discussion below describes the principal categories of assets that
the Company is authorized to acquire under the Guidelines, which may be amended
at any time by the Board of Directors of the Company to reflect competitive
conditions and other business considerations. As noted above, the Company has
decided that, for the foreseeable future, it does not plan to acquire any
additional assets or to fund any additional loans (beyond those which are
currently committed) in order to enhance its ability to meet its obligations
under its indebtedness. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations - General" under Item 7.
MORTGAGE-RELATED SECURITIES
SUBORDINATE AND RESIDUAL INTERESTS. The Company has the authority to
acquire subordinate and residual interests in mortgage-related securities backed
by single family residential, multi-family residential and commercial real
estate loans. Mortgage-related securities typically are divided into two or more
classes, sometimes called "tranches." The senior classes are higher "rated"
securities, which are rated from low investment grade "BBB" to higher investment
grade "AA" or "AAA." The junior, subordinated classes typically include one or
more lower rated, non-investment grade classes, and an unrated, higher-yielding,
credit support class (which generally is required to absorb the first losses on
the underlying mortgage loans).
Mortgage-related securities generally are issued either as
collateralized mortgage obligations ("CMOs") or pass-through certificates. CMOs
are debt obligations of special purpose corporations, owner trusts or other
special purpose entities secured by multi-family and commercial mortgage loans
or mortgage-related securities. Pass-through certificates evidence interests in
trusts, the primary assets of which are mortgage loans. CMOs and pass-through
certificates may be issued or sponsored by private originators of, or investors
in, mortgage loans, including savings and loan associations, mortgage bankers,
commercial banks, investment banks and other entities.
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In most mortgage loan securitizations, a series of mortgage-related
securities is issued in multiple classes in order to obtain investment-grade
ratings for the senior classes and thus increase their marketability. Each class
of mortgage-related securities is generally issued with a specific fixed or
variable coupon rate and has a stated maturity or final scheduled distribution
date. Principal prepayments on the underlying mortgage loans may cause the
mortgage-related securities to be retired substantially earlier than their
stated maturities or final scheduled distribution dates, although in many
instances mortgage loans may have penalties for or limitations on the ability of
the borrower to prepay the loan. Interest is paid or accrued on mortgage-related
securities on a periodic basis, typically monthly.
The credit quality of mortgage-related securities depends on the credit
quality of the underlying mortgage loans. Among the factors determining the
credit quality of the underlying mortgage loans are the creditworthiness of the
borrowers, the ratio of the mortgage loan balances to the value of the
properties securing the mortgage loans, the purpose of the mortgage loans (e.g.,
refinancing or new purchase), the balance of the mortgage loans, their terms and
the geographic diversification of the location of the properties, and, in the
case of commercial mortgage loans, the creditworthiness of the tenants.
The principal of and interest on the underlying mortgage loans may be
allocated among the several classes of a mortgage-related security in many ways,
and the credit quality of a particular class results primarily from the order
and timing of the receipt of cash flow generated from the underlying mortgage
loans. Subordinate and residual interests carry significant credit risks.
Typically, in a "senior/subordinate" structure, the subordinate and residual
interests provide credit protection to the senior classes by absorbing losses
from loan defaults or foreclosures before such losses are allocated to senior
classes. Moreover, typically, as long as the more senior tranches of securities
are outstanding, all prepayments on the mortgage loans generally are paid to
those senior tranches, at least until the end of a lock-out period. In some
instances, particularly with respect to subordinate interests in commercial
securitizations, the holders of subordinate interests are not entitled to
receive scheduled payments of principal until the more senior tranches are paid
in full or until the end of a lock-out period. Because of this structuring of
the cash flows from the underlying mortgage loans, subordinate and residual
interests in a typical securitization are subject to a substantially greater
risk of non-payment than the senior tranches. Accordingly, subordinate and
residual interests are assigned lower credit ratings, or no ratings at all.
Neither the subordinate and residual interests nor the underlying mortgage loans
are guaranteed by agencies or instrumentalities of the U.S. Government or by
other governmental entities and accordingly are subject, among other things, to
credit risks.
A subordinate and residual interest will be extremely sensitive to
losses on the underlying mortgage loans. For example, if the Company owns a $10
million subordinate interest in a mortgage-related security consisting of $100
million of underlying mortgage loans, a 7% loss on all the underlying mortgage
loans (assuming no principal paydown on such loans) will result in a 70% loss on
the subordinate interest. Accordingly, the holder of a subordinate and residual
interest is particularly interested in minimizing the loss frequency (the
percentage of the loan balances that default over the life of the mortgage
collateral) and the loss severity (the amount of loss on a defaulted mortgage
loan, I.E., the principal amount of the mortgage loan unrecovered after applying
any recovery to the expenses of foreclosure and accrued interest) on the
underlying mortgage loans.
The loss frequency on a pool of mortgage loans depends upon a number of
factors, most of which are beyond the control of the Company or the applicable
servicer. Among other things, the default frequency reflects broad conditions in
the economy generally and real estate particularly, economic conditions in the
local area in which the underlying mortgage property is located, the
loan-to-value ratio of the mortgage loan, the purpose of the loan, and the debt
service coverage ratio (with respect to commercial mortgage loans). The loss
severity depends upon many of the same factors described above, and also is
influenced by the servicer's ability to promptly return the loan to performing
status or to foreclose on the defaulted mortgage loan and sell the underlying
mortgaged property. Various legal issues may extend the time of foreclosure
proceedings or may require the expenditure of additional sums to sell the
underlying mortgaged property, in either case increasing the amount of loss with
respect to the loan.
Before acquiring a subordinate and residual interest, the Company
performs a number of due diligence tasks to evaluate the investment and to
verify the information and material provided by the seller. With respect to
mortgage-related securities backed by single family residential loans, the
Manager creates two sample pools: 1) a random sample and 2) an adverse sample,
with characteristics (such as high loan-to-value ratios or poor delinquency
histories) that make them likely to perform more poorly than the average loan in
the pool. The Manager obtains a broker's price opinion ("BPO") from one of its
approved brokers for each of the loans in the sample pools. The Manager
evaluates each BPO to verify its reasonableness, and, if appropriate, additional
information is obtained until the Manager is satisfied that a reasonable
determination of the value of the loan can be made. The Manager also estimates
the potential for increases or decreases in estimated property values based on
local real estate trends.
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Losses on mortgage loans are measured in two ways, loss frequency and
loss severity. Loss frequency is estimated by using industry standard predictive
models, supplemented by OCN's historical data and experience. Loss severity is
estimated by projecting the net resolution proceeds expected to be derived from
the defaulted loans based upon OCN's proprietary in-house computer models. This
net resolution analysis reviews all potential forms of resolution, including
full payoff, discounted payoff, reinstatement, foreclosure and sale,
deed-in-lieu and sale, and takes into account, among other things, real estate
value, carrying costs (that is, property taxes, insurance and maintenance) and
average months to foreclose in the particular state.
With respect to mortgage-related securities backed by multi-family
residential and commercial real estate loans, the Company determines on a
loan-by-loan basis which loans will undergo a full-scope review and which loans
will undergo a more streamlined "desktop analysis." Although the choice is a
subjective one, considerations that influence the choice for scope of review
often include loan size, debt service coverage ratio, loan to value ratio, loan
maturity, lease rollover, property type and geographic location. A full-scope
review may include, among other factors, a property site inspection,
tenant-by-tenant rent roll analysis, review of historical income and expenses
for each property securing the loan, a review of major leases for each property
(if available); recent appraisals (if available), engineering and environmental
reports (if available), and a BPO review. For those loans that are selected for
the more streamlined desktop analysis, the Manager's evaluation may include a
review of the property operating statements, summary loan level data and third
party reports, each as available. If the Manager's review of such information
does not reveal any unusual or unexpected characteristics or factors, no further
due diligence is performed. After completing the review of the documentation and
the property inspection, the formation compiled is analyzed to determine
collateral value for each property securing the loans. Based on these factors,
the Manager determines a resolution value for each loan for purposes of
projecting future cash flows after adjustments for estimated future losses.
Determining a resolution value is a subjective process, requiring,
ultimately, a business judgment. In making this determination, the Manager often
evaluates some of the following characteristics of the mortgage-related
security: (i) the type of collateral (e.g., conforming or subprime single family
residential mortgage collateral, multi-family residential mortgage collateral,
or office, hotel, industrial or retail mortgage collateral); (ii) the payment
status of the underlying mortgage (performing, nonperforming or subperforming);
(iii) the actual mortgage prepayment and default history; (iv) the ratio of the
unpaid mortgage balance to the current property value; (v) the current income
and cash flows generated by multi-family and commercial real estate, as compared
to the debt service requirements; and (vi) the region of the country in which
the collateral is concentrated. However, which of these characteristics (if any)
are important and how important each characteristic may be to the evaluation of
a particular mortgage-related security depends on the individual circumstances.
Because there are so many characteristics to consider, each subordinate and
residual interest must be analyzed individually, taking into consideration both
objective data as well as subjective analysis.
After completing the foregoing evaluations, the Manager models the
structure of the mortgage-related security based on the disclosure documents
that reveal its payment structure and the characteristics of the underlying
mortgage collateral. This modeling is done in order to estimate future cash
flows to be received by the subordinate or residual interests, after adjustments
for estimated future losses. Using that information, the Manager determines the
price at which it would effect the purchase of the subordinate or residual
interest on behalf of the Company.
Although there are some exceptions, most issuers of multi-class
mortgage-related securities elect to be treated, for federal income tax
purposes, as a Real Estate Mortgage Investment Conduit ("REMIC"). The Company
acquires subordinate and residual interests that are treated as regular
interests in REMICs, and also may acquire residual interests that are designated
as REMIC residual interests for federal income tax purposes. Unlike regular
interests in REMICs, REMIC residual interests typically generate excess
inclusion or other forms of "phantom income" that bear no relationship to the
actual economic income that is generated by a REMIC. Consequently, if a residual
interest that is designated as a REMIC residual interest generates a significant
amount of phantom income in any taxable year, the Company could be required to
borrow funds or to liquidate assets in order to meet the REIT distribution
requirement for such taxable year.
Subordinate interests generally are issued at a significant discount to
their outstanding principal balance, which gives rise to original issue discount
("OID") for federal income tax purposes. The Company will be required to accrue
the OID as taxable income over the life of the related subordinate interest on a
level-yield method in advance of the receipt of the related cash flow. The OID
income attributable to a subordinate interest generally increases the Company's
REIT distribution requirement in the early years of the Company's ownership of
the subordinate interest even though the Company may not receive the related
cash flow from the subordinate interest until a later taxable year. As a result,
the Company could be required to borrow funds or to liquidate assets in order to
satisfy the REIT distribution requirement for any taxable year.
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Unlike residential mortgage-related securities, which typically are
backed by thousands of single family mortgage loans, commercial mortgage-related
securities are backed generally by a more limited number of commercial or
multi-family mortgage loans with larger principal balances than those of single
family residential loans. As a result, a loss on a single mortgage loan
underlying a commercial mortgage-related security will have a greater negative
effect on the yield of such security, especially the subordinate interests.
Subordinate and residual interests in residential mortgage-related
securities may be backed by "non-conforming" mortgage loans, that is, single
family residential loans that do not qualify for sale to the Federal Home Loan
Mortgage Corporation ("FHLMC") or the Federal National Mortgage Association
("FNMA"). Subordinate and residual interests in residential mortgage-related
securities also may be backed by subprime mortgage loans, which also are known
as "B," "C" and "D" mortgage loans. B, C and D mortgage loans are loans made to
borrowers who have credit histories of a lower overall quality than "A"
borrowers. These credit histories generally result from previous repayment
difficulties, brief job histories, previous bankruptcies or other causes. Except
with respect to loans originated under programs sponsored by HUD, the
loan-to-value ratio for a B, C and D mortgage loan is typically significantly
lower than the loan-to-value ratio of an "A" mortgage loan, and the pass-through
coupon of a B, C and D mortgage loan is typically higher than the coupon on an A
mortgage loan. As a result of the typically lower loan-to-value ratios and
higher yields on B, C and D mortgage loans, the Company believes these
residential mortgage-related securities with B, C and D mortgage loan collateral
may justify accepting the higher credit risk associated with such borrowers.
Although the owner of subordinate and residual interests in
mortgage-related securities ordinarily cannot control the servicing of the
underlying mortgage loans, the Company generally emphasizes investments in
subordinate and residual interests in which the Company acquires the right to
(i) direct the foreclosure upon any defaulted loan which backs such securities
and to take all other actions that a servicer generally may take in connection
with a defaulted loan and/or (ii) designate the Bank (or another party) as
special servicer with respect to any defaulted mortgage loan, subject to the
Company's right to exercise the rights set forth in clause (i). The Company
believes that these arrangements allow it to obtain the servicing expertise of
the Bank and enable the related subordinate and residual interests to constitute
Qualifying Interests for purposes of the Investment Company Act. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Risk of Loss of Investment Company Act Exemption" under Item 7. As
a result of the foregoing arrangements, however, the Company does not benefit
from receipt of material amounts of special servicing fees.
Because the acquisition and special servicing of problem loans and
distressed real estate is one of the Bank's business focuses, the Bank has an
established network of real estate professionals throughout the United States to
assist its asset management activities. The Bank maintains working relationships
with approved engineers, environmental consultants and real estate brokers
nationwide, and calls upon these local advisors for assistance when appropriate.
DISTRESSED REAL ESTATE
The Company has the authority to acquire commercial and multi-family
real estate acquired at foreclosure or by receipt of a deed-in-lieu thereof and
other underperforming and otherwise distressed commercial and multi-family real
estate. Commercial and multi-family properties are acquired individually or in
pools. The Company's policy is to conduct an investigation and evaluation of a
distressed real property before purchase. Prior to purchase, the Manager
identifies and contacts real estate brokers and/or appraisers in the market area
of the subject properties to obtain rent and sale comparables and develops pro
forma cash flows and estimates of value for each property. The Company also
engages construction engineering and environmental professionals to estimate the
scope and costs of potential renovation and other capital improvement costs.
This information is used to supplement due diligence that is performed by the
Manager's employees.
The Company's due diligence generally includes the review of market
studies for each applicable market. The studies typically include area economic
data, employment trends, absorption rates and market rental rates. Due diligence
also includes site inspections by the Manager's employees or agents and a review
of all available asset files and documentation. To the extent possible those
will include examinations of available legal documents, litigation files,
correspondence, title reports, operating statements, appraisals and engineering
and environmental reports. The information compiled is then analyzed to
determine a valuation for each property.
The property valuation process utilizes a variety of tools which may
include various proprietary financial models that have been developed by OCN and
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are available to the Company through the management agreement with the Manager.
Sources of information examined to determine value generally include: (i)
current and historical operating statements; (ii) existing appraisals; (iii)
rent and sales comparables; (iv) industry statistics and reports regarding
operating expenses such as those compiled by the Institute of Real Estate
Management; (v) leases; and (vi) deferred maintenance observed during site
inspections or described in structural reports, reports and correspondence found
in the asset files or by professionals engaged by the Manager.
The Manager develops projections of net operating income and cash flows
taking into account lease rollovers, tenant improvement costs and leasing
commissions. The Manager compares its estimates of revenue and expenses to
historical operating statements and estimates provided in appraisals and general
industry and regional statistics. Market capitalization rates and discount rates
are then applied to the cash flow projections to estimate values. These values
are then compared to available appraisals and market sale comparables to
determine recommended bid prices for each asset. The bids take into account
projected holding periods, capital costs and projected profit expectations.
Recommended bid prices are then reviewed with senior management and a decision
whether to bid is made. The amount offered by the Company generally will be the
price that the Manager estimates is sufficient to generate an acceptable
risk-adjusted return on the Company's investment.
After the Company acquires distressed real property, the Company's goal
generally is to improve the positioning and management of the property so as to
increase the cash flow from the property. If cash flows can be increased and the
property stabilized, the Company may begin to seek an opportunity to sell the
property. Although the period during which the Company will hold distressed real
properties will vary considerably from asset to asset, the Company believes that
most such properties will be held in its portfolio more than four years and
generally fewer than ten years.
If the Company is offered the opportunity to purchase a distressed real
property that is likely to be held for fewer than four years, the Company
generally will establish a corporation in which the Operating Partnership will
hold a 95% non-voting ownership interest to make the purchase. Such a
corporation is not eligible for taxation as a qualified REIT subsidiary, and any
profits that it earns on its activities are subject to federal corporate income
tax before they are distributable to the Company. If the Company purchases a
distressed real property with the intent to hold it in the Operating Partnership
for more than four years, but an opportunity arises to sell the property sooner,
the Company will consider certain strategies, such as a like-kind exchange, to
reduce any negative tax consequences relating to the sale.
The Company has the authority to acquire real estate located throughout
the United States or outside the United States or loans secured by such real
estate. The Company may not invest more than 25% of the Company's total assets
in foreign real estate.
The Company also has the authority to acquire real estate with known
environmental problems that materially impair the value of the property or loans
secured by such real estate. The Company may not invest more than 10% of its
total assets in environmentally distressed real estate.
The Company has the authority to participate in sale leaseback
transactions in which the Company purchases improved or unimproved real estate
and then leases such real estate back to the seller under a long-term triple net
lease. The Company also may provide financing necessary to build commercial
improvements on the land, to refinance existing debt on the property or to
provide additional funds to operate the business. After participating in a
number of these transactions, the Company may pool the leased real estate, and
issue debt backed by the real estate and the related leases in a securitization
transaction.
The Company has the authority to acquire real estate in exchange for
limited partnership interests in the Operating Partnership.
MORTGAGE LOANS
CONSTRUCTION LOANS AND MEZZANINE LOANS. The Company has the authority
to provide construction or rehabilitation financing on commercial property,
lending generally 85% to 90% of total project costs, and taking a first lien
mortgage to secure the debt ("construction loans"). The Company also may invest
in loans that are subordinate to first lien mortgage loans on commercial real
estate ("mezzanine loans"). For example, on a commercial property subject to a
first lien mortgage loan with a principal balance equal to 70% of the value of
the property, the Company could lend the owner of the property (typically a
partnership) an additional 15% to 20% of the value of the property. Typically
the loan is secured, either by the property subject to the first lien (giving
the Company a second lien position) or by a controlling equity interest in the
owner. Construction and mezzanine loans provide the
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Company with the right to receive a stated interest rate on the loan balance,
and also may provide the Company with the right to receive a percentage of gross
revenues from the property, payable to the Company on an ongoing basis, and/or a
percentage of any increase in value of the property, payable upon maturity or
refinancing of the loan, or otherwise allow the Company to charge an interest
rate that provides an attractive risk-adjusted return.
DISTRESSED MORTGAGE LOANS. The Company has the authority to purchase
nonperforming and subperforming mortgage loans, particularly those secured by
commercial properties, that are in default or for which default is likely or
imminent or for which the borrower is currently making monthly payments in
accordance with a forbearance plan. Because nonperforming and subperforming
loans generally are purchased at a discount to both the unpaid principal amount
of the loan and the estimated value of the security property, successful
resolution can provide total returns which are in excess of an equivalent
investment in performing mortgage loans. The Company classifies such loans as
discount loans and maintains them in a separate portfolio from its other loans.
The Company believes that it has a competitive advantage relative to
many of its competitors as a result of the Manager's experience in managing and
resolving discount loans, the Manager's large investment in the computer
systems, technology and other resources which are necessary to conduct this
business, the Manager's national reputation and the strategic relationships and
contacts developed by the Manager in connection with these activities.
Commercial and multi-family discount loans generally are reviewed
individually. Prior to making an offer to purchase discount loans, the Manager
conducts an extensive investigation and evaluation of the loan. Evaluations of
potential discount loans are conducted primarily by the Manager's employees who
specialize in the analysis of nonperforming loans, often with further
specialization based on geographic or collateral specific factors. The Manager's
employees regularly use third parties, such as brokers, who are familiar with
the property's type and location, to assist them in conducting an evaluation of
the collateral property, and depending on the circumstances, particularly in the
case of commercial real estate loans, may use subcontractors, such as local
counsel and engineering and environmental experts, to assist in the evaluation
and verification of information and the gathering of other information not
previously made available by the potential seller.
The Company determines the amount to offer to acquire discount loans by
using the Manager's proprietary modeling system and loan information database
which focuses on the anticipated recovery amount, timing and cost of resolving
the loan. The amount offered by the Company generally is at a discount from both
the stated value of the loan and the value of the underlying collateral and is
sufficient to generate an acceptable return on the Company's investment. Upon
acquisition, the servicing of the loan is transferred to the Manager.
After a discount loan is acquired, the Manager utilizes its computer
software system to resolve the loan as expeditiously as possible in accordance
with specified procedures. The various resolution alternatives generally include
the following: (i) the borrower brings the loan current in accordance with
original or modified terms, (ii) the borrower repays the loan or a negotiated
amount of the loan, (iii) the borrower agrees to deed the property to the
Company in lieu of foreclosure, in which case it is classified as real estate,
or (iv) the Company forecloses on the loan and the property is acquired at the
foreclosure sale either by a third party or by the Company, in which case it is
classified as real estate.
PERFORMING MORTGAGE LOANS FOR SECURITIZATION. The Company has the
authority to purchase single family residential loans to pool in a special
purpose entity and to issue mortgage-related securities backed by such loans.
The Company generally intends to retain the subordinate and residual interests
in any such mortgage-related securities and the right to service (by assignment
to the Bank) the loans which back such securities.
FEDERAL INCOME TAX CONSIDERATIONS
The statements in this discussion are based on current provisions of
the Code, regulations promulgated under the Code by the Treasury Regulations,
the legislative history of the Code, existing administrative rulings and
practices of the IRS and judicial decisions. No assurance can be given that
future legislative, judicial or administrative actions or decisions, which may
be retroactive in effect, will not affect the accuracy of any statements in this
Annual Report with respect to the transactions entered into or contemplated
prior to the effective date of such changes.
The Company's ability to qualify and to be taxed as a REIT under the
requirements of the Code and the Treasury Regulations promulgated thereunder is
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dependent upon actual operating results and compliance with distribution and
other requirements. Accordingly, no assurance can be given that the actual
results of the Company's operations for any particular taxable year will satisfy
such requirements. For a discussion of the tax consequences of failure to
qualify as a REIT, see " Failure to Qualify" below.
TAXATION OF THE COMPANY
The Company has made an election to be taxed as a REIT under Sections
856 through 860 of the Code, commencing with its short taxable year beginning on
the day prior to the closing of the Initial Public Offering, and ending on
December 31, 1997, and intends to continue to maintain such election through
calendar 1998. The following discussion sets forth the material aspects of the
Code sections that govern the federal income tax treatment of a REIT and its
shareholders, which are highly technical and complex. The discussion does not
address taxation of the Company in the event that it ceases to qualify as a
REIT. The discussion is qualified in its entirety by the applicable Code
provisions, the Treasury Regulations and administrative and judicial
interpretations thereof, all of which are subject to change prospectively or
retroactively.
The Company generally will not be subject to federal corporate income
tax on its net income that is distributed currently to its shareholders. That
treatment substantially eliminates the "double taxation" (I.E., taxation at both
the corporate and shareholder levels) that generally results from an investment
in a corporation. However, the Company will be subject to federal income tax in
the following circumstances. First, the Company will be taxed at regular
corporate rates on any undistributed REIT taxable income, including
undistributed net capital gains. Second, under certain circumstances, the
Company may be subject to the "alternative minimum tax" on its undistributed
items of tax preference, if any. Third, if the Company has (i) net income from
the sale or other disposition of "foreclosure property" that is held primarily
for sale to customers in the ordinary course of business or (ii) other
nonqualifying income from foreclosure property, it will be subject to tax at the
highest corporate rate on such income. Fourth, if the Company has net income
from prohibited transactions (which are, in general, certain sales or other
dispositions of property (other than foreclosure property) held primarily for
sale to customers in the ordinary course of business), such income will be
subject to a 100% tax. A shared appreciation provision may give rise to income
from a prohibited transaction if the debt instrument was in default, or default
was imminent, when the instrument was acquired. Fifth, if the Company should
fail to satisfy the 75% gross income test or the 95% gross income test (as
discussed below), and nonetheless has maintained its qualification as a REIT
because certain other requirements have been met, it will be subject to a 100%
tax on the net income attributable to the greater of the amount by which the
Company fails the 75% or 95% gross income test. Sixth, if the Company should
fail to distribute during each calendar year at least the sum of (i) 85% of its
REIT ordinary income for such year, (ii) 95% of its REIT capital gain net income
for such year and (iii) any undistributed taxable income from prior periods, the
Company would be subject to a 4% excise tax on the excess of such required
distribution over the amounts actually distributed. Seventh, if the Company
acquires any asset from a C corporation (I.E., a corporation generally subject
to full corporate-level tax) in a merger or other transaction in which the basis
of the asset in the Company's hands is determined by reference to the basis of
the asset (or any other asset) in the hands of the C corporation and the Company
recognizes gain on the disposition of such asset during the 10-year period
beginning on the date on which it acquired such asset, then to the extent of
such asset's "built-in-gain" (I.E., the excess of the fair market value of such
asset at the time of acquisition by the Company over the adjusted basis in such
asset at such time), the Company will be subject to tax at the highest regular
corporate rate applicable (as provided in Treasury Regulations that have not yet
been promulgated). The results described above with respect to the tax on
"built-in-gain" assume that the Company will elect pursuant to IRS Notice 88-19
to be subject to the rules described in the preceding sentence if it were to
make any such acquisition. Finally, the Company will be subject to tax at the
highest marginal corporate rate on the portion of any Excess Inclusion income
derived by the Company from REMIC residual interests equal to the percentage of
the stock of the Company held by the United States, any state or political
subdivision thereof, any foreign government, any international organization, any
agency or instrumentality of any of the foregoing, any other tax-exempt
organization (other than a farmer's cooperative described in Section 521 of the
Code) that is exempt from taxation under the unrelated business taxable income
provisions of the Code, or any rural electrical or telephone cooperative (each,
a "Disqualified Organization"). Any such tax on the portion of any Excess
Inclusion allocable to stock of the Company held by a Disqualified Organization
will reduce the cash available for distribution from the Company to all
shareholders.
REQUIREMENTS FOR QUALIFICATION
The Code defines a REIT as a corporation, trust or association: (i)
that is managed by one or more trustees or directors; (ii) the beneficial
ownership of which is evidenced by transferable shares, or by transferable
certificates of beneficial interest; (iii) that would be taxable as a domestic
corporation, but for Sections 856 through 860 of the Code; (iv) that is neither
a financial institution nor an insurance company subject to certain provisions
of the Code; (v) the beneficial ownership of which is held by 100 or more
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persons; (vi) not more than 50% in value of the outstanding shares of which is
owned, directly or indirectly, by five or fewer individuals (as defined in the
Code to include certain entities) during the last half of each taxable year (the
"5/50 Rule"); (vii) that makes an election to be a REIT (or has made such
election for a previous taxable year) and satisfies all relevant filing and
other administrative requirements established by the IRS that must be met in
order to elect and maintain REIT status; (viii) that uses a calendar year for
federal income tax purposes and complies with the recordkeeping requirements of
the Code and Treasury Regulations promulgated thereunder; and (ix) that meets
certain other tests, described below, regarding the nature of its income and
assets. The Code provides that conditions (i) to (iv), inclusive, must be met
during the entire taxable year and that condition (v) must be met during at
least 335 days of a taxable year of 12 months, or during a proportionate part of
a taxable year of less than 12 months. Conditions (v) and (vi) do not apply
until after the first taxable year for which an election is made by the Company
to be taxed as a REIT. For purposes of determining stock ownership under the
5/50 Rule, a supplemental unemployment compensation benefits plan, a private
foundation or a portion of a trust permanently set aside or used exclusively for
charitable purposes generally is considered an individual. A trust that is a
qualified trust under Code Section 401(a), however, generally is not considered
an individual and beneficiaries of such trust are treated as holding shares of a
REIT in proportion to their actuarial interests in such trust for purposes of
the 5/50 Rule.
The Company's subsidiaries include the General Partner and the Limited
Partner. Code Section 856(i) provides that a corporation that is a "qualified
REIT subsidiary" shall not be treated as a separate corporation, and all assets,
liabilities and items of income, deduction and credit of a "qualified REIT
subsidiary" shall be treated as assets, liabilities and items of income,
deduction and credit of the REIT. A "qualified REIT subsidiary" is a corporation
all of the capital stock of which is held by the REIT. Thus, in applying the
requirements described herein, any "qualified REIT subsidiaries" of the Company
will be ignored, and all assets, liabilities and items of income, deduction and
credit of such subsidiaries will be treated as assets, liabilities and items of
income, deduction and credit of the Company. The General Partner and the Limited
Partner are "qualified REIT subsidiaries." Accordingly, neither the General
Partner nor the Limited Partner is subject to federal corporate income taxation,
although each may be subject to state and local taxation.
In the case of a REIT that is a partner in a partnership, Treasury
Regulations provide that the REIT will be deemed to own its proportionate share
of the assets of the partnership and will be deemed to be entitled to the gross
income of the partnership attributable to such share. In addition, the assets
and gross income of the partnership will retain the same character in the hands
of the REIT for purposes of Section 856 of the Code, including satisfying the
gross income and asset tests described below. Because the Company is a partner
in the Operating Partnership, the Company's proportionate share of the assets
and gross income of the Operating Partnership are treated as assets and gross
income of the Company for purposes of applying the requirements described
herein.
INCOME TESTS. In order for the Company to qualify and to maintain its
qualification as a REIT, two requirements relating to the Company's gross income
must be satisfied annually. First, at least 75% of the Company's gross income
(excluding gross income from prohibited transactions) for each taxable year must
consist of defined types of income derived directly or indirectly from
investments relating to real property or mortgages on real property (including
"rents from real property" and interest on obligations secured by mortgages on
real property or on interests in real property) or temporary investment income.
Second, at least 95% of the Company's gross income (excluding gross income from
prohibited transactions) for each taxable year must be derived from such real
property, mortgages on real property or temporary investments, and from
dividends, other types of interest, certain payments under hedging instruments
and gain from the sale or disposition of stock, securities and certain hedging
instruments, or from any combination of the foregoing. The specific application
of these tests to the Company is discussed below.
The term "interest," as defined for purposes of the 75% and 95% gross
income tests, generally does not include any amount received or accrued
(directly or indirectly) if the determination of such amount depends in whole or
in part on the income or profits of any person. However, an amount received or
accrued generally will not be excluded from the term "interest" solely by reason
of being based on a fixed percentage or percentages of receipts or sales. In
addition, an amount received or accrued generally will not be excluded from the
term "interest" solely by reason of being based on the income or profits of a
debtor if the debtor derives substantially all of its gross income from the
related property through the leasing of substantially all of its interests in
the property, to the extent the amounts received by the debtor would be
characterized as rents from real property if received by a REIT. Furthermore, to
the extent that interest from a loan that is based on the cash proceeds from the
sale of the property securing the loan constitutes a "shared appreciation
provision" (as defined in the Code), income attributable to such participation
feature will be treated as gain from the sale of the secured property, which
generally is qualifying income for purposes of the 75% and 95% gross income
tests.
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Interest on obligations secured by mortgages on real property or on
interests in real property is qualifying income for purposes of the 75% gross
income test. Any amount includible in gross income with respect to a regular or
residual interest in a REMIC generally is treated as interest on an obligation
secured by a mortgage on real property. If, however, less than 95% of the assets
of a REMIC consists of real estate assets (determined as if the Company held
such assets), the Company will be treated as receiving directly its
proportionate share of the income of the REMIC. In addition, if the Company
receives interest income with respect to a mortgage loan that is secured by both
real property and other property and the highest principal amount of the loan
outstanding during a taxable year exceeds the fair market value of the real
property on the date the Company purchased the mortgage loan, the interest
income will be apportioned between the real property and the other property,
which apportionment may cause the Company to recognize income that is not
qualifying income for purposes of the 75% gross income test.
Interest, OID and market discount income that the Company derives from
its investments in subordinate and residual interests generally will be
qualifying interest income for purposes of both the 75% and the 95% gross income
tests, except to the extent that less than 95% of the assets of a REMIC in which
the Company holds an interest consists of real estate assets (determined as if
the Company held such assets), and the Company's proportionate share of the
income of the REMIC includes income that is not qualifying income for purposes
of the 75% and 95% gross income tests. Most of the income that the Company
recognizes with respect to its investments in loans will be qualifying income
for purposes of both gross income tests. In some cases, however, the loan amount
may exceed the value of the real property securing the loan, which will result
in a portion of the income from the loan being classified as qualifying income
for purposes of the 95% gross income test, but not for purposes of the 75% gross
income test. It is also possible that, in some instances, the interest income
from a loan may be based in part on the borrower's profits or net income, which
generally will disqualify the income from the loan for purposes of both the 75%
and the 95% gross income tests.
The Company may originate or acquire construction loans or mezzanine
loans that have shared appreciation provisions. The Company generally will be
required to recognize income from a shared appreciation provision over the term
of the related loan using the constant yield method pursuant to certain Treasury
Regulations. The Company may also acquire distressed mortgage loans with shared
appreciation provisions. Such loans may be subject to the 100% tax on net
income. See "Taxation of the Company" above.
The Company may originate or acquire and securitize loans through the
issuance of non-REMIC CMOs. As a result of such transactions, the Company will
retain an equity ownership interest in the loans that, after considering the
notes issued in the securitization, has economic characteristics similar to
those of a subordinate interest. In addition, the Company may resecuritize
mortgage-related securities (or non-REMIC CMOs) through the issuance of
non-REMIC CMOs, retaining an equity interest in the mortgage-related securities
used as collateral in the resecuritization transaction. The Company does not
intend to enter into any such transactions that could cause the Company to fail
to satisfy the gross income tests or the asset tests described herein.
The Company may receive income not described above that is not
qualifying income for purposes of the 75% and 95% gross income tests. For
example, certain fees for services rendered by the Operating Partnership will
not be qualifying income for purposes of the gross income tests. It is not
anticipated that the Operating Partnership will receive a significant amount of
such fees. Such fees include, without limitation: (i) fees for servicing loans,
(ii) fees for performing underwriting or appraisal services for others and (iii)
fees for managing property owned by others. The Company will monitor the amount
of nonqualifying income produced by its assets and intends to manage its
portfolio in order to comply at all times with the two gross income tests.
The rent received by the Company from the tenants of its real property
("Rent") will qualify as "rents from real property" in satisfying the gross
income tests for a REIT described above only if several conditions are met.
First, the amount of Rent must not be based, in whole or in part, on the income
or profits of any person. However, an amount received or accrued generally will
not be excluded from the term "rents from real property" solely by reason of
being based on a fixed percentage or percentages of receipts or sales. Second,
the Code provides that the Rent received from a tenant will not qualify as
"rents from real property" in satisfying the gross income tests if the Company,
or a direct or indirect owner of 10% or more of the Company, owns 10% or more of
such tenant, taking into account both direct and constructive ownership (a
"Related Party Tenant"). Third, if Rent attributable to personal property,
leased in connection with a lease of real property, is greater than 15% of the
total Rent received under the lease, then the portion of Rent attributable to
such personal property will not qualify as "rents from real property." Finally,
for the Rent to qualify as "rents from real property," the Company generally
must not operate or manage the real property or furnish or render services to
the tenants of such real property, other than through an "independent
contractor" who is adequately compensated and from whom the Company derives no
revenue. (An "independent contractor" for this purpose generally means a service
provider that is not (i) an employee of the Company or (ii) in general, an
entity which owns 35% or more of the Company or an entity of which the persons
owning a greater than 35% equity interest also own 35% or more of the Company.)
The "independent contractor" requirement, however, does not
15
<PAGE>
apply to the extent the services provided by the Company are "usually or
customarily rendered" in connection with the rental of space for occupancy only
and are not otherwise considered "rendered to the occupant." Pursuant to a de
minimus exception, the Company may provide non-customary services to its tenants
other than through an independent contractor without disqualifying the income
from the property as long as the amount the Company receives for the
impermissible services does not exceed 1% of the Company's gross income from the
property. The amount that the Company receives that is attributable to
impermissible services cannot be valued at less than 150% of the direct cost to
the Company of providing the services.
It is the Company's policy that it will not charge Rent for any portion
of any Real Property that is based, in whole or in part, on the income or
profits of any person (except by reason of being based on a fixed percentage or
percentages of receipts of sales, as described above) to the extent that the
receipt of such Rent would jeopardize the Company's status as a REIT. In
addition, it is the Company's intention that, to the extent that it receives
Rent from a Related Party Tenant, such Rent will not cause the Company to fail
to satisfy either the 75% or 95% gross income test. It is also the Company's
intention that it will not allow the Rent attributable to personal property
leased in connection with any lease of real property to exceed 15% of the total
Rent received under the lease, if the receipt of such Rent would cause the
Company to fail to satisfy either the 75% or 95% gross income test. Finally, the
Company intends that it will not operate or manage its real property or furnish
or render noncustomary services to the tenants of its real property other than
through an "independent contractor," to the extent that such operation or the
provision of such services would jeopardize the Company's status as a REIT.
REITs generally are subject to tax at the maximum corporate rate on any
income from foreclosure property (other than income that would be qualifying
income for purposes of the 75% gross income test), less expenses directly
connected with the production of such income. "Foreclosure property" is defined
as any real property (including interests in real property) and any personal
property incident to such real property (i) that is acquired by a REIT as the
result of such REIT having bid in such property at foreclosure, or having
otherwise reduced such property to ownership or possession by agreement or
process of law, after there was a default (or default was imminent) on a lease
of such property or on an indebtedness owed to the REIT that such property
secured, (ii) for which the related loan was acquired by the REIT at a time when
default was not imminent or anticipated and (iii) for which such REIT makes a
proper election to treat such property as foreclosure property. The Company does
not anticipate that it will receive any income from foreclosure property that is
not qualifying income for purposes of the 75% gross income test, but, if the
Company does receive any such income, the Company intends to make an election to
treat the related property as foreclosure property.
If property is not eligible for the election to be treated as
foreclosure property ("Ineligible Property") because the related loan was
acquired by the REIT at a time when default was imminent or anticipated, income
received with respect to such Ineligible Property may not be qualifying income
for purposes of the 75% or 95% gross income test. The Company anticipates that
any income it receives with respect to Ineligible Property will be qualifying
income for purposes of the 75% and 95% gross income tests.
Net income derived from a "prohibited transaction" is subject to a 100%
tax. The term "prohibited transaction" generally includes a sale or other
disposition of property (other than foreclosure property) that is held primarily
for sale to customers in the ordinary course of a trade or business. The Company
believes that no asset owned by the Company or the Operating Partnership will be
held for sale to customers and that a sale of any such asset will not be in the
ordinary course of the Company's or the Operating Partnership's business.
Whether property is held "primarily for sale to customers in the ordinary course
of a trade or business" depends, however, on the facts and circumstances in
effect from time to time, including those related to a particular property.
Nevertheless, the Company will attempt to comply with the terms of safeharbor
provisions in the Code prescribing when asset sales will not be characterized as
prohibited transactions. Complete assurance cannot be given, however, that the
Company can comply with the safeharbor provisions of the Code or avoid owning
property that may be characterized as property held "primarily for sale to
customers in the ordinary course of a trade or business."
From time to time the Company enters into hedging transactions with
respect to one or more of its assets or liabilities. Any such hedging
transactions could take a variety of forms, including interest rate swap
contracts, interest rate cap or floor contracts, futures or forward contracts
and options. To the extent that the Company enters into an interest rate swap or
cap contract to hedge its interest rate risk with respect to indebtedness
incurred or to be incurred to acquire or carry real estate assets, any periodic
income or gain from the disposition of such contract should be qualifying income
for purposes of the 95% gross income test, but not the 75% gross income test. To
the extent that the Company hedges with other types of financial instruments or
in other situations, it may not be entirely clear how the income from those
transactions will be treated for purposes of the various income tests that apply
to REITs under the Code. The Company intends to structure any hedging
transactions in a manner that does not jeopardize its status as a REIT.
Accordingly, the Company may conduct some or all of its hedging activities
through a corporate subsidiary that is fully subject to federal corporate income
tax.
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<PAGE>
If the Company fails to satisfy one or both of the 75% and 95% gross
income tests for any taxable year, it nevertheless may qualify as a REIT for
such year if it is entitled to relief under certain provisions of the Code.
Those relief provisions generally will be available if the Company's failure to
meet such tests is due to reasonable cause and not due to willful neglect, the
Company attaches a schedule of the sources of its income to its return and any
incorrect information on the schedule was not due to fraud with intent to evade
tax. It is not possible, however, to state whether in all circumstances the
Company would be entitled to the benefit of those relief provisions. As
discussed above, even if those relief provisions apply, a 100% tax would be
imposed on the net income attributable to the greater of the amount by which the
Company fails the 75% or 95% gross income test.
ASSET TESTS. The Company, at the close of each quarter of each taxable
year, also must satisfy two tests relating to the nature of its assets. First,
at least 75% of the value of the Company's total assets must be represented by
cash or cash items (including certain receivables), government securities, "real
estate assets," or, in cases where the Company raises new capital through stock
or long-term (at least five-year) debt offerings, temporary investments in stock
or debt instruments during the one-year period following the Company's receipt
of such capital. The term "real estate assets" includes interests in real
property, interests in mortgages on real property to the extent the principal
balance of a mortgage does not exceed the fair market value of the associated
real property, regular or residual interests in a REMIC (except that, if less
than 95% of the assets of a REMIC consists of "real estate assets" (determined
as if the Company held such assets), the Company will be treated as holding
directly its proportionate share of the assets of such REMIC), and shares of
other REITs. For purposes of the 75% asset test, the term "interest in real
property" includes an interest in mortgage loans or land and improvements
thereon, such as buildings or other inherently permanent structures (including
items that are structural components of such buildings or structures), a
leasehold of real property, and an option to acquire real property (or a
leasehold of real property). An "interest" in real property also generally
includes an interest in mortgage loans secured by controlling equity interests
in entities treated as partnerships for federal income tax purposes that own
real property, to the extent that the principal balance of the mortgage does not
exceed the fair market value of the real property that is allocable to the
equity interest. Second, of the investments not included in the 75% asset class,
the value of any one issuer's securities owned by the Company may not exceed 5%
of the value of the Company's total assets, and the Company may not own more
than 10% of any one issuer's outstanding voting securities (except for its
interests in the Operating Partnership, the General Partner, the Limited
Partner, any other qualified REIT subsidiary, partnership or any other REIT).
The Company expects that any distressed real properties, subordinate
and residual interests, IOs, Inverse IOs and temporary investments that it
acquires generally will be qualifying assets for purposes of the 75% asset test,
except to the extent that less than 95% of the assets of a REMIC in which the
Company owns an interest consists of "real estate assets" and the Company's
proportionate share of those assets includes assets that are nonqualifying
assets for purposes of the 75% asset test. Loans also will be qualifying assets
for purposes of the 75% asset test to the extent that the principal balance of
each mortgage loan does not exceed the value of the associated real property.
The Company will monitor the status of the assets that it acquires for purposes
of the various asset tests and intends to manage its portfolio in order to
comply at all times with such tests.
If the Company should fail to satisfy the asset tests at the end of a
calendar quarter, such a failure would not cause it to lose its REIT status if
(i) it satisfied the asset tests at the close of the preceding calendar quarter
and (ii) the discrepancy between the value of the Company's assets and the asset
test requirements arose from changes in the market values of its assets and was
not wholly or partly caused by the acquisition of one or more non-qualifying
assets. If the condition described in clause (ii) of the preceding sentence were
not satisfied, the Company still could avoid disqualification by eliminating any
discrepancy within 30 days after the close of the calendar quarter in which it
arose.
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<PAGE>
RECORDKEEPING REQUIREMENTS. Pursuant to applicable Treasury
Regulations, in order to be able to elect to be taxed as a REIT, the Company
must maintain certain records and request on an annual basis certain information
from its shareholders designed to disclose the actual ownership of its
outstanding stock. The Company intends to comply with such requirements.
DISTRIBUTION REQUIREMENTS
The Company, in order to avoid corporate income taxation of the
earnings that it distributes, is required to distribute with respect to each
taxable year dividends (other than capital gain dividends) to its shareholders
in an aggregate amount at least equal to (i) the sum of (A) 95% of its "REIT
taxable income" (computed without regard to the dividends paid deduction and its
net capital gains) and (B) 95% of the net income (after tax), if any, from
foreclosure property, minus (ii) the sum of certain items of noncash income.
Such distributions must be paid in the taxable year to which they relate, or in
the following taxable year if declared before the Company timely files its
federal income tax return for such year and if paid on or before the first
regular dividend payment date after such declaration. To the extent that the
Company does not distribute all of its net capital gain or distributes at least
95%, but less than 100%, of its "REIT taxable income," as adjusted, it will be
subject to tax thereon at regular ordinary and capital gains corporate tax
rates. Furthermore, if the Company should fail to distribute during each
calendar year (or, in the case of distributions with declaration and record
dates falling in the last three months of the calendar year, by the end of the
January immediately following such year) at least the sum of (i) 85% of its REIT
ordinary income for such year, (ii) 95% of its REIT capital gain income for such
year and (iii) any undistributed taxable income from prior periods, the Company
would be subject to a 4% nondeductible excise tax on the excess of such required
distribution over the amounts actually distributed. The Company intends to make
distributions sufficient to satisfy the annual distribution requirements,
although it incurred a liability as a result of the above-mentioned excise tax
in connection with a decision to defer payment of a dividend on the Common Stock
in the fourth quarter of 1998. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Proposed Change in REIT Status"
under Item 7.
It is possible that, from time to time, the Company may experience
timing differences between (i) the actual receipt of income and actual payment
of deductible expenses and (ii) the inclusion of that income and deduction of
such expenses in arriving at its REIT taxable income. For example, the Company
will recognize taxable income in excess of its cash receipts when, as generally
happens, OID accrues with respect to its subordinated interests. Furthermore,
some loans, IOs and Inverse IOs may be deemed to have OID, in which case the
Company will be required to recognize taxable income in advance of the related
cash flow. In addition, pursuant to certain Treasury Regulations, the Company
may be required to recognize the amount of any payment to be made pursuant to a
shared appreciation provision over the term of the related loan using the
constant yield method. OID generally will be accrued using a methodology that
does not allow credit losses to be reflected until they are actually incurred.
In addition, the Company may recognize taxable market discount income upon the
receipt of proceeds from the disposition of, or principal payments on,
subordinated interests and loans that are "market discount bonds" (I.E.,
obligations with a stated redemption price at maturity that is greater than the
Company's tax basis in such obligations), although such proceeds often will be
used to make non-deductible principal payments on related borrowings. The
Company also may recognize Excess Inclusion or other "phantom" taxable income
from REMIC residual interests. It also is possible that, from time to time, the
Company may recognize net capital gains attributable to the sale of depreciated
property that exceeds its cash receipts from the sale. Finally, the Company may
recognize taxable income without receiving a corresponding cash distribution if
it forecloses on or makes a "significant modification" (as defined in Treasury
Regulations Section 1.1001-3(e)) to a loan, to the extent that the fair market
value of the underlying property or the principal amount of the modified loan,
as applicable, exceeds the Company's basis in the original loan. Therefore, the
Company may have less cash than is necessary to meet its annual 95% distribution
requirement or to avoid corporate income tax or the excise tax imposed on
certain undistributed income. In such a situation, the Company may find it
necessary to arrange for short-term (or possibly long-term) borrowings or to
raise funds through the issuance of capital stock.
Under certain circumstances, the Company may be able to rectify a
failure to meet the distribution requirements for a year by paying "deficiency
dividends" to its shareholders in a later year, which may be included in the
Company's deduction for dividends paid for the earlier year. Although the
Company may be able to avoid being taxed on amounts distributed as deficiency
dividends, it will be required to pay to the IRS interest based upon the amount
of any deduction taken for deficiency dividends.
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<PAGE>
FAILURE TO QUALIFY
If the Company fails to qualify for taxation as a REIT in any taxable
year, and the relief provisions do not apply, the Company will be subject to tax
(including any applicable alternative minimum tax) on its taxable income at
regular corporate rates. Distributions to the Company's shareholders in any year
in which the Company fails to qualify will not be deductible by the Company nor
will they be required to be made. In such event, to the extent of the Company's
current and accumulated earnings and profits, all distributions to shareholders
will be taxable as ordinary income and, subject to certain limitations of the
Code, corporate distributees may be eligible for the dividends received
deduction. Unless entitled to relief under specific statutory provisions, the
Company also will be disqualified from taxation as a REIT for the four taxable
years following the year during which the Company ceased to qualify as a REIT.
It is not possible to state whether in all circumstances the Company would be
entitled to such statutory relief.
COMPETITION
GENERAL. The Company's competition varies by business line and
geographic market. In many cases, the acquisition of mortgage-related
securities, real estate and commercial and multi-family loans is based on
competitive bidding, which involves the risk that the Company may bid too low
(which generates no business) or too high (which could result in an acquisition
at an economically unattractive price). Many of the Company's competitors are
larger and have greater financial resources than the Company, and thus may be
better able than the Company to pursue business opportunities or to survive
periods of industry consolidation.
MORTGAGE-RELATED SECURITIES. Until recently the competition for
subordinate interests in mortgage-related securities was intense and dominated
by a relatively few large entities, including Criimi Mae, Inc. Other significant
purchasers of these securities from time to time have included General Electric
Capital Corporation, First Chicago Commercial Assets, Wilshire Real Estate
Investment Trust, Amresco, Inc., Clarion Capital Corp. and Anthracite Capital,
Inc. Recent volatility in the U.S. and foreign stock markets in general and the
market for high-risk debt securities in particular has significantly decreased
the number of entities which are willing to purchase subordinate interests at
current prices and resulted in Criimi Mae, Inc. filing for bankruptcy.
Currently, the Company is unable to predict the market for such securities in
the future or the nature of any competition which it may encounter for such
securities in the event that it resumes investment activities.
REAL ESTATE. The markets in which the Company invests in commercial and
multi-family real estate are located nationwide and characterized by competitive
factors that vary based upon the type of real estate and geographic region. In
general, in periods of increasing real estate values the market for commercial
and multi-family real estate is highly competitive. The Company's competitors
for investments in real estate include Goldman Sach's Whitehall Street Real
Estate Funds, Cargill Financial Services, Colony Capital Management, Lone Star
Financial and other REITs, insurance companies and institutional lenders.
COMMERCIAL AND MULTI-FAMILY LENDING ACTIVITIES. The markets in which
the Company conducts commercial and multi-family lending activities are located
nationwide and characterized by competitive factors that vary based upon the
type of loan product and geographic region. The Company's competitors for
commercial and multi-family loans include commercial banks, thrift institutions,
insurance companies, finance companies, asset-based lenders and other REITs.
ITEM 2. PROPERTIES
The Company does not maintain an office. It relies on the facilities
provided by its Manager, OCC. For information regarding real estate acquired by
the Company for investment, see "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Comparison of Financial
Condition at December 31, 1998 and 1997 - Investment in Real Estate" under Item
7.
ITEM 3. LEGAL PROCEEDINGS
Neither the Company nor the Operating Partnership is currently involved
in any material litigation nor, to the Company's knowledge, is any material
litigation currently threatened against the Company or the Operating
Partnership.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
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<PAGE>
PART II
ITEM 5. MARKETS FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
PRICE RANGE OF THE COMMON STOCK
The Common Stock began trading on the Nasdaq Stock Market's National
Market ("NASDAQ") on May 14, 1997 under the symbol "OAIC". On May 1, 1998, the
Common Stock began trading on the New York Stock Exchange under the symbol
"OAC." Upon effectiveness of the NYSE listing, the Company delisted its common
stock from NASDAQ. The following table sets forth for the indicated periods the
high and low bid prices for the common stock, as traded on each market.
<TABLE>
<CAPTION>
1998 1997
------------------------- -------------------------
HIGH LOW HIGH LOW
--------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
First quarter ..................... $ 21.000 $ 16.750 $ N/A $ N/A
Second quarter .................... 18.875 15.875 20.125 17.875
Third quarter...................... 17.000 6.125 24.875 19.750
Fourth quarter..................... 6.938 3.125 24.000 17.500
</TABLE>
At the close of business on March 9, 1999, the Company's Common Stock
price was $4.187.
NUMBER OF HOLDERS OF COMMON STOCK
At March 9, 1999, 18,965,000 shares of Common Stock were outstanding
and held by approximately 87 holders of record, which does not reflect the
number of beneficial owners of the Common Stock. The following table sets forth
the amount of cash dividends declared on the Common Stock during the periods
indicated.
1998 1997
--------- --------
First quarter................................ $ 0.25 $ --
Second quarter .............................. 0.49 0.10
Third quarter................................ 0.44 0.24
Fourth quarter............................... -- 0.39
(1) Includes June 1998 special dividend of $0.08 per share attributable to the
Company's remaining undistributed 1997 taxable income.
(2) The Board of Directors has deferred declaration and payment of the
Company's final 1998 dividend, which is expected to range from $14.6
million, or $0.77 per share, to $16.1 million, or $0.85 per share. The
Board expects to pay this dividend in 1999, although there can be no
assurance as to whether or when that dividend will be paid.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following table presents selected consolidated financial data of
the Company at the dates and for the periods indicated. The selected balance
sheet data at December 31, 1998 and 1997, and the operations data for the year
ended December 31, 1998 and for the period May 14, 1997 to December 31, 1997,
have been derived from the consolidated financial statements audited by
20
<PAGE>
PricewaterhouseCoopers LLP, independent certified public accountants. The
selected consolidated financial data should be read in conjunction with, and is
qualified in its entirety by reference to, the information in the consolidated
financial statements and related notes set forth elsewhere herein.
<TABLE>
<CAPTION>
------------ ------------
(Dollars in Thousands, except share data) 1998 1997
------------ ------------
<S> <C> <C>
OPERATIONS DATA:
Net interest income ............................................. $ 34,789 $ 13,462
Real estate income, net ......................................... 1,140 1,494
Expenses ........................................................ 13,317 3,155
Loss on securities, derivatives and real estate ................. (86,267) --
Extraordinary gain on repurchase of debt ........................ 615 --
Minority interest in net loss (income) of consolidated subsidiary 4,855 (9)
------------ ------------
Net (loss) income ............................................. $ (58,186) $ 11,792
COMMON STOCK DATA:
Earnings (loss) per share:
Basic ......................................................... $ (3.07) $ 0.62
Diluted ....................................................... $ (3.07) $ 0.60
Weighted average common shares outstanding:
Basic ......................................................... 18,965,000 19,108,789
Diluted ....................................................... 18,965,000 19,564,770
Book value per share ............................................ $ 11.66 $ 14.30
Cash dividends per share ........................................ $ 1.18 $ 0.73
BALANCE SHEET DATA:
Total assets ...................................................... $ 888,326 $ 288,003
Cash and cash equivalents ......................................... 53,365 48,677
Securities available for sale ..................................... 351,154 146,027
Commercial and multi-family loans, net ............................ 65,283 9,481
Residential loans, net ............................................ 8,058 6,350
Discount loan portfolio, net ...................................... 5,618 26,979
Investment in real estate, net .................................... 208,059 45,430
Minority interest ................................................. 23,914 2,942
Securities sold under agreements to repurchase .................... 138,612 --
Obligations outstanding under line of credit ...................... 34,472 --
Obligations outstanding under line of credit - real estate ........ 142,557 --
11.5% Redeemable Notes due 2005 ................................... 143,000 --
Shareholders' equity .............................................. 221,176 271,258
SELECTED OTHER DATA AND RATIOS:
Average assets .................................................... $ 708,190 $ 289,215
Average equity .................................................... 268,966 284,260
Return on average assets .......................................... (8.22)% 6.56%
Return on average equity .......................................... (21.63)% 6.67%
Net interest spread ............................................... 3.21% 8.56%
Net interest margin ............................................... 6.49% 8.56%
</TABLE>
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<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion of the Company's consolidated financial
condition, results from operations, and capital resources and liquidity should
be read in conjunction with the Consolidated Financial Information and the
Consolidated Financial Statements and related notes included elsewhere herein.
GENERAL
The Company reported a net loss of $58.2 million or $3.07 per fully
diluted share for the year ended December 31, 1998. These losses were primarily
attributable to: (i) $65.1 million of losses on subordinate and residual
interests in mortgage-related securities and derivatives, which were adversely
affected by increased prepayments of the underlying mortgage loans and the
substantial volatility in U.S. and foreign stock markets in the second half of
1998, which has resulted in widening mortgage spreads and declining market
liquidity and (ii) $17.1 million of losses incurred in connection with the
Company's AAA-rated portfolio of agency interest only ("IO") and inverse
floating rate interest only ("Inverse IO") classes of mortgage-related
securities backed by single family residential loans (the "IO Portfolio"), which
were adversely affected in the first quarter of 1998 by a projected increase in
prepayments of the underlying mortgages in response to a decrease in market
interest rates. Moreover, as a result of these conditions, in recent months
there has been a general "flight to quality" by investors, with the result that
the market for the subordinate and residual mortgage-related securities has been
substantially reduced or eliminated. These factors have adversely affected the
operations and financial condition of numerous companies in the financial
service, REIT and mortgage-backed security sectors, including the Company.
As a result of the foregoing developments, particularly as they relate
to the Company's subordinate and residual mortgage-related securities, the
Company has been receiving requests from its lenders to pledge additional
collateral or post additional cash margins (referred to herein collectively as
"collateral") pursuant to the terms of its loan agreements, which it has been
able to meet as of the date hereof. The Company has decided that, for the
foreseeable future, it does not plan to acquire any additional assets or fund
any additional loans (beyond those which are currently committed), and it will
work to accelerate the stabilization of its existing assets and increase its
overall liquidity position. As a result, the Company has curtailed each of its
business lines, which include the acquisition of subordinate and residual
interests in residential and commercial mortgage-related securities,
underperforming real estate and residential and commercial real estate loans,
including construction and renovation loans.
PROPOSED CHANGE IN REIT STATUS
On December 21, 1998, the Company announced that its Board of Directors
had approved a proposal to terminate the Company's status as a REIT effective
for calendar 1999. The proposal, which requires amendment of the Company's
Articles of Incorporation, is subject to shareholder approval. The Board
currently anticipates that this proposal will be considered at the Annual
Meeting of Shareholders of the Company which is scheduled to be held in May
1999. If approved, the Company will be treated as a general corporation for
federal, state and local tax purposes and will be subject to federal, state and
local income tax on its taxable income. In addition, the Company would not be
eligible to re-elect REIT status until 2004.
The Board of Directors action is motivated by the desire to enhance
shareholder value. Unlike general corporations, REITs are penalized for not
distributing at least 95% of taxable income to their shareholders, although
general corporations do pay corporate income tax on taxable income. By
eliminating the dividend requirement, retained earnings can be used to enhance
liquidity, improve shareholders' equity and facilitate the transition of the
Company to a different strategy.
Currently, it is not anticipated that the proposal to terminate the
Company's status as a REIT, if adopted by shareholders, will result in any
material change in the Company's current plans to cease to acquire additional
assets or fund additional loans or, in the event that the Company resumes
investment activities, in the Company's investment guidelines and practices or
corporate structure, although there can be no assurance that this will be the
case.
Consistent with the Company's focus on enhancing shareholder value and
improving liquidity, the Board of Directors has deferred declaration and payment
of the Company's final 1998 dividend, which is expected to range from $14.6
million, or $0.77 per share, to $16.1 million, or $0.85 per share. The Board
expects to pay this dividend in 1999, although there can be no assurance as to
whether or when that dividend will be paid.
22
<PAGE>
Assuming that the Company's status as a REIT will terminate for 1999
and that the Company will be taxed as a general corporation for 1999 and future
years, the Company will be subject to federal income taxes on taxable income
earned during 1999 and thereafter and will no longer be entitled to a deduction
for any dividends paid to shareholders. In addition, the Company will not be
subject to the distribution rules applicable to REITs. Corporate shareholders
that satisfy certain holding period requirements will be entitled to a dividends
received deduction on dividends paid out of current or accumulated earnings and
profits. The Company, however, does not currently anticipate paying dividends on
its common stock following termination of its REIT status (except to the extent
necessary to meet the remainder of the REIT distribution requirement for 1998).
Any distributions on the Common Stock will be treated as dividends for federal
income tax purposes to the extent of the Company's current or accumulated
earnings and profits and, as such, will be eligible for any applicable dividends
received deduction for corporate shareholders (except to the extent that such
dividends constitute all or a portion of the remainder of the Company's REIT
distribution requirement for 1998) and will be treated as ordinary dividend
income for other shareholders.
The Company anticipates that as a result of the deferral of its final
1998 dividend it will be subject to a 4% non-deductible excise tax imposed by
Section 4981 of the Code on REITs that fail to make certain distributions by
calendar year-end. Pursuant to Section 4981 of the Code, if the Company should
fail to distribute during each calendar year (or, in the case of distribution
with declaration and record dates falling in the last three months of the
calendar year, by the end of January immediately following such year) at least
the sum of: (i) 85% of the Company's ordinary income for the calendar year, (ii)
95% of the Company's capital gain net income for the calendar year and (iii) any
undistributed taxable income from prior periods, the Company would be subject to
a 4% nondeductible excise tax on the excess of such required distribution over
the amounts actually distributed. The Company currently estimates that the
deferral of its quarterly dividend will result in the incurrence of an excise
tax liability under Section 4981 of the Code of approximately $0.4 million.
COMPARISON OF OPERATING RESULTS FOR THE YEAR ENDED DECEMBER 31, 1998 AND THE
PERIOD MAY 14, 1997 TO DECEMBER 31, 1997
GENERAL. Net loss for the year ended December 31, 1998 was $58.2
million, a decrease of $70.0 million, compared to net income of $11.8 million
for the period ended December 31, 1997. This decrease was due primarily to
impairment losses on securities, derivatives and real estate of $86.3 million
and an increase in other expenses of $10.2 million, which were partially offset
by an increase in net interest income of $22.0 million.
INTEREST INCOME. Interest income increased $49.5 million to $63.0
million for the year ended December 31, 1998 from $13.5 million for the period
May 14, 1997 to December 31, 1997. This increase was primarily due to additional
interest of $16.6 million on loans and $37.1 million on the securities available
for sale portfolio, which was partially offset by a decrease of $4.3 million on
repurchase agreements and interest-bearing deposits. The increase in interest
resulted from additional investments in interest earning assets. Securities
available for sale increased from an average balance of $101.0 million to $396.9
million, residential loans increased from an average balance of $3.7 million to
$95.4 million and commercial and multi-family loans increased from an average
balance of $6.6 million to $59.4 million. The average balance on repurchase
agreements and interest-bearing deposits decreased from $101.7 million in 1997
to $25.1 million in 1998.
INTEREST EXPENSE. The Company had no interest expense during 1997,
compared to $27.5 million during 1998. The Company was newly-formed and
unleveraged during 1997 (OAC commenced operations on May 14, 1997). Interest
expense does not include the expense associated with the borrowings secured by
investments in real estate, which is included in determining the operations of
the Company's real estate. See " -Real Estate Income, Net" below.
NET INTEREST INCOME. Net interest income represents the difference
between income on interest-earning assets and expense on interest-bearing
liabilities. Net interest income depends upon the relative amount of
interest-earning assets and interest-bearing liabilities, and the interest rate
earned or paid on them.
The following table sets forth certain information relating to the
Company's consolidated statements of financial condition and consolidated
statement of operations form the periods indicated, and reflects the average
yield on assets and average cost of liabilities for the periods indicated. Such
yields and costs are derived by dividing income or expense by the average
balance of assets or liabilities, respectively, for the periods shown. Average
balances are derived from average daily balances. The yields include
amortization of fees which are considered adjustments to yields.
23
<PAGE>
<TABLE>
<CAPTION>
For the Three Months Ended December 31,
-------------------------------------------------------------------------
(Dollars In Thousands) 1998 1997
--------------------------------- ------------------------------------
Average Annualized Average Annualized
Balance Interest Yield/Rates Balance Interest Yield/Rates
------- -------- ----------- ------- -------- -----------
<S> <C> <C> <C> <C> <C> <C>
Interest-earning assets:
Repurchase agreements and interest-bearing
deposits ..................................... $ 25,176 $ 203 3.16% $ 101,715 $ 1,388 5.41%
Securities available for sale .................. 396,965 13,456 13.56 101,047 2,866 11.25
Commercial and multi-family loan portfolio, net. 59,408 1,950 13.13 6,637 245 14.65
Match funded residential loans, net ............ 93,929 1,915 8.16 -- -- --
Residential loan portfolio, net ................ 95,444 1,949 8.17 3,671 60 6.48
Discount loans, net ............................ 7,752 397 20.49 26,636 908 13.52
-------- -------- ----- ---------- -------- -----
Total interest-earning assets ................ $679,214 $ 19,870 11.70% $ 239,706 $ 5,467 9.05%
-------- -------- ----- ---------- -------- -----
Interest-bearing liabilities:
Securities sold under agreements to repurchase.. $159,001 $ 3,361 8.46% $ -- $ -- --%
Obligations outstanding under lines of credit .. 96,902 1,687 6.96 -- -- --
11.5% Redeemable Notes due 2005 ................ 143,000 4,111 11.50 -- -- --
Bonds match funded ............................. 91,372 1,531 6.70 -- -- --
-------- -------- ----- ---------- -------- -----
Total interest-bearing liabilities ........... $490,275 $ 10,690 8.72% $ -- $ -- --%
-------- -------- ----- ---------- -------- -----
Net interest income/spread (1)..................... $ 9,180 2.98% $ 5,467 9.05%
======== ========
Net interest margin (2)............................ 5.41% 9.05%
For the Year Ended For the Period May 14, 1997 to
December 31, 1998 December 31, 1997
--------------------------------- ------------------------------------
Average Annualized Average Annualized
Balance Interest Yield/Rates Balance Interest Yield/Rates
------- -------- ----------- ------- -------- -----------
<S> <C> <C> <C> <C> <C> <C>
Interest-earning assets:
Repurchase agreements and interest-bearing
deposits ..................................... $ 26,209 $ 1,213 4.63% $ 155,757 $ 5,539 5.72%
Securities available for trading ............... 21,757 107 0.49 -- -- --
Securities available for sale .................. 312,433 43,446 13.91 76,423 6,363 13.39
Commercial and multi-family loan portfolio, net. 43,862 5,736 13.08 2,691 245 14.64
Match funded residential loans, net ............ 23,675 1,915 8.09 -- -- --
Residential loan portfolio, net ................ 104,494 8,424 8.06 1,604 66 6.62
Discount loans, net ............................ 13,802 2,117 15.34 16,453 1,249 12.20
-------- -------- ----- ---------- -------- -----
Total interest-earning assets ................ $546,232 $ 62,958 11.53% $ 252,928 $ 13,462 8.56%
-------- -------- ----- ---------- -------- -----
Interest-bearing liabilities:
Securities sold under agreements to repurchase.. $146,533 $ 11,683 7.97% $ -- $ -- --%
Obligations outstanding under lines of credit... 93,425 6,516 6.97 -- -- --
11.5% Redeemable Notes due 2005 ................ 67,814 7,799 11.50 -- -- --
Bonds match funded ............................. 23,031 1,530 6.65 -- -- --
-------- -------- ----- ---------- -------- -----
Total interest-bearing liabilities ........... $330,803 $ 27,528 8.32% $ -- $ -- --%
-------- -------- ----- ---------- -------- -----
Net interest income/spread (1)..................... $ 35,430 3.21% $ 13,462 8.56%
======== ========
Net interest margin (2)............................ 6.49% 8.56%
</TABLE>
(1) Interest rate spread represents the difference between the average rate on
interest-earning assets and the average cost of interest-bearing
liabilities.
(2) Net interest income divided by average interest-earning assets.
PROVISION FOR LOAN LOSSES. The allowance for loan losses was
established in 1998. The provision for loan losses during 1998 amounted to $0.6
million, which reflected the Company's evaluation of current economic
conditions, a credit review of loans, an analysis of specific loan situations
and the size and composition of the commercial and multi-family loan portfolio.
At December 31, 1997, the Company had not established an allowance for loan
losses on the single family residential loan portfolio or its discount loan
portfolios.
24
<PAGE>
REAL ESTATE INCOME, NET. Real estate income, net decreased $0.4 million
to $1.1 million for the year ended December 31, 1998, compared to 1997. This
decrease was primarily due to a $20.5 million increase in rental income, offset
by a $10.3 million increase in rental operation expense, a $3.4 million increase
in depreciation and amortization expense, and a $7.2 million increase in
interest expense. These increases in real estate operating income and expenses,
compared to 1997, were largely the result of an increase in OAC's investment in
real estate, net of $208.1 million at December 31, 1998, compared to $45.4
million at December 31, 1997, which was not leveraged. Real estate income, net
does not include writedowns in the value of real estate which are included in
losses on securities, derivatives and real estate, as discussed below.
OTHER EXPENSES. Other expenses increased $10.2 million to $13.3 million
for the year ended December 31, 1998, compared to 1997. This increase was
largely due to a $4.1 million increase in management fees, a $5.3 million
increase in other expenses (which consisted generally of servicing, accounting,
audit, legal, excise tax, and bond amortization expenses), and a $1.5 million
increase in due diligence expense. These increases in other expenses were
largely the result of OAC becoming fully invested and leveraging its assets in
1998. The management fees payable by the Company to OCC totaled $5.9 million for
the year ended December 31, 1998.
LOSSES ON SECURITIES, DERIVATIVES AND REAL ESTATE. Due primarily to
accelerated prepayment speeds, widening mortgage spreads, and declining market
liquidity, all of which adversely affected the Company's securities available
for sale and derivatives, OAC recognized a $86.3 million charge to earnings
during 1998. This charge was comprised primarily of a $79.7 million write-down
of the securities available for sale portfolio (subordinate and residual
mortgage-backed securities), a loss of $2.6 million on derivatives and a $3.9
million charge on a property located in Halifax, Nova Scotia, as discussed under
"Comparison of Financial Condition at December 31, 1998 and 1997 - Investment in
Real Estate" below.
MINORITY INTEREST IN NET LOSS OF CONSOLIDATED SUBSIDIARY. Minority
interest in net loss of consolidated subsidiary increased $4.9 million for the
year ended December 31, 1998, which represented the portion of the Operating
Partnership's loss attributed to the limited partnership interest owned by
IMIHC, an affiliate of OCC. OAC has a 91.3% ownership interest in the Operating
Partnership.
EXTRAORDINARY GAIN ON REPURCHASE OF DEBT. On September 30, 1998, OAC
repurchased in the open market $7.0 million of its $150.0 million outstanding
11.5% Redeemable Notes due 2005. This resulted in OAC realizing an extraordinary
gain of $0.6 million during the third quarter of 1998. At December 31, 1998, the
outstanding balance of the Redeemable Notes was $143.0 million.
25
<PAGE>
COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 1998 AND 1997
The following table sets forth information relating to certain of the
Company's assets and liabilities at the dates indicated:
<TABLE>
<CAPTION>
December 31, December 31, Increase
1998 1997 (Decrease)
--------------- -------------- --------------
ASSETS:
<S> <C> <C> <C>
Cash and amounts due from depository institutions.................. $ 3,484,929 $ 331,047 $ 3,153,882
Interest-bearing deposits.......................................... 49,880,276 48,346,076 1,534,200
Securities available for sale, at fair value....................... 351,153,971 146,026,907 205,127,064
Commercial and multi-family loan portfolio, net.................... 65,282,965 9,481,436 55,801,529
Residential loan portfolio, net.................................... 8,058,445 6,350,043 1,708,402
Match funded residential loans, net................................ 173,609,873 -- 173,609,873
Discount loan portfolio, net....................................... 5,618,022 26,978,888 (21,360,866)
Investment in real estate, net..................................... 208,058,721 45,430,039 162,628,682
Principal and interest receivable.................................. 7,475,795 2,518,272 4,957,523
Deposits on pending asset acquisitions............................. -- 1,000,000 (1,000,000)
Other assets....................................................... 15,702,816 1,540,633 14,162,183
--------------- -------------- --------------
Total assets.................................................... $ 888,325,813 $ 288,003,341 $ 600,322,472
=============== ============== ==============
LIABILITIES:
Securities sold under agreements to repurchase..................... $ 138,611,824 $ -- $ 138,611,824
Obligations outstanding under lines of credit...................... 34,472,404 -- 34,472,404
Obligations outstanding under lines of credit-
secured by real estate .......................................... 142,556,880 -- 142,556,880
11.5% Redeemable Notes due 2005.................................... 143,000,000 -- 143,000,000
Bonds - match funded loan agreement................................ 163,403,966 -- 163,403,966
Dividends and distributions payable................................ -- 7,458,750 (7,458,750)
Accrued expenses, payables and other liabilities................... 21,190,288 6,344,783 14,845,505
--------------- -------------- --------------
Total liabilities............................................... 643,235,362 13,803,533 629,431,829
--------------- -------------- --------------
Minority interest ..................................................... 23,914,058 2,941,541 20,972,517
--------------- -------------- --------------
Shareholders' equity:.................................................. $ 221,176,393 $ 271,258,267 $ (50,081,874)
--------------- -------------- --------------
Total liabilities and shareholders' equity......................... $ 888,325,813 $ 288,003,341 $ 600,322,472
=============== ============== ==============
</TABLE>
SECURITIES AVAILABLE FOR SALE. The Company's investment in securities
available for sale at December 31, 1998 increased by $205.1 million to $351.2
million from $146.0 million at December 31, 1997.
At December 31, 1998, OAC's securities available for sale portfolio was $351.2
million and consisted of:
o Non-investment grade and unrated subordinate commercial mortgage-backed
securities having an amortized cost of $115.7 million and a fair value
of $117.1 million,
o Unrated residential subprime residuals having an amortized cost of
$209.0 million and a fair value of $218.7 million, and
o Unrated subordinate residential mortgage-backed securities having an
amortized cost of $15.4 million and a fair value of $15.4 million.
OAC's unrated subprime residual portfolio of $218.7 million consisted of:
o $110.0 million of seasoned residuals (securitized between 1994 and
1997) with overcollateralization reserves funded at approximately
$122.5 million, and
o $108.7 million of unseasoned residuals (securitized in 1998) with
overcollateralization reserves funded at approximately $26.6 million.
26
<PAGE>
The following table sets forth the fair value and composition of the
Company's securities available for sale at the dates indicated.
<TABLE>
<CAPTION>
December 31,
----------------------------
Mortgage-related securities: 1998 1997
---------- ---------
Single family residential: (Dollars In Thousands)
Interest only:
<S> <C> <C>
AAA-rated interest-only............................ $ -- $ 730
FHLMC.............................................. -- 21,178
FNMA............................................... -- 22,573
Subordinates......................................... 15,390 9,444
Subprime residuals................................... 218,724 --
---------- ----------
Total single family residential.................. $ 234,114 $ 53,925
---------- ---------
Multi-family residential and commercial:
Interest only:
AAA-rated interest-only............................ $ 441 $ 866
A-rated interest-only.............................. 222 480
Non-rated interest-only ........................... 3,135 4,803
Non-rated principal-only............................. 276 960
Subordinates......................................... 112,966 84,993
---------- ----------
Total multi-family residential and commercial...... 117,040 92,102
---------- ----------
Total mortgage-related securities.................. $ 351,154 $ 146,027
========== ==========
</TABLE>
The following tables detail the Company's securities available for sale
portfolio at December 31, 1998, and its estimates of expected yields on such
securities, taking into consideration expected prepayment and loss rates
together with other factors. Included in the tables are the following terms:
ACTUAL DELINQUENCY - Represents the total unpaid principal balance of
loans more than 30 days delinquent at the indicated date as a percentage of the
unpaid principal balance of the collateral at such date.
ACTUAL LIFE-TO-DATE CPR - The Constant Prepayment Rate is used to
measure the average prepayment rate for the underlying mortgage pool(s) over the
period of time lapsed since the issuance of the securities through the date
indicated and is calculated as follows:
<TABLE>
<CAPTION>
<S> <C> <C>
Actual Life-to-Date CPR = 100 x [(1 - Final Aggregate Balance actual ) ( 12 ) ]
------------------------------------- ---------------
Final Aggregate Balance scheduled months in period
</TABLE>
ACTUAL LIFE-TO-DATE LOSSES - Represents cumulative losses expressed as
a percentage of the unpaid balance of the original collateral at the indicated
date.
CLASS DESIGNATION LETTER - Refers to the credit rating designated by
the rating agency for each securitization transaction. Classes designated "A"
have a superior claim on payment to those rated "B", which are superior to those
rated "C." Additionally, multiple letters have a superior claim to designations
with fewer letters. Thus, for example, "BBB" is superior to "BB," which in turn
is superior to "B." The lower class designations in any securitization will
receive interest payments subsequent to senior classes and will experience
losses prior to any senior class. The lowest potential class designation is not
rated ("NR") which, if included in a securitization, will always receive
interest last and experience losses first. IO securities receive the excess
interest remaining after the interest payments have been made on all senior
classes of bonds based on their respective principal balances. There is no
principal associated with IO securities and they are considered liquidated when
the particular class they are contractually tied to is paid down to zero.
Principal only ("PO") securities receive excess principal payments after the
principal has been made on all classes of bonds based on their respective
payment schedules. There is no interest associated with PO securities and they
are sold at a discount. The return on PO securities is earned through the
receipt of the payments and the collection of the discounted amount.
27
<PAGE>
CLASS SIZE - Represents the percentage size of a particular class
relative to the total outstanding balance of all classes.
COLLATERAL BALANCE - represents, in the case of residuals, the unpaid
principal balance of the collateral of the entire securities at the indicated
date and, in the case of subordinates, the outstanding principal balance of the
entire securitization at the indicated date.
ISSUE DATE - Represents the date on which the indicated securities were
issued.
OVER-COLLATERIZATION LEVEL - For residual interests in residential
mortgage-backed securities, over-collaterization ("OC") is the amount by which
the collateral balance exceeds the sum of the bond principal amounts. OC is
achieved by applying monthly a portion of the interest payments of the
underlying mortgages toward the reduction of the class certificate principal
amounts, causing them to amortize more rapidly than the aggregate loan balance.
The OC percentage, expressed as a percentage of the outstanding collateral
balance, represents the first tier of loss protection afforded to the
non-residual holders. The OC percentage also determines whether the
over-collaterization target has been satisfied as of a specific date, such that
cash flows to the residual holder are warranted. To the extent not consumed by
losses on more highly rated bonds, OC is remitted to the residual holders.
Reserve funds ("RF") are actual cash reserves expressed as a percentage of the
original collateral balance at issuance.
RATING - Represents the rating, if any, on the security or securities
by the indicated rating agencies.
SECURITIZATION - Series description.
SECURITY - Represents the name of the class associated with each
securitization held by the Company. This has no relationship to a formal rating
but is for identification purposes (although the names are usually in
alphabetical or numeric order from the highest rated to the lowest rated).
SUBORDINATION LEVEL - Represents the credit support for each
mortgage-backed security by indicating the percentage of outstanding bonds whose
right to receive payment is subordinate to the referenced security. The
subordinate classes must experience a complete loss before any additional losses
would affect the particular referenced security.
WEIGHTED AVERAGE DSCR - Represents debt service coverage ratio, which
is calculated by dividing cash flow available for debt service by debt service.
WEIGHTED AVERAGE LTV- Represents the ratio of the loan amount to the
value of the underlying collateral.
YIELD TO MATURITY - Yield to maturity represents a measure of the
average rate of return that is earned on a security if held to maturity.
28
<PAGE>
The following tables details the Company's securities available for
sale portfolio at December 31, 1998:
<TABLE>
<CAPTION>
OVER
CLASS COLLATERIZATION
ISSUE DESIGNATION RATING COLLATERAL BALANCE LEVEL AT PRODUCT TYPE AT
SECURITIZATION SECURITY DATE LETTER AGENCIES ISSUANCE 12/31/98 12/31/98 12/31/98
------------------ ------------ ------- ---------- ------------ ---------- ---------- -------------- ---------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
RESIDENTIAL MORTGAGE
BACKED SECURITIES (Dollars In Thousands)
RESIDUALS:
SASCO 1998-2(1) X Jan-98 NR S&P, Fitch $600,052 $ 480,920 1.09% OC 24% Fixed, 69%
2/28 ARM
SASCO 1998-3(1) X Mar-98 NR S&P, Fitch 769,671 643,182 2.09% OC 9% Fixed, 74%
2/28 ARM
MLMI 1998-FF1(2) X Jun-98 NR S&P, Fitch 198,155 181,344 1.64% OC 18% 1/29 ARM, 79%
2/28 ARM
PANAM 1997-1(3) X Dec-97 NR S&P, Moody's 113,544 93,671 4.12% OC 31% 6mo ARM, 62%
Prepay Pen. 2/28 ARM
LHELT 1998-2(4) X Jun-98 NR Moody's, Fitch 209,225 184,986 2.67% OC 40% Fixed, 37%
2/28 ARM
EQUICON 1994-2(5) B Fix, B-2 Oct-94 NR S&P, Moody's, 78,846 26,712 5.59% OC 100% Fixed
Fitch
QS Fix, QS-2 NR
B Var., B-2 NR 32,306 7,580 14.64% OC 100% 6mo ARM
EQUICON 1995-1(5) B Fix, B-2 May-95 NR S&P, Moody's, 70,024 21,500 15.22% OC 100% Fixed
Fitch
B Var., B-2 NR 70,519 8,553 24.19% OC 100% 6mo ARM
EQUICON 1995-2(5) B Fix, B-2 Oct-95 NR S&P, Moody's 79,288 30,654 12.79% OC 100% Fixed
B Var., B-2 NR 39,667 9,716 17.35% OC 100% 6mo ARM
ACCESS 1996-1(6) B Fix, B-2 Feb-96 NR S&P, Moody's 120,015 48,597 6.53% OC 100% Fixed
B Var., B-2 NR 55,362 14,074 12.63% OC 100% 6mo ARM
ACCESS 1996-2(6) B-I, B-1 May-96 NR S&P, Moody's 142,259 61,062 11.63% OC 100% Fixed
BI-S, BI-S-1 NR
B-II, B-1 NR 68,345 17,985 10.93% OC 100% ARM
BII-S, NR
BII-S-1
ACCESS 1996-3(6) B-I, B-1 Aug-96 NR S&P, Moody's 107,712 46,796 9.82% OC 100% Fixed
BI-S, BI-S-1 NR
B-II, B-1 NR 99,885 26,757 17.99% OC 100% ARM
BII-S, NR
BII-S-1
ACCESS 1996-4(6) B, B-1 Nov-96 NR S&P, Moody's 239,778 90,794 13.17% OC 49% Fixed, 51% ARM
B-S, B-S-1 NR
ACCESS 1997-1(6) B, B-1 Feb-97 NR S&P, Moody's 276,442 130,539 13.88% OC 56% Fixed, 44% ARM
B-S, B-S-1 NR
ACCESS 1997-2(6) B, B-1 May-97 NR S&P, Moody's 185,197 95,395 8.74% OC 50% Fixed, 50% ARM
B-S, B-S-1 NR
ACCESS 1997-3(6) B, B-1 Oct-97 NR S&P, Moody's 199,884 116,848 5.50% OC 45% Fixed, 55% ARM
B-S, B-S-1 NR
OCWEN 98 - OAC-1 N/A Nov-98 NR S&P, Moody's 182,178 172,013 4.97% OC 22% Fixed, 78% ARM
CMR1(8) Deferred Comp Apr-96 NR S&P, Duff 47,802(9) 27,632(10) 7.62% RF 100% Amortizing
CMR2(8) Deferred Comp Nov-96 NR S&P, Duff, Fitch 106,692(9) 60,085(10) 8.02% RF 90.5% Amort 9.5% IO
mortgages
CMR3(8) Deferred Comp Nov-96 NR S&P, Duff, Fitch 195,610(9) 112,231(10) 11.18% RF 74.35% Amort 25.7%
IO mortgages
CMR4(8) Deferred Comp Feb-97 NR S&P, Duff, Fitch 108,630(9) 74,247(10) 5.32% RF 90.3% Amort 9.7% IO
mortgages
CMR6(8) Deferred Comp May-97 NR S&P, Duff, Fitch 91,442(9) 62,935(10) 5.52% RF 95.7% Amort 4.3% IO
mortgages
SUBORDINATES:
SBMS 1997-HUD1 (11) B5 Apr-97 B2, n.a. Moody's, DCR 9,785 9,476 4.70% 94% Fixed
B6 Apr-97 NR 16,998 11,412 N/A
ORMBS 1998-R1 (12) B4 Mar-98 NR Moody's, DCR 32,718 31,656 N/A 94% Fixed
GECMS 1994-12 (13) B4 Mar-94 NR Moody's, Fitch, 2,069 1,564 N/A 100% Fixed
S&P
</TABLE>
29
<PAGE>
<TABLE>
<CAPTION>
WEIGHTED WEIGHTED ACTUAL ACTUAL
AVERAGE AVERAGE ACTUAL LIFE TO DATE LIFE TO DATE YIELD TO
INTEREST RATE LTV AT: DELINQUENCY AT: CPR AT: LOSSES AT: MATURITY AT:
SECURITIZATION SECURITY AT: 12/31/98 12/31/98 12/31/98 12/31/98 12/31/98 PURCHASE 12/31/98
- -------------- -------- ------------ -------- ------------- ----------- ------------ -------- --------
RESIDENTIAL MORTGAGE
BACKED SECURITIES (Dollars In Thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
RESIDUALS:
SASCO 1998-2 X 10.17% 74.47% 10.61% 20.90% $ 119 16.00% 7.13%
SASCO 1998-3 (1) X 9.79 76.07 7.26 20.80 52 17.04 7.54
MLMI 1998-FF1 (2) X 9.15 76.99 5.99 13.50 46 18.57 14.69
PANAM 1997-1 (3) X 10.10 75.99 15.09 18.06 129 22.45 13.65
Prepay Pen. 25.69 46.05
LHELT 1998-2 (4) X 10.05 76.04 7.37 18.70 0 18.55 23.57
EQUICON 1994-2 (5) B Fix, B-2 9.94 66.18 15.32 33.74 612 18.00 49.27
QS Fix, QS-2
B Var., B-2 11.10 74.58 32.78 39.27 269 18.00 23.67
EQUICON 1995-1 (5) B Fix, B-2 12.03 63.15 29.53 30.05 568 18.00 20.98
B Var., B-2 11.69 73.59 46.16 34.61 648 18.00 37.88
EQUICON 1995-2 (5) B Fix, B-2 10.87 69.61 30.68 33.01 516 18.00 34.42
B Var., B-2 11.76 72.97 47.05 41.10 338 18.00 53.16
ACCESS 1996-1 (6) B Fix, B-2 10.86 70.21 30.26 32.61 1,207 18.00 40.96
B Var., B-2 11.64 74.89 37.73 42.34 647 18.00 50.46
ACCESS 1996-2 (6) B-I, B-1 11.01 70.99 29.19 33.36 1,294 18.00 16.57
BI-S, BI-S-1
B-11, B-1 11.53 74.89 45.82 48.45 401 18.00 21.36
BII-S,
BII-S-1
ACCESS 1996-3 (6) B-I, B-1 11.45 74.59 32.25 35.19 731 18.00 19.48
BI-S, BI-S-1
B-II, B-1 11.98 76.14 43.85 51.72 469 18.00 24.67
BII-S,
BII-S-1
ACCESS 1996-4 (6) B, B-1 11.89 73.94 42.48 42.22 1,125 18.00 16.04
B-S, B-S-1
ACCESS 1997-1 (6) B, B-1 11.49 75.45 39.67 41.22 1,898 18.00 16.19
B-S, B-S-1
ACCESS 1997-2 (6) B, B-1 11.38 74.01 35.84 41.76 725 18.00 10.69
B-S, B-S-1
ACCESS 1997-3 (6) B, B-1 11.19 74.77 30.02 40.47 379 18.00 18.12
B-S, B-S-1
OCWEN 98-OAC-1 (7) N/A 8.74 75.95 3.15 30.20 0 N/A N/A
CMR1 (8) Deferred Comp 13.46 N/A 36.03 20.09 511 18.00 38.50
CMR2 (8) Deferred Comp 12.51 N/A 32.09 21.40 1,232 18.00 31.90
CMR3 (8) Deferred Comp 13.64 N/A 18.31 17.58 1,737 18.00 16.30
CMR4 (8) Deferred Comp 13.80 N/A 37.13 17.51 620 18.00 21.10
CMR6 (8) Deferred Comp 13.61 N/A 35.40 19.84 112 18.00 26.10
SUBORDINATES:
SBMS 1997-HUD1 (11) B5 9.82 110.54 17.54 13.95 5,172 16.87 18.97
B6 22.86 26.60
ORMBS 1998-R1 (12) B4 8.98 117.19 30.83 4.45 1,945 13.75 10.17
GECMS 1994-12 (13) B4 6.83 49.40 0.42 6.60 N/A(14) 19.37 20.50
</TABLE>
30
<PAGE>
ISSUERS:
(1) Structured Asset Securities Corp.
(2) Merrill Lynch Mortgage Investors, Inc.
(3) Pan American Bank, FSB.
(4) Lehman Home Equity Loan Trust.
(5) Equicon Mortgage Loan Trust.
(6) Access Financial Mortgage Loan Trust.
(7) Ocwen Residential Mortgage-Backed Securities.
(8) City Mortgage Receivable.
(9) Dollar equivalent of amounts in British pounds at the rate of exchange that
prevailed a the time of issuance.
(10) Dollar equivalent of amounts in British pounds at the rate of exchange at
12/31/98.
(11) Salomon Brothers Mortgage Securities.
(12) Ocwen Mortgage Loan Trust.
(13) GE Capital Mortgage Services, Inc.
(14) Not available.
<TABLE>
<CAPTION>
CLASS SUBORDINATION
DESIGNATION RATING LEVEL AT
SECURITIZATION SECURITY ISSUE DATE LETTER AGENCIES ISSUANCE 12/31/98
- -------------- -------- ---------- ------ -------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
COMMERCIAL MORTGAGE
BACKED SECURITIES
NASC 1996 MD-V (1) B-2 Apr-96 B S&P, Duff, Fitch 0.00% 0.00%
CSFB 1995-AEW1 (2) E Oct-95 BB S&P, Fitch 13.75 27.98
F-1 B 4.80 9.95
G-1 NR 0.00 0.00
G-2 NR 0.00 0.00
MRAC 1996-C2 (3) K Dec-96 B- Fitch, Moody's 2.50 2.69
L-1 NR-PO 0.00 0.00
L-2 NR-IO 0.00 0.00
BTC 1997-S1 (4) E, F Dec-97 BB/B S&P, Fitch 19.00 30.74
Equity NR 0.00 0.00
DLJ 1993-MF17 (5) B-2 Nov-93 BB Moody's, Duff 4.59 5.25
B-3 B 1.28 1.47
C-1 NR 0.00 0.00
S-1 AAA-IO 32.18 36.83
S-2 A-IO 18.02 20.63
MLMCI 1993-M1 (6) B Sep-93 NR Moody's, S&P 2.00 6.50
</TABLE>
31
<PAGE>
<TABLE>
<CAPTION>
Actual Actual
Weighted Weighted life life
Average Average Actual to date to date Class Size % Yield to Collateral
DSCR at LTV at Delinquency CPR at losses at Total as of Maturity at Balance at
SECURITIZATION Security Issuance Issuance 12/31/98 12/31/98 12/31/98 Issuance 12/31/98 Purchase 12/31/98 Issuance 12/31/98
- -------------- -------- -------- -------- --------- -------- --------- -------- -------- -------- -------- -------- --------
(Dollars in thousands)
COMMERCIAL MORTGAGE
BACKED SECURITIES
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
NASC 1996 MD-V (1) B-2 1.69 62.0% 0.0% 0.0% $ 0 4.36% 4.47% 9.90% 9.98% $ 773,693 $755,005
CSFB 1995-AEW1 (2) E 1.26 71.8% 1.7% n/a $ 708,282 11.00 22.81 7.93 7.89 288,906 138,731
F-1 1.80 3.73 9.75 9.84
G-1 4.80 9.95 12.84 12.23
G-2 5.72 11.35 14.87 13.97
MRAC 1996-C2 (3) K 1.36 69.1% 0.8% n/a $ 0 1.50 1.62 12.10 12.41 512,102 475,011
L-1 2.50 2.69 12.31 13.86
L-2 2.50 2.69 12.82 14.48
BTC 1997-S1 (4) E, F 1.27 106.0% 18.6% 36.35% $4,768,345 14.50 23.46 8.36 8.50 303,946 187,855
Equity 19.00 30.74 21.19 25.59
DLJ 1993-MF17 (5) B-2 1.36 73.7% 0.0% 0.0% $ 0 9.41 10.77 12.29 12.65 139,183 121,609
B-3 3.31 3.78 11.39 15.40
C-1 1.28 1.47 -29.82 14.53
S-1 67.82 63.17 16.69 -3.64
S-2 14.15 16.20 14.46 -8.67
MLMCI 1993-M1 (6) B 1.51 56.0% 47.3% n/a $ 0 9.00 26.95 13.65 9.45 258,765 13,239
</TABLE>
ISSUERS:
(1) Nomura Asset Securities Corporation
(2) CS First Boston Mortgage Securities Corp.
(3) Midland Realty Acceptance Corp.
(4) BTC Mortgage Investors Trust 1997-S1
(5) DLJ Mortgage Acceptance Corp.
(6) Merrill Lynch Mortgage Capital, Inc.
The following table sets forth the principal amount of mortgage loans
by the geographic location of the property securing the mortgages that underly
the Company's securities available for sale portfolio at December 31, 1998.
<TABLE>
<CAPTION>
Description California Florida Texas New York Maryland Other (1)
------------------------------- ---------- ---------- ---------- ---------- ---------- -----------
(Dollars In Thousands)
<S> <C> <C> <C> <C> <C> <C>
Single family residential ..... $ 776,170 $ 315,824 $ 210,133 $ 133,363 $ 159,636 $ 2,523,144
Multi-family and commercial.... 201,729 130,596 161,033 107,520 88,914 986,982
---------- ---------- ---------- ---------- ---------- -----------
Total.......................... $ 974,899 $ 446,420 $ 371,166 $ 240,883 $ 248,550 $ 3,510,126
========== ========== ========== ========== ========== ===========
Percentage (2)................. 16.8% 7.7% 6.4% 4.2% 4.3% 60.6%
========== ========== ========== ========== ========== ===========
</TABLE>
(1) (1) No other individual state makes up more than 5% of the total.
Includes $55.2 million of loans secured by single family residences
located in United Kingdom which back the securities issued by City
Mortgage Receivable 1-6, which were acquired by the Company from the
United Kingdom operations of Cityscape Financial Corp. See "Certain
Transaction" under Item 13.
(2) Based on a percentage of the total unpaid principal balance of the
underlying loans.
32
<PAGE>
The following table summarizes information relating to the Company's
mortgage-related securities available for sale at December 31, 1998.
<TABLE>
<CAPTION>
ANTICIPATED ANTICIPATED
ORIGINAL UNLEVERAGED WEIGHTED
ANTICIPATED YIELD TO AVERAGE
AMORTIZED PERCENT YIELD TO MATURITY AT REMAINING
RATING/DESCRIPTION COST FAIR VALUE OWNED MATURITY 12/31/98 (2) COUPON LIFE (3)
- --------------------------------- -------- --------- ------- ---------- ------------ ------ ---------
SINGLE FAMILY RESIDENTIAL (Dollars In Thousands)
<S> <C> <C> <C> <C> <C> <C> <C>
Unrated residuals................ $209,071 $ 218,724 100% 17.90% 13.48% 0.00% 2.57%
B-rated subordinates............. 4,738 4,738 100 16.87 18.82 7.75 7.11
Unrated subordinates............. 10,652 10,652 41 15.16 11.19 7.03 6.27
-------- ---------
Total single family........... 224,461 234,114
-------- ---------
MULTI-FAMILY/COMMERCIAL
BB-rated subordinates............ 62,327 62,770 68 8.67 8.62 7.86 4.38
B-rated subordinates............. 29,850 30,076 80 10.42 10.65 8.39 10.09
Unrated subordinates............. 19,377 20,120 89 14.04 15.80 9.97 5.56
AAA-rated IOs.................... 454 441 100 16.69 (3.67) 34.00 6.11
A-rated IOs...................... 236 222 100 14.46 (8.84) 65.00 2.22
Unrated IOs (1).................. 3,135 3,135 100 12.82 16.25 7.23 11.18
Unrated POs (1).................. 276 276 100 12.31 14.32 0.00 11.21
-------- ---------
Total multi-family/
commercial.................. 115,655 117,040
-------- ---------
Total mortgage
related securities.......... $340,116 $ 351,154
======== =========
</TABLE>
(1) These securities relate to the same mortgage-related security,
thus giving the Company both the principal and interest
components to the particular class.
(2) Changes in the December 31, 1998 anticipated yield to maturity
from that originally anticipated are primarily the result of
changes in prepayment assumptions and to a lesser extent loss
assumptions.
(3) Equals the weighted average duration based off of December 31,
1998 book value.
The following table sets forth the property types of the Company's
commercial mortgage-backed securities at December 31, 1998, based upon the
principal amount.
Percentage
Property type Invested
------------------------------ ------------
Multi-family.................. 26.0%
Retail........................ 26.0
Hotel......................... 14.5
Office........................ 7.7
Industrial.................... 4.8
Mixed use..................... 2.8
Other......................... 18.2
--------
Total......................... 100.0%
========
Subordinate and residual interests in mortgage-related securities
provide credit support to the more senior classes of the mortgage-related
securities. Principal from the underlying mortgage loans generally is allocated
first to the senior classes, with the most senior class having a priority right
to the cash flow from the mortgage loans until its payment requirements are
satisfied. To the extent that there are defaults and unrecoverable losses on the
underlying mortgage loans, resulting in reduced cash flows, the most subordinate
security will be the first to bear this loss. Because subordinate and residual
interests generally have no credit support, to the extent there are realized
losses on the mortgage loans comprising the mortgage collateral for such
securities, the Company may not recover the full amount or, indeed, any of its
initial investment in such subordinate and residual interests. The Company
generally owns the most subordinate classes of the securities in which it
invests and therefore will be the first to bear any credit losses.
The Company determines the present value of anticipated cash flows of
its mortgage-related securities utilizing valuation assumptions appropriate at
the time of each acquisition or securitization transaction. The significant
valuation assumptions include the anticipated prepayment speeds and the
anticipated credit losses related to the underlying mortgages. In order to
determine the present value of this estimated excess cash flow, the Company
currently applies a discount rate of 18% to the projected cash flows on the
unrated classes of securities. The annual prepayment rate of the securitized
loans is a function of full and partial prepayments and
33
<PAGE>
defaults. The Company makes assumptions as to the prepayment rates of the
underlying loans, which the Company believes are reasonable, in estimating fair
values of the subordinate securities and residual securities retained. During
1998, the Company utilized proprietary prepayment curves generated by the
Company (reaching an approximate range of annualized rates of 30%-40%). In its
estimates of annual loss rates, the Company utilizes assumptions that it
believes are reasonable. The Company estimates annual losses of between 0.22%
and 2.06% of the underlying loans.
The credit risk of mortgage-related securities is affected by the
nature of the underlying mortgage loans. In this regard, the risk of loss on
securities backed by commercial and multi-family loans and single family
residential loans made to borrowers who, because of prior credit problems, the
absence of a credit history or other factors, are unable or unwilling to qualify
as borrowers under guidelines established by the FHLMC and the FNMA for
purchases of loans by such agencies, generally involve more risk than securities
backed by single family residential loans which conform to the requirements
established by FHLMC and FNMA for their purchase by such agencies.
Subordinate and residual interests are affected by the rate and timing
of payments of principal (including prepayments, repurchase, defaults and
liquidations) on the mortgage loans underlying a series of mortgage-related
securities. The rate of principal payments may vary significantly over time
depending on a variety of factors, such as the level of prevailing mortgage loan
interest rates and economic, demographic, tax, legal and other factors.
Prepayments on the mortgage loans underlying a series of mortgage-related
securities are generally allocated to the more senior classes of
mortgage-related securities. Although in the absence of defaults or interest
shortfalls all subordinates receive interest, amounts otherwise allocable to
residuals generally are used to make payments on more senior classes or to fund
a reserve account for the protection of senior classes until
overcollateralization or the balance in the reserve account reaches a specified
level. In periods of declining interest rates, rates of prepayments on mortgage
loans generally increase, and if the rate of prepayments is faster than
anticipated, then the yield on subordinates will be positively affected and the
yield on residuals will be negatively affected. Accelerated prepayment speeds on
residential mortgage-backed securities were a significant factor in the $79.7
million loss on securities recorded by the Company during 1998.
Accelerated prepayment speeds also significantly affected the IO
Portfolio in the first half of 1998, at which time the portfolio was sold. The
IO Portfolio consisted of IOs, which are classes of mortgage-related securities
that are entitled to payments of interest but no (or only nominal) payments of
principal, and Inverse IOs, which bear interest at a floating rate that varies
inversely with (and often at a multiple of) changes in a specified index. As a
result of an increase in prepayment speeds due to declining interest rates in
the first quarter of 1998, the Company incurred $17.1 million of losses on its
IO Portfolio and, following the sale of the IO Portfolio to affiliates of the
Company in May 1998 at a price equal to its amortized cost plus accrued
interest, the Company discontinued investing in IOs and Inverse IOs.
The Company marks its securities portfolio to fair value at the end of
each month based upon broker/dealer marks, subject to an internal review
process. For those securities which do not have an available market quotation,
the Company requests market values and underlying assumptions from the various
broker/dealers that underwrote, are currently financing the securities or have
had prior experience with the type of securities. Because the Company's
subordinate and residual securities are not readily marketable, trades can be
infrequent (and under some market conditions, non-existent) and most
broker/dealers do not have the securities modeled. In these circumstances the
market value is typically available from only a small group of broker/dealers,
and in most cases from only one broker/dealer. When valuations are obtained from
two or more broker/dealers, the average dealer mark is utilized. As of each
reporting period, the Company evaluates whether and to what extent any
unrealized loss is to be recognized as other than temporary.
COMMERCIAL AND MULTI-FAMILY LOAN PORTFOLIO. The Company's investment in
commercial and multi-family loans amounted to $65.3 million at December 31,
1998, a $55.8 million increase over the $9.5 million investment at December 31,
1997.
The Company's commercial lending activities focus on real estate
lending opportunities in selected major metropolitan markets throughout the
United States where the Company believes there are significant supply
constraints and where employment and/or population growth and other demand
generators are expected to remain strong. The Company's general approach to
commercial lending is to capitalize on the core capabilities of the Manager and
its affiliates, which include an ability to assess the value creation potential
of underutilized real estate and to oversee and manage the conversion,
rehabilitation and/or construction process. The Company seeks to make loans to
borrowers who have a proven ability to acquire such assets and enhance value
through a process of repositioning or development. Loans are usually structured
to provide current income along with either exit fees or gross revenue
participation features. Loans may be originated as first mortgage loans or
structured as subordinated debt or mezzanine financing.
34
<PAGE>
The following table sets forth the composition of the Company's
commercial and multi-family loan portfolio by type of loan at the dates
indicated.
<TABLE>
<CAPTION>
December 31,
------------------------------------
1998 1997
-------------- --------------
<S> <C> <C>
Multi-family residential loans ................. $ 20,544,269 $ 1,357,333
Commercial real estate and land loans:
Hotels..................................... 21,304,912 8,423,608
Office buildings........................... 24,123,894 44,383
-------------- --------------
Total loans............................... 65,973,075 9,825,324
Deferred fees................................... (48,434) (343,888)
Allowance for loan losses....................... (641,676) --
-------------- --------------
Commercial and multi-family loans, net..... $ 65,282,965 $ 9,481,436
============== ==============
</TABLE>
The Company maintains an allowance for loan losses at a level which
management considers adequate to provide for potential losses based upon an
evaluation of known and inherent risks. At December 31, 1998, the Company had an
allowance for loan losses in the amount of $0.6 million on the commercial and
multi-family loan portfolio. At December 31, 1997, no allowance for loan losses
had been provided.
The following table sets forth certain information regarding the loans
in the Company's commercial and multi-family loan portfolio at December 31,
1998.
35
<PAGE>
<TABLE>
<CAPTION>
LOAN AMOUNT LOAN PER STABILIZED
OUTSTANDING RATIO OF UNIT/ DEBT
LOAN AT DECEMBER TYPE OF LOAN TO SQUARE COVERAGE COUPON
LOAN LOCATION AMOUNT 31, 1998 LOAN COST FOOT RATIO(1) RATE SIZE
- --------------- ----------------- ------- ----------- ------------ -------- ------ -------- ------ -----------
MULTI-FAMILY (Dollars In Thousands)
RESIDENTIAL:
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fourth &
Harrison ..... San Francisco, CA $11,550 $ 4,198 Construction 85% $201 1.22 9.630% 160 units
241 Church
Street ....... New York, NY 30,280 13,684 Conversion 88 582 N/A 9.000 52 units
459 Washington
Street ....... New York, NY 3,455 2,662 Conversion 61 314 N/A 10.500 11 units
COMMERCIAL:
Doubletree
Hotel ........ Lowell, MA 7,652 7,447 Renovation 85 31 1.9 10.000 249 rooms
Hawthorn Suites
Hotel ........ Schaumburg, IL 7,629 --- Construction 65 56 1.59 8.750 136 suites
Thompson
Street Hotel . New York, NY 17,715 1,806 Construction 80 209 1.66 10.000 100 rooms
Wyndham Garden
Hotel ........ Wilmington, DE 13,300 12,052 Renovation 67 61 2.2 8.650 291 rooms
Landmark III-
GTE .......... Burlington, MA 33,058 24,124 Renovation 85 114 1.18 9.250 291,007 sq.ft.
-------- -------
$124,639 $65,973
======== =======
</TABLE>
(1) Represents the net income of the stabilized property divided
by debt service required by the loan.
During October 1998, the Company closed a commitment to finance a hotel
construction loan in New York, New York in the amount of $17.7 million, of which
$1.2 million had been funded. See "Note 6 to the Consolidated Financial
Statements" under Item 8.
RESIDENTIAL LOAN PORTFOLIO. The Company's investment in residential
loans increased to $8.0 million at December 31, 1998 from a $6.4 million
investment at December 31, 1997. These loans were acquired with the intent of
accumulating such loans, executing a securitization and retaining a subordinate
interest.
At December 31, 1998, $4.1 million or 49.5% of the residential loan
portfolio was past due 90 days or more, compared to $0.3 million or 0.1%,
respectively, at December 31, 1997
On November 13, 1998, the Company completed the securitization of 1,808
first and second single family residential mortgage loans having an aggregate
unpaid principal balance of $182.2 million. The mortgage loans were acquired by
the Operating Partnership during 1997 and 1998. After the payment in full of all
transaction expenses and the repayment in full of the approximately $136.0
million warehouse facility secured by such mortgage loans, the securitization
will net the Company approximately $35.0 million in cash from the
securitization. The Company retained an approximately $10.1 million
non-investment grade equity certificate, which will entitle the Company to any
available excess cash flow, and the Bank will continue to service the mortgage
loans. As a result of this transaction, at December 31, 1998 the Company had
$163.4 million of match funded indebtedness which is secured by $173.6 million
of match funded residential loans, net.
36
<PAGE>
DISCOUNT LOAN PORTFOLIO. The Company believes that, under appropriate
circumstances, the acquisition of nonperforming and underperforming mortgage
loans at discounts offers significant opportunities to the Company. Discount
loans generally have collateral coverage which is sufficiently in excess of the
purchase price of the loan, such that successful resolutions can produce total
returns which are in excess of an equivalent investment in performing mortgage
loans. See "Business - Investment Guidelines Mortgage Loans" under Item 1 for a
discussion of the Company's approach to acquiring mortgage loans.
Nonperforming and subperforming mortgage loans may presently be in
default or may have a greater than normal risk of future defaults and
delinquencies, compared to newly-originated, high-quality loans of comparable
type, size and geographic concentration. Returns on an investment of this type
depend on the borrower's ability to make required payments or, in the event of
default, the ability of the loan's servicer to foreclose and liquidate the
mortgage loan. There can be no assurance that the Company will be able to
liquidate a defaulted mortgage loan successfully (through sale of the security
property or otherwise) or in a timely fashion.
At December 31, 1998, the Company's net discount loan portfolio
amounted to $5.6 million or 0.6% of the Company's total assets. All of the
Company's discount loan portfolio is secured by first mortgage liens on real
estate.
At December 31, 1998, the Company's discount loans primarily consisted of
a 13.83% participation interest in a loan pool, which had an outstanding
principal balance of $6.9 million. The collateral for the loans consists
primarily of three office buildings located in midtown Manhattan, New York. The
loans are serviced by the Bank, which holds the remaining interest in these
loans.
The following table sets forth the activity in the Company's gross
discount loan portfolio during the periods indicated:
<TABLE>
<CAPTION>
December 31,
-----------------------------
1998 1997
------------- ------------
(Dollars In Thousands)
<S> <C> <C>
Balance at beginning of period ................. $ 42,528,782 --
Acquisitions ................................... -- 44,686,413
Resolutions and repayments(1) .................. (2,349,969) (1,281,846)
Loans transferred to investment in real estate . (33,436,930) --
Foreign exchange gain (loss) ................... 116,953 (875,785)
------------ ------------
Balance at end of period ....................... $ 6,858,836 $ 42,528,782
============ ============
</TABLE>
(1) Resolutions and repayments consists of loans which were resolved in a
manner which resulted in partial or full repayment of the loan to the
Company, as well as principal payments on loans which have been brought
current in accordance with their original or modified terms (whether
pursuant to forbearance agreements or otherwise) or on other loans
which have not been resolved.
Discount loans decreased from $42.5 million at December 31, 1997 to
$6.9 million at December 31, 1998 primarily as a results of foreclosure on (i) a
Canadian loan with an unpaid principal balance of $27.6 million (Cdn. $38.3
million), which was secured by a 402,529 square foot shopping center located in
Halifax, Nova Scotia, (ii) a loan with an unpaid principal balance of $6.6
million which was secured by a 43,205 square foot office building in Dayton,
Ohio, and (iii) a loan with an unpaid principal balance of $3.9 million which
was secured by a 223,355 square foot shopping center located in Havre, Montana.
For additional information regarding the properties acquired by the Company
through these foreclosures, see "Investment in Real Estate" below.
The acquisition cost for a pool of discount loans is allocated to each
individual loan within the pool based upon the Company's pricing methodology.
The discount which is associated with commercial real estate loans which are
current, and which the Company believes will remain current, is accreted into
interest income as a yield adjustment using the interest method over the
contractual maturity of the loan. For all other loans interest is earned as cash
is received. Gains on the repayment and discharge of loans are reported as
interest income on discount loans. Upon receipt of title to property securing a
discount loan, the loans are transferred to investment real estate.
37
<PAGE>
INVESTMENT IN REAL ESTATE. The Company's real estate investment
approach had sought value creation opportunities that can be realized through
increased management focus and capital investment. The Company generally has
sought underperforming properties that can be acquired and renovated at
discounts to replacement cost. In evaluating opportunities, the Company has
focused on a series of key investment criteria. These include analysis of the
level of proposed new supply and development constraints in the markets where it
is considering investing. An underlying premise of the Company's real estate
investment philosophy has been that, while demand for real estate has remained
relatively constant over time, sudden and dramatic increases in supply have
driven boom and bust real estate cycles.
At December 31, 1998, the Company's investments in real estate
consisted of eight properties which had an aggregate carrying value of $208.1
million. A total of four of the properties currently owned by the Company with
an aggregate carrying value of approximately $143.8 million are located in San
Francisco, California. Three of these properties are located in the financial
district of San Francisco, and one property is located in the adjacent civic
center district of San Francisco. The Company believes that the office market in
San Francisco, particularly the financial district, satisfies its general real
estate investment philosophy because in management's view it is characterized by
limited new supply and significant barriers to entry. Low vacancy rates, coupled
with lack of new construction, currently are increasing rental rates. Government
regulation of development in conjunction with local construction costs and a
lack of developable land provide significant barriers to entry to this area. The
Company believes that its investments in real estate in San Francisco are well
located and benefit from their proximity to the majority of the city's office,
retail and hotel accommodations.
The Company's earthquake insurance relating to its four properties in
San Francisco, is in the aggregate amount of $50 million, which is the probable
maximum loss estimated to be sustained in the event the most powerful earthquake
recorded in California were to occur at the properties, as determined by an
independent structural engineer. In the event of such probable maximum loss of
$50 million, such damage would be insured, less a deductible of approximately
$12.8 million. In the event of a more catastrophic earthquake or damages in
excess of $50 million, the Company would not be insured for such losses.
The Company's net investment in real estate increased to $208.1 million
at December 31, 1998 from $45.4 million at December 31, 1997 and is comprised of
the following properties:
<TABLE>
<CAPTION>
Book Value at
Date December 31,
Acquired Property Location Square Feet Property Type 1998
--------- ----------------------- -------------------- ----------- ------------- -------------
(Dollars In Thousands)
<S> <C> <C> <C> <C> <C> <C>
04/08/98 225 Bush Street........ San Francisco, CA 570,637 Office Bldg. $ 104,884
09/23/97 450 Sansome Street..... San Francisco, CA 130,437 Office Bldg. 18,018
01/23/98 690 Market Street...... San Francisco, CA 124,692 Office Bldg. 14,038
09/03/97 10 U.N. Plaza.......... San Francisco, CA 71,636 Office Bldg. 9,431
07/22/98 841 Prudential Drive... Jacksonville, FL 488,080 Office Bldg. 32,827
11/10/97 Cortez Plaza........... Bradenton, FL 289,686 Shopping Ctr. 19,319
04/09/98 7075 Bayers Road....... Halifax, Nova Scotia 402,529 Shopping Ctr. 11,514
10/01/98 Holiday Village........ Havre, MT 223,355 Shopping Ctr. 1,791
Accumulated depreciation
and amortization (3,763)
-------------
$ 208,059
=============
</TABLE>
Set forth below is a brief description of each of the Company's
investments in real estate at December 31, 1998.
225 BUSH STREET. In April 1998, the Company acquired an existing
570,637 square foot, 22-story, Class A office building located at 225 Bush
Street in the financial district of San Francisco, California for $100.2
million. Bush Street was originally constructed in 1923, expanded in 1994 and
brought up to 1992 building code seismic standards during 1992-94. Originally
built as the world headquarters of Chevron of USA, Inc. ("Chevron"), it was sold
in 1994 as Chevron sought to relocate its executive offices. The Company is
projecting to make an additional investment of approximately $17.0 million to
make tenant improvements and pay leasing commissions and to upgrade mechanical,
HVAC, and electrical systems, fire life/safety systems under the Americans with
Disabilities Act of 1990 (the "ADA"), as well as upgrades and improvements to
the ground floor retail and annex entrance lobby.
38
<PAGE>
Approximately $7.5 million is budgeted for 1999. As of December 31, 1998, the
Bush Street Property was 96% leased.
450 SANSOME STREET. In September 1997, the Company acquired a 130,437
square foot, 16-story, Class B office building located at 450 Sansome Street in
the financial district of San Francisco, California. The Company purchased this
property for $17.2 million. The building was 77% leased as of December 31, 1998.
The property was built in 1967 and upgraded in certain respects in 1989 and
1990. The property was acquired from a lender who had taken title through
foreclosure. As a result, average rent per square foot amounted to approximately
$18.00 at the date of acquisition. During the next five years, leases on 86% of
the space in the property expire. The Company plans to invest approximately $7.3
million in this property in various renovations including the entrance lobby,
elevator cabs, bathrooms, hallways, certain building systems and compliance with
the ADA as well as tenant improvements and pay leasing commissions.
Approximately $4.0 million is budgeted for 1999. Two new leases totaling
approximately 12,800 square feet were executed in December 1998 and will result
in an increased occupancy level to 87% by April 1999.
690 MARKET STREET. In January 1998, the Company acquired a 124,692
square foot, 16-story, Class C office building located at 690 Market Street in
the financial district of San Francisco, California. The property was purchased
for $13.7 million. The property was originally constructed in 1888 and has
undergone numerous renovations. At the date of acquisition, approximately 41% of
the building was available for releasing by the end of 1998, of which existing
rents averaged $14.06 per square foot. The Company has recently executed nine
new leases totaling approximately 13,800 square feet, which increased building
occupancy to 82% as of December 31, 1998. The Company is investing approximately
$6.0 million in structural upgrades, a sprinkler system and ADA upgrades,
deferred maintenance, tenant improvements and leasing commissions. Approximately
$5.0 million is budgeted for 1999
10 UNITED NATIONS PLAZA. In September 1997, the Company acquired a
71,636 square foot, six-story, Class B office building located at 10 United
Nations Plaza in the civic center district of San Francisco. The Company
purchased this property, which was built in 1982, for $9.1 million. At the date
of acquisition, the property was substantially leased and the average rent per
square foot was $13.76. The building was 9% leased as of December 31, 1998, and
was approximately 49% leased as of March 15, 1999, which is consistent with the
acquisition strategy to re-tenant the building. The property is currently being
marketed for lease to tenants with full floor or full building space
requirements. The Company is investing approximately $3.6 million in this
property to fund cosmetic improvements to enhance the lobby and hallways,
install ADA upgrades, fund deferred maintenance and tenant improvements and pay
leasing commissions. Approximately $3.4 million is budgeted for 1999.
PRUDENTIAL BUILDING. On July 22, 1998, the Company purchased the
Prudential Building, a 488,080 square foot, 22 story office building located in
the central business district of Jacksonville, Florida for an aggregate purchase
price of $36.0 million, plus closing costs. The purchase price was funded with
cash on hand and advances from a line of credit. Simultaneously with this
closing, the Company also leased 98% of the building back to the Prudential
Insurance Co. of America, and sold two adjacent parking areas to a neighboring
hospital for approximately $4.1 million. The Prudential lease has a term of four
years with options to vacate the premises during the term of the lease, as well
as three subsequent five-year extension options. The Company also entered into
an agreement with the hospital pursuant to which the hospital is to lease up to
150,000 square feet in the Prudential Building for a nine-year period should
Prudential exercise its termination option.
CORTEZ PLAZA. In November 1997, the Company purchased Cortez Plaza, a
289,686 square foot shopping center located in Bradenton, Florida, a suburb of
Tampa. The Company purchased this property, which was built in 1956 and
renovated in 1988, for $18.4 million. In a separate transaction, the fee simple
title to a large portion of the shopping center that had been subject to a
ground lease was purchased simultaneously for $0.7 million, which resulted in a
total investment in this property of $19.3 million. By simultaneously acquiring
fee simple title to a ground lease that encumbered a large part of the shopping
center's parking lot, the Company believes that it immediately improved the
value and marketability of the project. As of December 31, 1998, the shopping
center was 97% leased with national and regional tenants, including Publix,
PetSmart, Circuit City, Montgomery Ward (which currently is in bankruptcy but
paying rent) and BankAmerica, comprising 70.5% of the leaseable area. Below
market leases covering approximately 15% of the center expire during 1999 and
2000.
BAYER'S ROAD SHOPPING CENTRE. In April 1998, the Company acquired the
Bayers Road Shopping Centre, which is located at 7075 Bayers Road in Halifax,
Nova Scotia. The property was acquired by foreclosure on the loans secured by
the property, which was acquired by the Company at a discount in September 1997.
The property contains 402,529 square feet of space, which consists primarily of
retail space but also includes some office space and storage space. The original
buildings were built in 1956 and were enclosed and expanded in several phases
between 1971 and 1987. Major tenants of the property currently consist of
Zellers, Lawton's and Mark's Work Warehouse. The property was approximately 81%
39
<PAGE>
leased at December 31, 1998. The Company currently is implementing an operating
plan to establish the second level as a strong community shopping center
anchored with both national and regional value-oriented retailers, while filling
the lower level with service providers, discount retailers and entertainment
uses. The upper level would remain office space. Additional capital required for
the redevelopment and budgeted for 1999 totals $10.8 million.
HOLIDAY VILLAGE SHOPPING CENTRE. In October 1998, the Company acquired
the Holiday Village Shopping Centre, which is located at 1753 Highway 2 West in
Havre, Montana. The property was acquired by foreclosure on the loan secured by
the property, which was acquired by the Company at a discount in November 1997.
The property contains 223,355 square feet of retail space. The original building
was built in 1978. Ownership of the property may be subject to two ground
leases, the status of which is currently being litigated. The major tenant at
the property currently is Herberger's. The property was approximately 47% leased
at December 31, 1998. The Company currently is developing a leasing plan to
stabilize the property that will include leasing one of the anchor vacant space
to a national or regional anchor tenant and lease the balance of the in-line
space to local and regional tenants.
The following table sets forth the cost of improvements for each
investment in real estate through December 31, 1998.
<TABLE>
<CAPTION>
Budgeted Actual Book Rents due
Initial Cost of Cost of Value at and accrued Total
Cost to Improvements Improvements Impairment December 31, Accumulated at end of Rental
Property Company for 1999 to Date Writedown Sales 1998 Depreciation period Income
- -------------------- ------- ------------ ------------ ---------- --------- ----------- ------------ ----------- ------
(Dollars In Thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
225 Bush Street..... $101,632 $ 7,536 $ 3,252 $ $ $104,884 $ 1,594 $ 982 $ 7,866
450 Sansome Street.. 17,205 3,988 813 18,018 472 168 2,316
690 Market Street... 13,707 5,014 331 14,038 265 31 1,985
10 U.N. Plaza....... 9,080 3,414 351 9,431 246 6 1,036
841 Prudential Dr... 32,827 484 -- 32,827 380 291 3,689
Cortez Plaza........ 19,244 1,354 75 19,319 524 449 2,935
7075 Bayers Road.... 15,219 10,782 197 (3,902) 11,514 274 147 2,689
Holiday Village..... 1,791 -- -- 1,791 8 45 186
Park Center I....... 1,534 -- -- (1,534) -- -- -- --
-------- -------- -------- -------- -------- -------- ---------- -------- --------
Total............ $212,239 $ 32,572 $ 5,019 $ (3,902) $ (1,534) $211,822 $ 3,763 $ 2,119 $ 22,702
======== ======== ======== ======== ======== ======== ========== ======== ========
</TABLE>
The following table sets forth a summary schedule of the total lease
expirations for the Company's investments in real estate for leases in place as
of December 31, 1998, assuming that none of the tenants exercise renewal options
or termination rights, if any, at or prior to the scheduled expirations.
<TABLE>
<CAPTION>
Percentage of Average Base
Aggregate Annualized Rent per Percentage of
Number of Sq. Ft. Portfolio Base Rent of Sq. Ft. Aggregate
Year of Lease Leases of Expiring Leased Expiring Expiring Portfolio
Expiration(1) Expiring Leases Sq. Ft. Leases(2) Leases(3) Base Rent
------------- -------- -------------- ------------- ----------- ------------ ----------------
<S> <C> <C> <C> <C> <C> <C>
1999 78 251,069 14.27% $ 3,985,174 15.87 14.05%
2000 41 141,298 8.03 2,375,084 16.81 8.37
2001 47 118,420 6.73 2,163,758 18.27 7.63
2002 44 587,407 33.38 9,234,379 15.72 32.56
2003 18 34,973 1.99 770,985 22.05 2.72
2004 5 70,697 4.02 1,785,673 25.26 6.30
2005 4 29,120 1.65 209,195 7.18 0.74
2006 7 108,902 6.19 660,449 6.06 2.33
2007 5 116,019 6.59 2,283,263 19.68 8.05
2008 7 142,122 8.08 3,109,179 21.88 10.96
2009 & beyond 6 159,573 9.07 1,782,696 11.17 6.29
----- ---------- -------- ----------- -------
262 1,759,600 100.00% $28,359,835 100.00%
===== ========== ======== =========== =======
</TABLE>
(1) Lease year runs from January 1 to December 31 for all properties.
(2) Base rent is calculated based on the amount of rent
scheduled from January 1 of the listed year to the lease expiration.
(3) Average base rent per square foot is calculated using the annualized
base rent divided by the square footage.
40
<PAGE>
Noncancelable operating leases with tenants expire on various dates
through 2028. The future minimum rental income (base rent) to be received under
leases existing as of December 31, 1998, are as follows:
(Dollars In Thousands)
1999..................................... $ 25,230
2000..................................... 23,791
2001..................................... 21,464
2002..................................... 19,143
2003..................................... 15,074
Thereafter............................... 47,246
---------
Total $ 151,948
=========
SIGNIFICANT PROPERTIES. Set forth below is additional information with
respect to the Bush Street Property and the Prudential Building, which were
deemed "significant" under Commission requirements as of December 31, 1998.
BUSH STREET PROPERTY; DEPRECIATION. For federal income tax purposes,
the basis, net of accumulated depreciation, of the Bush Street Property
aggregated approximately $103.4 million at December 31, 1998. The real property
associated with the Bush Street Property (other than land) generally will be
depreciated for federal income tax purposes over 39 years using the straight
line method. For financial reporting purposes, the Bush Street Property is
recorded at its historical cost and is depreciated using the straight line
method over its estimated useful life, which is estimated to be 39 years.
BUSH STREET PROPERTY; REAL ESTATE TAXES. The 1998 annual real estate
taxes on the Bush Street Property are estimated to be approximately $1.2
million. The city of San Francisco real estate tax is 1.19% of assessed value.
BUSH STREET PROPERTY; OCCUPANCY. At December 31, 1998, the Bush Street
Property was leased to 33 tenants which are engaged in a variety of businesses,
including oil, law, technology, engineering, publication, consulting and
philanthropy. The following table sets forth information relating to occupancy
of and net effective rent for the Bush Street Property for the periods
indicated.
Average Occupancy*
-----------------------------------------------------------
1998 1997 1996 1995
----- ------ ------ ------
97% 94% 78% 82%
Net Effective Rent per Square Foot*
-----------------------------------------------------------
1998 1997 1996 1995
------ ------ ------ ------
$20.18 $16.35 $16.17 $*
* Data is not available for periods prior to 1995 or as indicated.
BUSH STREET PROPERTY; LEASE EXPIRATIONS. The following table sets forth
a summary schedule of the total lease expirations for the Bush Street Property
for leases in place as of December 31, 1998, assuming that none of the tenants
exercise renewal options or termination rights, if any, at or prior to the
scheduled expirations.
<TABLE>
<CAPTION>
Year of Lease 2009 &
Expiration 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Beyond
---------------- --------- --------- ------- ------- ------- ------- ------ ------ --------- --------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
No. of leases
Expiring.......... 9 7 8 7 2 2 1 1 4 3 2
Square footage of
Expiring leases... 129,711 63,036 21,416 28,994 4,204 45,996 1,574 2,210 88,519 78,956 23,942
Percent of total
Leased square feet. 26.55 12.90 4.38 5.93 0.86 9.41 0.32 0.45 18.12 16.16 4.90
Annualized rent of
Expiring leases... 2,550,710 1,088,351 460,580 457,677 136,838 909,120 47,220 44,752 2,028,888 2,600,798 742,144
Percent of total
Annualized rent... 23.05 9.83 4.16 4.14 1.24 8.21 0.43 0.40 18.33 23.50 6.71
Annualized rent per
square foot of
Expiring leases... 19.66 17.27 21.51 15.79 32.55 19.77 30.00 20.25 22.92 32.94 31.00
</TABLE>
41
<PAGE>
At December 31, 1998, the only tenant of the Bush Street Property which
occupied 10% or more of the rentable square footage in the building was Chevron,
which is engaged in the oil business. Chevron leases 133,358 rentable square
feet on nine floors. Chevron has subleased all of its space except for three
floors totaling 63,031 square feet. Of the 63,031 square feet that Chevron
occupies, the leases on 45,674 square feet expire in June 1999. Management is in
negotiations with Chevron to extend those leases. The lease on the remaining
space comprising 17,347 square feet on the 22nd floor expires in June 2000.
Space sub-leased by Chevron totals 70,337 square feet. These sub-leases extend
beyond Chevron's term (at the end of which they will become direct leases with
the Company), and have varying terms, as reflected in the lease expiration
schedule.
PRUDENTIAL BUILDING; DEPRECIATION. For federal income tax purposes, the
basis, net of accumulated depreciation, of the Prudential Building aggregated
approximately $32.4 million at December 31, 1998. The real property associated
with the Prudential Building (other than land) generally will be depreciated for
federal income tax purposes over 39 years using the straight-line method. For
financial reporting purposes, the Prudential Building is recorded at its
historical cost and is depreciated using the straight-line method over its
estimated useful life, which is estimated to be 39 years.
PRUDENTIAL BUILDING; REAL ESTATE TAXES. The 1998 annual real estate
taxes paid on the Prudential Building were approximately $588,772. The Duval
county real estate tax is 1.92 percent of assessed value.
PRUDENTIAL BUILDING; OCCUPANCY. At December 31, 1998, the Prudential
Building was leased to five tenants engaged in insurance and food services.
Information about the occupancy rate and the average effective annual rental per
square foot for the Prudential Building for the last five years is not
meaningful because the building was substantially occupied by its owner,
Prudential Insurance Company of America ("Prudential"), during this period.
PRUDENTIAL BUILDING; LEASE EXPIRATIONS. The following table sets forth
a summary schedule of the total lease expirations for the Prudential Building
for leases in place as of December 31, 1998, assuming that none of the tenants
exercise renewal options or termination rights, if any, at or prior to the
scheduled expirations.
<TABLE>
<CAPTION>
Year of Lease 2009 &
Expiration 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Beyond
----------------------- ------ ------- ------- ---------- ---- ---- ---- ---- ---- ---- ------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
No. of leases
Expiring............. 1 2 1 1 -- -- -- -- -- -- ---
Square footage of
Expiring Leases...... -- 3,022 2,832 474,570 -- -- -- -- --- -- ---
Percent of total
leased square feet... -- 0.63% 0.59% 98.78% -- -- -- -- -- -- ---
Annualized rent of
Expiring leases...... $3,900 $39,041 $43,324 $7,555,154 -- -- -- -- -- -- ---
Percent of total
Annualized rent...... 0.05% 0.51% 0.57% 98.87% -- -- -- -- -- -- ---
Annualized rent per
square foot of
expiring leases...... $ -- $ 12.92 $ 15.30 $ 15.92 -- -- -- -- -- -- ---
</TABLE>
At December 31, 1998, the only tenant of the Prudential Building which
occupied 10% or more of the rentable square footage in the building was
Prudential, which is engaged in the insurance business. Prudential leases
474,570 rentable square feet on 22 floors. The other two minor leases, totaling
5,749 square feet, provide support services for Prudential. As noted above, the
Company has entered into an agreement with a local hospital pursuant to which
the hospital is to lease up to 150,000 square feet in the Prudential Building
for a nine-year period should Prudential exercise its termination option.
INDEBTEDNESS-GENERAL. The Company's investments in real estate,
subordinate and residual interests in mortgage-related securities and other
assets, such as single family residential loans, generally depend upon
short-term borrowings such as repurchase agreements and warehouse
facilities/lines of credit with financial institutions or institutional lenders
to finance the Company's acquisition of such assets on a short-term basis in the
case of repurchase agreements and on a one to three-year basis in the case of
warehouse facilities/lines of credit. There can be no assurance that such
financing will continue to be available on terms reasonably satisfactory to the
Company. The inability of the Company to arrange additional borrowings such as
repurchase agreements and warehouse facilities/lines of credit or to repay,
extend or replace existing borrowings when they expire would have a material
adverse
42
<PAGE>
effect on the Company's business, financial condition and results of operations
and on the Company's outstanding securities.
SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE. Securities sold under
agreements to repurchase were $138.6 million at December 31, 1998. These
obligations are secured by certain of the Company's investments in subordinated
interests in commercial mortgage-backed securities, residual interests in
subprime residential loan securitizations, and U.K. mortgage loan residual
securities.
OBLIGATIONS OUTSTANDING UNDER LINES OF CREDIT. Obligations outstanding
under lines of credit amounted to $34.5 million at December 31, 1998. The
borrowings are comprised of $34.5 million pursuant to a three year agreement,
which is collateralized by commercial loans.
OBLIGATIONS OUTSTANDING UNDER LINES OF CREDIT - REAL ESTATE.
Obligations outstanding under lines of credit secured by real estate amounted to
$142.6 million at December 31, 1998. These borrowings have a three-year term and
an interest rate that floats in accordance with LIBOR.
MINORITY INTEREST. At December 31, 1998, minority interest totaled
$23.9 million and represented OCN's ownership through IMIHC of 1,808,733 units
in the Operating Partnership. On May 7, 1998, the Company sold 1,473,733 units
in the Operating Partnership to IMIHC for $24.5 million. On February 17, 1998,
the Company sold 175,000 shares of common stock for cash in an aggregate amount
of approximately $3.1 million to certain officers and directors of the Company
and OCN. In connection with this stock issuance, IMIHC sold a like number of
shares of Common Stock to the Company and invested in a like number of units in
the Operating Partnership in order to comply with the stock ownership
restrictions imposed on REITs under the Code. See "Note 1 to the Consolidated
Financial Statements" under Item 8.
SHAREHOLDERS' EQUITY. Shareholders' equity decreased by $50.1 million
from December 31, 1997 to December 31, 1998. The decrease was due to a net loss
of $58.2 million, a cumulative currency translation adjustment of $1.9 million
and $22.4 million in cash dividends paid during 1998, which were offset in part
by a $14.0 million capital contribution in connection with the sale of the IO
Portfolio and an $18.4 million increase in unrealized gain on securities
available for sale. Shareholders' equity increased to $271.3 million from May
14, 1997 to December 31, 1997 as a result of the net proceeds from the Initial
Public Offering in May 1997 and net income of $11.8 million during the period,
which were offset in part by the change in unrealized losses on securities
available for sale of $7.3 million, the repurchase of 160,000 shares of Common
Stock (the effect of which was offset by a concurrent issuance of limited
partnership units in the Operating Partnership) for $3.0 million and dividends
declared on the Common Stock of $13.9 million. See the Consolidated Statement of
Changes in Shareholders' Equity in the Consolidated Financial Statements under
Item 8.
CAPITAL RESOURCES AND LIQUIDITY
Liquidity is a measurement of the Company's ability to meet potential
cash requirements, including ongoing commitments to repay borrowings, fund
investments, engage in loan acquisition and lending activities, and for other
general business purposes. Additionally, to maintain its status as a REIT under
the Code, the Company must distribute annually at least 95% of its taxable
income. The primary sources of funds for liquidity during 1998 consisted of
reverse repurchase agreements, proceeds from issuance of the Redeemable Notes,
other secured borrowings, maturities and principal payments on loans and
securities, proceeds from the sale of Operating Partnership units to IMIHC, and
proceeds from the securitization of a portion of the residential loan portfolio.
The Company's operating activities provided cash flows of $67.8 million
in 1998. The Company's investing activities used cash flows of $694.5 million
during 1998. During 1998, cash flows from investing activities were used
primarily to purchase securities available for sale, originate or purchase
loans, and purchase commercial real estate. The Company's financing activities
provided cash flows of $632.9 million during 1998 and primarily consisted of
proceeds from lines of credit and repurchase agreements of $315.6 million,
proceeds from the issuance of the Redeemable Notes of $150.0 million, and
proceeds from the securitization of the Company's residential loan portfolio of
$173.9 million.
At December 31, 1998, OAC's total closed transactions since the Initial
Public Offering, net of repayments, were $870.5 million. Of this amount, $811.8
million has been funded and the remaining $58.7 million is to be funded over the
construction and renovation periods, which range from two to 18 months. In
addition, for 1999, the Company has budgeted $32.6 million of capital
expenditures on its investments in real estate in order to reposition such
properties in the market.
Based on its monthly interest and other expenses, monthly cash
receipts, existing commitments, capital expenditure plans
43
<PAGE>
and rate of collateral calls through January 31, 1999, the Company believes that
its existing sources of funds will be adequate for purposes of meeting its
short-term (one-year or less) and long-term liquidity needs. However, there can
be no assurance that this will be the case. Material increases in monthly
interest expense or in collateral calls, or material decreases in monthly cash
receipts, generally would negatively impact the Company's liquidity. On the
other hand, material decreases in monthly interest expense or in collateral
calls generally would positively affect the Company's liquidity.
OTHER TRENDS AND CONTINGENCIES
Fluctuations in interest rates will continue to impact the Company's
net interest income to the extent the Company's fixed rate assets are funded by
variable rate debt or the Company's variable rate assets reprice on a different
schedule, or in relation to a different index than its floating rate debt. At
December 31, 1998, the Company had interest rate swap agreements with a notional
amount of $200.8 million and a fair value of ($4.1) million in order to limit
partially the adverse effects of rising interest rates on the remaining
floating-rate debt. For a tabular presentation of these agreements and other
information, see Note 4 to the Consolidated Financial Statements under Item 8.
When the Company's swap agreements expire, the Company will have interest rate
risk to the extent interest rates increase on any floating-rate borrowings
unless the swaps are replaced or other steps are taken to mitigate this risk.
The flexibility in the Company's leverage is dependent upon, among
other things, the value of unencumbered assets, which are inherently linked to
prevailing interest rates and changes in the credit of the underlying assets. At
December 31, 1998, the Company had unencumbered residential loans and securities
having a fair value totaling approximately $68.9 million ($35.5 million of
subordinate and residual mortgage-backed securities, $25.4 million of commercial
mortgage-backed securities, and $8.0 million of residential loans). At January
31, 1999, the Company had unencumbered residential loans and securities having a
fair value totaling approximately $53.3 million ($33.1 million of subordinate
and residual mortgage-backed securities, $12.7 million of commercial
mortgage-backed securities, and $7.5 million of residential loans).
In certain circumstances, including, among other things, increases in
interest rates, changes in market spreads, or decreases in credit quality of
underlying assets, the Company would be required to provide additional
collateral in connection with its short-term, floating-rate borrowing
facilities. During the fourth quarter of 1998, the Company was required to and
did fund requests for additional collateral calls on outstanding repurchase
agreements collateralized by securities available for sale which aggregated
$13.7 million, $0.8 million and $3.4 million in October, November and December,
respectively. In October 1998, the Company funded requests for additional margin
deposits in connection with it swaps positions that aggregated $3.3 million. No
additional deposits were made in November 1998, and the Company pulled back
margin deposits in connection with its swaps and future positions of $2.5
million in December 1998.
During January 1999, the Company funded requests for additional
collateral calls on outstanding repurchase agreements collateralized by
securities available for sale in the amount of $2.1 million. No additional
deposits were made in January 1999 in connection with its existing swaps and
future positions.
At December 31, 1998, the Company had total consolidated indebtedness
of $622.0 million, of which all but $143.0 million of outstanding Redeemable
Notes was secured indebtedness, as well as $21.2 million of other liabilities.
This consolidated indebtedness consisted of: (i) $138.6 million of repurchase
agreements, of which $90.8 million was scheduled to mature in one year; (ii)
lines of credit aggregating $177.0 million, which mature in 2001 (subject to
extension by the Company under certain conditions until 2002) and are secured by
real estate, loans and/or securities; (iii) $143.0 million of outstanding
Redeemable Notes, which mature in 2005; and (iv) $163.4 million of match funded
indebtedness which is secured by $173.6 million of match funded residential
loans, net, which was incurred in November 1998 as a result of the
securitization of 1,808 first and second single family residential mortgage
loans and the retention by the Company of an approximately $10.1 million
non-investment grade equity security in the special purpose entity which was
established to effect the securitization. See Note 7 to the Consolidated
Financial Statement under Item 8.
Mortgage-related securities which are subject to repurchase agreements,
as well as loans and real estate which secure other indebtedness, periodically
are revalued by the lender, and a decline in such value may result in the lender
requiring the Company to provide additional collateral to secure the
indebtedness. Although to date the Company has had adequate cash, cash
equivalents and other unencumbered assets to meet calls for additional
collateral, to repay a portion of the related indebtedness, or to meet its other
operating and financing requirements, including its current capital expenditure
plans, there can be no assurance that sufficient levels of such assets will
continue to be available.
44
<PAGE>
The Company's recent decision to discontinue future investment
activities effectively means that the Company's future profitability, and its
ability to meet its indebtedness obligations, will be dependent on its existing
assets. Circumstances which result in decreased income from the Company's
assets, including without limitation market and economic conditions which
adversely affect leasing income from the Company's investments in real estate,
payments on its loans, and yield on its securities, could adversely affect the
ability of the Company to meet its indebtedness obligations, as could market and
economic conditions which increase the cost of the Company's variable rate or
short-term liabilities, as noted above.
If the Company is unable to fund additional collateral needs or to
repay, renew or replace maturing indebtedness on terms reasonably satisfactory,
the Company would be required to sell, under adverse market conditions, a
portion of its assets, and could incur losses as a result. Furthermore, an
extremely limited market for subordinate and residual interests in
mortgage-related securities currently exists and there can be no assurance that
a liquid market for such securities will fully develop. Therefore, the Company's
ability to dispose of such securities promptly in such situations may be
limited.
The indenture under which the Redeemable Notes were issued (the
"Indenture") prohibits the Company from incurring or issuing debt, other than
certain permitted indebtedness ("Permitted Indebtedness"), if certain financial
tests are not satisfied. One such test requires that the ratio of adjusted FFO
to adjusted fixed charges for the previous four fiscal quarters exceeds 1.25 to
1.00. Given that FFO for 1998 was $(41.2) million, reflecting write-downs of the
securities available for sale portfolio of $79.7 million predominantly in the
second half of the year, the Company does not expect this financial test to be
satisfied during 1999. Permitted Indebtedness, the incurrence of which is not
limited under the Indenture, includes: (i) up to $150 million of debt that may
be incurred under certain warehouse lines of credit or mortgage loan repurchase
agreements; (ii) match funded debt that may be incurred by a special purpose,
bankruptcy remote subsidiary of the Company; (iii) renewals or refinancings of
existing debt structured to meet certain conditions; (iv) debt that may be
incurred in hedge transactions; (v) up to $10 million of capital lease and
purchase money financing; and (vi) up to $50 million of additional debt. The
Company believes that it can meet it financing needs from sources of Permitted
Indebtedness during 1999, although there can be no assurance that this will be
the case.
In addition to payment and, in the case of the Company's secured
indebtedness, collateralization requirements, the Company is subject to various
other covenants in the agreements evidencing its indebtedness, including the
maintenance of specified amounts of equity. At December 31, 1998 and at January
31, 1999, the Company was in compliance with all obligations under the
agreements evidencing its indebtedness with respect to the Company's equity and
the Operating Partnership's equity, as defined in the applicable agreement.
There can be no assurance that additional operating losses will not result in
the Company's violation of its financial and non-financial covenants in the
future. In the event of a default in such covenants, the lender generally would
be able to accelerate repayment of the indebtedness and pursue other available
remedies, which could result in defaults on other indebtedness of the Company,
unless the applicable lender or lenders allowed the Company to remain in
violation of the agreements. Were a default to be declared, the Company would
not be able to continue to operate without the consent of its lenders. The
Company currently is considering various alternatives to enhance its ability to
meet its payment and other obligations under its indebtedness and the funding
requirements discussed above, including the sale of certain assets and the
potential tax and other consequences associated therewith. There can be no
assurance that the Company will have sufficient liquidity to meet these
obligations on a short-term or long-term basis.
YEAR 2000 DATE CONVERSION
As the year 2000 approaches, a critical business issue has emerged
regarding how existing application software programs and operating systems can
accommodate this date value. Many existing application software products in the
marketplace were designed to accommodate only two-digit date entries. Beginning
in the year 2000, these systems and products will need to be able to accept
four-digit entries to distinguish years beginning with 2000 from prior years. As
a result, computer systems and software used by many companies may need to be
upgraded to comply with such Year 2000 requirements.
The Company is dependent upon data processing systems and software to
conduct its business. The data processing systems and software include those
developed, purchased and maintained by OCC, as well as OCN and its other
subsidiaries, which provide management services to the Company. The Company does
not own nor maintain computer equipment or software.
OCN has established a project plan to achieve Year 2000 readiness of
its mission critical and non-mission critical systems, including hardware
infrastructure and software applications. The project plan is divided into six
phases: identification, evaluation, remediation, validation, risk assessment and
contingency planning. As of December 31, 1998, OCN had substantially completed
the systems identification, evaluation, remediation, and validation phases of
the project.
45
<PAGE>
As part of the idenitifcation and evaluation phases of the project, the
Company has documented critical operating functions within each business unit,
as well as strategic third-party and vendor relationships. OCN has retained a
business continuity expert to prepare contingency plans and assist with the
testing and validation of these plans. OCN expects to complete its Year 2000
risks assessment and contingency planning efforts during the first half of 1999.
The cost of OCN's Year 2000 project, which is budgeted at $2.0 million, will be
borne by OCN. The Company does not expect to incur any costs in connection with
achieving Year 2000 compliance. Until the risk assessment phase is completed,
the Company will not know the complete extent of the risks associated with Year
2000 issues, including an analysis of the most reasonable likely worst case Year
2000 scenario, nor can the Company prepare a contingency plan. As a result,
neither is ready at this time.
FUNDS FROM OPERATIONS
The Company generally considers FFO to be a useful financial
performance measure of the operating performance of a REIT because such measure
does not recognize: (i) depreciation and amortization of real estate assets as
operating expenses, which management believes are not meaningful in evaluating
income-producing real estate because such real estate historically has not
depreciated, and (ii) gains/losses from debt restructuring and sales of
property. In addition, FFO together with net income and cash flow, provides
investors with an additional basis to evaluate the ability of a REIT to incur
and service debt and to fund acquisitions and other capital expenditures. FFO
does not represent cash provided by operating activities in accordance with GAAP
and should not be considered an alternative to net income as an indication of
the results of the Company's performance or to cash flows as a measure of
liquidity. For a discussion of the Company's operating, investing and financing
activities under GAAP, see "-Capital Resources and Liquidity" above. In 1995,
NAREIT established new guidelines clarifying its definition of FFO and requested
that REITs adopt this new definition beginning in 1996. As defined, FFO consists
of net income applicable to common shareholders (computed in accordance with
GAAP) excluding gains (losses) from debt restructuring and sales of property
(including furniture and equipment) plus real estate related depreciation and
amortization (excluding amortization of deferred financing costs) and after
adjustments for unconsolidated partnerships and joint ventures. Since other
REITs may calculate FFO in a different manner, there can be no assurance that
the Company's FFO is comparable with the FFO reported by other entities.
FFO for the year ended December 31, 1998, was $41.1 million compared to
$12.0 million for the period May 14, 1997, to December 31, 1997.
FFO differs from cash made available to holders of the Common Stock,
which is based on the Company's net taxable income. Distributions of dividends
to shareholders amounted to $22.4 million for the year ended December 31, 1998
and $13.9 million for the period May 14, 1997 to December 31, 1997.
The following table reconciles FFO and net income during the periods
indicated.
<TABLE>
<CAPTION>
For the Period
For the May 14, 1997
Year Ended to
December 31, 1998 December 31, 1997
----------------- -----------------
(Dollars in Thousands)
<S> <C> <C>
Net income ................................. $ (58,186) $ 11,792
Depreciation and amortization ........... 3,606 179
Loss on sale of IO portfolio ............ 13,958 --
Loss on sale of property ................ 115 --
Extraordinary gain on repurchase of debt (615) --
--------------- ---------------
FFO ........................................ $ (41,122) $ 11,971
=============== ===============
</TABLE>
INFLATION
Inflation has remained relatively low during the past few years and has
had a minimal impact on the operating performance of the Company's investment in
real estate. Nonetheless, certain of the tenants' leases contain provisions
designed to lessen the
46
<PAGE>
impact of inflation. Such provisions include clauses enabling the Company to
receive percentage rentals based on tenants' gross sales, which generally
increase as prices rise, and/or escalation clauses, which generally increase
rental rates during the terms of the leases. In addition, many of the leases are
for terms of less than ten years, which may enable the Company to replace
existing leases with new leases at higher base and/or percentage rentals if
rents of the existing leases are below the then-existing market rate. Office and
retail space in the properties is generally leased to tenants under lease terms
which provide for the tenants to pay for increases in operating expenses in
excess of specified amounts.
Notwithstanding the foregoing, inflation may have a negative impact on
some of the Company's other operating items. Interest and general and
administrative expenses may be adversely affected by inflation as these
specified costs could increase at a rate higher than rents. Also, for tenant
leases with stated rent increases, inflation may have a negative effect as the
stated rent increases in these leases could be lower than the increase in
inflation at any given time.
REIT STATUS
The Company has qualified and intends to continue to qualify through
calendar 1998 (but not thereafter) as a REIT under Sections 856 through 860 of
Code. Qualification for treatment as a REIT requires the Company to meet certain
criteria, including certain requirements regarding the nature of its ownership,
assets, income, and distributions of taxable income. A REIT generally will not
be subject to federal income taxation on that portion of its income that is
distributed to its shareholders if it distributes at least 95% of its taxable
income and meets certain other income and asset tests. The Company has until the
filing of its tax return to satisfy the distribution requirement. Since the
Company plans to distribute 100% of its taxable income, no provision has been
made for federal income taxes for the Company and its subsidiaries in the
accompanying Consolidated Financial Statements. As taxable income is finalized
and the tax return is filed, an additional distribution may be required which
may be significant. The Company may be subject to tax at normal corporate rates
on net income or capital gains not distributed. For additional information about
an anticipated excise tax liability to be incurred by the Company in connection
with the distribution requirements, See "Recent Developments" under Item 1.
RISK OF LOSS OF INVESTMENT COMPANY ACT EXEMPTION
The Company believes that it is not, and intends to conduct its
operations so as not to become, regulated as an investment company under the
Investment Company Act of 1940, as amended (the "Investment Company Act"). Under
the Investment Company Act, an investment company is required to register with
the Commission and is subject to extensive, restrictive and potentially adverse
regulations. The Investment Company Act exempts entities, however, that are
"primarily engaged in the business of purchasing or otherwise acquiring
mortgages and other liens on and interests in real estate" ("Qualifying
Interests"). Under current interpretations by the staff of the Securities and
Exchange Commission (the "Commission"), qualifying for this exemption requires
the Company, among other things, to maintain at least 55% of its assets in
Qualifying Interests and to maintain an additional 25% in Qualifying Interests
or other real estate-related assets. The Company's investments in real estate
and mortgage loans generally constitute Qualifying Interests, and the Company
believes that subordinate and residual interests in mortgage-related securities
constitute Qualifying Interests when the Company acquires the right to direct
the foreclosure upon any defaulted loan which backs such securities and to take
all other actions that a servicer generally may take in connection with a
defaulted loan.
At December 31, 1998, the Company believes that its Qualifying
Interests, including subordinate and residual interests, comprised over 85% of
the Company's total assets and over 92% when combined with other real-estate
related assets. As a result, the Company believes that it was and is not
required to register as an investment company under the Investment Company Act.
The Company does not intend, however, to seek an exemptive order, no-action
letter or other form of interpretive guidance from the Commission on this
position, and if the Commission were to take a different position, the Company
could be required either (i) to change the manner in which it conducts its
operations in order to avoid investment company registration or (ii) to register
as an investment company, either of which could have a material adverse effect
on the Company and its securities, could subject the Company to monetary
penalties and injunctive relief in an action brought by the Commission, could
cause the Company to be unable to enforce contracts with third parties and could
cause third parties to seek recission of relevant transactions.
47
<PAGE>
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
Market risk is the exposure to loss resulting from changes in interest
rates, foreign currency exchange rates, commodity prices, and equity prices. The
primary market risk to which the Company is exposed is interest rate risk, which
is highly sensitive to many factors, including governmental monetary and tax
policies, domestic and international economic and political considerations, and
other factors beyond the control of the Company. Changes in the general level of
interest rates can affect the Company's net interest income, which is the
difference between the interest income earned on interest-earning assets and the
interest expense incurred in connection with its interest-bearing liabilities,
by affecting the spread between the Company's interest-earning assets and
interest-bearing liabilities. Changes in the level of interest rates also can
affect, among other things, the ability of the Company to originate and acquire
loans, the value of the Company's mortgage-related securities and other
interest-earning assets, and its ability to realize gains from the sale of such
assets.
The Company may utilize a variety of financial instruments, including
interest rate swaps, caps, floors, and other interest rate contracts, in order
to limit the effects of interest rates on its operations. The use of these types
of derivatives to hedge interest-earning assets and/or interest-bearing
liabilities carries certain risks, including the risk that losses on a hedge
position will reduce the funds available for payments to holders of securities
and, indeed, that such losses may exceed the amount invested in such
instruments. A hedge may not perform its intended purpose of offsetting losses
or increased costs. Moreover, with respect to certain of the instruments used as
hedges, the Company is exposed to the risk that the counterparties with which
the Company trades may cease making markets and quoting prices in such
instruments, which may render the Company unable to enter into an offsetting
transaction with respect to an open position. If the Company anticipates that
the income from any such hedging transaction will not be qualifying income for
REIT income test purposes, the Company may conduct part or all of its hedging
activities through a to-be-formed corporate subsidiary that is fully subject to
federal corporate income taxation. The profitability of the Company 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 and net portfolio value should interest rates go up or down (shocked) by
100 to 400 basis points, assuming the yield curves of the rate shocks will be
parallel to each other. Net portfolio value is calculated as the sum of the
value of off-balance sheet instruments and the present value of cash in-flows
generated from interest-earning assets net of cash out-flows in respect of
interest-bearing liabilities. The cash flows associated with the loan portfolios
and securities available for sale are calculated based on prepayment and default
rates that vary by asset. Projected losses, as well as prepayments, are
generated based upon the actual experience with the subject pool, as well as
similar, more seasoned pools. To the extent available, loan characteristics such
as loan-to-value ratio, interest rate, credit history, prepayment penalty term
and product types are used to produce the projected loss and prepayment
assumptions that are included in the cash flow projections of the securities.
When interest rates are shocked, these projected loss and prepayment
assumptions are further adjusted. For example, under current market conditions,
a 100 basis point decline in the market interest rate is estimated to result in
a 200 basis point increase in the prepayment rate of a typical subprime
residential loan. Most commercial and multi-family loans are not subject to
prepayments as a result of prepayment penalties and contractual terms that
prohibit prepayments during specified periods. However, for those commercial and
multi-family loans where prepayments are not currently precluded by contract,
declines in interest rates are associated with steep increases in prepayment
speeds in computing cash flows. A risk premium is then calculated for each
asset, which, when added to the interest rate being modeled, results in a matrix
of discount rates that are applied to the cash flows computed by the model.
Since the net portfolio value consists of both fixed and adjustable components,
an inverse relationship between the market value of the net portfolio and net
interest income is possible. This could happen if more assets reprice during the
first year. In this case, more liabilities would be funded at the new lower
rates over a longer period of time during the year. The base interest rate
scenario assumes interest rates at December 31, 1998. Actual results could
differ significantly from those estimated in the table.
48
<PAGE>
Projected Percentage Change In
================================================================================
Change in Interest Rate Net Interest Income (1) Net Portfolio Value
================================================================================
-400 Basis Points (10.52)% 23.17%
-300 Basis Points (7.89) 16.31
-200 Basis Points (5.26) 10.04
-100 Basis Points (2.63) 3.82
Base Interest Rate 0 0
+100 Basis Points 2.63 (3.70)
+200 Basis Points 5.26 (8.27)
+300 Basis Points 7.89 (12.84)
+400 Basis Points 10.52 (19.90)
(1) Represents the estimated percentage change in net interest income over the
next twelve months, assuming that balances are rolled over and reinvested
at the shocked level of interest rate. For purposes of this calculation,
net interest income includes interest expense associated with the
investments in real estate.
ASSET AND LIABILITY MANAGEMENT
Asset and liability management involves managing the timing and
magnitude of the repricing of assets and liabilities. It is the objective of the
Company to attempt to control risks associated with interest rate movements. In
general, management's strategy is to match asset and liability balances within
maturity categories to limit the Company's exposure to earnings variations and
variations in the value of assets and liabilities as interest rates change over
time.
The Company utilizes a variety of off-balance sheet financing
techniques to assist it in the management of interest rate risk. These
techniques may include interest rate futures and interest rate swaps, pursuant
to which the parties exchange the difference between fixed-rate and
floating-rate interest payments on a specified principal amount (referred to as
the "notional amount") for a specified period without the exchange of the
underlying principal amount. Interest rate swaps are utilized by the Company to
protect against the increase in borrowing cost from floating rate debt or a
short-term, fixed-rate liability, such as reverse repurchase agreements, in an
increasing interest-rate environment. At December 31, 1998, the Company had
entered into interest rate swap agreements with an aggregate notional amount of
$200.8 million. See Note 4 to the Consolidated Financial Statements under Item
8.
Methods for evaluating interest rate risk include an analysis of the
Company's interest rate sensitivity "gap," which is defined as 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. Since 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.
49
<PAGE>
The following table sets forth the estimated maturity or repricing of
the Company's interest-earning assets and interest-bearing liabilities at
December 31, 1998. 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: (i) 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, (ii) fixed-rate
mortgage-related securities reflect estimated prepayments, which were estimated
based on analyses of broker estimates, the results of a prepayment model
utilized by the Company and empirical data, (iii) non-performing discount loans
reflect the estimated timing of resolutions which result in repayment to the
Company, and (iv) fixed-rate loans reflect scheduled contractual amortization,
with no estimated prepayment. Management believes that these assumptions
approximate actual experience and considers them reasonable; however, the
interest rate sensitivity of the Company's assets and liabilities in the table
could vary substantially if different assumptions were used or actual experience
differs from the historical experience on which the assumptions are based.
<TABLE>
<CAPTION>
December 31, 1998
------------------------------------------------------------
More than 1
Within 4 to 12 Year to 3 Years
3 Months Months 3 Years and Over Total
--------- --------- --------- --------- ---------
<S> <C> <C> <C> <C> <C>
Rate-Sensitive Assets: (Dollars In Thousands)
Interest-earning cash and repurchase
Agreements................................. $ 49,880 $ -- $ -- $ -- $ 49,880
Securities available for sale................ 26,215 40,811 81,741 202,387 351,154
Loan portfolio, net (1)...................... 42,355 86,744 59,346 58,506 246,951
Match funded loan agreements................. 2,061 60,778 57,962 52,809 173,610
Discount loan portfolio, net (1)............. -- 5,618 -- -- 5,618
--------- --------- --------- --------- ---------
Total rate-sensitive assets................ 120,511 193,951 199,049 313,702 827,213
--------- --------- --------- --------- ---------
Rate-Sensitive Liabilities:
Securities sold under agreements
to repurchase.............................. 138,612 -- -- -- 138,612
Bonds-match funded loan agreements........... 163,404 -- -- -- 163,404
Obligations outstanding under lines of credit 177,029 -- -- -- 177,029
Notes, debentures and other
interest-bearing obligations............... -- -- -- 143,000 143,000
--------- --------- --------- --------- ---------
Total rate-sensitive liabilities........... 479,045 -- -- 143,000 622,045
Interest rate sensitivity gap before
Off-balance sheet financial instruments.... (358,534) 193,951 199,049 170,702 205,168
Off-Balance Sheet Financial Instruments:
Interest rate swaps.......................... 200,780 -- (92,000) (108,780) --
--------- --------- --------- --------- ---------
Interest rate sensitivity gap.................. (157,754) 193,951 107,049 61,922 $ 205,168
--------- --------- --------- --------- =========
Cumulative interest rate sensitivity gap....... $(157,754) $ 36,197 $ 143,246 $ 205,168
========== ========= ========= =========
Cumulative interest rate sensitivity gap as a
percentage of total rate-sensitive assets.. (19.07%) 4.38% 17.32% 24.80%
</TABLE>
(1) Balances have not been reduced for non-performing loans.
As of December 31, 1998, the cumulative volume of assets maturing or
repricing within one year exceeded liabilities by $36.2 million, or 4.38% of
assets, implying moderate current-year income sensitivity to movements in the
level of interest rates.
50
<PAGE>
ITEM 8. FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
INDEX
Page
----
<S> <C>
Report of Management........................................................................... 52
Report of Independent Certified Public Accountants............................................. 53
Consolidated Statement of Financial Condition at December 31, 1998 and 1997.................... 54
Consolidated Statement of Operations for the Year Ended December 31, 1998 and for the Period
May 14, 1997 to December 31, 1997............................................................ 55
Consolidated Statement of Comprehensive Income (loss) for the year ended December 31, 1998
and for the Period May 14, 1997 to December 31, 1997......................................... 56
Consolidated Statement of Changes in Shareholders' Equity for the Year Ended December 31, 1998
and for the Period May 14, 1997 to December 31, 1997......................................... 57
Consolidated Statement of Cash Flows for the Year Ended December 31, 1998 and for the Period
May 14, 1997 to December 31, 1997............................................................ 58
Notes to Consolidated Financial Statements at December 31, 1998 and 1997....................... 59
</TABLE>
51
<PAGE>
REPORT OF MANAGEMENT
The management of Ocwen Asset Investment Corp. ("Ocwen" or the "Company") is
responsible for the preparation and fair presentation of the financial
statements and other financial information contained in this annual report. The
accompanying consolidated financial statements have been prepared in conformity
with generally accepted accounting principles applied on a consistent basis and
include amounts based on management's best estimates and judgments. Nonfinancial
information included in this annual report has also been prepared by management
and is consistent with the consolidated financial statements. In the opinion of
management, the consolidated financial statements fairly reflect the Company's
financial position, results of operations and cash flows.
To assure that financial information is reliable and assets are safeguarded,
management has established and maintains an effective system of internal
accounting controls and procedures that provide reasonable assurance as to the
integrity and reliability of the consolidated financial statements, the
protection of assets against loss from unauthorized use or disposition and the
prevention and detection of errors and irregularities on a timely basis.
PricewaterhouseCoopers LLP conducts its audit of the consolidated financial
statements in accordance with generally accepted auditing standards. Such
standards include the evaluation of internal accounting controls to establish a
basis for developing the scope of its examination of the consolidated financial
statements. In addition to the use of independent certified public accountants,
Ocwen maintains a professional staff of internal auditors who conduct financial,
procedural and special audits of the Company. To ensure their independence, both
PricewaterhouseCoopers LLP and the internal auditors have direct access to the
Audit Committee of the Board of Directors.
The Audit Committee, which consists solely of independent directors of the
Company, makes recommendations to the Board of Directors concerning the
appointment of the independent certified public accountants and meets with
PricewaterhouseCoopers LLP and the internal auditors to discuss the results of
their audits, the Company's internal accounting controls and financial reporting
matters.
/s/ WILLIAM C. ERBEY /s/ MARK S. ZEIDMAN
-------------------- -------------------
William C. Erbey Mark S. Zeidman
Chairman and Chief Executive Officer Senior Vice President and
Chief Financial Officer
52
<PAGE>
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Board of Directors and Shareholders of Ocwen Asset Investment Corp.
In our opinion, the accompanying consolidated statement of financial condition
and the related consolidated statements of operations, of comprehensive income
(loss), of changes in shareholders' equity and of cash flows present fairly, in
all material respects, the financial position of Ocwen Asset Investment Corp.
(the "Company") and its subsidiaries at December 31, 1998 and 1997 and the
results of their operations and their cash flows for the year ended December 31,
1998, and the period May 14, 1997 to December 31, 1997, in conformity with
generally accepted accounting principles. These financial statements are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with generally accepted auditing
standards which require that we plan and perform the audits to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statement, assessing the accounting
principles used and significant estimates made by management, and evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.
/s/ PRICEWATERHOUSECOOPERS LLP
- ------------------------------
PricewaterhouseCoopers LLP
Fort Lauderdale, Florida
January 28, 1999
53
<PAGE>
<TABLE>
<CAPTION>
OCWEN ASSET INVESTMENT CORP.
CONSOLIDATED STATEMENT OF FINANCIAL CONDITION
December 31, December 31,
1998 1997
------------- -------------
ASSETS:
<S> <C> <C>
Cash and amounts due from depository institutions ..................... $ 3,484,929 $ 331,047
Interest-bearing deposits ............................................. 49,880,276 48,346,076
Securities available for sale, at fair value .......................... 351,153,971 146,026,907
Commercial and multi-family loan portfolio, net ....................... 65,282,965 9,481,436
Residential loan portfolio, net ....................................... 8,058,445 6,350,043
Match funded residential loans, net ................................... 173,609,873 --
Discount loan portfolio, net .......................................... 5,618,022 26,978,888
Investment in real estate, net ........................................ 208,058,721 45,430,039
Principal and interest receivable ..................................... 7,475,795 2,518,272
Deposits on pending asset acquisitions ................................ -- 1,000,000
Other assets .......................................................... 15,702,816 1,540,633
------------- -------------
Total assets ........................................................ $ 888,325,813 $ 288,003,341
============= =============
LIABILITIES:
Securities sold under agreements to repurchase ........................ $ 138,611,824 $ --
Obligations outstanding under line of credit .......................... 34,472,404 --
Obligations outstanding under line of credit - secured by real estate . 142,556,880 --
11.5% Redeemable Notes due 2005 ....................................... 143,000,000 --
Bonds - match funded loan agreement ................................... 163,403,966 --
Dividends and distributions payable ................................... -- 7,458,750
Accrued expenses, payables and other liabilities ...................... 21,190,288 6,344,783
------------- -------------
Total liabilities ................................................... 643,235,362 13,803,533
------------- -------------
Minority interest ........................................................ 23,914,058 2,941,541
------------- -------------
Commitments and Contingencies (Note 15)
SHAREHOLDERS' EQUITY:
Preferred stock, $.01 par value; 25,000,000 shares authorized;
0 shares issued and outstanding ..................................... -- --
Common Stock, $.01 par value; 200,000,000 shares authorized;
18,965,000 shares issued and outstanding ........................... 189,650 189,650
Additional paid-in capital ............................................ 294,492,203 280,503,838
Cumulative dividends declared ......................................... (36,277,546) (13,898,849)
Retained earnings (deficit) ........................................... (46,394,403) 11,791,518
Accumulative other comprehensive income:
Unrealized gain (loss) on securities available for sale ............. 11,038,151 (7,327,890)
Cumulative translation adjustment ................................... (1,871,662) --
------------- -------------
Total other comprehensive income (loss) ........................... 9,166,489 (7,327,890)
------------- -------------
Total shareholders' equity ........................................ 221,176,393 271,258,267
------------- -------------
$ 888,325,813 $ 288,003,341
============= =============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS.
</TABLE>
54
<PAGE>
OCWEN ASSET INVESTMENT CORP.
CONSOLIDATED STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
For the Year Ended For the Period May 14,
December 31, 1997 to
1998 December 31, 1997
------------------ ---------------------
INTEREST INCOME:
<S> <C> <C>
Repurchase agreements and interest bearing deposits $ 1,212,517 $ 5,538,946
Securities held for trading ....................... 106,892 --
Securities available for sale ..................... 43,446,423 6,362,909
Commercial and Multi-family loans ................. 5,736,214 245,147
Match funded residential loans .................... 1,915,071 --
Residential loans ................................. 8,424,325 66,010
Discount loans .................................... 2,116,564 1,248,703
------------------ ------------------
62,958,006 13,461,715
------------------ ------------------
INTEREST EXPENSE:
Securities sold under agreements to repurchase .... 11,682,824 --
Obligations outstanding under lines of credit ..... 6,515,925 --
11.5% Redeemable Notes due 2005 ................... 7,798,597 --
Bonds-match funded loan agreements ................ 1,530,467 --
------------------ ------------------
27,527,813 --
------------------ ------------------
NET INTEREST INCOME BEFORE PROVISION FOR LOAN LOSSES . 35,430,193 13,461,715
Provision for loan losses ......................... 641,677 --
------------------ ------------------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 34,788,516 13,461,715
------------------ ------------------
REAL ESTATE-OPERATING INCOME:
Rental income ..................................... 22,701,796 1,320,090
Other ............................................. 37,801 902,665
------------------ ------------------
22,739,597 2,222,755
------------------ ------------------
REAL ESTATE-OPERATING EXPENSES:
Rental operation .................................. 10,803,153 549,369
Depreciation and amortization ..................... 3,606,490 179,088
Interest .......................................... 7,190,002 --
------------------ ------------------
21,599,645 728,457
------------------ ------------------
REAL ESTATE INCOME, NET .............................. 1,139,952 1,494,298
------------------ ------------------
OTHER EXPENSES:
Management fees ................................... 5,892,468 1,796,311
Due diligence expenses ............................ 1,817,924 326,025
Servicing fees .................................... 2,399,778 --
Foreign currency (gain) loss ...................... (116,953) 568,565
Other ............................................. 3,323,672 464,164
------------------ ------------------
13,316,889 3,155,065
------------------ ------------------
LOSSES ON SECURITIES, DERIVATIVES, AND REAL ESTATE ... (86,267,429) --
------------------ ------------------
(LOSS) INCOME BEFORE MINORITY INTEREST ............... (63,655,850) 11,800,948
Minority interest in net loss (income) of consolidated
subsidiary ....................................... 4,854,884 (9,430)
------------------ ------------------
NET (LOSS) INCOME BEFORE EXTRAORDINARY ITEM ....... (58,800,966) 11,791,518
Extraordinary gain on repurchase of debt ............. 615,047 --
------------------ ------------------
NET (LOSS) INCOME ................................. $ (58,185,919) $ 11,791,518
================== ==================
BASIC (LOSS) EARNINGS PER SHARE:
(Loss) income before extraordinary item ........... $ (3.10) $ 0.62
Extraordinary item ................................ 0.03 --
------------------ ------------------
Net (loss) income ................................. $ (3.07) $ 0.62
================== ==================
DILUTED (LOSS) EARNINGS PER SHARE:
(Loss) income before extraordinary item ........... $ (3.10) $ 0.60
Extraordinary item ................................ 0.03 --
------------------ ------------------
Net (loss) income ................................. $ (3.07) $ 0.60
================== ==================
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS.
</TABLE>
55
<PAGE>
<TABLE>
<CAPTION>
OCWEN ASSET INVESTMENT CORP.
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (LOSS)
For the Year For the Period
Ended May 14, 1997 to
December 31, 1998 December 31, 1997
------------------ ------------------
<S> <C> <C>
Net (loss) income ..................................................... $ (58,185,919) $ 11,791,518
Other comprehensive income:
Unrealized gain (loss) on securities available for sale ............ 8,967,096 (7,327,890)
Unrealized foreign currency translation adjustment ................. (1,871,662) --
Reclassification adjustment for losses included in net income ...... 9,398,945 --
------------------ ------------------
Other comprehensive income ......................................... 16,494,379 (7,327,890)
------------------ ------------------
Comprehensive (loss) income ........................................... $ (41,691,540) $ 4,463,628
================== ==================
Disclosure of reclassification adjustment:
Unrealized holding losses arising during the year on securities sold $ (70,251,978)
Add: Adjustment for losses included in net loss ................... 79,650,923
------------------
Net reclassification adjustment for losses recognized in other
Comprehensive income in prior years .............................. $ 9,398,945
==================
THE ACCOMPANYING NOTES ARE INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS.
</TABLE>
56
<PAGE>
<TABLE>
<CAPTION>
OCWEN ASSET INVESTMENT CORP.
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
FOR THE YEAR ENDED DECEMBER 31, 1998 AND FOR THE PERIOD
MAY 14, 1997 TO DECEMBER 31, 1997
Accumulated
Common Stock Additional Cumulative Retained Other
---------------------------- Paid-in dividends earnings Comprehensive
Shares Amount Capital declared (deficit) Income (loss) Total
------------- ------------- ------------- ------------- ------------- ------------ -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Issuance of common
stock .................. 19,125,000 $ 191,250 $ 283,496,750 $ -- $ -- $ -- $ 283,688,000
Repurchase of common
stock .................. (160,000) (1,600) (2,992,912) (2,994,512)
Net income ............... 11,791,518 11,791,518
Dividends ................ (13,898,849) (13,898,849)
Change in unrealized gain
(loss) on securities
available for sale ..... (7,327,890) (7,327,890)
------------- ------------- ------------- ------------- ------------- ------------ -------------
Balance at December
31, 1997 ............... 18,965,000 189,650 280,503,838 (13,898,849) 11,791,518 (7,327,890) 271,258,267
------------- ------------- ------------- ------------- ------------- ------------ -------------
Capital contribution ..... 13,988,365 13,988,365
Net (loss) ............... (58,185,921) (58,185,921)
Dividends ................ (22,378,697) (22,378,697)
Change in unrealized
gain (loss) on
Securities available
for sale ............... 18,366,041 18,366,041
Change in cumulative
translation adjustment . (1,871,662) (1,871,662)
------------- ------------- ------------- ------------- ------------- ------------ -------------
Balance at December
31, 1998................ 18,965,000 $ 189,650 $ 294,492,203 $ (36,277,546) $ (46,394,403) $ 9,166,489 $ 221,176,393
============= ============= ============= ============= ============= ============ =============
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS
</TABLE>
57
<PAGE>
<TABLE>
<CAPTION>
OCWEN ASSET INVESTMENT CORP.
CONSOLIDATED STATEMENT OF CASH FLOWS
For the Year For the Period
Ended May 14, 1997 to
December 31 December 31,
1998 1997
------------- -------------
<S> <C> <C>
Cash flows from operating activities:
Net (loss) income ........................................................... $ (58,185,919) $ 11,791,518
Adjustments to reconcile net income to net cash provided by
operating activities:
Premium amortization (discount accretion), net .......................... 15,012,575 6,236,654
Depreciation ............................................................ 3,606,490 179,088
Foreign exchange (gain) loss ............................................ (116,953) 568,565
Extraordinary gain on extinguishment of debt ............................ (615,047) --
Provision for loan losses ............................................... 641,677 --
Proceeds received on sale of securities held for trading ................ 39,408,287 --
Net losses on securities, derivative, and real estate ................... 86,267,429 --
Increase in interest receivable ......................................... (4,957,523) (2,518,272)
Increase in other assets ................................................ (14,316,713) (1,540,633)
Increase (decrease) in accrued expenses, payables and other liabilities . 5,934,062 6,344,783
Minority interest in earnings (losses) .................................. (4,854,884) 9,430
------------- -------------
Net cash provided by operating activities ...................................... 67,823,481 21,071,133
------------- -------------
Cash flows from investing activities:
Purchase of securities available for sale .................................... (357,279,884) (166,334,140)
Maturities and principal payments received on securities available for sale .. 42,872,223 6,654,881
Principal payments received from discount loans .............................. 2,174,388 932,366
Principal payments received from loans ....................................... 36,036,537 333,454
Purchase of loans ............................................................ (267,570,853) (16,091,515)
Purchase of discount loans ................................................... -- (28,465,429)
Proceeds received from sale of investment in real estate ..................... 1,397,201 --
Investment in real estate .................................................... (152,252,879) (45,609,127)
Deposits on pending asset acquisitions ....................................... 126,605 (1,000,000)
------------- -------------
Net cash used by investing activities .......................................... (694,496,662) (249,579,510)
------------- -------------
Cash flows from financing activities:
Proceeds from issuance of common stock, net of offering costs ................ -- 283,688,000
Dividend payments on common stock ............................................ (29,775,046) (6,502,500)
Proceeds received from sale of securities to affiliates ...................... 13,957,595 --
Proceeds from issuance of Notes .............................................. 150,000,000 --
Repurchase of Notes .......................................................... (6,309,944) --
Proceeds from issuance of bonds .............................................. 173,900,353 --
Principal payment on bonds ................................................... (12,071,246)
Proceeds from sale of operating partnership units ............................ 27,593,302 --
Increase in securities sold under agreements to repurchase ................... 114,410,572 --
Increase in obligations outstanding under lines of credit .................... 201,230,536 --
------------- -------------
Net cash provided by financing activities ...................................... 632,936,122 277,185,500
------------- -------------
Change in cumulative translation adjustment .................................... (1,574,859) --
Net increase in cash and cash equivalents ...................................... 4,688,082 48,677,123
Cash and cash equivalents at beginning of period ............................... 48,677,123 --
------------- -------------
Cash and cash equivalents at end of period ..................................... $ 53,365,205 $ 48,677,123
============= =============
Reconciliation of cash and cash equivalents at end of period:
Cash and amounts due from depository institutions ............................ $ 3,484,929 $ 331,047
Interest earning deposits .................................................... 49,880,276 48,346,076
------------- -------------
Total ..................................................................... $ 53,365,205 $ 48,677,123
============= =============
Supplement schedule of non-cash financing activities:
Interest paid ............................................................. 24,960,903 --
Non-cash activities:
Loans transferred through the foreclosure of discount loans to
Investment in real estate ............................................... 19,395,998 --
Change in unrealized gain (loss) on securities available for sale ......... 18,336,041 (7,327,890)
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONSOLIDATED FINANCIAL STATEMENTS
</TABLE>
58
<PAGE>
OCWEN ASSET INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
NOTE 1 ORGANIZATION
Ocwen Asset Investment Corp. ("OAC" or the "Company") has elected to be
taxed as a Real Estate Investment Trust ("REIT") under Sections 865 through 860
of the Internal Revenue Code of 1986, as amended (the "Code"). As such, the
Company will generally not be subject to federal income taxation on that portion
of its income that is distributed to shareholders if it distributes at least 95%
of its taxable income to its shareholders by the due date of its federal income
tax return and complies with various other requirements.
The Company was incorporated in the Commonwealth of Virginia on January
22, 1997 and was initially capitalized on February 12, 1997 through the sale of
100 shares of common stock for $1,600. On May 14, 1997, the Company completed an
initial public offering ("IPO") with the sale of 19,125,000 shares of common
stock, par value $.01 per share ("Common Stock"), at a price of $16.00 per share
(before underwriting and offering expenses), and commenced operations thereon.
The Company's consolidated financial statements include the accounts of
the Company and its subsidiaries. The Company directly owns two qualified REIT
subsidiaries, Ocwen General, Inc. (the "General Partner") and Ocwen Limited,
Inc. (the "Limited Partner"). General Partner and Limited Partner own 0.9% and
90.4%, respectively, of Ocwen Partnership, L.P. (the "Operating Partnership").
Additionally, through the General Partner and Limited Partner, the Company
established additional partnerships in Florida and California for real estate
investment purposes. The minority interest at December 31, 1998 represents a
8.7% interest (1,808,733 units) in the Operating Partnership held by Investors
Mortgage Insurance Holding Company ("IMIHC"), a wholly owned subsidiary of Ocwen
Financial Corporation ("OCN"). IMIHC also owns 1,540,000 shares, or 8.12%, of
the outstanding Common Stock.
The Company has entered into a management agreement with Ocwen Capital
Corporation ("OCC"), a wholly-owned subsidiary of OCN, under which OCC advises
the Company on various facets of its business and manages its day-to-day
operations, subject to the supervision of the Company's Board of Directors. For
its services, OCC receives a quarterly base management fee of 0.25% per quarter
on Average Invested Assets. The term "Average Invested Assets" for any period
means the average of the aggregate book value of the assets of the Company,
including the assets of all of its direct and indirect subsidiaries, before
reserves for depreciation or bad debts or other similar noncash reserves,
computed by taking the daily average of such values during such period;
provided, however, effective January 1, 1998, with respect to residential loans,
the phase means average net equity invested. In addition, OCC is entitled to
receive an annual incentive fee in an amount equal to 25% of the dollar amount
by which Funds From Operations ("FFO"), as adjusted, exceeds certain defined
levels per the management agreement. During 1998 and 1997, OCC earned from the
Company $5.9 million and $1.8 million, respectively in base management fees. No
incentive compensation was paid for 1998 and 1997. In addition, for such
periods, OCC was reimbursed $1.8 million and $0.3 million, respectively for
out-of-pocket costs and salary allocations for real estate due diligence tasks.
The Company also has entered into servicing agreements with Ocwen
Federal Bank, FSB (the "Bank"), a wholly-owned subsidiary of OCN, for the
servicing of all of the Company's mortgage loans. In addition, the Bank in its
capacity as servicer or special servicer receives fees from certain
mortgage-backed securities in which the Company owns a subordinate or residual
interest. As a special servicer, the Bank provides asset management and
resolution services with respect to defaulted mortgage loans subject to the
Company's right to direct the foreclosure, the management and disposal of
foreclosed properties and all other actions that a servicer may take in
connection with a defaulted loan. During 1998, the Bank earned from the Company
$2.4 million in servicing fees. No servicing fees were earned by the Bank in
1997.
59
<PAGE>
OCWEN ASSET INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
NOTE 2 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accounting and reporting policies of the Company and its
subsidiaries follow Generally Accepted Accounting Principals ("GAAP"). The
policies which materially affect the determination of the Company's financial
position, results of operations and cash flows are summarized below.
PRINCIPLES OF CONSOLIDATION
The Company's consolidated financial statements include the accounts of
OAC and its subsidiaries as described in Note 1 above. All significant
intercompany transactions and balances have been eliminated.
USE OF ESTIMATES
The preparation of financial statements in conformity with GAAP
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from those estimates. Material estimates that are particularly susceptible to
significant change in the near or medium term relate to the valuation of
securities available for sale and determination of the allowance for losses on
loans and discount loans.
SECURITIES AVAILABLE FOR SALE
Securities are classified as available for sale when in management's
judgement they may be sold in response to or in anticipation of changes in
interest rates and resulting prepayment risk, or other factors. Available for
sale securities are carried at fair value. Unrealized gains and losses on these
securities, along with any unrealized gains and losses on related risk
management instruments, are reported as a separate component of accumulated
other comprehensive income in shareholders' equity. Securities that the Company
has the positive intent and ability to hold to maturity are classified as
held-to-maturity and are carried at amortized cost. At December 31, 1998 and
1997, the Company had no securities classified as held-to-maturity. Interest and
dividend income on securities, including amortization of premiums and accretion
of discounts, are reported in earnings. Interest income is recognized using the
interest method. The specific identification method is used to determine
realized gains and losses on sales of securities, which are reported in
earnings. The carrying value of individual securities is reduced through
write-downs in earnings to reflect other-than-temporary impairments in value.
LOAN PORTFOLIO
Loans are generally reported at the principal amount outstanding, net
of the allowance for loan losses, purchase premium or discount, and any net
deferred loan fees. Interest income is recognized using the interest method or
on a basis approximating a level yield over the term of the loan. Loans are
placed on nonaccrual status when the loan is past due 90 days or more. Interest
accrued but not collected at the date a loan is placed on nonaccrual status is
reversed against interest income. In addition, the amortization of net deferred
loan fees is suspended when a loan is placed on nonaccrual status. Interest
income on nonaccrual loans is recognized only to the extent received in cash.
However, where there is doubt regarding the ultimate collectibility of the loan
principal, cash receipts, whether designated as principal or interest, are
thereafter applied to reduce the carrying value of the loan. Loans are restored
to accrual status only when interest and principal payments are brought current
and future payments are reasonably assured.
DISCOUNT LOAN PORTFOLIO
Certain mortgage loans, for which the borrower is not current as to
principal and interest payments or for which there is a reason to believe the
borrower will be unable to continue to make its scheduled principal and interest
payments, are acquired at a discount. The acquisition cost for a pool of loans
is allocated to each loan within the pool based upon the Company's pricing
methodology. The acquisition cost for a pool of discount loans is allocated on a
relative fair value basis to each loan within the pool. The Company believes
that it is able to reasonably estimate the amounts and timing of collections on
all of its discounted loans. For those commercial real estate loans which are
current and for which the Company believes that collecting the acquisition
amount of the loan and discount is probable, the discount is accreted into
interest income as a yield adjustment using the interest method over the
contractual maturity of the loan. For those commercial discount loans that
become nonperforming, the Company ceases accretion of the discount. Gains on the
repayment or discharge of the discount loans, including any remaining discount,
are reported as interest income.
60
<PAGE>
OCWEN ASSET INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
Discount loans are reported at their outstanding principal balance net
of any charge-offs and premiums or discounts. The Company periodically evaluates
loans in the discount loan portfolio for impairment. Individually identified
impaired loans are measured based on one of the following: the present value of
payments expected to be received (using a discount rate that equates the
Company's estimate of expected future cash flows to the acquisition price),
observable market prices, or the estimated fair value of the collateral (for
loans that are solely dependent on the collateral for repayment). If the
recorded investment in the impaired loan exceeds the measure of estimated fair
value, a valuation allowance is established as a component of the allowance for
loan losses. At December 31, 1998, the Company did not have any impaired loans.
ALLOWANCE FOR LOAN LOSSES
The allowance for estimated loan losses is maintained at a level that
management, based upon evaluation of known and inherent risks in the portfolio,
considers adequate to provide for inherent losses. Management's periodic
evaluation of the allowance for estimated loan losses is based upon an analysis
of the portfolio, historical loss experience, economic conditions and trends,
collateral values and other relevant factors. Future adjustments to the
allowance may be necessary if economic conditions and trends, collateral values
and other relevant factors differ substantially from the assumptions used in
making the evaluation.
INVESTMENT IN REAL ESTATE
Investment in real estate is recorded at cost less accumulated
depreciation. The Company reviews its investment in real estate for impairment
whenever events or changes in circumstances indicate that the carrying amount
may not be recoverable. Depreciation is computed on a straight-line basis over
the estimated useful lives of the assets as follows:
Buildings and improvements 39 years
Tenant improvements Lesser of lease term or useful life
Furniture, fixtures and equipment 7 years
Expenditures for repairs and maintenance are charged to operations as
incurred. Significant renovations are capitalized. Fees and costs incurred in
the successful negotiation of leases are deferred and amortized on a
straight-line basis over the terms of the respective leases. Rental revenue is
reported on a straight-line basis over the terms of the respective leases.
FOREIGN CURRENCY TRANSACTIONS AND TRANSLATION
The Company's investment in foreign assets are translated into U.S.
dollars at current exchange rates, and related revenues and expenses are
translated at average exchange rates for the period. Transaction gains and
losses that arise from exchange rate fluctuations on transactions denominated in
a currency other than U.S. dollars are included in the results of operations.
The assets, liabilities and results of operations of the Company's
foreign subsidiaries which have functional currencies other than U.S. dollar are
translated into U.S. dollars at current exchange rates for assets and
liabilities and average exchange rates for the period for the results of
operations. Resulting translation adjustments are included as a separate
component of accumulated other comprehensive income in shareholders' equity as
cumulative translation adjustments.
INCOME TAXES
The Company qualifies as a REIT under Sections 856 through 860 of the
Code of 1986, as amended. A REIT will generally not be subject to federal income
taxation on that portion of its income that is distributed to shareholders if it
distributes at least 95% of its taxable income by the due date of its federal
income tax return and complies with certain other requirements. Accordingly, no
provision has been made for federal income taxes for the Company and its
subsidiaries in the accompanying consolidated financial statements.
61
<PAGE>
OCWEN ASSET INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
CONSOLIDATED STATEMENT OF CASH FLOWS
For purposes of reporting cash flows, cash and cash equivalents include
non-interest earning deposits, interest earning deposits and all highly liquid
investments purchased with an original maturity date of three months or less.
Cash flows associated with hedges of identifiable transactions or events are
classified in the same category as the cash flows from the item being hedged.
BASIC AND DILUTED EARNINGS PER SHARE
Basic earnings per share is calculated based upon the weighted average
number of shares of Common Stock outstanding during the year. Diluted earnings
per share is calculated based upon the weighted average number of shares of
Common Stock outstanding and all dilutive potential common shares outstanding
during the year. The computation of diluted earnings per share includes the
impact of the exercise of the outstanding options to purchase Common Stock and
assumes that the proceeds from such issuance are used to repurchase common
shares at fair value. Common Stock equivalents would be excluded from the
diluted calculation if a net loss was incurred for the period as they would be
antidilutive.
RISKS AND UNCERTAINTIES
In the normal course of business, the Company encounters primarily two
significant types of economic risk: credit and market. Credit risk is the risk
of default on the company's loan portfolio that results from a borrowers'
inability or unwillingness to make contractually required payments. Market risk
reflects changes in the value of securities available for sale and investments
in real estate due to changes in interest rates or other market factors,
including the rate of prepayments of principal, the value of the collateral
underlying loans and the valuation of real estate held by the Company.
Additionally, the Company encounters significant tax risks. If OAC were
to fail to qualify as a REIT in any taxable year, OAC would be subject to
federal income tax (including any applicable alternative minimum tax) on its
taxable income at regular corporate rates, and distributions to shareholders
would not be deductible by OAC in computing its taxable income. Any such
corporate tax liability could be substantial and would reduce the amount of cash
available for distribution to shareholders, which in turn could have an adverse
impact on the value of, and trading prices for, the Company's common stock.
Unless entitled to relief under certain Code provisions, the Company could also
be disqualified from taxation as a REIT for the four taxable years following the
year during which OAC ceased to qualify as a REIT.
RECLASSIFICATION
Certain amounts included in the 1997 consolidated financial statements
have been reclassified in order to conform to the 1998 presentation.
RECENT ACCOUNTING STANDARDS
In June 1998, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities",
which amends FASB Statements No. 52 and 107, and supersedes FASB Statements No.
80, 105 and 119. SFAS No. 133 establishes accounting and reporting standards for
derivative instruments, including certain derivative instruments embedded in
other contracts and for hedging activities. SFAS No. 133 requires that an entity
recognize all derivatives as either assets or liabilities in the statement of
financial condition and measure those instruments at fair value. SFAS No. 133 is
effective for all fiscal quarters of fiscal years beginning after June 15, 1999.
Initial application of SFAS No. 133 should be as of the beginning of an entity's
fiscal quarter; on that date, hedging relationships must be designated anew and
documented pursuant to the provisions of SFAS No. 133. Earlier application of
SFAS No. 133 is encouraged but is permitted only as of the beginning of any
fiscal quarter that begins after issuance of SFAS No. 133. The Company has not
yet determined the impact on its results of operations, financial position or
cash flows as a result of implementing SFAS No. 133.
In October 1998, the FASB issued SFAS No. 134, "Accounting for
Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans
Held for Sale by a Mortgage Banking Enterprise", an amendment of FASB Statement
No. 65. This statement is effective for the first fiscal quarter beginning after
December 15, 1998. This Statement standardizes how mortgage banking firms
account for certain securities and other interests they retain after
securitizing mortgage loans that were held for sale. Adoption of this
pronouncement is not expected to have a material impact on the Company's
consolidated financial statements.
62
<PAGE>
OCWEN ASSET INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
NOTE 3 FAIR VALUE OF FINANCIAL INSTRUMENTS
Other than investment in real estate, substantially all of the
Company's assets are considered financial instruments. For the majority of the
Company's financial instruments, principally loans, fair values are not readily
available since there are no available trading markets as characterized by
current exchanges between willing parties. Accordingly, fair values can only be
derived or estimated using various valuation techniques, such as computing the
present value of estimated future cash flows using discount rates commensurate
with the risks involved. However, the determination of estimated future cash
flows is inherently subjective and imprecise. In addition, for those financial
instruments with option-related features, prepayment assumptions are
incorporated into the valuation techniques. It should be noted that minor
changes in assumptions or estimation methodologies could have a material effect
on these derived or estimated fair values.
The fair values reflected below are indicative of the interest rate
environments as of December 31, 1998 and 1997, and do not take into
consideration the effects of interest rate fluctuations. In different interest
rate environments, fair value results can differ significantly, especially for
certain fixed-rate financial instruments and non-accrual assets. In addition,
the fair values presented do not attempt to estimate the value of the Company's
anticipated future business activities. In other words, they do not represent
the Company's value as a going concern. Furthermore, the differences between the
carrying amounts and the fair values presented may not be realized.
Reasonable comparability of fair values among institutions is difficult
due to the wide range of permitted valuation techniques and numerous estimates
that must be made in the absence of secondary market prices. This lack of
objective pricing standards introduces a degree of subjectivity to these derived
or estimated fair values. Therefore, while disclosure of estimated fair values
of financial instruments is required, readers are cautioned in using this data
for purposes of evaluating the financial condition of the Company.
The following table sets forth the carrying amounts and the estimated
fair values of the Company's financial instruments at December 31, 1998 and
1997.
<TABLE>
<CAPTION>
1998 1997
------------------------- -----------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
----------- ----------- ---------- ----------
(Dollars In Thousands)
<S> <C> <C> <C> <C>
Cash and cash equivalents ................................. $ 53,365 $ 53,365 $ 48,677 $ 48,677
Securities available for sale ............................. 351,154 351,154 146,027 146,027
Loan portfolio, net ....................................... 73,341 73,341 15,831 15,831
Match funded loan agreements .............................. 173,610 173,610 -- --
Discount loan portfolio ................................... 5,618 5,618 26,979 26,979
Securities sold under agreements to repurchase ............ 138,612 138,612 -- --
Obligations outstanding under line of credit .............. 34,472 34,472 -- --
Obligations outstanding under lines of credit-real estate.. 142,557 142,557 -- --
11.5% Redeemable Notes due 2005 ........................... 143,000 108,680 -- --
Bonds-match funded loan agreement ......................... 163,404 163,404 -- --
Loan commitments .......................................... 58,666 58,666 74,300 74,300
</TABLE>
The methodologies used and key assumptions made to estimate fair value
follow:
CASH AND CASH EQUIVALENTS
Cash and cash equivalents have been valued at their carrying amounts as
these are reasonable estimates of fair value given the relatively short period
of time between origination of the instruments and their expected maturity.
63
<PAGE>
OCWEN ASSET INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
SECURITIES AVAILABLE FOR SALE
The Company marks its securities available for sale portfolio to fair
value at the end of each month based upon the lower of dealer marks or internal
values, subject to an internal review process. For those securities which do not
have an available market quotation, the Company will request market values and
underlying assumptions from the various dealers that underwrote, or currently
finance the securities, or have had prior experience with the valuation of these
types of securities. When marks are obtained from two or more dealers, the
average dealer mark will be utilized.
The Company will then compare dealer marks with its internal estimate
of value, together with the underlying assumptions, current market conditions
and any additional factors that may contribute to the assigned values. The lower
of dealer marks or internal values will generally be used for valuation
purposes.
Residual securities are anticipated to cash flow for the life of the
security once the over collateralization levels are achieved, which typically
occurs during the first nine to twelve months. Certain events can prevent a
security from cash flowing beyond that date, such as delinquency and cumulative
loss triggers. To the extent that the triggers are achieved and cash flows from
a security cease, uncertainty exists as to the remaining expected yield on such
security. As a result, Ocwen places all securities that do not provide current
cash flow after one year of issuance on non-accrual status. To the extent that
the residual resumes its cash flow, income will be reported for that month at
the lower of the actual cash flow or the income generated by the prospective
yield method.
On a quarterly basis the Company evaluates each individual security in
its available for sale portfolio to determine whether a decline in value below
amortized cost is other than temporary. In making this assessment, the Company
considers several factors, including but not limited to the following:
(1) Determining whether the present value of estimated future cash flows
discounted at a risk-free rate (the rate on monetary assets of a
comparable duration which are essentially risk free, i.e., Treasury
rate) is less than the amortized cost basis of the instrument;
(2) Examining whether the duration of the decline in market value has
exceeded six consecutive months; and
(3) Identifying the reasons for significant declines in value (i.e.,
greater than 20%).
For each security where the Company concludes that all or a portion of
the decrease in value is other than temporary, such amount is recognized as an
impairment charge in the statement of operations, establishing a new cost basis
for the security.
LOANS, MATCH FUNDED LOANS, AND DISCOUNT LOANS
The fair value of the loan portfolio, which includes commercial,
multi-family, residential loans and loan commitments, approximates the carrying
value as these instruments have variable market interest rates. The fair value
of the discount loan portfolio is estimated based upon current market yields at
which recent pools of similar mortgages have traded taking into consideration
the timing and amount of expected cash flows.
BORROWINGS
The fair value of securities sold under agreements to repurchase and
obligations outstanding under lines of credit approximates the carrying value as
these instruments have variable market interest rates.
The fair value of the 11.5% Redeemable Notes and bonds-match funded
loan agreement are based on quotes obtained from securities dealers.
64
<PAGE>
OCWEN ASSET INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
NOTE 4 RISK MANAGEMENT INSTRUMENTS
The Company enters into derivatives, particularly interest rate swaps,
to hedge interest rate exposures arising from mismatches between assets and
liabilities. Under interest rate swaps, the Company agrees with other parties to
exchange, at specified intervals, the difference between fixed-rate and
floating-rate interest amounts calculated by reference to an agreed notional
principal amount and the London Interbank Offered Rate ("LIBOR"). The terms of
these interest rate swaps allow the Company to receive a floating rate of
interest equal to LIBOR and to pay fixed interest rates.
The interest rates swaps are used to hedge current LIBOR rate debt
incurred to fund the Company's acquisitions of real estate and subordinate and
residual securities. None of the Company's interest rate swaps are held for
trading purposes. As of December 31, 1998, the Company held interest rate swaps
with a notional amount of approximately $200.8 million. The fair value of the
interest rate swaps are not recognized in the consolidated financial statements.
To qualify for hedge accounting the interest rate swap must meet two
criteria:
o the Company is exposed to interest rate risk as the result of a
debt it has incurred; and
o the interest rate swap reduces the Company's exposure to such risk.
If an interest rate swap does not qualify as a hedge, it is accounted
for as a trading asset at fair value, with any gain or loss included as a
component of current income.
The Company is exposed to credit loss if: (i) the counterparties to the
interest rate swap do not perform and (ii) the floating interest rate received
by the Company exceeds the fixed interest rate paid by it. All of the
counterparties have long-term debt ratings of A+ or above by Standard and Poor's
and A1 or above by Moody's. Although a swap generally may not be sold or
transferred without the consent of the counterparty, management does not believe
that this consent would be withheld. Although none of the Company's interest
rate swaps are exchange-traded, there are a number of financial institutions
which enter into these types of transactions as part of their day-to-day
activities.
The following table indicates the interest rate swaps outstanding at
December 31, 1998, pursuant to which the Company receives payments from a
counterparty based on a floating rate of interest equal to LIBOR and agrees to
pay a fixed rate of interest to such party on a specified notional amount.
Notional LIBOR Floating Rate at
Maturity Amount Index Fixed Rate End of Period Fair Value
-------- --------- ------- ---------- ------------- ----------
(Dollars In Thousands)
2003 $ 100,000 1-month 5.75% 5.56% $ (2,086)
2001 17,000 1-month 6.00 5.55 (339)
2001 75,000 1-month 6.00 5.62 (1,479)
2002 8,780 1-month 6.04 5.55 (240)
--------- --------
$ 200,780 $ (4,144)
========= ========
During 1998, the Company incurred a $2.6 million charge on futures
contracts used to hedge the Company's portfolio of single family residential
loans, as the future contracts were terminated because they were no longer
effective as hedges.
At December 31, 1998, the Company had a foreign currency swap contract
to hedge currency exposure in connection with its investment in residual
interests backed by residential mortgage loans originated in the United Kingdom,
which are held by a wholly-owned subsidiary of the Company. Under the terms of
the agreement, the Company exchanged 14.7 million British Pounds Sterling for
$23.5 million on January 29, 1999 based on the exchange rate on the date the
contract became effective. At December 31, 1998, the fair value of the foreign
currency swap contract was ($0.8) million. In addition, the Company entered into
a foreign exchange currency swap agreement on November 12, 1998 to hedge its
exposure in connection with its investment in the shopping center located in
Halifax, Nova Scotia, which is held by a wholly-owned subsidiary of the Company.
Under the terms of the agreement, the Company exchanged 20.0 million Canadian
dollars for $12.9 million on January 15, 1999 based on the exchange rate on the
date the contract became effective. At December 31, 1998, the fair value of the
Canadian currency contract was $0.02 million. Gains and losses on these foreign
currency translation instruments are included in the cumulative translation
adjustment.
65
<PAGE>
OCWEN ASSET INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
The fair value of the interest rate swaps and the foreign currency
swaps represent the estimated amount that the Company would receive or pay to
terminate these agreements taking into account current interest and exchange
rates. Market quotes are available for these agreements.
NOTE 5 SECURITIES AVAILABLE FOR SALE
The following table sets forth the amortized cost, fair value and gross
unrealized gains and losses on the Company's securities available for sale at
the dates indicated.
<TABLE>
<CAPTION>
Gross Gross
Amortized Unrealized Unrealized Fair
DECEMBER 31, 1998 Cost Gains Losses Value
--------- --------- --------- ---------
(Dollars In Thousands)
<S> <C> <C> <C> <C>
Mortgage-related securities:
Single family residential:
Subprime residuals ............... $ 209,071 $ 9,653 $ -- $ 218,724
Subordinates ..................... 15,390 -- -- 15,390
--------- --------- --------- ---------
224,461 9,653 -- 234,114
--------- --------- --------- ---------
Multi-family and commercial:
AAA-rated interest only .......... 454 -- (13) 441
A-rated interest only ............ 236 -- (14) 222
Non-rated interest only .......... 3,135 -- -- 3,135
Non-rated principal only ......... 276 -- -- 276
Subordinates ..................... 111,554 1,412 -- 112,966
--------- --------- --------- ---------
115,655 1,412 (27) 117,040
--------- --------- --------- ---------
$ 340,116 $ 11,065 $ (27) $ 351,154
========= ========= ========= =========
Gross Gross
Amortized Unrealized Unrealized Fair
DECEMBER 31, 1997 Cost Gains Losses Value
--------- --------- --------- ---------
(Dollars In Thousands)
<S> <C> <C> <C> <C>
Mortgage-related securities:
Single family residential:
FHLMC interest only .............. $ 26,011 $ 216 $ (5,049) $ 21,178
FNMA interest only ............... 27,290 184 (4,901) 22,573
AAA-rated interest only .......... 1,091 -- (361) 730
Subordinates ..................... 8,668 807 (31) 9,444
--------- --------- --------- ---------
63,060 1,207 (10,342) 53,925
--------- --------- --------- ---------
Multi-family and commercial:
AAA-rated interest only .......... 913 -- (47) 866
A-rated interest only ............ 504 -- (24) 480
Non-rated interest only .......... 4,976 -- (173) 4,803
Non-rated principal only ......... 1,017 -- (57) 960
Subordinates ..................... 82,885 2,536 (428) 84,993
--------- --------- --------- ---------
90,295 2,536 (729) 92,102
--------- --------- --------- ---------
$ 153,355 $ 3,743 $ (11,071) $ 146,027
========= ========= ========= =========
</TABLE>
66
<PAGE>
OCWEN ASSET INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
The following table summarizes the maturities of securities available
for sale at December 31, 1998. Maturities are based on weighted-average unpaid
principal balance and reflect anticipated future prepayments based on a
consensus of dealers in the market.
Amortized Cost Fair Value
-------------- ----------
(Dollars In Thousands)
Due within one year .......................... $ 55,987 $ 58,102
Due after 1 through 5 years .................. 183,992 188,859
Due after 5 through 10 years ................. 63,505 66,425
Due after 10 years ........................... 36,632 37,768
---------- ----------
$ 340,116 $ 351,154
========== ==========
Premiums amortized against and discounts accreted to income during the
years ended December 31, 1998 and 1997 are as follows:
For the Period
May 14, 1997 to
December 31, December 31,
1998 1997
------------ ----------------
(Dollars In Thousands)
Premiums amortized against interest income .. $ 63,768 $ 8,033
Discounts accreted to interest income ....... 48,756 1,709
------------ ---------------
Net premium amortization .................... $ 15,012 $ 6,324
============ ===============
During 1998, the Company recorded a charge of $79.7 million against its
portfolio of securities available for sale. The charge results from increases in
projected prepayment speeds during this period and a resulting shortening of the
weighted average lives of certain individual securities in the portfolio. As a
result, a determination was made to write down the recorded investment in those
securities where the reduction in fair value was considered to be other than
temporary. To the extent that longer term interest rates increase or the
relationship between short-term and long-term rates revert to their historical
spreads, the value of the portfolio could recover. To the extent that the
current environment persists, or that rates decrease further, additional
impairment losses may be recognized. During 1998, the cash proceeds from the
sale of securities was $53.4 million at a gross realized loss of $14.0 million.
In 1997, no securities were sold.
On May 7, 1998, the Company sold its entire portfolio of AAA-rated
interest only ("IO") and inverse floating rate interest only ("Inverse IO")
classes of mortgage related securities backed by single family residential loans
to affiliates of the Company, OCC and OCN for a cash price of $54.6 million,
which represents the IO Portfolio's amortized cost plus accrued interest and
exceeded the IO Portfolio's market value by approximately $14.0 million. Because
the IOs were being sold to a principal shareholder and another related party,
the $14.0 million by which amortized cost exceeded market value was recorded as
a charge to earnings and has been reflected on the Company's books as a capital
contribution.
NOTE 6 LOAN PORTFOLIO
The following table sets forth the components of the Company's loan
portfolio at the dates indicated.
<TABLE>
<CAPTION>
December 31, December 31,
1998 1997
-------------- --------------
<S> <C> <C>
Single family residential.................. $ 8,419,265 $ 6,465,080
Multi-family residential................... 20,544,269 1,357,333
Commercial real estate:
Office................................... 24,123,894 44,383
Hotel.................................... 21,304,912 8,423,608
-------------- --------------
Total loans............................ 74,392,340 16,290,404
Deferred fees.............................. (409,254) (458,925)
Allowance for loan losses.................. (641,676) --
-------------- --------------
Loans, net............................... $ 73,341,410 $ 15,831,479
============== ==============
</TABLE>
67
<PAGE>
OCWEN ASSET INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
The following table represents a summary of the Company's
non-performing loans (past due 90 days or more) at the dates indicated.
December 31, December 31,
1998 1997
------------ ------------
Non-performing loans:
Single family residential................... $ 4,165,201 $ 268,689
Multi-family................................ -- --
Commercial.................................. -- --
------------ ------------
$ 4,165,201 $ 268,689
============ ============
If non-accrual loans had been current in accordance with their original
terms, additional interest income of approximately $0.3 million for the year
ended December 31, 1998 would have been earned. No interest has been accrued on
loans greater than 89 days past due. At December 31, 1997, there were no loans
on nonaccrual status.
At and for the years ended December 31, 1998 and 1997, the Company had
no investment in impaired loans as defined in accordance with SFAS No. 114, as
amended by SFAS No. 118.
The allowance for loan losses was established in 1998. The provision
for loan losses during 1998 amounted to $0.6 million, or 1.0% of the net
commercial and multi-family loan portfolio.
The following table sets forth the geographic distribution of
properties securing the Company's loans at December 31, 1998:
<TABLE>
<CAPTION>
Single family Multi-family Commercial
Residential Residential Real Estate Total
--------------- --------------- --------------- ---------------
<S> <C> <C> <C> <C>
New York.......... $ 661,886 $ 16,345,675 $ 1,805,504 $ 18,813,045
California........ 1,551,675 4,198,594 -- 5,750,269
Massachusetts..... 53,835 -- 31,571,140 31,624,975
Delaware.......... -- -- 12,052,162 12,052,162
Florida........... 824,136 -- -- 824,136
Other............. 5,327,753 -- -- 5,327,753
--------------- --------------- --------------- ---------------
Total............. $ 8,419,265 $ 20,544,269 $ 45,428,806 $ 74,392,340
=============== =============== =============== ===============
</TABLE>
The following table sets forth certain information at December 31, 1998
regarding the dollar amount of loans maturing in the Company's loan portfolio
based on scheduled contractual amortization, as well as the dollar amount of
loans which have fixed or adjustable interest rates. Loan balances have not been
reduced for (i) undisbursed loan proceeds, unearned discounts and the allowance
for loan losses or (ii) nonperforming loans.
<TABLE>
<CAPTION>
Maturing in
-----------------------------------------------------------------------------------------
After One Year After Five Years
One Through Five Through Ten After Ten
Year or Less Years Years Years Total
------------ ------------ ------------ ------------ ------------
(Dollars In Thousands)
<S> <C> <C> <C> <C> <C>
Single family residential loans....... $ 916 $ 2,544 $ 2,054 $ 2,905 $ 8,419
Multi-family residential loans........ 20,544 -- -- -- 20,544
Commercial real estate................ 45,429 -- -- -- 45,429
------------ ------------ ------------ ------------ ------------
Total.............................. $ 66,889 $ 2,544 $ 2,054 $ 2,905 $ 74,392
============ ============ ============ ============ ============
</TABLE>
Scheduled contractual principal repayments may not reflect the actual
maturities of loans because of prepayments and, in the case of conventional
mortgage loans, due-on-sale clauses. The average life of mortgage loans,
particularly fixed-rate loans, tends to increase when current mortgage loan
rates are substantially higher than rates on existing mortgage loans and,
conversely, decrease when rates on existing mortgages are substantially higher
than current mortgage loan rates.
68
<PAGE>
OCWEN ASSET INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
The following table sets forth the activity in the Company's gross
loan portfolio during the periods indicated.
<TABLE>
<CAPTION>
For the For the Period
Year Ended May 14, 1997 to
December 31, December 31,
1998 1997
--------------- ---------------
<S> <C> <C>
Balance at beginning of period....................... $ 16,290,404 $ --
Originations:
Single family residential loans................... -- --
Multi-family residential loans.................... 19,186,936 1,357,333
Commercial real estate loans...................... 37,005,198 8,423,608
--------------- ---------------
Total loans originated......................... 56,192,134 9,780,941
--------------- ---------------
Purchases:
Single family residential loans................... 211,378,718 6,881,425
Secured borrowing (match funded loans)............... (183,470,633) --
Principal repayments, net............................ (25,998,283) (371,962)
--------------- ---------------
Net increase (decrease) in net loans................. 58,101,936 16,290,404
--------------- ---------------
Balance at end of period............................. $ 74,392,340 $ 16,290,404
=============== ===============
</TABLE>
NOTE 7 MATCH FUNDED RESIDENTIAL LOANS
On November 13, 1998, the Company securitized and transferred to OAC
Mortgage Residential Securities, Inc., a real estate mortgage investment conduit
(the "Trust"), $173.6 million (1,808 mortgage loans) of its residential loan
portfolio. On that date, the Trust issued two classes of notes secured by the
related group of mortgage loans. Loan Group I consisted of approximately 1,078
mortgage loans with an aggregate principal balance of approximately $91.2
million and original terms of up to 30 years and which are secured by first
liens on single family residential properties. Loan Group II consists of
approximately 730 mortgage loans with an aggregate principal balance of
approximately $91.0 million and original terms of up to 30 years and which are
secured by first or second liens on single family residential properties. Upon
the transfer, the Company received approximately $173.9 million of proceeds. The
transfer did not qualify as a sale under FASB 125, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities." Accordingly,
the amount of proceeds from the transfer are reported as a liability in the
consolidated statement of financial condition. At December 31, 1998, the Company
had not established an allowance for loan losses.
The following table sets forth the current unpaid principal balance,
excluding the premium amount of $1.9 million, and the geographic distribution of
properties securing the Company's match funded residential loans at December 31,
1998:
Single family
Residential
----------------
(Dollars In
Thousands)
Michigan................................ $ 44,303
California.............................. 17,460
Florida................................. 9,180
Other................................... 101,070
----------------
Total................................... $ 172,013
================
NOTE 8 DISCOUNT LOAN PORTFOLIO
The Company has acquired, through private sales and auctions, mortgage
loans at a discount because the borrowers are either not current as to principal
and interest payments or there is doubt as to the borrowers' ability to pay in
full the contractual principal and interest. The Company estimates the amounts
it will realize through foreclosure, collection or other resolution efforts and
the length of time required to complete the collection process in determining
the amounts it will bid to acquire such loans.
The resolution alternatives applied to the discount loan portfolio are:
(i) the borrower brings the loan current in accordance with original or modified
terms; (ii) the borrower repays the loan or a negotiated amount; (iii) the
borrower agrees to a deed-in-lieu of foreclosure, in which case it is classified
as investment in real estate and held for sale by the Company and; (iv) the
Company
69
<PAGE>
OCWEN ASSET INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
forecloses on the loan and the property is either acquired at the foreclosure
sale by a third party or by the Company, in which case it is classified as
investment in real estate and held for sale. Upon receipt of title to the
property, the loans are transferred to investment in real estate.
The Company's discount loan portfolio consists of the following at the
dates indicated:
December 31,
LOAN TYPE: ----------------------------
Commercial real estate loans: 1998 1997
----------------------------
(Dollars In Thousands)
Office .................................. $ 6,859 $ 11,893
Retail .................................. -- 30,636
---------- ----------
Total discount loans .................. 6,859 42,529
Discount (1) ............................ (1,241) (15,550)
---------- ----------
Discount loans, net ................... $ 5,618 $ 26,979
========== ==========
LOAN STATUS:
Current ................................. $ 6,859 $ 7,964
Past due 31 to 89 days .................. -- --
Past due 90 days or more ................ -- 34,565
---------- ----------
$ 6,859 $ 42,529
========== ==========
(1) Discount generally represents the difference between the purchase price
of discounted loans and their contractual face amount at the date of
acquisition.
At December 31, 1998, the Company had not established an allowance for
loan loss on the discount loan portfolio.
NOTE 9 INVESTMENT IN REAL ESTATE
The investment in real estate at December 31, 1998 was comprised of
four commercial office properties in San Francisco, California; an office
building in Jacksonville, Florida; and three shopping plazas located in (i)
Bradenton, Florida; (ii) Halifax, Nova Scotia; and (iii) Havre, Montana. The
following table sets forth the Company's investment in real estate at the dates
indicated:
<TABLE>
<CAPTION>
December 31,
-------------------------------------
1998 1997
-------------------------------------
<S> <C> <C>
Land............................................ $ 29,199,040 $ 5,250,105
Office buildings................................ 146,120,303 21,741,969
Retail.......................................... 31,597,052 18,602,922
Building improvements........................... 1,223,185 14,131
Tenant improvements and lease commissions....... 3,682,602 --
---------------- ----------------
211,822,182 45,609,127
Accumulated depreciation........................ (3,763,461) (179,088)
----------------- ----------------
Investment in real estate, net................ $ 208,058,721 $ 45,430,039
================ ================
</TABLE>
During 1998, the Company recorded an impairment charge of $3.9 million,
related to the shopping center in Halifax, Nova Scotia. This impairment charge
is included in the consolidated statement of operations in the line item losses
on securities, derivatives and real estate.
70
<PAGE>
OCWEN ASSET INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
NOTE 10 SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE AND OBLIGATIONS
OUTSTANDING UNDER LINES OF CREDIT
SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE. Securities sold under
agreements to repurchase were $138.6 million, with a weighted average interest
rate of 7.97%, at December 31, 1998. These obligations are secured by certain of
the Company's investments in subordinated interests in commercial
mortgage-backed securities, residual interests in subprime residential loan
securitizations, and U.K. mortgage loan residual securities. The following table
summarizes the maturity dates of OAC's securities sold under agreements to
repurchase and the fair value of the related collateral securities as of
December 31, 1998:
<TABLE>
<CAPTION>
Outstanding Commercial Securities Residential Securities
Maturity Date Borrowing Fair Value Fair Value
- ------------- --------- --------------------- ----------------------
(Dollars in Millions)
<S> <C> <C> <C>
0-30 days ................. $ 27.8 $ 34.1 $ 14.4
90-120 days ............... 49.7 39.9 45.9
6-12 months ............... 13.3 17.6 -
15 months and over ........ 47.8 - 138.3
--------- ---------- --------
Total ..................... $ 138.6 $ 91.6 $ 198.6
========= ========== ========
</TABLE>
The Company periodically enters into sales of securities under
agreements to repurchase the same securities. Obligations to repurchase
securities sold are reflected as a liability in the accompanying consolidated
statement of financial condition.
<TABLE>
<CAPTION>
December 31,
---------------------------
Other information concerning securities sold under agreements to repurchase: 1998 1997
---------- -------
(Dollars In Thousands)
<S> <C> <C>
Balance at end of year................................................ $ 138,612 $ --
Accrued interest payable at end of year............................... 428 --
Weighted average interest rate at end of year......................... 8.42% --
Average balance during the year....................................... 159,001 --
Weighted average interest rate during the year........................ 7.97% --
Maximum month-end balance............................................. 223,820 --
</TABLE>
Interest expense with respect to these obligations for the year ended
December 31, 1998 was $11.7 million. During 1998, the underlying securities sold
under agreements to repurchase were delivered into a third-party account that
recognizes the Company's rights and interests in these securities.
OBLIGATIONS OUTSTANDING UNDER LINES OF CREDIT. Obligations outstanding
under lines of credit amounted to $34.5 million at December 31, 1998. The
borrowings are pursuant to a three year agreement, which is collateralized by
commercial loans aggregating $57.0 million. The weighted average interest rate
at December 31, 1998 was 7.3%. Interest expense during 1998 was $7.2 million.
OBLIGATIONS OUTSTANDING UNDER LINES OF CREDIT - REAL ESTATE.
Obligations outstanding under lines of credit secured by real estate amounted to
$142.6 million at December 31, 1998. These borrowings have a three-year term and
an interest rate that floats in accordance with LIBOR. Set forth below is
information regarding OAC's indebtedness relating to its investment in real
estate at December 31, 1998:
71
<PAGE>
OCWEN ASSET INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
<TABLE>
<CAPTION>
Property Principal Amount Interest Rate Maturity Date
-------- ---------------- ------------- -------------
(Dollars In Millions)
<S> <C> <C> <C>
Bush Street Property...... $ 75.0(1) 7.3% April, 2001 (3)
Other..................... $ 67.6(2) 7.3% June, 2001 (3)
</TABLE>
1) Plus up to $5.0 million of additional advances for capital improvements
to the Bush Street Property.
2) Represents the portion of the outstanding balance under a $200 million
loan that is secured by real estate. As of December 31, 1998, OAC's
investments in Cortez Plaza, 450 Sansome Street, 10 U.N. Plaza,
Prudential Plaza and 690 Market Street secured this loan, and an
additional $34.5 million was borrowed and secured by commercial
mortgage loans under this line of credit.
3) Subject to certain conditions, the Company may extend the maturity date
by one year.
Interest expense during 1998 was $6.5 million.
NOTE 11 11.5% REDEEMABLE NOTES AND BONDS-MATCH FUNDED LOAN AGREEMENTS
In July, 1998, the Company completed the issuance of $150 million of
11.5% Redeemable Notes due 2005 under Rule 144A of the Securities Act of 1933,
as amended. Interest on the Notes is payable semi-annually on January 1 and July
1, beginning January 1, 1999, at a rate per annum of 11.5%. The Notes will
mature on July 1, 2005 and will be redeemable, at the option of the Company, in
whole or part, on or after July 1, 2002, at the redemption prices specified
below (expressed as percentages of the principal amount thereof), in each case,
together with accrued and unpaid interest, if any, thereon to the date of
redemption, upon not less than 30 nor more than 60 days' notice, if redeemed
during the twelve-month period beginning on July 1 of the years indicated below:
REDEMPTION
YEAR RATE
---- ----------
2002.................................... 105.750%
2003.................................... 102.875
2004 and thereafter..................... 100.000
During the first 36 months after the date of original issue of the
Notes, the Company may use the net proceeds of one or more offerings of its
common stock to redeem up to 25% of the aggregate principal amount of the Notes
at a redemption price of 111.50% of the principal amount thereof, plus accrued
and unpaid interest to the date of redemption, provided that, after any such
redemption, the aggregate principal amount of the Notes outstanding must equal
at least $112.5 million. On September 30, 1998, the Company repurchased in the
open market $7.0 million of the $150.0 million outstanding Notes. This resulted
in the Company realizing an extraordinary gain of $0.6 million. At December 31,
1998, the outstanding balance of the Notes was $143.0 million. Interest expense
on the Note for the year ended December 31, 1998 was $7.8 million.
On November 13, 1998, the Company securitized and transferred to the
trust $173.6 million of its residential loan portfolio. Upon the transfer, the
Company received approximately $173.4 million of proceeds. The transfer did not
qualify as a sale under FAS 125 "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities." Accordingly, the amount of
proceeds from the transfer are reported as a liability in the consolidated
statement of Financial Condition.
At December 31, 1998, bonds-match funded loan agreements amounted to
$163.4 million and with a weighted average interest rate of 8.09%. Interest
expense for the year ended December 31,1998 was $1.5 million.
NOTE 12 STOCK OPTION PLAN
In 1997, the Company adopted a non-qualified stock option plan (the
"Option Plan"), which provides options to purchase shares of Common Stock (or,
at the election of the Company, limited partnership interests ("Units") in the
Operating Partnership that may be redeemed for cash, or, at the election of the
General Partner, shares of Common Stock on a one-for-one basis). The maximum
aggregate number of shares of Common Stock that may be issued pursuant to
options granted under the Option Plan is 5,000,000. The purpose of the Option
Plan is to provide a means of performance-based compensation as an incentive for
OCC to enhance the value of the Common Stock.
72
<PAGE>
OCWEN ASSET INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
At the closing of the Initial Public Offering, the Company granted to
OCC 1,912,500 options under the Option Plan at an exercise price per share of
$16, the price at which the Common Stock was offered in the IPO. The options
vest one quarter each year upon the first four anniversaries of the closing date
of the Initial Public Offering. The options terminate on the tenth anniversary
of the closing date of the Initial Public Offering.
The following table sets for the information relating to the stock
options granted to OCC as of December 31, 1998.
<TABLE>
<CAPTION>
Options Granted Exercise Price Option Exercised Forfeited or Terminated Options Vested
--------------- -------------- ---------------- ----------------------- --------------
<S> <C> <C> <C> <C> <C>
1,912,500 $ 16.00 -- -- 478,125
</TABLE>
During 1998 and 1997, the Company recorded $0.2 million and $0.1
million of compensation expense, respectively, related to the stock options
granted to OCC in 1997. The compensation expense is based on the estimated fair
value of the options and was determined using the Black-Scholes option pricing
model. The fair value of the options was estimated using the following
assumptions:
Expected dividend yield................................. 15.625%
Expected stock price volatility......................... 17.910%
Risk-free interest rate................................. 5.391%
Expected remaining life of options...................... 3 years
NOTE 13 BASIC AND DILUTED EARNINGS PER SHARE
The Company is required to present both basic and diluted earnings per
share ("EPS") on the face of its statement of operations. Basic EPS is
calculated by dividing net income by the weighted average number of shares of
Common Stock outstanding during the year. Diluted EPS is calculated by dividing
net income by the weighted average number of shares of Common Stock outstanding
and the dilutive potential Common Stock related to outstanding stock options.
<TABLE>
<CAPTION>
1998 1997
-------------- --------------
<S> <C> <C>
Net (loss) income before extraordinary item................. $ (58,800,966) $ 11,791,518
Extraordinary item.......................................... 615,047 --
-------------- --------------
Net (loss) income........................................... $ (58,185,919) $ 11,791,518
============== ==============
BASIC EPS:
Weighted average shares of common stock..................... 18,965,000 19,108,789
Basic EPS before extraordinary item......................... $ (3.10) $ 0.62
Extraordinary item.......................................... 0.03 --
-------------- --------------
Basic EPS................................................... $ (3.07) $ 0.62
============== ==============
DILUTED EPS:
Weighted average shares of common stock..................... 18,965,000 19,108,789
Effect of dilutive securities:
Stock options............................................. -- 455,981
-------------- --------------
18,965,000 19,564,770
Diluted EPS before extraordinary item....................... $ (3.10) $ 0.60
Extraordinary item.......................................... 0.03 --
-------------- --------------
Diluted EPS................................................. $ (3.07) $ 0.60
============== ==============
</TABLE>
73
<PAGE>
OCWEN ASSET INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
NOTE 14 TAXATION
The Company has sought to qualify as a REIT under Sections 856 through
860 of the Code, as amended. A REIT will generally not be subject to federal
income taxation on that portion of its income that is distributed to its
shareholders if it distributes at least 95% of its taxable income and meets
certain other income and asset tests. The Company has until the filing of its
tax return to satisfy the distribution requirement. Since the Company plans to
distribute 100% of its taxable income, no provision has been made for federal
income taxes for the Company and its subsidiaries in the accompanying
consolidated financial statements. As taxable income is finalized and the tax
return is filed, an additional distribution may be required, which may be
significant.
At December 31, 1998, the Company had not declared the final 1998
dividend to meet the 95% distribution requirement. Accordingly, an excise tax of
$0.4 million had been recorded in the consolidated financial statements.
In addition, the Company has announced plans to terminate its REIT
status in 1999, subject to shareholder approval.
NOTE 15 COMMITMENTS AND CONTINGENCIES
At December 31, 1998, the Company had $58.7 million in outstanding
commitments to fund construction, multi-family and commercial loans. The
following table details the amounts committed at such date.
December 31, 1998
-----------------
(Dollars In Thousands)
Multi-family ............................................... $ 24,741
Hotels ..................................................... 24,991
Offices .................................................... 8,934
----------
Total committed amount ................................... $ 58,666
==========
NOTE 16 QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
The following tables sets forth the quarterly financial information for
the years indicated.
<TABLE>
<CAPTION>
4th 3rd 2nd 1st
Quarter Quarter Quarter Quarter
-------- -------- -------- --------
1998
(Dollars In Thousands)
<S> <C> <C> <C> <C>
Interest income ............................. $ 19,870 $ 20,289 $ 15,326 $ 7,472
Interest expense ............................. 10,690 10,598 5,547 694
Net interest income .......................... 9,180 9,691 9,779 6,778
Provision for loan losses .................... 85 351 101 105
Net interest income after provision for loan
Losses ...................................... 9,095 9,340 9,678 6,673
Real estate income, net ...................... 48 543 (255) 804
Other expenses ............................... 6,744 3,212 2,266 1,094
Loss on securities, derivatives, and real
estate ...................................... 53,544 15,646 -- 17,077
Minority interest in net loss (income) of
Operating Partnership ....................... 4,456 721 (511) 190
-------- -------- -------- --------
Net (loss) income before extraordinary item $(46,689) $ (8,254) $ 6,646 $(10,504)
======== ======== ======== ========
Extraordinary item ........................... -- 615 -- --
Net (loss) income ......................... $(46,689) $ (7,639) $ 6,646 $(10,504)
======== ======== ======== ========
Earnings per share:
Basic ........................................ $ (2.46) $ (0.40) $ 0.35 $ (0.55)
Diluted ...................................... $ (2.46) $ (0.40) $ 0.35 $ (0.55)
</TABLE>
74
<PAGE>
OCWEN ASSET INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998 AND 1997
<TABLE>
<CAPTION>
4th 3rd 2nd
Quarter Quarter Quarter
-------------- -------------- --------------
1997
(Dollars In Thousands)
<S> <C> <C> <C>
Interest income ................................... $ 5,467 $ 5,512 $ 2,483
Interest expense ................................... -- -- --
Net interest income ................................ 5,467 5,512 2,483
Provision for loan losses .......................... -- -- --
Net interest income after provision for loan
losses ............................................ 5,467 5,512 2,483
Real estate income, net ............................ 1,427 64 --
Other expenses ..................................... 1,504 1,226 423
Loss on securities, derivatives and real
estate............................................. -- -- --
Minority interest in net loss (income) of
Operating Partnership ............................. (9) -- --
-------------- -------------- --------------
Net (loss) income before extraordinary item......... $ 5,381 $ 4,350 $ 2,060
============== ============== ==============
Net (loss) income .................................. $ 5,381 $ 4,350 $ 2,060
============== ============== ==============
Earnings per share:
Basic............................................... $ 0.28 $ 0.23 $ 0.11
Diluted............................................. $ 0.28 $ 0.23 $ 0.11
</TABLE>
(1) The Company commenced operations on May 14, 1997.
75
<PAGE>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
DIRECTORS
The following table sets forth certain information concerning the
directors of the Company.
Name Age (1) Director Since
---- ------- --------------
William C. Erbey ....... 49 1997
Christine A. Reich ..... 37 1997
Benjamin W. Navarro .... 36 1998
Stuart L. Silpe ........ 42 1998
Peter W. Small ......... 56 1997
(1) As of March 15, 1999.
The principal occupation for the last five years of each director of
the Company, as well as some other information, is set forth below.
WILLIAM C. ERBEY. Mr. Erbey has served as the Chairman and Chief
Executive Officer of the Company since February 1997 and as the Treasurer of the
Company from February 1997 to May 1988. Mr. Erbey has served as the Chairman of
the Board of Directors of OCN since September 1996, as the Chief Executive
Officer of OCN since January 1988, and as the Chief Investment Officer of OCN
since January 1992. Mr. Erbey has served as the Chairman of the Board of
Directors of the Bank since February 1988 and as the Chief Executive Officer of
the Bank since June 1990. He also serves as a director and officer of many
subsidiaries of the Company and OCN. From 1983 to 1995, Mr. Erbey served as a
Managing General Partner of The Oxford Financial Group, a private investment
partnership that was the predecessor of OCN. From 1975 to 1983, Mr. Erbey served
at General Electric Capital Corporation ("GECC") in various capacities, most
recently as the President and Chief Operating Officer of General Electric
Mortgage Insurance Corporation. Mr. Erbey also served as the Program General
Manager of GECC's Commercial Financial Services Department and as the President
of Acquisition Funding Corporation. He received a Bachelor of Arts in Economics
from Allegheny College and a Master's degree from the Harvard Graduate School of
Business Administration.
CHRISTINE A. REICH. Ms. Reich has served as the President and a
director of the Company since February 1997. Ms. Reich has served as the
President of OCN since May 1998, as a Managing Director of OCN from June 1994 to
May 1988, as the Chief Financial Officer of OCN from January 1990 to May 1997,
as a Senior Vice President of OCN from January 1993 until June 1994 and as a
Vice President of OCN from January 1990 until January 1993. From 1987 to 1990,
Ms. Reich served as an officer of a subsidiary of OCN. Ms. Reich has served as
the President of the Bank since May 1998 and as a director of the Bank since
June 1993. Ms. Reich also serves as an officer and/or a director of many
subsidiaries of the Company and OCN. Prior to 1987, Ms. Reich was employed by
KPMG Peat Marwick LLP, most recently in the position of Manager. She holds a
Bachelor of Science in Accounting from the University of Southern California.
BENJAMIN W. NAVARRO. Mr. Navarro has served as a director of the
Company since March 1998. Mr. Navarro is Managing Director of Sherman Financial
Group, LLC, a company he founded in 1997 to purchase and securitize distressed
consumer debt. Formerly, Mr. Navarro served as Co-Head of Mortgage Sales and
Trading for Citicorp, with responsibility for the firm's purchases, sales and
securitizations of residential and commercial mortgages to institutional
clients. Prior to joining Citicorp in 1988, Mr. Navarro was with Goldman Sachs
for three years, where he worked on both the Whole Loan and Agency MBS desks.
Mr. Navarro started his career at Chemical Bank, where he completed the credit
training program and spent two years making loans to mortgage banks and thrifts.
Mr. Navarro received a Bachelor's degree in Finance from the University of Rhode
Island.
76
<PAGE>
STUART L. SILPE. Mr. Silpe has served as a director of the Company
since November 1998. Mr. Silpe is currently a consultant to the financial
services industry. Previously he served as Executive Director of the Financial
Institutions Group at CIBC Oppenheimer in New York. Mr. Silpe has had almost 20
years of mortgage finance experience, working with commercial banks, savings and
loans, mortgage banks, specialty finance companies and REITs. Mr. Silpe has held
senior positions with several major financial institutions including: Prudential
Securities, from 1991 to 1995, Morgan Stanley and Merrill Lynch. At Prudential
Securities, he was Director, Real Estate and Financial Services Group with
business development responsibilities for depository institutions. Mr. Silpe is
a graduate of the Wharton School at the University of Pennsylvania and of Emory
University.
PETER M. SMALL. Mr. Small has served as a director of the Company since
April 1997. Mr. Small served as President and Chief Executive Officer of
Spaulding and Slye Company, a commercial real estate company, for 15 years and
served as Chairman of its Board of directors from 1992 to 1996. While he was
President of Spaulding and Slye Company, Mr. Small directed the development of
over 100 commercial projects and later repositioned the company from a
development company to a service company providing consulting, asset management
and real estate services to major corporations and financial institutions.
Currently, Mr. Small manages a property portfolio, advises and invests in young
companies and consults and speaks about planning and managing real estate
organizations in changing environments. He serves as a director of Bariston
Partners, LLC, Benchmark Assisted Living, LLC, Spaulding and Slye Properties
Company and the United Way of Massachusetts Bay. Mr. Small also serves as a
Trustee of Bowdoin College, where he received a Bachelor of Arts in History.
EXECUTIVE OFFICERS WHO ARE NOT DIRECTORS
The following table sets forth certain information with respect to each
person who currently serves as an executive officer of the Company but does not
serve on the Company's Board of Directors. Executive officers of the Company are
elected annually by the Board of Directors and generally serve at the discretion
of the Board. There are no arrangements or understandings between the Company
and any person pursuant to which such person was elected as an executive officer
of the Company. Other than William C. Erbey and John R. Erbey, who are brothers,
no director or executive officer is related to any other director or executive
officer of the Company or any of its subsidiaries by blood, marriage or
adoption.
Name Age (1) Position
- -------------- ------- --------------------------------------
John R. Barnes ... 56 Senior Vice President
John R. Erbey .... 58 Senior Managing Director and Secretary
Mark S. Zeidman .. 47 Senior Vice President and Chief
Financial Officer
(1) As of March 15, 1999.
The background for the last five years of each executive officer of the
Company who is not a director, as well as certain other information, is set
forth below.
JOHN R. BARNES. Mr. Barnes has served as a Senior Vice President of the
Company since February 1997. Mr. Barnes has served as a Senior Vice President of
OCN and the Bank since May 1994 and served as a Vice President of OCN and the
Bank from October 1989 to May 1994. He also serves as an officer of many
subsidiaries of the Company and OCN. Mr. Barnes was a Tax Partner in the firm of
Deloitte Haskins & Sells from 1986 to 1989 and in the firm of Arthur Young & Co.
from 1979 to 1986. Mr. Barnes was the Partner in Charge of the Cleveland Office
Tax Department of Arthur Young & Co. from 1979 to 1984. He is a graduate of Ohio
State University.
JOHN R. ERBEY. Mr. Erbey has served as Senior Managing Director of the Company
since May 1998, as Secretary of the Company since February 1997, and as a
Managing Director of the Company from February 1997 to May 1998. Mr. Erbey has
served as Senior Managing Director of OCN since May 1998 and as Secretary of OCN
since June 1989. Mr. Erbey has served as a director of the Bank since 1990, as a
Senior Managing Director of the Bank since May 1998, and as Secretary of the
Bank since July 1989. He also serves as an officer and/or a director of many
subsidiaries of the Company and OCN. From 1971 to 1989, Mr. Erbey was a member
of the Law Department of Westinghouse Electric Corporation and held various
management positions, including Associate General Counsel and Assistant
Secretary from 1984 to 1989. Previously, he held the positions of Assistant
General Counsel of the Industries and International Group and Assistant General
Counsel of the Power Systems Group of Westinghouse. He is a graduate of
Allegheny College and Vanderbilt University School of Law.
77
<PAGE>
MARK S. ZEIDMAN. Mr. Zeidman has served as Senior Vice President and
Chief Financial Officer of the Company since June 1997. Mr. Zeidman also has
served as Senior Vice President and Chief Financial Officer of OCN and the Bank
since May 1997 and serves as an officer of many subsidiaries of the Company and
OCN. From 1986 until May 1997, Mr. Zeidman was employed by Nomura Securities
International, Inc., most recently as Managing Director. Prior to 1986, Mr.
Zeidman held positions with Shearson Lehman Brothers and Coopers & Lybrand. Mr.
Zeidman is a Certified Public Accountant. He holds a Bachelor of Arts degree
from the University of Pennsylvania, a Master of Business Administration from
the Wharton School of Business and a Masters of International Affairs from the
School of International Affairs at Columbia University.
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Exchange Act of 1934, as amended (the "Exchange
Act"), requires the Company's executive officers and directors, and persons who
own more than 10% of the Common Stock, to file reports of ownership and changes
in ownership with the Commission. Officers, directors and greater than 10%
shareholders are required by Commission regulations to furnish the Company with
copies of all Section 16(a) forms they file. Specific due dates for these
reports have been established by the Commission, and the Company is required to
report any failure to timely file such reports by those due dates during the
1998 fiscal year.
To the Company's knowledge, based solely upon review of the copies of
such reports furnished to the Company and written representations that no other
reports were required, all Section 16(a) filing requirements applicable to its
officers, directors and greater than 10% shareholders were complied during 1998,
except that Benjamin W. Navarro inadvertently failed to timely file a Form 3 to
report beneficial ownership of no shares of Common Stock at the time he became a
director of the Company. Mr. Navarro made the required filing promptly after
becoming aware of this, and such failure to file did not give rise to any
liability under Section 16(b) of the Exchange Act.
ITEM 11. EXECUTIVE COMPENSATION.
The Company has not paid, and does not intend to pay, any annual
compensation to the Company's executive officers for their services as executive
officers. Moreover, the Company has not granted, and does not intend to grant,
any options to purchase shares of stock to the executive officers or directors.
Notwithstanding that the Company has no employees and does not pay its executive
officers any compensation, the Board of Directors has formed a Compensation
Committee, comprised of the Independent Directors, to address any upcoming
compensation matters. In particular, the Board of Directors has the discretion
to change the base management fee payable to the Manager, if necessary, in order
to align the fee more closely to the actual costs of providing management
services to the Company.
The Company pays the Independent Directors an annual fee of $20,000,
plus an additional fee of $1,000 for each additional meeting of the Board of
Directors attended in person after the first four meetings. In addition, an
annual fee of $2,000 is paid to the chair of any committee of the Board. The
Company currently pays no cash compensation to its directors which are not
Independent Directors. The Company reimburses all directors for their
out-of-pocket expenses in connection with their service on the Board of
Directors.
78
<PAGE>
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The following table sets forth certain information regarding the
beneficial ownership of the Common Stock as of the date indicated by (i) each
director and executive officer of the Company, (ii) all directors and executive
officers of the Company as a group and (iii) all persons known by the Company to
own beneficially 5% or more of the outstanding Common Stock. The table is based
upon information supplied to the Company by directors, officers and principal
stockholders and filings under the Exchange Act.
Shares of Common
Stock Beneficially
Owned as of
March 9, 1999
-----------------------------------------
Name of Beneficial Owner Amount (1) Percent (1)
- ----------------------------------- ------------------- -------------
FMR Corp. 2,464,700(2) 13.0%
82 Devonshire Street
Boston, MA 02109
Wellington Management Company, LLP 1,663,200(3) 8.8
75 State Street
Boston, MA 02109
Ocwen Financial Corporation 1,653,300(4) 8.7
1675 Palm Beach Lakes Blvd
West Palm Beach, FL 33401
Directors and Executive Officers:
William C. Erbey 1,653,300(5) 8.7
Benjamin W. Navarro 10,000 *
Christine A. Reich 15,500(6) *
Stuart L. Silpe 0 *
Peter M. Small 60,000 *
John R. Barnes 0 *
John R. Erbey 2,000 *
Mark S. Zeidman 1,200(7) *
All Directors and Executive Officers
as a Group (8 persons) 1,742,000 9.2
* Less than 1%
(1) For purposes of this table, pursuant to rules promulgated under the
Exchange Act an individual is considered to beneficially own any shares
of Common Stock if he or she directly or indirectly has or shares (i)
voting power, which includes the power to vote or to direct the voting
of the shares, or (ii) investment power, which includes the power to
dispose or direct the disposition of the shares. Unless otherwise
indicated, (i) an individual has sole voting power and sole investment
power with respect to the indicated shares and (ii) individual holdings
amount to less than 1% of the outstanding shares of Common Stock.
(2) Based on information contained in a Schedule 13G filed with the
Commission as of February 12, 1999 by FMR Corp. Fidelity Management &
Research Company ("Fidelity"), a wholly-owned subsidiary of FMR Corp.
and an investment adviser registered under the Investment Advisers Act
of 1940, is the beneficial owner of 2,464,700 shares as a result of
acting as investment adviser to various investment companies registered
under the Investment Company Act of 1940. Fidelity has sole power to
dispose of all such shares, but has no voting power over any of such
shares.
79
<PAGE>
(3) Based on information contained in a Schedule 13G filed with the
Commission as of February 9, 1999 by Wellington Management Company, LLP
("WMC") in its capacity as investment adviser. WMC may be deemed to
beneficially own 1,663,200 shares which are held of record by clients
of WMC. Includes 1,051,700 shares as to which shared voting power is
claimed and 1,663,200 shares as to which shared disposal power is
claimed.
(4) Based on records available to the Company, as well as information
contained in a Schedule 13G filed with the Commission by OCN, the
Manager, IMIHC and William C. Erbey on February 10, 1999. Includes: (a)
113,300 shares held by FF Plaza Partners ("FF Plaza"), a partnership of
which Mr. Erbey, his spouse and Delaware Permanent Corporation, a
corporation wholly-owned by Mr. Erbey, are general partners; and (b)
1,540,000 shares owned directly by IMIHC and as to which OCN and Mr.
Erbey share voting and investment power. Does not include options
granted to the Manager to acquire 478,125 shares. Mr. Erbey has
disclaimed beneficial ownership of the 1,540,000 shares owned of record
by IMIHC and the options granted to the Manager to acquire 478,125
shares.
(5) Includes: (a) 113,300 shares held by FF Plaza; and (b) 1,540,000 shares
owned directly by IMIHC and as to which William C. Erbey shares voting
and investment power. Does not include options granted to the Manager
to acquire 478,125 shares. Mr. Erbey has disclaimed beneficial
ownership of the 1,540,000 shares owned of record by IMIHC and the
options granted to the Manager to acquire 478,125 shares.
(6) The shares are held by the CPR Family Limited Partnership pursuant to
which Christine A. Reich and her husband share voting and investment
power. Ms. Reich has disclaimed beneficial ownership of such shares.
(7) Includes 200 shares held by Mr. Zeidman's daughter. Mr. Zeidman has
disclaimed beneficial ownership of such shares.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
CERTAIN RELATIONSHIPS
The Manager, subject to the supervision of the Board of Directors of
the Company, manages the Company pursuant to a Management Agreement. The
Management Agreement provides for an annual base management fee of 0.25% per
quarter (1% per annum), calculated and paid quarterly based upon the Average
Invested Assets of the Company for such quarter. The term "Average Invested
Assets" for any period means the average of the aggregate book value of the
assets of the Company, including the assets of all of its direct and indirect
subsidiaries, before reserves for depreciation or bad debts or other similar
noncash reserves, computed by taking the daily average of such values during
such period; provided, however, effective January 1, 1998, with respect to
residential loans, the phase means average net equity invested. The Board of
Directors is authorized to adjust the base management fee if necessary to align
the fee more closely with the actual costs of management services. The Manager
also is entitled to receive incentive compensation for each fiscal quarter. See
"Business-Management Fees" under Item 1.
For the year ended 1998, the Company paid the Manager $5.9 million in
base management fees and no incentive compensation. In addition, for such
period, the Manager was reimbursed $1.8 million for out of pocket costs and
salary allocations for due diligence tasks.
In addition to being Chairman of the Board of Directors and Chief
Executive Office of the Company, William C. Erbey is Chairman of the Board and
Chief Executive Officer of the Manager, the Bank and of OCN. William C. Erbey
owns or has voting power over approximately 32.0% of the outstanding common
stock of OCN. Christine A. Reich is not only President of and a member of the
Board of Directors of the Company, but also is President of the Manager, the
Bank and OCN. Similarly, each of the Company's executive officers also serves as
an executive officer of the Manager and of OCN.
CERTAIN TRANSACTIONS
In 1998, the Company entered into a number of transactions with OCN and
the Bank, in addition to the services rendered by the Manager to the Company
pursuant to the Management Agreement, as discussed above. In this regard, the
Bank services all of the Company's mortgage loans pursuant to servicing
agreements (one for commercial loans and one for residential loans), the forms
of which were approved by the Independent Directors. In addition to servicing
the Company's mortgage loans, the Bank is the special servicer for the loans
underlying most of the mortgage-backed securities owned by the Company, and the
Independent Directors have approved those transactions in their quarterly
meetings.
80
<PAGE>
On February 17, 1998, the Company issued an aggregate of 175,000 shares
of Common Stock to William C. Erbey, Christine A. Reich, Jordan C. Paul (a
former executive officer of the Company and OCN) and Barry N. Wish (a director
of OCN), who acquired 113,300 shares, 2,500 shares, 2,500 shares and 56,700
shares, respectively. The per share purchase price for the Common Stock was the
weighted average sales price per share of Common Stock on the last trading day
before the transaction. In connection with this stock issuance, IMIHC exchanged
175,000 shares of Common Stock for a like number of limited partnership units in
the Operating Partnership in order to comply with the stock ownership
restrictions imposed on REITs under the Code.
On April 24, 1998, the Company acquired securitized mortgage loan
residuals for approximately (pound)33.7 million (approximately $56.3 million)
from the United Kingdom subsidiary of Cityscape Financial Corp. ("CFC"). (The
dollar equivalent amounts set forth herein are based on an exchange rate on
April 24, 1998 of $1.667 per British pound.) This purchase was made in
connection with OCN's acquisition of substantially all of the assets, and
certain liabilities of the United Kingdom operations of CFC. The Company funded
this acquisition with a loan from Greenwich Capital Financial Products in the
principal amount of approximately (pound)19.0 million ($31.8 million), which was
collateralized by the residuals, and a loan from IMIHC in the principal amount
of approximately (pound)14.7 million ($24.5 million), which was collateralized
by unrelated assets and subsequently converted to equity via the purchase of
limited partnership interests in the Operating Partnership. The mortgage loan
residuals acquired by the company were previously issued as a part of six prior
securitizations effected by CFC's U.K. operations. In connection with the
foregoing acquisition, the Company entered into an agreement for the Bank to
service the securitized mortgage loan residuals.
On May 7, 1998, the Company sold its entire portfolio of AAA-rated IO
and Inverse IO classes of mortgage related securities backed by single family
residential loans to William C. Erbey and Barry N. Wish, for a cash price of
$54.6 million, which represented the IO Portfolio's amortized cost plus accrued
interest and exceeded the IO portfolio's market value by approximately $14.0
million (which represented 82% of the $17.1 million aggregated loss recorded by
the Company on such securities during the first quarter of 1998). Because the
IOs were sold to a principal shareholder and another related party, the $14.0
million by which amortized cost exceeded market value was recorded as a charge
to earnings for the quarter ended March 31, 1998 in accordance with GAAP. The
$14.0 million received in excess of market value upon sale of the IO Portfolio
has been reflected on the Company's books as a capital contribution, effectively
reestablishing the Company's equity positions.
Additionally, during 1998 the Bank and the Company were co-bidders on
16 pools of residential mortgages with an aggregate principal amount of
approximately $95.8 million, of which the Company acquired $49.1 million.
81
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PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Exhibits
3.1 Amended and Restated Articles of Incorporation (1)
3.2 Bylaws (3)
4.1 Form of Common Stock certificate (1)
4.2 Form of indenture between the Company and Norwest Bank
Minnesota, National Association, as trustee thereunder for the
11.5% Redeemable Notes due 2005 (2)
10.1 First Amended and Restated Management Agreement (4)
10.2 Form of Registration Rights Agreement (1)
10.3 Third Amended and Restated Agreement of Limited Partnership of
Ocwen Partnership L.P. (4)
10.4 Form of Stock Option Plan (1)
10.5 Purchase and Sale Agreement between Ocwen Capital Corporation
and Pacific Resources Development, Inc. as of March 31, 1998
(4)
10.6 Assignment and Assumption Agreement, dated April 7, 1998, by
and between Ocwen Capital Corporation and OAIC Bush Street,
LLC (5)
10.7 Loan Agreement between OAIC Bush Street, LLC and Salomon
Brothers Realty Corp. as of April 7, 1998 (5)
10.8 Purchase and Sale Agreement between Prudential Insurance
Company of America and Ocwen Capital Corporation, dated June
9, 1998 (6)
10.9 Loan Agreement between OAC and Merrill Lynch Mortgage Capital
Inc. as of March 30, 1998 (4)
10.10 Loan Agreement between OAC and Greenwich Financial Products
Inc. as of April 24, 1998 (4)
10.11 Amended and Restated Loan Agreement by and among, inter alia,
OAIC California Partnership, L.P., OAIC California Partnership
II, L.P., Salomon Brothers Realty Corp. and LaSalle National
Bank, dated as of June 10, 1998. (4)
27 Financial Data Schedule for the period ended December 31, 1997
(3)
99.1 Investment Guidelines (4)
99.2 Risk Factors (3)
================================================================================
82
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(1) Incorporated by reference to the Company's
Registration Statement on Form S-11 (File No.
333-21965), as amended, declared effective by the
Commission on May 14, 1997.
(2) Incorporated by reference to the Company's
Registration Statement on Form S-4 (File No.
333-64047), as amended, as declared effective by the
Commission on February 12, 1999.
(3) Filed herewith.
(4) Incorporated by reference to the Company's Quarterly
Report on Form 10-Q for the quarterly period ended
June 30, 1998.
(5) Incorporated by reference to the Current Report on
Form 8-K filed by the Company with the Commission on
April 23, 1998.
(6) Incorporated by reference to the Current Report on
Form 8-K filed by the Company with the Commission on
August 6, 1998.
(b) Financial Statements and Schedules
The following consolidated financial statements of Ocwen Asset
Investment Corp. and report of PricewaterhouseCoopers, LLP, independent
certified public accountants, are included in Item 8 hereof.
(1) Report of Independent Certified Public Accountants
(2) Consolidated Statements of Financial Condition at
December 31, 1998 and December 31, 1997
(3) Consolidated Statement of Operations for each of the
two years in the period ended December 31, 1998
(4) Consolidated Statements of Comprehensive Income for
each of the two years in the period ended December
31, 1998
(5) Consolidated Statement of Changes in Stockholders'
Equity for each of the two years in the period ended
December 31, 1998
(6) Consolidated Statement of Cash Flows for each of the
two years in the period ended December 31, 1998
(7) Notes to Consolidated Financial Statements
Financial statement schedules have been omitted because they are not
applicable or the required information is shown in the consolidated financial
statements or notes thereto.
83
<PAGE>
REPORTS ON FORM 8-K FILED DURING THE QUARTER ENDED DECEMBER 31, 1998
(1) A Form 8-K filed on October 27, 1998, which contained a news release
announcing the Company's financial results for the three months ended
September 30, 1998.
(2 A Form 8-K filed on December 22, 1998, which contained a news release
proposing changes to the Company's tax status and deferring its quarterly
dividend.
84
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SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities
Exchange Act of 1934, as amended, the Registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized.
OCWEN ASSET INVESTMENT CORP.
By: /s/ WILLIAM C. ERBEY
------------------------------------
William C. Erbey
Chairman and Chief Executive Officer
Date: March 15, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, this report has been signed below by the following persons on behalf of
the registrant and in the capacities and on the date indicated:
/s/ WILLIAM C. ERBEY Date: March 15, 1999
- -----------------------
William C. Erbey
Chairman of the Board and Chief Executive Officer
(principal executive officer)
/s/ CHRISTINE A. REICH Date: March 15, 1999
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Christine A. Reich
President and Director
/s/ BENJAMIN W. NAVARRO Date: March 15, 1999
- -----------------------
Benjamin W. Navarro
Director
/s/ STUART L. SILPE Date: March 15, 1999
- -----------------------
Stuart L. Silpe
Director
/s/ PETER M. SMALL Date: March 15, 1999
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Peter M. Small
Director
/s/ MARK S. ZEIDMAN Date: March 15, 1999
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Mark S. Zeidman
Senior Vice President and Chief Financial Officer
(principal financial and accounting officer)
85
BYLAWS
OF
OCWEN ASSET INVESTMENT CORP.
<PAGE>
TABLE OF CONTENTS
Page
ARTICLE I OFFICES........................................................... 1
Section 1. Principal Office........................................ 1
Section 2. Additional Offices...................................... 1
Section 3. Fiscal and Taxable Years................................ 1
ARTICLE II DEFINITONS....................................................... 1
ARTICLE III. MEETINGS OF SHAREHOLDERS....................................... 3
Section 1. Place................................................... 3
Section 2. Annual Meeting.......................................... 3
Section 3. Special Meetings........................................ 4
Section 4. Notice.................................................. 4
Section 5. Scope of Notice......................................... 5
Section 6. Organization............................................ 5
Section 7. Quorum.................................................. 6
Section 8. Voting.................................................. 6
Section 9. Proxies................................................. 7
Section 10. Voting of Shares by Certain Holders..................... 7
Section 11. Inspectors.............................................. 8
Section 12. Fixing Record Date...................................... 8
Section 13. Action Without a Meeting................................ 9
Section 14. Voting by Ballot........................................ 9
Section 15. Voting List............................................. 9
Section 16. Shareholder Proposals................................... 10
ARTICLE IV DIRECTORS........................................................ 11
Section 1. General Powers.......................................... 11
Section 2. Number, Tenure and Qualifications....................... 12
Section 3. Changes in Number; Vacancies............................ 12
Section 4. Resignations............................................ 13
Section 5. Removal of Directors.................................... 13
Section 6. Annual and Regular Meetings............................. 13
Section 7. Special Meetings........................................ 13
Section 8. Notice.................................................. 14
Section 9. Quorum.................................................. 14
Section 10. Voting.................................................. 14
Section 11. Telephone Meetings...................................... 15
Section 12. Action Without a Meeting................................ 15
Section 13. Compensation............................................ 16
Section 14. Policies and Resolutions................................ 16
Section 15. Nominations............................................. 16
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ARTICLE V COMMITTEES........................................................ 18
Section 1. Committees of the Board................................. 18
Section 2. Telephone Meetings...................................... 19
Section 3. Action By Committees Without a Meeting.................. 19
ARTICLE VI OFFICERS......................................................... 20
Section 1. General Provisions...................................... 20
Section 2. Subordinate Officers, Committees and Agents............. 20
Section 3. Removal and Resignation................................. 21
Section 4. Vacancies............................................... 21
Section 5. General Powers.......................................... 21
Section 6. Duties of the Chairman of the Board..................... 21
Section 7. Duties of the Chief Executive Officer and the President. 22
Section 8. Duties of the Senior Managing Directors,
Managing Directors, Executive Vice Presidents,
Senior Vice Presidents and Vice Presidents........ 23
Section 9. Duties of the Treasurer................................. 23
Section 10. Duties of the Secretary................................. 23
Section 11. Other Duties of Officers................................ 24
Section 12. Salaries................................................ 24
ARTICLE VII CONTRACTS, NOTES, CHECKS AND DEPOSITS........................... 24
Section 1. Contracts............................................... 24
Section 2. Checks and Drafts....................................... 25
Section 3. Deposits................................................ 25
ARTICLE VIII SHARES......................................................... 25
Section 1. Share Certificates .................................... 25
Section 2. Lost Certificate........................................ 26
Section 3. Transfer Agents and Registrars.......................... 26
Section 4. Transfer of Shares...................................... 26
Section 5. Stock Ledger............................................ 27
ARTICLE IX DISTRIBUTIONS.................................................... 27
Section 1. Declaration............................................. 27
Section 2. Contingencies........................................... 28
ARTICLE X SEAL.............................................................. 28
Section 1. Seal.................................................... 28
Section 2. Affixing Seal........................................... 28
ARTICLE XI WAIVER OF NOTICE................................................. 29
Waiver of Notice.................................................... 29
ii
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ARTICLE XII AMENDMENT OF BYLAWS............................................. 29
Section 1. By Directors............................................ 29
Section 2. By Shareholders......................................... 30
iii
<PAGE>
BYLAWS
OF
OCWEN ASSET INVESTMENT CORP.
The Board of Directors of Ocwen Asset Investment Corp. (the
"Corporation") hereby sets out the Bylaws of the Corporation in their entirety,
as follows:
ARTICLE I
OFFICES
Section 1. PRINCIPAL OFFICE. The principal office of the Corporation
shall be located at 1675 Palm Beach Lakes Boulevard, West Palm Beach, Florida
33401, or at any other place or places as the Board of Directors may designate.
Section 2. ADDITIONAL OFFICES. The Corporation may have additional
offices at such places as the Board of Directors may from time to time determine
or the business of the Corporation may require.
Section 3. FISCAL AND TAXABLE YEARS. The fiscal and taxable years of
the Corporation shall begin on January 1 and end on December 31.
ARTICLE II
DEFINITIONS
For purposes of these Bylaws, the following words shall have the
meanings set forth below:
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(a) For the purposes of this Section C, the term "Manager"
means the Person responsible for directing day-to-day business affairs of the
Corporation, including any Person to which the Manager subcontracts
substantially all such functions.
(b) For purposes of this Section C, "Affiliate" of a Person
shall mean (i) any Person directly or indirectly owning, controlling, or
holding, with power to vote ten percent or more of the outstanding voting
securities of such other Person, (ii) any Person ten percent or more of whose
outstanding voting securities are directly or indirectly owned, controlled, or
held, with power to vote, by such other Person, (iii) any Person directly or
indirectly controlling, controlled by, or under common control with such other
Person, (iv) any executive officer, director, trustee or general partner of such
other Person, and (v) any legal entity for which such Person acts as an
executive officer, director, trustee or general partner.
(c) For the purposes of this Section C, an indirect
relationship shall include circumstances in which a director's spouse, children,
parents, siblings or mothers-, fathers-, sisters- or brothers-in-law is or has
been associated with the Manager or any of its Affiliates.
(d) For the purposes of this Section C, a business
relationship is material PER SE if the gross revenue derived from the potential
director from the Manager and its Affiliates exceeds 5% of his or her (i) annual
gross revenue from all sources in either of the last two years and (ii) net
worth, on a fair market value basis.
(e) The term "Person" means and includes any natural person,
corporation, partnership, association, trust, limited liability company or any
legal entity.
(f) Notwithstanding anything herein to the contrary, at all
times beginning ninety (90) days following the initial public offering of the
Corporation's shares (except during a
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<PAGE>
period not to exceed sixty (60) days following the death, resignation,
incapacity or removal from office of a director prior to expiration of the
director's term of office), a majority of the Board of Directors shall be
"Independent Directors." "Independent Directors" shall mean any director who
within the last two years has not directly or indirectly (i) been employed by
the Manager or any of its Affiliates or been an officer or director of the
Manager or any of its Affiliates, (ii) performed services for the Manager or any
of its Affiliates or (iii) had any material business or professional
relationship with the Manager or any of its Affiliates.
ARTICLE III
MEETINGS OF SHAREHOLDERS
Section 1. PLACE. All meetings of shareholders shall be held at 1675
Palm Beach Lakes Boulevard, West Palm Beach, Florida 33401, or at such other
place within the United States as shall be stated in the notice of the meeting.
Section 2. ANNUAL MEETING. The Chief Executive Officer, the President
or the Board of Directors may fix the time of the annual meeting of the
shareholders for the election of Directors and the transaction of any business
as may be properly brought before the meeting, but if no such date and time is
fixed by the Chief Executive Officer, the President or the Board of Directors,
the meeting for any calendar year shall be held on the fourth Thursday in May,
if that day is not a legal holiday. If that day is a legal holiday, the annual
meeting shall be held on the next succeeding business day that is not a legal
holiday.
Section 3. SPECIAL MEETINGS. The Chief Executive Officer, the
President, a majority of
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<PAGE>
the Board of Directors or a majority of the Independent Directors may call
special meetings of the shareholders. Special meetings of shareholders also
shall be called by the Secretary upon the written request of the holders of
shares entitled to cast not less than ten percent (10%) of all the votes
entitled to be cast at such meeting. Such request shall state the purpose of
such meeting and the matters proposed to be acted on at such meeting. The
Secretary shall inform such shareholders of the reasonably estimated cost of
preparing and mailing notice of the meeting and, upon payment to the Corporation
of such costs, the Secretary shall give notice to each shareholder entitled to
notice of the meeting. Unless requested by shareholders entitled to cast a
majority of all the votes entitled to be cast at such meeting, a special meeting
need not be called to consider any matter which is substantially the same as a
matter voted on at any annual or special meeting of the shareholders held during
the preceding twelve months.
Section 4. NOTICE. Not less than 10 nor more than 60 days before each
meeting of shareholders, the Secretary shall give to each shareholder entitled
to vote at such meeting and to each shareholder not entitled to vote who is
entitled to notice of the meeting, written or printed notice stating the time
and place of the meeting and, in the case of a special meeting or as otherwise
may be required by statute, the purpose for which the meeting is called, either
by mail or by presenting it to such shareholder personally or by leaving it at
his or her residence or usual place of business. If mailed, such notice shall be
deemed to be given when deposited in the United States mail addressed to the
shareholder at his or her post office address as it appears on the records of
the Corporation, with postage thereon prepaid.
Notice of a meeting of shareholders to act on (i) an amendment of the
Articles of Incorporation of the Corporation (the "Articles of Incorporation"),
(ii) plan of merger or share
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<PAGE>
exchange, (iii) the sale, lease, exchange or other disposition of all, or
substantially all, the property of the Corporation otherwise than in the usual
and regular course of its business, or (iv) the dissolution of the Corporation,
shall be given in the manner provided above, to each shareholder, whether or not
entitled to vote, not less than twenty-five nor more than sixty days before the
date of the meeting. Any such notice shall state that one of the purposes of the
meeting is to consider the particular extraordinary corporate act and, when
applicable, shall be accompanied by a copy of the (i) proposed amendment, (ii)
plan of merger or share exchange, or (iii) agreement pursuant to which the
disposition of all or substantially all of the Corporation's property will be
effected.
Section 5. SCOPE OF NOTICE. No business shall be transacted at a
special meeting of shareholders except that specifically designated in the
notice of the meeting. Subject to the provisions of Section 16 of this Article
III, any business of the Corporation may be transacted at the annual meeting
without being specifically designated in the notice, except such business as is
required by statute to be stated in such notice.
Section 6. ORGANIZATION. At every meeting of the shareholders, the
Chairman of the Board, if there be one, shall conduct the meeting or, in the
case of vacancy in office or absence of the Chairman of the Board, one of the
following officers present shall conduct the meeting and act as Chairman in the
order stated: the Vice Chairman of the Board, if there be one, the Chief
Executive Officer, the President, the Senior Managing Directors, the Managing
Directors, the Executive Vice Presidents, the Senior Vice Presidents and the
Vice Presidents, in their order of rank and seniority, or a Chairman chosen by
the shareholders entitled to cast a majority of the votes which all shareholders
present in person or by proxy are entitled to cast. The Secretary, or,
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<PAGE>
in his or her absence, an Assistant Secretary, or in the absence of both the
Secretary and Assistant Secretaries, a person appointed by the Chairman shall
act as Secretary.
Section 7. QUORUM. At any meeting of shareholders, the presence in
person or by proxy of shareholders entitled to cast a majority of all the votes
entitled to be cast at such meeting shall constitute a quorum; but this Section
7 shall not affect any requirement under any statute, the Articles of
Incorporation or these Bylaws for the vote necessary for the adoption of any
measure. If such quorum shall not be present at any meeting of the shareholders,
the shareholders representing a majority of the shares entitled to vote at such
meeting, present in person or by proxy, may vote to adjourn the meeting from
time to time to a date not more than 120 days after the original record date
without notice other than announcement at the meeting until such quorum shall be
present. At such adjourned meeting at which a quorum shall be present, any
business may be transacted which might have been transacted at the meeting as
originally notified. Any meeting at which Directors are to be elected shall be
adjourned only from day to day, as may be directed by shareholders representing
a majority of the shares who are present in person or by proxy and who are
entitled to vote on the election of Directors.
Section 8. VOTING. A plurality of all the votes cast at a meeting of
shareholders duly called and at which a quorum is present shall be sufficient to
elect a director. There shall be no cumulative voting. Each share may be voted
for as many individuals as there are Directors to be elected and for whose
election the share is entitled to be voted. A majority of the votes cast at a
meeting of shareholders duly called and at which a quorum is present shall be
sufficient to approve any other matter which may properly come before the
meeting, unless more than a majority of the votes cast is required by statute,
by the Articles of Incorporation or by these
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<PAGE>
Bylaws. Each shareholder of record shall have the right, at every meeting of
shareholders, to one vote for each share held.
Section 9. PROXIES. A shareholder may vote the shares owned of record
by him or her, either in person or by proxy executed in writing by the
shareholder or by his or her duly authorized attorney in fact. Such proxy shall
be filed with the Secretary of the Corporation before or at the time of the
meeting. No proxy shall be valid after eleven months from the date of its
execution, unless otherwise provided in the proxy.
Section 10. VOTING OF SHARES BY CERTAIN HOLDERS. Shares registered in
the name of another corporation, if entitled to be voted, may be voted by the
president, a vice president or a proxy appointed by the president or a vice
president of such other corporation, unless some other person who has been
appointed to vote such shares pursuant to a bylaw or a resolution of the board
of directors of such other corporation presents a certified copy of such bylaw
or resolution, in which case such person may vote such shares. Any fiduciary may
vote shares registered in his or her name as such fiduciary, either in person or
by proxy.
Shares of its own stock indirectly owned by this Corporation shall not
be voted at any meeting and shall not be counted in determining the total number
of outstanding shares entitled to be voted at any given time, unless they are
held by it in a fiduciary capacity, in which case they may be voted and shall be
counted in determining the total number of outstanding shares at any given time.
The Board of Directors may adopt by resolution a procedure by which a
shareholder may certify in writing to the Corporation that any shares registered
in the name of the shareholder are held for the account of a specified person
other than the shareholder. The resolution shall set
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<PAGE>
forth the class of shareholders who may make the certification, the purpose for
which the certification may be made, the form of certification and the
information to be contained in it; if the certification is with respect to a
record date or closing of the stock transfer books, the time after the record
date or closing of the stock transfer books within which the certification must
be received by the Corporation; and any other provisions with respect to the
procedure which the Board of Directors considers necessary or desirable. On
receipt of such certification, the person specified in the certification shall
be regarded as, for the purposes set forth in the certification, the shareholder
of record of the specified shares in place of the shareholder who makes the
certification.
Section 11. INSPECTORS. At any meeting of shareholders, the Chairman of
the meeting may, or upon the request of any shareholder shall, appoint one or
more persons as inspectors for such meeting. Such inspectors shall ascertain and
report the number of shares represented at the meeting based upon their
determination of the validity and effect of proxies, count all votes, report the
results and perform such other acts as are proper to conduct the election and
voting with impartiality and fairness to all the shareholders.
Each report of an inspector shall be in writing and signed by him or
her or by a majority of them if there is more than one inspector acting at such
meeting. If there is more than one inspector, the report of a majority shall be
the report of the inspectors. The report of the inspector or inspectors on the
number of shares represented at the meeting and the results of the voting shall
be PRIMA FACIE evidence thereof.
Section 12. FIXING RECORD DATE. For the purpose of determining
shareholders entitled to notice of or to vote at any meeting of the shareholders
or any adjournment thereof, or entitled to
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<PAGE>
receive payment for any distribution, or in order to make a determination of
shareholders for any other proper purpose, the Board of Directors may fix in
advance a date as the record date for any such determination of shareholders,
such date in any case to be not more than seventy days prior to the date on
which the particular action, requiring such determination of shareholders, is to
be taken. If no record date is fixed for the determination of shareholders
entitled to notice of or to vote at a meeting of shareholders, or shareholders
entitled to receive payment of a distribution, the date on which notice of the
meeting is mailed or the date on which the resolution of the Board of Directors
declaring such distribution is adopted, as the case may be, shall be the record
date for such determination of shareholders. When a determination of
shareholders entitled to vote at any meeting of shareholders has been made as
provided in this section such determination shall apply to any adjournment
thereof.
Section 13. ACTION WITHOUT A MEETING. Any action required or permitted
to be taken at a meeting of shareholders may be taken without a meeting if a
consent in writing, setting forth such action, is signed by each shareholder
entitled to vote on the matter and any other shareholder entitled to notice of a
meeting of shareholders (but not to vote thereat) has waived in writing any
right to dissent from such action, and such consent and waiver are filed with
the minutes of proceedings of the shareholders.
Section 14. VOTING BY BALLOT. Voting on any question or in any election
may be VIVA VOCE unless the presiding officer shall order or any shareholder
shall demand that voting be by ballot.
Section 15. VOTING LIST. The officer or agent having charge of the
stock transfer books for shares of the Corporation shall make, at least ten (10)
days before each meeting of
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<PAGE>
shareholders, a complete list of the shareholders entitled to vote at such
meeting or any adjournment thereof, with the address of and the number of shares
held by each. Such list, for a period of ten (10) days prior to such meeting,
shall be kept on file at the registered office of the Corporation or at its
principal place of business or at the office of its transfer agent or registrar
and shall be subject to inspection by any shareholder at any time during usual
business hours. Such list shall also be produced and kept open at the time and
place of the meeting and shall be subject to the inspection of any shareholder
during the whole time of the meeting. The original stock transfer books shall be
prima facie evidence as to who are the shareholders entitled to examine such
list or transfer books or to vote at any meeting of shareholders. If the
requirements of this section have not been substantially complied with, the
meeting shall, on the demand of any shareholder in person or by proxy, be
adjourned until the requirements are complied with.
Section 16. SHAREHOLDER PROPOSALS. To be properly brought before an
annual meeting of shareholders, business must be (i) specified in the notice of
meeting (or any supplement thereto) given by or at the direction of the Board of
Directors, (ii) otherwise properly brought before the meeting by or at the
direction of the Board of Directors, or (iii) otherwise properly brought before
the meeting by a shareholder. In addition to any other applicable requirements,
for business to be properly brought before an annual meeting by a shareholder,
the shareholder must have given timely notice thereof in writing to the
Secretary of the Corporation. To be timely, a shareholder's notice must be
given, either by personal delivery or by United States mail, postage prepaid, to
the Secretary of the Corporation not later than ninety (90) days in advance of
the annual meeting. A shareholder's notice to the Secretary shall set forth as
to each matter the shareholder proposes to bring before the annual meeting (i) a
brief description of the business
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<PAGE>
desired to be brought before the annual meeting (including the specific proposal
to be presented) and the reasons for conducting such business at the annual
meeting, (ii) the name and record address of the shareholder proposing such
business, (iii) the class and number of shares of the Corporation that are
beneficially owned by the shareholder, and (iv) any material interest of the
shareholder in such business.
In the event that a shareholder attempts to bring business before an
annual meeting without complying with the provisions of this Section 16, the
Chairman of the meeting shall declare to the meeting that the business was not
properly brought before the meeting in accordance with the foregoing procedures,
and such business shall not be transacted. No business shall be conducted at the
annual meeting except in accordance with the procedures set forth in this
Section 16, PROVIDED, HOWEVER, that nothing in this Section 16 shall be deemed
to preclude discussion by any shareholder of any business properly brought
before the annual meeting.
ARTICLE IV
DIRECTORS
Section 1. GENERAL POWERS. The Board of Directors shall have full power
to conduct, manage, and direct the business and affairs of the Corporation, and
all powers of the Corporation, except those specifically reserved or granted to
the shareholders by statute or by the Articles of Incorporation or these Bylaws,
shall be exercised by, or under the authority of, the Board of Directors. Unless
otherwise agreed between the Corporation and the Director, each individual
Director, including each Independent Director, may engage in other business
activities of the type conducted by the Corporation and is not required to
present to the Corporation any
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<PAGE>
investment opportunities presented to them even though the investment
opportunities may be within the scope of the Corporation's investment policies.
Section 2. NUMBER, TENURE AND QUALIFICATIONS. The number of Directors
of the Corporation shall be not less than one (1) nor more than nine (9).
Directors need not be shareholders in the Corporation.
At all times beginning ninety (90) days following the initial public
offering of the Corporation's shares (except during a period not to exceed sixty
(60) days following the death, resignation, incapacity or removal from office of
a Director prior to the expiration of the Director's term of office), a majority
of the Directors shall be Independent Directors.
Section 3. CHANGES IN NUMBER; VACANCIES. Any vacancy occurring on the
Board of Directors may, subject to the provisions of Section 5 of this Article
IV, be filled by a majority of the remaining members of the Board of Directors,
although such majority is less than a quorum; provided, however, that a majority
of Independent Directors shall nominate replacements for vacancies among the
Independent Directors, which replacements must be elected by a majority of the
Directors, including a majority of the Independent Directors. Any vacancy
occurring by reason of an increase in the number of Directors may be filled by
action of a majority of the entire Board of Directors including a majority of
Independent Directors. If the shareholders of any class or series are entitled
separately to elect one or more Directors, a majority of the remaining Directors
elected by that class or series or the sole remaining Director elected by that
class or series may fill any vacancy among the number of Directors elected by
that class or series. A Director elected by the Board of Directors to fill a
vacancy shall be elected to hold office until the next annual meeting of
shareholders or until his or her successor is elected and
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qualified. The Board of Directors may declare vacant the office of a Director
who has been declared of unsound mind by an order of court, who has pled guilty
or NOLO CONTENDERE to, or been convicted of, a felony involving moral turpitude,
or who has willfully violated the Corporation's Articles of Incorporation or
these Bylaws.
Section 4. RESIGNATIONS. Any Director or member of a committee may
resign at any time. Such resignation shall be made in writing and shall take
effect at the time specified therein, or if no time be specified, at the time of
the receipt by the Chairman of the Board, the Chief Executive Officer, the
President or the Secretary.
Section 5. REMOVAL OF DIRECTORS. The shareholders may, at any time,
remove any Director, with or without cause, by the affirmative vote of the
holders of not less than two-thirds of all the shares entitled to vote on the
election of Directors and may elect a successor to fill any resulting vacancy
for the balance of the term of the removed Director.
Section 6. ANNUAL AND REGULAR MEETINGS. An annual meeting of the Board
of Directors shall be held immediately after and at the same place as the annual
meeting of shareholders, no notice other than this bylaw being necessary. The
Board of Directors may provide, by resolution, the time and place, either within
or without the Commonwealth of Virginia, for the holding of regular meetings of
the Board of Directors without other notice than such resolution.
Section 7. SPECIAL MEETINGS. Special meetings of the Board of Directors
may be called by or at the request of the Chief Executive Officer, the
President, a majority of the Board of Directors or a majority of the Independent
Directors then in office. The person or persons authorized to call special
meetings of the Board of Directors may fix any place, either within or without
the Commonwealth of Virginia, as the place for holding any special meeting of
the
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Board of Directors called by them.
Section 8. NOTICE. Notice of any special meeting of the Board of
Directors shall be given by written notice delivered personally, telegraphed,
telecopied or mailed to each Director at his or her business or resident
address. Personally delivered, telegraphed or telecopied notices shall be given
at least two days prior to the meeting. Notice by mail shall be given at least
five days prior to the meeting. If mailed, such notice shall be deemed to be
given when deposited in the United States mail properly addressed, with postage
thereon prepaid. If given by telegram, such notice shall be deemed to be given
when the telegram is delivered to the telegraph company. Neither the business to
be transacted at, nor the purpose of, any annual, regular or special meeting of
the Board of Directors need be stated in the notice, unless specifically
required by statute or these Bylaws.
Section 9. QUORUM. Subject to the provisions of Section 10 of this
Article IV, a majority of the entire Board of Directors shall constitute a
quorum for transaction of business at any meeting of the Board of Directors,
provided that, if less than a quorum is present at said meeting, a majority of
the Directors present may adjourn the meeting from time to time without further
notice.
Subject to the provisions of Section 10 of this Article IV, the
Directors present at a meeting which has been duly called and convened may
continue to transact business until adjournment, notwithstanding the withdrawal
of enough Directors to leave less than a quorum.
Section 10. VOTING. (a) Except as provided in subsection (b) of this
Section 10, the action of the majority of the Directors present at a meeting at
which a quorum is present shall be the action of the Board of Directors, unless
the concurrence of a greater proportion is required for
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such action by the Articles of Incorporation, these Bylaws, or applicable
statute.
(b) Notwithstanding anything in these Bylaws to the contrary,
(i) any action pertaining to a sale or other disposition of an "Initial
Investment," as defined in the Corporation's registration statement on Form S-11
(the "Registration Statement"), as declared effective by the Securities and
Exchange Commission (the "SEC") in connection with the Corporation's initial
public offering of common shares (the "Initial Public Offering") (ii) any action
pertaining to the refinancing of or prepayment of any principal on the "Assumed
Indebtedness" as defined in the Registration Statement as declared effective by
the SEC in connection with the Initial Public Offering, (iii) any action
pertaining to the purchase of any real estate asset, (iv) any other action
pertaining to any transaction involving the Corporation, including the purchase,
sale, lease, or mortgage of any real estate asset or any other transaction, in
which an advisor, Director or officer of the Corporation, or any Affiliate of
any of the foregoing persons, has any direct or indirect interest other than
solely as a result of their status as a director, officer, or shareholder of the
Corporation and (v) subject to the Corporation having sufficient funds, any
decision to decrease the Corporation's quarterly distributions to holders of
common shares below $.15 per common share, must be approved by a majority of the
Directors, including a majority of the Independent Directors, even if the
Independent Directors constitute less than a quorum.
Section 11. TELEPHONE MEETINGS. Members of the Board of Directors may
participate in a meeting by means of a conference telephone or similar
communications equipment if all persons participating in the meeting can hear
each other at the same time. Participation in a meeting by these means shall
constitute presence in person at the meeting.
Section 12. ACTION WITHOUT A MEETING. Any action required or permitted
to be taken at
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any meeting of the Board of Directors may be taken without a meeting, if a
consent in writing to such action is signed by each Director and such written
consent is filed with the minutes of proceedings of the Board of Directors.
Section 13. COMPENSATION. Directors shall receive such reasonable
compensation for their services as Directors as the Board of Directors may fix
or determine from time to time; such compensation may include a fixed sum,
shares of the Corporation and reimbursement of reasonable expenses incurred in
traveling to and from or attending regular or special meetings of the Board of
Directors or of any committee thereof.
Section 14. POLICIES AND RESOLUTIONS. It shall be the duty of the Board
of Directors to insure that the purchase, sale, retention and disposal of the
Corporation's assets, the investment policies and the borrowing policies of the
Corporation and the limitations thereon or amendment thereof are at all times:
(a) consistent with such policies, limitations and
restrictions as are contained in these Bylaws, or in the Corporation's Articles
of Incorporation, or as described in the Registration Statement or in the
Corporation's ongoing periodic reports filed with the SEC following the Initial
Public Offering, subject to revision from time to time at the discretion of the
Board of Directors without shareholder approval unless otherwise required by
law; and
(b) in compliance with the restrictions applicable to real
estate investment trusts pursuant to the Internal Revenue Code of 1986, as
amended.
Section 15. NOMINATIONS. Subject to the rights of holders of any class
or series of shares having a preference over the common shares as to
distributions or upon liquidation, nominations for the election of Directors
shall be made by the Corporation's notice of the meeting of
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shareholders for such election, the Board of Directors, or by any shareholder
entitled to vote in the election of Directors generally. However, any
shareholder entitled to vote in the election of Directors generally may nominate
one or more persons for election as Directors at a meeting only if written
notice of such shareholder's intent to make such nomination or nominations has
been given, either by personal delivery or by United States mail, postage
prepaid, to the Secretary of the Corporation not later than (i) with respect to
an election to be held at an annual meeting of shareholders, ninety (90) days in
advance of such meeting, and (ii) with respect to an election to be held at a
special meeting of shareholders for the election of Directors, the close of
business on the seventh (7th) day following the date on which notice of such
meeting is first given to shareholders. Each notice shall set forth: (a) the
name and address of the shareholder who intends to make the nomination and of
the person or persons to be nominated; (b) a representation that the shareholder
is a holder of record of shares of the Corporation entitled to vote at such
meeting and intends to appear in person or by proxy at the meeting to nominate
the person or persons specified in the notice; (c) a description of all
arrangements or understandings between the shareholder and each nominee and any
other person or persons (naming such person or persons) pursuant to which the
nomination or nominations are to be made by the shareholder; (d) such other
information regarding each nominee proposed by such shareholder as would be
required to be included in a proxy statement filed pursuant to the proxy rules
of the SEC, had the nominee been nominated, or intended to be nominated, by the
Board of Directors; and (e) the consent of each nominee to serve as a Director
of the Corporation if so elected. The Chairman of the meeting may refuse to
acknowledge the nomination of any person not made in compliance with the
foregoing procedure.
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ARTICLE V
COMMITTEES
Section 1. COMMITTEES OF THE BOARD. The Board of Directors may appoint
from among its members an executive committee and other committees comprised of
two or more Directors. The Board of Directors shall appoint an audit committee
of which is comprised entirely of Independent Directors. The Board of Directors
may delegate to any committee any of the powers of the Board of Directors except
the power to elect Directors, declare distributions on shares, recommend to the
shareholders any action which requires shareholder approval, amend or repeal
these Bylaws, approve any merger or share exchange which does not require
shareholder approval, or issue shares. However, if the Board of Directors has
given general authorization for the issuance of shares, a committee of the Board
of Directors, in accordance with a general formula or method specified by the
Board of Directors by resolution or by adoption of a stock option plan, may fix
the terms of shares, subject to classification or reclassification, and the
terms on which any shares may be issued.
Notice of committee meetings shall be given in the same manner as
notice for special meetings of the Board of Directors.
One-third, but not less than two, of the members of any committee shall
be present in person at any meeting of such committee in order to constitute a
quorum for the transaction of business at such meeting, and the act of a
majority present shall be the act of such committee. The Board of Directors may
designate a chairman of any committee, and such chairman or any two members of
any committee may fix the time and place of its meetings unless the Board shall
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otherwise provide. In the absence or disqualification of any member of any such
committee, the members thereof present at any meeting and not disqualified from
voting, whether or not they constitute a quorum, may unanimously appoint another
Director to act at the meeting in the place of such absent or disqualified
members; provided, however, that in the event of the absence or disqualification
of an Independent Director, such appointee shall be an Independent Director.
Each committee shall keep minutes of its proceedings and shall report
the same to the Board of Directors at the meeting next succeeding, and any
action by the committees shall be subject to revision and alteration by the
Board of Directors, provided that no rights of third persons shall be affected
by any such revision or alteration.
Subject to the provisions hereof, the Board of Directors shall have the
power at any time to change the membership of any committee, to fill all
vacancies, to designate alternative members to replace any absent or
disqualified member, or to dissolve any such committee.
Section 2. TELEPHONE MEETINGS. Members of a committee of the Board of
Directors may participate in a meeting by means of a conference telephone or
similar communications equipment if all persons participating in the meeting can
hear each other at the same time. Participation in a meeting by these means
shall constitute presence in person at the meeting.
Section 3. ACTION BY COMMITTEES WITHOUT A MEETING. Any action required
or permitted to be taken at any meeting of a committee of the Board of Directors
may be taken without a meeting, if a consent in writing to such action is signed
by each member of the committee and such written consent is filed with the
minutes of proceedings of such committee.
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ARTICLE VI
OFFICERS
Section 1. GENERAL PROVISIONS. The officers of the Corporation may
consist of a Chairman of the Board, a Vice Chairman of the Board, a Chief
Executive Officer, a President, one or more Senior Managing Directors, one or
more Managing Directors, one or more Executive Vice Presidents, one or more
Senior Vice Presidents, one or more Vice Presidents, a Treasurer, one or more
Assistant Treasurers, a Secretary, and one or more Assistant Secretaries and
such other officers as may be elected in accordance with the provisions of
Section 2 of this Article VI. The officers of the Corporation shall be elected
annually by the Board of Directors at the first meeting of the Board of
Directors held after each annual meeting of shareholders. If the election of
officers shall not be held at such meeting, such election shall be held as soon
thereafter as may be convenient. Each officer shall hold office until his or her
successor is elected and qualifies or until his or her death, resignation or
removal in the manner hereinafter provided. Any two or more offices may be held
by the same person. In its discretion, the Board of Directors may leave unfilled
any office except that of President and Secretary. Election or appointment of an
officer or agent shall not of itself create contract rights between the
Corporation and such officer or agent.
Section 2. SUBORDINATE OFFICERS, COMMITTEES AND AGENTS. The Board of
Directors may from time to time elect such other officers and appoint such
committees, employees, other agents as the business of the Corporation may
require, including one or more Assistant Secretaries, and one or more Assistant
Treasurers, each of whom shall hold office for such period, have such authority,
and perform such duties as are provided in these Bylaws, or as the Board of
Directors may from time to time determine. The Directors may delegate to any
officer or committee the
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power to elect subordinate officers and to retain or appoint employees or other
agents.
Section 3. REMOVAL AND RESIGNATION. Any officer or agent of the
Corporation may be removed by the Board of Directors if in its judgment the best
interests of the Corporation would be served thereby, but such removal shall be
without prejudice to the contract rights, if any, of the person so removed. Any
officer of the Corporation may resign at any time by giving written notice of
his or her resignation to the Board of Directors, the Chairman of the Board, the
Chief Executive Officer, the President or the Secretary. Any resignation shall
take effect at the time specified therein or, if the time when it shall become
effective is not specified therein, immediately upon its receipt. The acceptance
of a resignation shall not be necessary to make it effective unless otherwise
stated in the resignation.
Section 4. VACANCIES. A vacancy in any office may be filled by the
Board of Directors for the balance of the term.
Section 5. GENERAL POWERS. All officers of the Corporation as between
themselves and the Corporation shall, respectively, have such authority and
perform such duties in the management of the property and affairs of the
Corporation as may be determined by resolution of the Board of Directors, or in
the absence of controlling provisions in a resolution of the Board of Directors,
as may be provided in these Bylaws.
Section 6. DUTIES OF THE CHAIRMAN OF THE BOARD. The Chairman of the
Board shall preside at all meetings of the Board of Directors and the
shareholders. The Chairman of the Board shall have such other powers and perform
such other duties as are prescribed by these Bylaws and as usually pertain to
such office and as may be assigned to him or her at any time or from time to
time by the Board of Directors.
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Section 7. DUTIES OF THE CHIEF EXECUTIVE OFFICER AND THE PRESIDENT. The
Chief Executive Officer shall be the chief executive officer of the Corporation,
shall have the responsibility for carrying out the policies of the Board of
Directors, subject to the direction of the Board, and shall have general
supervision over the business and affairs of the Corporation. The President
shall report to the Chief Executive Officer and shall have the responsibility
for carrying out the policies of the Board of Directors and the Chief Executive
Officer, subject to their direction. In the absence of the Chairman of the
Board, the Chief Executive Officer (or the President in the case where the Chief
Executive Officer and the Chairman of the Board are the same individual or the
Chief Executive Office is absent) shall preside at meetings of the Board of
Directors and the shareholders. The Chief Executive Officer or the President may
employ and discharge employees and agents of the Corporation, except as
otherwise prescribed by the Board of Directors, and may delegate those powers.
The Chief Executive Officer or the President may vote the Shares or other
securities of any other domestic or foreign corporation of any type or kind
which may at any time be owned by the Corporation, may execute any shareholders'
or other consents in respect thereof and may in his or her discretion delegate
such powers by executing proxies, or otherwise, on behalf of the Corporation.
The Board of Directors by resolution from time to time may confer like powers
upon any other person or persons. The Chief Executive Officer and the President
shall have such other powers and perform such other duties as are prescribed by
these Bylaws and as usually pertain to such office and as may be assigned to him
or her at any time or from time to time by the Board of Directors.
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Section 8. DUTIES OF THE SENIOR MANAGING DIRECTORS, MANAGING DIRECTORS,
EXECUTIVE VICE PRESIDENTS, SENIOR VICE PRESIDENTS AND VICE PRESIDENTS. Each
Senior Managing Director, Managing Director, Executive Vice President, Senior
Vice President and Vice President, if any, shall have such powers and duties as
may from time to time be assigned to him or her by the Chief Executive Officer,
the President or the Board of Directors. Any Senior Managing Director, Managing
Director, Executive Vice President, Senior Vice President or Vice President may
sign and execute in the name of the Corporation deeds, mortgages, bonds,
contracts or other instruments authorized by the Board of Directors, except
where the signing and execution of such documents shall be expressly delegated
by the Board of Directors, the Chief Executive Officer or the President to some
other officer or agent of the Corporation or shall be required by law or
otherwise to be signed or executed.
Section 9. DUTIES OF THE TREASURER. The Treasurer shall have such
powers and duties as may be assigned to him or her by the Chief Executive
Officer, the President or the Board of Directors. The Treasurer may sign and
execute in the name of the Corporation share certificates, deeds, mortgages,
bonds, contracts or other instruments, except in cases where the signing and the
execution thereof shall be expressly delegated by the Board of Directors or by
these Bylaws to some other officer or agent of the Corporation or shall be
required by law or otherwise to be signed or executed.
Section 10. DUTIES OF THE SECRETARY. The Secretary shall act as
secretary of all meetings of the Board of Directors, the Executive Committee and
all other Committees of the Board and shareholders of the Corporation. He or she
shall keep and preserve the minutes of all such meetings in the proper book or
books provided for that purpose. He or she shall see that all notices required
to be given by the Corporation are duly given and served; shall have custody of
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the seal of the Corporation and shall affix the seal or cause it to be affixed
to all share certificates of the Corporation and to all documents the execution
of which on behalf of the Corporation under its corporate seal is duly
authorized in accordance with law or the provisions of these Bylaws; shall have
custody of all deeds, leases, contracts and other important corporate documents;
shall have charge of the books, records and papers of the Corporation relating
to its organization and management as a Corporation; shall see that all reports,
statements and other documents required by law (except tax returns) are properly
filed; and shall, in general perform, all the duties incident to the office of
Secretary and such other duties as from time to time may be assigned to him or
her by the Board of Directors, the Chief Executive Officer or the President.
Section 11. OTHER DUTIES OF OFFICERS. Any officer of the Corporation
shall have, in addition to the duties prescribed herein or by law, such other
duties as from time to time shall be prescribed by the Board of Directors, the
Chief Executive Officer or the President.
Section 12. SALARIES. The salaries of the officers shall be fixed from
time to time by the Board of Directors, and no officer shall be prevented from
receiving such salary by reason of the fact that he or she is also a Director of
the Corporation.
ARTICLE VII
CONTRACTS, NOTES, CHECKS AND DEPOSITS
Section 1. CONTRACTS. The Board of Directors may authorize any officer
or agent to enter into any contract or to execute and deliver any instrument in
the name of and on behalf of the Corporation and such authority may be general
or confined to specific instances.
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Section 2. CHECKS AND DRAFTS. All checks, drafts or other orders for
the payment of money, notes or other evidences of indebtedness issued in the
name of the Corporation shall be signed by such officer or officers, agent or
agents of the Corporation and in such manner as shall from time to time be
determined by the Board of Directors.
Section 3. DEPOSITS. All funds of the Corporation not otherwise
employed shall be deposited from time to time to the credit of the Corporation
in such banks, trust companies or other depositories as the Board of Directors
may designate.
ARTICLE VIII
SHARES
Section 1. SHARE CERTIFICATES. Each shareholder shall be entitled to a
certificate or certificates which shall represent and certify the number of
shares of each kind and class of shares held by him or her in the Corporation.
Each certificate shall be signed by the Chairman of the Board, the Chief
Executive Officer, the President, a Senior Managing Director or a Managing
Director and countersigned by the Secretary or an Assistant Secretary or the
Treasurer or an Assistant Treasurer and may be sealed with the corporate seal.
The signatures may be either manual or facsimile. Certificates shall be
consecutively numbered; and if the Corporation shall, from time to time, issue
several classes of shares, each class may have its own number series. A
certificate is valid and may be issued whether or not an officer who signed it
is still an officer when it is issued. Each certificate representing shares
which is restricted as to its transferability or voting powers, which is
preferred or limited as to its distributions or as to its share of the assets
upon liquidation or which is redeemable at the option of the Corporation, shall
have a statement of such restriction, limitation, preference or redemption
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provision, or a summary thereof, plainly stated on the certificate. In lieu of
such statement or summary, the Corporation may set forth upon the face or back
of the certificate a statement that the Corporation will furnish to any
shareholder, upon request and without charge, a full statement of such
information.
Section 2. LOST CERTIFICATE. The Board of Directors may direct a new
certificate to be issued in place of any certificate previously issued by the
Corporation alleged to have been lost, stolen or destroyed upon the making of an
affidavit of that fact by the person claiming the share certificate to be lost,
stolen or destroyed. When authorizing the issuance of a new certificate, the
Board of Directors may, in its discretion and as a condition precedent to the
issuance thereof, require the owner of such lost, stolen or destroyed
certificate or his or her legal representative to advertise the same in such
manner as it shall require and/or to give bond, with sufficient surety, to the
Corporation to indemnify it against any loss or claim which may arise as a
result of the issuance of a new certificate.
Section 3. TRANSFER AGENTS AND REGISTRARS. At such time as the
Corporation lists its securities on a national securities exchange or qualifies
for trading in the over-the-counter market, the Board of Directors shall appoint
one or more banks or trust companies in such city or cities as the Board of
Directors may deem advisable, from time to time, to act as transfer agents
and/or registrars of the shares of the Corporation; and, upon such appointments
being made, no certificate representing shares shall be valid until
countersigned by one of such transfer agents and registered by one of such
registrars.
Section 4. TRANSFER OF SHARES. No transfers of shares of the
Corporation shall be made if (i) void AB INITIO pursuant to any provision of the
Corporation's Articles of Incorporation or (ii) the Board of Directors, pursuant
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to any provision of the Corporation's Articles of Incorporation, shall have
refused to permit the transfer of such shares. Permitted transfers of shares of
the Corporation shall be made on the stock records of the Corporation only upon
the instruction of the registered holder thereof, or by his or her attorney
thereunto authorized by power of attorney duly executed and filed with the
Secretary or with a transfer agent or transfer clerk, and upon surrender of the
certificate or certificates, if issued, for such shares properly endorsed or
accompanied by a duly executed stock transfer power and the payment of all taxes
thereon. Upon surrender to the Corporation or the transfer agent of the
Corporation of a certificate for shares duly endorsed or accompanied by proper
evidence of succession, assignment or authority to transfer, as to any transfers
not prohibited by any provision of the Corporation's Articles of Incorporation
or by action of the Board of Directors thereunder, it shall be the duty of the
Corporation to issue a new certificate to the person entitled thereto, cancel
the old certificate and record the transaction upon its books.
Section 5. STOCK LEDGER. The Corporation shall maintain at its
principal office or at the office of its counsel, accountants or transfer agent,
an original or duplicate stock ledger containing the name and address of each
shareholder and the number of shares of each class held by such shareholder.
ARTICLE IX
DISTRIBUTIONS
Section 1. DECLARATION. Distributions upon the shares of the
Corporation may be declared by the Board of Directors, subject to applicable
provisions of law and the Articles of Incorporation. Distributions may be paid
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in cash, property or shares of the Corporation, subject to applicable provisions
of law and the Articles of Incorporation.
Section 2. CONTINGENCIES. Before payment of any distributions, there
may be set aside out of any funds of the Corporation available for distributions
such sum or sums as the Board of Directors may from time to time, in its
absolute discretion, think proper as a reserve fund for contingencies, for
equalizing distributions, for repairing or maintaining the property of the
Corporation, its subsidiaries or any partnership for which it serves as general
partner, or for such other purpose as the Board of Directors shall determine to
be in the best interest of the Corporation, and the Board of Directors may
modify or abolish any such reserve in the manner in which it was created.
ARTICLE X
SEAL
Section 1. SEAL. The Corporation may have a corporate seal, which may
be altered at will by the Board of Directors. The Board of Directors may
authorize one or more duplicate or facsimile seals and provide for the custody
thereof.
Section 2. AFFIXING SEAL. Whenever the Corporation is required to place
its corporate seal to a document, it shall be sufficient to meet the
requirements of any law, rule or regulation relating to a corporate seal to
place the word "(SEAL)" adjacent to the signature of the person authorized to
execute the document on behalf of the Corporation.
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ARTICLE XI
WAIVER OF NOTICE
Whenever any notice is required to be given pursuant to the Articles of
Incorporation or these Bylaws of the Corporation or pursuant to applicable law,
a waiver thereof in writing, signed by the person or persons entitled to such
notice, whether before or after the time stated therein, shall be deemed
equivalent to the giving of such notice. Neither the business to be transacted
at nor the purpose of any meeting need be set forth in the waiver of notice,
unless specifically required by statute. The attendance of any person at any
meeting shall constitute a waiver of notice of such meeting, except where such
person attends a meeting for the express purpose of objecting to the transaction
of any business on the ground that the meeting is not lawfully called or
convened.
ARTICLE XII
AMENDMENT OF BYLAWS
Section 1. BY DIRECTORS. The Board of Directors shall have the power to
adopt, alter or repeal any Bylaws of the Corporation and to make new Bylaws,
except that the Board of Directors shall not alter or repeal this Article XII or
any Bylaws made by the shareholders and provided that any amendment to Section
2, Section 3, Section 5, Section 9, or Section 10(b) of Article IV requires the
affirmative vote of 80% of the entire Board of Directors, including a majority
of the Independent Directors.
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Section 2. BY SHAREHOLDERS. The shareholders shall have the power to
adopt, alter or repeal any Bylaws of the Corporation and to make new Bylaws,
provided that any amendment to Section 2, Section 3, Section 5, Section 9, or
Section 10(b) of Article IV requires the affirmative vote of the holders of
two-thirds of all the outstanding shares entitled to vote on the election of
Directors, voting separately as a class.
Dated: December 14, 1998
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EXHIBIT 99.2
RISK FACTORS
Each of the factors set forth below could, directly or indirectly,
affect the Company's results of operations and financial condition. Capitalized
terms that are not defined herein shall have the meaning ascribed in the Annual
Report on Form 10-K of the Company to which this Exhibit relates.
RECENT OPERATING LOSSES OF THE COMPANY AND DECISION TO DISCONTINUE INVESTMENT
ACTIVITIES COULD ADVERSELY AFFECT FUTURE OPERATIONS OF THE COMPANY
The Company reported a net loss of $58.2 million or $3.07 per fully
diluted share for the year ended December 31, 1998. This loss was primarily
attributable to a $79.7 million charge on subordinate and residual interests in
mortgage-related securities and derivatives, which were adversely affected by
increased prepayments of the underlying mortgage loans and the substantial
volatility in U.S. and foreign stock markets commencing in mid-July 1998, which
has resulted in widening mortgage spreads and declining market liquidity.
Moreover, as a result of these conditions, in the latter half of 1998 there was
a general "flight to quality" by investors, with the result that the market for
subordinate and residual interests in mortgage-related securities has been
substantially reduced or eliminated. These factors adversely affected the
operations and financial condition of numerous companies in the financial
service, real estate investment trust and mortgage-backed security sectors,
including the Company.
In connection with these factors, the Company has decided that, for the
foreseeable future, it does not plan to acquire any additional assets or fund
any additional loans (beyond those which are currently committed), and it will
work to accelerate the stabilization of its existing assets and increase its
overall liquidity position. As a result, the Company has curtailed each of its
business lines, which include the acquisition of subordinate and residual
interests in residential and commercial mortgage-related securities,
underperforming real estate and residential and commercial real estate loans,
including construction and renovation loans.
The future success of the Company will be primarily dependent on its
ability to continue to be able to meet its obligations under its indebtedness.
This ability will depend largely on the Company's future performance, which, in
turn, is subject to prevailing economic conditions and to financial, business
and other factors beyond its control, including levels of interest rates. This
ability also could be significantly adversely affected by the Company's decision
to discontinue future investment activities, which effectively means that the
Company's future profitability, and its ability to meet its indebtedness
obligations, will be dependent on its existing assets. There can be no assurance
that the Company's existing assets will be sufficient to ensure future
profitable operations or enable the Company to meet its indebtedness
obligations, or that such assets will not be further significantly adversely
affected by changes in market and economic conditions and other factors.
Moreover, it can be anticipated that unless and until the Company resumes
investment activities, income from the Company's portfolio of investment
securities and loans, which along with investments in real estate comprise the
Company's three principal business lines, will decrease as securities and loans
mature and are repaid in the ordinary course of business.
THE COMPANY'S ABILITY TO COMPLY WITH INDEBTEDNESS REQUIREMENTS NOT ASSURED
The Company has significant debt service obligations. The Company's
investments in real estate, subordinate and residual interests in
mortgage-related securities and other assets, such as single-family residential
loans, generally depend upon short-term borrowings such as repurchase agreements
and warehouse facilities/lines of credit with financial institutions or
institutional lenders to finance the Company's acquisition of such assets on a
short-term basis in the case of repurchase agreements and on a one-to-three year
basis in the case of warehouse facilities/lines of credit. There can be no
assurance that such financing will continue to be available on terms reasonably
satisfactory to the Company. The inability of the Company to arrange additional
borrowings such as repurchase agreements and warehouse facilities/lines of
credit or to extend, repay or replace existing borrowings when they expire would
have a material adverse effect on the Company's business, financial condition
and results of operations and on the Company's outstanding securities.
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As a result of market and economic conditions, from time-to-time the
Company has been required to pledge additional collateral or post additional
cash margins (referred to herein collectively as "collateral") to secure its
indebtedness. Although to date the Company has had adequate cash and
unencumbered assets to meet such calls for additional collateral and its other
operating and financing requirements, there can be no assurance that sufficient
levels of unencumbered assets will continue to be available. If the Company is
unable to fund additional collateral needs or to repay, renew or replace
maturing indebtedness on terms reasonably satisfactory to the Company, the
Company would be required to sell, under adverse market conditions, a portion of
its assets, and could incur losses as a result. Furthermore, an extremely
limited market for subordinate and residual interests in mortgage-related
securities exists and there can be no assurance that one will fully develop,
thereby limiting the Company's ability to dispose of such securities promptly
for fair value in such situations.
In addition to payment and, in the case of the Company's secured
indebtedness, collateralization requirements, the Company is subject to various
other covenants in the agreements evidencing its indebtedness, including
financial covenants which require the maintenance of specified amounts of
equity. Other covenants affirmatively impose standards of management,
administration and reporting with respect to the real property assets of the
Company, and require the observance of certain administrative activities, loan
to value ratios and advance limitations with respect to mortgage loans. With
respect to the securities available for sale, certain covenants also seek to
control the debt exposure of the lender based on the default and prepayment
experience of the loans that comprise the mortgage pools underlying the
securities, factors which are outside of the Company's control. The Company's
ability to continue to meet these financial requirements will be dependent on
its results of operations.
In the event of a default in the Company's covenants or other terms of
the Company's indebtedness, the lender generally would be able to accelerate
repayment of the subject indebtedness and pursue other available remedies, which
could result in defaults on other indebtedness of the Company, unless the
applicable lender or lenders allowed the Company to remain in violation of the
agreements. Were a default to be declared, the Company would not be able to
continue to operate without the consent of its lenders.
OWNERSHIP OF SUBORDINATE AND RESIDUAL INTERESTS SUBJECT TO CREDIT, PREPAYMENT
AND LIQUIDITY RISKS
The Company invests in subordinate and residual interests in
collateralized mortgage obligations ("CMOs"), including CMOs, which have
qualified as real estate mortgage investment conduits ("REMICs") under the Code.
These securities are subject to a number of risks, as outlined below.
CREDIT RISK. Subordinate and residual interests in mortgage-related
securities provide credit support to the more senior classes of the
mortgage-related securities. Principal from the underlying mortgage loans
generally is allocated first to the senior classes, with the most senior class
having a priority right to the cash flow from the mortgage loans until its
payment requirements are satisfied. To the extent that there are defaults and
unrecoverable losses on the underlying mortgage loans, resulting in reduced cash
flows, the most subordinate security will be the first to bear this loss.
Because subordinate and residual interests generally have no credit support, to
the extent there are realized losses on the mortgage loans comprising the
mortgage collateral for such securities, the Company may not recover the full
amount or, indeed, any of its initial investment in such subordinate and
residual interests. The Company generally owns the most subordinate classes of
the securities in which it invests and therefor will be the first to bear any
credit losses.
The degree of credit risk is affected by the nature of the underlying
mortgage loans. In this regard, the risk of loss on securities backed by
commercial and multifamily loans and single-family residential loans made to
borrowers who, because of prior credit problems, the absence of a credit history
or other factors, are unable or unwilling to qualify as borrowers under
guidelines established by the Federal Home Loan Mortgage Corporation ("FHLMC")
and the Federal National Mortgage Association ("FNMA") for purchases of loans by
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such agencies ("subprime residential loans"), generally involve more risk than
securities backed by single-family residential loans which conform to the
requirements established by FHLMC and FNMA for their purchase by such agencies.
At December 31, 1998, the Company's securities available for sale amounted to
$351.2 million and consisted of (i) non-investment grade and unrated subordinate
securities backed by commercial real estate loans and having an amortized cost
of $115.7 million and a fair value of $117.1 million, (ii) unrated residuals in
securities backed by subprime single-family residential loans having an
amortized cost of $209.0 million and a fair value of $218.7 million and (iii)
unrated subordinate interests in securities backed by other single-family
residential loans having an amortized cost of $15.4 million and a fair value of
$15.4 million.
PREPAYMENT RISK. Subordinate and residual interests are affected by the
rate and timing of payments of principal (including prepayments, repurchases,
defaults and liquidations) on the mortgage loans underlying a series of
mortgage-related securities. The rate of principal payments may vary
significantly over time depending on a variety of factors, such as the level of
prevailing mortgage loan interest rates and economic, demographic, tax, legal
and other factors. Prepayments on the mortgage loans underlying a series of
mortgage-related securities are generally allocated to the more senior classes
of mortgage-related securities. Although in the absence of defaults or interest
shortfalls subordinates receive interest, amounts otherwise allocable to
residuals generally are used to make payments on more senior classes or to fund
a reserve account for the protection of senior classes until
overcollateralization or the balance in the reserve account reaches a specified
level. In periods of declining interest rates, rates of prepayments on mortgage
loans generally increase, and if the rate of prepayments is faster than
anticipated, then the yield on subordinates generally will be positively
affected and the yield on residuals generally will be negatively affected.
Accelerated prepayment speeds as a result of declining market interest rates
were a significant factor in the $79.7 million loss on securities available for
sale recorded by the Company during the year ended December 31, 1998.
LIQUIDITY RISK. As a result of the risks associated with subordinate
and residual interests in mortgage-related securities, and because they
generally are unrated or rated non-investment grade, such securities generally
are traded less frequently than investment-grade securities and may not provide
holders thereof with liquidity of investment. This is particularly the case
since U.S. and foreign stock markets began experiencing substantial volatility
in mid-July 1998, which has substantially adversely affected the market for
subordinate and residual interests in mortgage-related securities.
SUBORDINATE AND RESIDUAL INTERESTS MAY GENERATE TAXABLE INCOME
EXCEEDING CASH FLOW. Subordinate and residual interests, including residual
interests which are designated as REMIC residual interests under Section 860D of
the Code, receive cash flow in excess of amounts needed to make payments on
other classes of the security or to fund a related reserve account. Cash flow
otherwise allocable to subordinate or residual interests is used to protect
senior classes of securities from credit losses on the underlying mortgage
loans. Moreover, in any given year, the taxable income produced by a subordinate
or residual interest may exceed its cash flow. If the Company was deemed to have
a substantial amount of such "phantom income" in any particular year, the
Company could be required to borrow funds or to liquidate assets in order to
meet the REIT distribution requirement for such year.
VALUE AND REVENUES OF REAL ESTATE DEPENDENT ON CONDITIONS BEYOND THE COMPANY'S
CONTROL
GENERAL. Investment in underperforming real estate is subject to
varying degrees of risk which are generally incident to the ownership of real
property. Revenues may be adversely affected by adverse changes in national or
local economic conditions, competition from other properties offering the same
or similar services, changes in interest rates and in the availability, cost and
terms of mortgage funds, the impact of present or future laws and regulations,
including without limitation those dealing with zoning, the environment, access
by disabled persons and taxation, the ongoing need for capital improvements
(particularly in older structures), changes in real estate tax rates and other
operating expenses, adverse changes in governmental rules and fiscal policies,
civil unrest, acts of nature, including earthquakes, hurricanes and other
natural disasters, acts of war and other factors which are beyond the control of
the Company. Revenues also may be affected by problems experienced by lessees,
which may weaken their financial condition and result in failure to make rental
payments when due. At any time, a lessee of the Company's properties may seek
the protection of bankruptcy laws, which could result in rejection and
termination of the lessee's lease and thereby cause a reduction in cash flow
available for distribution to the Company. As a result of the foregoing factors,
no assurances can be given that the fair market value and/or revenues of the
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Company's investments in real estate will not decrease in the future or that the
Company will be able to vary its real estate portfolio in response to changes in
economic or other conditions.
VALUE AND REVENUES OF REAL ESTATE DEPENDENT IN PART ON EXTERNAL
MANAGEMENT. The value and revenues of underperforming real estate acquired by
the Company is dependent in part upon the ability of the Manager to operate the
real estate in a manner which is sufficient to maintain or increase revenues in
excess of operating expenses and debt service requirements, which will be
affected by many of the risks which are inherent in investments in real estate
and over which the Company has no control. The underperforming real estate
acquired by the Company to date generally has had significant amounts of
unleased space or restrictive or below market rents in place. As part of its
initial repositioning of a property after an acquisition, the Company, in
addition to making any necessary capital expenditures, generally pursues a
policy of replacing some existing tenants with tenants which have higher lease
payments and/or a higher probability of expansion and renewal. Although this
strategy may adversely affect tenant retention rates in the early years of
ownership of a property, management believes that the strategy will be
beneficial to the Company in the long term. There can be no assurance, however,
that the Company's tenant retention rate will increase as each property is
repositioned or stabilized or that the net present value of new or renewed
leases will substantially exceed the net present value of leases with existing
tenants.
GEOGRAPHIC CONCENTRATION OF REAL ESTATE SUBJECT TO LOCAL MARKET RISK.
Geographic locations can have a substantial effect on the market value of and
revenues from real estate and on the ability of borrowers to repay loans secured
by properties in such a location. Value and revenues can be affected by national
and local economic conditions and other factors that are beyond the control of
the Company. At December 31, 1998, the Company's investments in real estate
included four properties with an aggregate varying value of $143.8 million
located in San Francisco, California. In addition, at the same date the Company
had an $11.5 million loan for the construction of an apartment building in San
Francisco, of which $4.2 million had been disbursed at such date. As a result of
this concentration of investments, the Company's operations will be dependent to
a large extent on the economic conditions in this area.
INSURANCE MAY NOT COVER ALL REAL ESTATE LOSSES. The Company maintains
comprehensive insurance coverage on its real estate, including coverage against
events of a catastrophic nature, such as earthquakes, hurricanes and other
natural disasters. There can be no assurance that insurance against such events
will continue to be obtainable on terms that are acceptable to the Company or at
all. Moreover, changes in building codes and ordinances, environmental
considerations and other factors also might make it not feasible to use
insurance proceeds to replace a property if it is damaged or destroyed. Under
such circumstances, the insurance proceeds received by the Company might not be
adequate to restore its economic position with respect to the affected
distressed real property.
REAL PROPERTIES WITH ENVIRONMENTAL PROBLEMS WILL INCREASE COSTS AND MAY CREATE
LIABILITY FOR THE COMPANY
Operating costs and the value of real property may be affected by the
obligation to pay for the cost of complying with existing environmental laws,
ordinances and regulations, as well as the cost of future legislation. Under
various federal, state and local environmental laws, ordinances and regulations,
a current or previous owner or operator of real property may be liable for the
costs of removal or remediation of hazardous or toxic substances on, under or in
such property. Such laws often impose liability whether or not the owner or
operator knew of, or was responsible for, the presence of such hazardous or
toxic substances. Therefore, an environmental liability could have a material
adverse effect on the underlying value of a real property, and the revenue
therefrom. Although the Company believes that its pre-acquisition due diligence
identified all material environmental concerns which relate to its current
investments in real estate and accurately assessed the costs and liabilities to
be concurred by it in this regard, there can be no assurance that such
investments will not involve unknown material environmental concerns or material
unanticipated environmental costs in the future.
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The Company also evaluates the potential for significant environmental
problems prior to acquiring or originating a loan because there is a risk for
any mortgage loan, particularly a multifamily residential and commercial real
estate loan, that hazardous substances or other environmentally restricted
substances could be discovered on the related real estate. Through foreclosure,
the Company could become the owner of the real estate that secured its loan and
might be required to remove such substances from the affected properties or to
engage in abatement procedures at its sole cost and expense. There can be no
assurance that the cost of such removal or abatement will not substantially
exceed the value of the affected properties or the loans secured by such
properties, that the Company would have adequate remedies against the prior
owners or other responsible parties or that the Company would be able to resell
the affected properties either prior to or following completion of any such
removal or abatement procedures. If such environmental problems are discovered
prior to foreclosure, the Company generally will not foreclose on the related
loan; however, the value of such property as collateral will generally be
substantially reduced, and as a result, the Company may suffer a loss upon
collection of the loan.
GREATER RISKS OF LOSS FROM COMMERCIAL AND MULTIFAMILY CONSTRUCTION AND
RENOVATION LENDING ACTIVITIES
The Company's investments include loans for the construction or
renovation of commercial and multifamily real estate, including a mezzanine loan
which is subordinate to the first lien on the property which secures the loan.
Multifamily and commercial real estate lending, particularly construction and
renovation lending, is generally considered to involve a higher degree of risk
than single-family residential lending because of a variety of factors,
including generally larger loan balances, dependency on successful completion or
operation of the project for repayment, difficulties in estimating construction
and renovation costs and loan terms that often require little or no amortization
of the loan over its term (typically five years) and, instead, provide for a
balloon payment at stated maturity. Furthermore, mezzanine loans, which are
subordinate to a senior loan or loans, and construction loans generally have
higher loan-to-value ratios than conventional loans. Although the Company's
borrowers generally have an equity investment of 10% to 15% of total project
costs, such equity may not be sufficient to protect the Company's investment in
these higher-yielding loans.
GREATER RISKS OF LOSS FROM DISTRESSED MORTGAGE LOANS
Nonperforming and subperforming mortgage loans may presently be in
default or may have a greater than normal risk of future defaults and
delinquencies, as compared to newly-originated, high-quality loans of comparable
type, size and geographic concentration. Returns on an investment of this type
depend on the borrower's ability to make required payments or, in the event of
default, the ability of the loan's servicer to foreclose and liquidate the
mortgage loan. There can be no assurance that the servicer can liquidate a
defaulted mortgage loan successfully or in a timely fashion.
ALLOWANCES FOR LOAN LOSSES MAY NOT BE ADEQUATE TO COVER LOSSES
At December 31, 1998, the Company had established a $0.6 million
allowance for loan losses on its commercial and multifamily loan portfolio and
had not established such an allowance on its single-family residential or
discount loan portfolio. Although the Company believes that these actions were
adequate at such date and in accordance with generally accepted accounting
principles, future additions to allowances for loan losses may be necessary due
to changes in economic conditions, increases in loans and the performance of the
Company's loan portfolios. Increases in the Company's provisions for losses on
loans would adversely affect the Company's results of operations.
POTENTIAL ADVERSE EFFECTS OF CHANGES IN INTEREST RATES
The Company's operations are significantly affected by current interest
rates, which are highly sensitive to many factors, including governmental
monetary and tax policies, domestic and international economic and political
considerations and other factors beyond the control of the Company. Changes in
the general level of interest rates will affect the Company's net interest
income, which is the difference between the interest income earned on
interest-earning assets and the interest expense incurred in connection with its
interest-bearing liabilities, by affecting the spread between the Company's
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interest-earning assets and interest-bearing liabilities. The Company uses
short-term, floating-rate borrowings such as repurchase agreements and lines of
credit to acquire long-term interest-earning assets such as mortgage loans and
subordinate and residual interests in mortgage-related securities, some of which
will have a fixed rate of interest and/or longer effective maturities than the
related borrowings and thus may expose the Company to a maturity mismatch. As a
consequence, in an increasing interest rate environment the Company's borrowing
costs could exceed the income earned on the Company's interest-earning assets
acquired with borrowed funds, thereby reducing the Company's net interest income
and ability to make payments on its indebtedness.
Changes in the level of interest rates also affect the value and
average life of the Company's mortgage-related securities, which are
substantially affected by prepayment rates on the underlying mortgage loans, and
other interest-earning assets and the Company's ability to realize gains from
the sale of such assets. In periods of declining mortgage interest rates,
prepayments on mortgage-related securities generally increase. If general
interest rates also decline, the amounts available for reinvestment by the
Company during such periods are likely to be reinvested at lower interest rates
than the Company was earning on the securities that were prepaid.
Mortgage-related securities, particularly residual interests, may decrease in
value as a result of increases in interest rates and may benefit less than other
fixed-income securities from declining interest rates because of the risk of
prepayment. If general interest rates increase, the credit risk associated with
subordinate and residual interests could be increased if borrowers with
adjustable or floating-rate loans are unable to meet increased debt service
requirements and default on the underlying mortgages. By reducing the likelihood
of loan prepayments, increases in interest rates also could extend the weighted
average maturity of a security, which could adversely affect the Company to the
extent that the cost of the borrowings incurred by the Company to fund the
security are increasing faster than the yield on the security is increasing, if
at all. In general, changes in both prepayment rates and interest rates will
change the total return on mortgage-related securities, which will in turn
affect the Company's ability to make payments on its indebtedness, including the
Notes. Declining interest rates contributed significantly to the losses incurred
by the Company on its subordinate and residual mortgage-related securities
during the year ended December 31, 1998.
Changes in interest rates also affect the costs of financing the
acquisition of real estate and thus the value of real estate, as well as the
Company's ability to originate and acquire loans, although it is not looking to
do so at this time. Changes in interest rates also may affect the Company's
ability to incur additional indebtedness or raise capital on acceptable terms.
POTENTIAL ADVERSE EFFECTS OF HEDGING STRATEGIES
The Company may utilize a variety of financial instruments, including
interest rate swaps, caps, floors and other interest rate exchange contracts, in
order to limit the effects of interest rates on its operations. Among the risks
inherent with respect to the purchase and/or sale of such derivative instruments
are (i) interest rate risk, which consists of the risks relating to fluctuating
interest rates; (ii) basis risk, which consists of the risk of loss associated
with variations in the spread between the asset yield and the funding and/or
hedge costs; (iii) credit or default risk, which consists of the risk of
insolvency or other inability of the counterparty to a particular transaction to
perform its obligations thereunder; (iv) prepayment risk, which consists of
reinvestment risk to the extent the Company is not able to reinvest repayments,
if any, at a yield which is comparable to the yield being generated on the
particular security; (v) liquidity risk, which consists of the risk that the
Company may not be able to sell a particular security at a particular price;
(vi) legal enforceability risk, which consists of the risks related to Company's
ability to enforce the terms of a particular instrument or to obtain or collect
upon a legal judgment in the United States in the event that the counterparty to
the transaction is a foreign entity or the underlying collateral is located in a
foreign jurisdiction; and (vii) volatility risk, which consists of the risk that
actual volatility (i.e., the degree of uncertainty relating to the price of the
underlying asset) differs from the historical volatility or "implied" volatility
of the instrument.
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FOREIGN INVESTMENTS SUBJECT TO CURRENCY CONVERSION RISKS AND UNCERTAINTY OF
FOREIGN LAWS
The Company currently has investments in real estate and
mortgage-related securities backed by real estate located outside the United
States. Foreign investments are subject to most of the same risks faced by the
Company's domestic operations, as well as risks customarily associated with
United States corporations conducting foreign activities. These risks include
fluctuations in foreign exchange rates and controls (which the Company attempts
to mitigate with currency hedging agreements as available and economical),
expropriation, nationalization and other economic, tax and regulatory policies
of foreign governments and policies of the United States affecting foreign
investments.
THE COMPANY IS SUBJECT TO INTENSE COMPETITION
The Company's competition varies by business line and geographic
market. In many cases, the acquisition of mortgage-related securities, real
estate and commercial and multi-family loans is based on competitive bidding,
which involves the risk that the Company may bid too low (which generates no
business) or too high (which could result in an acquisition at an economically
unattractive price). Many of the Company's competitors are larger and have
greater financial resources than the Company, and thus may be better able than
the Company to pursue business opportunities or to survive periods of industry
consolidation. For additional information, see "Competition" under Item 1 of the
Annual Report on Form 10-K to which this Exhibit relates.
INVESTMENT POLICIES OF THE COMPANY MAY BE CHANGED BY IT WITHOUT APPROVAL OF
SHAREHOLDERS
The investment, financing, borrowing and distribution policies of the
Company and its policies with respect to all other activities, including growth,
debt, capitalization and operations, are determined by the Board of Directors.
These policies may be amended or revised at any time and from time to time at
the discretion of the Board of Directors without a vote of the shareholders of
the Company. In addition, the Board of Directors may change the Company's
policies with respect to conflicts of interest, provided that such changes are
consistent with applicable requirements. A change in these policies could
adversely affect the Company's financial condition, results of operations or the
market price of its outstanding securities.
POTENTIAL ADVERSE TAX CONSEQUENCES OF FAILURE TO QUALIFY AS A REIT
The Company believes that it has been organized and operated so as to
qualify as a REIT under Sections 856 to 860 of the Code, commencing with its
short taxable year ended December 31, 1997. The Company intends to continue to
operate as a REIT for calendar year 1998 and, subject to shareholder approval,
to change its status to a taxable corporation commencing in calendar year 1999.
The Company believes that, based on certain assumptions, including without
limitation that the Company will meet the 95% distribution requirement described
below for calendar 1998 (as to which there can be no assurance), the Company has
been organized and operated in a manner that has enabled it to qualify and to be
taxed as a REIT under the Code, and that its proposed method of operation will
enable it to continue to so qualify through calendar 1998, although there can be
no assurance that the Company is now or will continue to be organized and
operated in a manner so as to so qualify or remain so qualified. Qualification
and taxation as a REIT involves the satisfaction of numerous requirements (some
on an annual and quarterly basis) established under highly technical and complex
Code provisions for which there are only limited judicial and administrative
interpretations and involves the determination of various factual matters and
circumstances not entirely within the Company's control. The Company's
qualification and taxation as a REIT depends on the Company's ability to meet
(through actual annual operating results, distribution levels and diversity of
stock ownership) the various qualification and distribution tests imposed under
the Code. If the Company were to fail to qualify as a REIT in any taxable year,
the Company would be subject to federal income tax (including any applicable
alternative minimum tax) on its taxable income at regular corporate rates.
Moreover, unless entitled to relief under certain statutory provisions, the
Company also would be disqualified from treatment as a REIT for the four taxable
years following the year during which qualification was lost.
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The Company must distribute annually at least 95% of its net taxable
income (excluding any net capital gains) to avoid corporate income taxation on
the earnings that it distributes. In addition, the Company will be subject to a
4% nondeductible excise tax on the amount, if any, by which certain
distributions paid by it with respect to any calendar year are less than the sum
of (i) 85% of its ordinary income for that year, (ii) 95% of its capital gain
net income for that year and (iii) 100% of its undistributed taxable income from
prior years.
Although the Company reported a loss for financial reporting purposes
for the year ended December 31, 1998, it had substantial income for federal
income tax purposes during this period. As a result, in order to qualify and be
taxed as a REIT for such period, the Company is required to distribute a final
dividend which is expected to range from $14.6 million, or $0.77 per share, to
$16.1 million, or $0.85 per share. The Company deferred payment of this dividend
in 1998, which resulted in it incurring a nondeductible excise tax liability of
$0.4 million, and anticipates that it will pay such dividend during 1999 in
order to comply with the 95% distribution requirement for calendar 1998. There
can be no assurance, however, as to whether or when the Company will make such
distribution and satisfy the distribution requirement. Moreover, satisfaction of
the distribution requirement could cause the Company (i) to sell assets in
adverse market conditions, (ii) to distribute amounts that represent a return of
capital or (iii) to distribute amounts that would otherwise be spent on future
acquisitions, unanticipated capital expenditures or repayment of debt. Gain from
the disposition of any asset held primarily for sale to customers in the
ordinary course of business generally will be subject to a 100% tax.
LOSS OF INVESTMENT COMPANY ACT EXEMPTION COULD HAVE ADVERSE CONSEQUENCES
The Company believes that it is not, and intends to conduct its
operations so as not to become, regulated as an investment company under the
Investment Company Act of 1940, as amended (the "Investment Company Act"). Under
the Investment Company Act, a non-exempt entity that is an investment company is
required to register with the Commission and is subject to extensive,
restrictive and potentially adverse regulation relating to, among other things,
operating methods, management, capital structure, dividends and transactions
with affiliates. The Investment Company Act exempts entities that, directly or
through majority-owned subsidiaries, are "primarily engaged in the business of
purchasing or otherwise acquiring mortgages and other liens on and interests in
real estate" ("Qualifying Interests"). Under current interpretations by the
staff of the Commission, in order to qualify for this exemption, the Company,
among other things, must maintain at least 55% of its assets in Qualifying
Interests and also may be required to maintain an additional 25% in Qualifying
Interests or other real estate-related assets. The assets that the Company may
acquire therefore may be limited by the provisions of the Investment Company
Act. The Company's investments in real estate and mortgage loans generally
constitute Qualifying Interests, and the Company believes that subordinate and
residual interests in mortgage-related securities constitute Qualifying
Interests for purposes of the Investment Company Act when the Company acquires
the right to direct the foreclosure upon any defaulted loan which backs such
securities and to take all other actions that a servicer generally may take in
connection with a defaulted loan. At December 31, 1998, the Company believes
that its Qualifying Interests, including subordinate and residual interests in
mortgage-related securities which the Company believes meet the criteria set
forth above, comprised over 86% of the Company's total assets and that the
Company's Qualifying Interests and other real-estate related assets comprised
over 95% of the Company's total assets. As a result, the Company believes that
it was not required to register as an investment company under the Investment
Company Act. The Company does not intend to seek an exemptive order, no-action
letter or other form of interpretive guidance from the Commission or staff to
confirm this position. If the Commission or its staff were to take a different
position with respect to whether the Company's subordinate and residual
interests constitute Qualifying Interests, the Company could be required either
(a) to change the manner in which it conducts its operations to avoid being
required to register as an investment company or (b) to register as an
investment company, either of which could have a material adverse effect on the
Company and its securities, could subject the Company to monetary penalties and
injunctive relief in an action brought by the Commission, could cause the
Company to be unable to enforce contracts with third parties and could cause
third parties to seek recission of relevant transactions.
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DEPENDENCE OF THE COMPANY UPON EXTERNAL MANAGEMENT
The Company is managed by the Manager, subject to the supervision of
the Board of Directors of the Company. Thus, the Company is dependent on the
services of the Manager and its officers and employees for the success of the
Company. Moreover, the Manager's personnel are employees of the Bank, and
accordingly, the Company's success depends in part on the continuing ability of
OCN to hire and retain knowledgeable personnel. This ability may be affected, in
turn, by OCN's continued financial health. Finally, the Company is subject to
the risk that the Manager will terminate the Management Agreement and that no
suitable replacement can be found to manage the Company.
The Manager is a wholly-owned subsidiary of OCN, a registered savings
and loan holding company that conducts substantial operations through the Bank,
a federally-chartered savings bank. Both OCN and the Bank are subject to
extensive government supervision and regulation, which is intended primarily for
the protection of depositors. In addition, each of OCN and the Bank is subject
to changes in federal and state laws, including changes in tax laws that could
materially affect the real estate industry, as well as changes in regulations,
governmental policies and accounting principles. Such changes may increase OCN's
and the Bank's costs of doing business and assist their competitors. Any such
added burdens may adversely affect the Manager's ability to carry out its
management functions and/or the Bank's ability to provide mortgage loan
servicing for the Company, as well as affect the ability of the Manager and its
affiliates to enter into other arrangements with the Company.
MANAGER ENTITLED TO BROAD INDEMNIFICATION FROM THE COMPANY
Pursuant to the Management Agreement between the Company and the
Manager, the Company is obligated to indemnify the Manager and its directors and
officers from any action or claim that they are accountable or liable for the
debts or obligations of the Company. In addition, the Company is required to
indemnify the Manager and its directors and officers for acts performed pursuant
to the Management Agreement, except for claims arising from acts constituting
bad faith, willful misconduct, gross negligence or reckless disregard of their
duties under the Management Agreement. There can be no assurance that these
requirements will not adversely affect the Company's operations in the future.
POTENTIAL CONFLICTS OF INTEREST BETWEEN THE COMPANY AND ITS AFFILIATES COULD BE
DISADVANTAGEOUS TO THE COMPANY
The Company is subject to the following potential conflicts of interest
arising from its relationship with the Manager and its affiliates:
(i) OCN beneficially owns 1,540,000 shares or 8.1% of the
outstanding Common Stock, as well as options to purchase 1,912,500
shares of Common Stock. OCN also indirectly holds an 8.7% limited
partnership interest in the Operating Partnership.
(ii) Two of the members of the Board of Directors of the
Company and all of its officers are employed by the Bank and generally
devote a majority or more of their time to the affairs of the Bank and
OCN. As a result of their positions with the Company and the Bank, two
directors and the officers of the Company have fiduciary duties to both
the Company and the Bank and must consider the same in making decisions
on behalf of these respective entities, including without limitation
decisions of the type referred to in paragraphs (iv) and (v) below.
(iii) Pursuant to the Management Agreement, the Manager
renders management services to the Company for a management fee based
on average invested assets, which also benefits the Manager as the
asset size of the Company increases, regardless of the performance of
the Company's assets. In addition, the incentive portion of the
management fee, which is based on the Company's FFO, as adjusted, may
create an incentive for the Manager to recommend investments that have
greater income potential but are generally more speculative than if the
management fee did not include a performance component.
9
<PAGE>
(iv) Although the Manager has granted to the Company the first
option to acquire underperforming real estate and subordinate and
residual interests backed by loans which were not formerly owned by the
Manager and its affiliates, OCN, the Bank and other affiliates of the
Manager invest in other assets that the Company invests in, including a
wide variety of mortgage-related securities and single-family,
multifamily and commercial real estate loans, including subperforming
and nonperforming loans. The Manager and its affiliates have no
obligation to make investment opportunities available to the Company,
and as a result, the Company's ability to invest in certain real estate
related assets may be limited to the extent that such assets are
attractive to OCN or one of its affiliates.
(v) Because they share certain investment strategies, from
time to time the Company has acquired assets from OCN, the Bank and
other affiliates of the Manager, co-participated in investment
transactions with these entities or persons and sold assets to the
same.
The Board of Directors of the Company, which includes a majority of
Independent Directors (as defined in the Company's Articles of Incorporation)
have established general guidelines for the Company's investments, borrowings
and operations and potential conflicts of interest (the "Guidelines"). The
Independent Directors review transactions engaged in by the Company on a
quarterly basis to monitor compliance with the Guidelines and review the
Company's investment policies annually. The Independent Directors rely primarily
on information provided to them by the Manager in conducting these reviews and
do not otherwise participate in the Company's daily operations.
The Management Agreement and the Guidelines do not limit or restrict
the right of the Manager or any of its directors, officers, employees or
affiliates from engaging in any business or rendering services of any kind to
any other person, including the purchase of or rendering advice to others
purchasing real estate assets that meet the Company's policies and criteria.
FAILURE OF COMPUTER SYSTEMS TO RECOGNIZE THE YEAR 2000 COULD ADVERSELY AFFECT
THE COMPANY'S OPERATIONS
As the year 2000 approaches, a critical business issue has emerged
regarding how existing application software programs and operating systems can
accommodate this date value. Many existing application software products in the
marketplace were designed to accommodate only two-digit entries. Beginning in
the year 2000, these systems and products will need to be able to accept
four-digit entries to distinguish years beginning with 2000 from prior years. As
a result, computer systems and software used by many companies may need to be
upgraded to comply with year 2000 requirements.
The Company is dependent upon data processing systems and software to
conduct its business. The data processing systems and software include those
developed, purchased and maintained by the Manager, as well as OCN and its other
subsidiaries, which provide management services to the Company. The Company does
not own or maintain computer equipment or software.
There can be no assurance that the failure of the Manager, the Company
or third parties to adequately address their respective year 2000 issues will
not have a material adverse effect on the Company. For additional information,
see "Year 2000 Data Conversion" under Item 7 of the Annual Report on Form 10-K
to which this Exhibit relates.
10
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
Consolidated Statement of Financial Condition at December 31, 1998 and the
Consolidated Statement of Operations for the Year Ended December 31, 1998 and is
qualified in its entirety by reference to such financial statements.
</LEGEND>
<CIK> 0001033643
<NAME> OCWEN ASSET INVESTMENT CORP.
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<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
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0
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