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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
(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 NUMBER: 1-13447
ANNALY MORTGAGE MANAGEMENT, INC.
(Exact Name of Registrant as Specified in its Governing Instruments)
MARYLAND 22-3479661
(State or other jurisdiction of (I.R.S. Employer
incorporation of organization) Identification Number)
12 East 41st Street, Suite 700
New York, New York 10017
(Address of Principal Executive Offices)
(212) 696-0100
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on Which Registered
Common Stock, Par Value $.01 Per Share New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
None.
Indicate by check mark whether the Registrant (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 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. [ ]
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At March 25, 1999 the aggregate market value of the voting stock held by non-
affiliates of the Registrant was $119,537,928.
The number of shares of the Registrant's Common Stock outstanding on March 25,
1999 was 12,696,798
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the Registrant's definitive Proxy Statement dated March 25, 1999,
issued in connection with the 1999 Annual Meeting of Stockholders of the
Registrant to be held on May 17, 1999 are incorporated by reference into Parts I
And III.
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ANNALY MORTGAGE MANAGEMENT, INC.
- - ---------------------------------------------
1999 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
<TABLE>
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PART I
PAGE
<S> <C>
ITEM 1. BUSINESS 1-31
ITEM 2. PROPERTIES 32
ITEM 3. LEGAL PROCEEDINGS 32
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 32
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY
AND RELATED SHAREHOLDER MATTERS 32
ITEM 6. SELECTED FINANCIAL DATA 33-34
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS 35-48
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK 49-50
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 51
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE 51
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT 51
ITEM 11. EXECUTIVE COMPENSATION 51
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
AND MANAGEMENT 51
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 51
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS
ON FORM 8-K 51-52
FINANCIAL STATEMENTS F-1 TO F-14
SIGNATURES 61
EXHIBIT INDEX 62
</TABLE>
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PART I
ITEM 1. BUSINESS
THE COMPANY
Annaly Mortgage Management, Inc. (the "Company") was incorporated in the
State of Maryland on November 25, 1996. The Company commenced operations on
February 18, 1997 upon the consummation of its sale of 3,600,000 shares of
Common Stock in an offering exempt from registration under the Securities Act
and state securities laws (the "Private Placement"). The Company raised
additional capital on July 31, 1997 upon the consummation of the its sale of
87,800 shares of Common Stock to certain directors, officers and employees of
the Company (the "Direct Offering"). The Company completed its initial public
offering of 8,946,100 shares on October 14, 1997.
Annaly Mortgage Management, Inc. specializes in investing in Mortgage-Backed
Securities. Its principal business objective is to generate net income for
distribution to stockholders from the spread between the interest income on its
Mortgage-Backed Securities (as defined below) and the costs of borrowing to
finance its acquisition of Mortgage-Backed Securities. The Company has elected
to be taxed as a Real Estate Investment Trust, (a "REIT"). The Company is self-
advised and self-managed. The management of the Company manages the day-to-day
operations, subject to the supervision of the Company's Board of Directors.
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 the
Private Securities Litigation Reform Act of 1995. 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 or periods, or by the
use of forward-looking terminology, such as "may," "will," "believe," "expect,"
"anticipate," "continue," or similar terms or variations on those terms, or the
negative of those terms. Actual results could differ materially from those set
forth in forward-looking statements due to a variety of factors, including, but
not limited to, changes in interest rates, changes in yield curve, changes in
prepayment rates, the availability of Mortgage-Backed Securities for purchase,
the availability of financing and, if available, the terms of any such
financing. For a discussion of the risks and uncertainties which could cause
actual results to differ from those contained in the forward-looking statements,
see "Risk Factors." 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.
Reference is made to the Glossary commencing on page 53 of this report for
definitions of terms used in the following description of the Company's business
and elsewhere in this report.
BUSINESS STRATEGY
GENERAL
The Company's principal business objective is to generate income for
distribution to its stockholders, primarily from the net cash flows on its
Mortgage-Backed Securities qualifying as Qualified REIT Real Estate Assets (as
defined below). The Company's net cash flows result primarily from the
difference between (i) the interest income on its Mortgage-Backed Security
investments and (ii) the borrowing and financing costs of the Mortgage-Backed
Securities. To achieve its business objective and generate dividend yields, the
Company's strategy is:
. to purchase Pass-Through Certificates, CMOs and other Mortgage-Backed
interest rates based on changes in short-term market interest rates;
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. to acquire only those Mortgage-Backed Securities which the Company
believes it has the necessary expertise to evaluate and manage, which can
be readily financed and which are consistent with the Company's balance
sheet guidelines and risk management objectives and generally to seek to
acquire assets whose investment returns are attractive in more than a
limited range of scenarios;
. to finance purchases of Mortgage-Backed Securities with the proceeds
of equity offerings and, to the extent permitted by the Company's Capital
Investment Policy, to utilize leverage to increase potential returns to
stockholders through borrowings (primarily under repurchase agreements);
. to attempt to structure its borrowings to have interest rate
adjustment indices and interest rate adjustment periods that, on an
aggregate basis, generally correspond (within a range of one to six
months) to the interest rate adjustment indices and interest rate
adjustment periods of the adjustable and floating rate Mortgage-Backed
Securities purchased by the Company;
. to utilize interest rate caps, swaps and similar instruments to
mitigate the risk of the cost of its variable rate liabilities
increasing at a faster rate than the earnings on its assets during a
period of rising interest rates;
. to seek to minimize prepayment risk by structuring a diversified
portfolio with a variety of prepayment characteristics and through other
means; and
. to issue new equity or debt and increase the size of the balance sheet
when opportunities in the market for Mortgage-Backed Securities are
likely to allow growth in earnings per share.
The Company obtains cost efficiencies through its facilities-sharing
arrangement with Fixed Income Discount Advisory Company, ("FIDAC") and by virtue
of management's experience in managing portfolios of Mortgage-Backed Securities
and in arranging collateralized borrowings. The Company will strive to become
even more cost-efficient over time by:
. seeking to raise additional capital from time to time in order to
increase its ability to invest in Mortgage- Backed Securities as
operating costs are not anticipated to increase as quickly as assets and
because growth will increase the Company's purchasing influence with
suppliers of Mortgage-Backed Securities;
. striving to lower its effective borrowing costs over time through
seeking direct funding with collateralized lenders rather than using
financial intermediaries and investigating the possibility of using
commercial paper and medium term note programs;
. improving the efficiency of its balance sheet structure by
investigating the issuance of uncollateralized subordinated debt,
preferred stock and other forms of capital; and
. utilizing information technology to the fullest extent possible in its
business, which technology the Company believes can be developed to
improve the Company's ability to monitor the performance of its Mortgage-
Backed Securities, improve its ability to assess credit risk, improve
hedge efficiency and lower operating costs.
"Mortgage-Backed Securities" which may be acquired by the Company include (i)
securities (or interests therein) evidencing undivided ownership interests in a
pool of mortgage loans, the holders of which receive a "pass-through" of the
principal and interest paid in connection with the underlying mortgage loans in
accordance with the holders' respective, undivided interests in the pool ("Pass-
Through Certificates"), and (ii) adjustable- or fixed-rate debt obligations
(bonds) that are collateralized by mortgage loans or mortgage certificates
("CMOs"). "Pass-Through Certificates" include mortgage participation
certificates issued by the Federal Home Loan Mortgage Corporation ("FHLMC"),
mortgage pass-through certificates issued by the Federal National Mortgage
Association ("FNMA"), fully modified pass-through mortgage-backed certificates
guaranteed by the Government National Mortgage Association
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("GNMA"), and privately-issued pass-through certificates ("Privately-Issued
Certificates") issued by a third party issuer other than FHLMC, FNMA and GNMA.
The term "Qualified REIT Real Estate Assets" means Mortgage-Backed Securities
and other assets of the type described in section 856(c) (6)(B) of the Internal
Revenue Code of 1986, as amended (the "Code").
The Company's "Capital Investment Policy" is a set of policies established by
the Company, including a majority of its independent directors, establishing
guidelines for management relating to asset acquisitions, credit risk
management, capital and leverage, interest rate risk management and prepayment
risk management.
MORTGAGE-BACKED SECURITIES
GENERAL
The Company's Capital Investment Policy provides that at least 75% of its
total assets will be comprised of High Quality Mortgage-Backed Securities and
High Quality Short-Term Investments. The term "High Quality" as used herein
means securities (i) which are rated within one of the two highest rating
categories by at least one of the nationally recognized rating agencies, (ii)
that are unrated but are either guaranteed by the United States government or an
agency of the United States government, or (iii) that are unrated or whose
ratings have not been updated but are determined to be of comparable quality to
rated High Quality Mortgage-Backed Securities on the basis of credit enhancement
features that meet the High Quality credit criteria approved by the Company's
Board of Directors. To date, all of the Mortgage-Backed Securities acquired by
the Company have been High Quality Mortgage-Backed Securities which, although
not rated, carry an implied "AAA" rating. The term "Short-Term Investments"
means short-term bank certificates of deposit, short-term United States treasury
securities, short-term United States government agency securities, commercial
paper, reverse repurchase agreements, short-term CMOs, short-term asset-backed
securities and other similar types of short-term investment instruments, all of
which have maturities or average durations of less than one year.
In accordance with the Company's Capital Investment Policy, the remainder of
the Company's assets, comprising not more than 25% of total assets, may consist
of Mortgage-Backed Securities and other Qualified REIT Real Estate Assets which
are unrated or rated less than High Quality, but which are at least "investment
grade" (rated "BBB" or better by Standard & Poors Corporation ("S&P") or the
equivalent by another nationally recognized rating organization) or, if not
rated, are determined by the Company to be of comparable credit quality to an
investment which is rated "BBB" or better. The foregoing-described Mortgage-
Backed Securities, comprising in the aggregate not more than 25% of the
Company's total assets, are sometimes referred to herein as "Limited Investment
Assets." The Company intends to structure its portfolio to maintain a minimum
weighted average rating (including the Company's deemed comparable ratings for
unrated Mortgage-Backed Securities based on a comparison to rated Mortgage-
Backed Securities with like characteristics) of its Mortgage-Backed Securities
of at least single "A" under the S&P rating system and at the comparable level
under the other rating systems.
Allocation of the Company's investments among the permitted investment types
may vary from time-to-time based on the evaluation by the Company's Board of
Directors of economic and market trends and the Company's perception of the
relative values available from such types of investments, provided that in no
event will the Company's investment in Limited Investment Assets exceed 25% of
the Company's total assets.
To date, all of the Mortgage-Backed Securities acquired by the Company have
been Agency Certificates or CMO's issued or guaranteed by FHLMC, FNMA or GNMA,
which carry an implied "AAA" rating. Prior to acquiring any unrated securities,
the Company intends to engage an independent consultant with expertise in rating
"investment grade" securities to assist the Company in evaluating the
creditworthiness of such securities and determining whether such securities are
qualified to be purchased under the Capital Investment Policy. In making such
evaluations, the Company will look at similar criteria utilized by S&P and other
nationally recognized rating organizations. Such criteria may include a review
of the cash flow and other characteristic of the security, an analysis of the
components of the security and a valuation of comparable assets.
The Company acquires only those Mortgage-Backed Securities which the Company
believes it has the necessary expertise to evaluate and manage, which are
consistent with the Company's balance sheet guidelines and risk
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management objectives and which the Company believes can be readily financed.
Since the intention of the Company is generally to hold its Mortgage-Backed
Securities until maturity, the Company generally does not seek to acquire assets
whose investment returns are only attractive in a limited range of scenarios.
The Company believes that future interest rates and mortgage prepayment rates
are very difficult to predict. Therefore, the Company seeks to acquire Mortgage-
Backed Securities, which the Company believes will provide acceptable returns
over a broad range of interest rate and prepayment scenarios.
The Mortgage-Backed Securities acquired and to be acquired by the Company
to date have consisted of Pass-Through Certificates and CMOs, and may in the
future include other Mortgage-Backed Securities, including mortgage derivative
securities representing the right to receive interest only or a
disproportionately large amount of interest. The Agency certificates acquired by
the Company to date have included both adjustable and fixed-rate securities. The
CMO's acquired by the Company to date similarly have included both adjustable-
rate CMO's (commonly referred to as "floater") and fixed-rate CMO's. It is
expected in the future that the Mortgage-Backed securities to be acquired by the
Company will continue to consist primarily of Agency Certificates and CMO's
issued or guaranteed by FHLMC, FNMA or GNMA. The Company has not and will not
invest in REMIC residuals, other CMO residuals or Mortgage-Backed Securities,
such as inverse floaters, which have imbedded leverage as part of their
structural characteristics.
DESCRIPTION OF MORTGAGE-BACKED SECURITIES
The Mortgage-Backed Securities in which the Company invests provide funds for
mortgage loans made primarily to residential homeowners. These include
securities, which represent interests in pools of mortgage loans made by lenders
such as savings and loan institutions, mortgage bankers and commercial banks.
Pools of mortgage loans are assembled for sale to investors (such as the
Company) by various governmental, government-related and private organizations.
Interests in pools of Mortgage-Backed Securities differ from other forms of
traditional debt securities, which normally provide for periodic payments of
interest in fixed amounts with principal payments at maturity or specified call
dates. Instead, Mortgage-Backed Securities provide for a monthly payment, which
consists of both interest and principal. In effect, these payments are a "pass-
through" of the monthly interest and principal payments made by the individual
borrower on its residential mortgage loans, net of any fees paid to the issuer
or guarantor of such securities. Additional payments result from prepayments of
principal resulting from the sale of the underlying residential property,
refinancing or foreclosure, net of fees or costs, which may be incurred. Some
mortgage-backed securities, such as securities issued by GNMA, are described as
"modified pass-through." These securities entitle the holder to receive all
interest and principal payments owed on the mortgage pool, net of certain fees,
regardless of whether or not the mortgagors actually make mortgage payments when
due.
The investment characteristics of pass-through Mortgage-Backed Securities
differ from those of traditional fixed-income securities. The major differences
include the payment of interest and principal on the mortgage-backed securities
on a more frequent schedule, as described above, and the possibility that
principal may be prepaid at any time due to prepayments on the underlying
mortgage loans or other assets. These differences can result in significantly
greater price and yield volatility than is the case with traditional fixed-
income securities.
The occurrences of mortgage prepayments are affected by factors including the
level of interest rates, general economic conditions, the location and age of
the mortgage and other social and demographic conditions. Generally prepayments
on pass-through mortgage-backed securities increase during periods of falling
mortgage interest rates and decrease during periods of rising mortgage interest
rates. Reinvestment of prepayments may occur at higher or lower interest rates
than the original investment, thus affecting the yield of the Company's
investments.
FHLMC CERTIFICATES
FHLMC is a privately owned government-sponsored enterprise created pursuant
to an Act of Congress (Title III of the Emergency Home Finance Act of 1970, as
amended, 12 U.S.C. (S)(S) 1451-1459), on July 24, 1970. The principal activity
of FHLMC currently consists of the purchase of conventional Conforming Mortgage
Loans or participation interests therein and the resale of the loans and
participations so purchased in the form of guaranteed Mortgage-Backed
Securities. FHLMC guarantees to each holder of FHLMC Certificates the timely
payment of interest at the applicable
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pass-through rate and ultimate collection of all principal on the holder's pro
rata share of the unpaid principal balance of the related Mortgage Loans, but
does not guarantee the timely payment of scheduled principal of the underlying
Mortgage Loans. The obligations of FHLMC under its guarantees are solely those
of FHLMC and are not backed by the full faith and credit of the United States.
If FHLMC were unable to satisfy such obligations, distributions to holders of
FHLMC Certificates would consist solely of payments and other recoveries on the
underlying Mortgage Loans and, accordingly, monthly distributions to holders of
FHLMC Certificates would be affected by delinquent payments and defaults on such
Mortgage Loans.
FHLMC Certificates may be backed by pools of Single-Family Mortgage Loans
or Multifamily Mortgage Loans. Such underlying Mortgage Loans may have original
terms to maturity of up to 40 years. FHLMC Certificates may be issued under cash
programs (composed of Mortgage Loans purchased from a number of sellers) or
guarantor programs (composed of Mortgage Loans purchased from one seller in
exchange for participation certificates representing interests in the Mortgage
Loans purchased). FHLMC Certificates may pay interest at a fixed rate or
adjustable rate. The interest rate paid on FHLMC ARM Certificates adjusts
periodically within 60 days prior to the month in which the interest rates on
the underlying Mortgage Loans adjust. The interest rates paid on FHLMC ARM
Certificates issued under FHLMC's standard ARM programs adjust in relation to
the Treasury Index. Other specified indices used in FHLMC ARM programs include
the 11th District Cost of Funds Index published by the Federal Home Loan Bank of
San Francisco, LIBOR and other indices. Interest rates paid on fully-indexed
FHLMC ARM Certificates equal the applicable index rate plus a specified number
of basis points ranging typically from 125 to 250 basis points. In addition, the
majority of series of FHLMC ARM Certificates issued to date have evidenced pools
of Mortgage Loans with monthly, semi-annual or annual interest adjustments.
Adjustments in the interest rates paid are generally limited to an annual
increase or decrease of either 100 or 200 basis points and to a lifetime cap of
500 or 600 basis points over the initial interest rate. Certain FHLMC programs
include Mortgage Loans, which allow the borrower to convert the adjustable
mortgage interest rate to a fixed rate. Adjustable-Rate Mortgage Loans ("ARMs")
which are converted into fixed-rate Mortgage Loans are repurchased by FHLMC or
by the seller of such loan to FHLMC at the unpaid principal balance thereof plus
accrued interest to the due date of the last adjustable rate interest payment.
An "ARM Certificate" means a Mortgage-Backed Security that features adjustments
of the underlying interest rate at predetermined times based on an agreed margin
to an established index, such as LIBOR, the Treasury Index or the CD Rate.
"LIBOR" means the London Interbank Offered Rate as it may be defined, and for a
period of time specified, in a Mortgage-Backed Security or borrowing of the
Company. "Treasury Index" means the monthly/weekly average yield of the
benchmark U.S. Treasury securities, as published by the Board of Governors of
the Federal Reserve System. "CD Rate" means the weekly average of secondary
market interest rates on six-month negotiable certificates of deposit, as
published by the Federal Reserve Board in its Statistical Release H.15(519),
Selected Interest Rates.
FNMA CERTIFICATES
FNMA is a privately owned, federally chartered corporation organized and
existing under the Federal National Mortgage Association Charter Act (12 U.S.C.
(S) 1716 et seq.). FNMA provides funds to the mortgage market primarily by
purchasing home Mortgage Loans from local lenders, thereby replenishing their
funds for additional lending. FNMA guarantees to the registered holder of a
FNMA Certificate that it will distribute amounts representing scheduled
principal and interest (at the rate provided by the FNMA Certificate) on the
Mortgage Loans in the pool underlying the FNMA Certificate, whether or not
received, and the full principal amount of any such mortgage loan foreclosed or
otherwise finally liquidated, whether or not the principal amount is actually
received. The obligations of FNMA under its guarantees are solely those of FNMA
and are not backed by the full faith and credit of the United States. If FNMA
were unable to satisfy such obligations, distributions to holders of FNMA
Certificates would consist solely of payments and other recoveries on the
underlying Mortgage Loans and, accordingly, monthly distributions to holders of
FNMA Certificates would be affected by delinquent payments and defaults on such
Mortgage Loans.
FNMA Certificates may be backed by pools of Single-Family or Multifamily
Mortgage Loans. The original terms to maturities of the Mortgage Loans
generally do not exceed 40 years. FNMA Certificates may pay interest at a fixed
rate or adjustable rate. Each series of FNMA ARM Certificates bears an initial
interest rate and margin tied to an index based on all loans in the related
pool, less a fixed percentage representing servicing compensation and FNMA's
guarantee fee. The specified index used in each such series has included the
Treasury Index, the 11th District Cost of Funds Index published by the Federal
Home Loan Bank of San Francisco, LIBOR and other indices. Interest rates paid
on fully-
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indexed FNMA ARM Certificates equal the applicable index rate plus a specified
number of basis points ranging typically from 125 to 250 basis points. In
addition, the majority of series of FNMA ARM Certificates issued to date have
evidenced pools of Mortgage Loans with monthly, semi-annual or annual interest
rate adjustments. Adjustments in the interest rates paid are generally limited
to an annual increase or decrease of either 100 or 200 basis points and to a
lifetime cap of 500 or 600 basis points over the initial interest rate. Certain
FNMA programs include Mortgage Loans, which allow the borrower to convert the
adjustable mortgage interest rate of its ARM to a fixed rate. ARMs which are
converted into fixed-rate Mortgage Loans are repurchased by FNMA or by the
seller of such loans to FNMA at the unpaid principal balance thereof plus
accrued interest to the due date of the last adjustable rate interest payment.
Adjustments to the interest rates on FNMA ARM Certificates are typically subject
to lifetime caps and periodic rate or payment caps.
GNMA CERTIFICATES
GNMA is a wholly owned corporate instrumentality of the United States within
the Department of Housing and Urban Development ("HUD"). Section 306(g) of
Title III of the National Housing Act of 1934, as amended (the "Housing Act"),
authorizes GNMA to guarantee the timely payment of the principal of and interest
on certificates which represent an interest in a pool of mortgages insured by
the FHA under the Housing Act or Title V of the Housing Act of 1949, or
partially guaranteed by the VA under the Servicemen's Readjustment Act of 1944,
as amended, or Chapter 37 of Title 38, United States Code and other loans
eligible for inclusion in mortgage pools underlying GNMA Certificates. Section
306(g) of the Housing Act provides that "the full faith and credit of the United
States is pledged to the payment of all amounts which may be required to be paid
under any guaranty under this subsection." An opinion, dated December 12, 1969,
of an Assistant Attorney General of the United States provides that such
guarantees under section 306(g) of GNMA Certificates of the type which may be
purchased or received in exchange by the Company are authorized to be made by
GNMA and "would constitute general obligations of the United States backed by
its full faith and credit."
At present, most GNMA Certificates are backed by Single-Family Mortgage Loans.
The interest rate paid on GNMA Certificates may be fixed rate or adjustable
rate. The interest rate on GNMA Certificates issued under GNMA's standard ARM
program adjusts annually in relation to the Treasury Index. Interest rates paid
on GNMA ARM Certificates typically equal the index rate plus 150 basis points.
Adjustments in the interest rate are generally limited to an annual increase or
decrease of 100 basis points and to a lifetime cap of 500 basis points over the
initial coupon rate.
SINGLE-FAMILY AND MULTIFAMILY PRIVATELY-ISSUED CERTIFICATES
Single-Family and Multifamily Privately-Issued Certificates are Pass-Through
Certificates that are not issued by FHLMC, FNMA or GNMA (the "Agencies") and
that are backed by a pool of conventional Single-Family or Multifamily Mortgage
Loans, respectively. Single-Family and Multifamily Privately-Issued Certificates
are issued by originators of, investors in, and other owners of Mortgage Loans,
including savings and loan associations, savings banks, commercial banks,
mortgage banks, investment banks and special purpose "conduit" subsidiaries of
such institutions.
While Agency Certificates are backed by the express obligation or guarantee of
one of the Agencies, as described above, Single-Family and Multifamily
Privately-Issued Certificates are generally covered by one or more forms of
private (i.e., non-governmental) credit enhancements. Such credit enhancements
provide an extra layer of loss coverage in the event that losses are incurred
upon foreclosure sales or other liquidations of underlying mortgaged properties
in amounts that exceed the equity holder's equity interest in the property and
result in Realized Losses. Forms of credit enhancements include, but are not
limited to, limited issuer guarantees, reserve funds, private mortgage guaranty
pool insurance, over-collateralization and subordination.
Subordination is a form of credit enhancement frequently used and involves the
issuance of multiple classes of Senior-Subordinated Mortgage-Backed Securities.
Such classes are structured into a hierarchy of levels for purposes of
allocating Realized Losses and also for defining priority of rights to payment
of principal and interest. Typically, one or more classes of Senior Securities
are created which are rated in one of the two highest rating levels by one or
more nationally recognized rating agencies and which are supported by one or
more classes of Mezzanine Securities and Subordinated Securities that bear
Realized Losses prior to the classes of Senior Securities. Mezzanine Securities
for purposes of this Prospectus will refer to any classes that are rated below
the two highest levels but no lower than a single
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"B" level under the S&P rating system (or comparable level under other rating
systems) and are supported by one or more classes of Subordinated Securities
which bear Realized Losses prior to the classes of Mezzanine Securities. For
purposes of this Prospectus, Subordinated Securities will refer to any class
that bears the "first loss" from Realized Losses or that is rated below a single
"B" level (or, if unrated, is deemed by the Company to be below such level based
on a comparison of characteristics of such class with other rated Subordinated
Securities with like characteristics). In some cases, only classes of Senior
Securities and Subordinated Securities are issued. By adjusting the priority of
interest and principal payments on each class of a given series of Senior-
Subordinated Mortgage-Backed Securities, issuers are able to create classes of
Mortgage-Backed Securities with varying degrees of credit exposure, prepayment
exposure and potential total return, tailored to meet the needs of sophisticated
institutional investors.
COLLATERALIZED MORTGAGE OBLIGATIONS AND MULTI-CLASS PASS-THROUGH SECURITIES
Mortgage-Backed Securities in which the Company may invest may include
collateralized mortgage obligations ("CMOs") and multi-class pass-through
securities. CMOs are debt obligations issued by special purpose entities that
are secured by mortgage-backed certificates, including, in many cases,
certificates issued by government and government-related guarantors, including,
GNMA, FNMA and FHLMC, together with certain funds and other collateral. Multi-
class pass-through securities are equity interests in a trust composed of
mortgage loans or other mortgage-backed securities. Payments of principal and
interest on underlying collateral provide the funds to pay debt service on the
CMO or make scheduled distributions on the multi-class pass-through securities.
CMOs and multi-class pass-through securities may be issued by agencies or
instrumentalities of the U.S. Government or by private organizations. The
discussion of CMOs in the following paragraphs is similarly applicable to multi-
class pass-through securities.
In a CMO, a series of bonds or certificates is issued in multiple classes.
Each class of CMOs, often referred to as a "tranche," is issued at a specific
coupon rate (which, as discussed below, may be an adjustable rate subject to a
cap) and has a stated maturity or final distribution date. Principal
prepayments on collateral underlying a CMO may cause it to be retired
substantially earlier than the stated maturities or final distribution dates.
Interest is paid or accrues on all classes of a CMO on a monthly, quarterly or
semi-annual basis. The principal and interest on underlying mortgages may be
allocated among the several classes of a series of a CMO in many ways. In a
common structure, payments of principal, including any principal prepayments, on
the underlying mortgages are applied to the classes of the series of a CMO in
the order of their respective stated maturities or final distribution dates, so
that no payment of principal will be made on any class of a CMO until all other
classes having an earlier stated maturity or final distribution date have been
paid in full.
Other types of CMO issues include classes such as parallel pay CMOs, some of
which, such as Planned Amortization Class CMOs ("PAC Bonds"), provide protection
against prepayment uncertainty. Parallel pay CMOs are structured to provide
payments of principal on certain payment dates to more than one class. These
simultaneous payments are taken into account in calculating the stated maturity
date or final distribution date of each class which, as with other CMO
structures, must be retired by its stated maturity date or final distribution
date but may be retired earlier. PAC Bonds generally require payment of a
specified amount of principal on each payment date so long as prepayment speeds
on the underlying collateral fall within a specified range. PAC Bonds are always
parallel pay CMOs with the required principal payment on such securities having
the highest priority after interest has been paid to all classes.
Other types of CMO issues include Targeted Amortization Class CMOs ("TAC
Bonds"), that are similar to PAC Bonds. While PAC Bonds maintain their
amortization schedule within a specified range of prepayment speeds, TAC Bonds
are generally targeted to a narrow range of prepayment speeds or a specified
prepayment speed. TAC Bonds can provide protection against prepayment
uncertainty since cash flows generated from higher prepayments of the underlying
mortgage-related assets are applied to the various other pass-through tranches
so as to allow the TAC Bonds to maintain their amortization schedule.
CMOs may be subject to certain rights of issuers thereof to redeem such CMOs
prior to their stated maturity dates, which may have the effect of diminishing
the Company's anticipated return on its investment. Privately-Issued Single-
Family and Multifamily CMOs are supported by private credit enhancements similar
to those used for Privately-Issued Certificates and are often issued as Senior-
Subordinated Mortgage-Backed Securities. The Company will only acquire CMOs or
multi-class pass-through certificates that constitute debt obligations or
beneficial ownership in grantor trusts
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holding Mortgage Loans, or regular interests in REMICs, or that otherwise
constitute Qualified REIT Real Estate Assets (provided that the Company has
obtained a favorable opinion of its tax advisor or a ruling from the IRS to that
effect).
One or more tranches of a CMO may have coupon rates, which reset periodically
at a specified increment over an index such as LIBOR. These adjustable rate
tranches known as "floating rate CMOs", or "floaters" may be backed by fixed or
adjustable-rate mortgages. To date, fixed-rate mortgages have been more
commonly utilized for this purpose. Floating rate CMOs are typically issued
with lifetime caps on the coupon rate thereon. These caps, similar to the caps
on adjustable-rate mortgages described in "Floating Rate Mortgage-Backed
Securities" below, represent a ceiling beyond which the coupon rate on a
floating rate CMO may not be increased regardless of increases in the interest
rate index to which the floating rate CMO is geared.
FLOATING RATE MORTGAGE-BACKED SECURITIES
CMOs in which the Company may invest include floating rate CMOs ("Floaters").
The interest rates on Floaters are reset at periodic intervals to an increment
over some predetermined interest rate index. There are two main categories of
indices: (i) those based on U.S. Treasury securities, and (ii) those derived
from calculated measures such as a cost of funds index or a moving average of
mortgage rates. Commonly utilized indices include the one-year Treasury rate,
the three-month Treasury bill rate, the six-month Treasury bill rate, rates on
long-term Treasury securities, the 11th District Federal Home Loan Bank Costs of
Funds Index, the National Median Cost of Funds, the one-month or three-month
LIBOR, the prime rate of a specific bank, or commercial paper rates. Some
indices, such as the one-year Treasury rate, closely mirror changes in market
interest rate levels. Others, such as the 11th District Home Loan Bank Cost of
Funds Index, tend to lag changes in market rate level. The Company will seek to
diversify its investments in Floaters among a variety of indices and reset
periods so that the Company is not at any one time unduly exposed to the risk of
interest rate fluctuations. In selecting the type of Floaters for investment,
the Company will also consider the liquidity of the market for such Floaters.
The Company believes that Floaters are particularly well-suited to facilitate
its ability to accomplish the Company's investment objective of high current
income, consistent with modest volatility of net asset value, because the value
of the Floaters should remain relatively stable as compared to that of
traditional fixed-rate debt securities paying comparable rates of interest.
While the value of Floaters, like other debt securities, generally varies
inversely with changes in market interest rates (increasing in value during
periods of declining interest rates and decreasing in value during periods of
increasing interest rates), the value of Floaters should generally be more
resistant to price swings than other debt securities because the interest rates
of Floaters move with market interest rates. Accordingly, as interest rates
change, the value of the Company's shares should be more stable than that of
funds which invest primarily in securities backed by fixed-rate mortgages or in
other non-mortgage-backed debt securities, which do not provide for adjustment
in the interest rates thereon in response to change in interest rates.
Floaters typically have caps, which limit the maximum amount by which the
interest rate may be increased or decreased at periodic intervals or over the
life of the Floater. To the extent that interest rates rise faster than the
allowable caps on Floaters, such Floaters will behave more like fixed-rate
securities. Consequently, interest rate increases in excess of caps can be
expected to cause Floaters to behave more like traditional debt securities than
adjustable-rate securities and, accordingly, to decline in value to a greater
extent than would be the case in the absence of such caps.
Floaters, like other Mortgage-Backed Securities, differ from conventional
bonds in that principal is to be paid back over the life of Floaters rather than
at maturity. As a result, the holder of the Floaters (i.e., the Company)
receives monthly scheduled payments of principal and interest and may receive
unscheduled principal payments representing prepayments on the underlying
mortgages. When the holder reinvests the payments and any unscheduled
prepayments it receives, it may receive a rate of interest on the reinvestment
which is lower than the rate on the existing Floaters. For this reason,
Floaters are less effective than longer-term debt securities as a means of
"locking in" longer-term interest rates.
Floaters, while having less risk of price decline during periods of rapidly
rising rates than certain fixed-rate Mortgage-Backed Securities of comparable
maturities, could have less potential for capital appreciation than such
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securities. In addition, to the extent Floaters are purchased at a premium,
mortgage foreclosures and unscheduled principal prepayments will result in some
loss of the holders' principal investment to the extent of the premium paid. On
the other hand, if Floaters are purchased at a discount, an unscheduled
prepayment of principal could increase total return and accelerate the
recognition of income to the Company and, as a result, could increase the amount
of income received by stockholders to the extent that the Company distributes
such income.
OTHER FLOATING RATE INSTRUMENTS
The Company may also invest in structured floating rate notes issued or
guaranteed by government agencies, such as FNMA and FHLMC. Such instruments are
typically structured to reflect an interest rate arbitrage (i.e., the difference
between the agency's cost of funds and the income stream from specified assets
of the agency) and their reset formulas may provide more attractive returns than
other floating rate instruments. The indices used to determine resets are the
same as those referred to under "--Floating Rate Mortgage-Backed Securities"
above.
SUBORDINATED INTERESTS
The Company may acquire Subordinated Interests, which are classes of Mortgage-
Backed Securities that are junior to other classes of such series of Mortgage-
Backed Securities in the right to receive payments from the underlying
mortgages. The subordination is for credit enhancement and may be for all
payment failures on the Mortgage Loans securing or underlying such series of
Mortgage-Backed Securities. The subordination will not be limited to those
resulting from certain types of risks, such as those resulting from war,
earthquake or flood, or the bankruptcy of a mortgagor. The subordination may be
for the entire amount of the series of Mortgage-Backed Securities or may be
limited in amount. The Subordinated Interests held by the Company will be part
of its Limited Investment Assets that in the aggregate will not constitute more
than 25% of the Company's total assets.
It is anticipated that substantially all of the Subordinated Interests which
the Company may acquire will be rated at least investment grade by one of the
rating agencies. If not so rated, the Company will establish reserves against
future potential losses in an amount equivalent to the credit enhancement
required to achieve an investment grade credit rating.
Any Subordinated Interests acquired by the Company will be limited in amount
and bear yields which the Company believes are commensurate with the risks
involved. The market for Subordinated Interests is not extensive and may be
illiquid. In addition, the Company's ability to sell Subordinated Interests
will be limited by Sections 856 through 860 of the Code, (the "REIT Provisions
of the Code"). Accordingly, the Company intends to purchase Subordinated
Interests for investment purposes only. Although publicly offered Subordinated
Interests generally will be rated, the risks of ownership will be substantially
the same as the ownership of unrated Subordinated Interests because the rating
does not address the possibility that the Company might suffer a lower than
anticipated yield or fail to recover its initial investment. The Company will
not purchase any Subordinated Interests that do not qualify as Qualified REIT
Real Estate Assets.
MORTGAGE LOANS
The Company may from time to time invest a small percentage of its assets
directly in Single-Family, Multi-Family or Commercial Mortgage Loans. The
Company expects that substantially all of such Mortgage Loans acquired by it
would be ARMs. The interest rate on an ARM is typically tied to an index (such
as LIBOR or the interest rate on United States Treasury Bills), and is
adjustable periodically at various intervals. Such Mortgage Loans are typically
subject to lifetime interest rate caps and periodic interest rate and/or payment
caps. The acquisition of Mortgage Loans generally involves credit risk. The
Company may obtain credit enhancement to mitigate such risk; however, there can
be no assurances that the Company will able to obtain such credit enhancement or
that such credit enhancement will mitigate the credit risk of the underlying
Mortgage Loans.
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POLICIES AND PROCEDURES
CAPITAL INVESTMENT POLICIES
Under the Capital Investment Policy adopted by the Company, at least 75% of
the Company's total assets are comprised of "High Quality" Mortgage-Backed
Securities and "High Quality" Short-Term Investments. The term "High Quality"
as used herein means securities (i) which are rated within one of the two
highest rating categories by at least one of the nationally recognized rating
agencies, (ii) that are unrated but are either guaranteed by the United States
government or an agency of the United States government, or (iii) that are
unrated or whose ratings have not been updated but are determined to be of
comparable quality to rated High Quality Mortgage-Backed Securities on the basis
of credit enhancement features that meet the High Quality credit criteria
approved by the Company's Board of Directors. The remainder of the Company's
assets, comprising not more than 25% of total assets, may consist of other
Qualified REIT Real Estate Assets which are unrated or rated less than High
Quality but which are at least "investment grade" (rated "BBB" or better by S&P
or the equivalent by another nationally recognized rating organization (each, a
"Rating Agency")) or, if not rated, are determined by the Company to be of
comparable credit quality to an investment which is rated "BBB" or better.
Prior to investing in any unrated securities, the Company will follow certain
procedures described under "Mortgage-Backed Securities -- General." See "Risk
Factors -- Operations Risks -- Risks of Unrated Assets." Mortgage-Backed
Securities to be acquired by the Company may include, but will not be limited
to, Mortgage-Backed Securities backed by single-family residential mortgage
loans and Mortgage-Backed Securities backed by loans on multi-family, commercial
or other real estate-related properties.
At December 31, 1998 and 1997, all of the Mortgage-Backed Securities held by
the Company were Agency Certificates or CMO's issued or guaranteed by FHLMC,
FNMA, or GNMA which, although not rated, carry an implied "AAA" rating. All such
Securities held by the Company at December 31, 1998 and 1997 were backed by
Single-Family Mortgage Loans, of which at December 31, 1998 and 1997,
approximately 69% and 87%, respectively, had coupon rates which adjust over time
(subject to certain limitations and lag periods) in conjunction with changes in
short-term interest rates. The Company intends to continue to invest primarily
in adjustable-rate Mortgage-Backed Securities. The Company may also invest on a
limited basis in mortgage derivative securities representing the right to
receive interest only or a disproportionately large amount of interest. The
Company has not and will not invest in real estate mortgage investment conduit
("REMIC") residuals, other CMO residuals or any Mortgage-Backed Securities, such
as inverse floaters, which have imbedded leverage as part of their structural
characteristics. At December 31, 1998 and 1997, the weighted average yield on
the Company's portfolio of earning assets was 6.43% and 6.57%, respectively.
The Company attempts to structure its borrowings to have interest rate
adjustment indices and interest rate adjustment periods that, on an aggregate
basis, correspond generally (within a range of one to six months) to the
interest rate adjustment indices and periods of the adjustable-rate Mortgage-
Backed Securities owned by the Company. However, the Company is subject to the
risk that periodic rate adjustments on borrowings may be less frequent than rate
adjustments on its Mortgage-Backed Securities. At December 31, 1998 and 1997,
the weighted average cost of funds for all of the Company's borrowings was 5.21%
and 6.16%, respectively, and the weighted average term to next rate adjustment
of such borrowings was 29 days and 16 days, respectively. See "Risk Factors --
Operations Risks -- Risks Associated with Differences Between Mortgage-Backed
Security and Borrowing Characteristics; Rate Adjustment Caps".
The Company generally expects to maintain a ratio of debt-to-equity of
between 8:1 and 12:1, although the ratio may vary from time to time depending
upon market conditions and other factors deemed relevant by management of the
Company. For purposes of calculating this ratio, the Company's equity is equal
to the value of the Company's investment portfolio on a mark-to-market basis,
less the book value of the Company's obligations under repurchase agreements and
other collateralized borrowings. At December 31, 1998 and 1997, the ratio of
debt-to-equity of the Company was 10:1 and 7:1, respectively.
To the extent consistent with its election to qualify as a REIT, the Company
may enter into hedging transactions to attempt to protect its portfolio of
Mortgage-Backed Securities and related borrowings against the effects of major
interest rate changes. Such hedging would be used to mitigate declines in the
market value of the Company's Mortgage-Backed Securities during periods of
increasing or decreasing interest rates and to limit or cap the rate on the
Company's borrowings. Such transactions would be entered into solely for the
purpose of hedging interest rate or prepayment risk and not for speculative
purposes. These hedging transactions may include interest rate swaps, the
purchase or sale of interest rate collars, caps or floors, and the purchase of
"interest only" Mortgage-Backed Securities. No hedging strategy can totally
eliminate interest rate risk and the Company's ability to enter into such
hedging transactions may be limited
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by provisions of the Code relating to qualifying assets and qualifying income
and transaction costs associated with entering into such transactions. To date,
the Company has not entered into any hedging transactions. See "Capital
Investment Policy" and "Certain Federal Income Tax Considerations."
The Company constantly monitors its Mortgage-Backed Securities and the income
from such assets and, to the extent the Company enters into hedging transactions
in the future, will monitor income from its hedging transactions as well, so as
to ensure at all times that the Company maintains its qualification as a REIT
and its exempt status under the Investment Company Act of 1940, as amended (the
"Investment Company Act"). See "Certain Federal Income Tax Considerations" and
"Risk Factors -- Legal and Other Risks."
CREDIT RISK MANAGEMENT
The Company has not taken on credit risk to date, but may do so in the future.
In such event, the Company will review credit risk and other risk of loss
associated with each investment and determine the appropriate allocation of
capital to apply to such investment under its Capital Investment Policy. The
Board of Directors will monitor the overall portfolio risk and determine
appropriate levels of provision for loss.
CAPITAL AND LEVERAGE
The Company expects generally to maintain a ratio of debt-to-equity of between
8:1 and 12:1, although the ratio may vary from time to time depending upon
market conditions and other factors deemed relevant by management, including the
composition of the Company's balance sheet, haircut levels required by lenders,
the market value of the Mortgage-Backed Securities in the Company's portfolio
and "Excess Capital Cushion" percentages (as described below) set by the Board
of Directors from time to time. For purposes of calculating this ratio, the
Company's equity is equal to the value of the Company's investment portfolio on
a mark-to-market basis less the book value of the Company's obligations under
repurchase agreements and other collateralized borrowings. At December 31, 1998
and 1997, the Company's ratio of debt-to-equity was 10:1 and 7:1, respectively.
The Company's goal is to strike a balance between the under-utilization of
leverage, which reduces potential returns to stockholders, and the over-
utilization of leverage, which could reduce the Company's ability to meet its
obligations during adverse market conditions. The Company's Capital Investment
Policy limits management's ability to acquire additional assets during times
when the Company's debt-to-equity ratio exceeds 12:1. In this way, the Company
intends that use of balance sheet leverage will be controlled. The actual
capital base as defined for the purpose of this policy is equal to the market
value of total assets less the book value of total collateralized borrowings.
The actual capital base, as so defined, represents the approximate liquidation
value of the Company and approximates the market value of assets that can be
pledged or sold to meet over-collateralization requirements for the Company's
borrowings. The unpledged portion of the Company's actual capital base is
available to be pledged or sold as necessary to maintain over-collateralization
levels for the Company's borrowings.
Management is prohibited from acquiring additional assets during periods when
the actual capital base of the Company is less than the minimum amount required
under the Capital Investment Policy (except when such asset acquisitions may be
necessary to maintain REIT status or the Company's exemption from the Investment
Company Act). In addition, when the actual capital base falls below the risk-
managed capital requirement, management will be required to submit to the Board
a plan for bringing the actual capital base into compliance with the Capital
Investment Policy guidelines. It is anticipated that in most circumstances this
goal will be achieved over time without overt management action through the
natural process of mortgage principal repayments and increases in the market
values of Mortgage-Backed Securities as their coupon rates adjust upwards to
market levels. Management anticipates that the actual capital base is likely to
exceed the risk-managed capital requirement during periods following new equity
offerings and during periods of falling interest rates and that the actual
capital base could fall below the risk-managed capital requirement during
periods of rising interest rates.
The first component of the Company's capital requirements is the current
aggregate over-collateralization amount or "haircut" the lenders require the
Company to hold as capital. The haircut for each Mortgage-Backed Security is
determined by the lender based on the risk characteristics and liquidity of that
asset. Haircut levels on individual
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borrowings generally range from 3% to 5% for Agency Certificates to 20% for
certain Privately-Issued Certificates, and the Company anticipates that haircut
levels will average 3% to 10% for the Company as a whole. At December 31, 1998,
the weighted average haircut level on the Company's securities was 3.5%. At
December 31, 1997, the weighted average haircut level on the Company's
securities was 3.6%. Should the market value of the pledged assets decline, the
Company will be required to deliver additional collateral to the lenders in
order to maintain a constant over-collateralization level on its borrowings.
The second component of the Company's capital requirement is the "Excess
Capital Cushion." The Excess Capital Cushion is an additional amount of capital
in excess of the haircut maintained by the Company in order to help the Company
meet the demands of the lenders for additional collateral should the market
value of the Company's Mortgage-Backed Securities decline. The aggregate Excess
Capital Cushion equals the sum of liquidity cushion amounts assigned under the
Capital Investment Policy to each of the Company's Mortgage-Backed Securities.
Excess Capital Cushions are assigned to each Mortgage-Backed Security based on
management's assessment of the Mortgage-Backed Security's market price
volatility, credit risk, liquidity and attractiveness for use as collateral by
lenders. The process of assigning Excess Capital Cushions relies on management's
ability to identify and weigh the relative importance of these and other
factors. Consideration is also given to hedges associated with the Mortgage-
Backed Security and any effect such hedges may have on reducing net market price
volatility, concentration or diversification of credit and other risks in the
balance sheet as a whole and the net cash flows that can be expected to arise
from the interaction of the various components of the Company's balance sheet.
The Board of Directors thus reviews on a periodic basis various analyses
prepared by management of the risks inherent in the Company's balance sheet,
including an analysis of the effects of various scenarios on the Company's net
cash flow, earnings, dividends, liquidity and net market value. Should the
Board of Directors determine that the minimum required capital base set by the
Company's Capital Investment Policy is either too low or too high, the Board of
Directors may raise or lower the capital requirement accordingly.
The Capital Investment Policy stipulates that at least 25% of the capital base
maintained to satisfy the Excess Capital Cushion shall be invested in Agency
Certificates, AAA-rated adjustable-rate Mortgage-Backed Securities or assets
with similar or better liquidity characteristics. To date, 100% of the
Company's Mortgaged-Backed Securities are Agency Certificates, though this may
change in the future.
Pursuant to the Company's overall business strategy, a substantial portion of
the Company's borrowings are short-term or variable-rate. The Company's
borrowings are implemented primarily through repurchase agreements (a borrowing
device evidenced by an agreement to sell securities or other assets to a third-
party and a simultaneous agreement to repurchase them at a specified future
date and price, the price difference constituting interest on the borrowing),
but in the future may also be obtained through loan agreements, lines of credit,
Dollar-Roll Agreements (an agreement to sell a security for delivery on a
specified future date and a simultaneous agreement to repurchase the same or a
substantially similar security on a specified future date) and other credit
facilities with institutional lenders and issuance of debt securities such as
commercial paper, medium-term notes, CMOs and senior or subordinated notes. The
Company enters into financing transactions only with institutions that it
believes are sound credit risks and follows other internal policies designed to
limit its credit and other exposure to financing institutions.
It is expected that repurchase agreements will continue to be the principal
financing devices utilized by the Company to leverage its Mortgage-Backed
Securities portfolio. The Company anticipates that, upon repayment of each
borrowing in the form of a repurchase agreement, the collateral will immediately
be used for borrowing in the form of a new repurchase agreement. To date, the
Company has entered into uncommitted facilities with twenty-three (23) lenders
for borrowings in the form of repurchase agreements. The Company has not at the
present time entered into any commitment agreements under which the lender would
be required to enter into new repurchase agreements during a specified period of
time, nor does the Company presently plan to have liquidity facilities with
commercial banks. The Company, however, may enter into such commitment
agreements in the future if deemed favorable to the Company. The Company enters
into repurchase agreements primarily with national broker/dealers, commercial
banks and other lenders which typically offer such financing. The Company enters
into collateralized borrowings only with financial institutions meeting credit
standards approved by the Company's Board of Directors, and monitors the
financial condition of such institutions on a regular basis.
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A repurchase agreement, although structured as a sale and repurchase
obligation, acts as a financing under which the Company effectively pledges its
Mortgage-Backed Securities as collateral to secure a short-term loan. Generally,
the other party to the agreement makes the loan in an amount equal to a
percentage of the market value of the pledged collateral. At the maturity of the
repurchase agreement, the Company is required to repay the loan and
correspondingly receives back its collateral. While used as collateral,
Mortgage-Backed Securities continue to pay principal and interest which inure to
the benefit of the Company. In the event of the insolvency or bankruptcy of the
Company, certain repurchase agreements may qualify for special treatment under
Title II of the United States Code (the "Bankruptcy Code") , the effect of which
is, among other things, to allow the creditor under such agreements to avoid the
automatic stay provisions of the Bankruptcy Code and to foreclose on the
collateral agreements without delay. In the event of the insolvency or
bankruptcy of a lender during the term of a repurchase agreement, the lender may
be permitted, under applicable insolvency laws, to repudiate the contract, and
the Company's claim against the lender for damages therefrom may be treated
simply as an unsecured creditor. In addition, if the lender is a broker or
dealer subject to the Securities Investor Protection Act of 1970, or an insured
depository institution subject to the Federal Deposit Insurance Act, the
Company's ability to exercise its rights to recover its securities under a
repurchase agreement or to be compensated for any damages resulting from the
lender's insolvency may be further limited by those statutes. These claims would
be subject to significant delay and, if and when received, may be substantially
less than the damages actually suffered by the Company.
Substantially all of the Company's borrowing agreements require the Company to
deposit additional collateral in the event the market value of existing
collateral declines, which may require the Company to sell assets to reduce the
Company's borrowings. The Company's liquidity management policy is designed to
maintain a cushion of equity sufficient to provide required liquidity to respond
to the effects under its borrowing arrangements of interest rate movements and
changes in market value of its Mortgage-Backed Securities, as described above.
However, a major disruption of the repurchase or other market relied on by the
Company for short-term borrowings would have a material adverse effect on the
Company unless the Company were able to arrange alternative sources of financing
on comparable terms. See "Risk Factors -- Operations Risks -- Risks Associated
with Leverage" and -- Risk of Decrease in Net Interest Income Due to Interest
Rate Fluctuations."
The Company's Bylaws do not limit its ability to incur borrowings, whether
secured or unsecured.
INTEREST RATE RISK MANAGEMENT
To the extent consistent with its election to qualify as a REIT, the Company
follows an interest rate risk management program intended to protect its
portfolio of Mortgage-Backed Securities and related debt against the effects of
major interest rate changes. Specifically, the Company's interest rate risk
management program is formulated with the intent to offset the potential adverse
effects resulting from rate adjustment limitations on its Mortgage-Backed
Securities and the differences between interest rate adjustment indices and
interest rate adjustment periods of its adjustable-rate Mortgage-Backed
Securities and related borrowings. The Company's interest rate risk management
program encompasses a number of procedures, including the following: (i) the
Company attempts to structure its borrowings to have interest rate adjustment
indices and interest rate adjustment periods that, on an aggregate basis,
generally correspond to the interest rate adjustment indices and interest rate
adjustment periods of the adjustable-rate Mortgage-Backed Securities purchased
by the Company, so as to limit any mismatching of such aggregates to a range of
one to six months, and (ii) the Company attempts to structure its borrowing
agreements relating to adjustable-rate Mortgage-Backed Securities to have a
range of different maturities and interest rate adjustment periods (although
substantially all will be less than one year). As a result, the Company expects
to be able to adjust the average maturity/adjustment period of such borrowings
on an ongoing basis by changing the mix of maturities and interest rate
adjustment periods as borrowings come due and are renewed. Through use of these
procedures, the Company intends to minimize any differences between interest
rate adjustment periods of adjustable-rate Mortgage-Backed Securities and
related borrowings that may occur.
Although it has not done so to date, the Company may purchase from time to
time interest rate caps, interest rate swaps, interest rate collars, caps or
floors, "interest only" Mortgage-Backed Securities and similar instruments to
attempt to mitigate the risk of the cost of its variable rate liabilities
increasing at a faster rate than the earnings on its assets during a period of
rising interest rates or to mitigate prepayment risk. In this way, the Company
may hedge as much of the interest rate risk as management determines is in the
best interests of the stockholders of the Company, given the cost of
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such hedging transactions and the need to maintain the Company's status as a
REIT. See "Certain Federal Income Tax Considerations -- General -- Gross Income
Tests." This determination may result in management electing to have the Company
bear a level of interest rate risk that could otherwise be hedged when
management believes, based on all relevant facts, that bearing such risk is
advisable.
The Company seeks to build a balance sheet and undertake an interest rate risk
management program which is likely, in management's view, to enable the Company
to generate positive earnings and maintain an equity liquidation value
sufficient to maintain operations given a variety of potentially adverse
circumstances. Accordingly, the hedging program addresses both income
preservation, as discussed in the first part of this section, and capital
preservation concerns. With regard to the latter, the Company monitors its
"duration." This is the expected percentage change in market value of the
Company's assets that would be caused by a 1% change in short and long term
interest rates. To monitor duration and the related risks of fluctuations in
the liquidation value of the Company's equity, the Company models the impact of
various economic scenarios on the market value of the Company's Mortgage-Backed
Securities, liabilities and interest rate agreements. See "Risk Factors --
Operations Risks -- Risk of Decrease in Net Interest Income Due to Interest
Rate Fluctuations." At December 31, 1998 and 1997, the Company estimates that
the weighted average duration of the Company's assets was 2% for both. The
Company believes that the Company's interest rate risk management program will
allow the Company to maintain operations throughout a wide variety of
potentially adverse circumstances. Nevertheless, in order to further preserve
the Company's capital base (and lower its duration) during periods when
management believes a trend of rapidly rising interest rates has been
established, management may decide to enter into or increase hedging activities
and/or sell assets. Each of these types of actions may lower the earnings and
dividends of the Company in the short term in order to further the objective of
maintaining attractive levels of earnings and dividends over the long term.
The Company may elect to conduct a portion of its hedging operations
through one or more subsidiary corporations which would not be a Qualified REIT
Subsidiary and would be subject to Federal and state income taxes. "Qualified
REIT Subsidiary" means a corporation whose stock is entirely owned by the REIT
at all times during such corporation's existence. In order to comply with the
nature of asset tests applicable to the Company as a REIT, the value of the
securities of any subsidiary held by the Company (other than a Qualified REIT
Subsidiary) must be limited to less than 5% of the value of the Company's total
assets as of the end of each calendar quarter and no more than 10% of the voting
securities of any such subsidiary may be owned by the Company. See "Certain
Federal Income Tax Considerations -- General -- Asset Tests." A taxable
subsidiary would not elect REIT status and would distribute any net profit after
taxes to the Company and its other stockholders. Any dividend income received by
the Company from any such taxable subsidiary (combined with all other income
generated from the Company's assets, other than Qualified REIT Real Estate
Assets) must not exceed 25% of the gross income of the Company. See "Certain
Federal Income Tax Considerations -- General -- Gross Income Tests." Before the
Company forms any such taxable subsidiary corporation for its hedging
activities, the Company will obtain an opinion of counsel to the effect that the
formation and contemplated method of operation of such corporation will not
cause the Company to fail to satisfy the nature of assets and sources of income
tests applicable to it as a REIT.
The Company believes that it has developed a cost-effective asset/liability
management program to provide a level of protection against interest rate and
prepayment risks. However, no strategy can completely insulate the Company from
interest rate changes, prepayment risks and defaults by counter-parties.
Further, as noted above, certain of the Federal income tax requirements that the
Company must satisfy to qualify as a REIT limit the Company's ability to fully
hedge its interest rate and prepayment risks. The Company monitors carefully,
and may have to limit, its asset/liability management program to assure that it
does not realize excessive hedging income, or hold hedging assets having excess
value in relation to total assets, which would result in the Company's
disqualification as a REIT or, in the case of excess hedging income, the payment
of a penalty tax for failure to satisfy certain REIT income tests under the
Code, provided such failure was for reasonable cause. See "Certain Federal
Income Tax Considerations -- General." In addition, asset/liability management
involves transaction costs which increase dramatically as the period covered by
the hedging protection increases. Therefore, the Company may be prevented from
effectively hedging its interest rate and prepayment risks.
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PREPAYMENT RISK MANAGEMENT
The Company seeks to minimize the effects of faster or slower than anticipated
prepayment rates through structuring a diversified portfolio with a variety of
prepayment characteristics, investing in Mortgage-Backed Securities with
prepayment prohibitions and penalties, investing in certain Mortgage-Backed
Security structures which have prepayment protections, and balancing assets
purchased at a premium with assets purchased at a discount. Prepayment risk is
monitored by management and the Board of Directors through periodic review of
the impact of a variety of prepayment scenarios on the Company's revenues, net
earnings, dividends, cash flow and net balance sheet market value.
CERTAIN FEDERAL INCOME TAX CONSIDERATIONS
GENERAL
The following discussion summarizes certain Federal income tax
considerations to the Company and holders of the Common Stock. This discussion
is based on existing Federal income tax law, which is subject to change,
possibly retroactively. The following summary does not purport to describe all
of the tax considerations that may be relevant to a prospective stockholder.
This discussion does not address tax considerations applicable to certain types
of investors subject to special treatment under the Federal income tax laws
(including financial institutions, insurance companies, broker-dealers and,
except to the extent discussed below, tax-exempt entities and foreign taxpayers)
and it does not discuss any aspects of state, local or foreign tax law. This
discussion assumes that stockholders hold their Common Stock as a "capital
asset" (generally, property held for investment) under the Code. Stockholders
are advised to consult their tax advisors as to the specific tax consequences of
purchasing, holding and disposing of the Common Stock, including the application
and effect of Federal, state, local and foreign income and other tax laws.
The Company has elected to become subject to tax as a REIT, for Federal
income tax purposes, commencing with the taxable year ending December 31, 1997.
The Board of Directors of the Company currently expects that the Company will
continue to operate in a manner that will permit the Company to maintain its
qualification as a REIT for the taxable year ending December 31, 1997 and in
each taxable year thereafter. This treatment will permit the Company to deduct
dividend distributions to its stockholders for Federal income tax purposes, thus
effectively eliminating the "double taxation" that generally results when a
corporation earns income and distributes that income to its stockholders in the
form of dividends.
The continued qualification and taxation of the Company as a REIT will
depend upon the Company's ability to meet, on a continuing basis, distribution
levels and diversity of stock ownership, and the various qualification tests
imposed by the Code as discussed below.
If the Company were not to qualify as a REIT in any particular year, it
would be subject to Federal income tax as a regular, domestic corporation, and
its stockholders would be subject to tax in the same manner as stockholders of
such corporation. In this event, the Company could be subject to potentially
substantial income tax liability in respect of each taxable year that it fails
to qualify as a REIT, and the amount of earnings and cash available for
distribution to its stockholders could be significantly reduced or eliminated.
The following is a brief summary of certain technical requirements that the
Company must meet on an ongoing basis in order to qualify, and remain qualified,
as a REIT under the Code:
STOCK OWNERSHIP TESTS
(i) The capital stock of the Company must be transferable, (ii) the
capital stock of the Company must be held by at least 100 persons 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), and (iii) no more than 50% of the value
of such capital stock may be owned, directly or indirectly, by five or fewer
individuals (as defined in the Code to include certain entities) at any time
during the last half of the taxable year. Tax-exempt entities, other than
private foundations and certain unemployment compensation trusts, are generally
not treated as individuals for these purposes. The requirements of items (ii)
and (iii) above are not applicable to the first taxable year for which an
election to be taxed as a REIT is made. However, these stock ownership
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requirements must be satisfied in the Company's second taxable year and in each
subsequent taxable year. The Company's Articles of Incorporation provide
restrictions regarding the transfer of the Company's shares in order to aid in
meeting the stock ownership requirements. See "Description of Capital Stock --
Restrictions on Ownership and Transfer."
ASSET TESTS
The Company must generally meet the following asset tests (the "REIT Asset
Tests") at the close of each quarter of each taxable year:
(a) at least 75% of the value of the Company's total assets must consist
of Qualified REIT Real Estate Assets, government securities, cash and cash items
(the "75% Asset Test"); and
(b) the value of securities held by the Company but not taken into account
for purposes of the 75% Asset Test must not exceed (i) 5% of the value of the
Company's total assets in the case of securities of any one issuer, or (ii) 10%
of the outstanding voting securities of any such issuer.
At December 31, 1998 and 1997, 100% of the Company's assets were Qualified
REIT Real Estate Assets. The Company expects that substantially all of its
assets will continue to be Qualified REIT Real Estate Assets. In addition, the
Company does not expect that the value of any security of any one entity would
ever exceed 5% of the Company's total assets, and the Company does not expect to
own more than 10% of any one issuer's voting securities.
The Company monitors closely the purchase, holding and disposition of its
assets in order to comply with the REIT Asset Tests. In particular, the Company
intends to limit and diversify its ownership of any assets not qualifying as
Qualified REIT Real Estate Assets to less than 25% of the value of the Company's
assets and to less than 5%, by value, of any single issuer. If it is anticipated
that these limits would be exceeded, the Company intends to take appropriate
measures, including the disposition of non-qualifying assets, to avoid exceeding
such limits.
GROSS INCOME TESTS
The Company must generally meet the following gross income tests (the "REIT
Gross Income Tests") for each taxable year:
(a) at least 75% of the Company's gross income must be derived from
certain specified real estate sources including interest income and gain from
the disposition of Qualified REIT Real Estate Assets or "qualified temporary
investment income" (i.e., income derived from "new capital" within one year of
the receipt of such capital) (the "75% Gross Income Test");
(b) at least 95% of the Company's gross income for each taxable year must
be derived from sources of income qualifying for the 75% Gross Income Test,
dividends, interest, and gains from the sale of stock or other securities
(including certain interest rate swap and cap agreements entered into to hedge
variable rate debt incurred to acquire Qualified REIT Real Estate Assets) not
held for sale in the ordinary course of business (the "95% Gross Income Test");
and
(c) less than 30% of the Company's gross income is derived from the sale
of Qualified REIT Real Estate Assets held for less than four years, stock or
securities held for less than one year (including certain interest rate swap and
cap agreements entered into to hedge variable rate debt incurred to acquire
Qualified Real Estate Assets) and certain "dealer" property (the "30% Gross
Income Test"). Pursuant to recently enacted legislation, the 30% Gross Income
tax has been repealed for taxable years beginning after August 5, 1997.
The Company intends to maintain its REIT status by carefully monitoring its
income, including income from hedging transactions and sales of Mortgage-Backed
Securities, to comply with the REIT Gross Income Tests. In
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particular, the Company will treat income generated by its interest rate caps
and other hedging instruments as non-qualifying income for purposes of the 95%
Gross Income Test unless it receives advice from its tax advisor that such
income constitutes qualifying income for purposes of such test. Under certain
circumstances, for example, (i) the sale of a substantial amount of Mortgage-
Backed Securities to repay borrowings in the event that other credit is
unavailable or (ii) an unanticipated decrease in the qualifying income of the
Company which may result in the non-qualifying income exceeding 5% of gross
income or a breach of the 30% Gross Income Test, the Company may be unable to
comply with certain of the REIT Gross Income Tests. See "--Taxation of the
Company" for a discussion of the tax consequences of failure to comply with the
REIT Provisions of the Code.
DISTRIBUTION REQUIREMENT
The Company must generally distribute to its stockholders an amount equal
to at least 95% of the Company's REIT taxable income before deductions of
dividends paid and excluding net capital gain.
TAXATION OF THE COMPANY
In any year in which the Company qualifies as a REIT, the Company will
generally not be subject to Federal income tax on that portion of its REIT
taxable income or capital gain which is distributed to its stockholders. The
Company will, however, be subject to Federal income tax at normal corporate
income tax rates upon any undistributed taxable income or capital gain.
Notwithstanding its qualification as a REIT, the Company may also be
subject to tax in certain other circumstances. If the Company fails to satisfy
either the 75% or the 95% Gross Income Test, but nonetheless maintains its
qualification as a REIT because certain other requirements are met, it will
generally be subject to a 100% tax on the greater of the amount by which the
Company fails either the 75% or the 95% Gross Income Test. The Company will also
be subject to a tax of 100% on net income derived from any "prohibited
transaction," and if the Company has (i) net income from the sale or other
disposition of "foreclosure property" which is held primarily for sale to
customers in the ordinary course of business or (ii) other non-qualifying income
from foreclosure property, it will be subject to Federal income tax on such
income at the highest corporate income tax rate. In addition, if the Company
fails to distribute during each calendar year at least the sum of (i) 85% of its
REIT ordinary income for such year and (ii) 95% of its REIT capital gain net
income for such year, the Company would be subject to a 4% Federal excise tax on
the excess of such required distribution over the amounts actually distributed
during the taxable year, plus any undistributed amount of ordinary and capital
gain net income from the preceding taxable year. The Company may also be subject
to the corporate alternative minimum tax, as well as other taxes in certain
situations not presently contemplated.
If the Company fails to qualify as a REIT in any taxable year and certain
relief provisions of the Code do not apply, the Company would be subject to
Federal income tax (including any applicable alternative minimum tax) on its
taxable income at the regular corporate income tax rates. Distributions to
stockholders in any year in which the Company fails to qualify as a REIT would
not be deductible by the Company, nor would they generally be required to be
made under the Code. Further, unless entitled to relief under certain other
provisions of the Code, the Company would also be disqualified from re-electing
REIT status for the four taxable years following the year during which it became
disqualified.
The Company intends to monitor on an ongoing basis its compliance with the
REIT requirements described above. In order to maintain its REIT status, the
Company will be required to limit the types of assets that the Company might
otherwise acquire, or hold certain assets at times when the Company might
otherwise have determined that the sale or other disposition of such assets
would have been more prudent.
TAXABLE SUBSIDIARIES
Hedging activities and the creation of Mortgage-Backed Securities through
securitization may be done through a taxable subsidiary of the Company. The
Company and one or more other entities may form and capitalize one or more
taxable subsidiaries. In order to ensure that the Company would not violate the
more than 10% voting stock of a single issuer limitation described above, the
Company would own only nonvoting preferred and common stock and the other
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entities would own all of the voting common stock. The value of the Company's
investment in such a subsidiary must also be limited to less than 5% of the
value of the Company's total assets at the end of each calendar quarter so that
the Company can also comply with the 5% of value, single issuer asset limitation
described above under "-- General -- Asset Tests." The taxable subsidiary would
not elect REIT status and would distribute only net after-tax profits to its
stockholders, including the Company. Before the Company engages in any hedging
or securitization activities or forms any such taxable subsidiary corporation,
the Company will obtain an opinion of its tax advisor to the effect that such
activities or the formation and contemplated method of operation of such
corporation will not cause the Company to fail to satisfy the REIT Asset and
REIT Gross Income Tests.
TAXATION OF STOCKHOLDERS; COMMON STOCK
Distributions (including constructive distributions) made to holders of
Common Stock, other than tax-exempt entities, will generally be subject to tax
as ordinary income to the extent of the Company's current and accumulated
earnings and profits as determined for Federal income tax purposes. If the
amount distributed exceeds a stockholder's allocable share of such earnings and
profits, the excess will be treated as a return of capital to the extent of the
stockholder's adjusted basis in the Common Stock, which will reduce the
stockholder's basis in the Common Stock but not be subject to tax, and
thereafter as a gain from the sale or exchange of a capital asset.
Distributions designated by the Company as capital gain dividends will
generally be subject to tax as long-term capital gain to stockholders, to the
extent that the distribution does not exceed the Company's actual net capital
gain for the taxable year. Distributions by the Company, whether characterized
as ordinary income or as capital gain, are not eligible for the corporate
dividends received deduction. In the event that the Company realizes a loss for
the taxable year, stockholders will not be permitted to deduct any share of that
loss. Further, if the Company (or a portion of its assets) were to be treated as
a taxable mortgage pool, any "excess inclusion income" that is allocated to a
stockholder would not be allowed to be offset by a net operating loss of such
stockholder. Future Treasury Department regulations may require that the
stockholders take into account, for purposes of computing their individual
alternative minimum tax liability, certain tax preference items of the Company.
Dividends declared during the last quarter of a taxable year and actually
paid during January of the following taxable year are generally treated as if
received by the stockholder on December 31 of the taxable year in which declared
and not on the date actually received. In addition, the Company may elect to
treat certain other dividends distributed after the close of the taxable year as
having been paid during such taxable year, but stockholders will be treated as
having received such dividend in the taxable year in which the distribution is
actually made.
Upon a sale or other disposition of the Common Stock, a stockholder will
generally recognize a capital gain or loss in an amount equal to the difference
between the amount realized and the stockholder's adjusted basis in such stock,
which gain or loss will be long-term if the stock has been held for more than
one year. Any loss on the sale or exchange of a share of Common Stock held by a
stockholder for six months or less will generally be treated as a long-term
capital loss to the extent of any long-term capital gain dividends received by
such stockholder with respect to such share of its stock.
The Company is required under Treasury Department regulations to demand
annual written statements from the record holders of designated percentages of
its capital stock disclosing the actual and constructive ownership of such stock
and to maintain permanent records showing the information it has received as to
the actual and constructive ownership of such stock and a list of those persons
failing or refusing to comply with such demand.
In any year in which the Company does not qualify as a REIT, distributions
made to its stockholders would be taxable in the same manner discussed above,
except that no distributions could be designated as capital gain dividends,
distributions would be eligible for the corporate dividends received deduction,
the excess inclusion income rules would not apply to the stockholders, and
stockholders would not receive any share of the Company's tax preference items.
In such event, however, the Company could be subject to potentially substantial
Federal income tax liability, and the amount of earnings and cash available for
distribution to its stockholders could be significantly reduced or eliminated.
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TAXATION OF TAX-EXEMPT ENTITIES
Subject to the discussion below regarding a "pension-held REIT," a tax-
exempt stockholder is generally not subject to tax on distributions from the
Company or gain realized on the sale of the Common Stock, provided that such
stockholder has not incurred indebtedness to purchase or hold its Common Stock,
that its shares are not otherwise used in an unrelated trade or business of such
stockholder, and that the Company, consistent with its present intent, does not
hold a residual interest in a REMIC that gives rise to "excess inclusion" income
as defined under section 860E of the Code. If the Company were to be treated as
a "taxable mortgage pool," however, a substantial portion of the dividends paid
to a tax-exempt stockholder may be subject to tax as UBTI. Although the Company
does not believe that the Company, or any portion of its assets, will be treated
as a taxable mortgage pool, no assurance can be given that the IRS might not
successfully maintain that such a taxable mortgage pool exists.
If a qualified pension trust (i.e., any pension or other retirement trust
that qualifies under section 401(a) of the Code) holds more than 10% by value of
the interests in a "pension-held REIT" at any time during a taxable year, a
substantial portion of the dividends paid to the qualified pension trust by such
REIT may constitute UBTI. For these purposes, a "pension-held REIT" is any REIT
(i) that would not have qualified as a REIT but for the provisions of the Code
which look through qualified pension trust stockholders to the qualified pension
trust's beneficiaries in determining ownership of stock of the REIT and (ii) in
which at least one qualified pension trust holds more than 25% by value of the
interests of such REIT or one or more qualified pension trusts (each owning more
than a 10% interest by value in the REIT) hold in the aggregate more than 50% by
value of the interests in such REIT. Assuming compliance with the Ownership
Limit provisions it is unlikely that pension plans will accumulate sufficient
stock to cause the Company to be treated as a pension-held REIT.
Distributions to certain types of tax-exempt stockholders exempt from
Federal income taxation under sections 501 (c) (7), (c) (9), (c) (17), and (c)
(20) of the Code may also constitute UBTI, and such prospective investors should
consult their tax advisors concerning the applicable "set aside" and reserve
requirements.
STATE AND LOCAL TAXES
The Company and its stockholders may be subject to state or local taxation
in various jurisdictions, including those in which it or they transact business
or reside. The state and local tax treatment of the Company and its stockholders
may not conform to the Federal income tax consequences discussed above.
Consequently, prospective stockholders should consult their own tax advisors
regarding the effect of state and local tax laws on an investment in the Common
Stock.
CERTAIN UNITED STATES FEDERAL INCOME TAX CONSIDERATIONS APPLICABLE TO
FOREIGN HOLDERS
The following discussion summarizes certain United States Federal tax
consequences of the acquisition, ownership and disposition of the Common Stock
by a purchaser of the Common Stock that, for United States Federal income tax
purposes, is not a "United States person" (a "Non-United States Holder"). For
purposes of this discussion, a "United States person" means: a citizen or
resident of the United States; a corporation, partnership, or other entity
created or organized in the United States or under the laws of the United States
or of any political subdivision thereof; or an estate or trust whose income is
includible in gross income for United States Federal income tax purposes
regardless of its source. This discussion does not consider any specific facts
or circumstances that may apply to a particular Non-United States Holder.
Prospective investors are urged to consult their tax advisors regarding the
United States Federal tax consequences of acquiring, holding and disposing of
Common Stock, as well as any tax consequences that may arise under the laws of
any foreign, state, local or other taxing jurisdiction.
DIVIDENDS
Dividends paid by the Company out of earnings and profits, as determined
for United States Federal income tax purposes, to a Non-United States Holder
will generally be subject to withholding of United States Federal income tax at
the rate of 30%, unless reduced or eliminated by an applicable tax treaty or
unless such dividends are treated as effectively connected with a United States
trade or business. Distributions paid by the Company in excess of its earnings
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and profits will be treated as a tax-free return of capital to the extent of the
holder's adjusted basis in his Common Stock, and thereafter as gain from the
sale or exchange of a capital asset as described below. If it cannot be
determined at the time a distribution is made whether such distribution will
exceed the earnings and profits of the Company, the distribution will be subject
to withholding at the same rate as dividends. Amounts so withheld, however, will
be refundable or creditable against the Non-United States Holder's United States
Federal tax liability if it is subsequently determined that such distribution
was, in fact, in excess of the earnings and profits of the Company. If the
receipt of the dividend is treated as being effectively connected with the
conduct of a trade or business within the United States by a Non-United States
Holder, the dividend received by such holder will be subject to the United
States Federal income tax on net income that applies to United States persons
generally (and, with respect to corporate holders and under certain
circumstances, the branch profits tax).
GAIN ON DISPOSITION
A Non-United States Holder will generally not be subject to United States
Federal income tax on gain recognized on a sale or other disposition of the
Common Stock unless (i) the gain is effectively connected with the conduct of a
trade or business within the United States by the Non-United States Holder, (ii)
in the case of a Non-United States Holder who is a nonresident alien individual
and holds the Common Stock as a capital asset, such holder is present in the
United States for 183 or more days in the taxable year and certain other
requirements are met, or (iii) the Non-United States Holder is subject to tax
under the FIRPTA rules discussed below. Gain that is effectively connected with
the conduct of a trade or business within the United States by a Non-United
States Holder will be subject to the United States Federal income tax on net
income that applies to United States persons generally (and, with respect to
corporate holders and under certain circumstances, the branch profits tax) but
will not be subject to withholding. Non-United States Holders should consult
applicable treaties, which may provide for different rules.
The Company does not expect to hold assets that would be treated as "United
States real property interests" under the provisions of the Foreign Investment
in Real Property Tax Act of 1980 ("FIRPTA"). Therefore, the FIRPTA provisions
relating to certain distributions to foreign persons and to certain gains
realized by foreign persons on the sale of stock should not apply to non-United
States Holders of the Common Stock.
INFORMATION REPORTING AND BACKUP WITHHOLDING
Under temporary United States Treasury regulations, United States
information reporting requirements and backup withholding tax will generally not
apply to dividends paid on the Common Stock to a Non-United States Holder at an
address outside the United States. Payments by a United States office of a
broker of the proceeds of a sale of the Common Stock is subject to both backup
withholding at a rate of 31% and information reporting unless the holder
certifies its Non-United States Holder status under penalties of perjury or
otherwise establishes an exemption. Information reporting requirements (but not
backup withholding) will also apply to payments of the proceeds of sales of the
Common Stock by foreign offices of United States brokers, or foreign brokers
with certain types of relationships to the United States, unless the broker has
documentary evidence in its records that the holder is a Non-United States
Holder and certain other conditions are met, or the holder otherwise establishes
an exemption.
Backup withholding is not an additional tax. Any amounts withheld under the
backup withholding rules will be refunded or credited against the Non-United
States Holder's United States Federal income tax liability, provided that the
required information is furnished to the Internal Revenue Service.
These information reporting and backup withholding rules are under review
by the United States Treasury and their application to the Common Stock could be
changed by future regulations.
FUTURE REVISIONS IN POLICIES AND STRATEGIES
The Board of Directors has established the investment policies and
operating policies and strategies set forth in this Prospectus. The Board of
Directors has the power to modify or waive such policies and strategies without
the consent of the stockholders to the extent that the Board of Directors
determines that such modification or waiver is in the best interests of
stockholders. Among other factors, developments in the market which affect the
policies and strategies
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mentioned herein or which change the Company's assessment of the market may
cause the Board of Directors to revise the Company's policies and strategies.
COMPETITION
The Company believes that its principal competition in the business of
acquiring and holding Mortgage-Backed Securities are financial institutions such
as banks, savings and loans, life insurance companies, institutional investors
such as mutual funds and pension funds, and certain other investors such as
mutual funds and pension funds, and certain other mortgage REITs. The existence
of these competitive entities, as well as the possibility of additional entities
forming in the future, may increase the competition for the acquisition of
mortgage-backed securities resulting in higher prices and lower yields on such
assets.
RISK FACTORS
OPERATIONS RISKS
GENERAL
The results of the Company's operations are affected by various factors,
many of which are beyond the control of the Company. The results of the
Company's operations depend on, among other things, the level of net interest
income generated by the Company's Mortgage-Backed Securities, the market value
of such Mortgage-Backed Securities and the supply of and demand for such
Mortgage-Backed Securities. The Company's net interest income varies primarily
as a result of changes in short-term interest rates, borrowing costs and
prepayment rates, the behavior of which involves various risks and uncertainties
as set forth below. Prepayment rates, interest rates and borrowing costs depend
on the nature and terms of the Mortgage-Backed Securities, conditions in
financial markets, the fiscal and monetary policies of the United States
government and the Board of Governors of the Federal Reserve System,
international economic and financial conditions, competition and other factors,
none of which can be predicted with any certainty. Since changes in interest
rates may significantly affect the Company's activities, the operating results
of the Company depend, in large part, upon the ability of the Company to
effectively manage its interest rate and prepayment risks while maintaining its
status as a REIT. See "-- Risks Associated with Interest Rate Changes and
Hedging" and "Business Strategy --Capital Investment Policy -- Interest Rate
Risk Management."
RISKS ASSOCIATED WITH DIFFERENCES BETWEEN MORTGAGE-BACKED SECURITY
AND BORROWING CHARACTERISTICS; RATE ADJUSTMENT CAPS
At December 31, 1998 and 1997, all of the Mortgage-Backed Securities held
by the Company were Agency Certificates and CMO's backed by Single-Family
Mortgage Loans, of which approximately 69% and 87%, respectively had coupon
rates which adjust over time (subject to certain limitations and lag periods) in
conjunction with changes in short-term interest rates, such adjustments being
based on an objective index such as LIBOR, the Treasury Index or the CD Rate. It
is expected in the future that a substantial portion of the Company's Mortgage-
Backed Securities will continue to consist of adjustable-rate Pass-Through
Certificates ("ARM Certificates") or floating rate CMOs which also will be
subject to periodic interest rate adjustments based on such objective indices
("Floaters").
Interest rates on the Company's borrowings are expected to continue to be
based on short-term indices. To the extent any of the Company's Mortgage-Backed
Securities are financed with borrowings bearing interest based on or varying
with an index different from that used for the related Mortgage-Backed
Securities, so-called "basis" interest rate risk results. In such event, if the
index used for the Mortgage-Backed Securities is a "lagging" index that reflects
market interest rate changes on a delayed basis, and the rate borne by the
related borrowings reflects market rate changes more rapidly, the Company's net
interest income will be adversely affected in periods of increasing market
interest rates.
The Company's adjustable-rate Mortgage-Backed Securities are subject to
periodic rate adjustments which may not be matched precisely with increases or
decreases in rates borne by the borrowings or financings utilized by the
Company. In addition, the Company's fixed-rate Mortgage-Backed securities do
not provide for any rate adjustments. Accordingly,
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in a period of increasing interest rates, the Company could experience a
decrease in net interest income or a net loss because the interest rates on
borrowings could adjust faster than the interest rates on the Company's
adjustable-rate Mortgage-Backed Securities or because interest rates on the
Company's borrowings could increase without a corresponding adjustment in the
interest rates on the Company's fixed-rate Mortgage-Backed Securities.
Interest rates on the Company's adjustable-rate Mortgage-Backed Securities
are subject typically to periodic and lifetime interest rate caps which limit
the amount an interest rate can change during any given period. The Company's
borrowings are not subject to similar restrictions. Hence, in a period of
rapidly increasing interest rates, the Company could also experience a decrease
in net interest income or a net loss because the interest rates on borrowings
could increase without limitation while the interest rates on the Company's
Mortgage-Backed Securities (consisting primarily of ARM Certificates and
Floaters) would be limited by caps. While the Company may hedge certain risks
associated with interest rate increases, no hedging strategy can insulate the
Company completely from interest rate risk. To date, the Company has not
entered into any interest rate hedging agreements.
The Company expects that the net effect of these factors, all other factors
being equal, could be to lower the Company's net interest income or cause a net
loss during periods of rapidly rising market interest rates, which could
negatively impact the level of dividend distributions and reduce the market
price of the Common Stock. This reduction in net income, or net loss, could
occur in an increasing interest rate environment as a result of interest rate
increases in borrowings which are more rapid than interest rate increases on the
Company' adjustable-rate Mortgage-Backed Securities or as a result of periodic
and lifetime interest rate caps on the Company's adjustable-rate Mortgage-Backed
Securities.
PREPAYMENT RISKS OF MORTGAGE-BACKED SECURITIES
Prepayment rates on Mortgage-Backed Securities vary from time to time and
may cause changes in the amount of the Company's net interest income.
Prepayments of ARM Certificates and Floaters usually can be expected to increase
when mortgage interest rates fall below the then-current interest rates on ARMs
and decrease when mortgage interest rates exceed the then-current interest rate
on ARMs, although such effects are not predictable. Prepayment experience also
may be affected by the conditions in the housing and financial markets, general
economic conditions and the relative interest rates on fixed-rate and
adjustable-rate mortgage loans underlying Mortgage-Backed Securities. Some
Mortgage-Backed Securities are structured so that certain classes are provided
protection from prepayments for a period of time. However, in a period of
extremely rapid prepayments, during which earlier-paying classes may be retired
faster than expected, the protected classes may receive unscheduled payments of
principal earlier than expected and would have average lives that, while longer
than the average lives of the earlier-paying classes, would be shorter than
originally expected. The Company seeks to minimize prepayment risk through a
variety of means, including structuring a diversified portfolio with a variety
of prepayment characteristics, investing in certain Mortgage-Backed Security
structures which have prepayment protection, and balancing assets purchased at a
premium with assets purchased at a discount. No strategy, however, can
completely insulate the Company from prepayment risks arising from the effects
of interest rate changes. Prepayment risk may be increased if the Company
purchases interest-only strips to protect against interest rate increases.
Certain Mortgage-Backed Securities may have underlying mortgage loans which are
convertible to fixed-rate loans. Since converted loans are required to be
repurchased by the applicable Agency (FHLMC, FNMA or GNMA) or servicer, the
conversion of a loan results, in effect, in the prepayment of such loan.
Changes in anticipated prepayment rates of Mortgage-Backed Securities could
affect the Company in several adverse ways. A portion of the Mortgage-Backed
Securities to be acquired by the Company may be recently originated and bear
initial interest rates which are lower than their "fully-indexed" rates (the
applicable index plus margin). In the event that such a Mortgage-Backed
Security is prepaid faster than anticipated prior to or soon after the time of
adjustment to a fully-indexed rate, the Company will experience an adverse
effect on its net interest income during the time it holds such Mortgage-Backed
Security compared with holding a fully-indexed Mortgage-Backed Security and will
lose the opportunity to receive interest at the fully-indexed rate over the
expected life of the Mortgage-Backed Security. In addition, the faster than
anticipated prepayment of any Mortgage-Backed Security that is purchased at a
premium by the Company would generally result in a faster than anticipated
write-off of any remaining capitalized premium amount and consequent reduction
of the Company's net interest income by such amount. At December 31, 1997, a
majority of the Company's Mortgage-Backed Securities had been acquired at a
premium. While the effects of prepayments may be
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mitigated to the extent the Company acquires Mortgage-Backed Securities at a
discount, to date, a substantial majority of the Company's Mortgage-Backed
Securities have been acquired at a premium, rather than a discount.
RISKS ASSOCIATED WITH LEVERAGE
The Company's financing strategy is designed to increase the size of its
Mortgage-Backed Security investment portfolio by borrowing a substantial portion
(which may vary depending upon the mix of the Mortgage-Backed Securities in the
Company's portfolio and the application of the Company's Capital Investment
Policy requirements to such mix of Mortgage-Backed Securities) of the market
value of its Mortgage-Backed Securities. If the coupon income on the Mortgage-
Backed Securities purchased with borrowed funds fails to cover the cost of the
borrowings, the Company will experience net interest losses and may experience
net losses. Such losses could be increased substantially as a result of the
Company's substantial leverage.
The Company expects generally to maintain a ratio of debt-to-equity of
between 8:1 and 12:1, although the ratio may vary from time to time depending
upon market conditions and other factors deemed relevant by management. However,
the Company is not limited under its Bylaws in respect of the amount of its
borrowings, whether secured or unsecured, and the debt-to-equity ratio could at
times be greater than 12:1. For purposes of calculating the debt-to-equity
ratio, the Company's equity equals the value of the Company's investment
portfolio on a mark-to-market basis less the book value of the Company's
obligations under repurchase agreements and other collateralized borrowings.
At December 31, 1998 and 1997, the debt-to-equity ratio of the Company was 10:1
and 7:1, respectively.
The ability of the Company to achieve its investment objectives depends on
its ability to borrow money in sufficient amounts and on favorable terms.
Through increases in haircuts (i.e., the over-collateralization amount required
by a lender), decreases in the market value of the Company's Mortgage-Backed
Securities, increases in interest rate volatility, changes in the availability
of financing in the market, conditions then applicable in the lending market and
other factors, the Company may not be able to achieve the degree of leverage it
believes to be optimal, which may cause the Company to be less profitable than
it would be otherwise. In addition, as a result of the Company's intention to
structure its investment portfolio to qualify for an exemption from regulation
as an investment company, the Company may be limited in the types and amounts of
Mortgage-Backed Securities it can purchase which, in turn, may affect the
ability of the Company to achieve the degree of leverage it believes to be
optimal.
RISK OF DECLINE IN MARKET VALUE OF MORTGAGE-BACKED SECURITIES; MARGIN
CALLS AND DEFAULTS
Although, at December 31, 1998 and 1997 and as of the date hereof, none of
the Company's Mortgage-Backed Securities were or are cross-collateralized to
secure multiple borrowing obligations of the Company to a single lender, the
Company's Mortgaged-Backed Securities may be cross-collateralized in the future.
A decline in the market value of such assets may limit the Company's ability to
borrow or result in lenders initiating margin calls (i.e., requiring a pledge of
cash or additional Mortgage-Backed Securities to re-establish the ratio of the
amount of the borrowing to the value of the collateral). The Company's fixed-
rate Mortgage-Backed Securities generally are more susceptible to margin calls
as increases in interest rates tend to more negatively affect the market value
of fixed-rate Mortgage-Backed Securities than adjustable-rate Mortgage-Backed
Securities. This remains true despite effective hedging against such
fluctuations as the hedging instruments may not be part of the collateral
securing the collateralized borrowings. Additionally, it may be difficult to
realize the full value of the hedging instrument when desired for liquidity
purposes due to the applicable REIT Provisions of the Code. The Company could be
required to sell Mortgage-Backed Securities under adverse market conditions in
order to maintain liquidity. Such sales may be effected by the Company when
deemed necessary in order to preserve the capital base of the Company. If these
sales were made at prices lower than the amortized cost of the Mortgage-Backed
Securities, the Company would experience losses. A default by the Company under
its collateralized borrowings could also result in a liquidation of the
collateral, including any cross-collateralized assets, and a resulting loss of
the difference between the value of the collateral and the amount borrowed.
Additionally, in the event of a bankruptcy of the Company, certain
repurchase agreements may qualify for special treatment under the Bankruptcy
Code, the effect of which is, among other things, to allow the creditors under
such
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agreements to avoid the automatic stay provisions of the Bankruptcy Code and to
liquidate the collateral under such agreements without delay.
To the extent the Company is compelled to liquidate Mortgage-Backed
Securities qualifying as Qualified REIT Real Estate Assets to repay borrowings,
the Company may be unable to comply with the REIT Provisions of the Code
regarding assets and sources of income requirements, ultimately jeopardizing the
Company's status as a REIT. The Code does not provide for any mitigating
provisions with respect to the 30% Gross Income Test for the period ended
December 31, 1997. Accordingly, if the Company failed to meet the 30% Gross
Income Test, its status as a REIT would terminate automatically. The 30% Gross
Income Test means the requirement for each taxable year that less than 30% of
the Company's gross income is derived from the sale of Qualified REIT Real
Estate Assets held for less than four years, stock or securities held for less
than one year (including certain interest rate swap and cap agreements entered
into to hedge variable rate debt incurred to acquire Qualified Real Estate
Assets) and certain "dealer" property. Pursuant to recently enacted legislation,
the 30% Gross Income Test has been repealed for taxable years beginning after
August 5, 1997. See "Certain Federal Income Tax Considerations -- General --
Asset Tests", "-- Gross Income Tests" and "-- Recent Legislation."
RISKS OF INCREASED BORROWING COSTS AND FAILURE TO REFINANCE
OUTSTANDING BORROWINGS
Currently, all of the Company's borrowings are collateralized borrowings in
the form of repurchase agreements. The ability of the Company to enter into
repurchase agreements in the future will depend on the market value of the
Mortgage-Backed Securities pledged to secure the specific borrowings, the
availability of financing, and other conditions then applicable in the lending
market. The Company may effect additional borrowings through using other types
of collateralized borrowings, loan agreements, lines of credit, Dollar-Roll
Agreements and other credit facilities with institutional lenders or through the
issuance of debt securities. A "Dollar-Roll Agreement" is an agreement to sell
a security for delivery on a specified future date entered into simultaneously
with an agreement to repurchase the same or a substantially similar security
(with the same coupon and original maturity periods) on a specified future date.
The cost of borrowings under repurchase agreements generally corresponds to
LIBOR plus or minus a margin, although such agreements may not expressly
incorporate a LIBOR index. The cost of borrowings under other sources of funding
which the Company may use may refer or correspond to other short-term indices,
plus or minus a margin. The margins on such borrowings over or under LIBOR or
such other short-term indices may vary depending on the lender, the nature and
liquidity of the underlying collateral, the movement of interest rates, and the
availability of financing in the market and other factors. Increased borrowing
costs could adversely impact the Company's net income.
The Company's business strategy relies primarily on short-term borrowings
to fund Mortgage-Backed Securities with adjustable-rate coupons and long-term
maturities. Thus, the ability of the Company to achieve its investment
objectives depends not only on its ability to borrow money in sufficient amounts
and on favorable terms but also on the Company's ability to renew or replace on
a continuous basis its maturing short-term borrowings. In the event the Company
is not able to renew or replace maturing borrowings, the Company could be
required to sell Mortgage-Backed Securities under possibly adverse market
conditions and could incur losses as a result. In addition, in such event, the
Company may be required to terminate any hedging positions, which could result
in further costs to the Company. At the same time, the market value of the
assets in which the Company's liquidity capital is invested may have decreased.
A number of such factors in combination could cause difficulties for the Company
and might result in a liquidation of a major portion of the Company's Mortgage-
Backed Securities at disadvantageous prices with consequent losses, which could
have a material adverse effect on the Company and its solvency.
RISK OF DECREASE IN NET INTEREST INCOME DUE TO INTEREST
RATE FLUCTUATIONS
At December 31, 1998 and 1997, approximately 69% and 87%, respectively, of
the Company's Mortgage-Backed Securities had adjustable interest or pass-through
rates based on short-term interest rates, and all of the Company's borrowings
bore interest at short-term rates and had maturities of less than one year.
Consequently, changes in short-term interest rates may significantly influence
the Company's net interest income. While increases in short-term interest rates
will generally increase the yields on the Company's adjustable-rate Mortgage-
Backed Securities, rising short-term rates will also increase the costs of
borrowings by the Company which will be utilized to fund the Mortgage-Backed
Securities
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and, to the extent such costs rise more rapidly than the yields, the Company's
net interest income may be reduced or a net loss may result. Increases in short-
term rates relative to long-term rates could adversely impact the Company's net
income. In periods of high interest rates, the Company's net income may be less
than income generated through alternative investments of equal or lower risk,
which could negatively impact the price of the Common Stock. No assurance can be
given as to the amount or timing of changes in interest rates or their effect on
the Company's Mortgage-Backed Securities or net interest income.
RISKS ASSOCIATED WITH INTEREST RATE CHANGES AND USE OF
INTEREST RATE DERIVATIVES FOR HEDGING
The Company's operating strategy subjects it to interest rate risks as
described under "-- Risk of Decrease in Net Interest Income Due to Interest Rate
Fluctuations" above. The Company has adopted policies as part of its Capital
Investment Policy intended to protect against interest rate changes and
prepayments. See "Business Strategy -- Capital Investment Policy --Interest
Rate Risk Management." The Company may purchase from time to time interest rate
caps, interest rate swaps and similar instruments to attempt to mitigate the
risk of the cost of its variable rate liabilities increasing at a faster rate
than the earnings on its assets during a period of rising rates. However, it is
not expected that such hedging strategies will completely insulate the Company
against interest rate risk. To date, the Company has not entered into any
hedging transactions.
Developing an effective asset/liability management strategy is complex, and
no strategy can completely insulate the Company from risks associated with
interest rate changes and prepayments. In addition, to the extent the Company
engages in hedging, there can be no assurance that the Company's hedging
activities will have the desired beneficial impact on the Company's results of
operations or financial condition. Hedging typically involves costs, including
transaction costs, which increase dramatically as the period covered by the
hedge increases and which also increase during periods of rising and volatile
interest rates. The Company may increase its hedging activity, and thus increase
its hedging costs, during such periods when interest rates are volatile or
rising and hedging costs have increased. Such hedging costs may cause the
Company to conclude that a particular hedging transaction is not appropriate for
the Company, thereby affecting the Company's ability to mitigate interest rate
risk.
Federal tax laws applicable to REITs may substantially limit the Company's
ability to engage in asset/liability management transactions. Such Federal tax
laws may prevent the Company from effectively implementing hedging strategies
that the Company determines, absent such restrictions, would best insulate the
Company from the risks associated with changing interest rates and prepayments.
See "Certain Federal Income Tax Considerations -- General" and "-- Taxation of
the Company." In this regard, the amount of income the Company may earn from
its interest rate caps and other hedging instruments may be subject to
substantial limitations under the REIT Provisions of the Code. In particular,
income generated by such instruments is non-qualifying income for purposes of
the 75% Gross Income Test and is income form the sale of a security subject to
the 30% Gross Income Test for the period ended December 31, 1997. Additionally,
the Company will treat such income as non-qualifying income for the 95% Gross
Income Test unless it receives advice from its tax advisors that such income
constitutes qualifying income for purposes of such test. Pursuant to recently
enacted legislation, the 30% Gross Income Test has been repealed for taxable
years beginning after August 5, 1997, but such income would still not qualify
for the 75% Gross Income Test or, subject to the preceding sentence, the 95%
Gross Income Test. See "Certain Federal Income Tax Considerations -- General --
Gross Income Tests" and "-- Recent Legislation." This determination may result
in management electing to have the Company bear a level of interest rate risk
that might otherwise be hedged. The "75% Gross Income Test" means the
requirement for each taxable year that at least 75% of the Company's gross
income must be derived from certain specified real estate sources including
interest income and gain from the disposition of Qualified REIT Real Estate
Assets or "qualified temporary investment income" (i.e., income derived from
"new capital" within one year of the receipt of such capital). The "95% Gross
Income Test" means the requirement for each taxable year that at least 95% of
the Company's gross income for each taxable year must be derived from sources of
income qualifying for the 75% Gross Income Test, dividends, interest, and gains
from the sale of stock or other securities (including certain interest rate
swap and cap agreements entered into to hedge variable rate debt incurred to
acquire Qualified REIT Real Estate Assets) not held for sale in the ordinary
course of business.
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If the Company purchases interest rate caps or other interest rate
agreements to hedge against lifetime and periodic rate or payment caps, and the
provider of interest rate agreements becomes financially unsound or insolvent,
the Company may be forced to unwind its interest rate agreements with such
provider and may take a loss on such interest rate agreements. Although the
Company intends to purchase interest rate agreements only from financially sound
institutions and to monitor the financial strength of such institutions on a
periodic basis, no assurance can be given that the Company can avoid such third
party risks.
CREDIT RISKS ASSOCIATED WITH INVESTMENT STRATEGY
The Company's Capital Investment Policy provides that at least 75% of the
Company's total assets are to be comprised of High Quality Mortgage-Backed
Securities and High Quality Short-Term Investments. "Short-Term Investments"
means short-term bank certificates of deposit, short-term United States treasury
securities, short-term United States government agency securities, commercial
paper, reverse repurchase agreements, short-term CMOs, short-term asset-backed
securities and other similar types of short-term investment instruments, all of
which will have maturities or average lives of less than one year. The Capital
Investment Policy provides that the remainder of the Company's assets,
comprising not more than 25% of total assets, may consist of Mortgage-Backed
Securities and other Qualified REIT Real Estate Assets which are unrated or
rated less than High Quality. The Company's investment strategy seeks to
balance the risk and return potential of its investments in a manner that
attempts to maximize return while minimizing the risk of losses to the Company
through defaults on portfolio obligations. This strategy determines the relative
weightings within the Company's portfolio of Mortgage-Backed Securities of
different ratings. The Company attempts to structure its portfolio to maintain a
minimum weighted average rating (including the Company's deemed comparable
ratings for unrated Mortgage-Backed Securities based on a comparison to rated
Mortgage-Backed Securities with like characteristics) of its Mortgage-Backed
Securities of at least single "A" under the S&P rating system and at the
comparable level under the other rating systems. There can be no assurance the
Company's deemed comparable ratings will agree with assessments by others as to
how such Mortgage-Backed Securities would be rated. In addition, to the extent
that the Company invests in High Quality investments, the yield on such assets
may be lower than the yield on lower rated securities. To date, the Company has
invested solely in Agency Certificates and CMO's issued or guaranteed by FNMA,
FHLMC or GNMA which, although not rated, carry an implied "AAA" rating.
ABILITY TO ACQUIRE MORTGAGE-BACKED SECURITIES AT FAVORABLE YIELDS;
COMPETITION AND SUPPLY
The Company's net income depends, in large part, on the Company's ability
to acquire Mortgage-Backed Securities at favorable spreads over the Company's
borrowing costs. In acquiring Mortgage-Backed Securities, the Company competes
with other REITs, investment banking firms, savings and loan associations,
banks, insurance companies, mutual funds, other lenders, and other entities
purchasing Mortgage-Backed Securities, many of which have greater financial
resources than the Company. In addition, there are several mortgage REITs
similar to the Company, and others may be organized in the future. The effect of
the existence of additional REITs may be to increase competition for the
available supply of Mortgage-Backed Securities suitable for purchase by the
Company. Further, in fluctuating interest rate environments, the spread between
interest rates on adjustable-rate mortgage loans and interest rates on fixed-
rate mortgage loans may decrease, and may cease to exist or become negative.
Under such conditions, mortgagors tend to favor fixed-rate mortgage loans,
thereby decreasing the supply of adjustable-rate Mortgage-Backed Securities
available to the Company for purchase. The relative availability of adjustable-
rate Mortgage-Backed Securities may also be diminished by a number of other
market and regulatory considerations.
There can be no assurance that the Company will be able to continue to
acquire sufficient Mortgage-Backed Securities from mortgage suppliers at spreads
above the Company's cost of funds. The Company will also face competition for
financing sources, and the effect of the existence of additional mortgage REITs
may be to deny the Company access to sufficient funds to carry out its business
strategy and/or to increase the cost of funds to the Company.
RISKS OF LIMITED GUARANTEES BY FHLMC AND FNMA
As of December 31, 1998, by principal amount, approximately 30% of the
Company's Mortgage-Backed Securities were FHLMC Certificates or CMO's issued or
guaranteed by FHLMC and approximately 64% of the Company's
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Mortgage-Backed Securities were FNMA Certificates or CMO's issued or guaranteed
by FNMA. As of December 31, 1997, by principal amount, approximately 24% of the
Company's Mortgage-Backed Securities were FHLMC Certificates or CMO's issued or
guaranteed by FHLMC and approximately 61% of the Company's Mortgage-Backed
Securities were FNMA Certificates or CMO's issued or guaranteed by FNMA. FHLMC's
guarantee to holders of FHLMC Certificates and FNMA's guarantee to holders of
FNMA Certificates are subject to certain limitations.
FHLMC guarantees to each holder of FHLMC Certificates the timely payment of
interest at the applicable pass-through rate and ultimate collection of all
principal on the holder's pro rata share of the unpaid principal balance of the
underlying Mortgage Loans, but does not guarantee the timely payment of
scheduled principal of the underlying Mortgage Loans. The obligations of FHLMC
under its guarantees are solely those of FHLMC and are not backed by the full
faith and credit of the United States. If FHLMC were unable to satisfy such
obligations, distributions to holders of FHLMC Certificates would consist solely
of payments and other recoveries on the underlying Mortgage Loans and,
accordingly, monthly distributions to holders of FHLMC Certificates would be
affected by delinquent payments and defaults on such Mortgage Loans.
FNMA guarantees to the registered holder of a FNMA Certificate that it will
distribute amounts representing scheduled principal and interest (at the rate
provided by the FNMA Certificate) on the Mortgage Loans in the pool underlying
the FNMA Certificate, whether or not received, and the full principal amount of
any such Mortgage Loan foreclosed or otherwise finally liquidated, whether or
not the principal amount is actually received. The obligations of FNMA under its
guarantees are solely those of FNMA and are not backed by the full faith and
credit of the United States. If FNMA were unable to satisfy such obligations,
distributions to holders of FNMA Certificates would consist solely of payments
and other recoveries on the underlying Mortgage Loans and, accordingly, monthly
distributions to holders of FNMA Certificates would be affected by delinquent
payments and defaults on such Mortgage Loans.
LIMITATIONS ON RATINGS OF MORTGAGE-BACKED SECURITIES
A rating is not a recommendation to buy, sell or hold a security, inasmuch
as such rating does not comment as to the market price of the security or the
suitability of the security for a particular investor. There is no assurance
that a rating will remain for any given period of time or that a rating will not
be lowered or withdrawn entirely by a Rating Agency if in its judgment
circumstances so warrant.
RISKS OF UNRATED ASSETS
The Company's Capital Investment Policy provides that the Company's assets
may include certain assets which are unrated but are determined by the Company
to be of comparable quality to rate High Quality Mortgage-Backed Securities and
certain assets which are unrated but are determined by the Company to be of
comparable credit quality to an investment which is at least "investment grade"
(rated "BBB" or better by S&P or the equivalent by another nationally recognized
rating organization). Prior to acquiring any such unrated securities, the
Company intends to engage an independent consultant with expertise in rating
"investment grade" securities to assist the Company in evaluating the
creditworthiness of such securities and determining whether such securities are
qualified to be purchased under the Company's Capital Investment Policy. In
making such evaluations, the Company will look at similar criteria utilized by
S&P and other nationally recognized rating organizations. Such criteria may
include a review of the cash flow and other characteristic of the security, an
analysis of the components of the security and a valuation of comparable assets.
However, the Company is not expert in evaluating unrated assets, such unrated
assets will not carry the rating of a nationally recognized rating agency and
there can be no guarantee that the Company or any independent consultant engaged
by the Company will be able to make an accurate valuation of such unrated
assets. To date, the Company has not purchased unrated assets.
RISK OF ASSET CONCENTRATION
Although the Company seeks geographic diversification of the properties
underlying the Mortgage-Backed Securities which it acquires, it does not set
specific limitations on the aggregate percentage of underlying properties which
may be located in any one area. Consequently, properties underlying such
Mortgage-Backed Securities may be located in the same or a limited number of
geographical regions. Adverse changes in the economic conditions of the
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geographic regions in which the properties underlying the Mortgage-Backed
Securities are concentrated likely would have an adverse effect on real estate
values, interest rates and prepayment rates and increase the risk of default by
the obligors on the underlying mortgage loans; accordingly, the Company's
results of operations could be adversely affected. In addition, the properties
underlying all of the Mortgage-Backed Securities owned by the Company are
single-family (one- to four-units) properties. While, the Company believes that
asset concentration in Mortgage-Backed Securities backed by Single-Family
Mortgage Loans provides less risk than Mortgage-Backed Securities backed by
Multifamily and Commercial Mortgage Loans, a downturn in the residential housing
market could adversely affect the Company.
LEGAL AND OTHER RISKS
DEPENDENCE ON KEY PERSONNEL
The Company's operations depend in significant part upon the contributions
of its executive officers who presently devote at least 90% of their working
time to the business of the Company and intend in the future, as between the
Company and FIDAC, to devote at least 90% of their working time to the Company's
business. Although Michael Farrell, Chairman of the Board and Chief Executive
Officer, Timothy Guba, President and Chief Operating Officer Wellington St.
Claire, Vice Chairman of the Board, and Kathryn F. Fagan, Chief Financial
Officer currently have employment agreements with the Company, there can be no
assurance of the continued employment of all such officers. The loss of any key
person could have a material adverse effect on the Company's business and
results of operations.
LOSS OF INVESTMENT COMPANY ACT EXEMPTION WOULD ADVERSELY AFFECT
THE COMPANY
The Company at all times intends to conduct its business so as not to
become regulated as an investment company under the Investment Company Act.
Accordingly, the Company does not expect to be subject to the restrictive
provisions of the Investment Company Act. The Investment Company Act exempts
entities that are "primarily engaged in the business of purchasing or otherwise
acquiring mortgages and other liens on and interests in real estate"
("Qualifying Interests"). Under the current interpretation of the staff of the
Commission, in order to qualify for this exemption, the Company must maintain at
least 55% of its assets directly in mortgage loans, qualifying Pass-Through
Certificates and certain other qualifying interests in real estate. In addition,
unless certain Mortgage-Backed Securities represent all the certificates issued
with respect to an underlying pool of mortgages, such Mortgage-Backed Securities
may be treated as securities separate from the underlying mortgage loans and,
thus, may not qualify as Qualifying Interests for purposes of the 55%
requirement. Therefore, the Company's ownership of certain Mortgage-Backed
Securities may be limited by the provisions of the Investment Company Act. In
addition, in meeting the 55% requirement under the Investment Company Act, the
Company considers mortgage pass-through certificates issued with respect to an
underlying pool as to which the Company holds all issued certificates as
Qualifying Interests. If the Securities and Exchange Commission, or its staff,
adopts a contrary interpretation with respect to such securities, the Company
could be required to restructure its activities to the extent its holdings of
such mortgage pass-through certificates did not comply with the interpretation.
Such a restructuring could require the sale of a substantial amount of mortgage
pass-through certificates held by the Company at a time it would not otherwise
do so, which sale could occur under adverse market conditions and the Company
could incur losses as a result. Further, in order to insure that the Company at
all times continues to qualify for the above exemption from the Investment
Company Act, the Company may be required at times to adopt less efficient
methods of financing certain of its Mortgage-Backed Securities than would
otherwise be the case and may be precluded from acquiring certain types of
Mortgage-Backed Securities whose yield is somewhat higher than the yield on
Mortgage-Backed Securities that could be purchased in a manner consistent with
the exemption. The net effect of these factors may be to lower at times the
Company's net interest income. If the Company fails to qualify for exemption
from registration as an investment company, its ability to use leverage would be
substantially reduced and it would be unable to conduct its business as
described herein. Any such failure to qualify for such exemption could have a
material adverse effect on the Company. The Company believes that, as of the
date hereof, the Company's portfolio of Mortgage-Backed Securities would qualify
the Company for such exemption.
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FAILURE TO MAINTAIN REIT STATUS WOULD SUBJECT THE COMPANY TO ADDITIONAL TAX
In order to maintain its qualification as a REIT for Federal income tax
purposes, the Company must comply with the REIT Provisions of the Code,
including satisfying certain tests with respect to the sources of its income,
the nature and diversification of its assets, the amount of its distributions to
stockholders and the ownership of its stock.
The Company intends, at all times, to operate so as to qualify as a REIT
for Federal income tax purposes. To qualify as a REIT, the Company must satisfy
a series of complicated tests related to the nature of its assets and income and
it must also distribute substantially all of its income (as specially defined
for these purposes) to its stockholders. If the Company fails to qualify as a
REIT in any taxable year and certain relief provisions of the Code do not apply,
the Company would be subject to Federal income tax as a regular domestic
corporation, and its stockholders would be subject to tax in the same manner as
stockholders of such corporation. Distributions to stockholders in any year in
which the Company fails to qualify as a REIT would not be deductible by the
Company in computing its taxable income. As a result, the Company could be
subject to income tax liability, thereby significantly reducing or eliminating
the amount of cash available for distribution to its stockholders. Further, the
Company could also be disqualified from re-electing REIT status for the four
taxable years following the year during which it became disqualified.
No assurance can be given that future legislation, regulations,
administrative interpretations or court decisions will not significantly change
the tax laws with respect to the Company's qualification as a REIT or the
Federal income tax consequences of such qualification, which changes may reduce
or eliminate the Company's competitive advantage over non- REIT competitors. See
"Certain Federal Income Tax Considerations -- Taxation of the Company."
RISK OF FUTURE REVISIONS IN POLICIES AND STRATEGIES
The Board of Directors has established the investment policies and
operating policies and strategies set forth in this Prospectus as the investment
policies and operating policies and strategies of the Company. However, these
policies and strategies may be modified or waived by the Board of Directors,
subject in certain cases to approval by a majority of the Independent Directors,
without stockholder consent. Although a majority of the Board of Directors will
be comprised of Independent Directors, the initial selection of the Independent
Directors was made by the initial stockholders of the Company who are also
officers or directors of the Company. "Independent Director" means a director of
the Company who is not an officer or employee of the Company.
DILUTION; RISK OF POTENTIAL FUTURE OFFERINGS
The Company may in the future increase its capital resources by making
additional offerings of equity and debt securities, including classes and series
of preferred stock, additional classes and series of common stock, commercial
paper, medium-term notes and senior or subordinated notes. All debt securities
and classes of preferred stock will be senior to the Common Stock in a
liquidation of the Company. The effect of additional equity offerings may be the
dilution of the equity of stockholders of the Company or the reduction of the
price of shares of the Company's Common Stock, or both. The Company is unable
to estimate the amount, timing or nature of additional offerings as they will
depend upon market conditions and other factors.
ILLIQUIDITY OF CERTAIN INVESTMENTS
A small portion of the Company's portfolio may be invested in Mortgage-
Backed Securities for which the secondary trading market is not as well
developed as the market for certain other Mortgage-Backed Securities (or which
are otherwise considered less marketable or illiquid). Although the Company
expects that most of the Company's investments will be in Mortgage-Backed
Securities for which a resale market exists, certain of the Company's
investments may lack a regular trading market and may be illiquid. In addition,
during turbulent market conditions, the liquidity of all of the Company's
Mortgage-Backed Securities may be adversely impacted. There is no limit on the
percentage of the Company's investments that may be invested in illiquid
Mortgage-Backed Securities.
29
<PAGE>
ISSUANCE OF PREFERRED STOCK
The Articles of Incorporation authorize the Board of Directors to
reclassify any of the unissued shares of authorized capital stock into a class
or classes of preferred stock. The issuance of preferred stock could have the
effect of making an attempt to gain control of the Company more difficult by
means of a merger, tender offer, and proxy contest or otherwise. Preferred
stock, if issued, could have a preference on dividend payments over the Common
Stock which could affect the ability of the Company to make dividend
distributions to the holders of Common Stock. At present, the Company has no
intention to issue preferred stock; however, the Company may decide, in the
future, to issue preferred stock based upon its consideration of various
factors, including the Company's determination as to the most efficient method
for raising capital and consideration of the effect which such issuance will
have on the Common Stock.
RESTRICTIONS ON OWNERSHIP OF CAPITAL STOCK
In order that the Company may meet the requirements for qualification as a
REIT, the Articles of Incorporation prohibit any person from acquiring or
holding, directly or constructively, ownership of a number of shares of capital
stock in excess of 9.8% in number of shares or value (the "Ownership Limit") of
the outstanding shares. For this purpose the term "ownership" is defined as
either direct ownership or constructive ownership in accordance with the
constructive ownership provisions of section 544 of the Code. Any transfer of
shares of capital stock that would result in disqualification of the Company as
a REIT or that would (a) create a direct or constructive ownership of shares of
stock in excess of the Ownership Limit, or (b) result in the shares of stock
being beneficially owned (within the meaning section 856(a) of the Code) by
fewer than 100 persons (determined without reference to any rules of
attribution), or (c) result in the Company being "closely held" within the
meaning of section 856(h) of the Code, will be null and void, and the intended
transferee (the "purported transferee") will acquire no rights to such shares.
Any purported transfer of shares that would result in a person owning (directly
or constructively) shares in excess of the Ownership Limit (except as otherwise
waived by the Board of Directors) due to the unenforceability of the transfer
restrictions set forth above will constitute "Excess Securities." Excess
Securities will be transferred by operation of law to a trust to be established
by the Company for the exclusive benefit of a charitable organization, until
such time as the trustee of the trust, which shall be a banking institution
designated as trustee by the Company which is unaffiliated with either the
Company or the purported transferee, retransfers the Excess Securities. Subject
to the Ownership Limit, Excess Securities may be transferred by the trust to any
person (if such transfer would not result in Excess Securities) at a price not
to exceed the price paid by the purported transferee (or, if no consideration
was paid by the purported transferee, the fair market value of the Excess
Securities on the date of the purported transfer), at which point the Excess
Securities will automatically cease to be Excess Securities. See "Certain
Federal Income Tax Considerations -- General -- Stock Ownership Tests."
Subject to certain limitations, the Board of Directors may increase or
decrease the Ownership Limit. In addition, to the extent consistent with the
REIT Provisions of the Code, the Board of Directors has the right, pursuant to
the Company's Articles of Incorporation, to waive the Ownership Limit for and at
the request of a purchaser of the Common Stock. In connection with any such
waiver, the Company may require that the stockholder requesting such a waiver
enter into an agreement with the Company providing for the repurchase by the
Company of shares from the stockholder under certain circumstances to ensure
compliance with the REIT Provisions of the Code. Such repurchase would be at
fair market value as set forth in the agreement between the Company and such
stockholder. The consideration received by the stockholder in such repurchase
might be characterized as the receipt by the stockholder of a dividend from the
Company, and any stockholder entering into such an agreement with the Company
should consult its tax advisor in connection with its entering into such an
agreement. At present, the Company does not intend to waive the Ownership Limit
for any purchaser of shares of the Common Stock.
The provisions described above may inhibit market activity and a resulting
takeover or other transaction in which holders of some or a majority of the
Company's capital stock might receive a premium for their shares or which such
holders might believe to be otherwise in their best interests. Such provisions
also may make the Company an unsuitable investment vehicle for any person
seeking to obtain ownership of more than 9.8% of the outstanding shares of
capital stock.
30
<PAGE>
CAPITAL STOCK PRICE VOLATILITY RISK
With respect to the public market for the Common Stock, it is likely that
the market price of the Common Stock will be influenced by any variation between
the net yield on the company's Mortgage-Backed Securities and prevailing market
interest rates and by the market's perception of the Company's ability to
achieve earnings growth. The Company's earnings will be derived primarily from
any positive spread between the yield on the Company's Mortgage-Backed
Securities and the cost of the Company's borrowings. The positive spread between
the yield on the Company's Mortgage-Backed Securities and the cost of borrowings
will not necessarily be stable regardless of the Company's business strategy to
achieve such result over longer periods of time. Accordingly, in periods of high
interest rates, the net income of the Company, and therefore the dividend yield
on the Common Stock, may be less attractive compared with alternative
investments, which could negatively impact the price of the Common Stock. If the
anticipated or actual net yield on the Company's Mortgage-Backed Securities
declines or if prevailing market interest rates rise, thereby decreasing the
positive spread between the net yield on the Mortgage-Backed Securities and the
cost of the Company's borrowing, the market price of the Common Stock may be
adversely affected. The market price of the Company's Common Stock may also be
influenced by real or perceived future earnings variability caused by changes in
prepayment rates. In addition, if the market price of other REIT stocks decline
for any reason, or there is a broad-based decline in real estate values or the
Common Stock has been adversely affected due to any of the foregoing reasons,
the liquidity of the Common Stock may be negatively impacted and investors who
may desire or be required to sell shares of Common Stock may experience losses.
31
<PAGE>
ITEM 2. PROPERTIES
The Company's executive and administrative office is located at 12 East
41st Street, Suite 700, New York, New York 10017, telephone 212-696-0100. This
office is leased under a lease expiring December 2007.
ITEM 3. LEGAL PROCEEDINGS
At December 31, 1998, there were no pending legal proceedings to which the
Company was a party, or to which any of its property was subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company's stockholders during
the fourth quarter of 1998.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company's Common Stock began trading publicly on October 8, 1997 and is
traded on the New York Stock Exchange under the trading symbol "NLY". As of
March 25, 1999, the Company had 12,696,798 shares of common stock issued and
outstanding which was held by 3,240 holders of record.
The following table sets forth, for the periods indicated, the high, low,
and closing sales prices per share of Common Stock as reported on the New York
Stock Exchange composite tape and the cash dividends declared per share of
Common Stock.
<TABLE>
<CAPTION>
Stock Prices
High Low Close
<S> <C> <C> <C>
First Quarter ended March 31, 1998 $11.75 $10.00 $11.81
Second Quarter ended June 30, 1998 $11.31 $ 8.69 $ 9.06
Third Quarter ended September 30, 1998 $ 9.00 $ 6.75 $ 8.13
Fourth Quarter ended December 31, 1998 $ 9.00 $ 6.13 $ 8.25
Fourth Quarter ended December 31, 1997 $12.81 $10.00 $11.00
</TABLE>
<TABLE>
<CAPTION>
Cash Dividends
Declare Per Share
<S> <C>
First Quarter ended March 31, 1998 $ 0.32
Second Quarter ended June 30, 1998 $ 0.32
Third Quarter ended September 30, 1998 $ 0.27
Fourth Quarter ended December 31, 1998 $0.305
First Quarter ended March 31, 1997 $0.075
Second Quarter ended June 30, 1997 $0.255
Third Quarter ended September 30, 1997 $ 0.18
Fourth Quarter ended December 31, 1997 $ 0.22
</TABLE>
The company intends to pay quarterly dividends and to make such
distributions to its stockholders in amounts such that all or substantially all
of its taxable income in each year (subject to certain adjustments) is
distributed so as to qualify
32
<PAGE>
for the tax benefits accorded to a REIT under the Code. All distributions will
be made by the Company at the discretion of the Board of directors and will
depend on the earnings of the Company, the financial condition of the Company,
maintenance of REIT status and such other factors as the Board of Directors may
deem relevant from time to time.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data are derived from the audited
financial statements of the Company for the year ended December 31, 1998 and the
period from February 18, 1997 (commencement of operations) to December 31, 1997.
The selected financial data should be read in conjunction with the more detailed
information contained in the Financial Statements and Notes thereto and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" included elsewhere in this Form 10-K.
SELECTED FINANCIAL DATA
(DOLLARS IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
<TABLE>
<CAPTION>
FEBRUARY 18, 1997
(COMMENCEMENT OF
FOR THE YEAR ENDED OPERATIONS) THROUGH
DECEMBER 31, 1998 DECEMBER 31, 1997
------------------------------------------
<S> <C> <C>
STATEMENT OF OPERATIONS DATA:
Days in period 365 317
Interest income $ 89,986 $ 24,713
Interest expense 75,735 19,677
-----------------------------------------
Net interest income $ 14,251 $ 5,036
Gain on sale of mortgage-backed securities 3,344 735
General and administrative expenses (G&A expense) 2,106 852
-----------------------------------------
Net income $ 15,489 $ 4,919
=========================================
Basic net income per average share $ 1.22 $ 0.83
Diluted net income per average share $ 1.19 $ 0.80
Dividends declared per average share $ 1.21 $ 0.79
<CAPTION>
BALANCE SHEET DATA: DECEMBER 31, 1998 DECEMBER 31, 1997
- - ------------------ -----------------------------------------
<S> <C> <C>
Mortgage-Backed Securities, net $ 1,520,289 $ 1,161,779
Total assets 1,527,352 1,167,740
Repurchase agreements 1,280,510 918,869
Total liabilities 1,401,481 1,032,654
Stockholders' equity 125,871 135,086
Number of common shares outstanding 12,648,424 12,713,900
OTHER DATA:
Average total assets $ 1,499,875 $ 476,855
Average borrowings 1,360,040 404,140
Average equity 131,265 61,096
Yield on interest earning assets for the period 6.16% 6.34%
Cost of funds on interest bearing liabilities for the period 5.57% 5.61%
ANNUALIZED FINANCIAL RATIOS(1):
Net interest margin (net interest income/average total assets) 0.95% 1.22%
G&A expense as a percentage of average assets 0.14% 0.21%
G&A expense as a percentage of average equity 1.60% 1.61%
</TABLE>
33
<PAGE>
<TABLE>
<S> <C> <C>
Return on average assets 1.03% 1.19%
Return on average equity 11.80% 9.27%
</TABLE>
(1) Ratios for the 317-day period ended December 31, 1997 have been
annualized.
34
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
The Company is a real estate investment trust ("REIT") which acquires and
manages Mortgage-Backed Securities which can be readily financed. The Company
commenced operations on February 18, 1997 upon the closing of the Private
Placement, which resulted in proceeds to the Company of $33 million. The
Company received additional proceeds of $878,000 upon the closing of the Direct
Offering on July 31, 1997. The Company's initial public offering was completed
on October 14, 1997 raising net proceeds of $98.8 million. During the third
quarter of 1998, the Company initiated a stock buy back program. During the
year ended December 31, 1998, 109,600 shares were repurchased at a cost of
$903,163. Stock options exercised during the year ended December 31, 1998
totaled 44,124 shares for a aggregate exercise price of $195,100.
The Company's principal business objective is to generate net income for
distribution to stockholders from the spread between the interest income on its
Mortgage-Backed Securities and the costs of borrowing to finance its acquisition
of Mortgage-Backed Securities. The Company will seek to generate growth in
earnings and dividends per share in a variety of ways, including through (i)
issuing new Common Stock and increasing the size of the balance sheet when
opportunities in the market for Mortgage-Backed Securities are likely to allow
growth in earnings per share, (ii) continually reviewing the mix of Mortgage-
Backed Security types on the balance sheet in an effort to improve risk-adjusted
returns, and (iii) attempting to improve the efficiency of the Company's balance
sheet structure through the issuance of uncollateralized subordinated debt,
preferred stock and other forms of capital, to the extent management deems such
issuances appropriate.
RESULTS OF OPERATIONS
The Company's 1997 fiscal year commenced with the start of operations on
February 18, 1997. The 317-day period from February 18, 1997 to December 31,
1997 is referred to herein as "the period ended December 31, 1997." The year
ended December 31, 1998 is its calendar equivalent.
NET INCOME SUMMARY
Comparing net income for the period February 18, 1997 through December 31,
1997 to the year ended December 31, 1998 may be deceptive. The 317-day period
ended December 31, 1997 is a shortened operating period and not a full twelve
months. Also, average assets for the period ended December 31, 1997 totaled
$476.9 million; whereas, average assets for the year ended December 31, 1998
totaled $1.5 billion.
For the year ended December 31, 1998, net income, as calculated according
to Generally Accepted Accounting Principles ("GAAP"), was $15,488,923, or $1.22
basic earnings per share, as compared to the period ended December 31, 1997 of
$4,919,494 or $0.83 basic earnings per share. Taxable earnings for the year
ended December 31, 1998 was approximately $16,133,279 or $1.27 basic per average
share. Taxable income for the period ended December 31, 1997 was $4,884,308 or
$0.82 basic per average share. Net income per share is computed by dividing net
income by the weighted average number of shares of outstanding Common Stock
during the period, which was 12,709,116 and 5,952,123 for the year ended
December 31, 1998 and the period ended December 31, 1997, respectively.
Dividends per weighted average number of shares outstanding for the year ended
December 31, 1998 and the period ended December
35
<PAGE>
31, 1997 were $1.215 per share, $15,437,554 in total and $0.79 per share,
$4,689,662 in total. Return on average equity was 11.80% for the year ended
December 31, 1998 and 9.27% for the period ended December 31, 1997.
Management's policy is to focus on income and expense measures as a
percentage of equity rather than as a percentage of assets. Therefore,
improvements in asset-based measures such as net interest margin or operating
expenses as a percentage of assets do not necessarily translate into improved
stockholder returns. Improvements in net interest income or operating expenses
as a percentage of equity, however, indicate that the Company is effectively
utilizing its equity capital base. The Company seeks to increase net income as
a percentage of equity consistent with its Capital Investment Policy.
NET INCOME SUMMARY
------------------
(dollars in thousands, except per share amounts)
<TABLE>
<CAPTION>
Year Ended Period ended
December 31, December 31,
1998 1997
---------------------------------------
<S> <C> <C>
Days in Period 365 317
Interest Income $ 89,986 $ 24,713
Interest Expense 75,735 19,677
---------------------------------------
Net Interest Income 14,251 5,036
Gain on Sale of Mortgage-Backed Securities 3,344 735
General and Administrative Expenses 2,106 852
---------------------------------------
Net Income $ 15,489 $ 4,919
=======================================
Average Number of Outstanding Shares - Basic 12,709,116 5,952,123
Average Number of Outstanding Shares - Diluted 13,020,648 6,168,531
Basic Net Income Per Share $ 1.22 $ 0.83
Diluted Net Income Per Share $ 1.19 $ 0.80
Average Total Assets $ 1,499,875 $ 476,855
Average Equity $ 131,265 $ 61,096
Return on Average Assets (annualized for the period ended
December 31, 1997) 1.03% 1.19%
Return on Average Equity (annualized for the period ended
December 31, 1997) 11.80% 9.27%
</TABLE>
TAXABLE INCOME AND GAAP INCOME
For the year ended December 31, 1998 and for the period ended December 31,
1997, income as calculated for tax purposes (taxable income) differed from
income as calculated according to generally accepted accounting principles (GAAP
income). The differences were in the calculations of premium amortization and
general and administrative expenses.
The distinction between taxable income and GAAP income is important to the
Company's stockholders because dividends are declared on the basis of taxable
income. While the Company does not pay taxes so long as it satisfies the
requirements for exemption from taxation pursuant to the REIT Provisions of the
Code, each year the Company completes a corporate tax form wherein taxable
income is calculated as if the Company were to be taxed. This taxable income
level determines the amount of dividends the Company can pay out over time. The
table below presents the major differences between GAAP and taxable income for
the Company for the year ended December 31, 1998, the period ended December 31,
1997 and the four quarters in 1998.
36
<PAGE>
TAXABLE INCOME
--------------
<TABLE>
<CAPTION>
Taxable General Taxable Mortgage Taxable Gain on
GAAP Net & Administrative Amortization Sale of Securities Taxable Net
Income Differences Differences Differences Income
------------------------------------------------------------------------------------------
(dollars in thousands)
<S> <C> <C> <C> <C> <C>
For the Year Ended $15,489 $6 $ 969 ($331) $16,133
December 31, 1998
For the Period Ended
December 31, 1997 $ 4,919 $3 ($92) $ 54 $ 4,884
- - ----------------------------------------------------------------------------------------------------------------------
For the Quarter Ended $ 3,685 $3 $ 439 ($20) $ 4,107
December 31, 1998
For the Quarter Ended $ 3,709 $ 228 $ 83 $ 4,020
September 30, 1998
For the Quarter Ended $ 3,387 $2 $ 376 ($19) $ 3,746
June 30, 1998
For the Quarter Ended $ 4,708 $1 ($74) ($375) $ 4,260
March 31, 1998
</TABLE>
INTEREST INCOME AND AVERAGE EARNING ASSET YIELD
The Company had average earning assets of $1.5 billion and $448.3 million
for the year ended December 31, 1998 and the period ended December 31, 1997,
respectively. The Company's primary source of income for the year ended
December 31, 1998 and for the period ended December 31, 1997 was interest
income. A portion of income was generated by gains on sales of Mortgage-Backed
Securities. Interest income was $90.0 million and $24.7 million for the year
ended December 31, 1998 and for the period ended December 31, 1997,
respectively. The yield on average earning assets was 6.16% and 6.34%,
respectively, for the same periods. The table below shows the Company's average
balance of cash equivalents and Mortgage-Backed Securities, the yields earned on
each type of earning assets, the yield on average earning assets and interest
income for the year ended December 31, 1998, the period ended December 31, 1997
and the four quarters in 1998. Yields on interest earning assets declined 0.18%
for the year ended December 31, 1998 from the period ended December 31, 1997.
As previously mentioned, the average asset balance increased substantially for
the year ended December 31, 1998 and the result is increased net interest
income, even though the yield decreased.
AVERAGE EARNING ASSET YIELD
---------------------------
<TABLE>
<CAPTION>
Yield on
Average
Average Amortized
Amortized Cost Cost of Yield on
Average of Mortgage- Average Yield on Mortgage- Average
Cash Backed Earning Average Cash Backed Earning Interest
Equivalents Securities Assets Equivalents Securities Assets Income
-------------------------------------------------------------------------------------
(dollars in thousands) <C>
<S> <C> <C> <C> <C> <C> <C>
For the Year Ended December 31, 1998 $ 2 $1,461,789 $1,461,791 4.32% 6.16% 6.16% $89,985
For the Period Ended December 31, 1997 $30 $ 448,276 $ 448,306 4.20% 6.34% 6.34% $24,713
- - ---------------------------------------------------------------------------------------------------------------------------------
For the Quarter Ended December 31, 1998 $ 2 $1,446,094 $1,446,096 4.28% 6.12% 6.12% $22,136
For the Quarter Ended September 30, 1998 $ 2 $1,543,010 $1,543,012 4.20% 6.22% 6.22% $24,009
For the Quarter Ended June 30, 1998 $ 2 $1,550,968 $1,568,024 4.35% 6.13% 6.13% $23,762
For the Quarter Ended March 31, 1998 $ 2 $1,307,088 $1,307,090 4.45% 6.15% 6.15% $20,079
</TABLE>
The Constant Prepayment Rate (or "CPR") on the Company's portfolio of
Mortgage-Backed Securities for the year ended December 31, 1998 and for the
period ended December 31, 1997 was 23% and 17%, respectively. The increase in
the prepayment rate is reflected in the decline in yield on the average
interest-earning assets for the year ended December 31, 1998 from the period
ended December 31, 1997. "CPR" means an assumed rate of prepayment for the
37
<PAGE>
Company's Mortgage-Backed Securities, expressed as an annual rate of prepayment
relative to the outstanding principal balance of the Company's Mortgage-Backed
Securities. This CPR does not purport to be either a historical description of
the prepayment experience of the Company's Mortgage-Backed Securities or a
prediction of the anticipated rate of prepayment of the Company's Mortgage-
Backed Securities. Since a large portion of the Company's assets was purchased
at a premium to par value and only a small portion of the Company's assets was
purchased at a discount to par value, the premium balance in the Company's
portfolio is substantially higher than the discount balance. Principal
prepayments had a negative effect on the Company's earning asset yield for the
year ended December 31, 1998 and the period ended December 31, 1997 because the
Company adjusts its rates of premium amortization and discount accretion monthly
based upon the effective yield method, which takes into consideration changes in
prepayment speeds.
INTEREST EXPENSE AND THE COST OF FUNDS
The Company anticipates that its largest expense will usually be the cost
of borrowed funds. The Company had average borrowed funds of $1.4 billion and
total interest expense of $75.7 million for the year ended December 31, 1998.
Average borrowed funds for the period ended December 31, 1997 was $404.1 million
and the interest expense for the period was $19.7 million. The average cost of
funds was 5.57% and 5.61% for the year ended December 31, 1998 and the period
ended December 31, 1997, respectively. Interest expense is calculated in the
same manner for GAAP and tax purposes. Even though the cost of funds rate
declined for the year ended December 31, 1998, interest expense increased
because of the increase in the average repurchase balance to $1.4 billion.
With the Company's current asset/liability management strategy, changes in
the Company's cost of funds are expected to be closely correlated with changes
in short-term LIBOR, although the Company may choose to extend the maturity of
its liabilities at any time. The Company's average cost of funds was equal to
the average one-month LIBOR for the year ended December 31, 1998. The Company's
average cost of funds was 0.06% below one-month LIBOR for the period ended
December 31, 1997. The Company generally has structured its borrowings to
adjust with one-month LIBOR. During the year ended December 31, 1998, average
one-month LIBOR, which was 5.57%, was 0.03% higher than average six-month LIBOR,
which was 5.54%. During the period ended December 31, 1997, average one-month
LIBOR, which was 5.67% was 0.20% lower than average six-month LIBOR, which was
5.87%.
The table below shows the Company's average borrowed funds and average cost
of funds as compared to average one- and six-month LIBOR for the year ended
December 31, 1998, the period ended December 31, 1997 and the four quarters in
1998.
AVERAGE COST OF FUNDS
---------------------
<TABLE>
<CAPTION>
Average One- Average Cost
Average Month LIBOR of Funds Average Cost of
Average Average One- Average Relative to Relative to Funds Relative
Borrowed Interest Cost of Month Six-Month Average Six- Average One- to Average Six-
Funds Expense Funds LIBOR LIBOR Month LIBOR Month LIBOR Month LIBOR
-------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
For the Year Ended
December 31, 1998 $1,360,040 $75,735 5.57% 5.57% 5.54% 0.03% - 0.03%
For the Period Ended
December 31, 1997 $ 404,140 $19,677 5.61% 5.67% 5.87% (0.20%) (0.06%) (0.26%)
- - ---------------------------------------------------------------------------------------------------------------------------------
For the Quarter Ended
December 31, 1998 $1,371,240 $18,479 5.39% 5.36% 5.10% 0.26% 0.03% 0.29%
For the Quarter Ended
September 30, 1998 $1,460,612 $20,765 5.68% 5.62% 5.63% (0.01%) 0.06% 0.05%
For the Quarter Ended
June 30, 1998 $1,440,822 $20,178 5.60% 5.66% 5.75% (0.09%) (0.06%) (0.15%)
For the Quarter Ended
March 31, 1998 $1,167,483 $16,313 5.59% 5.64% 5.68% (0.04%) (0.05%) (0.09%)
</TABLE>
38
<PAGE>
NET INTEREST RATE AGREEMENT EXPENSE
The Company has not entered into any interest rate agreements to date. As
part of its asset/liability management process, the Company may enter into
interest rate agreements such as interest rate caps, floors and swaps. These
agreements would be entered into to reduce interest rate or prepayment risk and
would be designed to provide income and capital appreciation to the Company in
the event of certain changes in interest rates. However, even after entering
into such agreements, the Company would still be exposed to interest rate and
prepayment risks. The Company reviews the need for interest rate agreements on
a regular basis consistent with its Capital Investment Policy.
NET INTEREST INCOME
Net interest income, which equals interest income less interest expense,
totaled $14.3 million for the year ended December 31, 1998 and $5.0 million for
the period ended December 31, 1997. Net interest spread, which equals the yield
on the Company's average assets for the period less the average cost of funds
for the period, was 0.59% for the year ended December 31, 1998 and 0.73% for the
period ended December 31, 1997. Net interest margin, which equals net interest
income divided by average total assets, was 0.95% for the year ended December
31, 1998 and 1.22% on an annualized basis for the period ended December 31,
1997. Even though the interest rate spread and the net interest margin declined
from the previous year, net interest income increased due to the increased asset
size. Taxable net interest income was approximately $968,658 greater than GAAP
net interest income because of differing premium and discount amortization, for
the year ended December 31, 1998. Taxable net interest income was $92,406 less
than GAAP net interest income because of differing premium and discount
amortization, for the period ended December 31, 1997. The principal reason that
annualized net interest margin exceeded net interest spread is that average
assets exceeded average liabilities. A portion of the Company's assets is
funded with equity rather than borrowings. The Company did not have any
interest rate agreement expense for the year ended December 31, 1998 or for the
period ended December 31, 1997.
The table below shows interest income by earning asset type, average
earning assets by type, total interest income, yield on average interest earning
assets, average repurchase agreements, interest expense, average cost of funds,
and net interest income for the year ended December 31, 1998, the period ended
December 31, 1997, and the four quarters in 1998.
GAAP Net Interest Income
------------------------
(dollars in thousands)
<TABLE>
<CAPTION>
Average
Amortized
Cost of Interest Yield on
Mortgage- Income on Interest Average Average
Backed Mortgage- Average Income on Total Interest Balance of
Securities Backed Cash Cash Interest Farming Repurchase
Held Securities Equivalents Equivalents Income Assets Agreements
---------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
For the Year Ended
December 31, 1998 $1,461,790 $89,986 $ 2 $89,986 6.16% $1,360,040
For the Period Ended
December 31, 1997 $ 448,276 $24,682 $30 $31 $24,713 6.34% $ 404,140
- - ----------------------------------------------------------------------------------------------------------------------------
For the Quarter Ended
December 31, 1998 $1,446,094 $22,136 $ 2 $22,136 6.12% $1,371,240
For the Quarter Ended
September 30, 1998 $1,543,010 $24,009 $ 2 $24,009 6.22% $1,460,612
For the Quarter Ended
June 30, 1998 $1,550,968 $23,762 $ 2 $23,762 6.13% $1,440,822
For the Quarter Ended
March 31, 1998 $1,307,088 $20,079 $ 2 $20,079 6.15% $1,167,483
</TABLE>
<TABLE>
<CAPTION>
Average Net
Interest Cost of Interest
Expense Funds Income
---------------------------------
<S> <C> <C> <C>
For the Year Ended
December 31, 1998 $75,735 5.57% $14,250
For the Period Ended
December 31, 1997 $19,677 5.61% $ 5,036
- - ----------------------------------------------------------------
For the Quarter Ended
December 31, 1998 $18,479 5.39% $ 3,657
For the Quarter Ended
September 30, 1998 $20,765 5.68% $ 3,244
For the Quarter Ended
June 30, 1998 $20,178 5.60% $ 3,584
For the Quarter Ended
March 31, 1998 $16,313 5.59% $ 3,765
</TABLE>
39
<PAGE>
GAINS AND LOSSES ON SALES OF MORTGAGE-BACKED SECURITIES
For the year ended December 31, 1998, the Company sold Mortgage-Backed
Securities with an aggregate historical amortized cost of $565.2 million for an
aggregate gain of $3.3 million. During the period ended December 31, 1997 the
Company sold Mortgage-Backed Securities with a historical amortized cost of
$173.9 million for an aggregate gain of $735,303. Taxable net gains were
approximately $330,799 less than GAAP gains (losses) on sale of securities for
the year ended December 31, 1998 and $54,502 greater for the period ended
December 31, 1997. The difference between the sale price and the historical
amortized cost of the Mortgage-Backed Securities is a realized gain and
increased income accordingly. The Company does not expect to sell assets on a
frequent basis, but may from time to time sell existing assets to move into new
assets which management believes might have higher risk-adjusted returns or to
manage its balance sheet as part of management's asset/liability management
strategy.
CREDIT EXPENSES
The Company has not experienced credit losses on its portfolio of Mortgage-
Backed Securities to date, but losses may be experienced in the future. At
December 31, 1998 and 1997, the Company had limited its exposure to credit
losses on its portfolio of Mortgage-Backed Securities by purchasing only
securities, issued or guaranteed by FNMA, FHLMC or GNMA ("Agency certificates"),
which, although not rated, carry an implied "AAA" rating.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses ("operating expense" or "G&A expense")
were $2.1 million for the year ended December 31, 1998 and $851,990 for the
period ended December 31, 1997. Taxable G&A expenses were approximately $6,496
and $2,718 less than for GAAP purposes for the year ended December 31, 1998 and
the period ended December 31, 1997, respectively. Even though G&A expense
increased in total from the period ended December 31, 1997 to the year ended
December 31, 1998, G&A expense as a percentage of assets declined to 0.14% from
0.21%. The Company experienced economies of scale with the increasing asset
base and because it is internally managed. Also, it intends to continue to be a
low cost provider.
GAAP G&A EXPENSE AND OPERATING EXPENSE RATIOS
---------------------------------------------
<TABLE>
<CAPTION>
Total G&A Total G&A
Cash Comp and Expense/Average Expense/Average
Benefits Other G&A Total G&A Assets Equity
Expense Expense Expense (annualized) (annualized)
----------------------------------------------------------------------------------
(dollars in thousands)
<S> <C> <C> <C> <C> <C>
For the Year Ended
December 31, 1998 $1,210 $896 $2,106 0.14% 1.60%
For the Period Ended
December 31, 1997 $ 492 $360 $ 852 0.21% 1.61%
- - ---------------------------------------------------------------------------------------------------------------------
For the Quarter Ended
December 31, 1998 $ 380 $219 $ 599 0.15% 1.90%
For the Quarter Ended
September 30, 1998 $ 318 $210 $ 528 0.13% 1.61%
For the Quarter Ended
June 30, 1998 $ 252 $242 $ 494 0.13% 1.50%
For the Quarter Ended
March 31, 1998 $ 259 $225 $ 484 0.15% 1.44%
</TABLE>
40
<PAGE>
NET INCOME AND RETURN ON AVERAGE EQUITY
Net income was $15.5 million in the year ended December 31, 1998 and $4.9
million for the period ended December 31, 1997. Return on average equity was
11.80% for the year ended December 31, 1998 and 9.27% on an annualized basis for
the period ended December 31, 1997. The table below shows the Company's net
interest income, gain on sale of Mortgage-Backed Securities and G&A expense each
as a percentage of average equity, and the return on average equity for the year
ended December 31, 1998, the period ended December 31, 1997 and the four
quarters in 1998.
COMPONENTS OF RETURN ON AVERAGE EQUITY
--------------------------------------
<TABLE>
<CAPTION>
Gain on Sale of
Mortgage-Backed
Net Interest Securities/ G&A Return on
Income/Average Average Expense/Average Average
Equity Equity Equity Equity
-----------------------------------------------------------------------------
<S> <C> <C> <C> <C>
For the Year ended December 31, 1998 10.85% 2.55% 1.60% 11.80%
For the Period Ended December 31, 1997
(on an annualized basis) 9.49% 1.39% 1.61% 9.27%
-----------------------------------------------------------------------------------------------------------------------------
For the Quarter Ended December 31, 1998
(on an annualized basis) 11.45% 1.97% 1.90% 11.71%
For the Quarter Ended September 30, 1998
(on an annualized basis) 9.89% 3.03% 1.61% 11.31%
For the Quarter Ended June 30, 1998
(on an annualized basis) 10.92% 1.90% 1.50% 10.32%
For the Quarter March 31, 1998
(on an annualized basis) 11.18% 4.23% 1.44% 13.97%
</TABLE>
DIVIDENDS AND TAXABLE INCOME
The Company has elected to be taxed as a REIT under the Code. Accordingly,
the Company intends to distribute substantially all of its taxable income for
each year to stockholders, including income resulting from gains on sales of
Mortgage-Backed Securities. Through December 31, 1998, earned taxable income
exceeded dividend declarations by approximately $890,370 or $0.07 per share,
based on the number of shares of Common Stock outstanding at period end.
DIVIDEND SUMMARY
----------------
<TABLE>
<CAPTION>
Weighted Cumulative
Taxable Average Common Taxable Net Dividends Dividend Undistributed
Net Shares Income Declared Total Pay-out Taxable
Income Outstanding Per Share Per Share Dividends Ratio Income
---------------------------------------------------------------------------------------------------
(dollars in thousands, except per share data)
<S> <C> <C> <C> <C> <C> <C> <C>
For the Year Ended
December 31, 1998 $16,133 12,709,116 $1.27 $1.215 $15,438 95.7% $889
For the Period Ended
December 31, 1997 $ 4,884 5,952,123 $0.82 $ 0.79 $ 4,690 96.0% $194
- - -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
41
<PAGE>
<TABLE>
<S> <C> <C> <C> <C> <C> <C> <C>
For the Quarter Ended
December 31, 1998 $ 4,107 12,648,116 $0.32 $0.315 $ 3,859 93.96% $889
For the Quarter Ended
September 30, 1998 $ 4,020 12,704,194 $0.32 $ 0.27 $ 3,415 83.74% $641
For the Quarter Ended
June 30, 1998 $ 3,746 12,757,674 $0.29 $ 0.32 $ 4,082 108.39% $ 36
For the Quarter Ended
March 31, 1998 $ 4,260 12,727,405 $0.33 $ 0.32 $ 4,082 88.07% $372
</TABLE>
FINANCIAL CONDITION
MORTGAGE-BACKED SECURITIES
All of the Company's Mortgage-Backed Securities at December 31, 1998 and
1997 were Mortgage-Backed Securities backed by Single-Family Mortgage Loans. All
of the mortgage assets underlying such Mortgage-Backed Securities were secured
with a first lien position with respect to the underlying single-family
properties. At December 31, 1998 and 1997, all the Company's Mortgage-Backed
Securities were Agency Certificates, which, although not rated, carry an implied
"AAA" rating. All of the Company's earning assets are marked-to-market at
liquidation value.
Discount balances are accreted as an increase in interest income over the
life of discount Mortgage-Backed Securities and premium balances are amortized
as a decrease in interest income over the life of premium Mortgage-Backed
Securities. At December 31, 1998 and 1997, the Company had on its balance sheet
a total of $608,579 and $114,186, respectively, of unamortized discount (which
is the difference between the remaining principal value and current historical
amortized cost of Mortgage-Backed Securities acquired at a price below principal
value) and a total of $24.9 million and $21.5 million, respectively, of
unamortized premium (which is the difference between the remaining principal
value and the current historical amortized cost of Mortgage-Backed Securities
acquired at a price above principal value).
Mortgage principal repayments received were $486.3 million and $79.8
million for the year ended December 31, 1998 and for the period ended December
31, 1997, respectively. Given the Company's current portfolio composition, if
mortgage principal prepayment rates increase over the life of the Mortgage-
Backed Securities comprising the current portfolio, all other factors being
equal, the Company's net interest income should decrease during the life of such
Mortgage-Backed Securities as the Company will be required to amortize its net
premium balance into income over a shorter time period. Similarly, if mortgage
principal prepayment rates decrease over the life of such Mortgage-Backed
Securities, all other factors being equal, the Company's net interest income
should increase during the life of such Mortgage-Backed Securities as the
Company will amortize its net premium balance over a longer time period.
The table below summarizes the Company's Mortgage-Backed Securities, at the
dates indicated.
MORTGAGE-BACKED SECURITIES
--------------------------
<TABLE>
<CAPTION>
Estimated Fair
Amortized Estimated Value/ Weighted
Net Amortized Cost/Principal Fair Principal Average
Principal Value Premium Cost Value Value Value Yield
---------------------------------------------------------------------------------------------------
(dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C>
At December 31, 1998 $1,502,414 $24,278 $1,526,692 101.62% $1,520,289 101.19% 6.43%
At December 31, 1997 $1,138,365 $21,390 $1,159,755 101.88% $1,161,779 102.06% 6.57%
- - -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
42
<PAGE>
<TABLE>
<S> <C> <C> <C> <C> <C> <C> <C>
At September 30, 1998 $1,461,056 $24,244 $1,485,300 101.66% $1,483,195 101.52% 6.49%
At June 30, 1998 $1,541,520 $26,532 $1,568,052 101.72% $1,566,188 101.60% 6.50%
At March 31, 1998 $1,495,670 $25,265 $1,520,935 101.70% $1,518,847 101.55% 6.51%
</TABLE>
The tables below set forth certain characteristics of the Company's
Mortgage-Backed Securities. The index level for adjustable-rate Mortgage-Backed
Securities is the weighted average rate of the various short-term interest rate
indices which determine the coupon rate.
ADJUSTABLE-RATE MORTGAGE-BACKED SECURITY CHARACTERISTICS
--------------------------------------------------------
<TABLE>
<CAPTION>
Weighted Weighted Weighted
Average Average Weighted Average Term to Weighted
Principal Coupon Index Average Net Next Average
Value Rate Level Margin Adjustment Lifetime Cap
------------------------------------------------------------------------------------------------------
(dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
At December 31, 1998 $1,030,654 6.84% 5.18% 1.66% 12 months 10.63%
At December 31, 1997 $ 994,653 7.13% 5.52% 1.61% 22 months 10.78%
- - ---------------------------------------------------------------------------------------------------------------------------------
At September 30, 1998 $1,050,177 6.78% 5.20% 1.68% 13 months 10.42%
At June 30, 1998 $1,140,518 6.86% 5.20% 1.66% 15 months 10.42%
At March 31, 1998 $1,176,716 6.89% 5.45% 1.61% 12 months 10.00%
<CAPTION>
Principal Value at
Weighted Period End as % of
Average Asset Mortgage-
Yield Backed Securities
<S> <C> <C>
At December 31, 1998 6.42% 68.60%
At December 31, 1997 6.50% 87.38%
- - -----------------------------------------------------------------------
At September 30, 1998 6.51% 71.88%
At June 30, 1998 6.46% 73.98%
At March 31, 1998 6.46% 78.68%
</TABLE>
<TABLE>
<CAPTION>
FIXED-RATE MORTGAGE-BACKED SECURITY CHARACTERISTICS
---------------------------------------------------
Weighted Weighted Principal Value as
Principal Average Average % of Mortgage-
Value Coupon Rate Asset Yield Backed Securities
------------------------------------------------------------------------------------
(dollars in thousands)
<S> <C> <C> <C> <C>
At December 31, 1998 $471,760 6.55% 6.47% 31.40%
At December 31, 1997 $143,712 7.50% 7.08% 12.62%
----------------------------------------------------------------------------------------------------------------------
At September 30, 1998 $410,879 6.69% 6.47% 28.12%
At June 30, 1998 $401,002 6.82% 6.65% 26.02%
At March 31, 1998 $318,954 6.85% 6.70% 21.32%
</TABLE>
At December 31, 1998, the Company held Mortgage-Backed Securities with
coupons linked to the one-year, three-year, and five-year Treasury Indices, one-
month LIBOR and the six-month CD rate. The table below segments the Company's
adjustable-rate Mortgage-Backed Securities by type of adjustment index, coupon
adjustment frequency and annual and lifetime cap adjustment.
ADJUSTABLE-RATE MORTGAGE-BACKED SECURITIES BY INDEX
---------------------------------------------------
DECEMBER 31, 1998
-----------------
<TABLE>
<CAPTION>
1-Year 3-Year
One-Month Six-Month Treasury Treasury 5-Year Treasury
LIBOR CD Rate Index Index Index
----------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Weighted Average Adjustment Frequency 1 mo. 6 mo. 32 mo. 36 mo. 60 mo.
</TABLE>
43
<PAGE>
<TABLE>
<S> <C> <C> <C> <C> <C>
Weighted Average Term to Next Adjustment 1 mo. 3 mo. 23 mo. 9 mo. 2 mo.
Weighted Average Annual Period Cap None 1.00% 1.83% 2.00% 2.00%
Weighted Average Lifetime Cap at
December 31, 1998 9.16% 11.04% 11.76% 13.07% 11.57%
Mortgage Principal Value as Percentage of
Mortgage-Backed Securities at
December 31, 1998 29.60% 3.73% 33.33% 1.62% 0.32%
</TABLE>
At December 31, 1997, the Company held Mortgage-Backed Securities with
coupons linked to the one-year and three-year Treasury indices, one-month LIBOR,
and the six-month CD rate. The table below segments the Company's adjustable-
rate Mortgage Backed Securities by type of adjustment index, coupon adjustment
frequency, and annual and lifetime cap adjustment.
ADJUSTABLE-RATE MORTGAGE-BACKED SECURITIES BY INDEX
---------------------------------------------------
DECEMBER 31, 1997
-----------------
<TABLE>
<CAPTION>
1-Year 3-Year
One-Month Six-Month Treasury Treasury
LIBOR CD Rate Index Index
------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Weighted Average Adjustment Frequency 1 mo. 6 mo. 12 mo. 36 mo.
Weighted Average Term to Next Adjustment 1 mo. 3 mo. 6 mo. 12 mo.
Weighted Average Annual Period Cap None 2.00% 1.78% 2.00%
Weighted Average Lifetime Cap at
December 31, 1997 9.21% 10.88% 11.77% 14.16%
Mortgage Principal Value as Percentage of
Mortgage-Backed Securities at
December 31, 1997 30.94% 7.81% 48.45% .18%
</TABLE>
The table below shows unrealized gains and losses on the Mortgage-Backed
Securities in the Company's portfolio at the dates indicated.
UNREALIZED GAINS AND LOSSES
---------------------------
(dollars in the thousands)
<TABLE>
<CAPTION>
At December 31, At December 31, At September 30, At June 30, At March 31,
1998 1997 1998 1998 1998
---------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Unrealized Gain $ 3,302 $ 3,253 $ 7,060 $ 2,826 $ 2,622
Unrealized Loss (9,706) (1,229) (9,164) (4,736) (4,710)
---------------------------------------------------------------------------------------
Net Unrealized Gain ( Loss) (6,404) 2,024 (2,104) (1,910) (2,088)
=======================================================================================
Net Unrealized Gain (Loss) as % of
Mortgage-Backed Securities Principal Value (0.43%) 0.18% (0.14%) (0.12%) (0.14%)
Net Unrealized Gain (Loss) as % of
Mortgage-Backed Securities Amortized Cost (0.42%) 0.17% (0.14%) (0.12%) (0.14%)
</TABLE>
44
<PAGE>
INTEREST RATE AGREEMENTS
Interest rate agreements are assets that are carried on a balance sheet at
estimated liquidation value. At December 31, 1998 and 1997, there were no
interest rate agreements on the Company's balance sheet. No interest rate
agreements have been entered into since inception of the Company.
BORROWINGS
To date, the Company's debt has consisted entirely of borrowings
collateralized by a pledge of the Company's Mortgage-Backed Securities. These
borrowings appear on the balance sheet as repurchase agreements. At December
31, 1998, the Company had established uncommitted borrowing facilities in this
market with twenty-three lenders in amounts, which the Company believes, are in
excess of its needs. All of the Company's Mortgage-Backed Securities are
currently accepted as collateral for such borrowings. The Company, however,
limits its borrowings, and thus its potential asset growth, in order to maintain
unused borrowing capacity while increasing the liquidity and strength of its
balance sheet.
For the year ended December 31, 1998 and for the period ended December 31,
1997, the term to maturity of the Company's borrowings has ranged from one day
to one year, with a weighted average original term to maturity of 49 days and 50
days, respectively. The weighted average remaining maturity was 29 days and 16
days at December 31, 1998, and 1997, respectively. Many of the Company's
borrowings have a cost of funds which adjust monthly based on a fixed spread
over or under one-month LIBOR or based on the daily Fed Funds rate. As a
result, the average term to the next rate adjustment for the Company's
borrowings is typically shorter than the term to maturity for the Company's
Mortgage-Backed Securities. At December 31, 1998, the weighted average cost of
funds for all of the Company's borrowings was 5.21% and the weighted average
term to next rate adjustment was 29 days. At December 31, 1997, the weighted
average cost of funds for all the Company's borrowings was 6.16% and the
weighted average term to next rate adjustment was 16 days.
LIQUIDITY
Liquidity, which is the Company's ability to turn non-cash assets into
cash, allows the Company to purchase additional Mortgage-Backed Securities and
to pledge additional assets to secure existing borrowings should the value of
pledged assets decline. Potential immediate sources of liquidity for the
Company include cash balances and unused borrowing capacity. Unused borrowing
capacity will vary over time as the market value of the Company's Mortgage-
Backed Securities varies. The Company's balance sheet also generates liquidity
on an on-going basis through mortgage principal repayments and net earnings held
prior to payment as dividends. Should the Company's needs ever exceed these on-
going sources of liquidity, plus the immediate sources of liquidity discussed
above, management believes that the Company's Mortgage-Backed Securities could
in most circumstances be sold to raise cash. The maintenance of liquidity is
one of the goals of the Company's Capital Investment Policy. Under this policy,
asset growth is limited in order to preserve unused borrowing capacity for
liquidity management purposes.
STOCKHOLDERS' EQUITY
The Company uses "available-for-sale" treatment for its Mortgage-Backed
Securities; these assets are carried on the balance sheet at estimated market
value rather than historical amortized cost. Based upon such "available-for-
sale" treatment, the Company's equity base at December 31, 1998 was $125.9
million, or $9.95 per share. If the Company had used historical amortized cost
accounting, the Company's equity base at December 31, 1998 would have been
$132.3 million, or $10.46 per share. The Company's equity base at December 31,
1997 was $133.1 million, or $10.47 per share. Under the historical amortized
cost, the equity base at December 31, 1997 would have been $135.1 million, or
$10.62. The decline in book value from $10.47 to $9.95 is primarily due to the
change in the market value of the investment portfolio. The change had a $8.4
million negative impact on the book value of the Company from December 31, 1997
to December 31, 1998. This change reflects the disarray that was prevalent in
the fourth quarter in the fixed income markets. These conditions led to
multiple easings of monetary policy by the Federal Reserve Bank. Since the
Company classifies all investment securities as "available for sale", the entire
portfolio is recorded daily at market value, and is measured quarterly by the
average price provided by three independent sources.
45
<PAGE>
With the Company's "available-for-sale" accounting treatment, unrealized
fluctuations in market values of assets do not impact GAAP or taxable income but
rather are reflected on the balance sheet by changing the carrying value of the
asset and reflecting the change in stockholders' equity under "Accumulated Other
Comprehensive Income." By accounting for its assets in this manner, the Company
hopes to provide useful information to stockholders and creditors and to
preserve flexibility to sell assets in the future without having to change
accounting methods.
As a result of this mark-to-market accounting treatment, the book value and
book value per share of the Company are likely to fluctuate far more than if the
Company used historical amortized cost accounting. As a result, comparisons
with companies that use historical cost accounting for some or all of their
balance sheet may be misleading.
Unrealized changes in the estimated net market value of Mortgage-Backed
Securities have one direct effect on the Company's potential earnings and
dividends: positive market-to-market changes will increase the Company's equity
base and allow the Company to increase its borrowing capacity while negative
changes will tend to limit borrowing capacity under the Company's Capital
Investment Policy. A very large negative change in the net market value of the
Company's Mortgage-Backed Securities might impair the Company's liquidity
position, requiring the Company to sell assets with the likely result of
realized losses upon sale. "Net Unrealized Losses on Assets Available for Sale"
was $6.4 million, or 0.42% of the amortized cost of Mortgage-Backed Securities,
at December 31, 1998. "Net Unrealized Gain on Assets Available for Sale" was
$2.0 million, or 0.17% of the amortized cost of Mortgage-Backed Securities, at
December 31, 1997.
The table below shows the Company's equity capital base as reported and on
a historical amortized cost basis at December 31, 1998 and 1997, September 30,
1998, June 30, 1998, and March 31, 1998. Issuances of Common Stock, the level of
GAAP earnings as compared to dividends declared, and other factors influence the
historical cost equity capital base. The GAAP reported equity capital base is
influenced by these factors plus changes in the "Net Unrealized Gains (Losses)
on Assets Available for Sale" account.
STOCKHOLDERS' EQUITY
--------------------
<TABLE>
<CAPTION>
Net Unrealized GAAP
Historical Gains (Losses) on Reported Historical GAAP Reported
Amortized Cost Assets Available Equity Base Amortized Cost Equity (Book Value)
Equity Base for Sale (Book Value) Equity Per Share Per Share
-------------------------------------------------------------------------------------------------------
(dollars in thousands, except per share data)
<S> <C> <C> <C> <C> <C>
At December 31, 1998 $132,275 ($6,404) $125,871 $10.46 $ 9.95
At December 31, 1997 $133,063 $2,024 $135,087 $10.47 $10.62
- - --------------------------------------------------------------------------------------------------------------------------------
At September 30, 1998 $132,446 ($2,105) $130,342 $10.47 $10.30
At June 30, 1998 $133,055 ($1,910) $131,145 $10.43 $10.28
At March 31, 1998 $133,751 ($2,088) $131,663 $10.48 $10.32
</TABLE>
LEVERAGE
The Company's debt-to-GAAP reported equity ratio at December 31, 1998 and
1997 was 10:1 and 7:1, respectively. The Company generally expects to maintain
a ratio of debt-to-equity of between 8:1 and 12:1, although the ratio may vary
from time to time based upon various factors, including management's opinion of
the level of risk of its assets and liabilities, the Company's liquidity
position, the level of unused borrowing capacity and over-collateralization
levels required by lenders when the Company pledges assets to secure borrowings.
The target debt-to-GAAP reported equity ratio is determined under the
Company's Capital Investment Policy. Should the actual debt-to-equity ratio of
the Company increase above the target level due to asset acquisition and/or
46
<PAGE>
market value fluctuations in assets, management will cease to acquire new
assets. Management will, at such time, present a plan to its Board of Directors
to bring the Company back to its target debt-to-equity ratio; in many
circumstances, this would be accomplished in time by the monthly reduction of
the balance of Mortgage-Backed Securities through principal repayments.
ASSET/LIABILITY MANAGEMENT AND EFFECT OF CHANGES IN INTEREST RATES
Management continually reviews the Company's asset/liability management
strategy with respect to interest rate risk, mortgage prepayment risk, credit
risk and the related issues of capital adequacy and liquidity. The Company
seeks attractive risk-adjusted stockholder returns while maintaining a strong
balance sheet.
The Company seeks to manage the extent to which net income changes as a
function of changes in interest rates by matching adjustable-rate assets with
variable-rate borrowings. In addition, although it has not done so to date, the
Company may seek to mitigate the potential impact on net income of periodic and
lifetime coupon adjustment restrictions in its portfolio of Mortgage-Backed
Securities by entering into interest rate agreements such as interest rate caps
and interest rate swaps.
Changes in interest rates may also have an effect on the rate of mortgage
principal prepayments and, as a result, prepayments on Mortgage-Backed
Securities. The Company seeks to mitigate the effect of changes in the mortgage
principal repayment rate from an economic point of view by balancing assets
purchased at a premium with assets purchased at a discount. To date, the
aggregate premium exceeds the aggregate discount on Mortgage-Backed Securities
in the Company's portfolio. As a result, prepayments, which result in the
expensing of unamortized premium, will reduce the Company's net income compared
to what net income would be absent such prepayments.
STATUS OF YEAR 2000 COMPLIANCE
The company has made an ongoing effort to stay abreast of the year 2000
compliance issue. Hardware and software was checked for compliance and necessary
upgrades were completed. In consideration of the Year 2000 issues, the Company
has reviewed the ability of its own computers and computer programs to properly
recognize and handle dates in the Year 2000. Through the normal upgrading of
computer equipment, the Company has already replaced all computers that were not
Year 2000 compliant. The Company has also reviewed all the date fields embedded
in its internally developed spreadsheets, databases and other programs and has
determined that all such programs are using four-digit years in references to
dates. Therefore, the Company believes that all of its equipment and internal
systems are ready for the Year 2000. To date, the Company has incurred minimal
costs in order to be Year 2000 compliant.
The Company believes that most of its exposure to Year 2000 issues involves
the readiness of third parties. Each third party is subject to the Year 2000
issue. The Company is in the process of surveying pertinent third parties for
their compliance. As a result of communications with such third parties, the
Company believes that they are spending the appropriate and necessary resources
to try to identify Year 2000 issues and to resolve them or to mitigate the
impact of them to the best of their ability as they are identified.
INFLATION
Virtually all of the Company's assets and liabilities are financial in
nature. As a result, interest rates and other factors drive the Company's
performance far more than does inflation. Changes in interest rates do not
necessarily correlate with inflation rates or changes in inflation rates. The
Company's financial statements are prepared in accordance with GAAP and the
Company's dividends are determined by the Company's net income as calculated for
tax purposes; in each case, the Company's activities and balance sheet are
measured with reference to historical cost or fair market value without
considering inflation.
OTHER MATTERS
The Company calculated its qualified REIT Assets, as defined in the
Internal Revenue Code of 1986, as amended (the "Code"), to be 100% of its total
assets at December 31, 1998 and 1997, as compared to the Code
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requirement that at least 75% of its total assets must be qualified REIT Assets.
The Company also calculates that 96.4% and 97.1% of its revenue qualifies for
the 75% source of income test and 100% of its revenue qualifies for the 95%
source of income test under the REIT rules for the year ended December 31, 1998
and the period ended December 31, 997, respectively. The Company also met all
REIT requirements regarding the ownership of its Common Stock and the
distributions of its net income. Therefore, as of December 31, 1998 and 1997,
the Company believes that it qualified as a REIT under the provisions of the
Code.
The Company at all times intends to conduct its business so as not to
become regulated as an investment company under the Investment Company Act of
1940. If the Company were to become regulated as an investment company, then
the Company's use of leverage would be substantially reduced. The Investment
Company Act exempts entities that are "primarily engaged in the business of
purchasing or otherwise acquiring mortgages and other liens on and interests in
real estate" ("Qualifying Interests"). Under current interpretation of the
staff of the Commission, in order to qualify for this exemption, the Company
must maintain at least 55% of its assets directly in Qualifying Interests. In
addition, unless certain mortgage securitites represent all the certificates
issued with respect to an underlying pool of mortgages, such mortgage securities
may be treated as securities separate from the underlying mortgage loans and,
thus, may not be considered Qualifying Interests for purposes of the 55%
requirement. As of December 31, 1998 and 1997, the Company calculates that it
is in compliance with this requirement.
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ITEM. 7A QUANTITATIVE AND QUALITIATIVE 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 the value of the Company's Mortgage-Backed Securities 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 exchange 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. Currently, hedging
instruments have not been purchased by the Company. 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 400
basis points, assuming the yield curves of the rate shocks will be parallel to
each other and the current yield curve. Net portfolio value is defined as
interest-earning assets net of interest-bearing liabilities. All changes in
income and value are measured as percentage changes from the projected net
interest income and net portfolio value at the base interest rate scenario. The
base interest rate scenario assumes interest rates at December 31, 1998 and
various estimates regarding prepayment and all activities are made at each level
of rate shock. Actual results could differ significantly from these estimates.
<TABLE>
<CAPTION>
Projected Percentage Change in Projected Percentage Change in
Change in Interest Rate Net Interest Income Net Portfolio Value
- - ------------------------------------------------------------------------------------------------------------------
<S> <C> <C>
- - -400 Basis Points 60% 3%
- - -300 Basis Points 22% 3%
- - -200 Basis Points 43% 2%
- - -100 Basis Points 33% 2%
Base Interest Rate
+100 Basis Points (46%) (1%)
+200 Basis Points (77%) (3%)
+300 Basis Points (84%) (6%)
+400 Basis Points (85%) (11%)
</TABLE>
ASSET AND LIABILITY MANAGEMENT
Asset and liability management is concerned with 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. 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. Because different types of assets and
liabilities with the same or similar maturities may react differently to changes
in overall market rates or conditions, changes in interest rates may
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affect net interest income positively or negatively even if an institution were
perfectly matched in each maturity category.
The following table sets forth the estimated maturity or repricing of 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>
More than 1
Within 3 Year to 3 3 Years and
Months 4-12 Months Years Over Total
-------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Rate Sensitive Assets:
Mortgage-Backed Securities 614,235 226,655 178,557 507,246 1,526,693
Rate Sensitive Liabilities:
Repurchase Agreements 1,280,510 1,280,510
-------------------------------------------------------------------------------------------------
Interest rate sensitivity gap (666,275) 226,655 178,557 507,246
Cumulative rate sensitivity gap (666,275) (439,620) (261,063) 246,183
Cumulative interest rate
sensitivity gap as a percentage
of total rate-sensitive assets (44%) (29%) (17%) 16%
</TABLE>
50
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ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements of the Company and the related notes, together with the
Independent Auditors' Report thereon are set forth on pages F-1 through F-14 on
this Form 10-K.
ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 10 DIRECTORS AND OFFICERS OF THE REGISTRANT
The information required by Item 10 is incorporated herein by reference to the
definitive Proxy Statement filed pursuant to Regulation 14A under the headings
"Election of Directors," "Management of the Company," "Nominees for Directors of
the Company," and "Section 16(a) Beneficial Ownership Reporting Requirements."
ITEM 11 EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated herein by reference to the
definitive Proxy Statement filed pursuant to Regulation 14A under the heading
"Executive Compensation."
ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 12 is incorporated herein by reference to the
definitive Proxy Statement filed pursuant to Regulation 14A under the heading
"Security Ownership of Certain Beneficial Owners and Management."
ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated herein by reference to the
definitive Proxy Statement filed pursuant to Regulation 14A under the heading
"Certain Transactions."
PART IV
ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Documents filed as part of this report:
1. Financial Statements.
2. Schedules to Financial Statements:
All financial statement schedules not included have been omitted because they
are either inapplicable or the information required is provided in the Company's
Financial Statements and Notes thereto, included in Part II, Item 8, of this
Annual Report on Form 10-K.
3. Exhibits:
3.1 Articles of Incorporation of the Registrant (incorporated by reference to
Exhibit 3.1 to the Company's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
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<PAGE>
3.2 Articles of Amendment and Restatement of the Articles of Incorporation of
the Registrant (incorporated by reference to Exhibit 3.2 to the Company's
Registration Statement on Form S-11 (Registration No. 333-32913) filed
with the Securities and Exchange Commission on August 5, 1997).
3.3 Bylaws of the Registrant, as amended (incorporated by reference to
Exhibit 3.3 to the Company's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
4.1 Specimen Common Stock Certificate (incorporated by reference to Exhibit
4.1 to Amendment No. 1 to the Company's Registration Statement on Form S-
11(Registration No. 333-32913) filed with the Securities and Exchange
Commission on September 17, 1997.
10.1 Purchase Agreement, dated February 12, 1997, between the Registrant and
Freedman, Billings, Ramsey & Co., Inc. ("FBR") (incorporated by reference
to Exhibit 10.1 to the Company's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
10.2 Registration Rights Agreement, dated February 12, 1997, between the
Registrant and FBR (incorporated by reference to Exhibit 10.2 to the
Company's Registration Statement on Form S-11 (Registration No. 333-
32913) filed with the Securities and Exchange Commission on August 5,
1997).
10.3 Long-Term Stock Incentive Plan (incorporated by reference to Exhibit 10.3
to the Company's Registration Statement on Form S-11 (Registration No.
333-32913) filed with the Securities and Exchange Commission on August 5,
1997).
10.4 Employment Agreement, effective as of January 27, 1997, between the
Company and Michael A.J. Farrell (incorporated by reference to Exhibit
10.4 to the Company's Registration Statement on Form S-11 (Registration
No. 333-32913) filed with the Securities and Exchange Commission on
August 5, 1997).
10.5 Employment Agreement, effective as of January 27, 1997, between the
Company and Timothy J. Guba (incorporated by reference to Exhibit 10.5 to
the Company's Registration Statement on Form S-11 (Registration No. 333-
32913) filed with the Securities and Exchange Commission on August 5,
1997).
10.6 Employment Agreement, effective as of January 27, 1997, between the
Company and Wellington J. St. Claire (incorporated by reference to
Exhibit 10.6 to the Company's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
10.7 Form of Master Repurchase Agreement (incorporated by reference to Exhibit
10.7 to the Company's Registration Statement on Form S-11 (Registration
No. 333-32913) filed with the Securities and Exchange Commission on
August 5, 1997).
10.8 Form of Purchase Agreement between the Company and the purchasers in the
Direct Offering (incorporated by reference to Exhibit 10.8 to the
Company's Registration Statement on Form S-11 (Registration No. 333-
32913) filed with the Securities and Exchange Commission on August 5,
1997).
10.9 Employment Agreement, effective as of November 1, 1997, between the
Company and Kathryn F. Fagan (incorporated by reference to Exhibit 10.9
to the Company's Form 10-K for the fiscal year ended December 31, 1997).
23.1 Consent of Independent Accountants.
27. Financial Data Schedule
(b) Reports on Form 8-K
No reports on Form 8-K have been filed during the last quarter of the period
covered by this report.
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<PAGE>
GLOSSARY
As used in this Form 10K, the capitalized and other terms listed below have
the meanings indicated.
"Agency" means GNMA, FNMA or FHLMC.
"Agency Certificates" means GNMA Certificates, FNMA Certificates and FHLMC
Certificates.
"amortized cost" means, with respect to Mortgage-Backed Securities, the
purchase price as adjusted for subsequent amortization of discount or premium
and for principal repayments.
"ARM" means a Mortgage Loan or any mortgage loan underlying a Mortgage-
Backed Security that features adjustments of the underlying interest rate at
predetermined times based on an agreed margin to an established index. An ARM is
usually subject to periodic interest rate and/or payment caps and a lifetime
interest rate cap.
"ARM Certificate" means an adjustable-rate Pass-Through Certificate.
"Articles of Incorporation" means the Company's Articles of Incorporation,
as amended and restated by the Company's Articles of Amendment and Restatement,
filed with the State of Maryland.
"Bankruptcy Code" means Title 11 of the United State Code, entitled
"Bankruptcy."
"Board" or "Board of Directors" means the Board of Directors of the Company.
"Capital Investment Policy" means the policy established by the Company,
including a majority of the Independent Directors, establishing guidelines for
management relating to asset acquisitions, credit risk management, capital and
leverage, interest rate risk management and prepayment risk management, as more
fully described under "Business Strategy--Capital Investment Policy."
"capital stock" means the Common Stock and any additional classes of capital
stock authorized by the Board of Directors in the future.
"carrying value" means the value placed on an asset or liability for balance
sheet presentation purposes. With respect to Mortgage-Backed Securities and
interest rate cap agreements, the carrying value equals management's estimate of
the bid-side market value of that asset. Management will generally base its
estimate on the lowest of third-party bid-side indications of market value
obtained on a regular basis from firms making a market in or lending against
such assets. With respect to all other balance sheet items, carrying value
equals amortized cost.
"CD Rate" means the weekly average of secondary market interest rates on
six-month negotiable certificates of deposit, as published by the Federal
Reserve Board in its Statistical Release H.15(519), Selected Interest Rates.
"CMOs" or "Collateralized Mortgage Obligations" means adjustable- or fixed-
rate debt obligations (bonds) that are collateralized by Mortgage Loans or
mortgage certificates. CMOs are structured so that principal and interest
payments received on the collateral are sufficient to make principal and
interest payments on the bonds. Such bonds may be issued by United States
government sponsored entities or private issuers in one or more classes with
fixed or adjustable interest rates, maturities and degrees of subordination
which are characteristics designed for the investment objectives of different
bond purchasers.
"Code" means the Internal Revenue Code of 1986, as amended.
"Commercial Mortgage Loans" means Mortgage Loans secured by commercial
property.
"Commission" means the Securities and Exchange Commission.
"Common Stock" means the Company's shares of Common Stock, par value $0.01
per share.
53
<PAGE>
"Company" means Annaly Mortgage Management, Inc., a Maryland corporation.
"Conforming Mortgage Loans" means Single-Family Mortgage Loans that either
comply with requirements for inclusion in credit support programs sponsored by
FHLMC or FNMA or are FHA or VA Loans.
"coupon rate" means, with respect to Mortgage-Backed Securities, the
annualized cash interest income actually received from the asset, expressed as a
percentage of the face value of the asset.
"CPR" means an assumed rate of prepayment for the Company's Mortgage-Backed
Securities, expressed as an annual rate of prepayment relative to the
outstanding principal balance of the Company's Mortgage-Backed Securities. CPR
does not purport to be either a historical description of the prepayment
experience of the Company's Mortgage-Backed Securities or a prediction of the
anticipated rate of prepayment of the Company's Mortgage-Backed Securities.
"Direct Offering" means the Company's sale on July 31, 1997 of an aggregate
of 87,800 shares of Common Stock to certain directors, officers and employees of
the Company.
"DOL" means the Department of Labor.
"Dollar-Roll Agreement" means an agreement to sell a security for delivery
on a specified future date and a simultaneous agreement to repurchase the same
or a substantially similar security (with the same coupon and original maturity
periods) on a specified future date.
"duration" means the expected percentage change in the market value of the
Company's assets that would be caused by a 1% change in short and long term
interest rates.
"efficiency ratio" means general and administrative expenses as a percentage
of net interest income.
"ERISA" means the Employee Retirement Income Security Act of 1974, as
amended.
"ERISA Plan" means a pension, profit-sharing, retirement or other employee
benefit plan which is subject to Title I of ERISA.
"Excess Securities" means shares of capital stock representing ownership,
directly or constructively, in excess of 9.8%, in number of shares or value, of
any class of shares of the outstanding capital stock (except as otherwise waived
by the Board of Directors).
"Exchange Act" means the Securities Exchange Act of 1934, as amended.
"Excess Capital Cushion" is a term defined in the Company's Capital
Investment Policy. It represents a portion of the capital the Company is
required to maintain as part of this policy in order to continue to make asset
acquisitions. The Excess Capital Cushion is that part of the required capital
base which is in excess of the Company's haircut requirements
"face value" means, with respect to Mortgage-Backed Securities, the
outstanding principal balance of Mortgage Loans or Mortgage-Backed Securities
comprising the Mortgage-Backed Securities. In the absence of credit losses, the
face value equals the sum of the principal repayments that will be received by
the Company over the life of the Mortgage-Backed Security.
"Federal Reserve Board" means the Board of Governors of the Federal Reserve
System.
"Fed Funds Rate" means the interest rate charged by banks with excess
reserves at a Federal Reserve System district bank to banks needing overnight
loans to meet reserve requirements.
"FHA" means the United States Federal Housing Administration.
54
<PAGE>
"FHA Loans" means Mortgage Loans insured by the FHA.
"FHLMC" means the Federal Home Loan Mortgage Corporation.
"FHLMC ARM Certificates" means adjustable-rate FHLMC Certificates.
"FHLMC Certificates" means mortgage participation certificates issued by
FHLMC, either in certificate or book-entry form.
"FIDAC" means Fixed Income Discount Advisory Company, a Delaware
corporation.
"Floaters" means adjustable-rate CMOs.
"FNMA" means the Federal National Mortgage Association.
"FNMA ARM Certificates" means adjustable-rate FNMA Certificates.
"FNMA Certificates" means mortgage pass-through certificates issued by FNMA,
either in certificated or book-entry form.
"Founders' Shares" means the 80,000 shares of Common Stock issued to
founders of the Company in December 1996.
"fully-indexed rate" means, with respect to ARMs, the rate that would be
paid by the borrower ("gross") or received by the Company as owner of the
Mortgage Asset ("net") if the coupon rate on the ARM were able to adjust
immediately to a market rate without being subject to adjustment periods,
periodic caps, or life caps. It is equal to the current yield of the ARM index
plus the gross or net margin.
"GAAP" means generally accepted accounting principles.
"GNMA" means the Government National Mortgage Association.
"GNMA ARM Certificates" means adjustable-rate GNMA Certificates.
"GNMA Certificates" means fully modified pass-through mortgage-backed
certificates guaranteed by GNMA and issued either in certificated or book-entry
form.
"gross margin" means, with respect to ARMs, the coupon rate to be paid by
the borrower. The term "gross" is used to differentiate payments made by the
borrower with the lower "net" payments actually received by the Company after
the acquisition of a Mortgage Asset. The difference between the gross margin and
the net margin reflects loan servicing fees and other pre-determined contractual
deductions. The fully-indexed gross coupon rate equals the current yield on the
ARM index (six month LIBOR, one year Treasury, etc.) plus the gross margin. The
actual coupon rate paid by the borrower may be lower than the fully-indexed
gross rate at the initiation of the loan if originated at a "teaser rate" or
during periods of rising interest rates due to the limitations of the ARM
adjustment schedule and the periodic and life caps. If so, the coupon rate paid
by the borrower would move towards the fully-indexed gross rate over time.
"haircut" means the over-collateralization amount required by a lender in
connection with a collateralized borrowing.
"High Quality" means (i) securities which are rated within one of the two
highest rating categories by at least one of the nationally recognized rating
agencies, (ii) securities that are unrated but are guaranteed by the United
States government or an agency of the United States government, or (iii)
securities that are unrated or whose ratings have not been updated but are
determined to be of comparable quality to rated High Quality Mortgage-Backed
Securities on the
55
<PAGE>
basis of credit enhancement features that meet the High Quality credit criteria
approved by the Company's Board of Directors.
"Housing Act" means the National Housing Act of 1934, as amended.
"HUD" means the Department of Housing and Urban Development.
"Independent Director" means a director of the Company who is not an officer
or employee of the Company.
"interest-only strip," "interest only security" or "IO" means a type of
Mortgage-Backed Security which receives a portion of the interest payments from
an underlying pool of mortgage loans but will receive little or no principal
payments and hence will have little or no face value. The market value and yield
of an IO are unusually sensitive to the prepayment rates experienced on and
anticipated for the underlying pool of mortgage loans. The market values and
yields of IOs may increase as interest rates increase and, in certain
conditions, IOs may act in a counter-cyclical manner as compared to other
Mortgage-Backed Securities.
"interest rate adjustment indices" means, in the case of Mortgage-Backed
Securities, any of the objective indices based on the market interest rates of a
specified debt instrument (such as United States Treasury Bills in the case of
the Treasury Index and United States dollar deposits in London in the case of
LIBOR) or based on the average interest rate of a combination of debt
instruments (such as the 11th District Cost of Funds Index), used as a reference
base to reset the interest rate for each adjustment period on the Mortgage
Asset, and in the case of borrowings, is used herein to mean the market interest
rates of a specified debt instrument (such as repurchase agreements for
Mortgage-Backed Securities) as well as any of the objective indices described
above that are used as a reference base to reset the interest rate for each
adjustment period under the related borrowing instrument.
"interest rate adjustment period" means, in the case of Mortgage-Backed
Securities, the period of time set forth in the debt instrument that determines
when the interest rate is adjusted and, with respect to borrowings, is used to
mean the term to maturity of a short-term, fixed-rate debt instrument (such as a
30-day repurchase agreement) as well as the period of time set forth in a long-
term, adjustable-rate debt instrument that determines when the interest rate is
adjusted.
"interest rate agreement" means an agreement, such as an interest rate swap
cap, collar or floor, entered into for the purpose of hedging risks associated
with changes in interest rates..
"Investment Company Act" means the Investment Company Act of 1940, as
amended.
"IRS" means the United States Internal Revenue Service.
"LIBOR" means the London Interbank Offered Rate as it may be defined, and
for a period of time specified, in a Mortgage-Backed Security or borrowing of
the Company.
"lifetime interest rate cap" or "life cap" means in the case of a Mortgage
Loan that is an ARM, the maximum coupon rate that may accrue during any period
over the term of such Mortgage Loan as stated in the governing instruments
evidencing such Mortgage Loan, and in the case of a Mortgage-Backed Security
evidencing ARMs, the maximum weighted average coupon rate that may accrue during
any period over the term of such Mortgage-Backed Security as stated in the
governing instruments thereof.
"Limited Investment Assets" means assets of the Company, comprising not more
than 25% of total assets, which are unrated or rated less than High Quality.
"Maryland General Corporation Law" means the Corporations and Associations
Article of the Annotated Code of Maryland.
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"Mezzanine Securities" means Mortgage-Backed Securities rated below the two
highest levels but no lower than a single "B" level under the S&P rating system
(or comparable level under other rating systems) which are supported by one or
more classes of Subordinated Securities which bear Realized Losses prior to the
classes of Mezzanine Securities.
"Mortgage Loans" means Single-Family Mortgage Loans, Multifamily Mortgage
Loans and Commercial Mortgage Loans.
"Mortgage-Backed Securities" means (i) Pass-Through Certificates, and (ii)
CMOs.
"Multifamily Mortgage Loans" means Mortgage Loans secured by multifamily (in
excess of four units) residential property.
"Multifamily Privately-Issued Certificates" means Privately-Issued
Certificates evidencing ownership interests in a pool of Multifamily Mortgage
Loans.
"Multifamily CMOs" means CMOs that are collateralized by Multifamily
Mortgage Loans.
"net margin" is part of the calculation of the coupon rate to be received by
the Company as owner of an ARM. The term "net" is used to differentiate payments
actually received by the Company from a Mortgage Asset from the higher "gross"
payment made by the borrower. The difference between the gross margin and the
net margin reflects loan servicing fees and other pre-determined contractual
deductions. The fully-indexed net rate equals the current yield on the ARM index
(six month LIBOR, one year Treasury, etc.) plus the net margin. The actual
coupon rate received by the Company may be lower than the fully-indexed net rate
at the initiation of the loan if originated at a "teaser rate" or during periods
of rising interest rates due to the limitations of the ARM adjustment schedule
and the periodic and life caps. If so, the coupon rate received by the Company
would move towards the fully-indexed net coupon rate over time.
the "95% Gross Income Test" means the requirement for each taxable year that
at least 95% of the Company's gross income for each taxable year must be derived
from sources of income qualifying for the 75% Gross Income Test, dividends,
interest, and gains from the sale of stock or other securities (including
certain interest rate swap and cap agreements entered into to hedge variable
rate debt incurred to acquire Qualified REIT Real Estate Assets) not held for
sale in the ordinary course of business.
"Non-ERISA Plan" means a Plan that does not cover common law employees.
"Non-United States Holder" means a purchaser of the Common Stock that, for
United States Federal income tax purposes, is not a "United States person."
"Ownership Limit" means 9.8% of the outstanding shares of capital stock, as
may be increased or reduced by the Board of Directors of the Company.
"Pass-Through Certificates" means securities (or interests therein),
including Agency Certificates and Privately-Issued Certificates, evidencing
undivided ownership interests in a pool of Mortgage Loans, the holders of which
receive a "pass-through" of the principal and interest paid in connection with
the underlying Mortgage Loans in accordance with the holders' respective,
undivided interests in the pool.
"period ended December 31, 1997" means the period from the commencement of
operations by the Company on February 18, 1997 through December 31, 1997.
"periodic interest rate cap" or "periodic cap" means, with respect to ARMs,
the maximum change in the coupon rate permissible under the terms of the loan at
each coupon adjustment date. Periodic caps limit both the speed by which the
coupon rate can adjust upwards in a rising interest rate environment and the
speed by which the coupon rate can adjust downwards in a falling rate
environment.
"Plan" means a pension, profit-sharing, retirement or other employee benefit
plan which is subject to ERISA.
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"Plan Asset Regulations" means regulations of the DOL defining "plan
assets."
"Private Placement" means the sale by the Company on February 18, 1997 of
3,600,000 shares of Common Stock in an offering exempt from registration under
the Securities Act and state securities laws.
"Private Placement Shares" means the 3,600,000 shares of Common Stock issued
by the Company in the Private Placement.
"Privately-Issued Certificates" means privately-issued Pass-Through
Certificates issued by a third party issuer which is not an Agency Certificate.
"PTE" means a U.S. Department of Labor Prohibited Transaction Exemption.
"purported transferee" means the intended transferee in connection with any
transfer of shares of capital stock that would result in disqualification of the
Company as a REIT or that would (a) create a direct or constructive ownership of
shares of stock in excess of the Ownership Limit, (b) result in the shares of
stock being beneficially owned (within the meaning section 856(a) of the Code)
by fewer than 100 persons (determined without reference to any rules of
attribution), or (c) result in the Company being "closely held" within the
meaning of section 856(h) of the Code.
"Qualified REIT Real Estate Assets" means Pass-Through Certificates,
Mortgage Loans, Agency Certificates, and other assets of the type described in
section 856(c) (6)(B) of the Code.
"Qualified REIT Subsidiary" means a corporation whose stock is entirely
owned by the REIT at all times during such corporation's existence.
"Qualifying Interests" means "mortgages and other liens on and interests in
real estate," as defined in section 3(c)(5)(C) under the Investment Company Act.
"rating" means (i) the rating assigned to an asset by one or more of the
four nationally recognized rating agencies as adjusted to the rating scale under
the S&P rating system, (ii) in the case of assets rated differently by such
rating agencies, the rating deemed by management to most appropriately reflect
such asset's credit quality or (iii) for unrated assets, the Company's deemed
comparable rating.
"Rating Agency" means S&P or another nationally recognized rating agency.
"Realized Losses" means losses incurred in respect of Mortgage-Backed
Securities upon foreclosure sales and other liquidations of underlying mortgaged
properties that result in failure to recover all amounts due on the loans
secured thereby.
a "REIT" means a Real Estate Investment Trust.
"REIT Provisions of the Code" means sections 856 through 860 of the Code.
"REMIC" means Real Estate Mortgage Investment Conduit.
"repurchase agreement" means a borrowing device evidenced by an agreement to
sell securities or other assets to a third-party and a simultaneous agreement to
repurchase them at a specified future date and price, the price difference
constituting the interest on the borrowing.
"residuals" means the right to receive the remaining or residual cash flows
from a pool of Mortgage Loans or Mortgage-Backed Securities after distributing
required amounts to the holders of interests in or obligations backed by such
loans or securities and after payment of any required pool expenses.
58
<PAGE>
"S&P" means Standard & Poor's Corporation, a New York corporation.
"Securities Act" means the Securities Act of 1933, as amended.
"Senior Securities" means a class of Mortgage-Backed Security that has a
prior right to receive principal and/or interest from the underlying pool of
Mortgage Loans.
"Senior-Subordinated Mortgage-Backed Securities" means a series of Pass-
Through Certificates or CMOs in which one or more classes have a prior right to
receive principal and/or interest payments from the underlying pool of Mortgage
Loans.
the "75% Asset Test" at the close of each quarter of each taxable year means
the requirement that at least 75% of the value of the Company's total assets
must consist of Qualified REIT Real Estate Assets, government securities, cash
and cash items.
the "75% Gross Income Test" means the requirement for each taxable year that
at least 75% of the Company's gross income must be derived from certain
specified real estate sources including interest income and gain from the
disposition of Qualified REIT Real Estate Assets or "qualified temporary
investment income" (i.e., income derived from "new capital" within one year of
the receipt of such capital).
"Short-Term Investments" means the short-term bank certificates of deposit,
short-term United States treasury securities, short-term United States
government agency securities, commercial paper, reverse repurchase agreements,
short-term CMOs, short-term asset-backed securities and other similar types of
short-term investment instruments, all of which will have maturities or average
durations of less than one year.
"Single-Family Mortgage Loans" means Mortgage Loans secured by single-family
(one- to four-units) residential property.
"Single-Family Privately-Issued Certificates" means Privately-Issued
Certificates evidencing ownership interests in a pool of Single-Family Mortgage
Loans.
"Single-Family CMOs" means CMOs that are collateralized by Single-Family
Mortgage Loans.
"Subordinated Interests" means a class of Mortgage-Backed Securities that is
subordinated to one or more other classes of Mortgage-Backed Securities, all of
which classes share the same collateral.
"Subordinated Securities" means any class that bears the "first loss" from
Realized Losses or that is rated below a single "B" level (or, if unrated, is
deemed by the Company to be below such level).
"Tax-Exempt Entity" means a qualified pension, profit-sharing or other
employee retirement benefit plan, Keogh plans, bank commingled trust funds for
such plans, individual retirement accounts and other similar entities intended
to be exempt from Federal income taxation.
the "30% Gross Income Test" is the requirement for each taxable year that
less than 30% of the Company's gross income is derived from the sale of
Qualified REIT Real Estate Assets held for less than four years, stock or
securities held for less than one year (including certain interest rate swap and
cap agreements entered into to hedge variable rate debt incurred to acquire
Qualified Real Estate Assets) and certain "dealer" property.
"Treasury Department" means the United States Department of the Treasury.
"Treasury Index" means the weekly average yield of the benchmark U.S.
Treasury securities, as published by the Board of Governors of the Federal
Reserve System.
"UBTI" means "unrelated business taxable income" as defined in section 512
of the Code.
59
<PAGE>
"United States person" means a citizen or resident of the United States; a
corporation, partnership, or other entity created or organized in the United
States or under the laws of the United States or of any political subdivision
thereof; or an estate or trust whose income is includible in gross income for
United States Federal income tax purposes regardless of its source.
"VA" means the United States Department of Veterans Affairs.
"VA Loans" means Mortgage Loans partially guaranteed by the VA under the
Servicemen's Readjustment Act of 1944, as amended.
60
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
ANNALY MORTGAGE MANAGEMENT, INC.
Date: March 29, 1999 By: /s/ Michael A. J. Farrell
Michael A. J. Farrell
Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the date indicated.
<TABLE>
<CAPTION>
Signature Title Date
<S> <C> <C>
/s/ KEVIN P. BRADY Director March 30, 1999
Kevin P. Brady
/s/ KATHRYN F. FAGAN Chief Financial Officer and Treasurer March 30, 1999
Kathryn F. Fagan (principal financial and accounting officer)
/s/ MICHAEL A.J. FARRELL Chairman of the Board, Chief Executive Officer March 30, 1999
Michael A. J. Farrell and Director (principal executive officer)
/s/ JONATHAN D. GREEN Director March 30, 1999
Jonathan D. Green
/s/ TIMOTHY J. GUBA President, Chief Operating Officer and Director March 30, 1999
Timothy J. Guba
/s/ WELLINGTON J. ST. CLAIRE Vice Chairman of the Board and Director March 30, 1999
Wellington J. St. Claire
</TABLE>
61
<PAGE>
ANNALY MORTGAGE MANAGEMENT, INC.
<TABLE>
<CAPTION>
INDEX TO FINANCIAL STATEMENTS
- - --------------------------------------------------------------------------------
PAGE
<S> <C>
INDEPENDENT AUDITORS' REPORT F-2
FINANCIAL STATEMENTS:
Balance Sheets - December 31, 1998 and 1997 F-3
Statements of Operations for the Year Ended
December 31, 1998 and for the Period February 18,
1997 (Commencement of Operations) Through December 31, 1997 F-4
Statements of Stockholders' Equity for the Year Ended
December 31, 1998 and for the Period February 18,
1997 (Commencement of Operations) Through December 31, 1997 F-5
Statements of Cash Flows for the Year Ended December 31,
1998 and for the Period February 18, 1997 (Commencement
of Operations) Through December 31, 1997 F-6
Notes to Financial Statements F-7 - F-14
</TABLE>
F-1
<PAGE>
INDEPENDENT AUDITORS' REPORT
To the Stockholders of
Annaly Mortgage Management, Inc.
We have audited the accompanying balance sheets of Annaly Mortgage Management,
Inc. (the "Company") as of December 31, 1998 and 1997, and the related
statements of operations, stockholders' equity and cash flows for the year ended
December 31, 1998 and the period February 18, 1997 (commencement of operations)
through December 31, 1997. 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 in accordance with generally accepted auditing
standards. Those standards 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 statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provides a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material
respects, the financial position of the Company at December 31, 1998 and 1997
and the results of its operations and its cash flows for the year ended December
31, 1998 and the period February 18, 1997 (commencement of operations) through
December 31, 1997 in conformity with generally accepted accounting principles.
Deloitte & Touche
New York, New York
February 5, 1999
F-2
<PAGE>
ANNALY MORTGAGE MANAGEMENT, INC.
<TABLE>
<CAPTION>
BALANCE SHEETS
DECEMBER 31, 1998 AND 1997
- - -----------------------------------------------------------------------------------------------------------------------------
December 31, December 31,
1998 1997
------------------------------------------
<S> <C> <C>
ASSETS
CASH AND CASH EQUIVALENTS $ 69,020 $ 511,172
MORTGAGE-BACKED SECURITIES - At fair value 1,520,288,762 1,161,779,192
ACCRUED INTEREST RECEIVABLE 6,782,043 5,338,861
OTHER ASSETS 212,214 111,257
--------------- --------------
TOTAL ASSETS $ 1,527,352,039 $1,167,740,482
=============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Repurchase agreements $ 1,280,510,000 $ 918,869,000
Payable for Mortgage-Backed Securities purchased 111,921,205 105,793,723
Accrued interest payable 5,052,626 4,992,447
Dividends payable 3,857,663 2,797,058
Accounts payable 139,236 201,976
--------------- --------------
Total liabilities 1,401,480,730 1,032,654,204
-------------- -------------
STOCKHOLDERS' EQUITY:
Common stock: par value $.01 per share;
100,000,000 authorized, 12,758,024 and 12,713,900
shares issued and outstanding, respectively 127,580 127,139
Additional paid-in capital 132,770,175 132,705,765
Accumulated other comprehensive income (loss) (6,404,275) 2,023,751
Treasury stock at cost (109,600 shares) (903,163) -
Retained earnings 280,992 229,623
--------------- --------------
Total stockholders' equity 125,871,309 135,086,278
--------------- --------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 1,527,352,039 $1,167,740,482
=============== ==============
</TABLE>
See notes to financial statements.
F-3
<PAGE>
ANNALY MORTGAGE MANAGEMENT, INC.
<TABLE>
<CAPTION>
STATEMENTS OF OPERATIONS
- - ---------------------------------------------------------------------------------------------------------------------
FOR THE PERIOD
FEBRUARY 18, 1997
(COMMENCEMENT
FOR THE YEAR OF OPERATIONS)
ENDED THROUGH
DECEMBER 31, DECEMBER 31,
1998 1997
-----------------------------------------
<S> <C> <C>
INTEREST INCOME:
Mortgage-Backed Securities $ 89,985,526 $ 24,682,353
Money market account 105 30,782
-------------------- ------------------
Total interest income 89,985,631 24,713,135
INTEREST EXPENSE:
Repurchase agreements 75,735,280 19,676,954
-------------------- ------------------
NET INTEREST INCOME 14,250,351 5,036,181
GAIN ON SALE OF MORTGAGE-BACKED SECURITIES 3,344,106 735,303
GENERAL AND ADMINISTRATIVE EXPENSES 2,105,534 851,990
-------------------- ------------------
NET INCOME 15,488,923 4,919,494
-------------------- ------------------
OTHER COMPREHENSIVE INCOME (LOSS):
Urealized gain (loss) on available-for-sale securities (5,083,920) 2,759,054
Less: reclassification adjustment for gains included in net
income (3,344,106) (735,303)
-------------------- ------------------
Other comprehensive gain (loss) (8,428,026) 2,023,751
-------------------- ------------------
COMPREHENSIVE INCOME $ 7,060,897 $ 6,943,245
==================== ==================
NET INCOME PER SHARE:
Basic $ 1.22 $ 0.83
==================== ==================
Diluted $ 1.19 $ 0.80
==================== ==================
AVERAGE NUMBER OF SHARES OUTSTANDING:
Basic 12,709,116 5,952,123
==================== ==================
Diluted 13,020,648 6,168,531
==================== ==================
</TABLE>
See notes to financial statements.
F-4
<PAGE>
ANNALY MORTGAGE MANAGEMENT, INC.
<TABLE>
<CAPTION>
STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEAR ENDED DECEMBER 31, 1998 AND THE PERIOD FEBRUARY 18, 1997
(COMMENCEMENT OF OPERATIONS) THROUGH DECEMBER 31, 1997
- - ------------------------------------------------------------------------------------------------------------------------------
Common Additional
Stock Paid-in Treasury Comprehensive Retained
Par Value Capital Stock Income Earnings
------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
BALANCE, FEBRUARY 18, 1997 $ 800 $ 11,200 $ - $ (209)
Net income - - $ 4,919,494 4,919,494
Other comprehensive income:
Unrealized net losses on securities,
net of reclassification adjustment - - 2,023,751 -
-------------
Comprehensive income $ 6,943,245
=============
Issuance of common stock 126,339 132,694,565 -
Dividends declared for the year ended
December 31, 1997, $0.79 per
average share - - (4,689,662)
------- ----------- ------------
BALANCE, DECEMBER 31, 1997 127,139 132,705,765 229,623
------- ----------- ------------
Net income - - $ 15,488,923 15,488,923
Other comprehensive income:
Unrealized net losses on securities,
net of reclassification adjustment - - (8,428,026) -
-------------
Comprehensive income - - $ 7,060,897 -
=============
Exercise of stock options 441 194,658 -
Additional cost of initial public offering - (130,248) -
Stock buyback - - (903,163) -
Dividends declared for the year ended
December 31, 1998, $1.22 per average share - - - (15,437,554)
--------- ------------ ----------- ------------
BALANCE, DECEMBER 31, 1998 $ 127,580 $132,770,175 $ (903,163) $ 280,992
========= ============ =========== ============
Disclosure of reclassification amounts:
Unrealized holding losses arising during period $ (5,083,920)
Less reclassification adjustment of gains included
in net income (3,344,106)
------------
Net unrealized losses on securities $ (8,428,026)
============
<CAPTION>
Other
Comprehensive
Income Total
--------------------------------------------
<S> <S> <C>
BALANCE, FEBRUARY 18, 1997 $ - $ 11,791
Net income - -
Other comprehensive income:
Unrealized net losses on securities,
net of reclassification adjustment 2,023,751 6,943,245
Comprehensive income
Issuance of common stock - 132,820,904
Dividends declared for the year ended
December 31, 1997, $0.79 per
average share - (4,689,662)
BALANCE, DECEMBER 31, 1997 2,023,751 135,086,278
Net income -
Other comprehensive income:
Unrealized net losses on securities,
net of reclassification adjustment (8,428,026)
Comprehensive income - 7,060,897
Exercise of stock options - 195,099
Additional cost of initial public offering - (130,248)
Stock buyback - (903,163)
Dividends declared for the year ended
December 31, 1998, $1.22 per average share - (15,437,554)
----------- -------------
BALANCE, DECEMBER 31, 1998 $(6,404,275) $ 125,871,309
=========== =============
Disclosure of reclassification amounts:
Unrealized holding losses arising during period
Less reclassification adjustment of gains included
in net income
Net unrealized losses on securities
</TABLE>
See notes to financial statements.
F-5
<PAGE>
ANNALY MORTGAGE MANAGEMENT, INC.
<TABLE>
<CAPTION>
STATEMENTS OF CASH FLOWS
- - -----------------------------------------------------------------------------------------------------------------------
FEBRUARY 18, 1997
(COMMENCEMENT
OF OPERATIONS)
FOR THE YEAR ENDED THROUGH
DECEMBER 31, 1998 DECEMBER 31, 1997
---------------------------------------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 15,488,923 $ 4,919,494
Adjustments to reconcile net income to net cash provided by operating
activities:
Amortization of mortgage premiums and discounts, net 8,235,371 2,620,729
Depreciation of fixed assets 14,154 -
Gain on sale of Mortgage-Backed Securities (3,344,106) (735,303)
Increase in accrued interest receivable (1,443,182) (5,338,861)
Increase in other assets (115,112) (111,257)
Increase in accrued interest payable 60,179 4,992,447
(Decrease) increase in accounts payable (62,740) 201,976
------------------ ----------------
Net cash provided by operating activities 18,833,487 6,549,225
------------------ ----------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of Mortgage-Backed Securities (1,420,592,798) (1,310,362,097)
Proceeds from sale of Mortgage-Backed Securities 568,553,814 174,682,533
Principal payments on Mortgage-Backed Securities 486,337,605 79,832,420
------------------ ----------------
Net cash used in investing activities (365,701,379) (1,055,847,144)
------------------ ----------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from repurchase agreements 11,506,566,000 3,498,546,390
Principal payments on repurchase agreements (11,144,925,000) (2,579,677,390)
Proceeds from exercise of stock options 195,100 -
Proceeds from private placement equity offering - 32,979,904
Net proceeds from public offering - 98,962,999
Net proceeds from direct offering - 878,000
Additional cost of initial public offering (130,248) -
Purchase of Treasury Stock (903,163) -
Dividends paid (14,376,949) (1,892,604)
------------------ ----------------
Net cash provided by financing activities 346,425,740 1,049,797,299
------------------ ----------------
NET INCREASE IN CASH AND CASH EQUIVALENTS (442,152) 499,380
CASH AND CASH EQUIVALENTS, BEGINNING OF
PERIOD 511,172 11,792
------------------ ----------------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 69,020 $ 511,172
================== ================
SUPPLEMENTAL DISCLOSURE OF CASH FLOW
INFORMATION:
Interest paid $ 48,811,362 $ 14,684,507
================== =================
NONCASH FINANCING ACTIVITIES:
Net unrealized gain (loss) on available-for-sale securities $ (6,404,275) $ 2,023,751
================== =================
Dividends declared, not yet paid $ 3,857,663 $ 2,797,058
================== =================
</TABLE>
See notes to financial statements.
F-6
<PAGE>
ANNALY MORTGAGE MANAGEMENT, INC.
NOTES TO FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1998 AND FOR THE PERIOD
FEBRUARY 18, 1997 THROUGH DECEMBER 31, 1997
- - --------------------------------------------------------------------------------
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Annaly Mortgage Management, Inc. (the "Company") was incorporated in Maryland on
November 25, 1996. The Company commenced its operations of purchasing and
managing an investment portfolio of Mortgage-Backed Securities on February 18,
1997, upon receipt of the net proceeds from the private placement of equity
capital. On July 31, 1997, the Company received additional proceeds from a
direct offering to officers and directors. An initial public offering was
completed on October 14, 1997. A summary of the Company's significant accounting
policies follows:
CASH AND CASH EQUIVALENTS - Cash and cash equivalents includes cash on hand and
money market funds. The carrying amounts of cash equivalents approximates their
value.
MORTGAGE-BACKED SECURITIES - The Company invests primarily in mortgage pass-
through certificates, collateralized mortgage obligations and other mortgage-
backed securities representing interests in or obligations backed by pools of
mortgage loans (collectively, "Mortgage-Backed Securities").
Statement of Financial Accounting Standards No. 115, Accounting for Certain
Investments in Debt and Equity Securities ("SFAS 115"), requires the Company to
classify its investments as either trading investments, available-for-sale
investments or held-to-maturity investments. Although the Company generally
intends to hold most of its Mortgage-Backed Securities until maturity, it may,
from time to time, sell any of its Mortgage-Backed Securities as part of its
overall management of its balance sheet. Accordingly, this flexibility requires
the Company to classify all of its Mortgage-Backed Securities as available-for-
sale. All assets classified as available-for-sale are reported at fair value,
with unrealized gains and losses excluded from earnings and reported as a
separate component of stockholders' equity.
Unrealized losses on Mortgage-Backed Securities that are considered other than
temporary, as measured by the amount of decline in fair value attributable to
factors other than temporary, are recognized in income and the cost basis of the
Mortgage-Backed Securities is adjusted. There were no such adjustments for the
years ended December 31, 1998 and 1997.
Interest income is accrued based on the outstanding principal amount of the
Mortgage-Backed Securities and their contractual terms. Premiums and discounts
associated with the purchase of the Mortgage-Backed Securities are amortized
into interest income over the lives of the securities using the effective yield
method.
Mortgage-Backed Securities transactions are recorded on the date the securities
are purchased or sold. Purchases of newly issued securities are recorded when
all significant uncertainties regarding the characteristics of the securities
are removed, generally shortly before settlement date. Realized gains and losses
on Mortgage-Backed Securities transactions are determined on the specific
identification basis.
CREDIT RISK - At December 31, 1998 and 1997, the Company has limited its
exposure to credit losses on its portfolio of Mortgage-Backed Securities by only
purchasing securities from Federal Home Loan Mortgage Corporation ("FHLMC"),
Federal National Mortgage Association ("FNMA"), or Government National Mortgage
Association ("GNMA"). The payment of principal and interest on the FHLMC and
FNMA Mortgage-Backed Securities are guaranteed by those respective agencies and
the payment of principal and interest on the GNMA Mortgage-Backed Securities are
backed by the full-faith-and-credit of the U.S. government. At December 31, 1998
and 1997, all of the Company's Mortgage-Backed Securities have an implied "AAA"
rating.
INCOME TAXES - The Company has elected to be taxed as a Real Estate Investment
Trust ("REIT") and intends to comply with the provisions of the Internal Revenue
Code of 1986, as amended (the "Code") with respect thereto.
F-7
<PAGE>
Accordingly, the Company will not be subjected to Federal income tax to the
extent of its distributions to shareholders and as long as certain asset, income
and stock ownership tests are met.
USE OF ESTIMATES - The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
2. MORTGAGE-BACKED SECURITIES
The following table pertains to the Company's Mortgage-Backed Securities
classified as available-for-sale as of December 31, 1998, which are carried at
their fair value:
<TABLE>
<CAPTION>
FEDERAL FEDERAL GOVERNMENT
HOME LOAN NATIONAL NATIONAL TOTAL
MORTGAGE MORTGAGE MORTGAGE MORTGAGE
CORPORATION ASSOCIATION ASSOCIATION ASSETS
--------------------------------------------------------------------
<S> <C> <C> <C> <C>
Mortgage-Backed
Securities, gross $ 449,433,408 $ 955,650,670 $ 97,330,495 $ 1,502,414,573
Unamortized discount (184,996) (423,583) - (608,579)
Unamortized premium 8,852,370 14,264,277 1,770,397 24,887,044
-------------- ------------- ------------ ---------------
Amortized cost 458,100,782 969,491,364 99,100,892 1,526,693,038
Gross unrealized gains 659,557 2,092,119 549,900 3,301,576
Gross unrealized losses (3,487,784) (5,692,759) (525,309) (9,705,852)
-------------- ------------- ------------ ---------------
Estimated fair value $ 455,272,555 $ 965,890,724 $ 99,125,483 $ 1,520,288,762
============== ============= ============ ===============
</TABLE>
The following table pertains to the Company's Mortgage-Backed Securities
classified as available-for-sale as of December 31, 1997, which are carried at
their fair value:
<TABLE>
<CAPTION>
FEDERAL FEDERAL GOVERNMENT
HOME LOAN NATIONAL NATIONAL TOTAL
MORTGAGE MORTGAGE MORTGAGE MORTGAGE
CORPORATION ASSOCIATION ASSOCIATION ASSETS
-------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Mortgage-Backed
Securities, gross $ 273,119,008 $ 691,081,916 $ 174,164,513 $ 1,138,365,437
Unamortized discount (3,619) (110,567) - (114,186)
Unamortized premium 2,848,376 14,532,363 4,123,451 21,504,190
------------- ------------- --------------- ---------------
Amortized cost 275,963,765 705,503,712 178,287,964 1,159,755,441
Gross unrealized gains 376,485 1,948,068 928,453 3,253,006
Gross unrealized losses (115,190) (802,801) (311,264) (1,229,255)
------------- ------------- --------------- ---------------
Estimated fair value $ 276,225,060 $ 706,648,979 $ 178,905,153 $ 1,161,779,192
============= ============= =============== ===============
</TABLE>
The adjustable rate Mortgage-Backed Securities are limited by periodic caps
(generally interest rate adjustments are limited to no more than 1% every six
months) and lifetime caps. The weighted average lifetime cap was 10.6% and 10.8%
at December 31, 1998 and 1997, respectively.
During the year ended December 31, 1998, the Company realized $3,344,070 in
gains from sales of Mortgage-Backed Securities. Losses totaled $9,964 for the
year ended December 31, 1998. During the period ended
F-8
<PAGE>
December 31, 1997, the Company realized $735,303 in gains from sales of
Mortgage-Backed Securities. There were no losses on sales of Mortgage-Backed
Securities during the period ended December 31, 1997.
3. REPURCHASE AGREEMENTS
The Company had outstanding $1,280,510,000 and $918,869,000 of repurchase
agreements with a weighted average borrowing rate of 5.21% and 6.16% and a
weighted average remaining maturity of 29 days and 16 days as of December 31,
1998 and 1997, respectively. At December 31, 1998 and 1997, Mortgage-Backed
Securities actually pledged had an estimated fair value of $1,458,669,078 and
$936,859,658.
At December 31, 1998 and 1997, the repurchase agreements had the following
remaining maturities:
<TABLE>
<CAPTION>
DECEMBER 31, DECEMBER 31,
1998 1997
-------------------------------------------
<S> <C> <C>
Within 30 days $ 1,222,542,000 $ 590,960,000
30 to 59 days 31,346,000 51,776,000
60 to 89 days 26,622,000 -
90 to 119 days - 103,391,000
Over 120 days - 172,742,000
--------------------- -------------------
$1,280,510,000 $ 918,869,000
===================== ===================
</TABLE>
4. COMMON STOCK
During the period ended December 31, 1997, the Company completed a private
placement of equity capital. The Company received net proceeds of $32,979,904
from an issuance of 3,600,000 shares of common stock. The Company received
additional proceeds of $878,000 from an issuance of 87,800 shares of common
stock upon the closing of a direct offering to certain directors, officers, and
employees of the Company on July 31, 1997. The Company issued 9,006,100 shares
of common stock on October 14, 1997 during an initial public offering. Net
proceeds received in the offering were $98,832,751. During the year ended
December 31, 1998, 44,124 options were exercised at $195,099. Stock buybacks
during the year ended December 31, 1998 totaled 109,600 shares at a cost of
$903,163.
During the Company's year ending December 31, 1998, the Company declared
dividends to shareholders totaling $15,437,554, or $1.22 per weighted average
share, of which $11,579,891 was paid during the period and $3,857,663 was paid
on January 25, 1999. For Federal income tax purposes dividends paid for the
period is ordinary income to the Company stockholders.
During the period ended December 31, 1997, the Company declared dividends to
shareholders totaling $4,689,662, or $.79 per weighted average share, of which
$1,892,604 was paid during the period and $2,797,058 was paid on January 20,
1998. For Federal income tax purposes, dividends paid for the period are
ordinary income to the Company stockholders.
5. EARNINGS PER SHARE (EPS)
In February 1997, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting No. 128, Earnings Per Share (SFAS No. 128),
which requires dual presentation of Basic EPS and Diluted EPS on the face of the
income statement for all entities with complex capital structures. SFAS No. 128
also requires a reconciliation of the numerator and denominator of Basic EPS and
Diluted EPS computation. For the year ended December 31, 1998, the
reconciliation is as follows:
F-9
<PAGE>
<TABLE>
<CAPTION>
FOR THE YEAR ENDED
DECEMBER 31, 1998
----------------------------------------------
INCOME SHARES PER-SHARE
(NUMERATOR) (DENOMINATOR) AMOUNT
----------------------------------------------
<S> <C> <C> <C>
Net income $15,488,923
-----------
Basic EPS 15,488,923 12,709,116 $ 1.22
========
Effect of dilutive securities:
Dilutive stock options 311,532
----------- ----------
Diluted EPS $15,488,923 13,020,648 $ 1.19
=========== ========== ========
</TABLE>
Options to purchase 446,084 shares were outstanding during the period (Note 6)
and were dilutive as the exercise price (between $4.00 and $8.13) was less than
the average stock price for the year for the Company of $9.36. Options to
purchase 147,676 shares of stock were outstanding and not considered dilutive.
The exercise price (between $10.00 and $11.28) was greater than the average
stock price for the year of $9.36.
For the period ending December 31, 1997, the reconciliation is as follows:
<TABLE>
<CAPTION>
FOR THE PERIOD ENDED
DECEMBER 31, 1997
------------------------------------------------
INCOME SHARES PER-SHARE
(NUMERATOR) (DENOMINATOR) AMOUNT
---------- ------------ ---------
<S> <C> <C> <C>
Net income $4,919,494
----------
Basic EPS 4,919,494 5,952,123 $ 0.83
========
Effect of dilutive securities:
Dilutive stock options 216,408
---------- ---------
Diluted EPS $4,919,494 6,168,531 $ 0.80
========== ========= ========
</TABLE>
Options to purchase 348,500 shares were outstanding during the period (Note 6)
and were dilutive as the exercise price (between $4.00 and $10.00) was less than
the average stock price for the period for the Company (between $11.00 and
$12.00).
6. LONG TERM STOCK INCENTIVE PLAN
The Company has adopted a Long Term Stock Incentive Plan for executive officers,
key employees and nonemployee directors (the "Incentive Plan"). The Incentive
Plan authorizes the Compensation Committee of the Board of Directors to grant
awards, including incentive stock options as defined under section 422 of the
Code ("ISOs") and options not so qualified ("NQSOs"). The Incentive Plan
authorizes the granting of options or other awards for an aggregate of the
greater of 500,000 shares or 5% of the outstanding shares of the Company's
common stock.
F-10
<PAGE>
The Company adopted the disclosure-only provisions of Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation."
Accordingly, no compensation cost for the Incentive Plan has been determined
based on the fair value at the grant date for awards consistent with the
provisions of SFAS No. 123. For the Company's pro forma net earnings, the
compensation cost will be amortized over the four-year vesting period of the
options. The Company's net earnings per share would have been reduced to the pro
forma amounts indicated below:
<TABLE>
<CAPTION>
FOR THE PERIOD ENDING
-------------------------------------
DECEMBER 31, DECEMBER 31,
1998 1997
-------------------------------------
<S> <C> <C>
Net earnings - as reported $15,488,925 $ 4,919,494
Net earnings - pro forma 15,280,631 4,738,932
Earnings per share - as reported $ 1.22 $ 0.83
Earnings per share - pro forma $ 1.20 $ 0.80
</TABLE>
The fair value of each option grant is estimated on the date of grant using the
Black -Scholes option-pricing model with the following weighted average assum
ptions used for grants in the year ended December 31, 1998: dividend yield of 10
%; expected volatility of 33%; risk-free interest rate of 5.56%; and expected
lives of seven years. For the period ended December 31, 1997, dividend yield of
10%; expected volatility of 25%; risk-free interest rate of 6.07%; and expected
lives of four years.
Information regarding options is as follows:
<TABLE>
<CAPTION>
WEIGHTED
AVERAGE
EXERCISE
SHARES PRICE
------------------------------
<S> <C> <C>
Outstanding, January 1,1998 348,500 $ 6.42
Granted (240,326 ISOs, 46,500 NQSOs) 289,384 8.17
Exercised (44,124) 4.34
Expired - -
-------- ----------
Outstanding, December 31, 1998 593,760 $ 7.42
======== ==========
Weighted average fair value of options granted during the year
(per share) $ 1.99
========
</TABLE>
Information regarding options at December 31, 1997, is as follows:
<TABLE>
<CAPTION>
WEIGHTED
AVERAGE
EXERCISE
SHARES PRICE
---------------------------
<S> <C> <C>
Granted (311,000 ISOs, 37,500 NQSOs) 348,500 $ 6.42
Exercised - -
Expired - -
-------- --------
Outstanding, December 31, 1997 348,500 $ 6.42
======== ========
Weighted average fair value of options granted during the period
(per share) $ 2.07
========
</TABLE>
F-11
<PAGE>
The following table summarizes information about stock options outstanding at
December 31, 1998:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING
WEIGHTED
AVERAGE
REMAINING
RANGE OF OPTIONS CONTRACTUAL
EXERCISE PRICES OUTSTANDING LIFE (YRS.)
----------------------------------------------------
<S> <C> <C>
$ 4.00 166,626 3
$ 8.13 279,458 10
$ 8.94 7,500 4
$ 10.00 137,750 3
$ 11.25 2,426 4
===============
593,760 6.3
===============
</TABLE>
At December 31, 1998, 56,241 options were vested and not exercised.
7. COMPREHENSIVE INCOME
The Company adopted FASB Statement No. 130, Reporting Comprehensive Income.
Statement No. 130 requires the reporting of comprehensive income in addition to
net income from operations. Comprehensive income is a more inclusive financial
reporting methodology that includes disclosure of certain financial information
that historically has not been recognized in the calculation of net income. The
Company at December 31, 1998 and 1997 held securities classified as available-
for-sale. At December 31, 1998, the net unrealized losses totaled $6,404,275 and
at December 31, 1997 the net unrealized gains totaled $2,023,751.
8. LEASE COMMITMENTS
The Corporation has a noncancelable lease for office space, which commenced in
April 1998 and expires in December 2007.
The Corporation's aggregate future minimum lease payments are as follows:
1999 $ 92,804
2000 95,299
2001 97,868
2002 100,515
2003 and thereafter 582,406
---------
$ 968,892
=========
9. RELATED PARTY TRANSACTION
Included in "Other Assets" on the Balance sheet is an investment in Annaly
International Money Management, Inc. On June 24, 1998, the Company acquired
99,960 nonvoting shares, at a cost of $49,980. The officers and directors
of Annaly International Money Management Inc. are also officers and
directors of the Company.
F-12
<PAGE>
10. SUMMARIZED QUARTERLY RESULTS (UNAUDITED)
The following is a presentation of the quarterly results of operations for the
year ended December 31, 1998.
<TABLE>
<CAPTION>
QUARTERS ENDING
-----------------------------------------------------------------------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
1998 1998 1998 1998
-----------------------------------------------------------------------------
<S> <C>
Interest income from Mortgage-
Backed Securities and cash $ 20,078,721 $ 23,761,953 $ 24,008,567 $22,136,390
Interest expense on repurchase
agreements 16,313,474 20,177,580 20,765,301 18,478,925
------------ ------------ ------------ -----------
Net interest income 3,765,247 3,584,373 3,243,266 3,657,465
Gain on sale of
Mortgage-Backed Securities 1,427,084 295,875 993,630 627,517
General and administrative
expenses 484,181 493,718 528,240 599,185
------------ ------------ ------------ ------------
Net income $ 4,708,150 $ 3,386,530 $ 3,708,656 $ 3,685,797
============ ============ ============ ============
Net income per share:
Basic $ 0.37 $ 0.27 $ 0.29 $ 0.29
============ ============ ============ ============
Dilutive $ 0.36 $ 0.26 $ 0.29 $ 0.29
============ ============ ============ ============
Average number of shares
outstanding:
Basic 12,727,405 12,757,674 12,704,194 12,648,116
=========== =========== =========== ===========
Dilutive 12,923,195 12,959,771 12,785,765 12,731,192
=========== =========== =========== ===========
</TABLE>
F-13
<PAGE>
The following is a presentation of the quarterly results of operations for
the period February 18, 1997 (commencement of operations) through December
31, 1997.
<TABLE>
<CAPTION>
PERIOD ENDED QUARTERS ENDING
------------------------------------------------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
1997 1997 1997 1997
------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Interest income from Mortgage-
Backed Securities and cash $ 1,060,692 $ 5,448,215 $ 6,123,457 $12,080,771
Interest expense on repurchase
agreements 713,120 4,435,697 5,126,089 9,402,048
----------- ----------- ----------- -----------
Net interest income 347,572 1,012,518 997,368 2,678,723
Gain on sale of
Mortgage-Backed Securities - 229,865 429,400 76,038
General and administrative
expenses 64,047 185,849 227,245 374,849
----------- ----------- ----------- -----------
Net income $ 283,525 $ 1,056,534 $ 1,199,523 $ 2,379,912
=========== =========== =========== ===========
Net income per share:
Basic $ 0.08 $ 0.28 $ 0.32 $ 0.21
=========== =========== =========== ===========
Dilutive $ 0.07 $ 0.26 $ 0.29 $ 0.20
=========== =========== =========== ===========
Average number of shares
outstanding 3,680,000 3,680,000 3,739,170 11,449,777
=========== =========== =========== ===========
</TABLE>
* * * * * *
F-14
<PAGE>
<TABLE>
<CAPTION>
Rider 52.A
Exhibit Exhibit Description Sequentially
Number Numbered
Page
<S> <C> <C>
3.1 Articles of Incorporation of the Registrant (incorporated by reference
to Exhibit 3.1 to the Company's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
3.2 Articles of Amendment and Restatement of the Articles of Incorporation
of the Registrant (incorporated by reference to Exhibit 3.2 to the
Company's Registration Statement on Form S-11 (Registration No. 333-
32913) filed with the Securities and Exchange Commission on August 5,
1997).
3.3 Bylaws of the Registrant, as amended (incorporated by reference to
Exhibit 3.3 to the Company's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
4.1 Specimen Common Stock Certificate (incorporated by reference to
Exhibit 4.1 to Amendment No. 1 to the Company's Registration Statement
on Form S-11(Registration No. 333-32913) filed with the Securities and
Exchange Commission on September 17, 1997).
10.1 Purchase Agreement, dated February 12, 1997, between the Registrant
and Freedman, Billings, Ramsey & Co., Inc. ("FBR") (incorporated by
reference to Exhibit 10.1 to the Company's Registration Statement on
Form S-11 (Registration No. 333-32913) filed with the Securities and
Exchange Commission on August 5, 1997).
10.2 Registration Rights Agreement, dated February 12, 1997, between the
Registrant and FBR (incorporated by reference to Exhibit 10.2 to the
Company's Registration Statement on Form S-11 (Registration No. 333-
32913) filed with the Securities and Exchange Commission on August 5,
1997).
10.3 Long-Term Stock Incentive Plan (incorporated by reference to Exhibit
10.3 to the Company's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
10.4 Employment Agreement, effective as of January 27, 1997, between the
Company and Michael A.J. Farrell (incorporated by reference to Exhibit
10.4 to the Company's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
10.5 Employment Agreement, effective as of January 27, 1997, between the
Company and Timothy J. Guba (incorporated by reference to Exhibit 10.5
to the Company's Registration Statement on Form S-11 (Registration No.
333-32913) filed with the Securities and Exchange Commission on August
5, 1997).
10.6 Employment Agreement, effective as of January 27, 1997, between the
Company and Wellington J. St. Claire (incorporated by reference to
Exhibit 10.6 to the Company's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
10.7 Form of Master Repurchase Agreement (incorporated by reference to
Exhibit 10.7 to the Company's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
10.8 Form of Purchase Agreement between the Company and the purchasers in
the Direct Offering (incorporated by reference to Exhibit 10.8 to the
Company's Registration Statement on Form S-11 (Registration No. 333-
32913) filed with the Securities and Exchange Commission on August 5,
1997).
10.9 Employment Agreement, effective as of November 1, 1997, between the
Company and Kathryn F. Fagan (incorporated by reference to Exhibit
10.9 to the Company's Form 10-K for the fiscal year ended December 31,
1997).
23.1 Consent of Independent Accountants.
27. Financial Data Schedule
</TABLE>
62
<PAGE>
EXHIBIT 23.1
CONSENT OF INDEPENDENT ACCOUNTANTS
We hereby consent to the incorporation by reference in Registration Statement
No. 333-72985 on Form S-3 of Annaly Mortgage Management, Inc. of our report
dated February 5, 1999 appearing in this Annual Report on Form 10-K.
Deloitte & Touche LLP
New York, New York
March 31, 1999
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM DECEMBER 31,
1998 FORM 10-K AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 69
<SECURITIES> 1,520,289
<RECEIVABLES> 0
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 1,527,214
<PP&E> 75
<DEPRECIATION> 0
<TOTAL-ASSETS> 1,527,352
<CURRENT-LIABILITIES> 1,401,481
<BONDS> 0
0
0
<COMMON> 131,995
<OTHER-SE> (6,124)
<TOTAL-LIABILITY-AND-EQUITY> 1,527,352
<SALES> 0
<TOTAL-REVENUES> 93,330
<CGS> 0
<TOTAL-COSTS> 0
<OTHER-EXPENSES> 2,106
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 75,735
<INCOME-PRETAX> 15,489
<INCOME-TAX> 0
<INCOME-CONTINUING> 15,489
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 15,489
<EPS-PRIMARY> 1.22
<EPS-DILUTED> 1.19
</TABLE>
