<PAGE>
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
FORM 10-Q
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
------- EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED: JUNE 30, 1998
OR
_______ TRANSITION REPORT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE TRANSITION PERIOD FROM _____ TO _____
COMMISSION FILE NUMBER: 001-13637
APEX MORTGAGE CAPITAL, INC.
(Exact name of Registrant as specified in its Charter)
MARYLAND 95-4650863
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
865 SOUTH FIGUEROA STREET
LOS ANGELES, CALIFORNIA 90017
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (213) 244-0440
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
------- -------
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of the issuer's classes of common
stock, as of the last practicable date.
Common Stock ($0.01 par value) 6,052,000 as of August 5, 1998
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE>
APEX MORTGAGE CAPITAL, INC.
FORM 10-Q
INDEX
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
BALANCE SHEETS AT JUNE 30, 1998 (UNAUDITED) AND DECEMBER 31, 1997 3
STATEMENT OF OPERATIONS FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 1998
(UNAUDITED) 4
STATEMENT OF STOCKHOLDERS' EQUITY FOR THE THREE AND SIX MONTHS ENDED
JUNE 30, 1998 (UNAUDITED) 5
STATEMENTS OF CASH FLOWS FOR THE THREE AND SIX MONTHS ENDED JUNE 31, 1998
(UNAUDITED) 6
NOTES TO FINANCIAL STATEMENTS (UNAUDITED) 7
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS 14
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS 23
ITEM 2. CHANGES IN SECURITIES 23
ITEM 3. DEFAULTS UPON SENIOR SECURITIES 23
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 23
ITEM 5. OTHER INFORMATION 23
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 24
SIGNATURES 25
</TABLE>
2
<PAGE>
PART 1. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
APEX MORTGAGE CAPITAL, INC.
BALANCE SHEETS
<TABLE>
<CAPTION>
JUNE 30, 1998 DECEMBER 31, 1997
(Unaudited)
<S> <C> <C>
ASSETS
Cash and cash equivalents $ 38,867,000 $ 3,085,000
Mortgage-backed securities available-for-sale, at fair value (Note 3) 864,432,000 265,880,000
Other investments (Note 4) 113,000 174,000
Accrued interest receivable 5,349,000 1,316,000
Principal payments receivable 957,000 -
Receivable for unsettled securities 56,593,000 -
Other assets 752,000 852,000
------------ ------------
$967,063,000 $271,307,000
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Reverse repurchase agreements (Note 5) $753,752,000 $ 87,818,000
Payable for unsettled securities 120,860,000 88,638,000
Accrued interest payable 3,898,000 110,000
Dividend payable 1,560,000 268,000
Accrued expenses and other liabilities 1,133,000 1,476,000
------------ ------------
881,203,000 178,310,000
------------ ------------
Commitments and contingencies (Notes 10 and 11)
Stockholders' Equity
Preferred Stock, par value $0.01 per share; 50,000,000 shares authorized;
no shares outstanding
Common Stock, par value $0.01 per share; 100,000,000 shares
authorized; 6,700,100 shares outstanding (Notes 8 and 9) 67,000 67,000
Additional paid-in-capital 92,916,000 92,860,000
Accumulated other comprehensive income 1,444,000 188,000
Accumulated dividend distributions in excess of net income (2,131,000) (118,000)
Treasury stock, at cost (535,000 shares) (Note 7) (6,436,000) -
------------ ------------
85,860,000 92,997,000
------------ ------------
$967,063,000 $271,307,000
============ ============
</TABLE>
See accompanying notes to financial statements
3
<PAGE>
APEX MORTGAGE CAPITAL, INC.
STATEMENT OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS SIX MONTHS
ENDED ENDED
JUNE 30, 1998 JUNE 30, 1998
<S> <C> <C>
INTEREST INCOME:
Mortgage-backed securities $9,224,000 $13,949,000
Cash and cash equivalents 274,000 456,000
---------- -----------
9,498,000 14,405,000
INTEREST EXPENSE 8,999,000 13,010,000
---------- -----------
NET INTEREST INCOME 499,000 1,395,000
---------- -----------
GAINS ON INVESTMENT TRANSACTIONS, NET 469,000 469,000
GENERAL AND ADMINISTRATIVE EXPENSES:
Management fee (Note 8) 161,000 334,000
Audit and tax fees 11,000 23,000
Insurance expense 67,000 133,000
Directors' fees 20,000 40,000
Stock Option expense 28,000 56,000
Other 72,000 105,000
---------- -----------
359,000 691,000
---------- -----------
NET INCOME $ 609,000 $ 1,173,000
========== ===========
Basic $ 0.10 $ 0.18
========== ===========
Diluted $ 0.10 $ 0.18
========== ===========
Weighted Average Number of Shares Outstanding:
Basic 6,387,000 6,495,000
========== ===========
Diluted 6,387,000 6,495,000
========== ===========
Dividends Declared Per Share $ 0.25 $ 0.50
========== ===========
</TABLE>
See accompanying notes to financial statements
4
<PAGE>
Apex Mortgage Capital, Inc.
Statement of Stockholders' Equity
Three Months and Six Months Ended June 30, 1998
(Unaudited)
<TABLE>
<CAPTION>
Accumulated
Common Stock Additional Other
------------------------- Paid-in Comprehensive
Shares Amount Capital Income
---------- ---------- ------------ -------------
<S> <C> <C> <C> <C>
Balance, December 31, 1997 6,700,100 $ 67,000 $ 92,860,000 $ 188,000
Repurchases of common stock - - - -
Issuance of stock options
to non-employees (Note 9) - - 28,000 -
Net income - - - -
Other comprehensive income:
Net unrealized gain on
mortgage-backed securities
available-for-sale - - - 1,547,000
Comprehensive income
Dividends declared - - - -
---------- ---------- ------------ ------------
Balance, March 31, 1998 6,700,100 $ 67,000 $ 92,888,000 $ 1,735,000
Repurchases of common stock - - - -
Issuance of stock options
to non-employees (Note 9) - - 28,000 -
Net income - - - -
Other comprehensive income:
Net unrealized gain (loss) on
mortgage-backed securities
available-for-sale - - - (291,000)
Comprehensive income - - - -
Dividends declared - - - -
---------- ---------- ------------ ------------
Balance, June 30, 1998 6,700,100 $ 67,000 $ 92,916,000 $ 1,444,000
========== ========== ============ ===========
</TABLE>
<TABLE>
<CAPTION>
Accumulated
Dividend
Distribution Treasury
In Excess of Comprehensive Stock,
Net Income Income At Cost Total
------------ ------------- ------------ ------------
<S> <C> <C> <C> <C>
Balance, December 31, 1997 $ (118,000) $ - $ - $ 92,997,000
Repurchases of common stock - - (2,535,000) (2,535,000)
Issuance of stock options
to non-employees (Note 9) - - - 28,000
Net income 564,000 564,000 - 564,000
Other comprehensive income:
Net unrealized gain on
mortgage-backed securities
available-for-sale - 1,547,000 - 1,547,000
----------
Comprehensive income $2,111,000
==========
Dividends declared (1,626,000) - (1,626,000)
----------- ------------ ------------
Balance, March 31, 1998 $(1,180,000) $ - $ (2,535,000) $ 90,975,000
Repurchases of common stock - - (3,901,000) (3,901,000)
Issuance of stock options
to non-employees (Note 9) - - - 28,000
Net income 609,000 609,000 - 609,000
Other comprehensive income:
Net unrealized gain (loss) on
mortgage-backed securities
available-for-sale - (291,000) - (291,000)
----------
Comprehensive income $ 318,000
==========
Dividends declared (1,560,000) - (1,560,000)
----------- ------------ ------------
Balance, June 30, 1998 $(2,131,000) $ (6,436,000) $ 85,860,000
=========== ============ ============
</TABLE>
See accompanying notes to financial statements
5
<PAGE>
APEX MORTGAGE CAPITAL, INC.
STATEMENT OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS SIX MONTHS
ENDED ENDED
JUNE 30, 1998 JUNE 30, 1998
<S> <C> <C>
OPERATING ACTIVITIES:
Net Income $ 609,000 $ 1,173,000
Adjustments to reconcile net income to net cash
provided by operating activities:
Amortization 1,764,000 2,735,000
Net gain on sale of mortgage-backed securities (469,000) (469,000)
Change in assets and liabilities:
Accrued interest receivable (1,220,000) (4,033,000)
Principal payments receivable 4,652,000 (957,000)
Receivable for unsettled securities (56,593,000) (56,593,000)
Other Assets 52,000 100,000
Payable for unsettled securities 33,766,000 32,222,000
Accrued interest payable 2,520,000 3,788,000
Accrued expenses and other liabilities 594,000 (342,000)
------------- ---------------
Net cash used in operating activities (14,325,000) (22,376,000)
------------- ---------------
INVESTING ACTIVITIES:
Purchase of mortgage-backed securities (684,451,000) (1,242,095,000)
Proceeds from sales of mortgage-backed securities 461,602,000 461,602,000
Principal payments on mortgage-backed securities 119,941,000 181,127,000
Purchase of hedging assets - (80,000)
------------- ---------------
Net cash used in investing activities (102,908,000) (599,446,000)
------------- ---------------
FINANCING ACTIVITIES:
Net proceeds from reverse repurchase agreements 156,470,000 665,934,000
Dividend distributions (1,626,000) (1,894,000)
Purchase of treasury stock (3,901,000) (6,436,000)
------------- ---------------
Net cash provided by financing activities 150,943,000 657,604,000
------------- ---------------
NET INCREASE IN CASH AND CASH EQUIVALENTS 33,710,000 35,782,000
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 5,157,000 3,085,000
------------- ---------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 38,867,000 $ 38,867,000
============= ===============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest $ 6,463,000 $ 9,193,000
============= ===============
NONCASH INVESTING AND FINANCING ACTIVITIES:
Net unrealized gain (loss) on mortgage-backed
securities available-for-sale $ (291,000) $ 1,256,000
============= ===============
Dividends declared, not yet paid $ 1,560,000 $ 1,560,000
============= ===============
</TABLE>
See accompanying notes to financial statements
6
<PAGE>
APEX MORTGAGE CAPITAL, INC.
NOTES TO FINANCIAL STATEMENTS
QUARTER ENDED JUNE 30, 1998
(UNAUDITED)
NOTE 1 - THE COMPANY
Apex Mortgage Capital, Inc. (the "Company") was incorporated in Maryland on
September 15, 1997. The Company commenced its operations of acquiring and
managing a portfolio of mortgage assets on December 9, 1997, upon receipt
of the net proceeds from the initial public offering of the Company's
common stock. The Company uses its equity capital and borrowed funds to
seek to generate income based on the difference between the yield on its
mortgage backed securities and the cost of its borrowings. The Company is
structured for tax purposes as a real estate investment trust ("REIT")
under the Internal Revenue Code of 1986, as amended (the "Code").
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
These interim financial statements are unaudited, internally prepared
statements, that reflect the necessary interim adjustments which, in the
opinion of management, are necessary to present a fair statement of the
results for such interim period. The results of operations for this
interim period are not indicative of the results for a full fiscal year.
This filing should be read in conjunction with the Annual Report on Form
10-K for the year ended December 31, 1997.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and highly liquid
investments with original maturities of three months or less. The carrying
amount of cash equivalents approximates their fair value.
Mortgage-Backed Securities
The Company's mortgage-backed securities consist of securities backed by
single-family residential real estate mortgage loans. Mortgage-backed
securities are recorded at cost on the date the assets are purchased.
Realized gains and losses on sales of the securities are determined on a
specific identification basis. Substantially all of the Company's
mortgage-backed securities are expected to qualify as real estate assets
under the REIT provisions of the Code.
Interest income is accrued based on the outstanding principal amount of the
mortgage-backed securities and their contractual terms. Premiums and
discounts are amortized into interest income over the lives of the
securities using the effective yield method adjusted for the effects of
estimated prepayments.
The Company's policy is to generally classify its mortgage-backed
securities as available-for-sale. The mortgage-backed securities are
reported at fair value with unrealized gains and losses excluded from
earnings and reported in other comprehensive income.
7
<PAGE>
Other Investments
Other investments are held at fair value to the extent that they do not
qualify as hedging instruments. Changes in fair value are recorded as an
adjustment to net income. Other investments that qualify as hedging
instruments are recorded at amortized cost.
Interest Rate Hedging Transactions
The Company enters into interest rate swap and interest rate cap agreements
in order to mitigate the impact of rising interest rates on the cost of its
short-term borrowings. Amounts payable or receivable from such agreements
are accounted for on an accrual basis and recognized as a net adjustment to
interest expense. Premiums paid for cap agreements accounted for as hedges
are recorded as other investments and amortized over the lives of such
agreements as an adjustment to interest expense.
Stock Based Compensation
The Company grants stock options to its directors and officers and to
certain directors, officers and employees of its investment manager and the
investment manager itself, as discussed in note 9. Options granted to
directors of the Company are accounted for using the intrinsic method, and
generally no compensation expense is recognized in the statement of
operations for such options. Other options are accounted for using the
fair value method; such options are measured at their fair value when they
are granted and are recognized as a general and administrative expense
during the periods when the options vest and the related services are
performed.
Federal and State Income Taxes
The Company will elect to be taxed as a REIT and generally will not be
subject to federal and state taxes on its income to the extent it
distributes annually 95% of its predistribution taxable income to
stockholders and meets certain other asset, income and stock ownership
tests. As such, no accrual for income taxes has been included in the
financial statements.
Net Income Per Share
Net income per share is computed in accordance with Statement of Financial
Accounting Standards ("SFAS") No. 128, Earnings Per Share, and is
calculated on the basis of the weighted average number of common shares
outstanding during each period plus the additional dilutive effect of
common stock equivalents. The dilutive effect of outstanding stock options
is calculated using the treasury stock method.
Stock options that could potentially dilute basic net income per share in
the future were not included in the computation of diluted net income per
share because to do so would have been antidilutive for the period
presented.
Income Recognition
Income and expenses are recorded on the accrual basis of accounting.
Credit Risk
At June 30, 1998, the Company has limited its exposure to credit losses on
its portfolio of mortgage-backed securities by purchasing securities that
are either rated "AAA" by at least one nationally recognized rating agency
or are issued by the Federal Home Loan Mortgage Corporation ("FHLMC"),
Fannie Mae (formerly known as the Federal National Mortgage Corporation) or
the Government National Mortgage Association ("GNMA"). The payment of
principal and interest on the FHLMC, Fannie Mae and GNMA securities are
guaranteed by those respective agencies. At June 30, 1998, all of the
Company's mortgage-backed securities have an actual or implied "AAA"
rating.
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 at
the date
8
<PAGE>
of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from
those estimates.
Comprehensive Income
During the six months ended June 30, 1998, the Company adopted SFAS No.
130, Reporting Comprehensive Income. This statement establishes standards
for reporting and display of comprehensive income and its components in a
full set of general-purpose financial statements. Comprehensive income is
defined as "the change in equity of a business enterprise during a period
from transactions and other events and circumstances from non-owner
sources. It includes all changes in equity during a period except those
resulting from investments by owners and distributions to owners."
Recently Issued Accounting Standards
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
Accounting for Derivative Instruments and Hedging Activities. The
Statement establishes accounting and reporting standards requiring that
every derivative instrument (including certain derivative instruments
embedded in other contracts) be recorded in the balance sheet as either an
asset or liability measured at its fair value. The Statement requires that
changes in the derivative's fair value be recognized currently in earnings
unless specific hedge accounting criteria are met. Special accounting for
qualifying hedges allows a derivative's gains and losses to offset related
results on the hedged item in the income statement, and requires that a
company must formally document, designate, and assess the effectiveness of
transactions that receive hedge accounting. SFAS No. 133 is effective for
fiscal years beginning after June 15, 1999. A company may also implement
the Statement as of the beginning of any fiscal quarter after issuance
(that is, fiscal quarters beginning June 16, 1998 and thereafter).
Statement 133 cannot be applied retroactively. Statement 133 must be
applied to (a) derivative instruments and (b) certain derivative
instruments embedded in hybrid contracts that were issued, acquired, or
substantively modified after December 31, 1997 (and, at the company's
election, before January 1, 1998). The Company will adopt the reporting
requirements of SFAS No. 133 by the first quarter of 2000. An earlier
adoption may be made if circumstances warrant. The Company expects the
impact of the adoption of the reporting requirements of SFAS No. 133 to
include the recording of the approximate fair value of the Company's
interest rate swaps as comprehensive income.
NOTE 3 - MORTGAGE-BACKED SECURITIES
At June 30, 1998, mortgage-backed securities consisted of the following:
<TABLE>
<CAPTION>
Adjustable Rate Fixed Rate Mortgage
(in thousands) Mortgage Securities Securities Total
-------------------------------------------------------------
<S> <C> <C> <C>
Principal Amount $91,386 $769,490 $860,876
Unamortized Premium (Discount) 1,529 583 2,112
-------------------------------------------------------------
Amortized Cost 92,915 770,073 862,988
Unrealized Gains 22 2,048 2,070
Unrealized Losses (219) (407) (626)
-------------------------------------------------------------
Fair Value $92,718 $771,714 $864,432
=============================================================
</TABLE>
At December 31, 1997, mortgage-backed securities consisted of the
following:
<TABLE>
<CAPTION>
Adjustable Rate Fixed Rate Mortgage
(in thousands) Mortgage Securities Securities Total
----------------------------------------------------------
<S> <C> <C> <C>
Principal Amount $237,929 $24,826 $262,755
Unamortized Premium 2,743 194 2,937
----------------------------------------------------------
Amortized Cost 240,672 25,020 265,692
Unrealized Gains 162 41 203
Unrealized Losses (15) 0 (15)
----------------------------------------------------------
Fair Value $240,819 $25,061 $265,880
==========================================================
</TABLE>
9
<PAGE>
The contractual final maturity of the mortgage loans supporting the
mortgage-backed securities is generally between 15 and 30 years at
origination. Because of prepayments on the underlying mortgage loans, the
actual weighted-average maturity is expected to be less.
The adjustable rate mortgage-backed securities are typically subject to
periodic and lifetime caps that limit the amount an adjustable rate
mortgage-backed security's interest rate can change during any given period
and over the life of the asset. At June 30, 1998, the average periodic cap
on the adjustable rate mortgage assets was 1.9% per annum and the average
lifetime cap was equal to 11.6%. At December 31, 1997, the average
periodic cap on the adjustable rate mortgage assets was 2.0% per annum and
the average lifetime cap was equal to 11.4%.
During the quarter ended June 30, 1998 the Company realized $582,000 in
gains on the sale of $461.6 million of adjustable rate mortgage-backed
securities which were classified as available-for-sale.
NOTE 4 - OTHER INVESTMENTS
Other investments includes the carrying value of purchased interest rate
caps, entered into by the Company in order to mitigate the impact of rising
interest rates on the cost of its short-term borrowings. As discussed in
Note 10, the Company entered into certain interest rate swap transactions
during June, 1998. The execution of these swaps eliminated the need for a
portion of the cap protection previously purchased. As such a portion of
the caps are no longer effective as a hedge and are no longer accounted for
as such (see Note 2).
The terms of outstanding interest rate cap agreements are as follows:
<TABLE>
<CAPTION>
At June 30, 1998 At December 31, 1997
-------------------------------------------------
<S> <C> <C>
Notional Amount $900,000,000 $500,000,000
Average Contract Rate 10.4% 10.0%
Average Final Maturity January 24, 2002 December 24, 2001
</TABLE>
Under these agreements, the Company will receive cash payments to the
extent of the excess of three month London Interbank Offered Rate ("LIBOR")
over the agreements' contract rate times the notional amount.
NOTE 5 - REVERSE REPURCHASE AGREEMENTS
The Company has entered into reverse repurchase agreements to finance
certain of its mortgage-backed securities. These agreements are secured by
a portion of the Company's mortgage-backed securities and bear interest
rates that have historically moved in close relationship to LIBOR.
At June 30, 1998, the Company had outstanding $753,752,000 of reverse
repurchase agreements with a weighted average current borrowing rate of
5.62% and a maturity of 3.2 months. The reverse repurchase agreements were
collateralized by mortgage-backed securities with an estimated fair value
of $768,283,000.
At December 31, 1997, the Company had outstanding $87,818,000 of reverse
repurchase agreements with a weighted average current borrowing rate of
5.82% and a maturity of 2.8 months. The reverse repurchase agreements were
collateralized by mortgage-backed securities with an estimated fair value
of $90,043,000.
For the quarter ended June 30, 1998, the average reverse repurchase
agreement balance was $639,029,000 with a weighted average interest cost of
5.60%. The maximum reverse repurchase agreement balance outstanding during
the quarter ended June 30, 1998 was $753,752,000.
10
<PAGE>
For the six months ended June 30, 1998, the average reverse repurchase
agreement balance was $464,031,000 with a weighted average interest cost of
5.58%. The maximum reverse repurchase agreement balance outstanding during
the six months ended June 30, 1998 was $753,752,000.
NOTE 6 - FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table presents the amortized cost and estimated fair values
of the Company's financial instruments. SFAS No. 107, Disclosures About
Fair Value of Financial Instruments, defines the fair value of a financial
instrument as the amount at which the instrument could be exchanged in a
current transaction between willing parties, other than in a forced or
liquidation sale (dollars in thousands):
<TABLE>
<CAPTION>
At June 30, 1998 At December 31, 1997
Carrying Amount Fair Value Carrying Amount Fair Value
------------------------------- -------------------------------
<S> <C> <C> <C> <C>
Mortgage-backed securities $862,988 $864,432 $265,692 $265,880
Other Investments 113 83 174 174
Interest Rate Swaps - (1,212) - -
</TABLE>
Management bases its fair value estimates for mortgage-backed securities
and other investments primarily on third party price indications provided
by dealers who make markets in these financial instruments when such
indications are available. However, the fair value reported reflects
estimates and may not necessarily be indicative of the amounts the Company
could realize in a current market exchange. Cash and cash equivalents,
interest receivable and reverse repurchase agreements are reflected in the
financial statements at their costs, which approximates their fair value
because of the short-term nature of these instruments.
NOTE 7 - STOCK REPURCHASE PROGRAM
On January 13, 1998, the Company's board of directors authorized a program
to repurchase up to 750,000 shares of the Company's Common Stock. The
Company repurchased 337,300 shares of its common stock during the second
quarter and 535,000 shares for the six months ended June 30, 1998. The
average price per share repurchased during the quarter and the six months
ended June 30, 1998 was $11.57 and $12.03, respectively. The repurchased
shares are held in treasury at cost in the financial statements herein.
An additional 215,000 shares are currently authorized for potential
repurchase in the future. The Company may continue to repurchase shares in
the future when market conditions warrant.
NOTE 8 - TRANSACTIONS WITH AFFILIATES
The Company has entered into a Management Agreement (the "Management
Agreement") with TCW Investment Management Company (the "Manager"), a
wholly owned subsidiary of The TCW Group, Inc., under which the Manager
will manage its day-to-day operations, subject to the direction and
oversight of the Company's Board of Directors. The Company will pay the
Manager annual base management compensation, payable monthly in arrears,
equal to 3/4 of 1% of the average net invested capital as further defined
in the Management Agreement.
The Company paid the Manager $161,000 in base management compensation in
accordance with the terms of the Management Agreement for the quarter ended
June 30, 1998. The Company paid the Manager $334,000 in base management
compensation for the six months ended June 30, 1998.
11
<PAGE>
The Company will also pay the Manager, as incentive compensation, an amount
equal to 30% of the Net Income of the Company, before incentive
compensation, in excess of the amount that would produce an annualized
return on equity equal to the ten-year US Treasury rate plus 1% as further
defined in the Management Agreement.
The Company did not accrue for or pay the Manager any incentive
compensation for the quarter or six months ended June 30, 1998.
The Company may also grant stock options to directors, officers and key
employees of the Company, the Manager, its directors, officers and key
employees.
NOTE 9 - STOCK OPTIONS
The Company has adopted a stock option plan (the "1997 Stock Option
Plan") that provides for the grant of both qualified incentive stock
options that meet the requirements of Section 422 of the Code, and non-
qualified stock options, stock appreciation rights and dividend equivalent
rights. Stock options may be granted to directors, officers and key
employees of the Company, the Manager, its directors, officers and key
employees.
The exercise price for any stock option granted under the 1997 Stock Option
Plan may not be less than 100% of the fair market value of the shares of
common stock at the time the option is granted. Each option must terminate
no more than ten years from the date it is granted. Subject to anti-
dilution provisions for stock splits, stock dividends and similar events,
the 1997 Stock Option Plan authorizes the grant of options to purchase an
aggregate of up to 10% of the outstanding shares of the Company's common
stock, but not more than 1,000,000 shares of common stock.
No options were granted under the 1997 Stock Option Plan during the quarter
or six months ended June 30, 1998. The Company recognized compensation
expense of $28,000 during the quarter ended June 30, 1998 for stock options
previously granted to non-employees. The Company recognized compensation
expense of $56,000 during the six months ended June 30, 1998 for stock
options previously granted to non-employees.
If the Company had recorded stock option grants to Company directors at
fair value and related compensation expense, the pro forma effect on the
Company's net income and earnings per share would have been as follows:
<TABLE>
<CAPTION>
Quarter Ended Six Months Ended
June 30, 1998 June 30, 1998
-----------------------------------------
<S> <C> <C>
Net income - as reported $609,000 $1,173,000
Net income - pro forma 578,000 1,111,000
Basic and diluted earnings per share - as reported $ 0.10 $ 0.18
Basis and diluted earnings per share - pro forma $ 0.09 $ 0.17
</TABLE>
The fair value of each option grant was estimated to be $1.05 as of the
grant date using the Black-Scholes option pricing model with the following
assumptions: dividend yield of 11% per annum; expected volatility of 30%;
risk free interest rate of 5.82% per annum; and an expected life of 10
years.
Information regarding stock option activity for the quarter and six months
ended June 30, 1998 is as follows:
<TABLE>
<CAPTION>
Shares
----------
<S> <C>
Outstanding, beginning of period 400,000
Exercised -
Expired -
----------
Outstanding, end of period 400,000
==========
</TABLE>
12
<PAGE>
The remaining contractual life of each option is ten years. The options
vest in three equal installments on February 3, 1999, December 3, 1999 and
December 3, 2000.
NOTE 10 - CONTRACTUAL COMMITMENTS
During the quarter ended June 30, 1998 the Company entered into interest
rate swap agreements with original notional amounts as stated below. Under
these agreements, the Company receives a floating rate and pays a fixed
rate.
<TABLE>
<CAPTION>
Current
Notional Amount Termination Unrealized
(000) Type Fixed Rate Floating Rate Date Gains (Losses)
- -------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
$ 95,000 Interest Rate Swap 5.880% 1Mo LIBOR 5/29/00 $ (235)
30,000 Interest Rate Swap 5.905% 1Mo LIBOR 6/30/00 (91)
29,000 Interest Rate Swap 5.765% 1Mo LIBOR 7/25/00 4
63,000 Interest Rate Swap 5.775% 1Mo LIBOR 8/25/00 9
60,000 Interest Rate Swap 5.900% 1Mo LIBOR 5/18/01 (179)
100,000 Interest Rate Swap 5.883% 1Mo LIBOR 5/25/01 (226)
130,288 Interest Rate Swap 5.905% 1Mo LIBOR 5/25/01 (327)
57,000 Interest Rate Swap 5.750% 1Mo LIBOR 7/14/01 53
65,000 Interest Rate Swap 5.791% 1Mo LIBOR 7/25/01 4
48,803 Interest Rate Swap 5.960% 1Mo LIBOR 5/15/02 (224)
-------
$(1,212)
-------
</TABLE>
NOTE 11 - CONTINGENCIES
A mortgage company with a similar name recently filed suit against the
Company demanding that the Company not operate under the name "Apex
Mortgage Capital." The litigation was instituted by Apex Mortgage Corp.,
a Pennsylvania corporation engaged in the origination, trading and
servicing of mortgage loans, on November 24, 1997 in the United States
District Court for the Southern District of New York.
During the quarter ended June 30, 1998, the Company entered into a
settlement agreement with the plaintiff that resolved the matter. The
agreement was reached without material impact on the financial statements
or operations of the Company.
13
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Certain information contained in this Quarterly Report on Form 10-Q constitutes
"forward-looking statements" which can be identified by the use of forward-
looking terminology such as "may," "will," "should," "expect,"
"anticipate," "estimate," "intend," "continue," or "believes" or the
negatives thereof or other variations thereon or comparable terminology.
Discussed below are some important factors that would cause actual results to
differ materially from those in any forward-looking statements, including
changes in interest rates; domestic and foreign business, market, financial or
legal conditions; differences in the actual allocation of the assets of the
company from those assumed; and the degree to which assets are hedged and the
effectiveness of the hedge, among others. In addition, the degree of risk is
increased by the company's leveraging of its assets. For additional discussion
of factors that could cause actual results to differ from those contained in
such forward-looking statements, see "Risk Factors" in the Prospectus included
in the Registration Statement on Form S-11 (333-36069) filed by the Company on
November 29, 1997 and incorporated by reference as Exhibit 99.1 in the Company's
annual report on Form 10-K for the year ended December 31, 1997. The Company
does not undertake, and specifically disclaims any obligation, to update any
forward-looking statements to reflect occurrences or unanticipated events or
circumstances after the date of such statements.
GENERAL
Apex Mortgage Capital, Inc. (the "Company"), a Maryland corporation, was
formed on September 15, 1997, primarily to acquire United States agency and
other highly rated, single-family real estate mortgage securities and mortgage
loans. The Company commenced operations on December 9, 1997, upon receipt of
the net proceeds from the initial public offering of the Company's common stock.
The Company's principal executive offices are located at 865 South Figueroa
Street, Suite 1800, Los Angeles, California 90017, and its telephone number is
(213) 244-0440.
The Company uses its equity capital and borrowed funds to seek to generate
income based on the difference between the yield on its mortgage assets and the
cost of its borrowings. The Company will elect to be taxed as a real estate
investment trust ("REIT") under the Internal Revenue Code of 1986, as amended
(the "Code"). The Company should not generally be subject to federal taxes on
its income to the extent that it distributes its net income to its stockholders
and maintains its qualification as a REIT.
The goal of the Company is to be an efficient investor in mortgage assets. The
Company generally acquires mortgage assets primarily in the secondary mortgage
market through the operational experience and market relationships of TCW
Investment Management Company (the "Manager") and its affiliates.
The day-to-day operations of the Company are managed by the Manager subject to
the direction and oversight of the Company's Board of Directors, a majority of
whom are unaffiliated with the Manager. The Manager is a wholly-owned
subsidiary of The TCW Group, Inc. ("TCW"). The Manager was established in 1992
and TCW began operations in 1971 through one of its affiliates. The Company's
investment management team consists of selected members of TCW's mortgage-backed
securities group, all of whom have over ten years of experience in raising and
managing mortgage capital. The Company has elected to be externally managed by
the Manager to take advantage of the existing operational systems, expertise and
economies of scale associated with the Manager's current business operations,
among other reasons.
STRATEGY
To achieve its business objective and generate dividend yields that provide a
competitive rate of return for its stockholders, the Company's strategy is to:
. purchase primarily single-family mortgage assets;
. manage the credit risk of its mortgage assets through, among other activities
(i) carefully selecting mortgage assets to be acquired, (ii) complying with
the Company's policies with respect to credit risk concentration which, among
other things, require the Company to maintain a mortgage asset portfolio with
a weighted average rating generally equivalent to AA (or a comparable rating)
or better, (iii) actively monitoring the ongoing credit quality and
14
<PAGE>
servicing of its mortgage assets, and (iv) maintaining appropriate capital
levels and allowances for possible credit losses;
. finance purchases of mortgage assets with the net proceeds of equity
offerings and to utilize leverage to increase potential returns to
stockholders through borrowings (primarily reverse repurchase agreements)
with interest rates that will generally reflect changes in short-term market
interest rates; and
. utilize interest rate caps, swaps and similar financial instruments to
mitigate the risk of the cost of its variable-rate liabilities exceeding the
earnings on its mortgage assets during a period of rising interest rates.
During the quarter, the Company modified its emphasis on investing primarily in
adjustable-rate mortgage assets. Under the new policy as approved by the
Company's Board of Directors (including all of the independent directors who are
not affiliated with the Manager or TCW), the Company will be able to invest in
either fixed-rate mortgage assets or adjustable-rate mortgage assets without a
defined allocation to either asset category. Investments in fixed-rate mortgage
assets funded with borrowings are generally expected to be combined with hedging
instruments in order to mitigate interest rate risk to the extent possible. See
"Hedging Instruments and Other Investments" and "Effects of Interest Rate
Changes" below. The Company also refined its interest rate risk management
policy in light of a potential shift toward fixed-rate investments. Whereas the
previous policy generally required that the weighted average time to reset on
the Company's mortgage assets and borrowings remain within 90 days, the new
policy targets the difference between the weighted average duration of the
Company's mortgage assets and the related borrowings used for funding to one
year or less, taking into account all hedging transactions. At a meeting in May,
1998, the Board approved amending the Company's Investment Policy, Asset
Acquisition Policy and Interest Rate Risk Management Policy to reflect the
foregoing policy changes, copies of which are attached as Exhibits to this Form
10-Q.
Prepayment rates on mortgage assets are influenced by changes in current
interest rates and a variety of economic, geographic and other factors beyond
the control of the Company, and consequently, such prepayment rates cannot be
predicted with certainty. In periods of declining mortgage asset interest
rates, prepayments on mortgage assets generally increase. If general interest
rates decline as well, the proceeds of such payments received during such
periods are likely to be reinvested by the Company in assets yielding less than
the yields on the mortgage assets that were prepaid. In addition, the market
value of the mortgage assets may, because of the risk of prepayment, benefit
less than other fixed-income securities from declining interest rates.
Conversely, in periods of rising interest rates, prepayments on mortgage assets
generally decrease, in which case the Company would not have the prepayment
proceeds available to invest in assets with higher yields. Prepayment of
mortgage assets in such interest rate environments could negatively impact the
Company's financial condition, cash flows and results of operations.
The Company has established the foregoing strategies along with certain
operating policies and procedures to implement them. However, these strategies
and policies may be modified or waived by the Board of Directors at any time
without the consent or approval of the Company's stockholders. The ultimate
effect of any such changes is uncertain.
FINANCIAL CONDITION
- -------------------
MORTGAGE ASSETS
At June 30, 1998, the Company held $864,432,000 of mortgage assets as compared
to $265,880,000 at December 31, 1997. The original maturity of a significant
portion of the mortgage assets ranges from fifteen to thirty years; the actual
maturity is subject to change based on the prepayments of the underlying
mortgage loans.
15
<PAGE>
The following table is a schedule of mortgage assets held listed by security
type (dollars in thousands):
<TABLE>
<CAPTION>
June 30, 1998 December 31, 1997
-----------------------------------------------------------------
Carrying Percent of Carrying Percent of
Mortgage-Backed Securities Value Portfolio Value Portfolio
- -------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Adjustable Rate (1) $ 92,718 10.7% $240,819 90.6%
Fixed Rate 771,714 89.3% 25,061 9.4%
-------- ----- -------- -----
Totals $864,432 100.0% $265,880 100.0%
======== ===== ======== =====
</TABLE>
(1) At June 30, 1998, the interest rate indices for 95% and 5% of the
adjustable rate mortgage securities were based on the one-year U.S.
Treasury rate and the six-month London Inter-Bank Offered Rate,
respectively. At December 31, 1997, the interest rate index for all
adjustable rate mortgage securities was based on the one-year U.S.
Treasury rate.
The following table shows various weighted average characteristics of the
mortgage assets held by the Company at June 30, 1998 (dollars in thousands):
<TABLE>
<CAPTION>
Percent of Weighted
Total Par Amortized Market Current Average
Security Type Par Amount Amount Cost Basis Price Coupon Life (1)
- ----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
15 Year Agency/AAA Pass-throughs $330,245 38.4% 100.48% 100.51% 6.51% 3.5
20 Year Agency Pass-throughs 123,213 14.3% 100.41% 100.18% 6.50% 5.7
AAA CMOs 316,032 36.7% 99.49% 100.07% 6.81% 2.7
-------- ----- ------ ------ ---- ---
Total Fixed Rate Holdings 769,490 89.4% 100.08% 100.29% 6.63% 3.5
Adjustable Rate Holdings 91,386 10.6% 101.67% 101.46% 6.90% 0.9
-------- ----- ------ ------ ---- ---
Total Portfolio $860,876 100.0% 100.25% 100.42% 6.66% 3.2
======== ===== ====== ====== ==== ===
</TABLE>
The following table shows various weighted average characteristics of the
mortgage assets held by the Company at December 31, 1998 (dollars in thousands):
<TABLE>
<CAPTION>
Percent of Weighted
Total Par Amortized Current Average
Security Type Par Amount Amount Cost Basis Market Price Coupon Life (1)
- -----------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Fixed Rate Agency CMO $ 24,826 9.5% 100.78% 100.95% 7.50% 0.9
Adjustable Rate Holdings 237,929 90.5% 101.12% 101.21% 6.90% 0.6
-------- ----- ------ ------ ---- ---
Total Portfolio $262,755 100.0% 101.11% 101.19% 6.66% 0.6
======== ===== ====== ====== ==== ===
</TABLE>
(1) The weighted average life of the fixed rate mortgage securities is
based upon market prepayment expectations as of the dates shown. The
actual weighted average life could be longer or shorter depending on the
actual prepayment rates experienced over the life of the securities. The
weighted average life shown for the adjustable rate mortgage assets
represents the average time until the next coupon reset date. All averages
are shown in years.
16
<PAGE>
HEDGING INSTRUMENTS AND OTHER INVESTMENTS
The Company utilizes interest rate caps, swaps and similar financial instruments
to mitigate the risk of the cost of its variable-rate liabilities exceeding the
earnings on its mortgage assets during a period of rising interest rates. The
Company is currently utilizing both interest rate cap and interest rate swap
agreements.
Interest rate cap agreements consisted of London Interbank Offered Rate
("LIBOR") based agreements as follows:
<TABLE>
<CAPTION>
At June 30, 1998 At December 31, 1997
-------------------------------------------------------
<S> <C> <C>
Notional Amount $900,000,000 $500,000,000
Average Contract Rate 10.4% 10.0%
Average Final Maturity January 24, 2002 December 24, 2001
</TABLE>
Under these agreements, the Company will receive cash payments to the extent of
the excess of three-month LIBOR over the agreements' contract rate times the
notional amount. The interest rate cap agreements are reported as other
investments on the balance. A portion of the interest rate cap agreements do not
qualify for hedge accounting now that the Company has entered into additional
hedging transactions as discussed below.
During the quarter, the Company entered into interest rate swap agreements with
current notional amounts as stated below. Under these agreements, the Company
receives a floating rate and pays a fixed rate.
<TABLE>
<CAPTION>
Current
Notional Amount Termination Unrealized
(000) Type Fixed Rate Floating Rate Date Gains (Losses)
- ----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
$ 95,000 Interest Rate Swap 5.880% 1Mo LIBOR 5/29/00 $ (235)
30,000 Interest Rate Swap 5.905% 1Mo LIBOR 6/30/00 (91)
29,000 Interest Rate Swap 5.765% 1Mo LIBOR 7/25/00 4
63,000 Interest Rate Swap 5.775% 1Mo LIBOR 8/25/00 9
60,000 Interest Rate Swap 5.900% 1Mo LIBOR 5/18/01 (179)
100,000 Interest Rate Swap 5.883% 1Mo LIBOR 5/25/01 (226)
130,288 Interest Rate Swap 5.905% 1Mo LIBOR 5/25/01 (327)
57,000 Interest Rate Swap 5.750% 1Mo LIBOR 7/14/01 53
65,000 Interest Rate Swap 5.791% 1Mo LIBOR 7/25/01 4
48,803 Interest Rate Swap 5.960% 1Mo LIBOR 5/15/02 (224)
- ----------------- -------
$678,091 $(1,212)
================= ========
</TABLE>
The weighted average coupon the Company pays on the interest rate swap
agreements at June 30, 1998 was 5.86%. The weighted average life of the
agreements at June 30, 1998 was 2.4 years.
There can be no assurance that the Company will enter into hedging activities or
that, if entered into, such activities will have the desired beneficial impact
on the Company's results of operations or financial condition. Moreover, no
hedging activity can completely insulate the Company from the risks associated
with changes in interest rates and prepayment rates.
Hedging involves risk and typically involves costs, including transaction costs.
Such costs increase dramatically as the period covered by the hedging increases
and 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. The Company intends generally to hedge as much of the interest rate
risk as the Manager determines is in the best interest of the shareholders of
the Company given the cost of such hedging transactions and the Company's desire
to maintain its status as a REIT. The Company's policies do not contain
specific requirements as to the percentages or amount of interest rate risk
which the Manager is required to hedge.
17
<PAGE>
LIABILITIES
The Company has entered into reverse repurchase agreements to finance certain of
its mortgage-backed securities. These agreements are secured by a portion of
the Company's mortgage-backed securities and bear interest rates that have
historically moved in close relationship to LIBOR.
At June 30, 1998, the Company had outstanding $753,752,000 of reverse repurchase
agreements with a weighted average current borrowing rate of 5.62% and a
maturity of 3.2 months. The reverse repurchase agreements were collateralized
by mortgage-backed securities with an estimated fair value of $768,283,000.
At December 31, 1997, the Company had outstanding $87,818,000 of reverse
repurchase agreements with a weighted average current borrowing rate of 5.82%
and a maturity of 2.8 months. The reverse repurchase agreements were
collateralized by mortgage-backed securities with an estimated fair value of
$90,043,000.
The Company had $127,451,000 and $90,492,000 of other liabilities at June 30,
1998 and December 31, 1997, respectively, consisting primarily of payables for
unsettled securities. The Company anticipates settling all other liabilities
within one year by entering into additional reverse repurchase agreements.
RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JUNE 30, 1998
For the quarter ended June 30, 1998, the Company's net income was $609,000, or
$0.10 per share on both a basic and diluted basis, based on a weighted average
of 6,387,000 shares outstanding. Net interest income for the period was
$499,000 consisting of interest income on mortgage assets and cash balance less
interest expense on reverse repurchase agreements. The Company reported a net
gain primarily on the gains on investment transactions, net of $469,000. The
Company incurred operating expenses of $359,000 for the quarter consisting of
management fees, audit, tax, legal, printing, insurance and other expenses.
As a REIT, the Company is required to declare dividends amounting to 85% of each
year's taxable income by the end of each calendar year and to have declared
dividends amounting to 95% of its taxable income for each year by the time it
files its applicable tax return. The Company currently intends to distribute
approximately 100% of its taxable net income each year.
The Company anticipates that it will experience differences between its net
income based on generally accepted accounting principles ("GAAP") and its
taxable net income due primarily to differences in the methods used to amortize
purchase premiums and discounts and to the recognition of certain compensation
expenses that are not recognized for tax purposes. However, the taxable income
information shown on a quarter by quarter basis is subject to change upon the
final filing of the Company's annual income tax return. As the Company's
dividend distributions are generally based on expectations of annual earnings,
there may be differences between the quarterly taxable income reported and the
actual dividend declared during any given quarter.
18
<PAGE>
The following table provides a reconciliation between the Company's GAAP net
income and its taxable net income for the three months ended June 30, 1998:
<TABLE>
<CAPTION>
(Dollars in thousands)
Description GAAP Tax Difference
---- --- ----------
<S> <C> <C> <C>
Coupon Interest Income $11,261 $11,261 $ -
Less Amortization Expense 1,763 906 857
---------------------------------------------
Net Interest Income 9,498 10,355 857
Less Interest Expense 8,999 8,999 -
---------------------------------------------
Net Operating Income 499 1,356 857
Gains on Investment Transactions, Net 469 (804) 1,273
---------------------------------------------
Total Income 968 552 416
---------------------------------------------
Stock Option Expense 28 - 28
Other G & A Expenses 331 331 -
---------------------------------------------
Total G & A Expenses 359 331 28
---------------------------------------------
Net Income $ 609 $ 221 $ 388
=============================================
</TABLE>
The difference in amortization expense represents a timing difference that will
reverse in future periods or upon the sale of the related assets. The
difference in net gain or loss on the sale of assets represents the differing
basis in the assets sold as caused by the different amortization amounts
recognized since the acquisition of the related assets.
At June 30, 1998, the Company had distributed $2,018,000 in excess of reported
net income.
The following table reflects the average balances for each category of the
Company's interest earning assets as well as the Company's interest bearing
liabilities, with the corresponding effective rate of interest annualized for
the three months ended June 30, 1998 (dollars in thousands):
AVERAGE BALANCE AND RATE TABLE
(Dollars in thousands)
<TABLE>
<CAPTION>
For the Quarter Ended
June 30, 1998
--------------------------------------------
Average Balance Effective Rate
------------------ ------------------
<S> <C> <C>
Interest Earning Assets:
Mortgage Assets $681,123 5.42%
Cash and Cash Equivalents 21,974 5.00%
-------- -----
Total Interest Earning Assets 703,097 5.40%
-------- -----
Interest Bearing Liabilities:
Reverse Repurchase Agreements 639,029 5.63%
-------- -----
Net Interest Earning Assets and Spread $ 64,068 (0.23%)
======== =====
</TABLE>
19
<PAGE>
The effective yield data is computed by dividing the annualized net interest
income or expense into the average daily balance shown.
The Company experienced a negative net interest spread during the quarter ended
June 30, 1998 resulting from faster than expected prepayments on its mortgage
assets. When actual prepayment experience exceeds expectations, the Company
must amortize its purchase premiums over a shorter time period, resulting in a
reduced yield on the Company's mortgage assets. For the three months ended June
30, 1998, the Company's mortgage assets prepaid at an approximate average
annualized constant prepayment rate of 33%.
On January 13, 1998, the Company's board of directors authorized a program to
repurchase up to 750,000 shares of the Company's Common Stock. The Company
repurchased 337,300 shares of its Common Stock pursuant to the program during
the quarter ended June 30, 1998. The average price per share repurchased was
$11.57. The repurchased shares are held in treasury at cost in the financial
statements herein.
An additional 215,000 shares are currently authorized for potential repurchase
in the future. The Company may continue to repurchase shares in the future when
market conditions warrant.
Results of Operations for the Six Months Ended June 30, 1998
For the six months ended June 30, 1998, the Company's net income was $1,173,000,
or $0.18 per share on both a basic and diluted basis, based on a weighted
average of 6,495,000 shares outstanding. Net interest income for the period was
$1,395,000 consisting of interest income on mortgage assets and cash balance
less interest expense on reverse repurchase agreements. The Company reported a
net gain primarily on the gains on investment transactions, net of $469,000.
The Company incurred operating expenses of $691,000 for the period consisting of
management fees, audit, tax, legal, printing, insurance and other expenses.
The following table provides a reconciliation between the Company's GAAP net
income and its taxable net income for the six months ended June 30, 1998:
<TABLE>
<CAPTION>
(Dollars in thousands)
Description GAAP Tax Difference
---- --- ----------
<S> <C> <C> <C>
Coupon Interest Income $17,100 $17,100 $ -
Less Amortization Expense 2,695 1,079 1,616
--------------------------------------------------
Net Interest Income 14,405 16,021 1,616
Less Interest Expense 13,010 13,010 -
--------------------------------------------------
Net Operating Income 1,395 3,011 1,616
Gains on Investment Transactions, Net 469 (804) 1,273
--------------------------------------------------
Total Income 1,864 2,207 (343)
--------------------------------------------------
Stock Option Expense 56 - 56
Other G & A Expenses 635 631 4
Total G & A Expenses 691 631 60
--------------------------------------------------
Net Income $ 1,173 $ 1,576 $ (403)
==================================================
</TABLE>
The difference in amortization expense represents a timing difference that will
reverse in future periods or upon the sale of the related assets. The
difference in net gain or loss on the sale of assets represents the differing
basis in the assets sold as caused by the different amortization amounts
recognized since the acquisition of the related assets.
20
<PAGE>
The following table reflects the average balances for each category of the
Company's interest earning assets as well as the Company's interest bearing
liabilities, with the corresponding effective rate of interest annualized for
the six months ended June 30, 1998 (dollars in thousands):
AVERAGE BALANCE AND RATE TABLE
(Dollars in thousands)
<TABLE>
<CAPTION>
For the Six Months Ended
June 30, 1998
--------------------------------------------
Average Balance Effective Rate
------------------ ------------------
<S> <C> <C>
Interest Earning Assets:
Mortgage Assets $516,584 5.40%
Cash and Cash Equivalents 17,893 5.10%
-------- ----
Total Interest Earning Assets 534,477 5.39%
-------- ----
Interest Bearing Liabilities:
Reverse Repurchase Agreements 464,031 5.58%
-------- ----
Net Interest Earning Assets and Spread $ 70,446 (0.19%)
======== =====
</TABLE>
The effective yield data is computed by dividing the annualized net interest
income or expense into the average daily balance shown.
On January 13, 1998, the Company's board of directors authorized a program to
repurchase up to 750,000 shares of the Company's Common Stock. The Company
repurchased 535,000 shares of its Common Stock pursuant to the program during
the six months ended June 30, 1998. The average price per share repurchased was
$12.03. The repurchased shares are held in treasury at cost in the financial
statements herein.
Liquidity and Capital Resources
The Company's primary sources of funds for the quarter ended June 30, 1998
consisted of reverse repurchase agreements totaling $753,752,000. The Company
expects to continue to borrow funds in the form of reverse repurchase agreements
with maturities that generally correspond to the average reset date or average
life of the Company's mortgage assets after taking into account certain hedging
transactions. At June 30, 1998, the Company had borrowing arrangements with
fourteen different investment banking firms. Increases in short-term interest
rates could negatively impact the valuation of the Company's mortgage assets
which could limit the Company's borrowing ability or cause its lenders to
initiate margin calls.
The Company will also rely on the cash flow from operations, primarily monthly
principal and interest payments to be received on the mortgage assets, for
liquidity.
The Company believes that equity capital, combined with the cash flow from
operations and the utilization of borrowings, will be sufficient to enable the
Company to meet anticipated liquidity requirements. If the Company's cash
resources are at any time insufficient to satisfy the Company's liquidity
requirements, the Company may be required to liquidate mortgage assets or sell
debt or additional equity securities. If required, the sale of mortgage assets
at prices lower than the carrying value of such assets would result in losses.
The Company may in the future increase its capital resources by making
additional offerings of equity and debt securities, including classes of
preferred stock, common stock, commercial paper, medium-term notes, CMOs and
senior or subordinated notes. All debt securities, other borrowings, and
classes of preferred stock will be senior to the common stock
21
<PAGE>
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 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.
EFFECTS OF INTEREST RATE CHANGES
The Company invests in adjustable-rate mortgage assets that are typically
subject to periodic and lifetime interest rate caps that limit the amount an
adjustable-rate mortgage asset's interest rate can change during any given
period, as well as the minimum rate payable. The Company's borrowings will not
be subject to similar restrictions. Hence, in a period of increasing interest
rates, interest rates on its borrowings could increase without limitation by
caps, while the interest rates on its mortgage assets are generally limited by
caps. This problem will be magnified to the extent the Company acquires
mortgage assets that are not fully indexed. Further, some adjustable-rate
mortgage assets may be subject to periodic payment caps that result in some
portion of the interest being deferred and added to the principal outstanding.
This could result in receipt by the Company of less cash income on its
adjustable-rate mortgage assets than is required to pay interest on the related
borrowings. These factors could lower the Company's net interest income or
cause a net loss during periods of rising interest rates, which would negatively
impact the Company's financial condition, cash flows and results of operations.
The Company intends to fund a substantial portion of its acquisitions of
adjustable-rate mortgage assets with borrowings that have interest rates based
on indices and repricing terms similar to, but of somewhat shorter maturities
than, the interest rate indices and repricing terms of the mortgage assets.
Thus, the Company anticipates that in most cases the interest rate indices and
repricing terms of its mortgage assets and its funding sources will not be
identical, thereby creating an interest rate mismatch between assets and
liabilities. While the historical spread between relevant short-term interest
rate indices has been relatively stable, there have been periods, especially
during the 1979-1982 and 1994 interest rate environments, when the spread
between such indices was volatile. During periods of changing interest rates,
such interest rate mismatches could negatively impact the Company's financial
condition, cash flows and results of operations.
Prepayment rates generally increase when prevailing interest rates fall below
the interest rates on existing mortgage assets. In addition, prepayment rates
generally increase when the difference between long-term and short-term interest
rates declines. Prepayments of mortgage assets could adversely affect the
Company's results of operations in several ways. The Company anticipates that a
substantial portion of its adjustable-rate mortgage assets may bear initial
"teaser" interest rates that are lower than their "fully indexed" rates (the
applicable index plus a margin). In the event that such an adjustable-rate
mortgage asset is prepaid prior to or soon after the time of adjustment to a
fully indexed rate, the Company will have held the mortgage asset while it was
less profitable and lost the opportunity to receive interest at the fully
indexed rate over the expected life of the adjustable-rate mortgage asset. In
addition, the prepayment of any mortgage asset that had been purchased at a
premium by the Company would result in the immediate write-off of any remaining
capitalized premium amount and consequent reduction of the Company's net
interest income by such amount. Finally, in the event that the Company is
unable to acquire new mortgage assets to replace the prepaid mortgage assets,
its financial condition, cash flow and results of operations could be materially
adversely affected.
The Company also invests in fixed-rate mortgage assets that are expected to be
funded with short-term borrowings. During periods of rising interest rates, the
borrowing costs associated with funding such fixed-rate assets are subject to
increase while the income earned on such assets may remain substantially
unchanged. This would result in a narrowing of the net interest spread between
the related assets and borrowings and may even result in losses. The Company may
enter into derivative transactions seeking to mitigate the negative impact of a
rising interest rate environment. Hedging techniques will be based, in part, on
assumed levels of prepayments of the Company's mortgage assets. If prepayments
are slower or faster than assumed, the life of the mortgage assets will be
longer or shorter which would reduce the effectiveness of the Company's hedging
techniques and may result in losses on such transactions. Hedging techniques
involving the use of derivative securities are highly complex and may produce
volatile returns. The hedging activity of the Company will also be limited by
the asset and sources of income requirements applicable to the Company as a
REIT.
During the quarter, the Company increased its current allocation to fixed-rate
mortgage assets from 14.2% of the portfolio at March 31, 1998 to 89.3% at June
30, 1998. The Company may increase this allocation as market conditions
warrant. As mentioned above, there are certain risks associated with investing
in fixed-rate mortgage assets in combination with hedging instruments. The two
main risks the Company faces are that of extension risk and prepayment risk.
22
<PAGE>
Extension Risk
- --------------
Fixed-rate assets are generally acquired with a projected weighted average life
based on certain assumptions regarding prepayments. In general, when a fixed-
rate mortgage asset is acquired with borrowings, the Company will enter into an
interest rate swap agreement or other hedging instrument that effectively fixes
the Company's borrowing costs for a period close to the anticipated average life
of the related asset. This strategy is designed to protect the Company from
rising interest rates because the borrowing costs are fixed for the duration of
the asset. However, if prepayment rates decrease in a rising interest rate
environment, the life of the mortgage asset could extend beyond the term of the
swap agreement or other hedging instrument. This situation could negatively
impact the Company as borrowing costs would no longer be fixed after the end of
the hedging instrument while the income earned on the asset would remain fixed.
This situation may also cause the market value of the Company's mortgage assets
to decline with little or no offsetting gain from the related hedging
transactions. In certain situations, the Company may be forced to sell assets
and incur losses to maintain adequate liquidity.
Prepayment Risk
- ---------------
Fixed-rate assets in combination with hedging instruments are also subject to
prepayment risk. In falling interest rate scenarios, the fixed-rate mortgage
assets may prepay faster such that the average life becomes shorter than its
related hedging instrument. If this were to happen, the Company would
potentially need to reinvest at rates lower than that of the related hedging
instrument. This situation may result in the narrowing of interest rate spreads
or may cause losses.
PART 2. OTHER INFORMATION
Item 1. Legal Proceedings
A mortgage company with a similar name recently filed suit against the
Company demanding that the Company not operate under the name "Apex
Mortgage Capital." The litigation was instituted by Apex Mortgage
Corp., a Pennsylvania corporation engaged in the origination, trading
and servicing of mortgage loans, on November 24, 1997 in the United
States District Court for the Southern District of New York.
During the quarter ended June 30, 1998, the Company entered into a
settlement agreement with the plaintiff that resolved the matter. The
agreement was reached without material impact on the financial
statements or operations of the Company.
Item 2. Changes in Securities
Not Applicable
Item 3. Defaults Upon Senior Securities
Not Applicable
Item 4. Submission of Matters to a Vote of Security Holders
At the 1998 Annual Meeting of Shareholders held July 1, 1998 (after the
reporting period covered by this Form 10-Q) shareholders of record as
of April 30, 1998 were asked to vote to ratify the selection of
Deloitte & Touch LLP as the Company's independent auditors. 6,342,792
shares were voted for the proposal, 15,365 shares were voted against
the proposal, no shares were withheld, 21,150 shares abstained and no
shares were broker non-votes.
Item 5. Other Information
None
23
<PAGE>
Item 6. Exhibits and Reports on Form 8-K:
(a) Exhibits
Exhibit #27 Financial Data Schedule
Exhibit #99.1 Investment Policy
Exhibit #99.2 Asset Acquisition Policy
Exhibit #99.3 Interest Rate Risk Management Policy
(b) Reports on Form 8-K
None
24
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Apex Mortgage Capital, Inc.
Dated: August 14, 1998
By: /s/ Philip A. Barach
----------------------------
Philip A. Barach
President and Chief Executive Officer
(Principal Executive Officer)
By: /s/ Daniel K. Osborne
----------------------------
Daniel K. Osborne
Executive Vice President
Chief Operating Officer
Chief Financial Officer
(Principal Accounting Officer)
25
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION OF THE REGISTRANT AS OF JUNE 30,
1998 AND THE CONSOLIDATED STATEMENTS OF OPERATIONS OF THE REGISTRANT FOR THE
THREE MONTHS ENDED JUNE 30, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE
TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> APR-01-1998
<PERIOD-END> JUN-30-1998
<CASH> 38,867
<SECURITIES> 864,545
<RECEIVABLES> 62,899
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 752
<PP&E> 0
<DEPRECIATION> 0
<TOTAL-ASSETS> 967,063
<CURRENT-LIABILITIES> 881,203
<BONDS> 0
0
0
<COMMON> 67
<OTHER-SE> 85,866
<TOTAL-LIABILITY-AND-EQUITY> 967,063
<SALES> 0
<TOTAL-REVENUES> 9,498
<CGS> 0
<TOTAL-COSTS> 0
<OTHER-EXPENSES> 359
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 8,999
<INCOME-PRETAX> 609
<INCOME-TAX> 0
<INCOME-CONTINUING> 609
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 609
<EPS-PRIMARY> 0.10
<EPS-DILUTED> 0.10
</TABLE>
<PAGE>
EXHIBIT 99.1
Investment Policy
The Company's investment strategy will be to create a diversified portfolio
primarily of High Quality adjustable-rate and fixed-rate Mortgage Securities
that, in the aggregate, will preserve the capital base of the Company and
generate income for distribution to its stockholders. The mix of the Company's
portfolio between High-Quality adjustable-rate and fixed-rate Mortgage
Securities will vary with market conditions. The Company's Mortgage Assets will
be held primarily for investment. The Company intends generally to buy and hold
Mortgage Assets as long term investments and, therefore, will seek to have a low
portfolio turnover rate under normal market conditions. The Company's ability to
sell Mortgage Assets for gain is restricted by the REIT Provisions of the Code
and the rules, regulations and interpretations of the Service thereunder.
The Company anticipates that at least 75% of total Mortgage Assets will be
High Quality adjustable-rate and fixed-rate Mortgage Securities and Short-Term
Investments. The Mortgage Securities will consist of (i) privately issued
mortgage Pass-Through Certificates as well as Agency Certificates, (ii) certain
CMOs and (iii) Other Mortgage Securities, including certain Mortgage Derivative
Securities. The Company further anticipates that at least 50% of the Company's
total Mortgage Assets will be Agency Certificates or carry a AAA or comparable
rating from at least one of the Rating Agencies. The Company will generally not
acquire Inverse Floaters, REMIC Residuals or First Loss Subordinated Bonds. The
Company may acquire interest only, principal only or other Mortgage Derivative
Securities that receive a disproportionate share of interest income or
principal, either as an independent stand-alone investment opportunity or to
assist in the management of prepayment and other risks, but only on a limited
basis due to the greater risk of loss associated with Mortgage Derivative
Securities.
The remainder of the Company's investment portfolio, composing not more
than 25% of its total Mortgage Assets, may consist of unrated or rated Mortgage
Assets that are determined by the Manager to be of comparable quality to High
Quality Mortgage Securities, including (i) adjustable-rate and fixed-rate
Mortgage Loans secured by first liens on single-family (one-to-four units)
residential properties, (ii) Pass-Through Certificates or CMOs backed by
Mortgage Loans on single-family properties and (iii) Other Mortgage Securities.
The Company intends to securitize substantially all Mortgage Loans it acquires
into High Quality Mortgage Securities that are Qualified REIT Real Estate Assets
that will then be held for investment. Substantially all of the Company's
Mortgage Assets will constitute Qualified REIT Real Estate Assets.
The Company intends to purchase Mortgage Assets from broker-dealers and
banks that regularly make markets in Mortgage Securities. The Company also
intends to purchase Mortgage Securities from a variety of Suppliers of Mortgage
Assets (typically mortgage bankers, savings and loans, investment banking firms,
home builders and other firms involved in originating and packaging Mortgage
Loans). In acquiring Mortgage Assets, the Company will compete with other REITs,
investment banking firms, savings and loan associations, banks, mortgage
bankers, insurance companies, mutual funds, other lenders, Fannie Mae, FHLMC,
GNMA and other entities purchasing Mortgage Assets, some of which have greater
financial resources than the Company. There are several 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 Assets suitable for purchase by the Company. There can be no assurance
that the Company will be able to acquire sufficient Mortgage Assets from
Suppliers of Mortgage Assets at spreads above the Company's cost of funds.
The Company will not purchase any Mortgage Assets from its Affiliates other
than Mortgage Securities that may be purchased from a taxable subsidiary of the
Company that may be formed in connection with the securitization of Mortgage
Loans.
The Company does not intend to enter into any servicing or administrative
agreements (other than the Management Agreement) with the Manager or any
entities affiliated with the Manager.
<PAGE>
EXHIBIT 99.2
Asset Acquisition Policy
The Company will only acquire those Mortgage Assets that are consistent with
the Company's balance sheet guidelines and risk management objectives. Since the
intention of the Company is generally to hold its Mortgage Assets as long term
investments, the Company will generally not seek to acquire Mortgage Assets with
investment returns that are attractive only 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 will seek to acquire Mortgage
Assets that it believes will provide competitive returns over a broad range of
interest rate and prepayment scenarios.
The Company will acquire Mortgage Assets that it believes will maximize
returns on capital invested, after considering (i) the amount and nature of the
anticipated cash flow from the Mortgage Assets, (ii) the Company's ability to
pledge Mortgage Assets to secure collateralized borrowings, (iii) the increase
in the Company's capital requirement determined by the Company's Capital and
Leverage Policy resulting from the purchase and financing of Mortgage Assets,
(iv) the costs of financing, hedging, managing, securitizing and reserving for
Mortgage Assets, and (v) the Company's credit risk management policy. Prior to
acquisition of a Mortgage Asset, potential returns on capital employed are
assessed over the life of the Mortgage Asset and in a variety of interest rate,
yield spread, financing cost, credit loss and prepayment scenarios.
The Company will also give consideration to balance sheet management and risk
diversification issues. A specific Mortgage Asset that is being evaluated for
potential acquisition is deemed more or less valuable to the Company to the
extent it serves to increase or decrease certain interest rate or prepayment
risks that may exist in the balance sheet, to diversify or concentrate credit
risk, and to meet the cash flow and liquidity objectives the Company may
establish for the balance sheet from time to time. The Company will evaluate the
addition of a potential Mortgage Asset and its associated borrowings and hedges
to the balance sheet and the impact that the potential Mortgage Asset would have
on the risk in, and returns generated by, the Company's balance sheet as a whole
over a variety of scenarios.
The Company may also purchase the stock of other mortgage REITs or similar
companies when it believes that such purchase will yield relatively attractive
returns on capital employed. When the stock market valuations of such companies
are low in relation to the market value of their assets, such stock purchases
can be a way for the Company to acquire an interest in a pool of Mortgage Assets
at an attractive price. The Company does not, however, presently intend to
invest in the securities of other issuers for the purpose of exercising control
or to underwrite securities of other issuers.
The Company intends to acquire new Mortgage Assets, and will also seek to
expand its capital base in order to further increase the Company's ability to
acquire additional Mortgage Assets, when the potential returns from additional
Mortgage Assets appear attractive relative to the return expectations of
stockholders (as expressed principally by the effective dividend yield of the
Common Stock). The Company may in the future acquire Mortgage Assets by offering
its debt or equity securities in order to acquire such Mortgage Assets.
The Company generally intends to hold Mortgage Assets as long term
investments. In addition, the REIT Provisions of the Code limit in certain
respects the ability of the Company to sell Mortgage Assets. The Company may
decide to sell Mortgage Assets from time to time, however, for a number of
reasons including, without limitation, to dispose of a Mortgage Asset as to
which credit risk concerns have arisen, to reduce interest rate risk, to
substitute one type of Mortgage Asset for another to improve yield or to
maintain compliance with the 55% requirement under the Investment Company Act,
and generally to restructure the balance sheet when the Company deems such
action advisable. The Company will select any Mortgage Assets to be sold
according to the particular purpose such sale will serve. The Company has
complete discretionary authority to determine the timing of sales or the
selection of Mortgage Assets to be sold.
As a requirement for maintaining REIT status, the Company must distribute to
stockholders annually aggregate dividends equaling at least 95% of its Taxable
income. The Company will make additional distributions of capital when the
return expectations of the stockholders (as expressed principally by the
effective dividend yield of its Common Stock) appear to exceed returns
potentially available to the Company through making new investments in Mortgage
Assets. Subject to the limitations of applicable securities and state laws, the
Company can distribute capital by making purchases of its own Common Stock,
through paying down or repurchasing any outstanding uncollateralized debt
obligations, or through increasing the Company's dividend to include a return of
capital.
<PAGE>
EXHIBIT 99.3
Interest Rate Risk Management Policy
To the extent consistent with its election to qualify as a REIT, the
Company will follow an interest rate risk management policy intended to mitigate
the negative effects of major interest rate changes. The Company intends to
mitigate its interest rate risk from borrowings by attempting to control the
mismatch of the duration of its debts to the duration on its Mortgage Assets
financed with borrowings. Under normal market conditions, the Company will
attempt to target the difference between the market weighted average duration on
its Mortgage Assets financed with borrowings to the market weighted average
duration of such borrowings to one year or less, taking into account all hedging
transactions. There can be no assurance that the Company will be able to limit
such duration differences and there may be periods of time when the duration
difference will be greater than one year. This policy will be reviewed by the
Company's Board of Directors if the Company incurs long-term non-callable
borrowings and as market conditions change. In addition, the Company also
intends to manage differences in interest rate indices between its Mortgage
Assets and borrowings where adjustable rate Mortgage Assets are involved.
In addition to the foregoing duration guidelines, the Company intends to
mitigate lifetime cap risk associated with its adjustable-rate Mortgage Assets.
The policy will be to attempt to limit the effective interest rate on
substantially all of the Company's liabilities as a whole to a rate equal to the
weighted average lifetime cap of its adjustable-rate Mortgage Assets. Under
current market conditions, the Company does not intend to enter into
transactions to mitigate its periodic cap risk. The Company will manage this
risk through its leverage and asset/liability policies.
The Company intends to 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 beyond the earnings on its
Mortgage Assets during a period of rising rates. In this way, the Company
intends generally to hedge as much of the interest rate risk as is in its best
interests, given the cost of such hedging transactions and the need to maintain
the Company's status as a REIT. This determination may result in the Company
bearing a level of interest rate risk that could otherwise be hedged when the
Company believes, based on all relevant facts, that bearing such risk is
advisable. The Company may also, to the extent consistent with its compliance
with the REIT Provisions of the Code and Maryland law, utilize financial futures
contracts, options and forward contracts as a hedge against future interest rate
changes. The Company will not invest in financial futures contracts or options
thereon that would cause the Manager or the Company to have to register under
the Commodities Exchange Act. The Company's hedging strategy may lower the
earnings and dividends of the Company in the short-term in order to further the
objective of maintaining competitive levels of earnings and dividends over the
long-term. The Company does not intend to hedge for speculative purposes.
The Company may elect to conduct a portion of its hedging operations
through one or more subsidiary corporations that would not be a Qualified REIT
Subsidiary and would be subject to federal and state income taxes. In order to
comply with the nature of asset tests applicable to the Company as a REIT, the
value of the securities of any such subsidiary held by the Company must be
limited to less than 5% of the value of the Company's total Mortgage 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. 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 Mortgage Assets, other than Qualified REIT Real
Estate Assets) must not exceed 25% of the gross income of the Company.
