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: SEPTEMBER 30, 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: 001-11914
THORNBURG MORTGAGE ASSET CORPORATION
(Exact name of Registrant as specified in its Charter)
MARYLAND 85-0404134
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
119 E. MARCY STREET
SANTA FE, NEW MEXICO 87501
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (505) 989-1900
(Former name, former address and former fiscal year, if changed since last
report)
Indicate by check mark whether the Registrant (1) has filed all documents and
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
(1) Yes X No
(2) Yes X No
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the last practicable date.
Common Stock ($.01 par value) 21,489,663 as of November 13, 1998
<PAGE>
THORNBURG MORTGAGE ASSET CORPORATION
FORM 10-Q
INDEX
Page
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Balance Sheets at September 30, 1998 and
December 31, 1997 ....................................... 3
Statements of Operations for the three months and nine
months ended September 30, 1998 and September 30, 1997... 4
Statement of Stockholders' Equity for the three months
and nine months ended September 30, 1998................. 5
Statements of Cash Flows for the three months and nine
months ended September 30, 1998 and September 30, 1997... 6
Notes to Financial Statements............................ 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations............... 17
PART II. OTHER INFORMATION
Item 1. Legal Proceedings........................................... 33
Item 2. Changes in Securities ...................................... 33
Item 3. Defaults Upon Senior Securities ............................ 33
Item 4. Submission of Matters to a Vote of Security Holders......... 33
Item 5. Other Information........................................... 33
Item 6. Exhibits and Reports on Form 8-K............................ 33
SIGNATURES ......................................................... 34
<PAGE>
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
THORNBURG MORTGAGE ASSET CORPORATION
BALANCE SHEETS
(Amounts in thousands)
<TABLE>
<CAPTION>
September 30, 1998 December 31, 1997
------------------ -----------------
<S> <C> <C>
ASSETS
ARM assets: (Notes 2 and 3)
ARM securities $ 4,070,402 $ 4,519,707
ARM loans held for securitization 782,358 118,987
------------- -------------
4,852,760 4,638,694
Cash and cash equivalents 6,891 13,780
Accrued interest receivable 41,972 38,353
Receivable for assets sold 30,040 -
Prepaid expenses and other 4,661 289
------------- -------------
$ 4,936,324 $ 4,691,116
============= =============
LIABILITIES
Reverse repurchase agreements (Note 3) $ 4,550,502 $ 4,270,170
Other borrowings (Note 3) 6,916 10,018
Accrued interest payable 28,622 39,749
Dividends payable (Note 5) 1,670 11,810
Accrued expenses and other 3,976 1,215
------------- -------------
4,591,686 4,332,962
SHAREHOLDERS' EQUITY (Note 6)
Preferred stock: par value $.01 per
share; 2,760 shares authorized;
9.68% Cumulative Convertible Series A,
2,760 and 2,760 issued and
outstanding, respectively; aggregate
preference in liquidation $69,000 65,805 65,805
Common stock: par value $.01 per share;
47,240 shares authorized, 21,990 and
20,280 shares issued and
outstanding, respectively 220 203
Additional paid-in-capital 341,689 315,240
Accumulated other comprehensive income (55,832) (19,445)
Notes receivable from stock sales (4,632) (2,698)
Retained earnings (deficit) 2,054 (951)
Treasury stock: at cost, 500 and 0
shares, respectively (4,666) -
------------- -------------
344,638 358,154
------------- -------------
$ 4,936,324 $ 4,691,116
============= =============
</TABLE>
See Notes to Financial Statements.
<PAGE>
THORNBURG MORTGAGE ASSET CORPORATION
STATEMENTS OF OPERATIONS
(Amounts in thousands, except per share data)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
1998 1997 1998 1997
--------- --------- --------- -------
<S> <C> <C> <C> <C>
Interest income from ARM assets and cash $ 72,252 $ 68,088 $ 221,587 $ 174,710
Interest expense on borrowed funds (66,458) (54,862) (196,591) (137,977)
-------- --------- --------- ---------
Net interest income 5,794 13,226 24,996 36,733
-------- --------- --------- --------
Gain on sale of ARM assets 755 335 3,780 360
Provision for credit losses (561) (223) (1,402) (623)
Management fee (Note 7) (1,040) (974) (3,115) (2,661)
Performance fee (Note 7) - (931) (759) (2,569)
Other operating expenses (270) (251) (851) (689)
-------- --------- --------- --------
NET INCOME $ 4,678 $ 11,182 $ 22,649 $ 30,551
======== ========= ========= ========
Net income $ 4,678 $ 11,182 $ 22,649 $ 30,551
Dividend on preferred stock (1,670) (1,670) (5,009) (4,581)
-------- --------- --------- --------
Net income available to common
shareholders $ 3,008 $ 9,512 $ 17,640 $ 25,970
======== ========= ========= ========
Basic earnings per share $ 0.14 $ 0.50 $ 0.82 $ 1.49
======= ======== ======== =======
Diluted earnings per share $ 0.14 $ 0.49 $ 0.82 $ 1.48
======= ======== ======== =======
Average number of common shares
outstanding 21,858 19,152 21,488 17,437
======== ======== ======== =======
</TABLE>
See Notes to Financial Statements.
<PAGE>
THORNBURG MORTGAGE ASSET CORPORATION
STATEMENTS OF STOCKHOLDERS' EQUITY
Three Months and Nine Months Ended September 30, 1998 (Amounts in thousands,
except share data)
<TABLE>
<CAPTION>
Notes
Accum. Receiv-
Other able
Additional Compre- From Retained Compre-
Preferred Common Paid-in hensive Stock Earnings Treasury hensive
Stock Stock Capital Income Sales (Deficit) Stock Income Total
--------- ------- ----------- ---------- --------- --------- --------- --------- ---------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Balance, December 31, 1997 $ 65,805 $ 203 $ 315,240 $ (19,445) $ (2,698) $ (951) $ - $ 358,154
Comprehensive income:
Net income 17,971 $ 17,971 17,971
Other comprehensive
income:
Available-for-sale assets:
Fair value adjustment,
net of amortization - - - (10,875) - - (10,875) (10,875)
Deferred gain on sale
of hedges, net of
amortization - - - (909) - - (909) (909)
Other comprehensive --------
income (loss) $ 6,187
========
Issuance of common
stock (Note 5) - 17 26,261 - (1,934) - 24,344
Interest from notes
receivable from
stock sales - - 121 - - - 121
Dividends declared on
preferred stock -
$1.21 per share - - - - - (3,340) (3,340)
Dividends declared on
common stock -
$0.675 per share - - - - - (14,634) (14,634)
--------- ------- ----------- ---------- --------- --------- --------- ---------
Balance, June 30, 1998 65,805 220 341,622 (31,229) (4,632) (954) - 370,832
Comprehensive income:
Net income 4,678 $ 4,678 4,678
Other comprehensive
income:
Available-for-sale assets:
Fair value adjustment,
net of amortization - - - (24,264) - - (24,264) (24,264)
Deferred gain on sale
of hedges, net of
amortization - - - (339) - - (339) (339)
Other comprehensive --------
income (loss) $(19,925)
========
Purchase of treasury
stock (Note 5) - - - - - - (4,666) (4,666)
Interest from notes
receivable from
stock sales - - 67 - - - 67
Dividends declared on
preferred stock -
$0.605 per share - - - - - (1,670) (1,670)
--------- ------- ----------- ---------- --------- --------- --------- ---------
Balance, September 30, 1998 65,805 $ 220 $ 341,689 $ (55,832) $ (4,632) $ 2,054 $ (4,666) $344,638
========= ======= =========== ========== ========= ======== ========= =========
</TABLE>
See Notes to Financial Statements.
<PAGE>
THORNBURG MORTGAGE ASSET CORPORATION
STATEMENTS OF CASH FLOWS
(In thousands)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
1998 1997 1998 1997
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Operating Activities:
Net Income $ 4,678 $ 11,182 $ 22,649 $ 30,551
Adjustments to reconcile net income
to net cash provided by operating
activities:
Amortization 13,959 6,962 37,120 16,134
Net (gain) loss from investing
activities (194) (112) (2,378) 263
Change in assets and liabilities:
Accrued interest receivable (1,383) (2,377) (3,618) (13,711)
Receivable for assets sold 9,951 - (30,040) -
Prepaid expenses and other (2,213) (91) (4,370) (249)
Accrued interest payable (183) 5,298 (11,128) 5,824
Accrued expenses and other 2,650 3,140 2,761 7,907
Net cash provided by (used in) ------- -------- -------- -------
operating activities 27,265 24,002 10,996 46,719
------- -------- -------- -------
Investing Activities:
Available-for-sale ARM securities:
Purchases (327,140) (786,268) (1,479,934) (2,256,576)
Proceeds on sales 180,032 73,915 513,544 108,217
Proceeds from calls 12,227 - 128,006 -
Principal payments 420,676 208,511 1,202,405 494,546
Held-to-maturity ARM securities:
Principal payments - 14,207 16,152 44,732
ARM Loans:
Purchases (255,491) (31,325) (749,463) (45,075)
Principal payments 50,027 337 82,690 337
Sales - - 2,043 -
Purchase of interest rate cap agreements (99) (1,234) (641) (3,128)
Net cash provided by (used in) ------- -------- -------- ---------
investing activities 80,232 (521,857) (285,198) (1,656,947)
------- -------- -------- ---------
Financing Activities:
Net borrowings from reverse
repurchase agreements (91,206) 469,338 280,332 1,521,778
Repayments of other borrowings (892) (825) (3,102) (2,869)
Proceeds from preferred stock issued - - - 65,805
Proceeds from common stock issued - 48,350 24,344 68,768
Purchases of treasury stock (4,666) - (4,666) -
Dividends paid (8,266) (10,145) (29,784) (26,520)
Interest from notes receivable
from stock sales 68 - 189 -
Net cash provided by (used in) --------- -------- -------- ---------
financing activities (104,962) 506,718 267,313 1,626,962
--------- -------- -------- ---------
Net increase (decrease) in cash and
cash equivalents 2,535 8,863 (6,889) 16,734
Cash and cash equivalents at
beginning of period 4,356 11,564 13,780 3,693
Cash and cash equivalents at --------- -------- -------- ---------
end of period $ 6,891 $ 20,427 $ 6,891 $ 20,427
========= ======== ======== =========
</TABLE>
Supplemental disclosure of cash flow information
and non-cash activities are included in Note 3.
See Notes to Financial Statements
<PAGE>
NOTES TO FINANCIAL STATEMENTS
NOTE 1. SIGNIFICANT ACCOUNTING POLICIES
CASH AND CASH EQUIVALENTS
Cash and cash equivalents includes cash on hand and highly liquid
investments with original maturities of three months or less. The
carrying amount of cash equivalents approximates their value.
ADJUSTABLE-RATE MORTGAGE ASSETS
The Company's adjustable-rate mortgage ("ARM") assets are comprised
of both ARM securities and ARM loans, primarily secured by
single-family residential housing.
Effective the second quarter of 1998, the Company decided to change
its policy regarding its classification of ARM securities such that
each ARM security is classified as available-for-sale. The Company
changed its policy because the remaining amount of ARM securities
classified as held-to-maturity had become a relatively small
percentage of the portfolio, less than 8% of assets at March 31,
1998, and because it is apparent that as more mortgage REITs have
been formed, that it is industry practice to carry all mortgage
securities as available-for-sale. The Company had not classified any
ARM securities purchased since 1994 as held-to-maturity and does not
expect to do so in the future. Management has made the determination
that all of its ARM securities should be designated as
available-for-sale in order to be prepared to respond to potential
future opportunities in the market, to sell ARM securities in order
to optimize the portfolio's total return and to retain its ability
to respond to economic conditions that might require the Company to
sell assets in order to maintain an appropriate level of liquidity.
Since all ARM securities are designated as available-for-sale, they
are reported at fair value, with unrealized gains and losses
excluded from earnings and reported in accumulated other
comprehensive income as a separate component of shareholders'
equity.
Management has the intent and ability to hold the Company's ARM
loans for the foreseeable future and until maturity or payoff.
Therefore, they are carried at their unpaid principal balances, net
of unamortized premium or discount and allowance for loan losses.
Premiums and discounts associated with the purchase of the ARM
assets are amortized into interest income over the lives of the
assets using the effective yield method adjusted for the effects of
estimated prepayments.
ARM asset transactions are recorded on the date the ARM assets are
purchased or sold. Purchases of new issue ARM assets are recorded
when all significant uncertainties regarding the characteristics of
the assets are removed, generally shortly before settlement date.
Realized gains and losses on ARM asset transactions are determined
on the specific identification basis.
CREDIT RISK
The Company limits its exposure to credit losses on its portfolio of
ARM securities by purchasing ARM securities that have an investment
grade rating at the time of purchase and have some form of credit
enhancement or are guaranteed by an agency of the federal government
or are determined to be of equivalent credit quality as determined
by the Manager and approved by the Company's Board of Directors. An
investment grade security generally has a security rating of BBB or
Baa or better by at least one of two nationally recognized rating
agencies, Standard & Poor's, Inc. or Moody's Investor Services, Inc.
(the "Rating Agencies"). Additionally, the Company has also
purchased ARM loans and limits its exposure to credit losses by
restricting its whole loan purchases to ARM loans generally
originated to "A" quality underwriting standards or loans that have
at least five years of pay history and/or low loan to property value
ratios. The Company further limits its exposure to credit losses by
limiting its investment in investment grade securities that are
rated A, or equivalent, BBB, or equivalent, or ARM loans originated
to "A" quality underwriting standards ("Other Investments") to no
more than 30% of the portfolio.
The Company monitors the delinquencies and losses on the underlying
mortgage loans backing its ARM assets. If the credit performance of
the underlying mortgage loans is not as expected, the Company makes
a provision for possible credit losses at a level deemed appropriate
by management to provide for known losses as well as unidentified
potential future losses in its ARM assets portfolio. The provision
is based on management's assessment of numerous factors affecting
its portfolio of ARM assets including, but not limited to, current
and projected economic conditions, delinquency status, credit losses
to date on underlying mortgages and remaining credit protection. The
provision for ARM securities is made by reducing the cost basis of
the individual security for the decline in fair value which is other
than temporary, and the amount of such write-down is recorded as a
realized loss, thereby reducing earnings. The Company also makes a
monthly provision for possible credit losses on its portfolio of ARM
loans which is an increase to the reserve for possible loan losses.
The provision for possible credit losses on loans is based on loss
statistics of the real estate industry for similar loans, taking
into consideration factors including, but not limited to,
underwriting characteristics, seasoning, geographic location and
current and projected economic conditions. When a loan or a portion
of a loan is deemed to be uncollectible, the portion deemed to be
uncollectible is charged against the reserve and subsequent
recoveries, if any, are credited to the reserve.
Provisions for credit losses do not reduce taxable income and thus
do not affect the dividends paid by the Company to shareholders in
the period the provisions are taken. Actual losses realized by the
Company do reduce taxable income in the period the actual loss is
realized and would affect the dividends paid to shareholders for
that tax year.
DERIVATIVE FINANCIAL INSTRUMENTS
INTEREST RATE CAP AGREEMENTS
The Company purchases interest rate cap agreements (the "Cap
Agreements") to limit the Company's risks associated with the
lifetime or maximum interest rate caps of its ARM assets should
interest rates rise above specified levels. The Cap Agreements
reduce the effect of the lifetime cap feature so that the yield on
the ARM assets will continue to rise in high interest rate
environments as the Company's cost of borrowings also continue to
rise.
Under policies in effect prior to the second quarter of 1998, Cap
Agreements classified as a hedge against held-to-maturity assets
were initially carried at their fair value as of the time the Cap
Agreements and the related assets are designated as held-to-maturity
with an adjustment to equity for any unrealized gains or losses at
the time of the designation. Any adjustment to equity is thereafter
amortized into interest income as a yield adjustment in a manner
consistent with the amortization of any premium or discount. All Cap
Agreements are now classified as a hedge against available-for-sale
assets and are carried at their fair value with unrealized gains and
losses reported as a separate component of equity, consistent with
the reporting of such assets. The carrying value of the Cap
Agreements are included in ARM securities on the balance sheet. The
Company purchases Cap Agreements by incurring a one-time fee or
premium. The amortization of the premium paid for the Cap Agreements
is included in interest income as a contra item (i.e., expense) and,
as such, reduces interest income over the lives of the Cap
Agreements.
Realized gains and losses resulting from the termination of the Cap
Agreements that were hedging assets classified as held-to-maturity
under previous policies were deferred as an adjustment to the
carrying value of the related assets and are being amortized into
interest income over the terms of the related assets. Realized gains
and losses resulting from the termination of such agreements that
are hedging assets classified as available-for-sale are initially
reported in accumulated other comprehensive income as a separate
component of equity, consistent with the reporting of those assets,
and are thereafter amortized as a yield adjustment.
<PAGE>
INTEREST RATE SWAP AGREEMENTS
The Company enters into interest rate swap agreements in order to
manage its interest rate exposure when financing its ARM assets. In
general, the swap agreements have been utilized by the Company as a
cost effective way to lengthen the average repricing period of its
variable rate and short term borrowings. As the Company acquires
hybrid assets, it also enters into swap agreements in order to
manage the interest rate repricing mismatch (the difference between
the remaining fixed-rate period of a hybrid and the maturity of the
fixed-rate liability funding a hybrid) to approximately one year.
Revenues and expenses from the interest rate swap agreements are
accounted for on an accrual basis and recognized as a net adjustment
to interest expense.
INCOME TAXES
The Company has elected to be taxed as a Real Estate Investment
Trust ("REIT") and complies with the provisions of the Internal
Revenue Code of 1986, as amended (the "Code") with respect thereto.
Accordingly, the Company will not be subject to Federal income tax
on that portion of its income that is distributed to shareholders
and as long as certain asset, income and stock ownership tests are
met.
NET EARNINGS PER SHARE
Basic EPS amounts are computed by dividing net income (adjusted for
dividends declared on preferred stock) by the weighted average
number of common shares outstanding. Diluted EPS amounts assume the
conversion, exercise or issuance of all potential common stock
instruments unless the effect is to reduce a loss or increase the
earnings per common share.
Following is information about the computation of the earnings per
share data for the three and nine month periods ended September 30,
1998 and 1997 (Amounts in thousands except per share data):
<TABLE>
<CAPTION>
Weighted
Average Earnings
Income Shares Per Share
------------- ------------- -------------
<S> <C> <C> <C>
Three Months Ended
September 30, 1998
Net income $ 4,678
Less preferred stock dividends (1,670)
------------
Basic EPS, income available to
common shareholders 3,008 21,858 $ 0.14
===========
Effect of dilutive securities:
Stock options -
------------ -------------
Diluted EPS $ 3,008 21,858 $ 0.14
============ ============= ===========
Three Months Ended
September 30, 1997
Net income $ 11,182
Less preferred stock dividends (1,670)
------------
Basic EPS, income available to
common stockholders 9,512 19,152 $ 0.50
===========
Effect of dilutive securities:
Stock options 190
------------ -------------
Diluted EPS $ 9,512 19,342 $ 0.49
============ ============= ===========
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
Weighted
Average Earnings
Income Shares Per Share
------------- ------------- -------------
<S> <C> <C> <C>
Nine Months Ended
September 30, 1998
Net income $ 22,649
Less preferred stock dividends (5,009)
------------
Basic EPS, income available to
common shareholders 17,640 21,488 $ 0.82
===========
Effect of dilutive securities:
Stock options -
------------ -------------
Diluted EPS $ 17,640 21,488 $ 0.82
============ ============= ===========
Nine Months Ended
September 30, 1997
Net income $ 30,551
Less preferred stock dividends (4,581)
------------
Basic EPS, income available to
common stockholders 25,970 17,437 $ 1.49
===========
Effect of dilutive securities:
Stock options 162
------------ -------------
Diluted EPS $ 25,970 17,599 $ 1.48
============ ============= ===========
</TABLE>
The Company has granted options to directors and officers of the
Company and employees of the Manager to purchase 59,784 and 240,320
shares of common stock at average prices of $14.82 and $20.89 per
share during the nine months ended September 30, 1998 and 1997,
respectively. The conversion of preferred stock was not included in
the computation of diluted EPS because such conversion would
increase the diluted EPS.
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.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 130, Reporting Comprehensive Income. This statement
requires companies to classify items of other comprehensive income,
such as unrealized gains and losses on available-for-sale
securities, by their nature in a financial statement and display the
accumulated balance of other comprehensive income separately from
retained earnings and additional paid-in capital in the equity
section of a statement of financial position. The Company adopted
this statement in the first quarter of 1998.
In June 1998, the FASB issued SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities. SFAS No. 133
established a framework of accounting rules that standardize
accounting and reporting for all derivative instruments and is
effective for financial statements issued for fiscal years beginning
after June 15, 1999. The Statement requires that all derivative
financial instruments be carried on the balance sheet at fair value.
Currently the only derivative instruments that are not on the
Company's balance sheet at fair value are interest rate swap
agreements. The fair value of interest rate swap agreements is
disclosed in Note 4, Fair Value of Financial Instruments. The
Company believes that its use of interest rate swap agreements
qualify as cash-flow hedges as defined in the statement. Therefore,
changes in the fair value of these derivatives instruments will be
recorded in other comprehensive income when the Company adopts the
statement in the first quarter of its fiscal 2000 year.
In October 1998, the FASB issued SFAS No. 134, Accounting for
Mortgage-Backed Securities Retained after the Securitization of
Mortgage Loans Held for Sale by a Mortgage Banking Enterprise. This
Statement, which is effective for the first fiscal quarter beginning
after December 15, 1998, provides guidance to mortgage banking
entities who securitize mortgage loans such that their accounting
for securitized loans will the same as their accounting for
marketable securities. The Company has already been accounting for
its securitized loans in a manner consistent with the new statement
and therefore expects no changes to its financial position or
results of operations as a result of adopting SFAS No. 134.
NOTE 2. ADJUSTABLE-RATE MORTGAGE ASSETS AND INTEREST RATE CAP AGREEMENTS
The following tables present the Company's ARM assets as of September
30, 1998 and December 31, 1997. The ARM securities classified as
available-for-sale are carried at their fair value, while the
held-to-maturity ARM securities and ARM loans are carried at their
amortized cost basis (dollar amounts in thousands):
September 30, 1998:
<TABLE>
<CAPTION>
ARM Securities
--------------------------------------
Available- Held-to-
for-Sale Maturity Total ARM Loans
------------ ---------- ------------ ------------
<S> <C> <C> <C> <C>
Principal balance outstanding $ 3,974,291 $ - $ 3,974,291 $ 770,907
Net unamortized premium 102,981 - 102,981 11,935
Deferred gain from hedging (725) - (725) -
Allowance for losses (1,298) - (1,298) (484)
Interest rate cap agreements 9,649 - 9,649 -
Principal payment receivable 43,146 - 43,146 -
----------- ----------- ------------ -----------
Amortized cost, net 4,128,044 - 4,128,044 782,358
----------- ----------- ------------ -----------
Gross unrealized gains 3,703 - 3,703 -
Gross unrealized losses (61,345) - (61,345) (3,953)
----------- ----------- ------------ -----------
Fair value $ 4,070,402 $ - $ 4,070,402 $ 778,405
=========== =========== ============ ===========
Carrying value $ 4,070,402 $ - $ 4,070,402 $ 782,358
=========== =========== ============ ===========
</TABLE>
December 31, 1997:
<TABLE>
<CAPTION>
ARM Securities
--------------------------------------
Available- Held-to-
for-Sale Maturity Total ARM Loans
------------ ---------- ------------ ------------
<S> <C> <C> <C> <C>
Principal balance outstanding $ 3,984,770 $ 386,290 $ 4,371,060 $ 115,996
Net unamortized premium 119,133 5,025 124,158 3,033
Deferred gain from hedging - (1,217) (1,217) -
Allowance for losses (1,739) - (1,739) (42)
Interest rate cap agreements 11,144 2,160 13,304 -
Principal payment receivable 32,337 3,545 35,882 -
----------- ----------- ------------ -----------
Amortized cost, net 4,145,645 395,803 4,541,448 118,987
----------- ----------- ------------ -----------
Gross unrealized gains 11,075 5,609 16,684 -
Gross unrealized losses (32,816) (2,859) (35,675) -
----------- ----------- ------------ -----------
Fair value $ 4,123,904 $ 398,553 $ 4,522,457 $ 118,987
=========== =========== ============ ===========
Carrying value $ 4,123,904 $ 395,803 $ 4,519,707 $ 118,987
=========== =========== ============ ===========
</TABLE>
During the quarter ended September 30, 1998, the Company realized
$902,000 in gains and $147,000 in losses on the sale of $179.3 million
of ARM securities. During the same period of 1997, the Company realized
$446,000 in gains and $111,000 in losses on the sale of $73.6 million
of ARM securities. All of the ARM securities sold were classified as
available-for-sale.
During the nine months ended September 30, 1998, the Company realized
$4,388,000 in gains and $608,000 in losses on the sale of $511.1
million of ARM securities. During the same period of 1997, the Company
realized $1,301,000 in gains and $941,000 in losses on the sale of
$107.9 million of ARM securities. All of the ARM securities sold were
classified as available-for-sale.
As of September 30, 1998, the Company had reduced the cost basis of its
ARM securities due to potential future credit losses (other than
temporary declines in fair value) in the amount of $1,298,000. At
September 30, 1998, the Company is providing for potential future
credit losses on two securities that have an aggregate carrying value
of $12.1 million, which represent less than 0.3% of the Company's total
portfolio of ARM assets. Both of these assets are performing and one
has some remaining credit support that mitigates the Company's exposure
to potential future credit losses. Additionally, during the first nine
months of 1998, the Company, in accordance with its credit policies,
recorded a $442,000 provision for potential credit losses on its loan
portfolio, although no actual losses have been realized in the loan
portfolio to date.
The following table summarizes ARM loan delinquency information as of
September 30, 1998 (dollar amounts in thousands):
<TABLE>
<CAPTION>
Loan Loan Percent of Percent of
Delinquency Status Count Balance ARM Loans Total Assets
------------------ ------ --------- ---------- ------------
<S> <C> <C> <C> <C>
30 to 59 days 4 $ 1,239 0.16% 0.03%
60 to 89 days 2 240 0.03 0.00
90 days or more - - - -
In foreclosure 5 942 0.12 0.02
----- ------- --------- ----------
11 $ 2,421 0.31% 0.05%
===== ======= ========= ==========
</TABLE>
The following table summarizes the activity for the allowance for
losses on ARM loans for the nine months ended September 30, 1998
(dollar amounts in thousands):
Beginning balance $ 42
Provision for losses 442
Charge-offs, net 0
----------
Ending balance $ 484
==========
As of September 30, 1998, the Company had commitments to purchase
$474.4 million of ARM assets, $452 million of which were commitments to
purchase ARM loans. Subsequent to September 30, 1998, the Company
assigned the commitments to purchase ARM loans to a third party and
entered into one commitment to purchase $347 million of the ARM loans
in the form of securities or loans by December 29, 1998 and into
another commitment to purchase $105 million of the ARM loans in the
form of securities or loans by January 29, 1999.
The average effective yield on the ARM assets owned was 5.88% as of
September 30, 1998 and 6.38% as of December 31, 1997. The average
effective yield is based on historical cost and includes the
amortization of the net premium paid for the ARM assets and the Cap
Agreements, the impact of ARM principal payment receivables and the
amortization of deferred gains from hedging activity.
As of September 30, 1998 and December 31, 1997, the Company had
purchased Cap Agreements with a remaining notional amount of $4.117
billion and $4.156 billion, respectively. The notional amount of the
Cap Agreements purchased decline at a rate that is expected to
approximate the amortization of the ARM assets. Under these Cap
Agreements, the Company will receive cash payments should the
one-month, three-month or six-month London InterBank Offer Rate
("LIBOR") increase above the contract rates of the Cap Agreements which
range from 7.50% to 13.00% and average approximately 10.10%. The
Company's ARM assets portfolio had an average lifetime interest rate
cap of 11.61%. The Cap Agreements had an average maturity of 2.6 years
as of September 30, 1998. The initial aggregate notional amount of the
Cap Agreements declines to approximately $3.485 billion over the period
of the agreements, which expire between 1999 and 2004. The Company has
credit risk to the extent that the counterparties to the cap agreements
do not perform their obligations under the Cap Agreements. If one of
the counterparties does not perform, the Company would not receive the
cash to which it would otherwise be entitled under the conditions of
the Cap Agreement. In order to mitigate this risk and to achieve
competitive pricing, the Company has entered into Cap Agreements with
six different counterparties, five of which are rated AAA, and one is
rated AA.
NOTE 3. REVERSE REPURCHASE AGREEMENTS AND OTHER BORROWINGS
The Company has entered into reverse repurchase agreements to finance
most of its ARM assets. The reverse repurchase agreements are secured
by the market value of the Company's ARM assets and bear interest rates
that have historically moved in close relationship to LIBOR.
As of September 30, 1998, the Company had outstanding $4.551 billion of
reverse repurchase agreements with a weighted average borrowing rate of
5.75% and a weighted average remaining maturity of 2.3 months. As of
September 30, 1998, $1.104 billion of the Company's reverse repurchase
agreements were variable-rate term reverse repurchase agreements with
original maturities that range from three months to one year. The
interest rates of these term reverse repurchase agreements are indexed
to either the one or three-month LIBOR rate and reprice accordingly. In
addition, as of September 30, 1998, $741.5 million of the Company's
reverse repurchase agreements were collateralized by whole loans under
one year financing agreements that are indexed to the one-month LIBOR
rate and reprice either daily or once a month. The reverse repurchase
agreements at September 30, 1998 were collateralized by ARM assets with
a carrying value of $4.797 billion, including accrued interest.
At September 30, 1998, the reverse repurchase agreements had the
following remaining maturities (dollars in thousands):
Within 30 days $ 2,533,827
30 to 90 days 294,118
91 days to one year 1,722,557
------------
$ 4,550,502
============
As of September 30, 1998, the Company was a counterparty to seventeen
interest rate swap agreements having an aggregate notional balance of
$1.404 billion. Fifteen of these agreements with a notional balance of
$1.144 billion have a weighted average remaining term of 20.9 months
and the remaining two are cancelable monthly. In accordance with these
agreements, the Company will pay a fixed rate of interest during the
term of these agreements and receive a payment that varies monthly with
the one-month LIBOR rate. As a result of entering into these
agreements, the Company has reduced the interest rate variability of
its cost to finance its ARM securities by increasing the average period
until the next repricing of its borrowings from 45 days to 208 days.
The swap agreements at September 30, 1998 were collateralized by ARM
assets with a carrying value of $4.8 million, including accrued
interest.
As of September 30, 1998, the Company had financed a portion of its
portfolio of interest rate cap agreements with $6.9 million of other
borrowings which require quarterly or semi-annual payments until the
year 2000. These borrowings have a weighted average fixed rate of
interest of 7.90% and have a weighted average remaining maturity of 1.3
years. The other borrowings financing cap agreements at September 30,
1998 were collateralized by ARM securities with a carrying value of
$10.6 million, including accrued interest. The aggregate maturities of
these other borrowings are as follows (dollars in thousands):
1998 $ 1,407
1999 4,877
2000 632
----------
$ 6,916
==========
During the quarter ended September 30, 1998, the total cash paid for
interest was $69.3 million.
NOTE 4. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table presents the carrying amounts and estimated fair
values of the Company's financial instruments at September 30, 1998 and
December 31, 1997. Financial Accounting Standard Board ("FASB")
Statement 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 (dollar amounts in thousands):
<TABLE>
<CAPTION>
September 30, 1998 December 31, 1997
------------------------ ------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Assets:
ARM assets $ 4,852,338 $ 4,848,385 $ 4,634,612 $ 4,639,513
Cap agreements 422 422 4,082 1,931
Liabilities:
Other borrowings 6,916 7,055 10,018 10,321
Swap agreements 110 10,444 (50) 184
</TABLE>
The above carrying amounts for assets are combined in the balance sheet
under the caption ARM assets. The carrying amount for assets
categorized as available-for-sale is their fair value whereas the
carrying amount for assets held-to-maturity at December 31, 1997 is
their amortized cost.
The fair values of the Company's ARM securities, ARM loans and cap
agreements are based on market prices provided by certain dealers who
make markets in these financial instruments or third-party pricing
services. The fair value of the Company's long-term debt and interest
rate swap agreements, which are off-balance sheet financial
instruments, are based on market values provided by dealers who are
familiar with the terms of the long-term debt and swap agreements. The
fair values reported reflect 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, reverse
repurchase agreements and other liabilities are reflected in the
financial statements at their amortized cost, which approximates their
fair value because of the short-term nature of these instruments.
NOTE 5. COMMON AND PREFERRED STOCK
During the quarter ended September 30, 1998, the Company did not issue
any shares of common stock under its dividend reinvestment and stock
purchase plan ("DRP"). For the nine month period ended September 30,
1998, the Company issued 1,581,000 shares of common stock under its DRP
and received net proceeds of $24.3 million. The Company has also
purchased shares in the open market on behalf of the participants in
its DRP when the stock price is trading below book value instead of
issuing new shares below book value. In accordance with the terms and
conditions of the DRP, the Company pays the brokerage commission in
connection with these purchases.
On October 16, 1998, the Company declared a third quarter dividend of
$0.23 per common share which will be paid on November 18, 1998 to
common shareholders of record as of October 31, 1998. Additionally, on
September 18, 1998, the Company declared a third quarter dividend of
$0.605 per share to the shareholders of the Series A 9.68% Cumulative
Convertible Preferred Stock which was paid on October 13, 1998 to
preferred shareholders of record as of September 30, 1998. For federal
income tax purposes such dividends are expected to be ordinary income
to the Company's common and preferred shareholders, subject to year-end
allocations of the common dividend between ordinary income, capital
gain income and return of capital, depending on the composition and
amount of the Company's full year taxable income.
On July 13, 1998, the Board of Directors approved a common stock
repurchase program of up to 500,000 shares at prices below book value,
subject to availability of shares and other market conditions. On
September 18, 1998, the Board of Directors expanded this program by
approving the repurchase of up to an additional 500,000 shares. To
date, the company has repurchased 500,016 at an average price of $9.28
per share.
NOTE 6. STOCK OPTION PLAN
The Company has a Stock Option and Incentive Plan (the "Plan") which
authorizes the granting of options to purchase an aggregate of up to
1,800,000 shares, but not more than 5% of the outstanding shares of the
Company's common stock. The Plan authorizes the Board of Directors, or
a committee of the Board of Directors, to grant Incentive Stock Options
("ISOs") as defined under section 422 of the Internal Revenue Code of
1986, as amended, options not so qualified ("NQSOs"), Dividend
Equivalent Rights ("DERs"), Stock Appreciation Rights ("SARs"), and
Phantom Stock Rights ("PSRs").
The exercise price for any options granted under the Plan may not be
less than 100% of the fair market value of the shares of the common
stock at the time the option is granted. Options become exercisable six
months after the date granted and will expire ten years after the date
granted, except options granted in connection with an offering of
convertible preferred stock, in which case such options become
exercisable if and when the convertible preferred stock is converted
into common stock.
The Company issued DERs at the same time as ISOs and NQSOs based upon a
formula defined in the Plan. During 1998 the number of DERs issued is
based on 35% of the ISOs and NQSOs granted during 1998. The number of
PSRs issued are based on the level of the Company's dividends and on
the price of the Company's stock on the related dividend payment date
and is equivalent to the cash that otherwise would be paid on the
outstanding DERs and previously issued PSRs.
During the nine month period ended September 30, 1998, there were
59,784 options granted to buy common shares at an average exercise
price of $14.82 along with 20,931 DERs. As of September 30, 1998, the
Company had 612,402 options outstanding at exercise prices of $9.375 to
$22.625 per share, 469,461 of which were exercisable. The weighted
average exercise price of the options outstanding was $17.55 per share.
As of the September 30, 1998, there were 81,012 DERs granted, of which
52,032 were vested, and 4,237 PSRs granted. In addition, the Company
recorded a reduction of expense associated with the DERs and the PSRs
of $15,000 for the quarter ended September 30, 1998 and expense of
$6,000 for the nine months ended September 30, 1998.
Notes receivable from stock sales has resulted from the Company selling
shares of common stock through the exercise of stock options. The notes
have maturity terms ranging from 3 years to 9 years and accrue interest
at rates that range from 5.40% to 6.00% per annum. In addition, the
notes are full recourse promissory notes and are secured by a pledge of
the shares of the Common Stock acquired. Interest, which is credited to
paid-in-capital, is payable quarterly, with the balance due at the
maturity of the notes. The payment of the notes will be accelerated
only upon the sale of the shares of Common Stock pledged for the notes.
The notes may be prepaid at any time at the option of each borrower.
NOTE 7. TRANSACTIONS WITH AFFILIATES
The Company has a Management Agreement (the "Agreement") with Thornburg
Mortgage Advisory Corporation ("the Manager"). Under the terms of this
Agreement, the Manager, subject to the supervision of the Company's
Board of Directors, is responsible for the management of the day-to-day
operations of the Company and provides all personnel and office space.
The Agreement provides for an annual review by the unaffiliated
directors of the Board of Directors of the Manager's performance under
the Agreement.
The Company pays the Manager an annual base management fee based on
average shareholders' equity, adjusted for liabilities that are not
incurred to finance assets ("Average Shareholders' Equity" or "Average
Net Invested Assets" as defined in the Agreement) payable monthly in
arrears as follows: 1.1% of the first $300 million of Average
Shareholders' Equity, plus 0.8% of Average Shareholders' Equity above
$300 million.
For the quarters ended September 30, 1998 and 1997, the Company paid
the Manager $1,040,000 and $974,000, respectively, in base management
fees in accordance with the terms of the Agreement. For the nine month
periods ended September 30, 1998 and 1997, the Company paid the Manager
base management fees of $3,115,000 and $2,661,000, respectively.
The Manager is also entitled to earn performance based compensation in
an amount equal to 20% of the Company's annualized net income, before
performance based compensation, above an annualized Return on Equity
equal to the ten year U.S. Treasury Rate plus 1%. For purposes of the
performance fee calculation, equity is generally defined as proceeds
from issuance of common stock before underwriter's discount and other
costs of issuance, plus retained earnings. For the quarter ended
September 30, 1998, the Company did not pay the Manager any performance
based compensation because the Company's net income, as measured by
Return on Equity, did not exceed the ten year U.S. Treasury Rate plus
1%. For the quarter ended September 30, 1997, the Company paid the
Manager $931,000 in performance based compensation in accordance with
the terms of the Agreement and for the nine month periods ended
September 30, 1998 and 1997, the Company paid the Manager performance
based compensation in the amounts of $759,000 and $2,569,000,
respectively.
<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 constitute
"Forward-Looking Statements" within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Exchange Act, which can be
identified by the use of forward-looking terminology such as "may," "will,"
"expect," "anticipate," "estimate," or "continue" or the negatives thereof or
other variations thereon or comparable terminology. Investors are cautioned that
all forward-looking statements involve risks and uncertainties including, but
not limited to, risks related to the future level and relationship of various
interest rates, prepayment rates and the timing of new programs. The statements
in the "Risk Factors" of the Company's Prospectus Supplement dated July 14, 1997
and the "Effects of Interest Rate Changes" in this Report on Form 10-Q
constitute cautionary statements identifying important factors, including
certain risks and uncertainties, with respect to such forward-looking statements
that could cause the actual results, performance or achievements of the Company
to differ materially from those reflected in such forward-looking statements.
GENERAL
Thornburg Mortgage Asset Corporation (the "Company") is a mortgage acquisition
company that primarily invests in adjustable-rate and hybrid mortgage ("ARM")
assets comprised of ARM securities and ARM loans, thereby indirectly providing
capital to the single family residential housing market. Hybrid assets, which
are included in the Company's ARMs portfolio, have an interest rate that is
fixed for an initial period of time, generally 3 to 5 years, and then convert to
an adjustable-rate for the balance of the term of the loan. ARM securities
represent interests in pools of ARM loans, which often include guarantees or
other credit enhancements against losses from loan defaults. While the Company
is not a bank or savings and loan, its business purpose, strategy, method of
operation and risk profile are best understood in comparison to such
institutions. The Company leverages its equity capital using borrowed funds,
invests in ARM assets and seeks to generate income based on the difference
between the yield on its ARM assets portfolio and the cost of its borrowings.
The corporate structure of the Company differs from most lending institutions in
that the Company is organized for tax purposes as a real estate investment trust
("REIT") and therefore generally passes through substantially all of its
earnings to shareholders without paying federal or state income tax at the
corporate level.
The Company's ARM assets portfolio may consist of either agency or privately
issued (generally publicly registered) mortgage pass-through securities,
multiclass pass-through securities, collateralized mortgage obligations
("CMOs"), ARM loans or short-term investments that either mature within one year
or have an interest rate that reprices within one year. Beginning in 1998, the
Company began to acquire loans and securities backed by hybrid loans. The
Company will not invest more than 20% of its ARM assets in hybrids and will
limit its interest rate repricing mismatch (the difference between the remaining
fixed-rate period of a hybrid and the maturity of the fixed-rate liability
funding a hybrid) to approximately one year.
The Company's investment policy is to invest at least 70% of total assets in
High Quality adjustable-rate, variable-rate and hybrid mortgage securities and
short-term investments. High Quality means:
(1)securities that are unrated but are guaranteed by the U.S. Government
or issued or guaranteed by an agency of the U.S. Government;
(2)securities which are rated within one of the two highest rating
categories by at least one of either Standard & Poor's Corporation or
Moody's Investors Service, Inc. (the "Rating Agencies"); or
(3)securities that are unrated or whose ratings have not been updated but
are determined to be of comparable quality (by the rating standards of at
least one of the Rating Agencies) to a High Quality rated mortgage
security, as determined by the Manager (as defined below) and approved by
the Company's Board of Directors.
The remainder of the Company's ARM portfolio, comprising not more than 30% of
total assets, may consist of Other Investment assets, which may include:
(1)adjustable-rate, variable-rate or hybrid pass-through certificates,
multi-class pass-through certificates or CMOs backed by loans on
single-family, multi-family, commercial or other real estate-related
properties so long as they are rated at least Investment Grade, or
equivalent to such a rating as determined by management and approved by
the Board of Directors, at the time of purchase. "Investment Grade"
generally means a security rating of BBB or Baa or better by at least one
of the Rating Agencies;
(2)ARM loans secured by first liens on single-family residential properties,
generally underwritten to "A" quality standards, and acquired for the
purpose of future securitization; or
(3)a limited amount, currently $40 million as authorized by the Board of
Directors, of less than investment grade classes of ARM securities that
are created as a result of the Company's loan acquisition and
securitization efforts.
The Company has acquired ARM loans for the purpose of future securitization into
ARM securities for the Company's investment portfolio. As of September 30, 1998,
16.1% of the Company's ARM portfolio consisted of ARM loans held for future
securitization. The Company believes that its strategy to securitize ARM loans
will provide the Company with either higher yielding investments or an
additional source of whole pool assets, and give the Company greater flexibility
over the characteristics of the ARM assets acquired and held in its investment
portfolio. The Company plans on securitizing the loans that it acquires in order
to continue its current strategy of owning high quality, liquid ARM securities
and financing them in the reverse repurchase market or through capital markets
transactions that will provide the Company with a more permanent source of
financing for some of its assets. In pursuing these strategies the Company will
likely have a higher degree of credit risk than when acquiring investment grade
rated securities directly from the market. However, any additional credit risk
will be consistent with the Company's objectives of maintaining a portfolio with
high credit quality assets that provide an attractive return on equity.
The Company does not invest in REMIC residuals or other CMO residuals and,
therefore does not create excess inclusion income or unrelated business taxable
income for tax exempt investors. Therefore, the Company is a mortgage REIT
eligible for purchase by tax exempt investors, such as pension plans, profit
sharing plans, 401(k) plans, Keogh plans and Individual Retirement Accounts
("IRAs").
OVERVIEW OF RECENT EVENTS IN THE MORTGAGE MARKET
As has been true with most other mortgage finance companies, the Company has
been affected by the recent turmoil in the global and domestic financial
markets. Due to turbulent market conditions since September 30, 1998, the
Company has simultaneously seen its asset values decline, its margin
requirements for financing certain of its ARM assets increase, especially with
respect to its non-agency portfolio, the market value of its hedging instruments
decline, which has required the Company to post additional collateral, and
difficulty in financing its less than AA rated assets at acceptable valuations.
Additionally, due to the high level of prepayments on its agency securities,
which the Company must fund out of its excess liquidity prior to receipt of such
payments from FNMA and FHLMC, and the heightened sense of risk aversion on the
part of the Company's lenders, the Company's available excess cash and liquid
securities has diminished from levels maintained in prior periods. All of these
factors have combined to reduce the level of liquidity available to the Company.
The Company has undertaken several measures to increase its liquidity during
these difficult market conditions. First, the Company has requested that its
lenders not make margin calls on its loans backed by agency securities until
such payments have been received by the Company. Several lenders have agreed to
this request, and several lenders have also considered executing a separate
financing facility to assist the Company in bridging this timing difference.
Second, the Company has undertaken the sale of certain assets in order to reduce
its asset portfolio. Accordingly, the Company, during the fourth quarter to
date, has sold $363 million of assets and recorded a loss on sale of $3.4
million. Of this loss amount, $3.3 million is related to $146 million of ARM
securities that are indexed to the one-year U.S. Treasury index and which, as a
group, prepaid at an annualized rate of 49% during October and had a yield below
the Company's cost of funds. The Company believes that by selecting these
specific ARM securities for sale, it has not only increased its liquidity, but
it has improved the future return on its remaining ARM securities portfolio. The
Company believes that, barring further assets sales, its equity-to-assets ratio
before market value adjustments at the end of November will approximate 9.40%,
up from 8.15% at September 30, 1998. Lastly, the Company is attempting to
finance the majority of its $1.1 billion of whole loans and commitments to
purchase whole loans into a short-term callable financing transaction which
would be issued in the fourth quarter of 1998 and would be callable prior to
June of 1999. The benefit of such a financing would be to provide the Company
with a capital efficient method to finance its whole loan assets over year end
and enable the Company to call the transaction and refinance the loans at a
lower interest rate in the early part of 1999 in the event that market
conditions improve. However, the cost of such a financing is greater than
current financing rates available to the Company for whole loans and will
therefore adversely affect earnings in the fourth quarter and possibly during
the first half of 1999.
<PAGE>
FINANCIAL CONDITION
At September 30, 1998, the Company held total assets of $4.936 billion, $4.853
billion of which consisted of ARM assets, as compared to $4.691 billion and
$4.639 billion, respectively, at December 31, 1997. Since commencing operations,
the Company has purchased either ARM securities (backed by agencies of the U.S.
government or privately-issued, generally publicly registered, mortgage assets,
most of which are rated AA or higher by at least one of the Rating Agencies) or
ARM loans, including hybrids, generally originated to "A" quality underwriting
standards. At September 30, 1998, 79.9% of the assets held by the Company were
High Quality assets, exceeding the Company's investment policy minimum
requirement of investing at least 70% of its total assets in High Quality ARM
assets and cash and cash equivalents. Approximately 97% of the Company's ARM
loans, which comprise 16.1% of the ARMs portfolio, are expected to be
securitized into AAA securities which would bring the Company's High Quality
assets up to over 95% of total ARMs. Of the ARM assets currently owned by the
Company, 71.0% are adjustable-rate mortgage pass-through certificates that are
backed by ARM loans. The remainder are floating rate classes of CMOs (9.0%),
investments in floating rate classes of trusts backed by mortgaged-backed assets
(3.9%) or ARM loans (16.1%).
The following table presents a schedule of ARM assets owned at September 30,
1998 and December 31, 1997 classified by High Quality and Other Investment
assets and further classified by type of issuer and by ratings categories.
ARM ASSETS BY ISSUER AND CREDIT RATING
(Dollar amounts in thousands)
<TABLE>
<CAPTION>
September 30, 1998 December 31, 1997
------------------------- -------------------------
Carrying Portfolio Carrying Portfolio
Value Mix Value Mix
------------ ----------- ------------ -----------
<S> <C> <C> <C> <C>
HIGH QUALITY:
FHLMC/FNMA $ 2,691,164 55.5% $ 3,117,937 67.2%
Privately Issued:
AAA/Aaa Rating 523,187 10.8 476,615 10.3
AA/Aa Rating 661,872 13.6 782,206 16.8
----------- ----------- ----------- -----------
Total Privately Issued 1,185,059 24.4 1,258,821 27.1
----------- ----------- ----------- -----------
----------- ----------- ----------- -----------
Total High Quality 3,876,223 79.9 4,376,758 94.3
----------- ----------- ----------- -----------
OTHER INVESTMENT:
Privately Issued:
A Rating 91,944 1.9 115,055 2.5
BBB/Baa Rating 89,926 1.8 17,625 0.4
BB/Ba Rating and Other 12,309 0.3 10,269 0.2
Whole loans 782,358 16.1 118,987 2.6
----------- ----------- ----------- -----------
Total Other Investment 976,537 20.1 261,936 5.7
----------- ----------- ----------- -----------
Total ARM Portfolio $ 4,852,760 100.0% $ 4,638,694 100.0%
=========== =========== =========== ===========
</TABLE>
As of September 30, 1998, the Company had reduced the cost basis of its ARM
securities by a total of $1,298,000 due to potential future credit losses (other
than temporary declines in fair value). The Company is providing for potential
future credit losses on two securities that have an aggregate carrying value of
$12.1 million, which represent less than 0.3% of the Company's total portfolio
of ARM assets. Although both of these assets continue to perform, there is only
minimal remaining credit support to mitigate the Company's exposure to potential
future credit losses.
Additionally, during the three and nine months ended September 30, 1998, the
Company recorded a $247,000 and a $442,000 provision, respectively, for
potential credit losses on its loan portfolio, although no actual losses have
been realized in the loan portfolio to date. As of September 30, 1998, there
were 11 loans totaling $2.4 million that were delinquent, of which 7 loans
totaling $1.2 million were seriously delinquent (60 days or more delinquent).
Based on a review of the underlying property values, the Company does not expect
to realize a loss on any of the loans seriously delinquent as of September 30,
1998. The Company's credit reserve policy regarding ARM loans is to record a
monthly provision of 0.15% (annualized rate) on the outstanding principal
balance of loans (including loans securitized by the Company for which the
Company has retained first loss exposure), subject to adjustment on certain
loans or pools of loans based upon factors such as, but not limited to, age of
the loans, borrower payment history, low loan-to-value ratios and quality of
underwriting standards applied by the originator.
The following table classifies the Company's portfolio of ARM assets by type of
interest rate index.
ARM ASSETS BY INDEX
(Dollar amounts in thousands)
<TABLE>
<CAPTION>
September 30, 1998 December 31, 1997
------------------------ -------------------------
Carrying Portfolio Carrying Portfolio
Value Mix Value Mix
------------- ---------- ------------- -----------
<S> <C> <C> <C> <C>
ARM ASSETS:
INDEX:
One-month LIBOR $ 542,264 11.2% $ 115,198 2.5%
Three-month LIBOR 188,389 3.9 31,215 0.7
Six-month LIBOR 1,064,115 21.9 1,489,802 32.1
Six-month Certificate
of Deposit 370,743 7.6 278,386 6.0
Six-month Constant
Maturity Treasury 53,345 1.1 66,669 1.4
One-year Constant
Maturity Treasury 1,817,548 37.5 2,271,914 49.0
Cost of Funds 315,699 6.5 385,510 8.3
------------ ----------- ---------- -----------
4,352,103 89.7 4,638,694 100.0
------------ ----------- ---------- -----------
HYBRID ARM ASSETS 500,657 10.3 - 0.0
------------ ----------- ---------- -----------
$ 4,852,760 100.0% $ 4,638,694 100.0%
============ =========== ========== ===========
</TABLE>
The portfolio had a current weighted average coupon of 7.40% at September 30,
1998. If the portfolio had been "fully indexed," the weighted average coupon
would have been approximately 6.97%, based upon the composition of the portfolio
and the applicable indices at September 30, 1998. As of December 31, 1997, the
portfolio had a weighted average coupon of 7.56% and if the portfolio had been
"fully indexed," the weighted average coupon would have been approximately
7.64%, based upon the composition of the portfolio and the applicable indices at
that time.
At September 30, 1998, the current yield of the ARM assets portfolio was 5.88%,
compared to 6.38% as of December 31, 1997, with an average term to the next
repricing date of 254 days as of September 30, 1998, compared to 110 days as of
December 31, 1997. The increase in the number of days until the next repricing
of the ARMs is primarily due to the hybrid loans acquired by the Company during
the quarters ended June 30, 1998 and September 30, 1998, which, in general, do
not reprice for three to five years from their origination date. The current
yield includes the impact of the amortization of applicable premiums and
discounts, the cost of hedging, the amortization of the deferred gains from
hedging activity and the impact of principal payment receivables.
The reduction in the yield as of September 30, 1998, compared to December 31,
1997, is primarily because of the higher rate of ARM portfolio prepayments which
have occurred during 1998. The higher level of prepayments increased the amount
of premium amortization expense and increased the impact of non-interest earning
assets in the form of principal payment receivables. The constant prepayment
rate ("CPR") of the Company's ARM portfolio was 32% during the third quarter of
1998 compared to 34% during the second quarter of 1998 and compared to 22%
during the third quarter of 1997. The lower coupon of 7.40% decreased the ARM
portfolio yield by 0.16% as of September 30, 1998 compared to the end of 1997.
Additionally, higher premium amortization and the higher balance of principal
payment receivables decreased the portfolio yield by 0.35%, which was partially
offset by a 0.01% decrease in the net cost of hedging. When prepayment
experience exceeds expectations, the Company has to amortize its net purchase
premiums over a shorter time period, resulting in a reduced yield to maturity on
the Company's ARM assets. Conversely, if actual prepayment experience is less
than the assumed constant prepayment rate, the premium would be amortized over a
longer time period, resulting in a higher yield to maturity. The Company
monitors its prepayment experience on a monthly basis in order to adjust the
amortization of the net premium, as appropriate.
During the three months ended September 30, 1998, the Company purchased $327.1
million of ARM securities, 86.9% of which were High Quality assets, and $255.5
million of ARM loans, generally originated to "A" quality underwriting standards
or seasoned loans with over five years of good payment history and/or low
loan-to-value ratios. Of the ARM assets acquired during this period,
approximately 41% were hybrids, 28% were indexed to LIBOR, 21% were indexed to
U.S. Treasury bill rates, 5% were indexed to Certificate of Deposit rates and 5%
were indexed to other indices.
During the nine months ended September 30, 1998, the Company purchased $1,479.9
million of ARM securities, 93.6% of which were High Quality assets, and $749.5
million of ARM loans, generally originated to "A" quality underwriting standards
or seasoned loans with over five years of good payment history and/or low
loan-to-value ratios. Of the ARM assets acquired during the first nine months of
1998, approximately 36% were indexed to LIBOR, 23% were hybrids, 15% were
indexed to U.S. Treasury bill rates, 13% were indexed to a Cost of Funds Index,
11% were indexed to Certificate of Deposit rates and the remaining 2% to other
indices.
The Company sold ARM assets in the amount of $179.3 million at a net gain of
$755,000 and $511.8 million at a net gain of $3,780,000 during the three month
and nine month periods ended September 30, 1998, respectively. These sales
reflect the Company's desire to manage the portfolio with a view to enhancing
the total return of the portfolio. The Company monitors the performance of its
individual ARM assets and generally sells an asset when there is an opportunity
to replace it with an ARM asset that has an expected higher long-term yield or
more attractive interest rate characteristics. Almost 90% of the ARMs sold
during the three months ended September 30, 1998 were indexed to either the
one-year U.S. Treasury index or a Cost of Funds index, which are not indices
that the Company prefers to own long-term. The Company is presented with
investment opportunities in the ARM assets market on a daily basis and
management evaluates such opportunities against the performance of its existing
portfolio. At times, the Company is able to identify opportunities that it
believes will improve the total return of its portfolio by replacing selected
assets. In managing the portfolio, the Company may realize either gains or
losses in the process of replacing selected assets.
The fair value of the Company's portfolio of ARM assets classified as
available-for-sale declined by 0.88% from a negative adjustment of 0.52% of the
portfolio as of December 31, 1997, to a negative adjustment of 1.40% as of
September 30, 1998. This price decline was primarily because of a decline in the
levels of liquidity in the mortgage market, a widening of credit spreads
relative to treasury yields due to uncertainties regarding future economic
activity in the U.S. and global economies and because of increased future
prepayment expectations which have the effect of shortening the average life of
the Company's ARM assets and decreasing their fair value. The amount of the
negative adjustment to fair value on the ARM assets classified as
available-for-sale increased from $21.7 million as of December 31, 1997, to
$57.6 million as of September 30, 1998. As of September 30, 1998, all of the
Company's ARM securities are classified as available-for-sale and are carried at
their fair value.
The Company has purchased Cap Agreements in order to limit its exposure to risks
associated with the lifetime interest rate caps of its ARM assets should
interest rates rise above specified levels. The Cap Agreements act to reduce the
effect of the lifetime or maximum interest rate cap limitation. The Cap
Agreements purchased by the Company will allow the yield on the ARM assets to
continue to rise in a high interest rate environment just as the Company's cost
of borrowings would continue to rise, since the borrowings do not have any
interest rate cap limitation. At September 30, 1998, the Cap Agreements owned by
the Company had a remaining notional balance of $4.117 billion with an average
final maturity of 2.6 years, compared to a remaining notional balance of $4.156
billion with an average final maturity of 3.1 years at December 31, 1997.
Pursuant to the terms of the Cap Agreements, the Company will receive cash
payments if the one-month, three-month or six-month LIBOR index increases above
certain specified levels, which range from 7.50% to 13.00% and average
approximately 10.10%. The fair value of these Cap Agreements also tends to
increase when general market interest rates increase and decrease when market
interest rates decrease, helping to partially offset changes in the fair value
of the Company's ARM assets. At September 30, 1998, the fair value of the Cap
Agreements was $0.4 million, $9.2 million less than the amortized cost of the
Cap Agreements.
<PAGE>
The following table presents information about the Company's Cap Agreement
portfolio as of September 30, 1998:
CAP AGREEMENTS STRATIFIED BY STRIKE PRICE
(Dollar amounts in thousands)
<TABLE>
<CAPTION>
Cap Weighted
Hedged Weighted Agreement Average
ARM Assets Average Notional Strike Remaining
Balance (1) Life Cap Balance Price Term
------------- ----------- ------------- ----------- --------------
<S> <C> <C> <C> <C> <C>
$ 451,110 8.58% $ 449,949 7.50% 1.6 Years
537,133 9.70 538,033 8.00 3.5
183,538 10.14 183,668 8.50 1.5
277,513 10.54 277,398 9.00 1.2
148,563 10.89 147,930 9.50 2.0
322,670 11.04 323,553 10.00 3.7
448,813 11.39 448,549 10.50 2.1
367,881 12.08 369,791 11.00 3.2
560,905 12.64 560,899 11.50 3.7
554,474 13.29 552,825 12.00 2.4
172,906 14.22 172,865 12.50 1.7
106,265 16.17 91,788 13.00 1.4
----------- ----------- ----------- ----------- --------------
$ 4,131,771 11.43% $ 4,117,248 10.10% 2.6 Years
=========== =========== =========== =========== ==============
<FN>
-------------
(1)Excludes ARM assets that do not have life caps or are hybrids that
are match funded during a fixed rate period, in accordance with the
Company's investment policy.
</FN>
</TABLE>
As of September 30, 1998, the Company was a counterparty to seventeen interest
rate swap agreements having an aggregate notional balance of $1.404 billion.
Fifteen of these agreements with a notional balance of $1.144 billion have a
weighted average remaining term of 20.9 months and the remaining two are
cancelable monthly. In accordance with these agreements, the Company will pay a
fixed rate of interest during the term of these agreements and receive a payment
that varies monthly with the one-month LIBOR rate. As a result of entering into
these agreements, the Company has reduced the interest rate variability of its
cost to finance its ARM assets by increasing the average period until the next
repricing of its borrowings from 45 days to 208 days. Twelve of the swap
agreements with a notional balance of $453.6 million were entered into for the
purpose of hedging the interest rate repricing mismatch of its hybrid assets
(the difference between the remaining fixed-rate period of a hybrid and the
maturity of the fixed-rate liability funding a hybrid) to within approximately
one year, in furtherance of the Company's investment policy regarding hybrids.
RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 1998
For the quarter ended September 30, 1998, the Company's net income was
$4,678,000, or $0.14 per share (Basic EPS), based on a weighted average of
21,858,000 shares outstanding. That compares to $11,182,000, or $0.50 per share
(Basic EPS), based on a weighted average of 19,152,000 shares outstanding for
the quarter ended September 30, 1997. Net interest income for the quarter
totaled $5,794,000, compared to $13,226,000 for the same period in 1997. Net
interest income is comprised of the interest income earned on mortgage
investments less interest expense from borrowings. During the third quarter of
1998, the Company recorded a gain on the sale of ARM securities of $755,000 as
compared to a gain of $335,000 during the same period of 1997. Additionally,
during the third quarter of 1998, the Company reduced its earnings and the
carrying value of its ARM assets by reserving $561,000 for potential credit
losses, compared to $223,000 during the third quarter of 1997. During the
quarter ended September 30, 1998, the Company incurred operating expenses of
$1,310,000, consisting of a base management fee of $1,040,000, and other
operating expenses of $270,000. There was no performance based fee earned by the
Manager during the quarter. During the same period of 1997, the Company incurred
operating expenses of $2,156,000, consisting of a base management fee of
$974,000, a performance-based fee of $931,000 and other operating expenses of
$251,000. Total operating expenses decreased as a percentage of average assets
to 0.10% for the three months ended September 30, 1998, compared to 0.21% for
the same period of 1997.
The Company's return on average common equity was 3.5% for the quarter ended
September 30, 1998 compared to 12.7% for the quarter ended September 30, 1997.
The primary reason for the lower return on average common equity is the
Company's lower interest rate spread, discussed further below, partially offset
by the higher level of gains recorded this quarter on the sale of ARM securities
and lower operating expenses.
The table below highlights the historical trend and the components of return on
average common equity (annualized) and the 10-year U. S. Treasury average yield
during each respective quarter which is applicable to the computation of the
performance fee:
COMPONENTS OF RETURN ON AVERAGE COMMON EQUITY (1)
<TABLE>
<CAPTION>
ROE in
Excess of
Net Gain (Loss) Net 10-Year 10-Year
Interest Provision on ARM G & A Performance Preferred Income/ US Treas. US Treas.
For The Income/ For Losses/ Sales/ Expense (2)/ Fee/ Dividend/ Equity Average Average
Quarter Ended Equity Equity Equity Equity Equity Equity (ROE) Yield Yield
------------- ------- ----------- ---------- ------------ ----------- --------- ------- --------- ---------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Mar 31, 1996 13.37% - 0.03% 1.04% 1.27% - 11.08% 5.90% 5.18%
Jun 30, 1996 13.14% - - 1.00% 0.92% - 11.22% 6.72% 4.50%
Sep 30, 1996 13.42% 0.34% 0.88% 1.03% 1.07% - 11.86% 6.78% 5.08%
Dec 31, 1996 14.99% 1.32% 1.38% 1.46% 1.23% - 12.37% 6.35% 6.02%
Mar 31, 1997 18.85% 0.32% 0.01% 1.65% 1.43% 2.07% 13.40% 6.55% 6.85%
Jun 30, 1997 19.48% 0.34% 0.03% 1.81% 1.25% 2.67% 13.45% 6.71% 6.74%
Sep 30, 1997 17.66% 0.30% 0.45% 1.64% 1.24% 2.23% 12.70% 6.26% 6.44%
Dec 31, 1997 15.62% 0.33% 1.06% 1.59% 1.01% 2.12% 11.63% 5.92% 5.71%
Mar 31, 1998 14.13% 0.48% 1.89% 1.62% 0.94% 2.06% 10.91% 5.60% 5.31%
Jun 30, 1998 9.15% 0.53% 1.76% 1.58% 0.00% 1.96% 6.83% 5.60% 1.23%
Sep 30, 1998 6.82% 0.66% 0.89% 1.54% 0.00% 1.97% 3.54% 5.24% -1.70%
<FN>
(1) Average common equity excludes unrealized gain(loss)on available-for-sale
ARM securities.
(2) Excludes performance fees.
</FN>
</TABLE>
The decline in the Company's return on common equity from the third quarter of
1997 and from the second quarter of 1998 to the third quarter of 1998 is
primarily due to the decline in the net interest spread between the Company's
interest-earning assets and interest-bearing liabilities, an increase in the
Company's provision for losses and the decline in gains on ARM sales.
The Company's net interest spread declined from 0.79% as of September 30, 1997
and 0.13% as of June 30, 1998, to 0.09% as of September 30, 1998. The primary
reasons for these declines continues to be the relationship between the one-year
U. S. Treasury yield and LIBOR and the impact of the increased rate of ARM
prepayments. From September 30, 1997 to September 30, 1998, the one-year U.S.
Treasury yield declined by approximately 1.06% while LIBOR rates applicable to
the Company's borrowings decreased by only 0.37%, creating a negative index
spread as of September 30, 1998 of -0.93%. Approximately 38% of the Company's
ARM assets are indexed to the one-year U. S. Treasury bill yield and, therefore,
the yield on such assets declined with the index. To put this in historical
perspective, the one-year U.S. Treasury bill yield had a spread of -0.26% to the
average of the one-and three-month LIBOR rate as of December 31, 1997, compared
to having a spread of -0.02% at December 31, 1996, 0.04% on average during 1996
and -0.07% on average during 1995. For the five-year period from 1993 to 1997,
the average spread was 0.15%. The average spread during the three month period
ended September 30, 1998 was -0.53%, which was substantially worse than the
average spread during the previous quarter of -0.27%. The Company does not know
when or if the relationship between the one-year U. S. Treasury bill yield and
LIBOR will return to historical norms, but the Company's spreads are expected to
improve if that occurs. The Company is also continuing to decrease its exposure
to the one-year U. S. Treasury/LIBOR relationship as the portion of the
portfolio indexed to the one-year U. S. Treasury rate and financed with LIBOR
has been declining. The Company's ARM portfolio yield also was lower during the
third quarter of 1998 compared to the third quarter of 1997 because of an
increase in the prepayment rate of ARM assets. During the third quarter of 1998,
the average prepayment rate was 32%, compared to 22% during the comparable
period in 1997. The impact of this was to increase the average amount of
non-interest-earning assets in the form of principal payments receivable as well
as to increase the amortization expense related to writing off the Company's
premiums and discounts. The Company generally amortizes its premiums and
discounts on a monthly basis based on the most recent three-month average of the
prepayment rate of its ARM assets, thereby adjusting its amortization to current
market conditions, which is reflected in the yield of the ARM portfolio.
The Company's provision for losses has increased with the acquisition of whole
loans. The provision for loan losses is based on an annualized rate of 0.15% on
the outstanding principal balance of loans as of each month-end, subject to
certain adjustments as discussed above. As of September 30, 1998, the Company's
whole loans accounted for 16.1% of the Company's portfolio of ARM assets
compared to 11.6% as of June 30, 1998 and compared to 2.6% as of December 31,
1997. To date, the Company has not experienced any actual losses in its whole
loan portfolio, but based on industry standards, losses are expected and are
being provided for as the portfolio ages.
During the third quarter of 1998, the Company realized a net gain from the sale
of ARM securities in the amount of $755,000 compared to $335,000 during the
third quarter of 1997. These sales reflect the Company's desire to manage the
portfolio with a view to enhancing the total return of the portfolio over the
long-term while generating current earnings during this period of fast
prepayments and narrow interest spreads. The Company monitors the performance of
its individual ARM assets and selectively sells an asset when there is an
opportunity to replace it with an ARM asset that has an expected higher
long-term yield or more attractive interest rate characteristics. Almost 90% of
the ARMs sold during the three months ended September 30, 1998 were indexed to
either the one-year U.S. Treasury index or a Cost of Funds index, which are not
indices that the Company prefers to own long-term. While the Company has been
selling selected assets, it has been able to reinvest the proceeds in ARM assets
that are indexed to indices currently preferred by the Company and at prices
that reflect current market assumptions regarding prepayments speeds and
interest rates. Thus far, the newly purchased ARM assets, as a whole, have been
performing better than the portfolio acquired before 1998.
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 and, therefore, generally passes through
substantially all of its earnings to shareholders without paying federal income
tax at the corporate level. Since the Company, as a REIT, pays its dividends
based on taxable earnings, the dividends may at times be more or less than
reported earnings. The following table provides a reconciliation between the
Company's third quarter earnings as reported based on generally accepted
accounting principles and the Company's taxable income before its' common
dividend deduction:
RECONCILIATION OF REPORTED NET INCOME TO TAXABLE NET INCOME
(Dollar amounts in thousands)
<TABLE>
<CAPTION>
Three Month Period Ending September 30,
---------------------------------------
1998 1997
-------------- --------------
<S> <C> <C>
Net income $ 4,678 $ 11,182
Additions:
Provision for credit losses 561 223
Net compensation related items 53 20
Deductions:
Dividend on Series A Preferred Shares (1,670) (1,670)
Actual credit losses on ARM securities (424) (18)
------------ -------------
Taxable net income $ 3,198 $ 9,737
============ =============
</TABLE>
On August 7, 1998, the Board of Directors approved a rescheduling of the
Company's quarterly board meetings and the declaration, record and payment dates
of its regular cash dividend on its common stock. Under the new schedule, the
Board of Directors will meet after the close of each quarter end, enabling them
to review actual quarterly financial results as they consider the declaration of
common dividends. This action is also expected to provide a modest benefit to
the financial results of the Company as the Company will be able to retain
earnings over each quarter end, allowing the Company to leverage this additional
capital for an extended period of time, generating additional income for
shareholders when the additional assets are invested at a positive effective
margin. This action does not effect the dividend dates in connection with the
Company's Series A 9.68% Cumulative Convertible Preferred Shares.
The following table highlights the quarterly dividend history of the Company's
common shares:
COMMON DIVIDEND SUMMARY
(Dollar amounts in thousands, except per share data)
<TABLE>
<CAPTION>
Common Common Cumulative
Taxable Taxable Dividend Dividend Undistributed
For The Net Net Income Declared Pay-out Taxable
Quarter Ended Income (1) Per Share (2) Per Share (2) Ratio (3) Net Income
------------- ------------ ------------- ------------- --------- -------------
<S> <C> <C> <C> <C> <C>
Mar 31, 1996 $ 5,118 $ 0.41 $ 0.40 97% $ 188
Jun 30, 1996 6,169 0.42 0.40 103% (18)
Sep 30, 1996 6,708 0.42 0.40 96% 250
Dec 31, 1996 8,164 0.50 0.45 89% 1,115
Mar 31, 1997 8,226 0.50 0.48 95% 1,505
Jun 30, 1997 8,573 0.51 0.49 99% 1,603
Sep 30, 1997 9,737 0.51 0.50 100% 1,560
Dec 31, 1997 9,207 0.46 0.50 110% 629
Mar 31, 1998 8,645 0.42 0.375 93% 1,233
Jun 30, 1998 5,919 0.27 0.30 111% 556
Sep 30, 1998 3,198 0.15 0.23 (4) 155% 3,125 (4)
<FN>
(1) Taxable net income after preferred dividends.
(2) Weighted average common shares outstanding.
(3) Common dividend declared divided into applicable quarter's taxable
income available to common shareholders.
(4)The regular dividend for the third quarter of 1998 was declared on
October 16, 1998, payable on November 18, 1998 to shareholders of record
on October 31, 1998.
</FN>
</TABLE>
As of September 30, 1998, the Company's yield on its ARM assets portfolio,
including the impact of the amortization of premiums and discounts, the cost of
hedging, the amortization of deferred gains from hedging activity and the impact
of principal payment receivables, was 5.88%, compared to 6.58% as of September
30, 1997-- a decrease of 0.70%, and compared to 5.94% as of June 30, 1998 -- a
decrease of 0.06%. The Company's cost of funds as of September 30, 1998, was
5.78%, compared to 5.79% as of September 30, 1997 -- a decrease of 0.01%, and
compared to 5.81% as of June 30, 1998 - a decrease of 0.03%. As a result of
these changes, the Company's net interest spread as of September 30, 1998 was
0.09%, compared to 0.79% as of September 30, 1997 and compared to 0.13% as of
June 30, 1998. The decline in the net interest spread is largely attributable to
the decline in the ARM portfolio yield as discussed above. The decrease in the
Company's cost of funds as of quarter end is generally the result of actions
taken by the Federal Reserve Bank to decrease short-term interest rates by
0.25%. These Federal Reserve Bank actions were taken close to quarter end and,
therefore, had little impact on the Company's cost of funds during the quarter
which, on average, were 0.06% higher during the third quarter than during the
second quarter of 1998. The increase in the Company's average cost of funds
during the quarter was generally the impact of extending the average next
repricing date of the Company's borrowings and the impact of financing a larger
proportion of loans as compared to securities. The Company extended the average
number of days until the next repricing of its borrowings to 208 days as of
September 30, 1998 from 120 days as of June 30, 1998 in connection with the
Company's acquisition of hybrids which, in accordance with the Company's
investment policy, require a matching of fixed rate financing during a portion
of the fixed rate period of hybrids (to within approximately one year of the end
of the hybrid's fixed rate period). During the period of time when the Company
is accumulating loans for securitization, the Company incurs a higher cost of
funds to finance ARM loans as compared to securities. Current market conditions
aside, once the loans are securitized, the Company expects to realize a benefit
in its cost of funds and an improvement in its return from securitized loans as
compared to the return from the loans prior to their securitization.
<PAGE>
The following table highlights the components of net interest spread and the
annualized yield on net interest-earning assets as of each applicable quarter
end:
COMPONENTS OF NET INTEREST SPREAD AND YIELD ON NET INTEREST EARNING ASSETS (1)
(Dollar amounts in millions)
<TABLE>
<CAPTION>
ARM Assets
Average ---------------------------------------- Yield on Yield on
Interest Wgt. Avg. Weighted Interest Net Net Interest
As of the Earning Fully Indexed Average Yield Earning Cost of Interest Earning
Quarter Ended Assets Coupon Coupon Adj. (2) Assets Funds Spread Assets
------------- ---------- ------------- -------- -------- -------- ------- -------- ------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Mar 31, 1996 $ 2,025.8 7.56% 7.48% 0.99% 6.49% 5.60% 0.89% 1.32%
Jun 30, 1996 2,248.2 7.83% 7.28% 0.85% 6.43% 5.59% 0.84% 1.32%
Sep 30, 1996 2,506.0 7.80% 7.31% 0.80% 6.51% 5.71% 0.80% 1.32%
Dec 31, 1996 2,624.4 7.61% 7.57% 0.93% 6.64% 5.72% 0.92% 1.34%
Mar 31, 1997 2,950.6 7.93% 7.53% 0.89% 6.65% 5.67% 0.98% 1.54%
Jun 30, 1997 3,464.1 7.75% 7.57% 0.90% 6.67% 5.77% 0.90% 1.39%
Sep 30, 1997 4,143.7 7.63% 7.65% 1.07% 6.58% 5.79% 0.79% 1.22%
Dec 31, 1997 4,548.9 7.64% 7.56% 1.18% 6.38% 5.91% 0.47% 0.96%
Mar 31, 1998 4,859.7 7.47% 7.47% 1.23% 6.24% 5.74% 0.50% 0.92%
Jun 30, 1998 4,918.3 7.51% 7.44% 1.50% 5.94% 5.81% 0.13% 0.56%
Sep 30, 1998 4,963.7 6.97% 7.40% 1.52% 5.88% 5.78% 0.09% 0.46%
<FN>
(1)Yield on Net Interest Earning Assets is computed by dividing annualized
net interest income by the average daily balance of interest earning
assets.
(2)Yield adjustments include the impact of amortizing premiums and
discounts, the cost of hedging activities, the amortization of deferred
gains from hedging activities and the impact of principal payment
receivables. The following table presents these components of the yield
adjustments for the dates presented in the table above:
</FN>
</TABLE>
COMPONENTS OF THE YIELD ADJUSTMENTS ON ARM ASSETS
<TABLE>
<CAPTION>
Impact of Amort. of
Premium/ Principal Deferred Gain Total
As of the Discount Payments Hedging from Hedging Yield
Quarter Ended Amort. Receivable Activity Activity Adjustment
------------- -------- ---------- -------- -------------- ----------
<S> <C> <C> <C> <C> <C>
Mar 31, 1996 0.77% 0.11% 0.31% (0.20)% 0.99%
Jun 30, 1996 0.67% 0.07% 0.27% (0.16)% 0.85%
Sep 30, 1996 0.57% 0.08% 0.25% (0.10)% 0.80%
Dec 31, 1996 0.69% 0.09% 0.23% (0.08)% 0.93%
Mar 31, 1997 0.63% 0.13% 0.19% (0.07)% 0.89%
Jun 30, 1997 0.66% 0.13% 0.16% (0.05)% 0.90%
Sep 30, 1997 0.85% 0.12% 0.15% (0.05)% 1.07%
Dec 31, 1997 0.94% 0.14% 0.14% (0.04)% 1.18%
Mar 31, 1998 0.98% 0.16% 0.13% (0.04)% 1.23%
Jun 30, 1998 1.24% 0.17% 0.13% (0.04)% 1.50%
Sep 30, 1998 1.25% 0.18% 0.13% (0.04)% 1.52%
</TABLE>
<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 quarters ended September 30, 1998 and 1997:
AVERAGE BALANCE AND RATE TABLE
(Dollar amounts in thousands)
<TABLE>
<CAPTION>
For the Quarter Ended For the Quarter Ended
September 30, 1998 September 30, 1997
---------------------- ----------------------
Average Effective Average Effective
Balance Rate Balance Rate
----------- --------- ----------- ---------
<S> <C> <C> <C> <C>
Interest Earning Assets:
Adjustable-rate mortgage assets $ 4,959,879 5.82% $ 4,116,223 6.58%
Cash and cash equivalents 3,815 2.89 27,524 5.66
----------- -------- ----------- -------
4,963,694 5.82 4,143,747 6.57
----------- -------- ----------- -------
Interest Bearing Liabilities:
Borrowings 4,570,463 5.82 3,788,879 5.79
----------- -------- ----------- -------
Net Interest Earning Assets
and Spread $ 393,231 0.00% $ 354,868 0.78%
=========== ======== =========== =======
Yield on Net Interest Earning Assets (1) 0.47% 1.28%
======== =======
<FN>
(1) Yield on Net Interest Earning Assets is computed by dividing annualized
net interest income by the average daily balance of interest earning
assets.
</FN>
</TABLE>
As a result of the yield on the Company's interest-earning assets declining to
5.82% during the third quarter of 1998 from 6.58% during the third quarter of
1997 and the Company's cost of funds increasing to 5.82% during the third
quarter of 1998 from 5.79% during the third quarter of 1997, its net interest
income decreased by $7,432,000. This decrease in net interest income is a
combination of rate and volume variances. There was a combined unfavorable rate
variance of $8,181,000, which was almost entirely the result of a lower yield on
the Company's ARM assets portfolio and other interest-earning assets. The
increased average size of the Company's portfolio during the third quarter of
1998 compared to the same period of 1997 contributed to higher net interest
income in the amount of $749,000. The average balance of the Company's
interest-earning assets was $4.964 billion during the third quarter of 1998
compared to $4.144 billion during the third quarter of 1997 -- an increase of
20%.
For the quarter ended September 30, 1998, the Company's ratio of operating
expenses to average assets was 0.10% as compared to 0.21% for the same quarter
of 1997 and as compared to 0.10% for the previous quarter ended June 30, 1998.
The Company's expense ratios are among the lowest of any company investing in
mortgage assets, giving the Company what it believes to be a significant
competitive advantage over more traditional mortgage portfolio lending
institutions such as banks and savings and loans. This competitive advantage
enables the Company to operate with less risk, such as credit and interest rate
risk, and still generate an attractive long-term return on equity when compared
to these more traditional mortgage portfolio lending institutions. The Company
pays the Manager an annual base management fee, generally based on average
shareholders' equity, not assets, as defined in the Management Agreement,
payable monthly in arrears as follows: 1.1% of the first $300 million of Average
Shareholders' Equity, plus 0.8% of Average Shareholders' Equity above $300
million. Since this management fee is based on shareholders' equity and not
assets, this fee increases as the Company successfully accesses capital markets
and raises additional equity capital and is, therefore, managing a larger amount
of invested capital on behalf of its shareholders. In order for the Manager to
earn a performance fee, the rate of return on the shareholders' investment, as
defined in the Management Agreement, must exceed the average ten-year U.S.
Treasury rate during the quarter plus 1%. During the third quarter of 1998, the
Manager did not earn a performance fee because the Company's return on equity
declined to 3.5%. As presented in the following table, the performance fee is a
variable expense that fluctuates with the Company's return on shareholders'
equity relative to the average 10-year U.S. Treasury rate.
<PAGE>
The following table highlights the quarterly trend of operating expenses as a
percent of average assets:
ANNUALIZED OPERATING EXPENSE RATIOS
<TABLE>
<CAPTION>
Management Fee & Total
For The Other Expenses/ Performance Fee/ G & A Expense/
Quarter Ended Average Assets Average Assets Average Assets
------------- ---------------- ---------------- --------------
<S> <C> <C> <C>
Mar 31, 1996 0.09% 0.12% 0.21%
Jun 30, 1996 0.10% 0.09% 0.19%
Sep 30, 1996 0.10% 0.10% 0.20%
Dec 31, 1996 0.13% 0.11% 0.24%
Mar 31, 1997 0.14% 0.11% 0.25%
Jun 30, 1997 0.13% 0.09% 0.22%
Sep 30, 1997 0.12% 0.09% 0.21%
Dec 31, 1997 0.12% 0.05% 0.17%
Mar 31, 1998 0.10% 0.06% 0.16%
Jun 30, 1998 0.10% 0.00% 0.10%
Sep 30, 1998 0.10% 0.00% 0.10%
</TABLE>
RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1998
For the nine months ended September 30, 1998, the Company's net income was
$22,649,000, or $0.82 per share (Basic EPS), based on a weighted average of
21,488,000 shares outstanding. That compares to $30,551,000, or $1.49 per share
(Basic EPS), based on a weighted average of 17,437,000 shares outstanding for
the nine months ended September 30, 1997. Net interest income for the nine
months totaled $24,996,000, compared to $36,733,000 for the same period in 1997.
Net interest income is comprised of the interest income earned on mortgage
investments less interest expense from borrowings. During the first nine months
of 1998, the Company recorded a gain on the sale of ARM securities of
$3,780,000, compared to a gain of $360,000 during the same period of 1997.
Additionally, during the first nine months of 1998, the Company reduced its
earnings and the carrying value of its ARM assets by reserving $1,402,000 for
potential credit losses, compared to $623,000 during the same period of 1997.
During the nine months ended September 30, 1998, the Company incurred operating
expenses of $4,725,000, consisting of a base management fee of $3,115,000, a
performance-based fee of $759,000 and other operating expenses of $851,000.
During the same period of 1997, the Company incurred operating expenses of
$5,919,000, consisting of a base management fee of $2,661,000, a
performance-based fee of $2,569,000 and other operating expenses of $689,000.
Total operating expenses decreased as a percentage of average assets to 0.12%
for the nine months ended September 30, 1998, compared to 0.22% for the same
period of 1997.
The Company's return on average common equity was 7.0% for the nine months ended
September 30, 1998 compared to 13.2% for the nine months ended September 30,
1997. The primary reason for the lower return on average common equity is the
Company's lower interest rate spread, as discussed below, partially offset by
the higher level of gains recorded this period on the sale of ARM securities and
lower operating expenses.
The primary reasons for the decline in the Company's net interest spread, which
resulted in lower net interest income during the nine month period ended
September 30, 1998 as compared to the same period of 1997, continue to be the
relationship between the one-year U. S. Treasury yield and LIBOR and the impact
of increased ARM prepayment speeds. As discussed above, the average spread
between the one-year U. S. Treasury yield and the average of one- and
three-month LIBOR was 0.04% during 1996 and -0.07% during 1995 as compared to an
index spread of -0.93% as of September 30, 1998 and an average spread of -0.38%
for the nine months ended September 30, 1998. As mentioned above, for the
five-year period from 1993 to 1997, the average spread was 0.15%. The Company
does not know when or if the relationship between the one-year U. S. Treasury
bill yield and LIBOR will return to historical norms, but the Company's spreads
are expected to improve if that occurs. The Company's ARM portfolio yield also
was lower during the first nine months of 1998 compared to the first nine months
of 1997 because of an increase in the prepayment rate of ARM assets. During the
first nine months of 1998, the average prepayment rate was 32%, compared to 22%
during the comparable period in 1997. The impact of this was to increase the
average amount of non-interest-earning assets in the form of principal payments
receivable as well as to increase the amortization expense related to writing
off the Company's premiums and discounts.
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 nine month periods ended September 30, 1998 and 1997:
AVERAGE BALANCE AND RATE TABLE
(Dollar amounts in thousands)
<TABLE>
<CAPTION>
For the Nine Month For the Nine Month
Period Ended Period Ended
September 30, 1998 September 30, 1997
---------------------- ----------------------
Average Effective Average Effective
Balance Rate Balance Rate
----------- --------- ----------- ---------
<S> <C> <C> <C> <C>
Interest Earning Assets:
Adjustable-rate mortgage assets $ 4,906,926 6.02% $ 3,498,843 6.62%
Cash and cash equivalents 6,981 3.93 20,643 5.61
----------- -------- ----------- -------
4,913,907 6.01 3,519,486 6.62
----------- -------- ----------- -------
Interest Bearing Liabilities:
Borrowings 4,526,102 5.79 3,204,859 5.74
----------- -------- ----------- -------
Net Interest Earning Assets
and Spread $ 387,805 0.22% $ 314,627 0.88%
=========== ======== =========== =======
Yield on Net Interest Earning Assets (1) 0.68% 1.39%
======== =======
<FN>
(1) Yield on Net Interest Earning Assets is computed by dividing annualized
net interest income by the average daily balance of interest earning
assets.
</FN>
</TABLE>
As a result of the yield on the Company's interest-earning assets declining to
6.02% for the first nine months of 1998 from 6.62% for the same period of 1997
and the Company's cost of funds increasing to 5.79% from 5.74% for the same
respective time periods, its net interest income decreased by $11,737,000. This
decrease in net interest income is a combination of rate and volume variances.
There was a combined unfavorable rate variance of $17,475,000, which consisted
of an unfavorable variance of $16,250,000 resulting from the lower yield on the
Company's ARM assets portfolio and other interest-earning assets and an
unfavorable variance of $1,225,000 resulting from an increase in the Company's
cost of funds. The increased average size of the Company's portfolio during 1998
compared to the same period of 1997 contributed to higher net interest income in
the amount of $5,738,000. The average balance of the Company's interest-earning
assets was $4.914 billion during the first nine months of 1998 compared to
$3.519 billion during the same period of 1997 -- an increase of 40%.
During the first nine months of 1998, the Company realized a net gain from the
sale of ARM securities in the amount of $3,780,000 as compared to $360,000
during the same period of 1997. As discussed above, these sales reflect the
Company's desire to manage the portfolio with a view to enhancing the total
return of the portfolio over the long-term while generating current earnings
during this period of fast prepayments and narrow interest spreads. The Company
monitors the performance of its individual ARM assets and selectively sells an
asset when there is an opportunity to replace it with an ARM asset that has an
expected higher long-term yield or more attractive interest rate
characteristics. The Company sold $511.8 million of ARM assets during the first
nine months of 1998, most which were either indexed to a Cost of Funds index,
the one-year U. S. Treasury index or were prepaying faster than expected. While
the Company has been selling selected assets, it has been able to reinvest the
proceeds in ARM assets that are indexed to indices preferred by the Company and
at prices that reflect current market assumptions regarding prepayments speeds
and interest rates and thus far, as a whole, they have been performing better
than the portfolio acquired before 1998. Additionally, the Company recorded an
expense for credit losses in the amount of $1,402,000 during the nine months
ended September 30, 1998, compared to $623,000 during the same period of 1997.
The Company continued its provision level on the two ARM securities for which it
provided $900,000 for credit losses during this nine month period and, in
accordance with its credit reserve policy for loans, also recorded a provision
of $442,000 on its ARM loan portfolio and $60,000 on its portfolio of loans
securitized by the Company on which the Company retained the first loss credit
exposure.
For the nine months ended September 30, 1998, the Company's ratio of operating
expenses to average assets was 0.12% as compared to 0.22% for the same period of
1997. The primary reason for the decline in operating expenses is the variable
nature of the performance based fee paid to the Manager, which is based on the
performance of the Company relative to the average 10-year U.S. Treasury rate
during the applicable period. During the second and third quarters of 1998, the
Manager did not earn a performance fee because the Company's return on equity
declined to 6.8% and 3.5%, respectively, and, as a result, for the nine month
period of 1998, the Manager was paid $759,000, compared to $2,569,000 for the
same period of 1997.
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary source of funds for the quarters ended September 30, 1998
and 1997 consisted of reverse repurchase agreements, which totaled $4.551
billion and $3.981 billion at the respective quarter ends. Another significant
source of funds for the Company for the quarters ended September 30, 1998 and
1997 consisted of payments of principal and interest from its ARM assets
portfolio in the amounts of $558.3 million and $294.9 million, respectively. In
addition, during the quarter ended September 30, 1998, the Company received
$180.0 million from the sale of ARM assets and $12.2 million in proceeds from
ARM assets that were called during the quarter. In the future, the Company
expects its primary sources of funds will consist of borrowed funds under
reverse repurchase agreement transactions with one- to twelve-month maturities,
monthly payments of principal and interest on its ARM assets portfolio and asset
sales as needed. The Company's liquid assets generally consist of unpledged ARM
assets, cash and cash equivalents.
The borrowings incurred at September 30, 1998 had a weighted average interest
cost of 5.78%, which includes the cost of interest rate swaps, a weighted
average original term to maturity of 4.3 months and a weighted average remaining
term to maturity of 2.3 months. As of September 30, 1998, $1.104 billion of the
Company's reverse repurchase agreements were variable-rate term reverse
repurchase agreements with original maturities that range from three months to
one year. The interest rates of these term reverse repurchase agreements are
indexed to either the one or three-month LIBOR rate and reprice accordingly. In
addition, as of September 30, 1998, $741.5 million of the Company's reverse
repurchase agreements were collateralized by whole loans under one year
financing agreements that are indexed to the one-month LIBOR rate and reprice
either daily or once a month. These whole loan financing agreements are
scheduled to mature on November 30, 1998 and December 23, 1998. The Company is
in the process of negotiating new whole loan facilities to provide financing for
its whole loans beyond the expiration date of these agreements.
The Company has borrowing arrangements with 23 different financial institutions
and on September 30, 1998, had borrowed funds under reverse repurchase
agreements with 18 of these firms. Because the Company borrows money based on
the fair value of its ARM assets and because increases in short-term interest
rates can negatively impact the valuation of ARM assets, the Company's borrowing
ability could be limited and lenders may initiate margin calls in the event
short-term interest rates increase or the value of the Company's ARM assets
declines for other reasons. Additionally, certain of the Company's ARM assets
are rated less than AA by the Rating Agencies and have less liquidity than
assets that are rated AA or higher. Other mortgage assets which are rated AA or
higher by the Rating Agencies derive their credit rating based on a mortgage
pool insurer's rating. As a result of either changes in interest rates, credit
performance of a mortgage pool or a downgrade of a mortgage pool issuer, the
Company may find it difficult to borrow against such assets and, therefore, may
be required to sell certain mortgage assets in order to maintain liquidity. If
required, these sales could be at prices lower than the carrying value of the
assets, which would result in losses. For the quarter ended September 30, 1998,
the Company had adequate cash flow, liquid assets and unpledged collateral with
which to meet its margin requirements during such periods. However, the
Company's liquid assets and unpledged collateral were declining as a result of
adverse market conditions at the end of the third quarter and into the fourth
quarter. In order to maintain adequate liquidity, the Company undertook some
asset sales in the fourth quarter in order to reduce its leverage.
In December 1996, the Company's Registration Statement on Form S-3, registering
the sale of up to $200 million of additional equity securities, was declared
effective by the Securities and Exchange Commission. This registration statement
includes the possible issuances of common stock, preferred stock, warrants or
shareholder rights. As of September 30, 1998, the Company had $109 million of
its securities registered for future sale under this Registration Statement.
On July 13, 1998, the Board of Directors approved a common stock repurchase
program of up to 500,000 shares at prices below book value, subject to
availability of shares and other market conditions. On September 18, 1998, the
Board of Directors expanded this program by approving the repurchase of up to
1,000,000 shares at prices below book value. To date, the company has
repurchased 500,016 shares at an average price of $9.28 per share. The Company
has also purchased shares in the open market on behalf of the participants in
its DRP when the stock price is trading below book value instead of issuing new
shares below book value. In accordance with the terms and conditions of the DRP,
the Company pays the brokerage commission in connection with these purchases.
Subsequent to September 30, 1998, the Company and other investors in mortgage
assets became subject to significant changes that have affected the financing of
mortgage assets. A number of the Company's competitors with a greater proportion
of lesser quality mortgage assets have experienced significant deterioration of
their asset values and ability to finance such assets, causing some of them to
declare bankruptcy and others to sell assets at significant losses in order to
avoid insolvency. Although the Company's business plan anticipates periodic
disruptions in the mortgage market, the Company is still impacted by these
conditions, although to a lesser degree. First, some lower quality assets owned
by the Company cannot be financed at any price, and those that can be, are being
financed at lower values with requirements of higher over collateralization than
previously required. Secondly, in some cases with certain counterparties, high
quality assets also require more over collateralization and have experienced
price declines. Also, because of recent changes in market conditions it has
become apparent that the originally anticipated securitization structure of the
Company's loans will require more capital than is currently required by
financing them as loans, although the cost of financing would be expected to
decline upon securitization. Since the Company finds itself temporarily
constrained by its available capital, the Company is making arrangements to
continue the financing of most of its loans by issuing callable debt
collateralized by loans and to complete this financing by the end of 1998. Any
such callable debt transaction, if completed, would likely increase the
Company's cost of financing loans until the debt obligation is called. In the
event that such financing cannot be completed, the Company may be forced to sell
some or all of these ARM loans at a loss.
One of the primary reasons the Company's liquidity is impacted by the issues
discussed above has to do with FHLMC and FNMA payment receivables. It has been
standard industry practice of the mortgage finance market to exclude the value
of the payment receivable from the market value of a FHLMC or FNMA security,
although the executed agreement governing the financing of mortgage securities
allows for the inclusion of such payment receivables in the market value of a
security up until the respective payment date. In the past the Company has
accepted this practice and financed the FHLMC and FNMA receivables with its own
capital. However, given the current market conditions, the Company is requesting
its counterparties to include the value of the payment receivables in the value
of its securities and, thereby deferring margin calls for principal paydowns
until the applicable payment date. This alone would return the Company's
liquidity position to an appropriate level. At present, some of the Company's
counterparties are cooperating in this matter but the Company is not relying on
being able to successfully prevail in this matter. As a result, the Company has
and will continue to sell some assets in order to accelerate the speed at which
the Company is de-leveraging, increasing the Company's liquidity. The Company
expects to be able to sell sufficient assets to alleviate the impact of the
current market conditions without materially impacting its future operations. As
of November 13, 1998, thus far during the fourth quarter of 1998, the Company
has sold approximately $363 million of ARM assets at a loss of $3.4 million. The
Company does not expect to provide additional updates of the fourth quarter
sales until it releases its 1998 earnings in January of 1999, unless there are
material changes in the Company's situation. At this time the Company believes
it has adequate capital and liquidity resources to mitigate the impact of the
current market conditions and intends to continue to implement its current
business plan in the future.
EFFECTS OF INTEREST RATE CHANGES
Changes in interest rates impact the Company's earnings in various ways. While
the Company only invests in ARM assets, rising short-term interest rates may
temporarily negatively affect the Company's earnings and conversely falling
short-term interest rates may temporarily increase the Company's earnings. This
impact can occur for several reasons and may be mitigated by portfolio
prepayment activity as discussed below. First, the Company's borrowings will
react to changes in interest rates sooner than the Company's ARM assets because
the weighted average next repricing date of the borrowings is usually a shorter
time period. Second, interest rates on ARM loans are generally limited to an
increase of either 1% or 2% per adjustment period (commonly referred to as the
periodic cap) and the Company's borrowings do not have similar limitations.
Third, the Company's ARM assets lag changes in the indices due to the notice
period provided to ARM borrowers when the interest rate on their loans are
scheduled to change. The periodic cap only affects the Company's earnings when
interest rates move by more than 1% per six-month period or 2% per year.
The rate of prepayment on the Company's mortgage assets may decrease if interest
rates rise, or if the difference between long-term and short-term interest rates
increases. Decreased prepayments would cause the Company to amortize the
premiums paid for its ARM assets over a longer time period, resulting in an
increased yield on its mortgage assets. Therefore, in rising interest rate
environments where prepayments are declining, not only would the interest rate
on the ARM assets portfolio increase to re-establish a spread over the higher
interest rates, but the yield also would rise due to slower prepayments. The
combined effect could significantly mitigate other negative effects that rising
short-term interest rates might have on earnings.
Conversely, the rate of prepayment on the Company's mortgage assets may increase
if interest rates decline, or if the difference between long-term and short-term
interest rates diminishes. Increased prepayments would cause the Company to
amortize the premiums paid for its mortgage assets faster, resulting in a
reduced yield on its mortgage assets. Additionally, to the extent proceeds of
prepayments cannot be reinvested at a rate of interest at least equal to the
rate previously earned on such mortgage assets, the Company's earnings may be
adversely affected.
Lastly, because the Company only invests in ARM assets and approximately 8% to
10% of such mortgage assets are purchased with shareholders' equity, the
Company's earnings over time will tend to increase following periods when
short-term interest rates have risen and decrease following periods when
short-term interest rates have declined. This is because the financed portion of
the Company's portfolio of ARM assets will, over time, reprice to a spread over
the Company's cost of funds, while the portion of the Company's portfolio of ARM
assets that are purchased with shareholders' equity will generally have a higher
yield in a higher interest rate environment and a lower yield in a lower
interest rate environment.
YEAR 2000 ISSUES
The Year 2000 issues involve both hardware design flaws in which many computer
systems, and machines that use computer chips, will not correctly recognize the
date beginning in the Year 2000 and, additionally, software applications and
compilers that do not use a four-digit reference to years which might not behave
as intended once the Year 2000 is reached. Three general areas of concern are:
1) clocks built into computers and computer chips that will rollover to 1900 or
1980 instead of 2000, 2) purchased software that does not recognize the Year
2000 as a leap year or that does not use a four-digit reference to years, and 3)
internally developed applications that do not store the year as a four-digit
year. The Company invests in assets and enters into agreements that employ the
use of dates and is, therefore, concerned about the ability of equipment and
computer programs to interpret dates or recognize dates accurately.
In consideration of the Year 2000 issues, the Company's Manager 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 Manager has already replaced all computers that were not Year
2000 compliant. The software used by the Company has been internally developed
using products that are Year 2000 compliant. The Manager 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 not incurred any cost in order to be Year 2000 compliant since the Manager
is responsible for the expense of all equipment.
The Company believes that most of its exposure to Year 2000 issues involves the
readiness of third parties such as, but not limited to, loan servicers, security
master servicers, security paying agents and trustees, its stock transfer agent,
its securities custodian, the counterparties on its various financing agreements
and hedging contracts and vendors. The Manager, at its expense, will conduct a
survey of all such third parties to try to determine the readiness of such third
parties to handle Year 2000 dates and to try to determine the potential impact
of Year 2000 issues. The Company cannot be certain that such a survey will fully
identify all Year 2000 issues or to fully access the potential problems or loss
associated with Year 2000 issues or that any failure by these other third
parties to resolve Year 2000 issues would not have an adverse effect on the
Company's operations and financial condition. The Company and the Manager
believe 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.
OTHER MATTERS
As of September 30, 1998, the Company calculates its Qualified REIT Assets, as
defined in the Internal Revenue Code of 1986, as amended (the "Code"), to be
99.9% of its total assets, as compared to the Code requirement that at least 75%
of its total assets must be Qualified REIT Assets. The Company also calculates
that 99.9% of its 1998 revenue for the first nine months of 1998 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. The Company also met all REIT
requirements regarding the ownership of its common stock and the distributions
of its net income. Therefore, as of September 30, 1998, the Company believes
that it will continue to qualify 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 SEC, in order to qualify for this exemption, the Company must maintain at
least 55% of its assets directly in Qualifying Interests. In addition, unless
certain mortgage securities 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. The Company
calculates that it is in compliance with this requirement.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
At September 30, 1998, there were no pending legal proceedings to which
the Company was a party or of which any of its property was subject.
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
Not applicable
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K:
(a) Exhibits
None
(b) Reports on Form 8-K
None
<PAGE>
SIGNATURES
Pursuant to the requirements 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,
THORNBURG MORTGAGE ASSET CORPORATION
Dated: November 13, 1998 By: /s/ Larry A. Goldstone
-----------------------
Larry A. Goldstone,
President and Chief Operating Officer
(authorized officer of registrant)
Dated: November 13, 1998 By: /s/ Richard P. Story
--------------------
Richard P. Story,
Chief Financial Officer and Treasurer
(principal accounting officer)
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
September 30, 1998 Form 10-Q and is qualified in its entirety by reference to
such financial statements.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> SEP-30-1998
<CASH> 6,891
<SECURITIES> 4,071,700
<RECEIVABLES> 854,854
<ALLOWANCES> 1,782
<INVENTORY> 0
<CURRENT-ASSETS> 4,661
<PP&E> 0
<DEPRECIATION> 0
<TOTAL-ASSETS> 4,936,324
<CURRENT-LIABILITIES> 4,591,686
<BONDS> 0
0
65,805
<COMMON> 220
<OTHER-SE> 278,613
<TOTAL-LIABILITY-AND-EQUITY> 4,936,324
<SALES> 0
<TOTAL-REVENUES> 225,367
<CGS> 0
<TOTAL-COSTS> 0
<OTHER-EXPENSES> 4,725
<LOSS-PROVISION> 1,402
<INTEREST-EXPENSE> 196,591
<INCOME-PRETAX> 22,649
<INCOME-TAX> 0
<INCOME-CONTINUING> 22,649
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 22,649
<EPS-PRIMARY> 0.82
<EPS-DILUTED> 0.82
</TABLE>
