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, 1999
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
(DBA THORNBURG MORTGAGE, INC.)
(Exact name of Registrant as specified in its Charter)
MARYLAND 85-0404134
(State or other jurisdiction of (IRS 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 12, 1999
<PAGE>
THORNBURG MORTGAGE ASSET CORPORATION
(dba THORNBURG MORTGAGE, INC.)
FORM 10-Q
INDEX
<TABLE>
<CAPTION>
Page
----
<S> <C> <C>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets at September 30, 1999 and December 31, 1998 3
Consolidated Statements of Operations for the three and nine months ended
September 30, 1999 and September 30, 1998 4
Consolidated Statements of Shareholders' Equity for the nine months
ended September 30, 1999 and 1998 5
Consolidated Statements of Cash Flows for the three and nine months ended
September 30, 1999 and September 30, 1998 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 18
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 35
Item 2. Changes in Securities 35
Item 3. Defaults Upon Senior Securities 35
Item 4. Submission of Matters to a Vote of Security Holders 35
Item 5. Other Information 35
Item 6. Exhibits and Reports on Form 8-K 35
SIGNATURES 36
EXHIBIT INDEX 37
</TABLE>
2
<PAGE>
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
THORNBURG MORTGAGE ASSET CORPORATION AND SUBSIDIARIES
(DBA THORNBURG MORTGAGE, INC. AND SUBSIDIARIES)
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands)
September 30, 1999 December 31, 1998
-------------------- -------------------
<S> <C> <C>
ASSETS
Adjustable-rate mortgage ("ARM") assets: (Notes 2 and 3)
ARM securities $ 3,505,774 $ 3,094,657
Collateral for collateralized notes 942,054 1,147,350
ARM loans held for securitization 8,973 26,410
-------------------- -------------------
4,456,801 4,268,417
-------------------- -------------------
Cash and cash equivalents 34,617 36,431
Accrued interest receivable 32,395 37,939
Prepaid expenses and other 8,298 1,846
-------------------- -------------------
$ 4,532,111 $ 4,344,633
==================== ===================
LIABILITIES
Reverse repurchase agreements (Note 3) $ 3,259,352 $ 2,867,207
Collateralized notes (Note 3) 924,238 1,127,181
Other borrowings (Note 3) 1,527 2,029
Accrued interest payable 14,201 31,514
Dividends payable (Note 5) 1,670 1,670
Accrued expenses and other 3,777 3,209
-------------------- -------------------
4,204,765 4,032,810
-------------------- -------------------
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 21,990 shares
issued and 21,490 and 21,490 outstanding, respectively 220 220
Additional paid-in-capital 341,958 341,756
Accumulated other comprehensive income (loss) (65,777) (82,148)
Notes receivable from stock sales (4,632) (4,632)
Retained earnings (deficit) (5,562) (4,512)
Treasury stock: at cost, 500 and 500 shares, respectively (4,666) (4,666)
-------------------- -------------------
327,346 311,823
-------------------- -------------------
$ 4,532,111 $ 4,344,633
==================== ===================
</TABLE>
See Notes to Consolidated Financial Statements.
3
<PAGE>
<TABLE>
<CAPTION>
THORNBURG MORTGAGE ASSET CORPORATION
(DBA THORNBURG MORTGAGE, INC. AND SUBSIDIARIES)
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in thousands, except per share data)
Three Months Ended Nine Months Ended
September 30, September 30,
1999 1998 1999 1998
-------- -------- ---------- ---------
<S> <C> <C> <C> <C>
Interest income from ARM assets and cash $ 67,955 $72,252 $ 190,687 $221,587
Interest expense on borrowed funds (58,623) (66,458) (165,717) (196,591)
--------- -------- ---------- ---------
Net interest income 9,332 5,794 24,970 24,996
--------- -------- ---------- ---------
Gain on sale of ARM assets 15 755 50 3,780
Provision for credit losses (764) (561) (2,139) (1,402)
Management fee (Note 7) (1,023) (1,040) (3,061) (3,115)
Performance fee (Note 7) - - - (759)
Other operating expenses (405) (270) (1,033) (851)
--------- -------- ---------- ---------
NET INCOME $ 7,155 $ 4,678 $ 18,787 $ 22,649
========= ======== ========== =========
Net income $ 7,155 $ 4,678 $ 18,787 $ 22,649
Dividend on preferred stock (1,670) (1,670) (5,009) (5,009)
--------- -------- ---------- ---------
Net income available to common shareholders $ 5,485 $ 3,008 $ 13,778 $ 17,640
========= ======== ========== =========
Basic earnings per share $ 0.26 $ 0.14 $ 0.64 $ 0.82
========= ======== ========== =========
Diluted earnings per share $ 0.26 $ 0.14 $ 0.64 $ 0.82
========= ======== ========== =========
Average number of common shares outstanding 21,490 21,858 21,490 21,488
========= ======== ========== =========
</TABLE>
4
<PAGE>
<TABLE>
<CAPTION>
THORNBURG MORTGAGE ASSET CORPORATION AND SUBSIDIARIES
(DBA THORNBURG MORTGAGE, INC. AND SUBSIDIARIES)
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
Nine Months Ended September 30, 1999 and 1998
(In thousands, except share data)
Accum.
Addit- Other Receiv- Notes
Common ional Compre- able From Retained Compre-
Preferred Stock Paid-in hensive Stock Earnings/ Treasury hensive
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 22,649 $ 22,649 22,649
Other comprehensive
income:
Available-for-sale assets:
Fair value adjustment,
net of amortization. . . . . - - - (35,139) - - - (35,139) (35,139)
Deferred gain on sale of
hedges, net of
amortization . . . . . . . . - - - (1,248) - - - (1,248) (1,248)
---------
Other comprehensive income. . . $(13,738)
=========
Issuance of common
stock (Note 5) 17 26,261 (1,934) 24,344
Interest from notes
receivable from stock
sales 188 188
Purchase of treasury (4,666) (4,666)
stock (Note 5)
Dividends declared on
preferred stock - $1.815
per share . . . . . . . . . . - - - - - (5,009) - (5,009)
Dividends declared on
common stock - $0.675
per share . . . . . . . . . . - - - - - (14,635) - (14,635)
---------- ------ -------- --------- --------- --------- -------- ---------
Balance, September 30, 1998. . . . $ 65,805 $ 220 $341,689 $(55,832) $ (4,632) $ 2,054 $(4,666) $344,638
========== ====== ======== ========= ========= ========= ======== =========
Balance, December 31, 1998 . . . . $ 65,805 $ 220 $341,756 $(82,148) $ (4,632) $ (4,512) $(4,666) $311,823
Comprehensive income:
Net income 18,787 $ 18,787 18,787
Other comprehensive
income:
Available-for-sale assets:
Fair value adjustment, net
of amortization . . . . . . - - - 16,927 - - - 16,927 16,927
Deferred gain on sale of
hedges, net of
amortization . . . . . . . - - - (556) - - - (556) (556)
---------
Other comprehensive income $ 35,158
=========
Interest from notes receivable
from stock sales 202 202
Dividends declared on
preferred stock - $1.815
per share. . . . . . . . . . . . - - - - - (5,009) - (5,009)
Dividends declared on
common stock - $0.69
per share . . . . . . . . . . . - - - - - (14,828) - (14,828)
---------- ------ -------- --------- --------- --------- -------- ---------
Balance, September 30, 1999. . . . $ 65,805 220 $341,958 $(65,777) $ (4,632) $ (5,562) $(4,666) $327,346
========== ====== ======== ========= ========= ========= ======== =========
</TABLE>
See Notes to Consolidated Financial Statements.
5
<PAGE>
<TABLE>
<CAPTION>
THORNBURG MORTGAGE ASSET CORPORATION
(DBA THORNBURG MORTGAGE, INC. AND SUBSIDIARIES)
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Three Months Ended Nine Months Ended
September 30, September 30,
1999 1998 1999 1998
---------- ---------- ------------ ------------
<S> <C> <C> <C> <C>
Operating Activities:
Net Income $ 7,155 $ 4,678 $ 18,787 $ 22,649
Adjustments to reconcile net income to
net cash provided by operating activities:
Amortization 6,448 13,959 26,220 37,120
Net (gain) loss from investing activities 749 (194) 2,089 (2,378)
Change in assets and liabilities:
Accrued interest receivable 455 (1,383) 5,544 (3,618)
Receivable for assets sold - 9,951 - (30,040)
Prepaid expenses and other (851) (2,213) (6,452) (4,370)
Accrued interest payable (2,415) (183) (17,313) (11,128)
Accrued expenses and other 232 2,650 568 2,761
---------- ---------- ------------ ------------
Net cash provided by (used in) operating activities 11,773 27,265 29,443 10,996
---------- ---------- ------------ ------------
Investing Activities:
Available-for-sale ARM securities:
Purchases (298,916) (327,140) (1,236,172) (1,479,934)
Proceeds on sales 3,348 180,032 9,922 513,544
Proceeds from calls 2,108 12,227 6,234 128,006
Principal payments 237,360 420,676 816,982 1,202,405
Held-to-maturity ARM securities:
Principal payments - - - 16,152
Collateral for collateralized notes:
Principal payments 66,040 - 201,813 -
ARM Loans:
Purchases (9,534) (255,491) (11,345) (749,463)
Proceeds on sales 6,991 - 6,991 2,043
Principal payments 597 50,027 7,165 82,690
Purchase of interest rate cap agreements - (99) (1,910) (641)
---------- ---------- ------------ ------------
Net cash provided by (used in) investing activities 7,994 80,232 (200,320) (285,198)
---------- ---------- ------------ ------------
Financing Activities:
Net borrowings from reverse repurchase agreements 47,076 (91,206) 392,145 280,332
Repayments of collateralized notes (65,610) - (202,943) -
Net borrowings from other borrowings 183 (892) (502) (3,102)
Proceeds from common stock issued - - - 24,344
Purchase of treasury stock - (4,666) - (4,666)
Dividends paid (6,613) (8,266) (19,839) (29,784)
Interest from notes receivable from stock sales 68 68 202 189
---------- ---------- ------------ ------------
Net cash provided by (used in) financing activities (24,896) (104,962) 169,063 267,313
---------- ---------- ------------ ------------
Net increase (decrease) in cash and cash equivalents (5,129) 2,535 (1,814) (6,889)
Cash and cash equivalents at beginning of period 39,746 4,356 36,431 13,780
---------- ---------- ------------ ------------
Cash and cash equivalents at end of period $ 34,617 $ 6,891 $ 34,617 $ 6,891
========== ========== ============ ============
Supplemental disclosure of cash flow information
and non-cash activities are included in Note 3.
</TABLE>
See Notes to Financial Statements
6
<PAGE>
NOTES TO CONSOLIDATED 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.
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of the Thornburg
Mortgage Asset Corporation (dba Thornburg Mortgage, Inc.) (the "Company") and
its wholly owned special purpose finance subsidiaries, Thornburg Mortgage
Funding Corporation and Thornburg Mortgage Acceptance Corporation. The Company
formed these entities in connection with the issuance of the callable
collateralized notes discussed in Note 3. All material intercompany accounts
and transactions are eliminated in consolidation. In the opinion of management,
all material adjustments, consisting of normal recurring adjustments, considered
necessary for a fair presentation of the consolidated financial statements have
been included.
ADJUSTABLE-RATE MORTGAGE ASSETS
The Company's adjustable-rate mortgage ("ARM") assets are comprised of ARM
securities, ARM loans and collateral for AAA notes payable, which also consists
of ARM securities and ARM loans. Included in the Company's ARM assets are
hybrid ARM securities and loans ("Hybrid ARMs") that have a fixed interest rate
for an initial period, generally three to ten years, and then convert to an
adjustable-rate for their remaining term to maturity.
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.
The collateral for the AAA notes includes ARM securities and ARM loans which are
accounted for in the same manner as the ARM securities and ARM loans that are
not held as collateral.
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 securities and all ARM loans are recorded when
all significant uncertainties regarding the characteristics of the assets are
removed and, in the case of loans, underwriting due diligence has been
completed, generally shortly before the 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 only 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. 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, including the subordinate securities retained as
part of the Company's securitization of loans into AAA securities.
7
<PAGE>
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 estimated potential 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 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 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.
Credit losses on pools of loans that are held as collateral for AAA notes
payable are also covered by third party insurance policies that protect the
Company from credit losses above a specified level, limiting the Company's
exposure to credit losses on such loans. The Company makes a monthly provision
for possible credit losses on these loans the same as it does for loans that are
not held as collateral for AAA notes payable, except, it takes into
consideration its maximum exposure.
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
manage interest rate risk. To date, most of the Cap Agreements purchased 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. In similar fashion, the
Company has purchased Cap Agreements to limit the financing rate of the Hybrid
ARMs during their fixed rate term, generally for three to ten years. In
general, the cost of financing Hybrid ARMs hedged with Cap Agreements is capped
at a rate that is 0.75% to 1.00% below the fixed Hybrid ARM interest rate.
8
<PAGE>
All Cap Agreements are classified as a hedge against available-for-sale assets
or ARM loans and are carried at their fair value with unrealized gains and
losses reported as a separate component of equity. The carrying value of the
Cap Agreements is 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 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 were hedging
assets classified as available-for-sale were initially reported in a separate
component of equity, consistent with the reporting of those assets, and are
thereafter amortized as a yield adjustment.
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, swap
agreements have been utilized by the Company in two ways. One way has been to
use swap agreements as a cost effective way to lengthen the average repricing
period of its variable rate and short term borrowings. Additionally, as the
Company acquires Hybrid ARMs, 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 borrowing
funding a Hybrid ARM) to approximately one year or less. 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.
All Swap Agreements are classified as a liability hedge against the Company's
borrowings. As a result, the unrealized gains and losses on Swap Agreements are
off balance sheet and are reported in the Company's Notes to Financial
Statements.
OTHER HEDGING ACTIVITY
The Company also enters into hedging transactions in connection with the
purchase of Hybrid ARMs between the trade date and the settlement date.
Generally, the Company hedges the cost of obtaining future fixed rate financing
by entering into a commitment to sell similar duration fixed-rate
mortgage-backed securities ("MBS") on the trade date and settles the commitment
by purchasing the same fixed-rate MBS on the purchase date. Realized gains and
losses are deferred and amortized as a yield adjustment over the fixed rate
period of the financing.
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.
9
<PAGE>
Following is information about the computation of the earnings per share data
for the three and nine month periods ended September 30, 1999 and 1998 (amounts
in thousands except per share data):
<TABLE>
<CAPTION>
Earnings
Income Shares Per Share
---------- --------- ----------
<S> <C> <C> <C>
Three Months Ended September 30, 1999
- -------------------------------------
Net income $ 7,155
Less preferred stock dividends (1,670)
----------
Basic EPS, income available to
common shareholders 5,485 21,490 $ 0.26
==========
Effect of dilutive securities:
Stock options - 3
---------- ---------
Diluted EPS $ 5,485 21,493 $ 0.26
========== ========= ==========
Three Months Ended September 30, 1998
- -------------------------------------
Net income $ 4,678
Less preferred stock dividends (1,670)
Basic EPS, income available to
common stockholders 3,008 21,858 $ 0.14
==========
Effect of dilutive securities:
Stock options - -
---------- ---------
Diluted EPS $ 3,008 21,858 $ 0.14
========== ========= ==========
Earnings
Income Shares Per Share
Nine Months Ended September 30, 1999
- -------------------------------------
Net income $ 18,787
Less preferred stock dividends (5,009)
----------
Basic EPS, income available to
common shareholders 13,778 21,490 $ 0.64
==========
Effect of dilutive securities:
Stock options - 8
---------- ---------
Diluted EPS $ 13,778 21,498 $ 0.64
========== ========= ==========
Nine Months Ended September 30, 1998
- -------------------------------------
Net income $ 22,649
Less preferred stock dividends (5,009)
----------
Basic EPS, income available to
common stockholders 17,640 21,488 $ 0.82
==========
Effect of dilutive securities:
Stock options - -
---------- ---------
Diluted EPS $ 17,640 21,488 $ 0.82
========== ========= ==========
</TABLE>
The Company has granted options to directors and officers of the Company and
employees of the Manager to purchase 141,779 and 59,784 shares of common stock
at average prices of $9.0625 and $14.82 per share during the nine months ended
September 30, 1999 and 1998, respectively. The conversion of preferred stock
was not included in the computation of diluted EPS because such conversion would
increase the diluted EPS.
10
<PAGE>
RECENT ACCOUNTING PRONOUNCEMENTS
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, 2000. 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, the effective portion
of the hedge's change in the fair value of these derivatives instruments will be
recorded in other comprehensive income and the ineffective portion will be
included in earnings when the Company adopts the statement in the first quarter
of its fiscal 2001 year.
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.
11
<PAGE>
NOTE 2. ADJUSTABLE-RATE MORTGAGE ASSETS AND INTEREST RATE CAP AGREEMENTS
The following tables present the Company's ARM assets as of September 30, 1999
and December 31, 1998. The ARM securities classified as available-for-sale are
carried at their fair value, while the ARM loans are carried at their amortized
cost basis (dollar amounts in thousands):
<TABLE>
<CAPTION>
September 30, 1999:
Available-
for-Sale Collateral for
ARM Securities Notes Payable ARM Loans Total
---------------- ---------------- ----------- -----------
<S> <C> <C> <C> <C>
Principal balance outstanding $ 3,475,971 $ 928,525 $ 9,052 $4,413,548
Net unamortized premium 73,854 14,412 16 88,282
Deferred gain from hedging (392) - - (392)
Allowance for losses (1,551) (1,902) (95) (3,548)
Cap agreements 6,154 350 - 6,504
Principal payment receivable 18,472 669 - 19,141
---------------- ---------------- ----------- -----------
Amortized cost, net 3,572,508 942,054 8,973 4,523,535
---------------- ---------------- ----------- -----------
Gross unrealized gains 8,908 24 27 8,959
Gross unrealized losses (75,642) (11,041) (33) (86,716)
---------------- ---------------- ----------- -----------
Fair value $ 3,505,774 $ 931,037 $ 8,967 $4,445,778
================ ================ =========== ===========
Carrying value $ 3,505,774 $ 942,054 $ 8,973 $4,456,801
================ ================ =========== ===========
December 31, 1998:
Available-
for-Sale Collateral for
ARM Securities Notes Payable ARM Loans Total
---------------- ---------------- ----------- -----------
Principal balance outstanding $ 3,070,107 $ 1,131,007 $ 26,161 $4,227,275
Net unamortized premium 86,956 17,112 324 104,392
Deferred gain from hedging (613) - - (613)
Allowance for losses (1,242) (729) (75) (2,046)
Cap agreements 8,302 440 - 8,742
Principal payment receivable 14,330 - - 14,330
---------------- ---------------- ----------- -----------
Amortized cost, net 3,177,840 1,147,830 26,410 4,352,080
---------------- ---------------- ----------- -----------
Gross unrealized gains 1,070 38 53 1,161
Gross unrealized losses (84,253) (7,606) (87) (91,946)
---------------- ---------------- ----------- -----------
Fair value $ 3,094,657 $ 1,140,262 $ 26,376 $4,261,295
================ ================ =========== ===========
Carrying value $ 3,094,657 $ 1,147,350 $ 26,410 $4,268,417
================ ================ =========== ===========
</TABLE>
During the quarter ended September 30, 1999, the Company realized $15,000 in
gains on the sale of $10.4 million of ARM securities and ARM loans. During the
same period of 1998, the Company realized $902,000 in gains and $147,000 in
losses on the sale of $179.3 million of ARM securities. All of the ARM
securities sold were classified as available-for-sale.
During the nine months ended September 30, 1999, the Company realized $50,000 in
gains on the sale of $16.9 million of ARM securities and ARM loans. During the
same nine month period of 1998, the Company realized $4,388,000 in gains and
$608,000 in losses on the sale of $511.1 million of ARM securities. All of the
ARM securities sold were classified as available-for-sale.
As of September 30, 1999, 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 $1,551,000. At September 30, 1999, the Company
is providing for potential future credit losses on two assets that have an
aggregate carrying value of $10.2 million, which represents 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 1999, the Company, in accordance with its credit policies,
recorded a $1,193,000 provision for potential credit losses on its loan
portfolio, although no actual losses have been realized in the loan portfolio to
date.
12
<PAGE>
The following tables summarize ARM loan delinquency information as of September
30, 1999 and December 31, 1998 (dollar amounts in thousands):
<TABLE>
<CAPTION>
September 30, 1999
- --------------------
Loan Loan Percent of Percent of
Delinquency Status Count Balance ARM Loans Total Assets
- -------------------- ----- ----------- ----------- -------------
<S> <C> <C> <C> <C>
30 to 59 days 3 $ 2,309 0.21% 0.05%
60 to 89 days - - - -
90 days or more 3 899 0.08 0.02
In foreclosure 6 5,274 0.46 0.11
Real estate owned 1 331 0.03 0.01
----- ----------- ----------- -------------
13 $ 8,813 0.78% 0.19%
===== =========== =========== =============
December 31, 1998
- --------------------
Loan Loan Percent of Percent of
Delinquency Status Count Balance ARM Loans Total Assets
- -------------------- ----- ----------- ----------- -------------
30 to 59 days 4 $ 1,138 0.11% 0.03%
60 to 89 days 2 423 0.04 0.01
90 days or more 1 3,450 0.32 0.08
In foreclosure 5 1,097 0.10 0.02
----- ----------- ----------- -------------
12 $ 6,108 0.57% 0.14%
===== =========== =========== =============
</TABLE>
The following table summarizes the activity for the allowance for losses on ARM
loans for the nine months ended September 30, 1999 and 1998 (dollar amounts in
thousands):
1999 1998
------ -----
Beginning balance $ 804 $ 42
Provision for losses 1,193 442
Charge-offs, net - -
------ -----
Ending balance $1,997 $ 484
====== =====
As of September 30, 1999, the Company had commitments to purchase $7.1 million
of loans through its correspondent loan program which commenced operations
during the second quarter of 1999.
The average effective yield on the ARM assets owned, including the amortization
of the net premium paid for the ARM assets and the Cap Agreements, was 6.11% as
of September 30, 1999 and 5.86% as of December 31, 1998.
As of September 30, 1999 and December 31, 1998, the Company had purchased Cap
Agreements with a remaining notional amount of $3.437 billion and $4.026
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 5.75% to 13.00% and average approximately 9.75%. Of the Cap Agreements
owned by the Company as of September 30, 1999, $144 million are hedging the cost
of financing Hybrid ARMs and $3.293 billion are hedging the lifetime interest
rate cap of ARM assets. The Company's ARM assets portfolio, excluding ARM
assets that don't have a lifetime interest rate cap and Hybrid ARMs, had an
average lifetime interest rate cap of 11.68%. The Cap Agreements had an average
maturity of 2.0 years as of September 30, 1999. The initial aggregate notional
amount of the Cap Agreements declines to approximately $3.100 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.
13
<PAGE>
NOTE 3. REVERSE REPURCHASE AGREEMENTS, COLLATERALIZED NOTES PAYABLE AND OTHER
BORROWINGS
The Company has entered into reverse repurchase agreements to finance most of
its ARM assets. The reverse repurchase agreements are short-term borrowings
that are secured by the market value of the Company's ARM securities and bear
interest rates that have historically moved in close relationship to LIBOR.
As of September 30, 1999, the Company had outstanding $3.259 billion of reverse
repurchase agreements with a weighted average borrowing rate of 5.53% and a
weighted average remaining maturity of 3.2 months. As of September 30, 1999,
$1.564 billion of the Company's borrowings were variable-rate term reverse
repurchase agreements with original maturities that range from three months to
fourteen months. The interest rates of these term reverse repurchase agreements
are indexed to either the one- or three-month LIBOR rate and reprice
accordingly. The reverse repurchase agreements at September 30, 1999 were
collateralized by ARM assets with a carrying value of $3.494 billion, including
accrued interest.
At September 30, 1999, the reverse repurchase agreements had the following
remaining maturities (dollar amounts in thousands):
Within 30 days $1,462,743
31 to 89 days 89,576
90 days or greater 1,707,033
----------
$3,259,352
==========
As of September 30, 1999, the Company had entered into three whole loan
financing facilities. One of the whole loan financing facilities has a
committed borrowing capacity of $150 million, with an option to increase this
amount to $300 million. This facility matures in January 2000. One has an
uncommitted amount of borrowing capacity of $150 million and matures in April
2000. The third facility is for an unspecified amount of uncommitted borrowing
capacity and does not have a specific maturity date. As of September 30, 1999,
the Company had $1.5 million borrowed against these whole loan financing
facilities.
On December 18, 1998, the Company, through a special purpose finance subsidiary,
issued $1.144 billion of callable AAA notes ("Notes") collateralized by ARM
loans and ARM securities. As part of this transaction, the Company retained
ownership of a subordinated certificate in the amount of $32.4 million, which
represents the Company's maximum exposure to credit losses on the loans
collateralizing the Notes. As of September 30, 1999, the Notes had a net
balance of $924.2 million, an effective interest cost of 6.05% and were
collateralized by ARM loans with a principal balance of $837.8 million and ARM
securities with a balance of $123.0 million. The Notes mature on January 25,
2029 and are callable by the Company at par once the balance of the Notes is
reduced to 25% of their original balance. In connection with the issuance and
modification of the Notes, the Company incurred costs of approximately $6.0
million which is being amortized over the expected life of the Notes. Since the
Notes are paid down as the collateral pays down, the amortization of the
issuance cost will be adjusted periodically based on actual payment experience.
If the collateral pays down faster than currently estimated, then the
amortization of the issuance cost will increase and the effective cost of the
Notes will increase and, conversely, if the collateral pays down slower than
currently estimated, then the amortization of issuance cost will be decreased
and the effective cost of the Notes will also decrease.
As of September 30, 1999, the Company was a counterparty to nineteen interest
rate swap agreements ("Swaps") having an aggregate notional balance of $739.9
million. As of September 30, 1999, these Swaps had a weighted average remaining
term of 3.3 years. In accordance with these Swaps, the Company will pay a fixed
rate of interest during the term of these Swaps and receive a payment that
varies monthly with the one-month LIBOR rate. As a result of entering into
these Swaps and the Cap Agreements that also hedge the fixed rate period of
Hybrid ARMs, 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 27 days to 280 days. All of these Swaps were
entered into in connection with the Company's acquisition of Hybrid ARMs and
commitments to acquire Hybrid ARMs. The Swaps hedge the cost of financing
Hybrid ARMs during their fixed rate term, generally three to ten years. Due to
the favorable market value of the Swaps at September 30, 1999, they were not
collateralized by any ARM assets.
14
<PAGE>
During the quarter ended September 30, 1999, the Company paid off the remaining
balance of $1.3 million of other borrowings that had financed a portion of its
Cap Agreements.
The total cash paid for interest was $60.6 million during the quarter ended
September 30, 1999.
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, 1999 and December 31, 1998.
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, 1999 December 31, 1998
----------------------- -----------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
---------- ----------- ----------- ----------
<S> <C> <C> <C> <C>
Assets:
ARM assets $4,450,382 $4,439,359 $4,266,497 $4,259,374
Cap Agreements 6,419 6,419 1,920 1,920
Liabilities:
Callable collateralized notes 924,238 924,238 1,127,181 1,127,181
Other borrowings - - 2,029 2,077
Swap agreements 1,236 (3,809) (87) 7,326
</TABLE>
The above carrying amounts for assets are combined in the balance sheet under
the caption adjustable-rate mortgage assets. The carrying amount for assets
categorized as available-for-sale is their fair value whereas the carrying
amount for assets held for the foreseeable future is their amortized cost.
The fair values of the Company's ARM securities 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 values for ARM loans are
determined by the Company by using the same pricing models employed by the
Company in the process of determining a price to bid for loans in the open
market, taking into consideration the aggregate characteristics of groups of
loans such as, but not limited to, collateral type, index, margin, life cap,
periodic cap, underwriting standards, age and delinquency experience. 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, whole loan financing facilities, callable collateralized notes 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
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. The Company did not repurchase any shares of its
common stock under this program during the three or nine month periods ended
September 30, 1999. To date, the company has repurchased 500,016 at an average
price of $9.28 per share.
15
<PAGE>
On September 15, 1999, 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 12, 1999 to preferred shareholders of
record as of September 30, 1999.
On October 14, 1999, the Company declared a third quarter 1999 dividend of $0.23
per common share which will be paid on November 17, 1999 to common shareholders
of record as of October 31, 1999.
For federal income tax purposes, all 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 non-taxable income as return of capital, depending on the amount and
character of the Company's full year taxable income.
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, non-qualified stock
options ("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 1999 the number of DERs issued is based on 45% of
the ISOs and NQSOs granted during 1999. 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, 1999, there were 141,779
options granted to buy common shares at an average exercise price of $9.0625
along with 63,803 DERs. As of September 30, 1999, the Company had 744,473
options outstanding at exercise prices of $9.0625 to $22.625 per share, 488,516
of which were exercisable. The weighted average exercise price of the options
outstanding was $15.92 per share. As of the September 30, 1999, there were
141,925 DERs granted, of which 113,764 were vested, and 12,714 PSRs granted. In
addition, the Company recorded an expense associated with the DERs and the PSRs
of $26,000 and $72,000 for the three and nine month periods ended September 30,
1999, respectively.
Notes receivable from stock sales result from the Company selling shares of
common stock through the exercise of stock options partially for consideration
for notes receivable. 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. As of September 30, 1999, there
were $4.6 million of notes receivable from stock sales outstanding.
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.
16
<PAGE>
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, 1999 and 1998, the Company paid the Manager
$1,023,000 and $1,040,000, respectively, in base management fees in accordance
with the terms of the Agreement. For the nine month periods ended September 30,
1999 and 1998, the Company paid the Manager base management fees of $3,061,000
and $3,115,000, 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 quarters ended September 30, 1999 and 1998 and for the nine month period
ended September 30, 1999, 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 nine
month period ended September 30, 1998, the Company paid the Manager an incentive
fee of $759,000.
17
<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 and the
availablity of credit to finance mortgage assets. The statements in the "Risk
Factors" section of the Company's 1998 Annual Report on Form 10-K on page 13
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 (dba Thornburg Mortgage, Inc.) and
subsidiaries (the "Company") is a mortgage acquisition company that primarily
invests in adjustable-rate mortgage ("ARM") assets comprised of ARM securities
and ARM loans, thereby indirectly providing capital to the single family
residential housing market. 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. Thornburg Mortgage Asset Corporation began using the
dba Thornburg Mortgage, Inc. effective October 14, 1999. The Company will seek
approval from its shareholders to formally change its corporate name to
Thornburg Mortgage, Inc. at its year 2000 annual shareholders meeting. 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. In 1998, in connection with the Company's issuance of $1.1
billion of callable AAA notes, the Company formed two REIT qualified
subsidiaries. These subsidiaries are consolidated in the Company's financial
statements and federal and state tax returns.
In 1998, the Company began investing in hybrid ARM assets ("Hybrid ARMs") which
are included in the Company's references to ARM securities and ARM loans.
Hybrid ARMs have a fixed rate of interest for an initial period, generally 3 to
10 years, and then convert to an adjustable-rate for the balance of the term of
the Hybrid ARM. On July 15, 1999, the Company's Board of Directors expanded the
Company's investment policy to allow for the acquisition of Hybrid ARMs with an
initial fixed rate period of up to ten years. Previously, the Company's
investment policy limited the acquisition of Hybrid ARMs to Hybrid ARMs with
initial fixed rate periods of five years or less. To mitigate interest-rate
risk, it is the Company's policy to fund the Hybrid ARMs with long-term debt
obligations that mature within one year or less of the first interest rate reset
date of the Hybrid ARMs.
The Company's mortgage assets portfolio may consist of either agency or
privately issued securities (generally publicly registered) mortgage
pass-through securities, multiclass pass-through securities, collateralized
mortgage obligations ("CMOs"), collateralized bond obligations ("CBOs"),
generally backed by high quality mortgage backed securities, ARM loans, Hybrid
ARMs or short-term investments that either mature within one year or have an
interest rate that reprices within one year. The Company's investment policy
limits its investment in Hybrid ARMs to no more than 30% of its total investment
portfolio, and limits its interest rate repricing mismatch (the difference
between the remaining fixed-rate period of a Hybrid ARM and the maturity of the
fixed-rate liability funding a Hybrid ARM) to no more than one year. The
Company's investment policy further limits its investment in Hybrid ARMs that
have a fixed rate period of seven years or greater to no more than 10% of its
portfolio.
The Company's investment policy is to invest at least 70% of total assets in
High Quality adjustable and variable rate mortgage securities and short-term
investments. High Quality means:
18
<PAGE>
(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 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; or
(4) the portion of ARM or Hybrid ARM loans that have been deposited into a
trust and have received a credit rating of AA or better from at least one Rating
Agency.
The remainder of the Company's ARM asset portfolio, comprising not more than 30%
of total assets, may consist of Other Investment assets, which may include:
(1) adjustable or variable rate 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 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 (see description of "A" quality in
"Portfolio of Mortgage Assets - ARM and Hybrid ARM Loans"); or
(3) a limited amount, currently $70 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.
Since inception, the Company has generally invested less than 15%, currently
less than 4%, of its total assets in Other Investment assets, excluding loans
held for securitization. Despite the generally higher yield, the Company does
not expect to significantly increase its investment in Other Investment
securities. This is primarily due to the difficulty of financing such assets at
reasonable financing terms and values through all economic cycles. The Company
has never had a large investment in Other Investment securities and believes it
has always been very selective and cautious regarding these investments.
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").
FINANCIAL CONDITION
- --------------------
At September 30, 1999, the Company held total assets of $4.532 billion, $4.457
billion of which consisted of ARM assets, as compared to $4.345 billion and
$4.268 billion, respectively, at December 31, 1998. 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 generally originated to "A" quality underwriting
standards. At September 30, 1999, 95.9% of the assets held by the Company,
including cash and cash equivalents, were High Quality assets, far 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. Of the
ARM assets currently owned by the Company, 80.6% are in the form of
adjustable-rate pass-through certificates or ARM loans. The remainder are
floating rate classes of CMOs (15.4%) or investments in floating rate classes of
CBOs (4.0%) backed primarily by mortgaged-backed securities.
19
<PAGE>
The following table presents a schedule of ARM assets owned at September 30,
1999 and December 31, 1998 classified by High Quality and Other Investment
assets and further classified by type of issuer and by ratings categories.
<TABLE>
<CAPTION>
ARM ASSETS BY ISSUER AND CREDIT RATING
(Dollar amounts in thousands)
September 30, 1999 December 31, 1998
------------------------- -------------------------
Carrying Portfolio Carrying Portfolio
Value Mix Value Mix
------------- ---------- ------------- ----------
<S> <C> <C> <C> <C>
HIGH QUALITY:
FHLMC/FNMA $ 2,057,942 46.2% $ 2,072,871 48.6%
Privately Issued:
AAA/Aaa Rating 1,593,328(1) 35.8 1,398,659(1) 32.8
------------- ---------- ------------- ----------
AA/Aa Rating 612,520 13.7 597,493 14.0
------------- ---------- ------------- ----------
Total Privately Issued 2,205,848 49.5 1,996,152 46.8
------------- ---------- ------------- ----------
------------- ---------- ------------- ----------
Total High Quality 4,263,790 95.7 4,069,023 95.4
------------- ---------- ------------- ----------
OTHER INVESTMENT:
Privately Issued:
A Rating 52,089 1.2 40,591 1.0
BBB/Baa Rating 84,768 1.9 88,273 2.1
BB/Ba Rating and Other 47,098(1) 1.0 44,120(1) 0.9
Whole loans 9,056 0.2 26,410 0.6
------------- ---------- ------------- ----------
Total Other Investment 193,011 4.3 199,394 4.6
------------- ---------- ------------- ----------
Total ARM Portfolio $ 4,456,801 100.0% $ 4,268,417 100.0%
============= ========== ============= ==========
<FN>
(1) AAA Rating category includes $818.5 million and $1.020 billion as of
September 30, 1999 and December 31, 1998, respectively, of whole loans that have
been credit enhanced by an insurance policy purchased from a third-party and
credit support from an unrated subordinated certificate for $32.3 million
included in BB/Ba Rating and Other category and that are held as collateral for
callable AAA notes.
</TABLE>
As of September 30, 1999, the Company had reduced the cost basis of its ARM
securities by $1.6 million to reflect 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
$10.2 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 months ended September 30, 1999, the Company
recorded a $429,000 provision 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, 1999, the Company's ARM loan portfolio included nine loans that
are considered seriously delinquent (60 days or more delinquent) with an
aggregate balance of $6.2 million. The ARM loan portfolio also includes one
real estate property ("REO") that the Company owns as the result of the
foreclosure process in connection with one loan in the amount of $331,000. The
average original effective loan-to-value ratio of these nine delinquent loans
and REO is approximately 66%. 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.
20
<PAGE>
The following table classifies the Company's portfolio of ARM assets by type of
interest rate index.
<TABLE>
<CAPTION>
ARM ASSETS BY INDEX
(Dollar amounts in thousands)
September 30, 1999 December 31, 1998
---------------------- ----------------------
Carrying Portfolio Carrying Portfolio
Value Mix Value Mix
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
ARM ASSETS:
INDEX:
One-month LIBOR $ 694,516 15.6% $ 556,574 13.0%
Three-month LIBOR 177,175 4.0 181,143 4.2
Six-month LIBOR 679,752 15.2 939,824 22.0
Six-month Certificate of Deposit 326,926 7.3 313,268 7.3
Six-month Constant Maturity Treasury 38,890 0.9 49,023 1.2
One-year Constant Maturity Treasury 1,360,558 30.5 1,479,054 34.7
Cost of Funds 229,792 5.2 268,486 6.3
---------- ---------- ---------- ----------
3,507,609 78.7 3,787,372 88.7
---------- ---------- ---------- ----------
HYBRID ARM ASSETS 949,192 21.3 481,045 11.3
---------- ---------- ---------- ----------
$4,456,801 100.0% $4,268,417 100.0%
========== ========== ========== ==========
</TABLE>
The portfolio had a current weighted average coupon of 6.85% at September 30,
1999. This consisted of an average coupon of 6.56% on the Hybrid ARM portion of
the portfolio and an average coupon of 6.94% on the rest of the portfolio. If
the non-hybrid portion of the portfolio had been "fully indexed" at September
30, 1999, the weighted average coupon of the non-hybrid portion of the portfolio
would have been approximately 7.38%, based upon the current composition of the
portfolio and the applicable indices. As of December 31, 1998, the ARM
portfolio had a weighted average coupon of 7.28%, consisting of an average
coupon of 6.96% on the Hybrid ARMs and 7.32% on the remainder of the ARM
portfolio. The lower average coupon on the ARM portfolio as of September 30,
1999 compared to December 31, 1998 is primarily the result of the ARM portfolio
adjusting to the lower interest rate market that existed during the first half
of 1999 as individual ARM loans and securities reached their scheduled interest
rate reset dates. Due to rises in the interest rate market during the third
quarter, the average coupon on the non-hybrid portion of the Company's ARM
portfolio is expected to rise during the fourth quarter of 1999.
At September 30, 1999, the current yield of the ARM assets portfolio was 6.09%,
compared to 5.86% as of December 31, 1998, with an average term to the next
repricing date of 353 days as of September 30, 1999, compared to 253 days as of
December 31, 1998. The average term to the next repricing date includes the
effect of Hybrid ARMs which have an average remaining fixed-rate term of 3.8
years as of September 30, 1999. The non-hybrid portion of the ARM portfolio has
an average next repricing term of 93 days as of September 30, 1999. 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 improvement of 0.23% in the yield as of September 30, 1999, compared to
December 31, 1998, is due to a number of factors including reduced amortization
of purchase premiums, which improved by 0.67%, and a 0.01% improvement in the
impact of the non-interest earning principal payment receivables. These two
factors were partially offset by a 0.43% decrease in the weighted average coupon
and an increase in the cost of hedging by 0.02%.
21
<PAGE>
The following table presents various characteristics of the Company's ARM and
Hybrid ARM loan portfolio as of September 30, 1999. This information pertains
to both the loans held for securitization and the loans held as collateral for
the callable AAA notes payable.
<TABLE>
<CAPTION>
ARM AND HYBRID ARM LOAN PORTFOLIO CHARACTERISTICS
Average High Low
--------- ----------- -------
<S> <C> <C> <C>
Unpaid principal balance $273,750 $3,450,000 $1,975
Coupon rate on loans 7.25% 9.63% 5.00%
Pass-through rate 6.85% 9.23% 4.61%
Pass-through margin 2.00% 5.06% 0.48%
Lifetime cap 13.02% 16.75% 9.75%
Original Term (months) 344 480 72
Remaining Term (months) 325 360 64
</TABLE>
<TABLE>
<CAPTION>
<S> <C> <C> <C>
Geographic Distribution (Top 5 States): Property type:
California 21.46% Single-family 64.56%
Florida 11.96 DeMinimus PUD 20.76
Georgia 6.85 Condominium 9.51
New York 6.82 Other 5.17
New Jersey 4.83
Occupancy status: Loan purpose:
Owner occupied 84.00% Purchase 55.88%
Second home 11.28 Cash out refinance 25.83
Investor 4.72 Rate & term refinance 18.29
Documentation type: Periodic Cap:
Full/Alternative 96.34% None 58.54%
Other 3.66 3.00% 0.03
2.00% 39.65
Average effective original 1.00% 0.54
loan-to-value: 66.58% 0.50% 1.24
</TABLE>
On May 15, 1999, the Company commenced the operations of its correspondent
lending program under which the Company acquires ARM and Hybrid ARM loans that
have been originated in conformance with the Company's criteria by a network of
correspondent mortgage lenders approved by the Company. The Company has
selectively approved twenty correspondents and is currently either in
discussions or considering the applications of eight others. The Company
reviews the financial strength, the past ability to originate ARM and Hybrid ARM
products as well as the credit performance and prepayment characteristics of
past originations of a prospective correspondent in making its decision to
approve a correspondent. The Company's underwriting guidelines specify that
borrowers must be "A" quality only and are generally more restrictive than
current FNMA guidelines, other than the size of the loan. Over time, the
Company expects that most of the loans acquired through the correspondent
lending program will be non-conforming or "Jumbo" loans based on the size of
the loan. (Currently, any loan over $240,000 is non-conforming or a "Jumbo"
loan). However, most of the loans acquired to date through this program have
been conforming. The Company believes that one of the benefits of the
correspondent lending program will be the acquisition of loans at prices close
to par. In fact, the average price of the loans acquired to date has been at a
discount price. Acquiring loans at or below par eliminates the risk of having
to write-off the remaining premium balance if a loan prepays sooner than
expected and should help to stabilize the Company's net income during periods of
rapid prepayment of ARM assets.
During the quarter ended September 30, 1999, the Company purchased $308.5
million of ARM assets, 96.9% of which were High Quality assets. Of the ARM
assets acquired during the three months ended September 30, 1999, approximately
55% were Hybrids ARMs, 35% were indexed to the six-month certificate of deposit
index, 7% were indexed to U.S. Treasury bill rates and 3% were indexed to
one-month LIBOR.
During the nine months ended September 30, 1999, the Company purchased $1,247.5
million of ARM assets, 97.1% of which were High Quality assets. Of the ARM
assets acquired during the first nine months of 1999, approximately 50% were
Hybrid ARMs, 22% were indexed to LIBOR, 17% were indexed to U.S. Treasury bill
rates, 9% were indexed to the six-month certificate of deposit index and the
remaining 2% were indexed to a Cost of Funds index.
22
<PAGE>
As of September 30, 1999, the only purchase commitments that the Company had
were commitments to purchase $7.1 million of loans through its correspondent
loan program.
During the three month period ended September 30, 1999, the Company sold ARM
assets in the amount of $10.3 million for a gain of $15,000. During the nine
month period ended September 30, 1999, the Company sold ARM assets in the amount
of $24.3 million for a gain of $50,000. The Company acquires ARM assets for
investment purposes only and therefore generally does not realize significant
gains and losses from the sale of assets in the normal course of its business.
The Company does sell selected assets at times for the purpose of improving
long-term portfolio characteristics or to improve liquidity, as part of its ARM
portfolio management.
For the quarter ended September 30, 1999, the Company's ARM assets paid down at
an approximate average annualized constant prepayment rate of 22% compared to
32% for the quarter ended September 30, 1998 and 26% for the prior quarter ended
June 30, 1999. When prepayment experience exceeds expectations, the Company has
to amortize its 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.
The fair value of the Company's portfolio of ARM securities improved by 0.75%
from a negative adjustment of 2.62% of the portfolio as of December 31, 1998, to
a negative adjustment of 1.87% as of September 30, 1999. This negative
adjustment is substantially the same as at June 30, 1999 when the price
adjustment was 1.83%. The fair value adjustment was relatively stable during
the third quarter generally due to the outlook for slower prepayments, which had
a positive impact and which, for the most part, offset the negative impact of
rising interest rates and wider spreads on mortgage products. The price
improvement from year-end is primarily the result of an improved market for
mortgage products in general, as buying and selling activity has picked up
during 1999 with the improvement in the outlook regarding prepayments and the
financing of mortgage assets, compared to the end of 1998. The amount of the
negative adjustment to the fair value of the ARM securities decreased from $83.2
million as of December 31, 1998, to $66.7 million as of September 30, 1999.
The Company has purchased Cap Agreements in order to hedge exposure to changing
interest rates. The majority of the Cap Agreements have been purchased to limit
the Company's exposure to risks associated with the lifetime interest rate caps
of its ARM assets should interest rates rise above specified levels. These 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, 1999, the Cap
Agreements owned by the Company that are designated as a hedge against the
lifetime interest rate cap on ARM assets had a remaining notional balance of
$3.293 billion with an average final maturity of 1.9 years, compared to a
remaining notional balance of $4.026 billion with an average final maturity of
2.3 years at December 31, 1998. Pursuant to the terms of these 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
7.10% to 13.00% and average approximately 9.91%. The Company has also entered
into $144.2 million of Cap Agreements in connection with hedging the fixed rate
period of certain of its Hybrid ARM assets. In doing so, the Company
establishes a maximum cost of financing the Hybrid ARM assets during the term of
the designated Cap Agreements which generally corresponds to the initial fixed
rate term of Hybrid ARM assets. The Cap Agreements hedging Hybrid ARM assets as
of September 30, 1999 would receive cash payments if one-month LIBOR increases
above certain specified levels, which range from 5.75% to 6.00%, and have a
remaining average term of 3.7 years. The fair value of 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, 1999, the fair value of the
Company's Cap Agreements was $6.4 million, $0.1 million less than the amortized
cost of the Cap Agreements.
23
<PAGE>
The following table presents information about the Company's Cap Agreement
portfolio that is designated as a hedge against the lifetime interest rate cap
on ARM assets as of September 30, 1999:
<TABLE>
<CAPTION>
CAP AGREEMENTS STRATIFIED BY STRIKE PRICE
(Dollar amounts in thousands)
Hedged Weighted Cap Agreement Weighted
ARM Assets Average Notional Average
Balance (1) Life Cap Balance Strike Price Remaining Term
- ------------ --------- -------------- ------------- --------------
<S> <C> <C> <C> <C>
25,916 8.00% $ 26,000 7.10% 3.5 Years
400,984 8.74 401,003 7.50 0.6
522,011 10.15 522,073 8.00 2.5
159,522 11.07 158,458 8.50 0.5
242,832 11.35 242,888 9.00 0.2
84,934 11.43 85,203 9.50 1.6
286,587 11.73 287,535 10.00 2.7
309,905 12.22 309,797 10.50 1.6
177,119 12.35 176,908 11.00 4.8
528,908 12.83 528,915 11.50 2.9
382,279 13.50 381,934 12.00 2.1
91,916 14.09 92,092 12.50 1.3
108,390 15.96 80,296 13.00 0.4
- ------------ --------- -------------- ------------- --------------
3,321,303 11.68% $ 3,293,102 9.91% 1.9 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.
</TABLE>
As of September 30, 1999, the Company was a counterparty to twenty interest rate
swap agreements ("Swaps") having an aggregate notional balance of $739.9
million. As of September 30, 1999, these Swaps had a weighted average remaining
term of 3.3 years. In accordance with these Swaps, the Company will pay a fixed
rate of interest during the term of these Swaps and receive a payment that
varies monthly with the one-month LIBOR rate. All of these Swaps were entered
into in connection with the Company's acquisition of Hybrid ARMs. Generally, as
the Company enters into a commitment to purchase a Hybrid ARM asset, the Company
will simultaneously enter into a transaction to hedge the financing of the
Hybrid ARM to achieve a fixed rate during a substantial period of the Hybrid
ARMs fixed rate period. At times, since there is a period of time between the
commitment date and the actual cash purchase date of the Hybrid ARM, the Company
will enter into a short-term hedge transaction on the commitment date in order
to achieve a cost of financing on the cash settlement date that approximates the
Company's expected cost of financing at the time it entered into the commitment.
The Company generally does this by entering into a commitment to sell similar
duration fixed-rate MBS on the trade date and settles the commitment by
purchasing the same fixed-rate MBS on the purchase date. Realized gains and
losses are deferred and amortized as a yield adjustment over the fixed rate
period of the financing. The Swaps hedge the cost of financing Hybrid ARMs
during a substantial period of their fixed rate term, generally three to ten
years. The average remaining fixed rate term of the Company's Hybrid ARM assets
as of September 30, 1999 was 3.8 years. The Company has also entered into one
delayed Swap Agreement that becomes effective for a one year term, beginning in
April of 2002. This delayed Swap Agreement has a notional balance of $100
million and is designated to hedge the interest rate exposure of Hybrid ARM
assets upon the termination of certain other Swap Agreements. As of September
30, 1999, the Swaps had a positive fair value to the Company of $3.8 million
which was $5.0 million more favorable to the Company than their carrying value.
Since the Swaps are designated a liability hedge, the unrealized gain of $5.0
million is off balance sheet and is not recorded by the Company as Other
Comprehensive Income as part of the Company's shareholders' equity.
RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 1999
For the quarter ended September 30, 1999, the Company's net income was
$7,155,000, or $0.26 per share (Basic and Diluted EPS), based on a weighted
average of 21,490,000 shares outstanding. That compares to $4,678,000, or $0.14
per share (Basic and Diluted EPS), based on a weighted average of 21,858,000
shares outstanding for the quarter ended September 30, 1998. Net interest
income for the quarter totaled $9,332,000, compared to $5,794,000 for the same
period in 1998. Net interest income is comprised of the interest income earned
on mortgage investments less interest expense from borrowings. During the three
months ended September 30, 1999, the Company recorded $15,000 of gains from the
sale of ARM assets compared to a net gain of $755,000 during the same period of
1998. Additionally, during the third quarter of 1999, the Company reduced its
earnings and the carrying value of its ARM assets by reserving $764,000 for
potential credit losses, compared to $561,000 during the third quarter of 1998.
During the third quarter of 1999, the Company incurred operating expenses of
$1,428,000, consisting of a base management fee of $1,023,000 and other
operating expenses of $405,000. During the same period of 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.
24
<PAGE>
The Company's return on average common equity was 6.75% for the quarter ended
September 30, 1999 compared to 2.54% for the quarter ended September 30, 1998
and compared to 6.60% for the prior quarter ended June 30, 1999. The Company's
return on equity improved in this past quarter compared to the prior quarter
primarily because the Company's net interest income, the Company's core source
of income, improved.
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:
<TABLE>
<CAPTION>
COMPONENTS OF RETURN ON AVERAGE COMMON EQUITY (1)
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, 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% - 1.96% 6.83% 5.60% 1.23%
Sep 30, 1998 6.82% 0.66% 0.89% 1.54% - 1.97% 3.54% 5.24% -1.70%
Dec 31, 1998 7.27% 0.76% -4.88% 1.57% - 2.01% -1.95% 4.66% -6.61%
Mar 31, 1999 8.07% 0.84% - 1.58% - 2.05% 3.60% 4.98% -1.38%
Jun 30, 1999 11.17% 0.85% 0.04% 1.70% - 2.05% 6.60% 5.54% 1.06%
Sep 30, 1999 11.48% 0.94% 0.02% 1.76% - 2.05% 6.75% 5.88% 0.87%
- -------------
<FN>
(1) Average common equity excludes unrealized gain (loss) on available-for-sale ARM securities.
(2) Excludes performance fees.
</TABLE>
The Company's return on common equity of 6.75% in the third quarter of 1999 was
a substantial improvment over the 3.54% return in the third quarter of 1998 and
a modest improvement over the 6.60% return in the second quarter of 1999. The
Company's return on equity from net interest income has improved by 68% from
6.82% in the third quarter of 1998 compared to 11.48% during the same period in
1999. As presented above, there has been an improvement in the return on equity
from net interest income each quarter since the third quarter of 1998. As
presented in the table below, the most significant improvement in core earnings
resulted from the lower cost of funds which improved net interest income by $7.8
million. Coupon interest income has decreased by $12.1 million, but this was
partially offset by the decrease in the amortization of net premium which
declined by $7.8 million resulting in a net decrease in interest income on ARM
assets of $4.3 million. The decline in the amortization of the net premium is
primarily the result of the following three items: (1) a slow down in the rate
of ARM asset prepayments (22% rate of prepayments in the third quarter of 1999
versus 32% in the third quarter of 1998); (2) the decline in the average
interest coupon of the ARM portfolio (6.85% versus 7.40%) resulting in less
gross interest income to adjust to an appropriate yield; and (3) the cumulative
effect of recent purchases at lower prices such that there is less premium to be
amortized over the remaining expected life of the portfolio. During 1999, the
average purchase price of newly acquired ARM assets has been approximately 0.50%
above par as compared to the portfolio average remaining purchase price as of
December 31, 1998 of 2.47%. As of September 30, 1999, the average remaining
purchase price of the ARM portfolio is 2.00% and is expected to decline further
as the Company realizes the benefits of its newly created correspondent lending
business, the continued purchase of bulk loans and continues to selectively
purchase other ARM and Hybrid ARM assets at prices below the current portfolio
average.
25
<PAGE>
The following table presents the components of the Company's net interest income
for the quarters ended September 30, 1999 and 1998:
<TABLE>
<CAPTION>
COMPARATIVE NET INTEREST INCOME COMPONENTS
(Dollar amounts in thousands)
Quarters Ending
September 30,
-------------------
1999 1998
-------- ---------
<S> <C> <C>
Coupon interest income on ARM assets $74,078 $ 86,183
Amortization of net premium (5,240) (13,068)
Amortization of Cap Agreements (1,368) (1,358)
Amort. of deferred gain from hedging 185 467
Cash and cash equivalents 300 28
-------- ---------
Interest income 67,955 72,252
-------- ---------
Reverse repurchase agreements 43,609 66,252
AAA notes payable 14,179 -
Other borrowings 31 144
Interest rate swaps 804 62
-------- ---------
Interest expense 58,623 66,458
-------- ---------
Net interest income $ 9,332 $ 5,794
======== =========
</TABLE>
The following table presents 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, 1999 and 1998:
<TABLE>
<CAPTION>
AVERAGE BALANCE AND RATE TABLE
(Dollar amounts in thousands)
For the Quarter Ended For the Quarter Ended
September 30, 1999 September 30, 1998
----------------------- ----------------------
Average Effective Average Effective
Balance Rate Balance Rate
----------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Interest Earning Assets:
Adjustable-rate mortgage assets $4,538,040 5.97% $4,959,879 5.82%
Cash and cash equivalents 14,038 3.57 3,815 2.89
----------- ---------- ---------- ----------
4,552,078 5.97 4,963,694 5.82
----------- ---------- ---------- ----------
Interest Bearing Liabilities:
Borrowings 4,181,869 5.61 4,570,463 5.82
----------- ---------- ---------- ----------
Net Interest Earning Assets and Spread $ 370,209 0.36% $ 393,231 0.00%
=========== ========== ========== ==========
Yield on Net Interest Earning Assets (1) 0.82% 0.47%
========== ==========
<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.
</TABLE>
As a result of the yield on the Company's interest-earning assets improving to
5.97% during the third quarter of 1999 from 5.82% during the same period of 1998
and the Company's cost of funds decreasing to 5.61% from 5.82% during the same
time periods, net interest income increased by $3,538,000. This increase in net
interest income is primarily a favorable rate variance, partially offset by an
unfavorable volume variance. There was a combined favorable rate variance of
$4,161,000, composed of a favorable rate variance of $1,773,000 on the Company's
ARM assets portfolio and other interest-earning assets as well as a favorable
rate variance on borrowings of $2,388,000. The decreased average size of the
Company's portfolio during the third quarter of 1999 compared to the same period
in 1998 resulted in less net interest income in the amount of $622,000,
partially offsetting the more favorable rate variance. The average balance of
the Company's interest-earning assets was $4.552 billion during the third
quarter of 1999, compared to $4.964 billion during the third quarter of 1998 --
a decrease of 8%. The Company allowed its portfolio to decrease during the
third quarter of 1999 in order to increase liquidity, consistent with its
previously reported contingency plan in connection with preparation for Year
2000 issues and also in anticipation of potential reduced ability to finance
certain mortgage assets over year-end.
26
<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:
<TABLE>
<CAPTION>
COMPONENTS OF NET INTEREST SPREAD AND YIELD ON NET INTEREST EARNING ASSETS (1)
(Dollar amounts in millions)
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, 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%
Dec 31, 1998 4,526.2 6.79% 7.28% 1.42% 5.86% 5.94% -0.08% 0.61%
Mar 31, 1999 4,196.4 6.85% 7.03% 1.31% 5.71% 5.36% 0.35% 0.63%
Jun 30, 1999 4,405.3 7.10% 6.85% 1.11% 5.74% 5.40% 0.34% 0.82%
Sep 30, 1999 4,552.1 7.20% 6.85% 0.76% 6.09% 5.74% 0.35% 0.82%
<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:
</TABLE>
<TABLE>
<CAPTION>
COMPONENTS OF THE YIELD ADJUSTMENTS ON ARM ASSETS
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, 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%
Dec 31, 1998 1.18% 0.14% 0.14% (0.04)% 1.42%
Mar 31, 1999 1.09% 0.10% 0.15% (0.03)% 1.31%
Jun 30, 1999 0.87% 0.13% 0.13% (0.02)% 1.11%
Sep 30, 1999 0.51% 0.13% 0.13% (0.01)% 0.76%
</TABLE>
As of September 30, 1999, 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, and its cash and cash equivalents was 6.09%,
compared to 5.74% as of June 30, 1999-an increase of 0.35%. The Company's cost
of funds as of September 30, 1999, was 5.74%, compared to 5.40% as of June 30,
1999 - an increase of 0.34%. As a result of these changes, the Company's net
interest spread as of September 30, 1999 was 0.35%, compared to 0.34% as of June
30, 1999. The slight improvement in the net interest spread is largely
attributable to the impact of the slower rate of ARM portfolio prepayments on
the amortization of the purchase premium which more than offset the impact of
rising interest rates on the Company's cost of funds.
27
<PAGE>
The Company's spreads and net interest income have been negatively impacted
since early 1998 by the spread relationship between U.S. Treasury rates and
LIBOR. This spread relationship has negatively impacted the Company because a
portion of the Company's ARM portfolio is indexed to U.S. Treasury rates and the
interest rates on all of the Company's borrowings tend to change with changes in
LIBOR. During this period of time, U.S. Treasury rates decreased significantly
whereas LIBOR did not decrease to the same degree. As a result, the Company had
been reducing its exposure to ARM assets that are indexed to U.S. Treasury rates
through the product mix of its sales and acquisitions in order to reduce the
negative impact of this situation. Over recent months, the relationship between
U.S. Treasury rates and LIBOR has improved, although the Company does not know
if this improvement will continue or revert back to the relationship that
existed during 1998. The following table presents historical data since the
year the Company commenced operations regarding this relationship as well as
data regarding the percent of the Company's ARM portfolio that is indexed to
U.S. Treasury rates. As presented in the table below, the Company has reduced
the proportion of its ARM portfolio that is indexed to U.S. Treasury rates to
30.5% at September 30, 1999 from 49.0% as of the end of 1997. The data is as
follows:
<TABLE>
<CAPTION>
ONE-YEAR U.S. TREASURY RATES COMPARED TO ONE- AND THREE-MONTH LIBOR RATES
Average Spread
Between 1 Year
U.S. Treasury Percent of ARM
Average 1 Year Average 1 and 3 Rates and 1 & 3 Portfolio Index to
U.S. Treasury Month LIBOR Month LIBOR 1 Year U.S.
For the Year Ended Rates During Rates During Rates During Treasury Rates at
December 31, Period Period Period End of Period
- --------------------- --------------- ---------------- ---------------- ------------------
<S> <C> <C> <C> <C>
1993 3.43% 3.25% 0.18% 20.9
1994 5.32 4.61 0.71 15.5
1995 5.94 6.01 -0.07 19.3
1996 5.52 5.48 0.04 45.4
1997 5.63 5.69 -0.06 49.0
1998 5.05 5.57 -0.52 34.7
For the Quarter Ended
Mar 31, 1998 5.32 5.66 -0.34 44.3
- ---------------------
Jun 30, 1998 5.41 5.68 -0.27 38.8
Sep 30, 1998 5.10 5.62 -0.52 37.5
Dec 31, 1998 4.39 5.32 -0.93 34.7
Mar 31, 1999 4.67 4.98 -0.31 34.8
Jun 30, 1999 4.88 5.02 -0.14 32.5
Sep 30, 1999 5.16 5.36 -0.20 30.5
</TABLE>
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, 1999, the Company's
whole loans, including those held as collateral for the AAA notes payable and
those that have been securitized by the Company for which the Company has
retained credit loss exposure, accounted for 25.6% of the Company's portfolio of
ARM assets compared to 16.7% as of September 30, 1998. 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 reserved for as the
portfolio ages.
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 earnings as reported based on generally accepted accounting principles
and the Company's taxable income before its' common dividend deduction:
28
<PAGE>
<TABLE>
<CAPTION>
RECONCILIATION OF REPORTED NET INCOME TO TAXABLE NET INCOME
(Dollar amounts in thousands)
Quarters Ending
September 30,
------------------
1999 1998
-------- --------
<S> <C> <C>
Net income $ 7,155 $ 4,678
Additions:
Provision for credit losses 764 561
Net compensation related items 95 55
Deductions:
Dividend on Series A Preferred Shares (1,670) (1,670)
Capital loss carryover from 1998 (15) -
Actual credit losses on ARM securities (140) (425)
-------- --------
Taxable net income $ 6,189 $ 3,199
======== ========
</TABLE>
For the quarter ended September 30, 1999, the Company's ratio of operating
expenses to average assets was 0.13% compared to 0.10% for the same quarter in
1998. The primary reason for the increase in the ratio of operating expenses to
average assets in the respective third quarters in 1999 and 1998 is the lower
level of average assets during the 1999 third quarter. If average assets had
been the same in both quarters, the ratio in 1999 would have been 0.02% lower.
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 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 1999 and
1998, the Company did not pay the Manager a performance fee in accordance with
the terms of the Management Agreement. 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.
29
<PAGE>
The following table highlights the quarterly trend of operating expenses as a
percent of average assets:
<TABLE>
<CAPTION>
ANNUALIZED OPERATING EXPENSE RATIOS
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, 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% - 0.10%
Sep 30, 1998 0.10% - 0.10%
Dec 31, 1998 0.11% - 0.11%
Mar 31, 1999 0.12% - 0.12%
Jun 30, 1999 0.12% - 0.12%
Sep 30, 1999 0.13% - 0.13%
</TABLE>
RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1999
For the nine months ended September 30, 1999, the Company's net income was
$18,787,000, or $0.64 per share (Basic and Diluted EPS), based on a weighted
average of 21,490,000 shares outstanding. That compares to $22,649,000, or
$0.82 per share (Basic and Diluted EPS), based on a weighted average of
21,488,000 shares outstanding for the nine months ended September 30, 1998. Net
interest income for the quarter totaled $24,970,000, compared to $24,996,000 for
the same period in 1998. Net interest income is comprised of the interest
income earned on mortgage investments less interest expense from borrowings.
During the first nine months of 1999, the Company recorded a gain on the sale of
ARM securities of $50,000 as compared to a gain of $3,780,000 during the same
period of 1998. Additionally, during the first nine months of 1999, the Company
reduced its earnings and the carrying value of its ARM assets by reserving
$2,139,000 for potential credit losses, compared to $1,402,000 during the first
nine months of 1998. During the nine months ended September 30, 1999, the
Company incurred operating expenses of $4,094,000, consisting of a base
management fee of $3,061,000 and other operating expenses of $1,033,000. During
the same period of 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.
The Company's return on average common equity was 5.7% for the nine months ended
September 30, 1999 compared to 7.0% for the nine months ended September 30,
1998. The primary reasons for the lower return on average common equity is the
lower level of gains recorded during this nine month period on the sale of ARM
assets as compared to the same period during 1998 and the higher level of
provisions for credit losses commensurate with the increased size of the
Company's whole loan portfolio.
30
<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 nine month periods ended September 30, 1999 and 1998:
<TABLE>
<CAPTION>
AVERAGE BALANCE AND RATE TABLE
(Dollar amounts in thousands)
For the Nine Month For the Nine Month
Period Ended Period Ended
September 30, 1999 September 30, 1998
----------------------- ----------------------
Average Effective Average Effective
Balance Rate Balance Rate
----------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Interest Earning Assets:
Adjustable-rate mortgage assets $4,359,562 5.80% $4,906,926 6.02%
Cash and cash equivalents 25,007 6.37 6,981 3.93
----------- ---------- ---------- ----------
4,384,569 5.80 4,913,907 6.01
----------- ---------- ---------- ----------
Interest Bearing Liabilities:
Borrowings 4,010,895 5.51 4,526,102 5.79
----------- ---------- ---------- ----------
Net Interest Earning Assets and Spread $ 373,674 0.29% $ 387,805 0.22%
=========== ========== ========== ==========
Yield on Net Interest Earning Assets (1) 0.76% 0.68%
========== ==========
<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.
</TABLE>
The Company's net interest income was slightly less, $26,000, for the nine month
period ended September 30, 1999 compared to the same period in 1998. This
decrease in net interest income is the net result of a favorable rate variance
and an unfavorable volume variance. There was a net favorable rate variance of
$1,618,000, which consisted of an unfavorable variance of $7,970,000 resulting
from the lower yield on the Company's ARM assets portfolio and other
interest-earning assets and a favorable variance of $9,587,000 resulting from a
decrease in the Company's cost of funds. The decreased average size of the
Company's portfolio during the first nine months of 1999 compared to the same
period of 1998 resulted in lower net interest income in the amount of
$1,643,000. The average balance of the Company's interest-earning assets was
$4.385 billion during the first nine months of 1999 compared to $4.914 billion
during the same period of 1998 -- a decrease of 11%.
During the first nine months of 1999, the Company realized a net gain from the
sale of ARM assets in the amount of $50,000 as compared to $3,780,000 during the
first nine months of 1998. The Company considers selling assets as a portfolio
and liquidity management tool and not a core source of earnings. During 1998
the Company was focused on repositioning its portfolio into less prepayment
sensitive ARM assets and selling assets that were prepaying faster than expected
for which the Company could get a good value from a sale. As a result, the
Company was more active in selling a few selected assets in 1998 than it has
been year to date in 1999. In 1999, especially during the second and third
quarters, the Company has been focused on fully utilizing its capital capacity
after allowing the Company's assets to decrease during the latter part of 1998
and early 1999 and has, therefore, not been seeking opportunities to sell
assets.
The Company recorded an expense for credit losses in the amount of $2,139,000
during the nine months ended September 30, 1999, compared to $1,402,000 during
the same period of 1998. The increase in the provision reflects the increased
size of the Company's ARM loan portfolio which includes loans held for
securitization, loans held as collateral for AAA notes and securitized loans for
which the Company retained all of the classes of securities created upon
securitization, including the first loss classes, although the Company has
acquired third-party credit insurance that has reduced or capped the Company's
exposure to credit losses on securitized loans. To date, the Company has not
experienced any losses from its loan portfolio and the loans that are currently
delinquent appear to be adequately secured by their collateral value.
Therefore, the Company does not believe it will experience any loss from the
loans currently delinquent or from the one REO property owned as of September
30, 1999. The one REO property that the Company owned at June 30, 1999 was sold
for an amount above the Company's carrying value.
31
<PAGE>
For the nine months ended September 30, 1999 and 1998, the Company's ratio of
operating expenses to average assets was 0.12%. The biggest difference in
operating expenses during the first nine months of 1999 compared to 1998 was
that the Manager has not earned a performance fee during the first nine months
of 1999 compared to earning $759,000 during the same period of 1998. The
operating expense ratio is the same for both periods due to the effect of having
more average assets during 1998 compared to 1999.
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary source of funds for the quarter ended September 30, 1999
consisted of reverse repurchase agreements, which totaled $3.259 billion, and
callable AAA notes, which had a balance of $924.2 million. The Company's other
significant source of funds for the quarter ended September 30, 1999 consisted
of payments of principal and interest from its ARM assets in the amount of
$378.5 million. 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, capital market financing transactions
collateralized by ARM and Hybrid ARM loans, proceeds from monthly payments of
principal and interest on its ARM assets portfolio and occasional asset sales.
The Company's liquid assets generally consist of unpledged ARM assets, cash and
cash equivalents.
Total borrowings outstanding at September 30, 1999, had a weighted average
effective cost of 5.65%. The reverse repurchase agreements had a weighted
average remaining term to maturity of 3.2 months and the collateralized AAA
notes payable had a final maturity of January 25, 2029, but will be paid down as
the ARM assets collateralizing the notes are paid down. As of September 30,
1999, $1.564 billion of the Company's borrowings were variable-rate term reverse
repurchase agreements. Term reverse repurchase agreements are committed
financings with original maturities that range from three months to fourteen
months. The interest rates on these term reverse repurchase agreements are
indexed to either the one- or three-month LIBOR rate and reprice accordingly.
The interest rate on the collateralized AAA notes adjusts monthly based on
changes in one-month LIBOR.
The Company has arrangements to enter into reverse repurchase agreements with 25
different financial institutions and on September 30, 1999, had borrowed funds
with 12 of these firms. Because the Company borrows money under these
agreements based on the fair value of its ARM assets and because changes in
interest rates can negatively impact the valuation of ARM assets, the Company's
borrowing ability under these agreements could be limited and lenders may
initiate margin calls in the event interest rates change or the value of the
Company's ARM assets decline for other reasons. Additionally, certain of the
Company's ARM assets are rated less than AA by the Rating Agencies
(approximately 4.0%) 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. The Company had adequate liquidity throughout the
quarter ended September 30, 1999. Further, the Company believes it will
continue to have sufficient liquidity to meet its future cash requirements from
its primary sources of funds for the foreseeable future without needing to sell
assets.
As of September 30, 1999, the Company had $924.2 million of AAA collateralized
notes outstanding, which are not subject to margin calls. Due to the structure
of the collateralized notes, their financing is not based on market value or
subject to subsequent changes in mortgage credit markets, as is the case of the
reverse repurchase agreement arrangements.
As of September 30, 1999, the Company had entered into three whole loan
financing facilities. One of the whole loan financing facilities has a
committed borrowing capacity of $150 million, with an option to increase this
amount to $300 million. This facility matures in January 2000. One has an
uncommitted amount of borrowing capacity of $150 million and matures in April
2000. The third facility is for an unspecified amount of uncommitted borrowing
capacity and does not have a specific maturity date. As of September 30, 1999,
the Company had $1.5 million borrowed against these whole loan financing
facilities.
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, 1999, the Company had $109
million of its securities registered for future sale under this Registration
Statement.
32
<PAGE>
During 1998, the Board of Directors approved a common stock repurchase program
of up to 1,000,000 shares at prices below book value, subject to availability of
shares and other market conditions. The Company did not repurchase any shares
during the first nine months of 1999. To date, the Company has repurchased
500,016 shares at an average price of $9.28 per share.
The Company has a Dividend Reinvestment and Stock Purchase Plan (the "DRP")
designed to provide a convenient and economical way for existing shareholders to
automatically reinvest their dividends in additional shares of common stock and
for new and existing shareholders to purchase shares, as defined in the DRP.
During the first nine months of 1999, the Company purchased shares in the open
market on behalf of the participants in its DRP 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.
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 rates 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.
Interest rate changes may also impact the Company's ARM assets and borrowings
differently because the Company's ARM assets are indexed to various indices
whereas the interest rate on the Company's borrowings generally move with
changes in LIBOR. Although the Company has always favored acquiring LIBOR based
ARM assets in order to reduce this risk, LIBOR based ARMs are not generally well
accepted by home owners in the U.S. As a result, the Company has acquired ARM
assets indexed to a mix of indices in order to diversify its exposure to changes
in LIBOR in contrast to changes in other indices. During times of global
economic instability, U.S. Treasury rates generally decline because foreign and
domestic investors generally consider U.S. Treasury instruments to be a safe
haven for investments. The Company's ARM assets indexed to U.S. Treasury rates
then decline in yield as U.S. Treasury rates decline, whereas the Company's
borrowings and other ARM assets may not be affected by the same factors or to
the same degree. As a result, the Company's income can increase or decrease
depending on the relationship between the various indices to which the Company's
ARM assets are indexed, compared to changes in the Company's cost of funds.
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.
Conversely, 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.
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.
33
<PAGE>
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 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 primary software used by the Company has been internally developed using
products that are Year 2000 compliant. Other software that has been purchased
has also been certified to be Year 2000 compliant. The Manager has 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
Manager has incurred all costs in order for the Company to be Year 2000
compliant.
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, conducted a
survey, which was completed during the first half of 1999, 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.
All surveyed parties have either certified that they are Year 2000 compliant or
that they are in the testing stage and expect to be Year 2000 compliant. All
third parties that indicated they are in the testing stage are being re-surveyed
during the fourth quarter. Based on the surveys and re-surveys, the Company is
satisfied that the computer programs of all significant third parties that the
Company relies on will be ready for the Year 2000. The Company cannot be
certain that the survey fully identified all Year 2000 issues 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.
The Company has developed a contingency plan for what it believes to be likely
worst case scenarios. The Company believes that the most likely worst case
scenarios all impact the availability and cost of financing ARM assets over
year-end. For this reason, the Company has already entered into financing
arrangements that finances over 60% of the Company's ARM portfolio over
year-end. In addition, the Company has decided to increase its liquidity as
year-end approaches by de-emphasizing the acquisition of ARM assets over the
balance of the year. As an additional precaution, if it becomes prudent, the
Company may review the appropriateness of selling selected assets that could
prove to be difficult to finance over year-end, if acceptable financing
arrangements for such assets can not or are not expected to be consummated by
the end of the year. The Company is also discussing the financing of its agency
payment receivables with other financial institutions as another possible source
of liquidity. The Company believes that these steps, as part of its contingency
plan, are prudent measures in light of the uncertainty related to Year 2000
issues. Further, the Company believes that these steps will be sufficient to
address the most likely worst case scenarios, but the Company can provide no
certainty that such will prove to be the case.
OTHER MATTERS
As of September 30, 1999, the Company calculates its Qualified REIT Assets, as
defined in the Internal Revenue Code of 1986, as amended (the "Code"), to be
99.5% 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 99.4% of its 1999 revenue for the first nine months 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, 1999, the Company believes that it will
continue to qualify as a REIT under the provisions of the Code.
34
<PAGE>
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, 1999, 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
None
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K:
(a) Exhibits
See "Exhibit Index"
(b) Reports on Form 8-K
The Company filed the following Current Report on Form 8-K
during the period covered by this Form 10-Q:
(i) Current Report on Form 8-K, dated September 1, 1999
regarding the Registrant's Change in Certifying
Accountant.
35
<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
(dba THORNBURG MORTGAGE, INC.)
Dated: November 12, 1999 By: /s/ Larry A. Goldstone
-------------------------------------
Larry A. Goldstone
President and Chief Operating Officer
(authorized officer of registrant)
Dated: November 12, 1999 By: /s/ Richard P. Story
-------------------------------------
Richard P. Story,
Chief Financial Officer and Treasurer
(principal accounting officer)
36
<PAGE>
Exhibit Index
<TABLE>
<CAPTION>
Sequentially
Numbered
Exhibit Number Exhibit Description Page
- -------------- ---------------------------------------------------------------- ------------
<C> <S> <C>
3.2.1.1 Amendment to Article IV, Section 13 of the Bylaws of the Company 38
</TABLE>
37
<PAGE>
THORNBURG MORTGAGE ASSET CORPORATION
DBA THORNBURG MORTGAGE, INC.
AMENDMENT TO BYLAWS
(effective July 15, 1999)
Article IV, Section 13
The penultimate sentence in the third paragraph of Article IV Section 13 is
restated as follows:
Each contract for the services of a Manager entered into by the Board of
Directors shall have a term of no more than ten (10) years, renewable at or
prior to expiration of the contract.
38
<PAGE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
September 30, 1999 Form 10-Q and is qualified in its entirety by reference to
such financial statements.
</LEGEND>
<MULTIPLIER> 1000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> SEP-30-1999
<CASH> 34617
<SECURITIES> 4451281
<RECEIVABLES> 41463
<ALLOWANCES> 3548
<INVENTORY> 0
<CURRENT-ASSETS> 8298
<PP&E> 0
<DEPRECIATION> 0
<TOTAL-ASSETS> 4532111
<CURRENT-LIABILITIES> 4204765
<BONDS> 0
0
65805
<COMMON> 220
<OTHER-SE> 261321
<TOTAL-LIABILITY-AND-EQUITY> 4532111
<SALES> 0
<TOTAL-REVENUES> 190737
<CGS> 0
<TOTAL-COSTS> 0
<OTHER-EXPENSES> 4094
<LOSS-PROVISION> 2139
<INTEREST-EXPENSE> 165717
<INCOME-PRETAX> 18787
<INCOME-TAX> 0
<INCOME-CONTINUING> 18787
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 18787
<EPS-BASIC> .64
<EPS-DILUTED> .64
</TABLE>
