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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, 2000
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, 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) 21,572,460 as of November 13, 2000
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<PAGE>
<TABLE>
<CAPTION>
THORNBURG MORTGAGE, INC.
FORM 10-Q
INDEX
Page
----
PART I. FINANCIAL INFORMATION
<S> <C>
Item 1. Financial Statements
Consolidated Balance Sheets at September 30, 2000 and December 31, 1999 . . 3
Consolidated Statements of Operations for the three and nine months ended
September 30, 2000 and September 30, 1999. . . . . . . . . . . . . . . . . 4
Consolidated Statement of Shareholders' Equity for the nine months
ended September 30, 2000 and September 30, 1999. . . . . . . . . . . . . . 5
Consolidated Statements of Cash Flows for the three and nine months ended
September 30, 2000 and September 30, 1999. . . . . . . . . . . . . . . . . 6
Notes to Consolidated Financial Statements. . . . . . . . . . . . . . . . . 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations . . . . . . . . . . . . . . . . 19
PART II. OTHER INFORMATION
Item 1. Legal Proceedings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Item 2. Changes in Securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Item 3. Defaults Upon Senior Securities. . . . . . . . . . . . . . . . . . . . . . . 39
Item 4. Submission of Matters to a Vote of Security Holders. . . . . . . . . . . . . 39
Item 5. Other Information. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Item 6. Exhibits and Reports on Form 8-K. . . . . . . . . . . . . . . . . . . . . . 39
SIGNATURES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
EXHIBIT INDEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
</TABLE>
2
<PAGE>
<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
THORNBURG MORTGAGE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands)
September 30, 2000 December 31, 1999
(Unaudited)
------------------ -----------------
<S> <C> <C>
ASSETS
Adjustable-rate mortgage ("ARM") assets: (Notes 2 and 3)
ARM securities $ 3,297,473 $ 3,391,467
Collateral for collateralized notes 651,340 903,529
ARM loans held for securitization 126,340 31,102
------------------ -----------------
4,075,153 4,326,098
------------------ -----------------
Cash and cash equivalents 32,071 10,234
Accrued interest receivable 31,466 31,928
Prepaid expenses and other 1,560 7,705
------------------ -----------------
$ 4,140,250 $ 4,375,965
================== =================
LIABILITIES
Reverse repurchase agreements (Note 3) $ 2,983,493 $ 3,022,511
Collateralized notes payable (Note 3) 638,437 886,722
Other borrowings (Note 3) 110,331 21,289
Payable for assets purchased 93,167 110,415
Accrued interest payable 14,664 18,864
Dividends payable (Note 5) 1,670 1,670
Accrued expenses and other 4,065 3,607
------------------ -----------------
3,845,827 4,065,078
------------------ -----------------
COMMITMENTS (Note 2)
SHAREHOLDERS' EQUITY (Note 5)
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 342,229 342,026
Accumulated other comprehensive income (loss) (100,814) (82,489)
Notes receivable from stock sales (4,632) (4,632)
Retained earnings (deficit) (3,719) (5,377)
Treasury stock: at cost, 500 and 500 shares, respectively (4,666) (4,666)
------------------ -----------------
294,423 310,887
------------------ -----------------
$ 4,140,250 $ 4,375,965
================== =================
</TABLE>
See Notes to Consolidated Financial Statements.
3
<PAGE>
<TABLE>
<CAPTION>
THORNBURG MORTGAGE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
In thousands, except per share data)
Three Months Ended Nine Months Ended
September 30, September 30,
2000 1999 2000 1999
----------- ------------ ---------- ----------
<S> <C> <C> <C> <C>
Interest income from ARM assets and cash $ 71,017 $ 67,955 $ 216,808 $ 190,687
Interest expense on borrowed funds (62,039) (58,623) (189,761) (165,717)
------------ ------------ ---------- ----------
Net interest income 8,978 9,332 27,047 24,970
------------ ------------ ---------- ----------
Gain on sale of ARM assets - 15 49 50
Provision for credit losses (270) (764) (983) (2,139)
Management fee (Note 7) (1,029) (1,023) (3,086) (3,061)
Performance fee (Note 7) - - - -
Other operating expenses (663) (405) (1,532) (1,033)
------------ ------------ ---------- ----------
NET INCOME $ 7,016 $ 7,155 $ 21,495 $ 18,787
============ ============ ========== ==========
Net income $ 7,016 $ 7,155 $ 21,495 $ 18,787
Dividend on preferred stock (1,670) (1,670) (5,009) (5,009)
------------ ------------ ---------- ----------
Net income available to common shareholders $ 5,346 $ 5,485 $ 16,486 $ 13,778
============ ============ ========== ==========
Basic earnings per share $ 0.25 $ 0.26 $ 0.77 $ 0.64
============ ============ ========== ==========
Diluted earnings per share $ 0.25 $ 0.26 $ 0.77 $ 0.64
============ ============ ========== ==========
Average number of common shares outstanding 21,490 21,490 21,490 21,490
============ ============ ========== ==========
</TABLE>
See Notes to Consolidated Financial Statements.
4
<PAGE>
<TABLE>
<CAPTION>
THORNBURG MORTGAGE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (UNAUDITED)
Nine Months Ended September 30, 2000 and 1999
(In thousands, except share data)
Accum. Notes
Other Receiv-
Additional Compre- able From Retained Compre-
Preferred Common Paid-in Hensive Stock Earnings/ Treasury hensive
Stock Stock Capital Income Sales (Deficit) Stock Income Total
--------- ------ ---------- ---------- --------- ---------- -------- -------- ---------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Balance, December 31, 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
========= ====== ========== ========== ========= ========== ======== =========
Balance, December 31, 1999 $ 65,805 $ 220 $ 342,026 $ (82,489) $ (4,632) $ (5,377) $(4,666) $310,887
Comprehensive income:
Net income 21,495 $21,495 21,495
Other comprehensive income:
Available-for-sale assets:
Fair value adjustment, net
of amortization - - - (17,672) - - - (17,672) (17,672)
Deferred gain on sale of
hedges, net of amortization - - - (653) - - - (653) (653)
--------
Other comprehensive income $ 3,170
========
Interest from notes receivable
from stock sales 203 203
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, 2000 $ 65,805 $ 220 $ 342,229 $(100,814) $ (4,632) $ (3,719) $(4,666) $294,423
========= ====== ========== ========== ========= ========== ======== =========
</TABLE>
See Notes to Consolidated Financial Statements.
5
<PAGE>
<TABLE>
<CAPTION>
THORNBURG MORTGAGE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)
Three Months Ended Nine Months Ended
September 30, September 30,
2000 1999 2000 1999
---------- ---------- ---------- ------------
<S> <C> <C> <C> <C>
Operating Activities:
Net Income $ 7,016 $ 7,155 $ 21,495 $ 18,787
Adjustments to reconcile net income to net
cash provided by operating activities:
Amortization 4,067 6,448 13,282 26,220
Net (gain) loss from investing activities 270 749 934 2,089
Change in assets and liabilities:
Accrued interest receivable 33 455 462 5,544
Prepaid expenses and other 466 (851) 6,145 (6,452)
Accrued interest payable (423) (2,415) (4,200) (17,313)
Accrued expenses and other 1,018 232 458 568
---------- ---------- ---------- ------------
Net cash provided by operating activities 12,447 11,773 38,576 29,443
---------- ---------- ---------- ------------
Investing Activities:
Available-for-sale ARM securities:
Purchases (93,537) (298,916) (518,344) (1,236,172)
Proceeds on sales 22,812 3,348 112,255 9,922
Proceeds from calls 4,288 2,108 4,288 6,234
Principal payments 170,122 237,360 482,844 816,982
Collateral for collateralized notes payable:
Principal payments 48,179 66,040 249,577 201,813
ARM loans:
Purchases (111,899) (9,534) (131,895) (11,345)
Proceeds on sales - 6,991 - 6,991
Principal payments 1,438 597 2,970 7,165
Purchase of interest rate cap agreements - - (539) (1,910)
---------- ---------- ---------- ------------
Net cash provided by (used in) investing activities 41,403 (7,994) 201,156 (200,320)
---------- ---------- ---------- ------------
Financing Activities:
Net borrowings from (repayments of) reverse
repurchase agreements (93,735) 47,076 (39,018) 392,145
Repayments of collateralized notes (47,805) (65,610) (248,285) (202,943)
Net borrowing from (repayments of) other borrowings 91,923 183 89,042 (502)
Dividends paid (6,611) (6,613) (19,837) (19,839)
Interest from notes receivable from stock sales 68 68 203 202
---------- ---------- ---------- ------------
Net cash provided by (used in) financing activities (56,160) (24,896) (217,895) 169,063
---------- ---------- ---------- ------------
Net increase (decrease) in cash and cash equivalents (2,310) (5,129) 21,837 (1,814)
Cash and cash equivalents at beginning of period 34,381 39,746 10,234 36,431
---------- ---------- ---------- ------------
Cash and cash equivalents at end of period $ 32,071 $ 34,617 $ 32,071 $ 34,617
========== ========== ========== ============
</TABLE>
Supplemental disclosure of cash flow information and non-cash activities are
included in Note 3.
See Notes to Consolidated Financial Statements
6
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SIGNIFICANT ACCOUNTING POLICIES
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles
for interim financial information and with the instructions to Form
10-Q and Rule 10-01 of Regulation S-X. Therefore, they do not include
all of the information and footnotes required by generally accepted
accounting principles for complete financial statements.
In the opinion of management, all material adjustments, consisting of
normal recurring adjustments, considered necessary for a fair
presentation have been included. The operating results for the quarter
and nine-months ended September 30, 2000 are not necessarily
indicative of the results that may be expected for the calendar year
ending December 31, 2000.
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
Thornburg Mortgage, Inc (the "Company") and its wholly-owned
bankruptcy remote special purpose finance subsidiaries, Thornburg
Mortgage Funding Corporation, Thornburg Mortgage Acceptance
Corporation and Thornburg Mortgage Acceptance Corporation II and
a banking subsidiary, Thornburg Mortgage Home Loans, Inc.
("TMHL"). Each of these subsidiaries is a wholly-owned qualified
REIT subsidiary and is consolidated with the Company for
financial statement and tax reporting purposes. The Company
formed the wholly-owned bankruptcy remote special purpose finance
subsidiaries in connection with its securitization and whole loan
financing transactions discussed in Note 4. All material
intercompany accounts and transactions are eliminated in
consolidation.
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.
7
<PAGE>
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.
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 probable credit losses at a
level deemed appropriate by management to provide for known
losses as well as estimated losses inherent 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 estimated credit
losses on its portfolio of ARM loans, which is an increase to the
reserve for possible loan losses. The provision for estimated
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. Additionally, once a loan is 90 days
or more delinquent, the Company adjusts the value of the accrued
interest receivable to what it believes to be collectible and
generally stops accruing interest on the loan.
Credit losses on pools of loans that are held as collateral for
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 estimated credit
losses on these loans the same as it does for loans that are not
held as collateral for 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.
8
<PAGE>
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. These 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.
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 Cap 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 OPTIONS CONTRACTS
The Company purchases options on interest rate futures (the "Options
Contracts") to manage interest rate risk in the same manner as Cap
Agreements. To date, the Options Contracts purchased limit the
Company's risk associated with the lifetime or maximum interest rate
caps of its ARM assets should interest rates rise above specified
levels. These Options Contracts 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.
All Options Contracts 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 Options Contracts is
included in ARM securities on the balance sheet. The Company purchases
Options Contracts by incurring a one-time fee or premium. The
amortization of the premium paid for the Options Contracts is included
in interest income as a contra item (i.e., expense) and, as such,
reduces interest income over the lives of the Options Contracts.
INTEREST RATE SWAP AGREEMENTS
The Company enters into interest rate swap agreements (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 duration of a hybrid and the
maturity of the borrowing funding a Hybrid ARM) to a mismatched
duration of approximately one year or less. Revenues and expenses from
the Swap Agreements are accounted for on an accrual basis and
recognized as a net adjustment to interest expense.
9
<PAGE>
Realized gains and losses resulting from the termination and
replacement of Swap Agreements, are recorded as basis adjustments to
the hedged liabilities and are thereafter amortized as a yield
adjustment over the remaining term of the Swap Agreements. The
terminated and replacement Swap Agreements generally have the same
terms and conditions other than the fixed rate. The amortization of
the realized gains and losses as a yield adjustment to the fixed rate
of the replacement Swap Agreement results in approximately the same
fixed cost between the terminated and replacement Swap Agreements. The
Company terminates and replaces Swap Agreements as an additional
source of liquidity when it is able to do so while maintaining
compliance to its hedging policies.
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 Note 5.
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.
Following is information about the computation of the earnings per
share data for the three and nine month periods ended September 30,
2000 and 1999 (amounts in thousands except per share data):
<TABLE>
<CAPTION>
Earnings
Income Shares Per Share
-------- --------- ----------
Three Months Ended September 30, 2000
-------------------------------------
<S> <C> <C> <C>
Net income $ 7,016
Less preferred stock dividends (1,670)
--------
Basic EPS, income available to
common shareholders 5,346 21,490 $ 0.25
==========
Effect of dilutive securities:
Stock options - 26
-------- ---------
Diluted EPS $ 5,346 21,516 $ 0.25
======== ========= ==========
Three Months Ended September 30, 1999
-------------------------------------
Net income $ 7,155
Less preferred stock dividends (1,670)
--------
Basic EPS, income available to
common stockholders 5,485 21,490 $ 0.26
==========
Effect of dilutive securities:
Stock options - 3
-------- ---------
Diluted EPS $ 5,485 21,493 $ 0.26
======== ========= ==========
10
<PAGE>
Earnings
Income Shares Per Share
--------- -------- -----------
Nine Months Ended September 30, 2000
------------------------------------
Net income $ 21,495
Less preferred stock dividends (5,009)
---------
Basic EPS, income available to
common shareholders 16,486 21,490 $ 0.77
==========
Effect of dilutive securities:
Stock options - 6
--------- --------- ----------
Diluted EPS $ 16,486 21,496 $ 0.77
========= ========= ==========
Nine Months Ended September 30, 1999
------------------------------------
Net income $ 18,787
Less preferred stock dividends (5,009)
---------
Basic EPS, income available to
common stockholders 13,778 21,490 $ 0.64
==========
Effect of dilutive securities:
Stock options - 8
---------- ---------
Diluted EPS $ 13,778 21,498 $ 0.64
========= ========= ==========
</TABLE>
The Company has granted options to directors and officers of the
Company and employees of the Manager to purchase 200,022 and 141,779
shares of common stock at average prices of $7.375 and $9.0625 per
share during the nine months ended September 30, 2000 and 1999,
respectively. The conversion of preferred stock was not included in
the computation of diluted EPS because such conversion would increase
the diluted EPS.
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 the Swap Agreements. The fair value of Swap Agreements
is disclosed in Note 5, Fair Value of Financial Instruments. The
Company believes that its use of Swap Agreements qualify as cash-flow
hedges, as defined in the statement, and that its use of Cap
Agreements and Option Contracts qualify as fair value hedges, as
defined in the statement. Therefore, the effective hedge portion of
the derivative instrument's change in fair value 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, 2000 and December 31, 1999. 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, 2000
Available-
for-Sale Collateral for
ARM Securities Notes Payable ARM Loans Total
---------------- ---------------- ----------- -----------
<S> <C> <C> <C> <C>
Principal balance outstanding $ 3,319,946 $ 641,693 $ 126,937 $4,088,576
Net unamortized premium 59,763 12,303 (473) 71,593
Deferred gain from hedging (90) - - (90)
Allowance for losses (1,997) (2,886) (124) (5,007)
Cap Agreements/Options
Contracts 3,613 230 - 3,843
Principal payment receivable 17,264 - - 17,264
---------------- ---------------- ----------- -----------
Amortized cost, net 3,398,499 651,340 126,340 4,176,179
---------------- ---------------- ----------- -----------
Gross unrealized gains 2,765 12 11 2,788
---------------- ---------------- ----------- -----------
Gross unrealized losses (103,791) (15,750) (50) (119,591)
---------------- ---------------- ----------- -----------
Fair value $ 3,297,473 $ 635,602 $ 126,301 $4,059,376
================ ================ =========== ===========
Carrying value $ 3,297,473 $ 651,340 $ 126,340 $4,075,153
================ ================ =========== ===========
December 31, 1999:
Available-
for-Sale Collateral for
ARM Securities Notes Payable ARM Loans Total
---------------- ---------------- ----------- -----------
Principal balance outstanding $ 3,388,160 $ 890,701 $ 31,649 $4,310,510
Net unamortized premium 70,409 14,045 (445) 84,009
Deferred gain from hedging (351) - - (351)
Allowance for losses (1,930) (2,106) (102) (4,138)
Cap Agreements 4,923 320 - 5,243
Principal payment receivable 13,610 569 - 14,179
---------------- ---------------- ----------- -----------
Amortized cost, net 3,474,821 903,529 31,102 4,409,452
---------------- ---------------- ----------- -----------
Gross unrealized gains 5,462 29 65 5,556
---------------- ---------------- ----------- -----------
Gross unrealized losses (88,816) (13,165) (170) (102,151)
---------------- ---------------- ----------- -----------
Fair value $ 3,391,467 $ 890,393 $ 30,997 $4,312,857
================ ================ =========== ===========
Carrying value $ 3,391,467 $ 903,529 $ 31,102 $4,326,098
================ ================ =========== ===========
</TABLE>
During the first nine months of 2000, in accordance with its credit
policies, the Company provided for estimated credit losses on the
subordinated classes of its securitized loans in the amount of
$180,000 and recorded a $803,000 provision for estimated 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, 2000 and December 31, 1999 (dollar amounts in
thousands):
September 30, 2000
--------------------
Percent of Percent of
Loan Loan ARM Total
Delinquency Status Count Balance Loans (1) Assets
------------------------ ---------- ----------- --------- -------
60 to 89 days 1 $ 210 0.02% 0.01%
90 days or more 1 209 0.02 0.01
In foreclosure 6 4,253 0.36 0.10
---------- ----------- --------- -------
8 $ 4,672 0.40% 0.12%
========== =========== ========= =======
December 31, 1999
-----------------
Percent of Percent of
Loan Loan ARM Total
Delinquency Status Count Balance Loans (1) Assets
------------------------ ---------- ----------- --------- -------
60 to 89 days 1 $ 110 0.01 % 0.00 %
90 days or more - - - -
In foreclosure 10 5,450 0.49 0.12
---------- ----------- --------- -------
11 $ 5,560 0.50 % 0.12 %
========== =========== ========= =======
(1) ARM loans includes loans that the Company has securitized and retained
first loss credit exposure for total amounts of $1.179 billion and
$1.108 billion at September 30, 2000 and December 31, 1999,
respectively.
The following table summarizes the activity for the allowance for
losses on ARM loans for the nine months ended September 30, 2000 and
1999 (dollar amounts in thousands):
2000 1999
=========== ============
Beginning balance $ 2,208 $ 804
Provision for losses 803 1,193
Charge-offs, net - -
----------- ------------
Ending balance $ 3,011 $ 1,997
=========== ============
During the quarter ended September 30, 2000, the Company securitized
$13.7 million of ARM loans into Agency ARM securities. In addition,
the Company sold ARM securities in the amount of $22.8 million at no
gain or loss.
As of September 30, 2000, the Company had commitments to purchase
$199.7 million of ARM securities and $6.1 million of ARM loans.
As of September 30, 2000, the Company owned one real estate property
as a result of foreclosing on a delinquent loan in the aggregate
amount of $0.6 million, which is included in collateral for
collateralized notes on the balance sheet. The Company believes that
the above allowance is adequate to cover estimated losses from this
property.
The average effective yield on the ARM assets owned was 7.00% as of
September 30, 2000 and 6.38% as of December 31, 1999. The average
effective yield is based on historical cost and includes the
amortization of the net premium paid for the ARM assets and the Cap
Agreements, the impact of ARM principal payment receivables and the
amortization of deferred gains from hedging activity.
The Company purchases Interest Rate Options Contracts as an
alternative method of hedging the lifetime interest rate cap of ARM
assets. Since these Options Contracts are purchased in connection with
the Company's policy to hedge the lifetime cap of ARM assets along
with the Company's Cap Agreements, they are included in the discussion
about Cap Agreements below.
13
<PAGE>
As of September 30, 2000 and December 31, 1999, the Company had
purchased Cap Agreements and Options Contracts with a remaining
notional amount of $2.645 billion and $2.945 billion, respectively.
The notional amount of the Cap Agreements and Options Contracts
purchased decline at a rate that is expected to approximate the
amortization of the ARM assets. Under these Cap Agreements and Options
Contracts, 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 these hedging
instruments that range from 5.75% to 12.50% and average approximately
9.93%. Of the Cap Agreements and Options Contracts owned by the
Company as of September 30, 2000, $111.0 million are hedging the cost
of financing Hybrid ARMs and $2.534 billion are hedging the lifetime
interest rate cap of ARM assets. The Company's ARM assets portfolio
had an average lifetime interest rate cap of 11.64%. The Cap
Agreements and Options Contracts had an average maturity of 2.2 years
as of September 30, 2000. The initial aggregate notional amount of the
Cap Agreements declines to approximately $2.333 billion over the
period of the agreements, which expire between 2000 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 A, but the Company has a two-way collateral
agreement protecting its credit exposure with this counterparty.
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 assets and bear interest rates that have historically
moved in close relationship to LIBOR.
As of September 30, 2000, the Company had outstanding $2.983 billion
of reverse repurchase agreements with a weighted average borrowing
rate of 6.75% and a weighted average remaining maturity of 3.8 months.
As of September 30, 2000, $1.460 billion of the Company's borrowings
were variable-rate term reverse repurchase agreements with original
maturities that range from six months to twelve 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, 2000 were
collateralized by ARM assets with a carrying value of $3.282 billion,
including accrued interest.
At September 30, 2000, the reverse repurchase agreements had the
following remaining maturities (dollar amounts in thousands):
Within 30 days $ 967,395
31 to 89 days 475,628
90 days or greater 1,540,470
---------------
$ 2,983,493
===============
As of September 30, 2000, 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
2001. During the first quarter of 2000, the Company entered into a
second committed whole loan financing facility that also has a
borrowing capacity of $150 million. This second committed facility
matures in March of 2003, subject to an annual review and extension by
both parties. The third facility is for an unspecified amount of
uncommitted borrowing capacity and does not have a specific maturity
date. As of September 30, 2000, the Company had $110.3 million
borrowed against these whole loan financing facilities at an effective
cost of 7.19%. The amount borrowed on the whole loan financing
agreements at September 30, 2000 was collateralized by ARM loans with
a carrying value of $114.3 million, including accrued interest.
14
<PAGE>
One of the whole loan financing facility, discussed above, is a
securitization transaction in which the Company transfers groups of
whole loans to a wholly-owned bankruptcy remote special purpose
subsidiary. The subsidiary in turn simultaneously transfers its
interest in the loans to a trust which issues beneficial interests in
the loans in the form of a note and a subordinated certificate, which
are then used to collateralize borrowings.
On December 18, 1998, the Company, through a wholly-owned bankruptcy
remote special purpose finance subsidiary, issued $1.144 billion of
notes payable ("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,
2000, the Notes had a net balance of $638.4 million, an effective
interest cost of 7.36%, which changes each month at a spread to
one-month LIBOR. As of September 30, 2000, these Notes were
collateralized by ARM loans with a principal balance of $673.9
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, 2000, the Company was a counterparty to twenty
interest rate swap agreements ("Swaps") having an aggregate notional
balance of $575.8 million. As of September 30, 2000, these Swaps had a
weighted average remaining term of 2.3 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 29 days to 186 days. All of these
Swaps were entered into in connection with the Company's acquisition
of Hybrid ARMs. The Swaps hedge the cost of financing Hybrid ARMs
during their fixed rate term, generally three to ten years. As of
September 30, 2000, the Swap Agreements were collateralized by ARM
assets with a carrying value of $1.0 million, including accrued
interest
The total cash paid for interest was $62.0 million and $60.6 million
during the quarters ended September 30, 2000 and 1999, respectively.
15
<PAGE>
NOTE 4. FAIR VALUE OF FINANCIAL INSTRUMENTS AND OFF-BALANCE SHEET CREDIT RISK
The following table presents the carrying amounts and estimated fair
values of the Company's financial instruments at September 30, 2000
and December 31, 1999. 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, 2000 December 31, 1999
----------------------- ----------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
---------- ----------- ---------- -----------
<S> <C> <C> <C> <C>
Assets:
ARM assets $4,072,283 $4,056,506 $4,318,301 $4,305,060
Cap Agreements/Options
Contracts 2,870 2,870 7,797 7,797
Liabilities:
Collateralized notes payable 638,437 639,572 886,722 889,305
Other borrowings 110,331 110,331 21,289 21,289
Swap agreements 7,577 (900) 749 (11,527)
</TABLE>
The above carrying amounts for assets are combined in the balance
sheet under the caption adjustable-rate mortgage assets. The carrying
amount for securities, which are categorized as available-for-sale, is
their fair value whereas the carrying amount for loans, which are
categorized as held for the foreseeable future, is their amortized
cost.
The fair values of the Company's ARM securities, Cap Agreements and
Options Contracts are generally based on market prices provided by
certain dealers who make markets in these financial instruments or
third-party pricing services. If the fair value of an ARM security is
not reasonably available from a dealer or a third-party pricing
service, management estimates the fair value based on characteristics
of the security it receives from the issuer and available market
information. The fair values for ARM loans is estimated 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 aggregated 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 collateralized notes
payable 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, other borrowings 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.
The Company's transactions in interest rate swap agreements and
hedging activity using commitments to sell securities create
off-balance-sheet risk. These instruments involve market and credit
risk that is not recognized on the balance sheet. The principal risk
related to the swap agreements is the possibility that a counterparty
to the agreement may be unable or unwilling to meet the terms of the
agreement. With respect to commitments to sell securities, there is a
risk that the change in the value of the hedged item may not
substantially offset the change in the value of the commitment. The
Company reduces counterparty risk by dealing only with several
experienced counterparties with AA or better credit ratings or a
two-way collateral agreement is required.
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 quarter or nine-month period ended September 30,
2000. To date, the company has repurchased 500,016 at an average price
of $9.28 per share.
16
<PAGE>
On July 18, 2000, the Company declared the second quarter 2000
dividend of $0.23 per common share, which was paid on August 17, 2000
to common shareholders of record as of August 4, 2000.
On October 17, 2000, the Company declared the third quarter 2000
dividend of $0.25 per common share, which will be paid on November 17,
2000 to common shareholders of record as of November 6, 2000.
On September 15, 2000, 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 10,
2000 to preferred shareholders of record as of September 30, 2000.
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") that
authorizes the granting of options to purchase an aggregate of up to
1,800,000 shares, but not more than 5% of the outstanding shares of
the Company's common stock. The Plan authorizes the Board of
Directors, or a committee of the Board of Directors, to grant
Incentive Stock Options ("ISOs") as defined under section 422 of the
Internal Revenue Code of 1986, as amended, options not so qualified
("NQSOs"), Dividend Equivalent Rights ("DERs"), Stock Appreciation
Rights ("SARs"), and Phantom Stock Rights ("PSRs").
The exercise price for any options granted under the Plan may not be
less than 100% of the fair market value of the shares of the common
stock at the time the option is granted. Options become exercisable
six months after the date granted and will expire ten years after the
date granted, except options granted in connection with an offering of
convertible preferred stock, in which case such options become
exercisable if and when the convertible preferred stock is converted
into common stock.
The Company usually issues DERs at the same time ISOs and NQSOs are
granted. The number of PSRs issued is 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 quarter ended September 30, 2000, there were not any
options or DERs granted or exercised. During the nine month period
ended September 30, 2000, there were 210,022 options granted to buy
common shares at an average exercise price of $7.43 along with 215,500
DERs. As of September 30, 2000, the Company had 999,495 options
outstanding at exercise prices of $7.375 to $22.625 per share, 686,828
of which were exercisable. The weighted average exercise price of the
options outstanding was $13.80 per share. As of the September 30,
2000, there were 377,675 DERs outstanding, of which 349,514 were
vested, and 34,861 PSRs outstanding. In addition, the Company recorded
an expense associated with the DERs and the PSRs of $108,000 and
$154,000 for the three and nine month periods ended September 30,
2000, respectively, and $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 mature in 2006 and
2007and accrue interest at rates that range from 5.47% to 6.25% 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, 2000, there were $4.6
million of notes receivable from stock sales outstanding.
17
<PAGE>
NOTE 7. TRANSACTIONS WITH AFFILIATES
The Company has a Management Agreement (the "Agreement") with the
Manager. Under the terms of this Agreement, the Manager, subject to
the supervision of the Company's Board of Directors, is responsible
for the management of the day-to-day operations of the Company and
provides all personnel and office space. The Agreement provides for an
annual review by the unaffiliated directors of the Board of Directors
of the Manager's performance under the Agreement.
The Company pays the Manager an annual base management fee based on
average shareholders' equity, adjusted for liabilities that are not
incurred to finance assets ("Average Shareholders' Equity" or "Average
Net Invested Assets" as defined in the Agreement) payable monthly in
arrears as follows: 1.1% of the first $300 million of Average
Shareholders' Equity, plus 0.8% of Average Shareholders' Equity above
$300 million. In addition, during 1999, the two wholly owned REIT
qualified subsidiaries of the Company entered into separate Management
Agreements with the Manager for additional management services for a
combined amount of $1,250 per calendar quarter, paid in arrears.
On October 17, 2000, the Board of Directors and the Manager agreed to
amendments to the Agreement that included a 0.05% increase to the base
management fee formula, effectively immediately, and a cost of living
clause that will adjust the base management fee formula by the change
in the Consumer Price Index over the previous twelve month period,
effective as of each annual review of the Agreement. The 0.05%
adjustment to the base management fee formula is expected to increase
the cost of the base management fee by approximately $200,000 on an
annual basis.
For the quarters ended September 30, 2000 and 1999, the Company paid
the Manager $1,029,000 and $1,023,000, respectively, in base
management fees in accordance with the terms of the Agreements. For
the nine month periods ended September 30, 2000 and 1999, the Company
paid the Manager base management fees of $3,086,000 and $3,061,000,
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 and
nine-month periods ended September 30, 2000 and 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%.
Beginning in August 1999, the Company's wholly owned REIT qualified
subsidiaries entered into separate lease agreements with the Manager
for office space in Santa Fe. During the quarter and nine-month period
ended September 30, 2000, the combined amount of rent paid to the
Manager was $9,000 and $24,000, respectively.
18
<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," "plan," 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, availability and cost
of acquiring new assets and the timing of new programs. The statements in the
"Risk Factors" section of the Company's 1999 Annual Report on Form 10-K on page
17 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, Inc., including 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 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. The corporate structure of
the Company differs from most lending institutions in that the Company is
organized for tax purposes as a real estate investment trust ("REIT") and
therefore generally passes through substantially all of its earnings to
shareholders without paying federal or state income tax at the corporate level.
The Company has three qualified REIT subsidiaries that are involved in financing
its mortgage loan assets. The three financing subsidiaries, Thornburg Mortgage
Funding Corporation, Thornburg Mortgage Acceptance Corporation and Thornburg
Mortgage Acceptance Corporation II, are consolidated in the Company's financial
statements and federal and state tax returns. In 1999, the Company formed a new
qualified REIT subsidiary, Thornburg Mortgage Home Loans, Inc. ("TMHL"), to
originate loans for the Company according to the Company's underwriting
guidelines. This subsidiary received its HUD license during the second quarter
of 2000 and commenced marketing and originating ARM loans for the Company's
portfolio during the third quarter of 2000.
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. Hybrid ARM assets ("Hybrid ARMs")
are included in the Company's references to ARM securities and ARM loans.
Hybrid ARMs are typically 30-year loans that 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. The Company will
not invest more than 30% of its ARM assets in Hybrid ARMs and will limit 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 a duration of no more than one year. Hybrid ARMs with
fixed-rate periods greater than five years are further limited to no more than
10% of the Company's ARM assets.
On July 18, 2000, the Company's Board of Directors modified the Company's
investment policy to allow for the origination of fixed-rate loans with up to 30
year terms by the Company's subsidiary, TMHL, to be held for the purpose of sale
only and not for investment portfolio purposes. This modification of the
Company's investment policy to include fixed-rate loans will give the Company's
lending programs the ability to offer a more complete line of residential loan
products. The Company intends to hedge its pipeline of fixed rate loans and to
sell them on a regular basis pursuant to implementing its low risk business
plan. The Company does not believe that this modification, as directed by the
Company's Board of Directors, will materially affect the Company's exposure to
interest rate risk or credit risk.
19
<PAGE>
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:
(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 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 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");
(3) real estate properties acquired as a result of foreclosing on the Company's
ARM loans;
(4) 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; or
(5) fixed rate loans secured by first liens on single-family residential
properties held for sale.
Since inception, the Company has generally invested less than 15%, currently
approximately 5%, 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 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").
Acquisition of FASLA Holding Company
On December 23, 1999, the Company and the Manager entered into an agreement to
purchase FASLA Holding Company, whose principal holding is First Arizona
Savings, a privately held Phoenix-based federally chartered thrift institution
with six retail branch offices and, at that time, $138 million in assets. The
cash purchase price was $15 million, subject to certain adjustments. The
purchase agreement expired on August 31, 2000 and both parties mutually agreed
not to extend the agreement. The acquisition had been subject to regulatory
approval which had not yet been obtained as of August 31, 2000. Although the
Company may pursue other similar transactions in the future, as part of its
business plan to originate mortgage loans nationwide, the Company has decided to
apply for mortgage licenses on a state-by-state basis at this time. The Company
expects to have applied for licenses in a significant number of states by the
end of 2000 and has commenced originating mortgage loans as of the end of
September in Texas, Colorado and New Mexico.
Mortgage Banking Operations
The Company plans to convert its qualified REIT subsidiary, TMHL, into a taxable
REIT subsidiary during the fourth quarter of 2000 and to operate it as a full
service mortgage banking subsidiary. This mortgage banking subsidiary's primary
business will be to acquire residential mortgage loans, through bulk acquisition
as well as through both the Company's correspondent network and direct retail
origination. TMHL will then securitize the ARM and Hybrid ARM loans for sale to
20
<PAGE>
the Company at fair market value. This subsidiary is also expected to originate
fixed-rate loans for sale to third parties and to generate servicing revenues,
primarily in connection with secured loans sold to the Company. TMHL is
developing a variable cost model by entering into third-party contracts to
process, underwrite, close and service loans rather than making the initial and
ongoing investment of operating these functions internally. As part of this
variable-cost model, the administrative staff experienced in these functions and
responsible for overseeing these functions will be transferred from the Manager
to TMHL. Since TMHL will be engaged in businesses and generating revenues that
are not REIT qualified, it will be operated as a taxable REIT subsidiary and
will file a separate tax return. As a result of changes to the Internal Revenue
Code effective January 1, 2001, the Company expects to consolidate this
subsidiary for financial statement purposes.
FINANCIAL CONDITION
--------------------
At September 30, 2000, the Company held total assets of $4.140 billion, $4.075
billion of which consisted of ARM assets, as compared to $4.376 billion and
$4.326 billion, respectively, at December 31, 1999. 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, 2000, 94.8% 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, 85.6% are in the form of
adjustable-rate pass-through certificates or ARM loans. The remainder are
floating rate classes of CMOs (10.7%) or investments in floating rate classes of
CBOs (3.7%) backed primarily by ARM mortgaged-backed securities.
The following table presents a schedule of ARM assets owned at September 30,
2000 and December 31, 1999 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, 2000 December 31, 1999
------------------------ -------------------------
Carrying Portfolio Carrying Portfolio
Value Mix Value Mix
----------- ---------- ------------ ----------
<S> <C> <C> <C> <C>
HIGH QUALITY:
FHLMC/FNMA $2,071,044 50.8% $2,068,152 47.8%
Privately Issued:
AAA/Aaa Rating 1,385,640 (1) 34.1 1,585,099 (1) 36.6
AA/Aa Rating 366,778 9.0 459,858 10.6
----------- ---------- ------------ ----------
Total Privately Issued 1,752,418 43.1 2,044,957 47.2
----------- ---------- ------------ ----------
----------- ---------- ------------ ----------
Total High Quality 3,823,462 93.9 4,113,109 95.0
----------- ---------- ------------ ----------
OTHER INVESTMENT:
Privately Issued:
A Rating 13,885 0.3 49,995 1.2
BBB/Baa Rating 70,152 1.7 84,929 2.0
BB/Ba Rating or below 41,314 (1) 1.0 46,963 (1) 1.1
Whole loans 126,340 3.1 31,102 0.7
----------- ---------- ------------ ----------
Total Other Investment 251,691 6.1 212,989 5.0
----------- ---------- ------------ ----------
Total ARM Portfolio $4,075,153 100.0% $4,326,098 100.0%
========== =========== ============ ==========
<FN>
-------------------------
(1) AAA Rating category includes $651.3 million and $781.8 million as of
September 30, 2000 and December 31, 1999, respectively, of ARM loans that
have been credit enhanced to AAA by a combination of an insurance policy
purchased from a third-party and an unrated subordinated certificate
retained by the Company in the amount of $32.3 million and $32.2 million as
of September 30, 2000 and December 31, 1999, respectively. The subordinated
certificate is included in the BB/Ba Rating category.
</TABLE>
21
<PAGE>
As of September 30, 2000, the Company had reduced the cost basis of its ARM
securities by $1,997,000 due to estimated credit losses (other than temporary
declines in fair value). The estimated credit losses for ARM securities relate
to Other Investments that the Company purchased at a discount that included an
estimate of credit losses and to loans that the Company has securitized for its
own portfolio. Additionally, during the nine months ended September 30, 2000,
in accordance with its credit policies, the Company provided for estimated
credit losses on the subordinated classes of its securitized loans in the amount
of $180,000 and recorded a $803,000 provision for estimated credit losses on its
loan portfolio, although no actual losses have been realized in the loan
portfolio to date. As of September 30, 2000, the Company's ARM loan portfolio
included 8 loans that are considered seriously delinquent (60 days or more
delinquent) with an aggregate balance of $4.7 million. The ARM loan portfolio
also includes one property ("REO") that the Company acquired as the result of a
foreclosure process in the amount of $0.6 million. The average original
effective loan-to-value ratio on these 8 delinquent loans and REO is
approximately 63%. As of September 30, 2000, the Company had $3.0 million of
reserves for estimated credit losses for loans and REO. The Company believes
this level of reserves is adequate to cover estimated losses from these loans
and REO properties. The Company's credit reserve policy regarding ARM loans is
to record a provision based 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, historical loss experience, current
economic conditions and quality of underwriting standards applied by the
originator.
The following table classifies the Company's portfolio of ARM assets by type of
interest rate index.
<TABLE>
<CAPTION>
ARM ASSETS BY INDEX
(Dollar amounts in thousands)
September 30, 2000 December 31, 1999
---------------------- ---------------------
Carrying Portfolio Carrying Portfolio
Value Mix Value Mix
---------- ---------- ---------- ---------
<S> <C> <C> <C> <C>
ARM ASSETS:
INDEX:
One-month LIBOR $ 675,486 16.6% $ 680,449 15.7%
Three-month LIBOR 150,643 3.7 170,384 3.9
Six-month LIBOR 472,500 11.6 626,616 14.5
Six-month Certificate of Deposit 255,186 6.3 304,621 7.0
Six-month Constant Maturity Treasury 23,630 0.6 37,781 0.9
One-year Constant Maturity Treasury 1,236,811 30.3 1,359,229 31.4
Cost of Funds 173,697 4.2 213,800 5.0
---------- ---------- ---------- ---------
2,987,953 73.3 3,392,880 78.4
---------- ---------- ---------- ---------
HYBRID ARM ASSETS 1,087,200 26.7 933,218 21.6
---------- ---------- ---------- ---------
$4,075,153 100.0% $4,326,098 100.0%
========== ========== ========== =========
</TABLE>
The ARM portfolio had a current weighted average coupon of 7.68% at September
30, 2000. This consisted of an average coupon of 6.75% on the hybrid portion of
the portfolio and an average coupon of 8.04% on the rest of the portfolio. If
the non-hybrid portion of the portfolio had been "fully indexed," the weighted
average coupon would have been approximately 8.27%, based upon the current
composition of the portfolio and the applicable indices. As of December 31,
1999, the ARM portfolio had a weighted average coupon of 7.08%. This consisted
of an average coupon of 6.54% on the hybrid portion of the portfolio and an
average coupon of 7.22% on the rest of the portfolio. If the non-hybrid portion
of the portfolio had been "fully indexed," the weighted average coupon would
have been approximately 7.79%, based upon the composition of the portfolio and
the applicable indices at the time. The higher average interest coupon on the
ARM portfolio as of September 30, 2000 compared to the end of 1999 is reflective
of Federal Reserve Board interest rate increases that have been occurring since
June of 1999. The average interest rate on the ARM portion of the portfolio is
expected to continue to rise to the "fully indexed" rate.
22
<PAGE>
At September 30, 2000, the current yield of the ARM assets portfolio was 7.00%,
compared to 6.38% as of December 31, 1999, with an average term to the next
repricing date of 346 days as of September 30, 2000, compared to 344 days as of
December 31, 1999. As of September 30, 2000, hybrid ARMs comprised 26.7% of the
total ARM portfolio, up from 21.6% as of the end of 1999. The Company finances
its hybrid ARM portfolio with longer term borrowings such that the duration
mismatch of the hybrid ARMs and the corresponding borrowings is one year or
less. 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 increase in the yield of 0.62% as of September 30, 2000, compared to
December 31, 1999, is primarily due to the increased weighted average interest
rate coupon discussed above, which increased by 0.60%. The change in the yield
adjustment from amortizing the net portfolio premium had the effect of
decreasing the yield by 0.05%. The yield improved as a result of lower hedging
cost, which decreased by 0.08%, as higher cost hedges matured and were replaced
with lower cost hedges. The impact of non-interest earning principal payments
receivables increased slightly during the third quarter of 2000, decreasing the
portfolio yield by 0.01%.
The following table presents various characteristics of the Company's ARM and
Hybrid ARM loan portfolio as of September 30, 2000. This information pertains
to loans held for securitization, loans held as collateral for the notes payable
and loans TMA has securitized for its own portfolio for which the Company
retained credit loss exposure.
ARM AND HYBRID ARM LOAN PORTFOLIO CHARACTERISTICS
Average High Low
--------- ----------- -------
Unpaid principal balance $279,596 $3,450,000 $2,208
Coupon rate on loans 7.65% 10.00% 5.50%
Pass-through rate 7.32% 9.61% 5.11%
Pass-through margin 1.96% 5.06% 0.36%
Lifetime cap 12.91% 16.75% 9.75%
Original Term (months) 354 480 72
Remaining Term (months) 324 447 49
Geographic Distribution (Top 5 States): Property type:
California 27.60% Single-family 65.44%
Florida 10.06 DeMinimus PUD 19.44
Georgia 6.85 Condominium 9.95
New York 6.45 Other 5.17
New Jersey 4.44
Occupancy status: Loan purpose:
Owner occupied 85.76% Purchase 59.67%
Second home 10.02 Cash out refinance 22.81
Investor 4.22 Rate & term refinance 17.52
Documentation type: Periodic Cap:
Full/Alternative 93.51% None 55.14%
Other 6.49 2.00% 43.36
1.00% 0.43
Average effective original 0.50% 1.07
Loan-to-value: 68.55%
During the quarter ended September 30, 2000, the Company purchased $205.4
million of ARM assets, 44.5% of which were High Quality ARM securities, 1.0%
were Other Investment ARM securities, 50.1% were whole loans purchased in the
secondary market and 4.4% were ARM loans acquired through the Company's
correspondent loan network. Of the ARM assets acquired during the third quarter
of 2000, approximately 69% were Hybrid ARMs, 29% were indexed to U.S. Treasury
bill rates and 2% were ARMs indexed to other indexes. The Company also recorded
the unsettled purchase of $93.2 million of Agency ARM securities, most of which
are indexed to the one-year treasury rate, as of September 30, 2000.
Additionally, as of September 30, 2000, the Company has commitments to purchase
approximately $199.7 million of ARM securities that are being created during the
fourth quarter of 2000, all of which will be high quality and indexed to the
one-year treasury rate, and $6.1 million of loans through its correspondent
network.
23
<PAGE>
During the nine months ended September 30, 2000, the Company purchased $650.2
million of ARM assets, 75.5% of which were High Quality ARM securities, 4.2%
were Other Investment ARM securities and 20.3% were ARM loans. Of the ARM
assets acquired during the first nine months of 2000, approximately 45% were
indexed to U.S. Treasury bill rates, 45% were Hybrid ARMs and 10% were indexed
to LIBOR.
During the three month period ended September 30, 2000, the Company sold one
asset for $22.8 million for its carrying value and did not record any gain or
loss. During the three month period ended June 30, 2000, the Company
re-securitized Other Investment ARM securities with a $94.0 million par value,
and a carrying value of $89.4 million, into a new series of securities, $56.1
million of which was rated AAA, an interest only strip with a notional balance
of $45.0 million rated AAA, $11.7 million of which rated AA and the remaining
$26.2 million rated below AA. As a part of the re-securitization transaction,
the Company sold the AAA and AA rated ARM securities for a $49,000 gain and
retained the AAA rated interest only strip and the other securities rated below
AA. These are the only asset sales that occurred during the first nine months
of 2000.
For the quarter ended September 30, 2000, the Company's mortgage assets paid
down at an approximate average annualized constant prepayment rate of 18%
compared to 22% for the quarter ended September 30, 1999 and 16% for the quarter
ended June 30, 2000. When prepayment experience increases, 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 decreases, 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 assets classified as
available-for-sale decreased by 0.57% from a negative adjustment of 2.40% of the
portfolio as of December 31, 1999, to a negative adjustment of 2.97% as of
September 30, 2000. This price decrease was primarily due to the effect of
rising interest rates. The amount of the negative adjustment to fair value on
the ARM assets classified as available-for-sale increased from $83.4 million as
of December 31, 1999, to $101.0 million as of September 30, 2000. The fair
value of the Company's portfolio of ARM assets excludes an adjustment for fair
value changes in Swap Agreements, since the Swap Agreements hedge liabilities,
i.e. the financing of Hybrid ARMs. As of September 30, 2000, the unrecorded
positive fair value adjustment for Swap Agreements was $8.5 million. As of
September 30, 2000, all of the Company's ARM securities are classified as
available-for-sale and are carried at their fair value.
The fair value of the Company's portfolio of ARM assets classified as
available-for-sale increased by 0.17% from a negative adjustment of 3.14% of the
portfolio as of June 30, 2000, to a negative adjustment of 2.97% as of September
30, 2000. The price improvement was, in part, due to the rise in the interest
rate coupon on the ARM portfolio as a portion of the portfolio has had a chance
to reset to the current interest rate level. The amount of the negative
adjustment to fair value on the ARM assets classified as available-for-sale
decreased from $106.6 million as of June 30, 2000, to $101.0 million as of
September 30, 2000.
The Company has purchased Cap Agreements and Options Contracts in order to hedge
exposure to changing interest rates. The majority of the Cap Agreements and all
of the Options Contracts 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 hedging instruments act to
reduce the effect of the lifetime or maximum interest rate cap limitation.
These hedging instruments 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, 2000, the Cap
Agreements and Options Contracts 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 $2.534 billion with an average final maturity of 2.2 years,
compared to a remaining notional balance of $2.810 billion with an average final
maturity of 2.2 years at December 31, 1999. Pursuant to the terms of these
hedging instruments, 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 12.50% and average approximately 10.10%. The Company
has also entered into Cap Agreements with a notional balance of $111.0 as of
September 30, 2000 in connection with hedging the fixed rate period 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
that generally corresponds to within one year of the initial fixed rate term of
Hybrid ARM assets. The Cap Agreements hedging Hybrid ARM assets as of September
30, 2000 would receive cash payments if the one-month LIBOR Index increases
above certain specified levels, which range from 5.75% to 6.00% and average
approximately 5.94% and have a remaining term of 2.8 years. The fair value of
Cap Agreements and Options Contracts also tend 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, 2000, the fair value of the Company's Cap Agreements
and Options Contracts was $2.6 million, $1.0 million less than the amortized
cost of these hedging instruments.
24
<PAGE>
The following table presents information about the Company's Cap Agreement and
Options Contract portfolio that is designated as a hedge against the lifetime
interest rate cap on ARM assets as of September 30, 2000:
CAP AGREEMENTS/OPTIONS CONTRACTS STRATIFIED BY STRIKE PRICE
(Dollar amounts in thousands)
Hedged Weighted Cap Agreement/ Weighted
ARM Assets Average Options Contract Average
Balance (1) Life Cap Notional Balance Strike Price Remaining Term
------------ ---------- ----------------- ------------- --------------
26,953 8.01% $ 26,000 7.10% 2.5 Years
138,530 8.29 140,000 7.50 0.2
546,558 9.67 546,826 8.00 1.7
24,849 10.76 25,000 9.00 2.0
62,199 10.93 62,019 9.50 2.0
371,272 11.38 371,529 10.00 1.9
210,894 11.94 210,384 10.50 1.5
455,042 12.40 454,423 11.00 2.9
279,964 12.79 280,000 11.50 3.9
382,822 13.51 382,818 12.00 2.8
92,776 15.83 35,454 12.50 1.2
------------ ---------- ----------------- ------------- --------------
2,591,859 11.64% $ 2,534,453 10.10% 2.2 Years
============ ========== ================= ============= ==============
------------------------
(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.
As of September 30, 2000, the Company was a counterparty to twenty interest rate
swap agreements ("Swaps") having an aggregate notional balance of $575.8
million. As of September 30, 2000, these Swaps had a weighted average remaining
term of 2.3 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 and commitments
to acquire Hybrid ARMs. 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 29
days to 186 days. The Swaps hedge the cost of financing Hybrid ARMs to within a
one year duration 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, 2000 was 2.8 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 the other Swap Agreements.
RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2000
For the quarter ended September 30, 2000, the Company's net income was
$7,016,000, or $0.25 per share (Basic and Diluted EPS) compared to $7,155,000,
or $0.26 per share (Basic and Diluted EPS) for the quarter ended September 30,
1999. There were 21,490,000 weighted average common shares outstanding during
both periods. Net interest income for the quarter totaled $8,978,000, compared
to $9,332,000 for the same period in 1999. Net interest income is comprised of
the interest income earned on mortgage investments less interest expense from
borrowings. During the third quarter of 2000 the Company did not record any
gain or loss from the sale of assets whereas, during the third quarter of 1999,
the Company recorded a gain of $15,000 from the sale of assets. Additionally,
during the third quarter of 2000, the Company reduced its earnings and the
25
<PAGE>
carrying value of its ARM assets by reserving $270,000 for estimated credit
losses, compared to $764,000 during the same quarter of 1999. During the third
quarter of 2000, the Company incurred operating expenses of $1,692,000,
consisting of a base management fee of $1,029,000 and other operating expenses
of $663,000. During the same period 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. Total operating expenses were 0.16% as a
percentage of average assets for the three months ended September 30, 2000,
compared to 0.13% for the third quarter of 1999.
The Company's return on average common equity was 6.56% for the quarter ended
September 30, 2000 compared to 6.75% for the quarter ended September 30, 1999
and compared to 6.50% for the prior quarter ended June 30, 2000. The Company's
return on equity was higher in this past quarter compared to the prior quarter
primarily because the yield on the Company's ARM portfolio increased more than
its cost of funds, improving the net interest spread for the respective quarters
from an average of 0.23% for the second quarter of 2000 to 0.26% for the third
quarter of 2000. The yield on the Company's ARM portfolio increased from 6.73%
for the second quarter of 2000 to 6.99% for the third quarter, an improvement of
0.26%. The Company's average cost of funds for the most recent quarter
increased by 0.23%, from 6.50% for the prior quarter to 6.73% for the third
quarter of 2000. Based on market interest rates as of September 30, 2000 and
interest rate re-pricing characteristics of the Company's ARM portfolio and
borrowings, the Company expects the ARM portfolio yield to continue to increase
more than the Company's cost of funds during the fourth quarter as well.
However, there is uncertainty regarding future Federal Reserve actions to
increase or decrease interest rates in the future.
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 that is applicable to the computation of the
performance fee:
<TABLE>
<CAPTION>
COMPONENTS OF RETURN ON AVERAGE COMMON EQUITY (1)
ROE in
Gain Excess of
Net (Loss) G & A Net 10-Year 10-Year
For the Interest Provision on ARM Expense Preferred Income/ US Treas US Treas
Quarter Income/ For Losses/ Sales/ (2)/ Performance Dividend/ Equity Average Average
Ended Equity Equity Equity Equity Fee/ Equity Equity (ROE) Yield Yield
------------ ----------- ------------ ------- -------- ------------ ---------- --------- --------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
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%
Dec 31, 1999 11.09% 0.89% - 1.86% - 2.05% 6.29% 6.14% 0.15%
Mar 31, 2000 11.49% 0.41% - 1.82% - 2.06% 7.20% 6.47% 0.73%
Jun 30, 2000 10.74% 0.47% 0.06% 1.78% - 2.05% 6.50% 6.18% 0.32%
Sep 30, 2000 11.01% 0.33% - 2.08% - 2.05% 6.56% 5.89% 0.67%
<FN>
---------------------
(1) Average common equity excludes unrealized gain (loss) on available-for-sale ARM securities.
(2) Excludes performance fees.
</TABLE>
The modest decline in the Company's return on common equity in the third quarter
of 2000, compared to the third quarter of 1999, is primarily due to the effect
of lower net interest income and higher operating expenses, which were partially
offset by a decrease in the Company's provision for losses.
26
<PAGE>
The following table presents the components of the Company's net interest income
for the quarters ended September 30, 2000 and 1999:
COMPARATIVE NET INTEREST INCOME COMPONENTS
(Dollar amounts in thousands)
2000 1999
------------ -------------
Coupon interest income on ARM assets $ 74,738 $ 74,078
Amortization of net premium (3,885) (5,240)
Amortization of Cap Agreements (467) (1,368)
Amortization of deferred gain from hedging 285 185
Cash and cash equivalents 346 300
------------ -------------
Interest income 71,017 67,955
------------ -------------
Reverse repurchase agreements 50,867 43,609
AAA notes payable 12,375 14,179
Other borrowings 462 31
Interest rate swaps (1,665) 804
------------ -------------
Interest expense 62,039 58,623
------------ -------------
Net interest income $ 8,978 $ 9,332
============ =============
As presented in the table above, the Company's net interest income was $0.4
million lower in the third quarter of 2000 compared to the same three months of
1999. The Company's interest income was $3.1 million higher, primarily due to
higher interest rates and a lower level of net premium amortization, in part due
to slower prepayments during the third quarter of 2000 as compared to the same
period in 1999. The Company's amortization expense for Cap Agreements has also
declined, improving interest income further. This amortization expense has
declined as the Company's more expensive Cap Agreements have expired and have
been replaced with less expensive Cap Agreements and because a larger proportion
of the Company's ARM portfolio consists of ARMs that do not have lifetime caps
and Hybrid ARMs that are generally match funded during their fixed rate period,
eliminating any need to hedge their lifetime cap during their fixed rate period.
The Company's interest expense was $3.4 million higher in the third quarter of
2000 compared to the same three months of 1999. This interest expense increase
reflects the Federal Reserve Board actions to increase short-term interest rates
by 1.75% since June of 1999. The Company's hedging of its Hybrid ARM assets in
the form of Swap Agreements mitigated the Federal Reserve Board actions by
offsetting a portion of the increase in interest expense by $2.5 million, as
presented in the table above.
27
<PAGE>
The following table reflects the average balances for each category of the
Company's interest earning assets as well as the Company's interest bearing
liabilities, with the corresponding effective rate of interest annualized for
the quarters ended September 30, 2000 and 1999:
<TABLE>
<CAPTION>
AVERAGE BALANCE AND RATE TABLE
(Dollar amounts in thousands)
For the Quarter Ended For the Quarter Ended
September 30, 2000 September 30, 1999
----------------------- ---------------------
Average Effective Average Effective
Balance Rate Balance Rate
---------- ----------- ---------- ---------
<S> <C> <C> <C> <C>
Interest Earning Assets:
Adjustable-rate mortgage assets $4,046,485 6.99% $4,538,040 5.97%
Cash and cash equivalents 19,605 7.00 14,038 3.57
---------- ----------- ---------- ---------
4,066,090 6.99 4,552,078 5.97
---------- ----------- ---------- ---------
Interest Bearing Liabilities:
Borrowings 3,688,518 6.73 4,181,869 5.61
---------- ----------- ---------- ---------
Net Interest Earning Assets and Spread $ 377,572 0.26% $ 370,209 0.36%
========== =========== ========== =========
Yield on Net Interest Earning Assets (1) 0.88% 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.
</TABLE>
As a result of the yield on the Company's interest-earning assets increasing to
6.99% during the three months ended September 30, 2000 from 5.97% during the
same period of 1999 and the Company's cost of funds increasing to 6.73% from
5.61% during the same time periods, net interest income decreased by $354,000.
This decrease in net interest income is the combination of a rate variance and a
volume variance. There was a net unfavorable rate variance of $165,000,
primarily due to an unfavorable rate variance on borrowings of $11,714,000,
which was partially offset by a favorable rate variance of $11,549,000 on the
Company's ARM assets portfolio and other interest-earning assets. The decreased
average size of the Company's portfolio during the third quarter of 2000
compared to the same period in 1999 decreased net interest income in the amount
of $189,000. The average balance of the Company's interest-earning assets was
$4.066 billion during the third quarter of 2000, compared to $4.552 billion
during the third quarter of 1999 -- a decrease of 11%.
28
<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)
Yield on
Average Wgt Avg Yield on Net
As of the Interest Fully Weighted Interest Net Interest
Quarter Earning Indexed Average Yield Earning Cost of Interest Earning
Ended Assets Coupon Coupon Adj (2) Assets Funds Spread Assets
------------ --------- -------- --------- --------- -------- ------------- ----------- ------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
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% (3) -0.08% (3) 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%
Dec 31, 1999 $ 4,449.0 7.51% 7.08% 0.70% 6.38% 6.47% (3) -0.09% (3) 0.81%
Mar 31, 2000 $ 4,471.0 7.77% 7.26% 0.68% 6.58% 6.32% 0.26% 0.83%
Jun 30, 2000 $ 4,344.6 7.87% 7.48% 0.59% 6.89% 6.75% 0.15% 0.81%
Sep 30, 2000 $ 4,066.1 7.84% 7.68% 0.68% 7.00% 6.72% 0.29% 0.88%
<FN>
---------------
(1) Yield on Net Interest Earning Assets is computed by dividing
annualized net interest income for the applicable quarter by the
average daily balance of interest earning assets during the quarter.
(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.
(3) The year-end cost of funds and net interest spread are commonly
affected by significant, but generally temporary, year-end pressures
that raise the Company's cost of financing mortgage assets over
year-end. The effect generally begins during the latter part of
November and continues through January.
</TABLE>
COMPONENTS OF THE YIELD ADJUSTMENTS ON ARM ASSETS
Amort of
Impact of Deferred
As of the Premium/ Principal Gain From Total
Quarter Discount Payments Hedging Hedging Yield
Ended Amort Receivable Activity Activity Adjustment
------------ ---------- -------------- --------- --------- ----------
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%
Dec 31, 1999 0.51% 0.09% 0.11% (0.01)% 0.70%
Mar 31, 2000 0.57% 0.07% 0.07% (0.03)% 0.68%
Jun 30, 2000 0.46% 0.10% 0.06% (0.03)% 0.59%
Sep 30, 2000 0.56% 0.10% 0.05% (0.03)% 0.68%
As of September 30, 2000, the Company's yield on its ARM assets portfolio,
including the impact of the amortization of premiums and discounts, the cost of
hedging, the amortization of deferred gains from hedging activity and the impact
of principal payment receivables, was 7.00%, compared to 6.89% as of June 30,
2000-- an increase of 0.11%. The Company's cost of funds as of September 30,
2000, was 6.72%, compared to 6.75% as of June 30, 2000 -- a decrease of 0.03%.
29
<PAGE>
As a result of these changes, the Company's net interest spread as of September
30, 2000 was 0.29%, compared to 0.15% as of June 30, 2000. The increase in the
net interest spread is largely attributable to the increase in the yield on the
Company's ARM portfolio, coupled with a slight decrease in the Company's cost of
funds. As discussed in the Company's quarterly report on Form 10-Q dated June
30, 2000, the Federal Reserve raised short-term interest rates by 0.25% at the
end of March and another 0.50% at the end of May and has not taken any action to
raise short-term interest rates since that time. As a result, the interest rate
on the Company's various sources of borrowings had increased by 0.54% by the end
of June, but this was partially offset by the Company's use of Swap Agreements
such that the total cost of the Company's borrowings, including the effect of
hedging, only increased by the 0.43% to 6.75%. Since that time, short-term
interest rates have been relatively stable and, in fact, the Company's cost of
funds has improved slightly to 6.72%, when including the effect of hedging in
the form of Swap Agreements. Due to the repricing and maturity characteristics
of the Company's borrowings compared to the Company's assets, the Company's
borrowings react quicker to changes in interest rates, but the Company's ARM
assets also reprice to changes in interest rates, but over a longer period of
time. On average, as of the end of September 2000, the Company's borrowings
reprice in 186 days whereas the Company's assets, on average, reprice in 346
days. Since the Federal Reserve did not increase rates during the third quarter
of 2000, the Company's ARM assets, as expected, have repriced more than the
Company's borrowings and, therefore, the Company's margins, interest rate spread
and net income have improved.
The Company's spreads and net interest income has also been negatively impacted
since early 1998 by the spread relationship between U.S. Treasury rates and
LIBOR. This spread relationship has impacted the Company negatively 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. The Company has 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. In March
of this year, the U.S. Treasury announced that it would adjust its monthly
auction of one-year treasury bills to quarterly and that it would cease
auctioning the one-year treasury bill next year. As a consequence, a shortage
of one-year bills has developed, increasing its cost and lowering its yield.
Therefore, the relationship between the one-year treasury index and LIBOR was
negatively impacted during the second and third quarters of 2000 after improving
during 1999 and early 2000. The Company does not know when or if this
relationship will improve, although it expects that once the U.S. Treasury
ceases to auction new one-year treasury bills, that the method to compute the
one-year index will be based on outstanding U.S. treasury debt one year from
maturity which may improve the relationship back to its historical average. 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 one-year U.S. Treasury rates to 30.5% at September
30, 2000 from 49.0% as of the end of 1997. The data is as follows:
30
<PAGE>
<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 Indexed
U.S. Treasury Month LIBOR Month LIBOR to 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%
1999 5.08% 5.33% -0.25% 31.4%
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%
Dec 31, 1999 5.62% 5.96% -0.34% 31.4%
Mar 31, 2000 6.19% 6.02% 0.17% 31.7%
Jun 30, 2000 6.22% 6.55% -0.33% 29.8%
Sep 30, 2000 6.13% 6.66% -0.53% 30.5%
</TABLE>
The Company's provision for estimated credit losses decreased in the third
quarter of 2000 compared to the same period in 1999, in part, because the
Company discontinued reducing the cost basis of two securities that the Company
now believes have been reduced to a cost basis that fully reflects its estimate
of credit losses for these two securities. The outlook for estimated loss on
these two securities has improved as the underlying loans have been paying off
and real estate values have improved, primarily in the California market.
Additionally, during the third quarter, the Company decided to reduce its rate
of providing for losses on its whole loan credit exposure. During the third
quarter the Company reviewed the level of its loan loss reserves and reviewed
its identifiable loss exposure to currently delinquent loans and the lack of any
losses to date recorded in the portfolio and came to the conclusion that its
loan loss reserves had reached a level that it was appropriate to reduce the
rate at which the Company is recording provisions. The Company will continue to
review economic conditions and the quality of its loan portfolio and
periodically adjust the rate at which it provides for losses. The Company's
provision for estimated loan losses is based on a number of factors including,
but not limited to, the outstanding principal balance of loans, historical loss
experience, current economic conditions, borrower payment history, age of loans,
loan-to-value ratios and underwriter standards applied by the originator. The
Company includes the outstanding balance of loans which it has securitized and
retained an exposure to credit losses, although the credit losses in certain
securitization structures may be limited by third party credit enhancement
agreements. As of September 30, 2000, the Company's whole loans, including
those held as collateral for the notes payable and those that the Company has
securitized but retained credit loss exposure, accounted for 28.9% of the
Company's portfolio of ARM assets or $1.179 billion. To date, the Company has
not experienced any actual losses in its whole loan portfolio, although losses
are expected and are being estimated 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:
31
<PAGE>
RECONCILIATION OF REPORTED NET INCOME TO TAXABLE NET INCOME
(Dollar amounts in thousands)
Quarters Ending September 30,
-------------------------------
2000 1999
--------------- --------------
Net income $ 7,016 $ 7,155
Additions:
Provision for credit losses 270 764
Net compensation related items 179 95
Deductions:
Dividend on Series A Preferred Shares (1,670) (1,670)
Capital loss carryover from 1998 - (15)
Actual credit losses on ARM securities (265) (140)
--------------- --------------
Taxable net income $ 5,530 $ 6,189
--------------- --------------
--------------- --------------
Taxable income per share $ 0.26 $ 0.29
=============== ==============
For the quarter ended September 30, 2000, the Company's ratio of operating
expenses to average assets was 0.16% compared to 0.13% for the same period in
1999 and 0.13% for the prior quarter ended June 30, 2000. The ratio of
operating expenses to average assets increased by 0.01% because of the decrease
in the average assets of the Company from the level of average assets during the
third quarter of 1999 and the second quarter of 2000. The Company decreased
average assets during the third quarter of 2000 due to concerns over Federal
Reserve actions to raise interest rates. The Company expects to increase the
level of assets during the fourth quarter of 2000 back to a level comparable to
prior periods, since the Federal Reserve did not take any actions to increase
short-term interest rates during the third quarter and it does not appear likely
that it will take any further actions to raise short-term interest rates until
the end of the fourth quarter, if then. The Company has also experienced a
modest increase in certain expenses, namely legal and public relations, related
to its development of a direct loan origination capability. The Company also
experienced an increase in its expense for DERs and PSRs with the increase in
the number granted during the second quarter of 2000 and the effect of the
rising stock price for the Company's common stock. As the Company's common
stock price changes, the Company records a market value adjustment to its
liability in connection with outstanding PSRs.
The Company's expense ratios are among the lowest of any company investing in
mortgage assets, giving the Company what it believes to be a significant
competitive advantage over more traditional mortgage portfolio lending
institutions such as banks and savings and loans. This competitive advantage
enables the Company to operate with less risk, such as credit and interest rate
risk, and still generate an attractive long-term return on equity when compared
to these more traditional mortgage portfolio lending institutions. The Company
pays the Manager an annual base management fee, generally based on average
shareholders' equity, not assets, as defined in the Management Agreement,
payable monthly in arrears as follows: 1.1% of the first $300 million of
Average Shareholders' Equity, plus 0.8% of Average Shareholders' Equity above
$300 million. Since this management fee is based on shareholders' equity and
not assets, this fee increases as the Company successfully accesses capital
markets and raises additional equity capital and is, therefore, managing a
larger amount of invested capital on behalf of its shareholders. In order for
the Manager to earn a performance fee, the rate of return on the shareholders'
investment, as defined in the Management Agreement, must exceed the average
ten-year U.S. Treasury rate during the quarter plus 1%. The Company has not
paid the Manager a performance fee since the first quarter of 1998. 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.
32
<PAGE>
The following table highlights the quarterly trend of operating expenses as a
percent of average assets:
ANNUALIZED OPERATING EXPENSE RATIOS
Management Fee & Total
For the Other Expenses/ Performance Fee/ G & A Expense/
Quarter Ended Average Assets Average Assets Average Assets
------------- ----------------- ----------------- --------------
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%
Dec 31, 1999 0.13% - 0.13%
Mar 31, 2000 0.13% - 0.13%
Jun 30, 2000 0.13% - 0.13%
Sep 30, 2000 0.16% - 0.16%
RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2000
For the nine months ended September 30, 2000, the Company's net income was
$21,495,000, or $0.77 per share (Basic and Diluted EPS), based on a weighted
average of 21,490,000 shares outstanding. That compares to $18,787,000, or
$0.64 per share (Basic and Diluted EPS), based on a weighted average of
21,490,000 shares outstanding for the nine months ended September 30, 1999. Net
interest income for this most recent nine month period totaled $27,047,000,
compared to $24,970,000 for the same period in 1999. Net interest income is
comprised of the interest income earned on mortgage investments less interest
expense from borrowings. During the first nine months of 2000, the Company
recorded a gain on the sale of ARM securities of $49,000 as compared to a gain
of $50,000 during the same period of 1999. Additionally, during the first nine
months of 2000, the Company reduced its earnings and the carrying value of its
ARM assets by reserving $983,000 for potential credit losses, compared to
$2,139,000 during the same period of 1999. During the nine months ended
September 30, 2000, the Company incurred operating expenses of $4,618,000,
consisting of a base management fee of $3,086,000 and other operating expenses
of $1,532,000. During the same period of 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.
The Company's return on average common equity was 6.8% for the nine months ended
September 30, 2000 compared to 5.7% for the nine months ended September 30,
1999. The primary reasons for the higher return on average common equity is a
higher interest rate spread, as discussed below, and the lower level of
provisions for credit losses.
33
<PAGE>
The following table presents the components of the Company's net interest income
for the six month periods ended June 30, 2000 and 1999:
COMPARATIVE NET INTEREST INCOME COMPONENTS
(Dollar amounts in thousands)
2000 1999
--------- ---------
Coupon interest income on ARM assets $229,124 $215,654
Amortization of net premium (12,226) (22,845)
Amortization of Cap Agreements (1,938) (4,090)
Amortization of deferred gain from hedging 882 773
Cash and cash equivalents 966 1,195
--------- ---------
Interest income 216,808 190,687
--------- ---------
Reverse repurchase agreements 151,237 117,445
AAA notes payable 40,722 44,822
Other borrowings 1,097 105
Interest rate swaps (3,295) 3,345
--------- ---------
Interest expense 189,761 165,717
--------- ---------
Net interest income $ 27,047 $ 24,970
========= =========
As presented in the table above, the Company's net interest income was $2.1
million higher during the first nine months of 2000 compared to the same nine
months of 2000. The Company's interest income was $26.1 million higher,
primarily due to higher interest rates and a lower level of net premium
amortization, in part due to slower prepayments during the first nine months of
2000 as compared to the same period in 1999. The Company's amortization expense
for Cap Agreements has also declined, improving interest income further. This
amortization expense has declined as the Company's more expensive Cap Agreements
have expired and have been replaced with less expensive Cap Agreements and
because a larger proportion of the Company's ARM portfolio consists of ARMs that
do not have lifetime caps and Hybrid ARMs that are generally match funded during
their fixed rate period, eliminating any need to hedge their lifetime cap during
their fixed rate period. The Company's interest expense increased by $24.0
million, primarily due to higher interest rates. It is important to note that
the Company received a benefit from its use of Swaps to hedge the fixed rate
period of Hybrid ARMs, decreasing its interest expense by $3.3 million during
the first nine months of 2000 compared to an expense of $3.3 million during the
same period of 1999. The Company's use of hedges has mitigated the effect of
rising short-term interest rates on the financing of its Hybrid ARMs and
thereby, was an important factor in the Company's ability to maintain comparable
earnings between the third quarter of 2000 and 1999.
34
<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, 2000 and 1999:
<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, 2000 September 30, 1999
---------------------- -----------------------
Average Effective Average Effective
Balance Rate Balance Rate
----------- ---------- ----------- ----------
<S> <C> <C> <C> <C>
Interest Earning Assets:
Adjustable-rate mortgage assets $ 4,274,828 6.73% $ 4,359,562 5.80%
Cash and cash equivalents 19,075 6.75 25,007 6.37
----------- ---------- ----------- ----------
4,293,903 6.73 4,384,569 5.80
----------- ---------- ----------- ----------
Interest Bearing Liabilities:
Borrowings 3,915,744 6.46 4,010,895 5.51
----------- ---------- ----------- ----------
Net Interest Earning Assets and Spread $ 378,159 0.27% $ 373,674 0.29%
=========== ========== =========== ==========
Yield on Net Interest Earning Assets (1) 0.84% 0.76%
========== ==========
<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 net result of the yield on the Company's interest-earning assets increasing
to 6.73% during the first nine months of 2000 from 5.80% during the same period
of 1999 and the Company's cost of funds increasing to 6.46% from 5.51% for the
same respective time periods, its net interest income increased by $2,077,000.
This increase in net interest income is primarily the result of a favorable
rate variance as well as a less significant favorable volume variance. There
was a net favorable rate variance of $2,045,000, which consisted of a favorable
variance of $30,700,000 resulting from the higher yield on the Company's ARM
assets portfolio and other interest-earning assets and an unfavorable variance
of $28,655,000 resulting from the increase in the Company's cost of funds. The
slightly higher average amount of net interest earning assets during the first
nine months of 2000 compared to the same period of 1999, $378.2 million in 2000
compared to $373.7 million in 1999, also contributed to higher net interest
income in the amount of $32,000.
During the first nine months of 2000, the Company realized a net gain from the
sale of ARM securities in the amount of $49,000 as compared to $50,000 during
the first nine months of 1999. The gain from the sale of ARM securities during
2000 was a result of the Company's re-securitization of Other Investment ARM
securities and the subsequent sale of AAA and AA rated securities resulting from
this re-securitization. As a result of this transaction, the Company improved
its liquidity, the credit quality of its ARM portfolio and recorded a small
gain.
The Company recorded an expense for estimated credit losses in the amount of
$983,000 during the nine months ended September 30, 2000, compared to $2,139,000
during the same period of 1999. The Company's provision for estimated credit
losses has decreased in 2000, primarily because the Company discontinued
reducing the cost basis of two securities that the Company now believes have
been reduced to a cost basis that fully reflects its applicable estimate of
credit losses. The outlook for estimated loss on these two securities has
improved as the underlying loans have been paying off and real estate values
have improved, primarily in the California market.
For the nine months ended September 30, 2000, the Company's ratio of operating
expenses to average assets was 0.15% as compared to 0.12% for the same period of
1999. The ratio of operating expenses to average assets increased by 0.01% as a
result of the decrease in the amount of average assets during the first nine
months of 2000 compared to the same period during 1999. Additionally, the
Company's other expenses increased by approximately $499,000 for the nine months
ended September 30, 2000 compared to the same nine-month period in 1999. The
other expenses increased primarily due to increased usage of legal services in
connection with the Company's acquisition, financing and securitization of whole
loans, increased usage of investor and public relations services in order to
increase the visibility and awareness of the Company to potential new investors
and potential retail mortgage loan borrowers and due to other general corporate
matters.
35
<PAGE>
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary source of funds for the quarter ended September 30, 2000
consisted of reverse repurchase agreements, which totaled $2.983 billion,
callable AAA notes, which had a balance of $638.4 million and whole loan
financing facilities, which had a balance of $110.3 million. The Company's
other significant source of funds for the quarter ended September 30, 2000
consisted of payments of principal and interest from its ARM assets in the
amount of $294.4 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, funds borrowed from
whole loan financing facilities and 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, 2000, had a weighted average
effective cost of 6.87%. The reverse repurchase agreements had a weighted
average remaining term to maturity of 3.8 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. The whole loan
financing facilities are committed facilities that mature in January 2001 and
March 2003, subject to annual review. As of September 30, 2000, $1.460 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 six months to twelve 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 interest rates on the whole loan financing facilities are indexed to the
one-month LIBOR index and is subject to daily adjustment.
The Company has arrangements to enter into reverse repurchase agreements with 25
different financial institutions and on September 30, 2000, had borrowed funds
with 13 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 3.0%) 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. During the
third quarter of 2000, the Company increased its level of liquidity and 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, 2000, the Company had $638.4 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, 2000, the Company had entered into three whole loan
financing facilities. The Company borrows money under these facilities based on
the fair value of the ARM loans. Therefore, the amount of money available to
the Company under these facilities is subject to margin call based on changes in
fair value, which can be negatively effected by changes in interest rates and
other factors, including the delinquency status of individual loans. 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 2001. During the first quarter of 2000, the Company entered
into a second committed whole loan financing facility that also has a borrowing
capacity of $150 million. This second committed facility matures in March of
2003, subject to an annual review and extension by both parties. The third
facility is for an unspecified amount of uncommitted borrowing capacity and does
not have a specific maturity date. As of September 30, 2000, the Company had
$110.3 million borrowed against these whole loan financing facilities at an
effective cost of 7.19%.
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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, 2000, the Company had $109
million of its securities registered for future sale under this Registration
Statement.
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 2000. 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 2000, 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 rates can also affect the Company's net return on its Hybrid ARMs (net
of the cost of financing Hybrid ARMs). The Company has estimated the duration
of the fixed rate period of its Hybrid ARM and operates under a policy to hedge
a minimum of the duration of the fixed rate period less one year. The
financing of the unhedged fixed rate remaining period of one year or less is
subject to prevailing interest rates on the remaining balance of the Hybrid ARMs
at the expiration of the hedged period. As a result, if the cost of funds on
borrowings is higher at the expiration of the hedged period, the Company's net
interest spread on the remaining balance of a Hybrid ARM asset will be affected
unfavorably and conversely, if the cost of funds on borrowings is lower, the net
interest spread will be affected favorably.
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 homeowners 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 pressures or to
the same degree. As a result, the Company's income can improve or decrease
depending on the relationship between the various indices that the Company's ARM
assets are indexed to 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.
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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.
OTHER MATTERS
As of September 30, 2000, the Company calculates its Qualified REIT Assets, as
defined in the Internal Revenue Code of 1986, as amended (the "Code"), to be
99.2% 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 98.1% of its 2000 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, 2000, the Company believes that it will
continue to qualify as a REIT under the provisions of the Code.
The Company at all times intends to conduct its business so as not to become
regulated as an investment company under the Investment Company Act of 1940. If
the Company were to become regulated as an investment company, then the
Company's use of leverage would be substantially reduced. The Investment
Company Act exempts entities that are "primarily engaged in the business of
purchasing or otherwise acquiring mortgages and other liens on and interests in
real estate" ("Qualifying Interests"). Under current interpretation of the
staff of the SEC, in order to qualify for this exemption, the Company must
maintain at least 55% of its assets directly in Qualifying Interests. In
addition, unless certain mortgage securities represent all the certificates
issued with respect to an underlying pool of mortgages, such mortgage securities
may be treated as securities separate from the underlying mortgage loans and,
thus, may not be considered Qualifying Interests for purposes of the 55%
requirement. The Company calculates that it is in compliance with this
requirement.
On October 17, 2000, the Board of Directors and the Manager agreed to amendments
to the Agreement that included a 0.05% increase to the base management fee
formula, effective immediately, and a cost of living clause that will adjust the
base management fee formula by the change in the Consumer Price Index over the
previous twelve month period, effective as of each annual review of the
Agreement. The 0.05% adjustment to the base management fee formula is expected
to increase the cost of the base management fee by approximately $200,000 on an
annual basis.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
At September 30, 2000, 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
None
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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, INC.
Dated: November 13, 2000 By: /s/ Larry A. Goldstone
-----------------------------
Larry A. Goldstone
President and Chief Operating Officer
(authorized officer of registrant)
Dated: November 13, 2000 By: /s/ Richard P. Story
-----------------------------
Richard P. Story,
Chief Financial Officer and Treasurer
(principal accounting officer)
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Exhibit Index
Sequentially
Numbered
Exhibit Number Exhibit Description Page
--------------- --------------------------------------------- ----------------
10.1.1 Amendment No. 1 to the Management Agreement 42
27 Financial Data Schedule 44
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