================================================================================
--------------------------------------------------------------------------------
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
--- EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED: JUNE 30, 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) 21,489,663 as of July 31, 2000
--------------------------------------------------------------------------------
================================================================================
<PAGE>
<TABLE>
<CAPTION>
THORNBURG MORTGAGE, INC.
FORM 10-Q
INDEX
Page
----
PART I. FINANCIAL INFORMATION
<S> <C> <C>
Item 1. Financial Statements
Consolidated Balance Sheets at June 30, 2000 and December 31, 1999 3
Consolidated Statements of Operations for the three and six months ended
June 30, 2000 and June 30, 1999 4
Consolidated Statement of Shareholders' Equity for the six months
ended June 30, 2000 and June 30, 1999 5
Consolidated Statements of Cash Flows for the three and six months ended
June 30, 2000 and June 30, 1999 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 18
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 37
Item 2. Changes in Securities 37
Item 3. Defaults Upon Senior Securities 37
Item 4. Submission of Matters to a Vote of Security Holders 37
Item 5. Other Information 37
Item 6. Exhibits and Reports on Form 8-K 37
SIGNATURES 38
EXHIBIT INDEX 39
</TABLE>
2
<PAGE>
<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
THORNBURG MORTGAGE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands)
June 30, 2000 December 31, 1999
(Unaudited)
------------ -------------------
<S> <C> <C>
ASSETS
Adjustable-rate mortgage ("ARM") assets: (Notes 2 and 4)
ARM securities $ 3,292,151 $ 3,391,467
Collateral for collateralized notes 700,449 903,529
ARM loans held for securitization 29,744 31,102
------------ -------------------
4,022,344 4,326,098
------------ -------------------
Cash and cash equivalents 34,381 10,234
Accrued interest receivable 31,499 31,928
Prepaid expenses and other 2,026 7,705
------------ -------------------
$ 4,090,250 $ 4,375,965
============ ===================
LIABILITIES
Reverse repurchase agreements (Note 4) $ 3,077,228 $ 3,022,511
Collateralized notes payable (Note 4) 686,242 886,722
Other borrowings (Note 4) 18,408 21,289
Payable for assets purchased - 110,415
Accrued interest payable 15,087 18,864
Dividends payable (Note 6) 1,670 1,670
Accrued expenses and other 3,047 3,607
------------ -------------------
3,801,682 4,065,078
------------ -------------------
COMMITMENTS (Note 2)
SHAREHOLDERS' EQUITY (Note 6)
Preferred stock: par value $.01 per share; 2,760 shares
authorized; 9.68% Cumulative Convertible Series A,
2,760 and 2,760 issued and outstanding, respectively;
aggregate preference in liquidation $69,000 65,805 65,805
Common stock: par value $.01 per share; 47,240 shares
authorized , 21,990 and 21,990 shares issued and 21,490
and 21,490 outstanding, respectively 220 220
Additional paid-in-capital 342,161 342,026
Accumulated other comprehensive income (loss) (106,197) (82,489)
Notes receivable from stock sales (4,632) (4,632)
Retained earnings (deficit) (4,123) (5,377)
Treasury stock: at cost, 500 and 500 shares, respectively (4,666) (4,666)
------------ -------------------
288,568 310,887
------------ -------------------
$ 4,090,250 $ 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 Six Months Ended
June 30, June 30,
2000 1999 2000 1999
--------- --------- ---------- ----------
<S> <C> <C> <C> <C>
Interest income from ARM assets and cash $ 73,152 $ 63,087 $ 145,791 $ 122,732
Interest expense on borrowed funds (64,400) (54,015) (127,722) (107,094)
--------- --------- ---------- ----------
Net interest income 8,752 9,072 18,069 15,638
--------- --------- ---------- ----------
Gain on sale of ARM assets 49 35 49 35
Provision for credit losses (381) (689) (713) (1,375)
Management fee (Note 8) (1,033) (1,020) (2,057) (2,038)
Performance fee (Note 8) - - - -
Other operating expenses (420) (364) (868) (627)
--------- --------- ---------- ----------
NET INCOME $ 6,967 $ 7,034 $ 14,480 $ 11,633
========= ========= ========== ==========
Net income $ 6,967 $ 7,034 $ 14,480 $ 11,633
Dividend on preferred stock (1,670) (1,670) (3,340) (3,340)
--------- --------- ---------- ----------
Net income available to common shareholders $ 5,297 $ 5,364 $ 11,140 $ 8,293
========= ========= ========== ==========
Basic earnings per share $ 0.25 $ 0.25 $ 0.52 $ 0.39
========= ========= ========== ==========
Diluted earnings per share $ 0.25 $ 0.25 $ 0.52 $ 0.39
========= ========= ========== ==========
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)
Six Months Ended June 30, 2000 and 1999
(In thousands, except share data)
Accum. Notes
Other Receiv- Compre-
Additional Compre- able From Retained hensive
Preferred Common Paid-in hensive Stock Earnings/ Treasury Income/
Stock Stock Capital Income Sales (Deficit) Stock (Loss) 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 11,633 $11,633 11,633
Other comprehensive income:
Available-for-sale assets:
Fair value adjustment, net
of amortization - - - 19,131 - - - 19,131 19,131
Deferred gain on sale of
hedges, net of amortization - - - (425) - - - (425) (425)
---------
Other comprehensive income $30,339
=========
Interest from notes receivable
from stock sales 134 134
Dividends declared on preferred
stock - $1.21 per share - - - - - (3,340) - (3,340)
Dividends declared on common
stock - $0.46 per share - - - - - (9,886) - (9,886)
-------- ------- -------- ---------- -------- ---------- -------- --------
Balance, June 30, 1999 $65,805 $ 220 $341,890 $ (63,442) $(4,632) $ (6,105) $(4,666) $329,070
======== ======= ======== ========== ======== ========== ======== =========
Balance, December 31, 1999 $65,805 $ 220 $342,026 $ (82,489) $(4,632) $ (5,377) $(4,666) $310,887
Comprehensive income:
Net income 14,480 $14,480 14,480
Other comprehensive income:
Available-for-sale assets:
Fair value adjustment, net
of amortization - - - (23,254) - - - (23,254) (23,254)
Deferred gain on sale of
hedges, net of amortization - - - (454) - - - (454) (454)
---------
Other comprehensive income $(9,228)
=========
Interest from notes receivable
from stock sales 135 135
Dividends declared on preferred
stock - $1.21 per share - - - - - (3,340) - (3,340)
Dividends declared on common
stock - $0.46 per share - - - - - (9,886) - (9,886)
-------- ------- -------- ---------- -------- ---------- -------- --------
Balance, June 30, 2000 $65,805 $ 220 $342,161 $(106,197) $(4,632) $ (4,123) $(4,666) $288,568
======== ======= ======== ========== ======== ========== ======== =========
</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 Six Months Ended
June 30, June 30,
2000 1999 2000 1999
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Operating Activities:
Net Income $ 6,967 $ 7,034 $ 14,480 $ 11,633
Adjustments to reconcile net income to net
cash provided by operating activities:
Amortization 3,998 8,976 9,215 19,772
Net (gain) loss from investing activities 332 654 663 1,340
Change in assets and liabilities:
Accrued interest receivable 2,560 (2,982) 429 5,089
Prepaid expenses and other (391) (2,081) 5,679 (5,601)
Accrued interest payable 585 5,248 (3,777) (14,898)
Accrued expenses and other (235) 805 (560) 336
---------- ---------- ---------- ----------
Net cash provided by operating activities 13,816 17,654 26,129 17,671
---------- ---------- ---------- ----------
Investing Activities:
Available-for-sale ARM securities:
Purchases (26,090) (839,360) (424,807) (939,067)
Proceeds on sales 89,443 6,574 89,443 6,574
Proceeds from calls - 4,126 - 4,126
Principal payments 163,139 241,161 312,722 579,621
Collateral for collateralized notes payable:
Principal payments 155,757 62,515 201,398 135,773
ARM loans:
Purchases (17,267) - (19,996) -
Principal payments 903 1,476 1,532 6,568
Purchase of interest rate cap agreements (91) (441) (539) (1,910)
---------- ---------- ---------- ----------
Net cash provided by (used in) investing activities 365,794 (523,949) 159,753 (208,315)
---------- ---------- ---------- ----------
Financing Activities:
Net borrowings from (repayments of) reverse
repurchase agreements (226,581) 568,427 54,717 345,069
Repayments of collateralized notes (155,277) (62,581) (200,480) (137,333)
Net borrowing from (repayments of) other borrowings 9,886 (602) (2,881) (685)
Dividends paid (6,613) (6,613) (13,226) (13,226)
Interest from notes receivable from stock sales 68 68 135 134
---------- ---------- ---------- ----------
Net cash provided by (used in) financing activities (378,517) 498,699 (161,735) 193,959
---------- ---------- ---------- ----------
Net increase (decrease) in cash and cash equivalents 1,093 (7,596) 24,147 3,315
Cash and cash equivalents at beginning of period 33,288 47,342 10,234 36,431
---------- ---------- ---------- ----------
Cash and cash equivalents at end of period $ 34,381 $ 39,746 $ 34,381 $ 39,746
========== ========== ========== ==========
</TABLE>
Supplemental disclosure of cash flow information and non-cash activities are
included in Note 4.
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 six-months
ended June 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. The
Company formed these entities 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.
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.
7
<PAGE>
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 interest rate futures contracts (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 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 interest rate swap agreements are
accounted for on an accrual basis and recognized as a net adjustment
to interest expense.
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
9
<PAGE>
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 six month periods ended June 30, 2000 and
1999 (amounts in thousands except per share data):
<TABLE>
<CAPTION>
Earnings
Income Shares Per Share
-------- --------- ----------
<S> <C> <C> <C>
Three Months Ended June 30, 2000
--------------------------------
Net income $ 6,967
Less preferred stock dividends (1,670)
--------
Basic EPS, income available to
common shareholders 5,297 21,490 $ 0.25
==========
Effect of dilutive securities:
Stock options - -
-------- ---------
Diluted EPS $ 5,297 21,490 $ 0.25
======== ========= ==========
Three Months Ended June 30, 1999
--------------------------------
Net income $ 7,034
Less preferred stock dividends (1,670)
--------
Basic EPS, income available to
common stockholders 5,364 21,490 $ 0.25
==========
Effect of dilutive securities:
Stock options - 7
-------- ---------
Diluted EPS $ 5,364 21,497 $ 0.25
======== ========= ==========
10
<PAGE>
Earnings
Income Shares Per Share
-------- --------- ----------
Six Months Ended June 30, 2000
--------------------------------
Net income $14,480
Less preferred stock dividends (3,340)
--------
Basic EPS, income available to
common shareholders 11,140 21,490 $ 0.52
==========
Effect of dilutive securities:
Stock options - -
-------- ---------
Diluted EPS $11,140 21,490 $ 0.52
======== ========= ==========
Six Months Ended June 30, 1999
--------------------------------
Net income $11,633
Less preferred stock dividends (3,340)
--------
Basic EPS, income available to
common stockholders 8,293 21,490 $ 0.39
==========
Effect of dilutive securities:
Stock options - 2
-------- ---------
Diluted EPS $ 8,293 21,492 $ 0.39
======== ========= ==========
</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 six months ended June 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 interest rate swap agreements. The fair value of
interest rate swap agreements is disclosed in Note 5, Fair Value of
Financial Instruments. The Company believes that its use of interest
rate swap agreements qualify as cash-flow hedges as defined in the
statement. Therefore, the effective 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 June 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>
June 30, 2000
Available-
for-Sale Collateral for
ARM Securities Notes Payable ARM Loans Total
---------------- --------------- ----------- -------------
<S> <C> <C> <C> <C>
Principal balance outstanding $ 3,319,112 $ 689,872 $ 29,878 $ 4,038,862
Net unamortized premium 64,837 12,987 (18) 77,806
Deferred gain from hedging (175) - - (175)
Allowance for losses (2,217) (2,670) (116) (5,003)
Cap Agreements/Options
Contracts 4,050 260 - 4,310
Principal payment receivable 13,152 - - 13,152
---------------- --------------- ----------- -------------
Amortized cost, net 3,398,759 700,449 29,744 4,128,952
---------------- --------------- ----------- -------------
Gross unrealized gains 2,720 26 10 2,756
Gross unrealized losses (109,328) (12,688) (194) (122,210)
---------------- --------------- ----------- -------------
Fair value $ 3,292,151 $ 687,787 $ 29,560 $ 4,009,498
================ =============== =========== =============
Carrying value $ 3,292,151 $ 700,449 $ 29,744 $ 4,022,344
================ =============== =========== =============
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 quarter ended June 30, 2000, the Company re-securitized
Other Investment ARM securities with a par value of $94.0 million 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 million rated AAA, $11.7 million 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. During the quarter
ended June 30, 1999, the Company realized $35,000 in gains on the sale
of $6.5 million of ARM securities. All of the ARM securities sold were
classified as available-for-sale.
During the first six 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
$135,000 and recorded a $578,000 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
June 30, 2000 and December 31, 1999 (dollar amounts in thousands):
<TABLE>
<CAPTION>
June 30, 2000
---------------
Percent of Percent of
Loan Loan ARM Total
Delinquency Status Count Balance Loans (1) Assets
------------------------ ---------- ----------- --------- -------
<S> <C> <C> <C> <C>
60 to 89 days 5 $ 1,238 0.11% 0.03%
90 days or more 2 3,610 0.31 0.09
In foreclosure 5 1,050 0.09 0.02
---------- ----------- --------- -------
12 $ 5,898 0.51% 0.14%
========== =========== ========= =======
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 %
========== =========== ========= =======
<FN>
(1) ARM loans includes loans that the Company has securitized and
retained first loss credit exposure for total amounts of $1.148
billion and $1.108 billion at June 30, 2000 and December 31,
1999, respectively.
</TABLE>
The following table summarizes the activity for the allowance for
losses on ARM loans for the quarters ended June 30, 2000 and 1999
(dollar amounts in thousands):
2000 1999
------ ------
Beginning balance $2,208 $ 804
Provision for losses 578 764
Charge-offs, net - -
------ ------
Ending balance $2,786 $1,568
====== ======
As of June 30, 2000, the Company had commitments to purchase $11.7
million of ARM loans through its correspondent loan network.
As of June 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
more than adequate to cover estimated losses from this property.
The average effective yield on the ARM assets owned was 6.92% as of
June 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.
During the quarter ended June 30, 2000, the Company began to purchase
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.
As of June 30, 2000 and December 31, 1999, the Company had purchased
Cap Agreements and Options Contracts with a remaining notional amount
of $2.752 billion and $2.945 billion, respectively. The notional
amount of the Cap
13
<PAGE>
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 9.86%. Of the Cap Agreements and Options Contracts owned
by the Company as of June 30, 2000, $118.6 million are hedging the
cost of financing Hybrid ARMs and $2.633 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 11.59%. The Cap
Agreements and Options Contracts had an average maturity of 2.5 years
as of March 31, 2000. The initial aggregate notional amount of the Cap
Agreements declines to approximately $2.407 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. AGREEMENT TO PURCHASE FASLA HOLDING COMPANY
On December 23, 1999, the Company and Thornburg Mortgage Advisory
Corporation (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,
approximately $138 million in assets for $15 million, subject to
certain adjustments. The acquisition is subject to regulatory
approval, which is expected to be received by the end of 2000. Due to
ownership restrictions in the current IRS tax code applicable to
REITs, the purchase has been structured such that the Company will pay
95% of the purchase price for preferred stock of FASLA Holding Company
which will represent 95% of the economic interests in FASLA Holding
Company and the Manager will pay 5% of the purchase price for common
shares of FASLA Holding Company which will be voting shares that will
represent 5% of the economic value of FASLA Holding Company. In this
structure, FASLA Holding Company would be an unconsolidated taxable
subsidiary of the Company. During 1999, legislation was enacted by the
U.S. Congress, effective January 1, 2001, that will permit REITs to
have 100% ownership in qualified taxable subsidiaries, subject to
certain limitations, that would permit the Company and the Manager to
alter this structure such that FASLA Holding Company may become a
wholly-owned taxable subsidiary of the Company, consolidated for
financial reporting purposes.
NOTE 4. 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 June 30, 2000, the Company had outstanding $3.077 billion of
reverse repurchase agreements with a weighted average borrowing rate
of 6.78% and a weighted average remaining maturity of 4.5 months. As
of June 30, 2000, $2.133 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 June 30, 2000 were collateralized by
ARM assets with a carrying value of $3.273 billion, including accrued
interest.
At June 30, 2000, the reverse repurchase agreements had the following
remaining maturities (dollar amounts in thousands):
Within 30 days $1,138,271
31 to 89 days 641,694
90 days or greater 1,297,263
----------
$3,077,228
==========
14
<PAGE>
As of June 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 June 30, 2000, the Company had $18.4 million borrowed
against these whole loan financing facilities at an effective cost of
6.63%. The amount borrowed on the whole loan financing agreements at
June 30, 2000 was collateralized by ARM loans with a carrying value of
$19.1 million, including accrued interest.
The whole loan financing facility entered into during the first
quarter of 2000, 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 June 30, 2000,
the Notes had a net balance of $686.2 million, an effective interest
cost of 7.49%, which changes each month at a spread to one-month
LIBOR. As of June 30, 2000, these Notes were collateralized by ARM
loans with a principal balance of $722.1 million. The ARM security
that previously collateralized these Notes paid off during the quarter
ended June 30, 2000. 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 June 30, 2000, the Company was a counterparty to nineteen
interest rate swap agreements ("Swaps") having an aggregate notional
balance of $610.6 million. As of June 30, 2000, these Swaps had a
weighted average remaining term of 2.6 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 31 days to 213 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. Due to the
favorable market value of the Swaps at June 30, 2000, they were not
collateralized by any ARM assets.
The total cash paid for interest was $62.8 million and $48.2 million
during the quarters ended June 30, 2000 and 1999, respectively.
15
<PAGE>
NOTE 5. 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 June 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>
June 30, 2000 December 31, 1999
----------------------- -----------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
---------- ----------- ---------- -----------
<S> <C> <C> <C> <C>
Assets:
ARM assets $4,016,734 $4,003,888 $4,318,301 $4,305,060
Cap Agreements/Options
Contracts 5,610 5,610 7,797 7,797
Liabilities:
Collateralized notes payable 686,242 687,054 886,722 889,305
Other borrowings 18,408 18,408 21,289 21,289
Swap agreements 8,544 (5,958) 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 6. 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 six-month period ended June 30, 2000. To
date, the company has repurchased 500,016 at an average price of $9.28
per share.
16
<PAGE>
On April 17, 2000, the Company declared the first quarter 2000
dividend of $0.23 per common share, which was paid on May 17, 2000 to
common shareholders of record as of May 4, 2000.
On July 18, 2000, the Company declared the second quarter 2000
dividend of $0.23 per common share, which will be paid on August 17,
2000 to common shareholders of record as of August 4, 2000.
On June 15, 2000, the Company declared a second quarter dividend of
$0.605 per share to the shareholders of the Series A 9.68% Cumulative
Convertible Preferred Stock which was also paid on July 10, 2000 to
preferred shareholders of record as of June 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 7. 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 June 30, 2000, there were 200,022 options to
buy common shares and 210,000 DERs granted. As of June 30, 2000, the
Company had 999,495 options outstanding at exercise prices of $7.375
to $22.625 per share, 676,828 of which were exercisable. The weighted
average exercise price of the options outstanding was $13.80 per
share. As of the June 30, 2000, there were 377,675 DERs outstanding,
of which 349,514 were vested, and 24,734 PSRs outstanding. In
addition, the Company recorded an expense associated with the DERs and
the PSRs of $28,000 and $46,000 for the three and six month periods
ended June 30, 2000, respectively and for the same amounts for the
three and six month periods ended June 30, 1999, respectively.
Notes receivable from stock sales result from the Company selling
shares of common stock through the exercise of stock options partially
for consideration for notes receivable. The notes have remaining
maturity terms ranging from 6.5 year to 6.75 years and accrue interest
at rates that range from 5.47% to 6.00% per annum. In addition, the
notes are full recourse promissory notes and are secured by a pledge
of the shares of the Common Stock acquired. Interest, which is
credited to paid-in-capital, is payable quarterly, with the balance
due at the maturity of the notes. The payment of the notes will be
accelerated only upon the sale of the shares of Common Stock pledged
for the notes. The notes may be prepaid at any time at the option of
each borrower. As of June 30, 2000, there were $4.6 million of notes
receivable from stock sales outstanding.
17
<PAGE>
NOTE 8. 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.
For the quarters ended June 30, 2000 and 1999, the Company paid the
Manager $1,033,000 and $1,020,000, respectively, in base management
fees in accordance with the terms of the Agreement. For the six month
periods ended June 30, 2000 and 1999, the Company paid the Manager
base management fees of $2,057,000 and $2,038,000, 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
six-month periods ended June 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 six-month period
ended June 30, 2000, the combined amount of rent paid to the Manager
was $10,000 and $16,000, respectively.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Certain information contained in this Quarterly Report on Form 10-Q constitute
"Forward-Looking Statements" within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Exchange Act, which can be
identified by the use of forward-looking terminology such as "may," "will,"
"expect," "anticipate," "estimate," or "continue" or the negatives thereof or
other variations thereon or comparable terminology. Investors are cautioned
that all forward-looking statements involve risks and uncertainties including,
but not limited to, risks related to the future level and relationship of
various interest rates, prepayment rates and the timing of new programs. The
statements in the "Risk Factors" 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 indirectly providing
capital to the single-family residential housing market. ARM securities
represent interests in pools of ARM loans, which often include guarantees or
other credit enhancements against losses from loan defaults. While the Company
is not a bank or savings and loan, its business purpose, strategy, method of
operation and risk profile are best understood in comparison to such
18
<PAGE>
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 REIT qualified 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 REIT qualified 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 will commence 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.
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;
19
<PAGE>
(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 3%, 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 is $15 million, subject to certain adjustments. The
acquisition is subject to regulatory approval, which is expected to be received
by the end of 2000.
The primary purpose of this acquisition is to obtain nationwide lending
authority in order to expand the Company's acquisition channels for ARM loans.
The Company intends to initiate a mortgage banking division within First Arizona
Savings that would originate loans for sale to the Company, based upon the
Company's underwriting standards and ARM product design. It is also likely that
other standard loan products, including fixed-rate loans, would be originated
and sold to third party investors. The Company expects to avoid establishing an
expensive infrastructure involving substantial fixed costs generally associated
with starting up and operating a mortgage banking operation by utilizing "fee
based" third-party vendors who specialize in private label loan underwriting,
application processing and loan closing, and by utilizing a sub-servicer to
service the loans originated. The Company believes these third-party service
providers have developed both efficiencies and expertise through specialization
that afford the Company an opportunity to enter this business in a cost
effective manner with very little initial capital investment.
The Company also expects to continue operating First Arizona Savings as a full
service community bank within its current local market areas. First Arizona
Savings has traditionally been an originator of single-family residential loans,
both permanent and construction, based on underwriting standards that are
similar to the Company's and has generally retained ARM and Hybrid ARM loans for
its portfolio and has sold a significant percentage of its fixed-rate loan
production to FHLMC. First Arizona's primary source of funds has been retail
deposits and a limited amount of Federal Home Loan Bank advances. The Company
believes its acquisition and operation of First Arizona in this manner is a
consistent extension of the Company's existing business model that emphasizes
high credit quality lending and prudent interest rate risk management.
Due to the uncertainty of receiving regulatory approval and the timing of the
regulatory decision, the Company does not believe this acquisition will have a
material effect on the Company's operations during 2000. Further, the Company
believes that the combination of First Arizona's existing community-bank style
of operations and the projected mortgage banking operations will have a positive
effect on the Company's overall operations beginning in 2001.
FINANCIAL CONDITION
--------------------
At June 30, 2000, the Company held total assets of $4.090 billion, $4.022
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 June 30, 2000, 96.9% of the assets held by the Company, including
cash and cash equivalents, were High Quality assets, far exceeding the Company's
investment policy minimum requirement of investing at least 70% of its total
20
<PAGE>
assets in High Quality ARM assets and cash and cash equivalents. Of the ARM
assets currently owned by the Company, 85.2% are in the form of adjustable-rate
pass-through certificates or ARM loans. The remainder are floating rate classes
of CMOs (11.1%) 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 June 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)
June 30, 2000 December 31, 1999
---------------------- ----------------------
Carrying Portfolio Carrying Portfolio
Value Mix Value Mix
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
HIGH QUALITY:
FHLMC/FNMA $2,024,194 50.3% $2,068,152 47.8%
Privately Issued:
AAA/Aaa Rating 1,539,138(1) 38.3 1,585,099(1) 36.6
AA/Aa Rating 305,233 7.6 459,858 10.6
---------- ---------- ---------- ----------
Total Privately Issued 1,844,371 45.9 2,044,957 47.2
---------- ---------- ---------- ----------
Total High Quality 3,868,565 96.2 4,113,109 95.0
---------- ---------- ---------- ----------
OTHER INVESTMENT:
Privately Issued:
A Rating 14,310 0.4 49,995 1.2
BBB/Baa Rating 69,919 1.7 84,929 2.0
BB/Ba Rating or below 39,806(1) 1.0 46,963(1) 1.1
Whole loans 29,744 0.7 31,102 0.7
---------- ---------- ---------- ----------
Total Other Investment 153,779 3.8 212,989 5.0
---------- ---------- ---------- ----------
Total ARM Portfolio $4,022,344 100.0% $4,326,098 100.0%
========== ========== ========== ==========
<FN>
----------------
(1) AAA Rating category includes $722.1 million and $781.8 million as of June
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 $32.1 million and $32.2 million as of June 30,
2000 and December 31, 1999, respectively. The subordinated certificate is
included in the BB/Ba Rating category.
</TABLE>
As of March 31, 2000, the Company had reduced the cost basis of its ARM
securities by $2,217,000 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 six months ended June 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
$135,000 and recorded a $578,000 provision for estimated credit losses on its
loan portfolio, although no actual losses have been realized in the loan
portfolio to date. As of June 30, 2000, the Company's ARM loan portfolio
included 12 loans that are considered seriously delinquent (60 days or more
delinquent) with an aggregate balance of $5.9 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 12 delinquent loans and REO is
approximately 62%. As of June 30, 2000, the Company had $2.8 million of
reserves for estimated credit losses. 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.
21
<PAGE>
The following table classifies the Company's portfolio of ARM assets by type of
interest rate index.
<TABLE>
<CAPTION>
ARM ASSETS BY INDEX
(Dollar amounts in thousands)
June 30, 2000 December 31, 1999
------------------ ------------------
Carrying Portfolio Carrying Portfolio
Value Mix Value Mix
---------- ------ ---------- ------
<S> <C> <C> <C> <C>
ARM ASSETS:
INDEX:
One-month LIBOR $ 690,742 17.2% $ 680,449 15.7%
Three-month LIBOR 149,831 3.7 170,384 3.9
Six-month LIBOR 516,335 12.8 626,616 14.5
Six-month Certificate of Deposit 272,093 6.8 304,621 7.0
Six-month Constant Maturity Treasury 24,764 0.6 37,781 0.9
One-year Constant Maturity Treasury 1,200,163 29.8 1,359,229 31.4
Cost of Funds 183,550 4.6 213,800 5.0
---------- ------ ---------- ------
3,037,478 75.5 3,392,880 78.4
---------- ------ ---------- ------
HYBRID ARM ASSETS 984,866 24.5 933,218 21.6
---------- ------ ---------- ------
$4,022,344 100.0% $4,326,098 100.0%
========== ====== ========== ======
</TABLE>
The ARM portfolio had a current weighted average coupon of 7.48% at June 30,
2000. This consisted of an average coupon of 6.66% on the hybrid portion of the
portfolio and an average coupon of 7.76% on the rest of the portfolio. If the
non-hybrid portion of the portfolio had been "fully indexed," their weighted
average coupon would have been approximately 8.28%, 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 June 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.
At June 30, 2000, the current yield of the ARM assets portfolio was 6.89%,
compared to 6.38% as of December 31, 1999, with an average term to the next
repricing date of 341 days as of June 30, 2000, compared to 344 days as of
December 31, 1999. As of June 30, 2000, hybrid ARMs comprised 24.5% 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 0.51% as of June 30, 2000, compared to December 31,
1999, is primarily due to the increased weighted average interest rate coupon
discussed above, which increased by 0.40%. The lower yield adjustment from
amortizing the net portfolio premium had the effect of increasing the yield by
0.05%. The yield also improved as a result of lower hedging cost, which
decreased by 0.07%, 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 second quarter of 2000, decreasing the portfolio
yield by 0.01%.
22
<PAGE>
The following table presents various characteristics of the Company's ARM and
Hybrid ARM loan portfolio as of June 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.
<TABLE>
<CAPTION>
ARM AND HYBRID ARM LOAN PORTFOLIO CHARACTERISTICS
Average High Low
--------- ----------- ------
<S> <C> <C> <C>
Unpaid principal balance $268,997 $3,450,000 $ 183
Coupon rate on loans 7.52% 10.00% 5.00%
Pass-through rate 7.15% 9.48% 4.61%
Pass-through margin 1.90% 5.06% 0.61%
Lifetime cap 12.96% 16.75% 9.75%
Original Term (months) 342 480 72
Remaining Term (months) 316 359 52
</TABLE>
<TABLE>
<CAPTION>
Geographic Distribution (Top 5 States): Property type:
<S> <C> <C> <C>
California 20.39% Single-family 64.67%
Florida 10.95 DeMinimus PUD 20.35
Georgia 7.17 Condominium 9.96
New York 7.01 Other 5.02
New Jersey 4.90
Occupancy status: Loan purpose:
Owner occupied 84.73% Purchase 58.10%
Second home 10.65 Cash out refinance 24.55
Investor 4.62 Rate & term refinance 17.35
Documentation type: Periodic Cap:
Full/Alternative 93.16% None 59.98%
Other 6.84 2.00% 38.42
1.00% 0.47
Average effective original 0.50% 1.13
Loan-to-value: 68.15%
</TABLE>
During the quarter ended June 30, 2000, the Company purchased $43.4 million of
ARM assets, 9.5% of which were High Quality ARM securities, 50.6% were Other
Investment ARM securities purchased in connection with the re-securitization of
$89.4 million of the Company's Other Investment ARM securities, and 39.8% were
ARM loans acquired through the Company's correspondent loan network. Of the ARM
assets acquired during the second quarter of 2000, approximately 80% were
indexed to U.S. Treasury bill rates and 20% were Hybrid ARMs. Additionally, as
of June 30, 2000, the Company has commitments to purchase approximately $11.7
million of loans through its correspondent network.
During the six months ended June 30, 2000, the Company purchased $444.8 million
of ARM assets, 89.8% of which were High Quality ARM securities, 5.7% were Other
Investment ARM securities and 4.5% were ARM loans. Of the ARM assets acquired
during the first six months of 2000, approximately 52% were indexed to U.S.
Treasury bill rates, 34% were Hybrid ARMs and 14% were indexed to LIBOR.
During the quarter ended June 30, 2000, as previously mentioned, 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 were the only assets sold by the Company during both the three and
six month periods ended June 30, 2000.
For the quarter ended June 30, 2000, the Company's mortgage assets paid down at
an approximate average annualized constant prepayment rate of 16% compared to
26% for the quarter ended June 30, 1999 and 15% for the quarter ended March 31,
23
<PAGE>
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 0.74% from a negative adjustment of 2.40% of the
portfolio as of December 31, 1999, to a negative adjustment of 3.14% as of June
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 $106.6 million as of June 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 June 30, 2000, the unrecorded positive fair
value adjustment for Swap Agreements was $14.5 million. As of June 30, 2000,
all of the Company's ARM securities are classified as available-for-sale and are
carried at their fair value.
The Company has purchased Cap Agreements 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 June 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
$2.633 billion with an average final maturity of 2.4 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 10.04%. The Company
has also entered into Cap Agreements with a notional balance of $118.6 as of
June 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 June 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 5.93% and have a remaining term of 3.0 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 June 30, 2000, the fair value of the Company's Cap Agreements and
Options Contracts was $5.3 million, $1.3 million more 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 June 30, 2000:
<TABLE>
<CAPTION>
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
------------ --------- ----------------- ------------- --------------
<S> <C> <C> <C> <C>
26,951 8.01% $ 26,000 7.10% 2.8 Years
139,994 8.29 140,000 7.50 0.4
626,043 9.63 626,080 8.00 1.7
24,992 10.81 25,000 9.00 2.2
63,731 10.99 63,553 9.50 2.2
380,542 11.45 381,317 10.00 2.2
215,026 12.10 215,237 10.50 1.8
456,833 12.49 456,263 11.00 3.1
279,950 13.00 280,000 11.50 4.1
384,342 14.18 384,302 12.00 3.0
3,682 17.08 35,454 12.50 1.5
------------ --------- ----------------- ------------- --------------
2,602,086 11.59% $ 2,633,206 10.04% 2.4 Years
============ ========= ================= ============= ==============
<FN>
(1) Excludes ARM assets that do not have life caps or are hybrids that are
match funded during a fixed rate period, in accordance with the Company's
investment policy.
</TABLE>
As of June 30, 2000, the Company was a counterparty to nineteen interest rate
swap agreements ("Swaps") having an aggregate notional balance of $610.6
million. As of June 30, 2000, these Swaps had a weighted average remaining term
of 2.6 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 31
days to 213 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 June
30, 2000 was 3.3 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 JUNE 30, 2000
For the quarter ended June 30, 2000, the Company's net income was $6,967,000, or
$0.25 per share (Basic and Diluted EPS) compared to $7,034,000, also $0.25 per
share (Basic and Diluted EPS) for the quarter ended June 30, 1999. There were
21,490,000 weighted average common shares outstanding during both periods. Net
interest income for the quarter totaled $8,752,000, compared to $9,072,000 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 second quarter of 2000 and 1999, the Company recorded a gain of
$49,000 and $35,000, respectively, from the sale of ARM assets. Additionally,
during the second quarter of 2000, the Company reduced its earnings and the
carrying value of its ARM assets by reserving $381,000 for estimated credit
losses, compared to $689,000 during the same quarter of 1999. During the second
quarter of 2000, the Company incurred operating expenses of $1,453,000,
consisting of a base management fee of $1,033,000 and other operating expenses
of $420,000. During the same period of 1999, the Company incurred operating
expenses of $1,384,000, consisting of a base management fee of $1,020,000 and
other operating expenses of $364,000. Total operating expenses remained at
0.13% as a percentage of average assets for the three months ended June 30,
2000, the same as for the second quarter of 1999.
25
<PAGE>
The Company's return on average common equity was 6.50% for the quarter ended
June 30, 2000 compared to 6.60% for the quarter ended June 30, 1999 and compared
to 7.20% for the prior quarter ended March 31, 2000. The Company's return on
equity declined in this past quarter compared to the prior quarter primarily
because the Company's net interest income was lower due to the recent Federal
Reserve actions to raise interest rates. The Company's average cost of funds
during the quarter increased by 0.30% as compared to a 0.23% increase in the
Company's average ARM portfolio yield. Based on market interest rates as of
June 30, 2000 and interest rate re-pricing characteristics of the Company's ARM
portfolio and borrowings, the Company expects the ARM portfolio yield to
increase more than the Company's cost of funds over the remainder of the year.
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
Excess of
Net Gain (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%
<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 second
quarter of 2000, compared to the second 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 June 30, 2000 and 1999:
<TABLE>
<CAPTION>
COMPARATIVE NET INTEREST INCOME COMPONENTS
(Dollar amounts in thousands)
2000 1999
-------- --------
<S> <C> <C>
Coupon interest income on ARM assets $76,771 $71,586
Amortization of net premium (3,658) (7,837)
Amortization of Cap Agreements (633) (1,377)
Amortization of deferred gain from hedging 293 263
Cash and cash equivalents 379 452
-------- --------
Interest income 73,152 63,087
-------- --------
Reverse repurchase agreements 51,502 38,470
AAA notes payable 13,687 14,292
Other borrowings 351 35
Interest rate swaps (1,140) 1,218
-------- --------
Interest expense 64,400 54,015
-------- --------
Net interest income $ 8,752 $ 9,072
======== ========
</TABLE>
As presented in the table above, the Company's net interest income decreased by
$0.3 million in the second quarter of 2000 compared to the same three months of
1999. The Company's interest income was $10.1 million higher, primarily due to
higher interest rates and a lower level of net premium amortization, in part due
to slower prepayments during the second 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 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 June 30, 2000 and 1999:
<TABLE>
<CAPTION>
AVERAGE BALANCE AND RATE TABLE
(Dollar amounts in thousands)
For the Quarter Ended For the Quarter Ended
June 30, 2000 June 30, 1999
----------------------- ----------------------
Average Effective Average Effective
Balance Rate Balance Rate
----------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Interest Earning Assets:
Adjustable-rate mortgage assets $4,322,706 6.73% $4,374,336 5.73%
Cash and cash equivalents 21,921 6.92 30,940 5.85
----------- ---------- ---------- ----------
4,344,627 6.73 4,405,276 5.73
----------- ---------- ---------- ----------
Interest Bearing Liabilities:
Borrowings 3,965,483 6.50 4,034,856 5.35
----------- ---------- ---------- ----------
Net Interest Earning Assets and Spread $ 379,144 0.23% $ 370,420 0.38%
=========== ========== ========== ==========
Yield on Net Interest Earning Assets (1) 0.81% 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>
27
<PAGE>
As a result of the yield on the Company's interest-earning assets increasing to
6.73% during the three months ended June 30, 2000 from 5.73% during the same
period of 1999 and the Company's cost of funds increasing to 6.50% from 5.35%
during the same time periods, net interest income decreased by $320,000. This
decrease in net interest income is primarily a rate variance and to a lesser
extent a volume variance. There was a net unfavorable rate variance of
$422,000, primarily due to an unfavorable rate variance on borrowings of
$11,512,000, which was partially offset by a favorable rate variance of
$11,090,000 on the Company's ARM assets portfolio and other interest-earning
assets. The amount of net interest earning assets improved by $8,724,000 during
the second quarter of 2000 compared to the second quarter of 1999, producing a
favorable volume variance of $147,000. However, the decreased average size of
the Company's portfolio during the second quarter of 2000 compared to the same
period in 1999 decreased net interest income in the amount of $45,000. The
average balance of the Company's interest-earning assets was $4.345 billion
during the second three months of 2000, compared to $4.405 billion during the
second three months of 1999 -- a decrease of 1%.
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%
<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>
28
<PAGE>
<TABLE>
<CAPTION>
COMPONENTS OF THE YIELD ADJUSTMENTS ON ARM ASSETS
Amort of
Impact of Deferred Gain
As of the Premium/ Principal From Total
Quarter Discount Payments Hedging Hedging Yield
Ended Amort Receivable Activity Activity Adjustment
------------ ---------- -------------- --------- --------- -----------
<S> <C> <C> <C> <C> <C>
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%
</TABLE>
As of June 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 6.89%, compared to 6.58% as of March 31,
2000-- an increase of 0.31%. The Company's cost of funds as of June 30, 2000,
was 6.75%, compared to 6.32% as of March 31, 2000 -- an increase of 0.43%. As a
result of these changes, the Company's net interest spread as of June 30, 2000
was 0.15%, compared to 0.26% as of March 31, 2000. The decline in the net
interest spread is largely attributable to the increase in the Company's cost of
funds due to the impact of recent Federal Reserve actions to raise short-term
interest rates. 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. 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
Swaps such that the total cost of the Company's borrowings, including the effect
of hedging, only increased by the 0.43% to 6.75%. 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. On
average, as of the end of June 2000, the Company's borrowings reprice in 213
days whereas the Company's assets, on average, reprice in 341 days. Once the
Federal Reserve decides to stop increasing rates or to increase them at a slower
pace, as opposed to 0.75% in one quarter, the Company's assets are expected to
reprice more than the Company's borrowings and, therefore, the Company's
margins, interest rate spread and net income would improve.
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 quarter 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 29.8% at June 30, 2000 from 49.0% as
of the end of 1997. The data is as follows:
29
<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%
</TABLE>
The Company's provision for estimated credit losses decreased in the second
quarter of 2000 compared to the same period in 1999 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. 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 June 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 28.4%
of the Company's portfolio of ARM assets or $1.148 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:
30
<PAGE>
<TABLE>
<CAPTION>
RECONCILIATION OF REPORTED NET INCOME TO TAXABLE NET INCOME
(Dollar amounts in thousands)
Quarters Ending June 30,
------------------
2000 1999
-------- --------
<S> <C> <C>
Net income $ 6,967 $ 7,034
Additions:
Provision for credit losses 381 689
Net compensation related items 97 96
Deductions:
Dividend on Series A Preferred Shares (1,670) (1,670)
Capital loss carryover from 1998 (49) (35)
Actual credit losses on ARM securities (335) (323)
-------- --------
Taxable net income $ 5,391 $ 5,791
-------- --------
-------- --------
Taxable income per share $ 0.25 $ 0.27
======== ========
</TABLE>
For the quarter ended June 30, 2000, the Company's ratio of operating expenses
to average assets was 0.13% compared to 0.12% for the same period in 1999 and
0.13% for the prior quarter ended March 31, 2000. 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. As presented in the following table, the performance fee is a variable
expense that fluctuates with the Company's return on shareholders' equity
relative to the average 10-year U.S. Treasury rate.
The following table highlights the quarterly trend of operating expenses as a
percent of average assets:
<TABLE>
<CAPTION>
ANNUALIZED OPERATING EXPENSE RATIOS
Management Fee & Total
For the Other Expenses/ Performance Fee/ G & A Expense/
Quarter Ended Average Assets Average Assets Average Assets
------------- ----------------- ----------------- ---------------
<S> <C> <C> <C>
Mar 31, 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%
</TABLE>
RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE 30, 2000
For the six months ended June 30, 2000, the Company's net income was
$14,480,000, or $0.52 per share (Basic and Diluted EPS), based on a weighted
average of 21,490,000 shares outstanding. That compares to $11,633,000, or
$0.39 per share (Basic and Diluted EPS), based on a weighted average of
21,490,000 shares outstanding for the six months ended June 30, 1999. Net
interest income for this most recent six month period totaled $18,069,000,
31
<PAGE>
compared to $15,638,000 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 six months of 2000, the Company
recorded a gain on the sale of ARM securities of $49,000 as compared to a gain
of $35,000 during the same period of 1999. Additionally, during the first half
of 2000, the Company reduced its earnings and the carrying value of its ARM
assets by reserving $713,000 for potential credit losses, compared to $1,375,000
during the first half of 1999. During the six months ended June 30, 2000, the
Company incurred operating expenses of $2,925,000, consisting of a base
management fee of $2,057,000 and other operating expenses of $868,000. During
the same period of 1999, the Company incurred operating expenses of $2,665,000,
consisting of a base management fee of $2,038,000 and other operating expenses
of $627,000.
The Company's return on average common equity was 6.9% for the six months ended
June 30, 2000 compared to 5.1% for the six months ended June 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.
The following table presents the components of the Company's net interest income
for the six month periods ended June 30, 2000 and 1999:
<TABLE>
<CAPTION>
COMPARATIVE NET INTEREST INCOME COMPONENTS
(Dollar amounts in thousands)
2000 1999
--------- ---------
<S> <C> <C>
Coupon interest income on ARM assets $154,386 $141,577
Amortization of net premium (8,341) (17,605)
Amortization of Cap Agreements (1,471) (2,722)
Amortization of deferred gain from hedging 597 588
Cash and cash equivalents 620 894
--------- ---------
Interest income 145,791 122,732
--------- ---------
Reverse repurchase agreements 100,370 73,836
AAA notes payable 28,347 30,643
Other borrowings 635 74
Interest rate swaps (1,630) 2,541
--------- ---------
Interest expense 127,722 107,094
--------- ---------
Net interest income $ 18,069 $ 15,638
========= =========
</TABLE>
As presented in the table above, the Company's net interest income increased by
$2.4 million in the first half of 2000 compared to the same six months of 2000.
The Company's interest income was $23.1 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 half 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 $20.6 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 $1.6 million during the first half of 2000
compared to an expense of $2.5 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 second
quarter of 2000 and 1999.
The following table reflects the average balances for each category of the
Company's interest earning assets as well as the Company's interest bearing
liabilities, with the corresponding effective rate of interest annualized for
the six month periods ended June 30, 2000 and 1999:
32
<PAGE>
<TABLE>
<CAPTION>
AVERAGE BALANCE AND RATE TABLE
(Dollar amounts in thousands)
For the Six Month For the Six Month
Period Ended Period Ended
----------------------- ----------------------
June 30, 2000 June 30, 1999
----------------------- ----------------------
Average Effective Average Effective
Balance Rate Balance Rate
----------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Interest Earning Assets:
Adjustable-rate mortgage assets $4,389,000 6.62% $4,270,323 5.71%
Cash and cash equivalents 18,810 6.59 30,492 5.87
----------- ---------- ---------- ----------
4,407,810 6.62 4,300,815 5.71
----------- ---------- ---------- ----------
Interest Bearing Liabilities:
Borrowings 4,029,356 6.34 3,925,409 5.46
----------- ---------- ---------- ----------
Net Interest Earning Assets and Spread $ 378,454 0.28% $ 375,407 0.25%
=========== ========== ========== ==========
Yield on Net Interest Earning Assets (1) 0.82% 0.73%
========== ==========
<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 6.62% during the first half of 2000 from 5.71% during the first half of 1999
and the Company's cost of funds increasing to 6.34% from 5.46% for the same
respective time periods, its net interest income increased by $2,431,000. 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 $2,185,000, which consisted of a favorable
variance of $19,518,000 resulting from the higher yield on the Company's ARM
assets portfolio and other interest-earning assets and an unfavorable variance
of $17,333,000 resulting from the increase in the Company's cost of funds. The
increased average size of the Company's portfolio during the first half of 2000
compared to the same period of 1999 also contributed to higher net interest
income in the amount of $246,000. The average balance of the Company's
interest-earning assets was $4.408 billion during the first half of 2000
compared to $4.301 billion during the first half of 1999 -- an increase of 2.5%.
During the first half of 2000, the Company realized a net gain from the sale of
ARM securities in the amount of $49,000 as compared to $35,000 during the first
half 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
$713,000 during the six months ended June 30, 2000, compared to $1,375,000
during the same period of 1999. The Company's provision for estimated credit
losses decreased in the first half of 2000 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 six months ended June 30, 2000, the Company's ratio of operating
expenses to average assets was 0.13% as compared to 0.12% for the same period of
1999. The Company's other expenses increased by approximately $241,000 for the
six months ended June 30, 2000 compared to the same three-month period in 1999.
The other expenses increased primarily due to increased usage of legal services
in connection with the Company's financing and securitization of 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 due
to other general corporate matters.
33
<PAGE>
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary source of funds for the quarter ended June 30, 2000
consisted of reverse repurchase agreements, which totaled $3.077 billion, and
callable AAA notes, which had a balance of $686.2 million. The Company's other
significant source of funds for the quarter ended June 30, 2000 consisted of
payments of principal and interest from its ARM assets in the amount of $399.0
million. In the future, the Company expects its primary sources of funds will
consist of borrowed funds under reverse repurchase agreement transactions with
one- to twelve-month maturities, capital market financing transactions
collateralized by ARM and Hybrid ARM loans, proceeds from monthly payments of
principal and interest on its ARM assets portfolio and occasional asset sales.
The Company's liquid assets generally consist of unpledged ARM assets, cash and
cash equivalents.
Total borrowings outstanding at June 30, 2000, had a weighted average effective
cost of 6.89%. The reverse repurchase agreements had a weighted average
remaining term to maturity of 4.5 months and the collateralized AAA notes
payable had a final maturity of January 25, 2029, but will be paid down as the
ARM assets collateralizing the notes are paid down. As of June 30, 2000, $2.133
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 Company has arrangements to enter into reverse repurchase agreements with 25
different financial institutions and on June 30, 2000, had borrowed funds with
12 of these firms. Because the Company borrows money under these agreements
based on the fair value of its ARM assets and because changes in interest rates
can negatively impact the valuation of ARM assets, the Company's borrowing
ability under these agreements could be limited and lenders may initiate margin
calls in the event interest rates change or the value of the Company's ARM
assets decline for other reasons. Additionally, certain of the Company's ARM
assets are rated less than AA by the Rating Agencies (approximately 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
second 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 June 30, 2000, the Company had $686.2 million of AAA collateralized notes
outstanding, which are not subject to margin calls. Due to the structure of the
collateralized notes, their financing is not based on market value or subject to
subsequent changes in mortgage credit markets, as is the case of the reverse
repurchase agreement arrangements.
As of June 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 June 30, 2000, the Company had $18.4 million borrowed against these whole
loan financing facilities at an effective cost of 6.72%.
On December 23, 1999, the Company and the Manager entered into an agreement to
purchase FASLA Holding Company for $15 million, subject to certain adjustments,
in a cash transaction. The Company expects to complete this acquisition by the
end of 2000, depending upon the timing of receiving regulatory approval. The
Company expects to generate sufficient working capital in advance of the
purchase acquisition date in order to complete the acquisition with
cash-on-hand.
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 June 30, 2000, the Company had $109
million of its securities registered for future sale under this Registration
Statement.
34
<PAGE>
During 1998, the Board of Directors approved a common stock repurchase program
of up to 1,000,000 shares at prices below book value, subject to availability of
shares and other market conditions. The Company did not repurchase any shares
during the first six 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 six 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.
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.
35
<PAGE>
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 June 30, 2000, the Company calculates its Qualified REIT Assets, as
defined in the Internal Revenue Code of 1986, as amended (the "Code"), to be
99.0% 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 98.5% of its 2000 revenue for the first six 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 June 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.
36
<PAGE>
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
At June 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
(a) The Annual Meeting of Shareholders of the Company was held on
April 27, 2000.
(c) The following matters were voted upon and approved at the
Annual Meeting:
(1) Election of Directors
Votes
-----------------------
Nominee For Withheld
------------------- ---------- --------
Garrett Thornburg 19,823,965 261,832
Joseph H. Badal 19,828,435 257,362
Stuart C. Sherman 19,826,962 258,835
(2) Amendment to the registrant's Articles of Incorporation
to change the name of the Company to Thornburg Mortgage,
Inc.
Votes
-----------------------------------------------
For Against Abstain
------------------- ---------- --------
19,828,439 110,599 146,759
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
37
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized,
THORNBURG MORTGAGE, INC.
Dated: July 31, 2000 By: /s/ Larry A. Goldstone
--------------------------------------
Larry A. Goldstone
President and Chief Operating Officer
(authorized officer of registrant)
Dated: July 31, 2000 By: /s/ Richard P. Story
--------------------------------------
Richard P. Story,
Chief Financial Officer and Treasurer
(principal accounting officer)
38
<PAGE>
Exhibit Index
Sequentially
Numbered
Exhibit Number Exhibit Description Page
-------------- ----------------------- ------------
27 Financial Data Schedule 40
39
<PAGE>
