<PAGE> 1
================================================================================
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: MARCH 31, 1996
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: 0-26436
REDWOOD TRUST, INC.
(Exact name of Registrant as specified in its Charter)
MARYLAND 68-0329422
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
591 REDWOOD HIGHWAY, SUITE 3100
MILL VALLEY, CALIFORNIA 94941
(Address of principal executive offices) (Zip Code)
(415) 389-7373
(Registrant's telephone number, including area code)
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.
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) 8,418,945 as of May 10, 1996
================================================================================
<PAGE> 2
REDWOOD TRUST, INC.
FORM 10-Q
INDEX
<TABLE>
<CAPTION>
Page
----
<S> <C>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Balance Sheets at March 31, 1996 and March 31, 1995.......... 3
Statements of Operations for the three months
ended March 31, 1996 and March 31, 1995...................... 4
Statements of Stockholders' Equity for the three
months ended March 31, 1996.................................. 5
Statements of Cash Flows for the three months
ended March 31, 1996 and March 31, 1995...................... 6
Notes to Financial Statements................................ 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations..................... 16
PART II. OTHER INFORMATION
Item 1. Legal Proceedings................................................. 43
Item 2. Changes in Securities............................................. 43
Item 3. Defaults Upon Senior Securities................................... 43
Item 4. Submission of Matters to a Vote of Security Holders............... 43
Item 5. Other Information................................................. 43
Item 6. Exhibits and Reports on Form 8-K.................................. 43
SIGNATURES ............................................................... 44
</TABLE>
2
<PAGE> 3
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
REDWOOD TRUST, INC.
BALANCE SHEETS
(In thousands, except share data)
<TABLE>
<CAPTION>
March 31, 1996 December 31, 1995
-------------- -----------------
ASSETS
<S> <C> <C>
Cash and cash equivalents $ 9,705 $ 4,825
Mortgage assets 565,159 432,244
Interest rate agreements 1,233 547
Accrued interest receivable 4,496 3,270
Other assets 720 671
--------- ---------
$ 581,313 $ 441,557
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Reverse repurchase agreements $ 471,372 $ 346,335
Notes payable 37,349 23,981
Accrued interest payable 1,616 1,290
Accrued expenses and other liabilities 290 227
Dividends payable 2,540 1,434
--------- ---------
513,167 373,267
--------- ---------
Commitments and contingencies (See Note 10)
STOCKHOLDERS' EQUITY
Common stock, par value $.01 per share;
Authorized 50,000,000 shares, issued and
outstanding 5,521,376 and 5,517,299 shares 55 55
Additional paid-in capital 73,926 73,895
Net unrealized loss on assets available for sale (5,065) (5,476)
Undistributed income (deficit) (770) (184)
--------- ---------
68,146 68,290
--------- ---------
$ 581,313 $ 441,557
========= =========
</TABLE>
The accompanying notes are an integral part of these financial statements
3
<PAGE> 4
REDWOOD TRUST, INC.
STATEMENTS OF OPERATIONS
(In thousands, except share data)
<TABLE>
<CAPTION>
Three Months Ended
---------------------------------------
March 31, 1996 March 31, 1995
-------------- --------------
<S> <C> <C>
INTEREST INCOME
Mortgage assets $ 8,914 $ 2,155
Cash and investments 217 15
---------- ----------
9,131 2,170
INTEREST EXPENSE 6,202 1,533
INTEREST RATE AGREEMENTS
Interest rate agreement expense 151 16
---------- ----------
NET INTEREST INCOME 2,778 621
Provision for credit losses 332 18
---------- ----------
Net interest income after provision for credit losses 2,446 603
General and administrative expenses 492 201
---------- ----------
NET INCOME $ 1,954 $ 402
========== ==========
NET INCOME PER SHARE
Primary $ 0.32 $ 0.19
Fully diluted $ 0.32 $ 0.19
Weighted average shares of common stock and
common stock equivalents:
Primary 6,129,587 2,115,161
Fully diluted 6,132,648 2,115,161
Dividends declared per preferred share $ 0.00 $ 0.20
Dividends declared per common share $ 0.46 $ 0.00
</TABLE>
The accompanying notes are an integral part of these financial statements
4
<PAGE> 5
REDWOOD TRUST, INC.
STATEMENTS OF STOCKHOLDERS' EQUITY
For the Three Months Ended March 31, 1996
(In thousands, except share data)
<TABLE>
<CAPTION>
Net Unrealized
Common Stock Additional Loss on Assets
--------------------- Paid-in Available Undistributed
Shares Amount Capital for Sale Income (Deficit) Total
----------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Balance, December 31, 1995 5,517,299 $55 $ 73,895 ($5,476) ($ 184) $68,290
Shares issued pursuant to
dividend reinvestment plan 4,077 -- 79 -- -- $ 79
Offering costs -- -- (48) -- -- ($ 48
Net income -- -- -- -- 1,954 $ 1,954
Common stock
dividends declared -- -- -- -- (2,540) ($2,540
Fair value adjustment on
assets available for sale -- -- -- 411 -- $ 411
----------------------------------------------------------------------------------------
Balance, March 31, 1996 5,521,376 $55 $ 73,926 ($5,065) ($ 770) $68,146
========================================================================================
</TABLE>
The accompanying notes are an integral part of these financial statements
5
<PAGE> 6
REDWOOD TRUST, INC.
STATEMENTS OF CASH FLOWS
(In thousands, except share data)
<TABLE>
<CAPTION>
Three Months Ended
----------------------------------
March 31, 1996 March 31, 1995
-------------- --------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 1,954 $ 402
Adjustments to reconcile net income to net cash
provided by operating activities:
Amortization of mortgage asset premium and discount, net 530 (215)
Depreciation and amortization 17 4
Provision for credit losses on mortgage assets 332 18
Amortization of interest rate cap agreements 151 16
Increase in accrued interest receivable (1,226) (111)
Decrease (increase) in other assets (66) 45
Increase (decrease) in accrued interest payable 326 (11)
Increase (decrease) in accrued expenses and other 63 63
--------- --------
Net cash provided by operating activities 2,081 211
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of mortgage assets (166,852) (24,115)
Principal payments on mortgage assets 32,814 2,673
Purchase of interest rate cap agreements (165) (294)
--------- --------
Net cash used in investing activities (134,203) (21,736)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings from reverse repurchase agreements 125,037 15,695
Net borrowings from notes payable 13,368 5,927
Private placement issuance costs 0 (4)
Proceeds from stock issued pursuant to dividend reinvestment plan 79
Common stock issuance costs (48)
Dividends paid (1,434) (167)
--------- --------
Net cash provided by financing activities 137,002 21,451
Net increase (decrease) in cash and cash equivalents 4,880 (74)
Cash and cash equivalents at beginning of period 4,825 1,027
--------- --------
Cash and cash equivalents at end of period $ 9,705 $ 953
========= ========
Supplemental disclosure of cash flow information:
Cash paid for interest $ 5,876 $ 1,544
========= ========
</TABLE>
The accompanying notes are an integral part of these financial statements
6
<PAGE> 7
REDWOOD TRUST, INC.
NOTES TO FINANCIAL STATEMENTS
March 31, 1996
NOTE 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Redwood Trust, Inc. (the "Company") was incorporated in Maryland on
April 11, 1994. At incorporation 208,332 shares of the Company's
common stock, par value $.01 per share ("Common Stock") were issued to
various officers and employees of the Company.
On August 19, 1994, upon receipt of the net proceeds from the first
closing of its private placement of Units, the Company commenced its
operations of acquiring and managing mortgage assets. Each Unit
consisted of one share of Class A Convertible Preferred Stock, par
value $.01 per share ("Preferred Stock") and one Stock Purchase Warrant
("Warrant"). In this first closing, the Company issued 1,226,465 Units
at a price of $15 per Unit. The Company received proceeds of
$16,815,877, net of an underwriting discount of $1.05 per share and
other offering costs.
In October 1994, the Company completed a second closing of its private
placement of Units. The Company issued an additional 439,598 Units at a
price of $15 per Unit. The Company received proceeds of $5,968,937, net
of an underwriting discount of $1.05 per share and other offering
costs.
On August 9, 1995, the Company completed its initial public offering of
3,593,750 shares of common stock at $15.50 per share (the "Initial
Public Offering"). The Company received proceeds of $51,132,396, net of
an underwriting discount of $1.085 per share and other offering costs.
Concurrent with the completion of the Initial Public Offering, all
1,666,063 outstanding shares of Class A Convertible Preferred Stock
converted into 1,667,134 shares of Common Stock.
The Company's primary source of revenue is from the acquisition and
management of real estate mortgage loans and mortgage securities
(together "Mortgage Assets"). The Company acquires Mortgage Assets that
are secured by single-family, multifamily and commercial real estate
properties throughout the Untied States, with a special emphasis on
properties located in the State of California.
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 revenue
and expenses during the reported period. Actual results could differ
from those estimates.
A summary of the Company's significant accounting policies follows:
Cash and cash equivalents
Cash and cash equivalents include cash on hand and highly
liquid investments with original maturities of three months or
less. The carrying amount of cash equivalents approximates
their fair value.
Mortgage Assets
The Company's mortgage assets ("Mortgage Assets") may consist
of mortgage loans, mortgage loans which have been securitized
by the Company following acquisition, mortgage loans which
have been securitized by others prior to acquisition by the
Company and interest only strips ("IO Strips").
Statement of Financial Accounting Standards No. 115,
Accounting for Certain Investments in Debt and Equity
Securities ("SFAS 115"), requires the Company to classify its
investments as either trading
7
<PAGE> 8
investments, available-for-sale investments or
held-to-maturity investments. Although the Company generally
intends to hold most of its Mortgage Assets until maturity, it
may, from time to time, sell any of its Mortgage Assets as
part of its overall management of its balance sheet.
Accordingly, this flexibility requires the Company to classify
all of its Mortgage Assets as available-for-sale. All assets
classified as available-for-sale are reported at fair value,
with unrealized gains and losses excluded from earnings and
reported as a separate component of stockholders' equity.
Unrealized losses on Mortgage Assets that are considered
other-than-temporary, as measured by the amount of decline in
fair value attributable to factors other than temporary, are
recognized in income and the cost basis of the Mortgage Asset
is adjusted. Other-than-temporary unrealized losses are based
on management's assessment of various factors affecting the
Mortgage Assets; primarily, a deterioration of the credit
quality of the underlying mortgages, or a deterioration of the
credit protection available related to the mortgage loan pool.
Interest income is accrued based on the outstanding principal
amount of the Mortgage Assets and their contractual terms.
Discounts and premiums relating to Mortgage Assets are
amortized into interest income over the lives of the Mortgage
Assets using methods that approximate the effective yield
method. Gains or losses on the sale of Mortgage Assets are
based on the specific identification method.
IO Strips are accounted for under the prospective method.
Under this method, income is amortized over the asset's
estimated life based on a method which provides a constant
yield. At the end of each quarter, the yield over the
remaining life of the asset is recalculated based on expected
future cash flows. This new yield is then used to calculate
the subsequent quarter's financial statement income.
Under certain extended high interest rate periods, or in the
event of extremely high prepayment rates on the collateral,
the return on the Company's investment in an IO Strip could be
zero or negative. In the event that the projected return on an
investment in an IO Strip falls below a risk free rate, the
Company would record a write down of such investment to its
fair value.
Interest Rate Agreements
The rate the Company pays on its short-term and variable
borrowings will rise and fall without limit as short-term
market interest rates fluctuate. The rate the Company earns on
its adjustable rate assets, however, is limited by periodic
and lifetime caps.
Under the Company's hedging policy the Company does not hedge
specific assets or liabilities, but rather the Company hedges
the risk of overall limitations to its interest income. To
utilize hedge accounting, the policy requires risk reduction
and that there be at least a 50% correlation between changes
in the estimated fair value of the assets or liabilities
hedged and the hedge instruments. Interest Rate Agreements,
which include interest rate cap agreements (the "Cap
Agreements") and interest rate swap agreements (the "Swap
Agreements"), entered into by the Company are intended to
provide income throughout their effective period to offset
potential reduced net interest income under certain rising
interest rate scenarios. The Company periodically evaluates
the effectiveness of these hedges under various interest rate
scenarios.
The Company accounts for the Interest Rate Agreements as
hedges. Because the Mortgage Assets are carried at fair value,
the Company's Interest Rate Agreements are carried at fair
value, with unrealized gains and losses reported as a separate
component of equity.
The cost of each Cap Agreement is amortized over the effective
period of that Cap Agreement using the effective interest
method. The income and expense related to each Swap Agreement
is recognized on an accrual basis. Gains and losses on early
termination of Interest Rate Agreements are amortized as a
component of net interest income over the remaining term of
the original Interest Rate Agreement,
8
<PAGE> 9
or, if shorter, over the remaining term of associated Mortgage
Assets as adjusted for estimated future principal prepayments.
Unrealized losses on Interest Rate Agreements that are
considered other than temporary are recognized in income and
the cost basis of the Interest Rate Agreement is adjusted. The
other than temporary decline is measured as the amount of the
decline in fair value attributable to factors that are other
than temporary. Other than temporary unrealized losses are
based on management's assessment of various factors affecting
the Interest Rate Agreements; primarily, a deterioration of
the ability of the counterparty to perform under the terms of
the Interest Rate Agreement.
Premises, Furniture and Equipment
Leasehold improvements are stated at cost and are amortized on
a straight-line basis over the life of the lease. Furniture
and equipment is stated at cost and depreciated on an
accelerated basis over its estimated useful life. Expenditures
for repairs and maintenance are charged to expense when
incurred. Premises and equipment totaled $119,312 at March 31,
1996 and $113,515 at December 31, 1995. Depreciation expense
and leasehold improvements amortization for the three months
ended March 31, 1996 and March 31, 1995 totaled $8,895 and
$4,059, respectively. Accumulated depreciation and leasehold
improvement amortization totaled $37,297 at March 31, 1996 and
$31,367 at December 31, 1995.
Income Taxes
The Company has elected to be taxed as a Real Estate
Investment Trust ("REIT") and intends to comply with the REIT
provisions of the Internal Revenue Code (the "Code") and the
corresponding provisions of State law. Accordingly, the
Company will not be subject to Federal or state income tax to
the extent of its distributions to stockholders. In order to
maintain its status as a REIT, the Company is required, among
other requirements, to distribute at least 95% of its taxable
income.
Earnings per Share
Earnings per share are based on the weighted average shares of
common stock outstanding plus common equivalent shares arising
from the effect of convertible preferred stock, using the
if-converted method, and dilutive stock options and warrants,
using the treasury stock method. The treasury stock method
calculation assumes all dilutive stock options and warrants
are exercised and the funds generated by the exercise are used
to buy back outstanding common stock at the average market
price during the reporting period, for primary earnings per
share, or at the end of period market price if higher, for
fully diluted earnings per share.
Credit Risk
Most of the Company's Mortgage Assets have protection from
some degree of credit loss either through subordination,
insurance, third party guarantees, or other means. Many of the
Company's privately issued Mortgage Assets have received
ratings from one or more of the four nationally recognized
credit rating agencies. Based on these ratings, and on credit
criteria similar to those used by rating agencies, the Company
assigns a "rating equivalent" to each Mortgage Asset. For
purposes of assigning a rating equivalent to unrated pools of
whole loans or unrated securitized pools of mortgage loans,
the Company assigns a series of ratings to different portions
of the pool according to the Company's estimation of how the
pool would currently be structured and rated if it were newly
securitized. At March 31, 1996, the privately issued Mortgage
Assets held by the Company had rating equivalents ranging from
AAA to unrated, with a weighted average of AA; the weighted
average rating equivalent of all the Company's Mortgage Assets
was AA+. At December 31, 1995, the privately issued Mortgage
Assets held by the Company had rating equivalents ranging from
AAA to unrated, with a weighted average of A+; the weighted
average rating equivalent of all the Company's Mortgage Assets
was AA+.
9
<PAGE> 10
An allowance for credit losses is maintained at a level deemed
appropriate by management to provide for known losses as well
as unidentified potential losses in its Mortgage Asset
portfolio. The allowance is based upon management's assessment
of various factors affecting its privately issued Mortgage
Assets, including current and projected economic conditions,
delinquency status and credit protection. In determining the
allowance for credit losses, the Company's credit exposure is
considered based on its credit risk position in the mortgage
pool. These estimates are reviewed periodically and, as
adjustments become necessary, they are reported in earnings in
the periods in which they become known. The allowance is
increased by provisions charged to operations. When a loan or
portions of a loan is determined to be uncollectible, the
portion deemed uncollectible is charged against the allowance
and subsequent recoveries, if any, are credited to the
allowance. During the three months ended March 31, 1996 and
March 31, 1995 the Company provided for $331,516 and $18,436
in credit losses, respectively. During the three months ended
March 31, 1996 and March 31, 1995 the Company incurred no in
charge-offs. The reserve balance at March 31, 1996 and
December 31, 1995 was $821,229 and $489,713, respectively.
NOTE 2. MORTGAGE ASSETS
Mortgage Assets Excluding IO Strip
At March 31, 1996, Mortgage Assets, excluding IO Strips, consisted of
the following:
<TABLE>
<CAPTION>
FEDERAL HOME LOAN FEDERAL NATIONAL PRIVATELY ISSUED
MORTGAGE MORTGAGE MORTGAGE
(IN THOUSANDS) CORPORATION ASSOCIATION ASSETS TOTAL
----------------------------------------------------------------------
<S> <C> <C> <C> <C>
Mortgage Assets, Gross $ 81,985 $ 210,041 $ 281,781 $ 573,807
Unamortized Discount 0 (294) (16,560) (16,854)
Unamortized Premium 1,839 4,253 3,480 9,572
----------------------------------------------------------------------
Amortized Cost 83,824 214,000 268,701 566,525
Allowance for Credit Losses 0 0 (821) (821)
Gross Unrealized Gains 265 970 613 1,848
Gross Unrealized Losses (217) (487) (3,926) (4,630)
======================================================================
Estimated Fair Value $ 83,872 $ 214,483 $ 264,567 $ 562,922
======================================================================
</TABLE>
At December 31, 1995, Mortgage Assets, excluding IO Strips, consisted
of the following:
<TABLE>
<CAPTION>
FEDERAL HOME LOAN FEDERAL NATIONAL PRIVATELY ISSUED
MORTGAGE MORTGAGE MORTGAGE
(IN THOUSANDS) CORPORATION ASSOCIATION ASSETS TOTAL
----------------------------------------------------------------------
<S> <C> <C> <C> <C>
Mortgage Assets, Gross $ 46,160 $ 190,061 $ 207,404 $ 443,625
Unamortized Discount 0 (313) (16,719) (17,032)
Unamortized Premium 907 3,608 1,535 6,050
----------------------------------------------------------------------
Amortized Cost 47,067 193,356 192,220 432,643
Allowance for Credit Losses 0 0 (490) (490)
Gross Unrealized Gains 334 1,033 874 2,241
Gross Unrealized Losses (110) (458) (4,345) (4,913)
======================================================================
Estimated Fair Value $ 47,291 $ 193,931 $ 188,259 $ 429,481
======================================================================
</TABLE>
10
<PAGE> 11
At March 31, 1996 and December 31, 1995, all investments in Mortgage
Assets consisted of interests in adjustable rate mortgages on
residential properties. A majority of such properties are located in
the State of California. The securitized interests in pools of
adjustable rate mortgages from the Federal Home Loan Mortgage
Corporation and the Federal National Mortgage Association are
guaranteed as to principal and interest by those US government
agencies. The original maturity of the vast majority of the Mortgage
Assets is over a period of thirty years; the actual maturity is subject
to change based on the prepayments of the underlying mortgage loans.
At March 31, 1996, the average annualized effective yield was 7.59%
based on the amortized cost of the assets and 7.67% based on the fair
value of the assets. At December 31, 1995, the average annualized
effective yield on the Mortgage Assets was 7.66% based on the amortized
cost of the assets and 7.74% based on the fair value of the assets.
Most of the adjustable rate mortgage securities and loans are limited
by periodic caps (generally interest rate adjustments are limited to no
more than 1% every six months) and lifetime caps. At March 31, 1996 and
December 31, 1995 the weighted average lifetime cap was 11.53% and
11.54%, respectively.
IO Strips
The amortized cost and fair value of the Company's IO Strips are
summarized as follows:
<TABLE>
<CAPTION>
(IN THOUSANDS) MARCH 31, 1996 DECEMBER 31, 1995
-------------- -----------------
<S> <C> <C>
Amortized Cost $3,218 $3,593
Gross Unrealized Gains 0 0
Gross Unrealized Losses (981) (830)
------ ------
Estimated Fair Value $2,237 $2,763
====== ======
</TABLE>
The average annualized effective yield at March 31, 1996 on the IO
Strips was 8.76% based on the amortized cost of the assets and 13.14%
based on the fair value of the assets. The average annualized effective
yield at December 31, 1995 on the IO Strips was 9.99% based on the
amortized cost of the assets and 13.61% based on the fair value of the
assets.
NOTE 3. INTEREST RATE AGREEMENTS
The amortized cost and fair value of the Company's Interest Rate
Agreements are summarized as follows:
<TABLE>
<CAPTION>
(IN THOUSANDS) MARCH 31, 1996 DECEMBER 31, 1995
-------------- -----------------
<S> <C> <C>
Amortized Cost $2,534 $2,521
Gross Unrealized Gains 0 0
Gross Unrealized Losses (1,302) (1,974)
------ ------
Estimated Fair Value $1,233 $ 547
====== ======
</TABLE>
Cap Agreements
The Company had twenty-seven outstanding Cap Agreements at March 31,
1996 and twenty-three outstanding Cap Agreements at December 31, 1995.
Potential future earnings from each of these Cap Agreements are based
on variations in the London Interbank Offered Rate ("LIBOR"). Three of
the Cap Agreements at March 31, 1996 and December 31, 1995 had
contractually stated notional amounts which vary over the life of the
Cap Agreement. The sum of the notional amounts of the Company's Cap
Agreements in effect was $400,500,000 and $302,000,000 at March 31,
1996 and December 31, 1995, respectively. The weighted average cap
strike rate during the three months ended March 31, 1996 was 7.36%. The
weighted average cap strike rate during the three months ended March
31, 1995 was 7.85%. Under these Cap Agreements the Company will receive
11
<PAGE> 12
cash payments should an agreed-upon reference rate, either one-month or
three-month LIBOR, increase above the strike rates of the Cap
Agreements.
Cap Agreements outstanding at March 31, 1996 are as follows:
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS) AVERAGE CAP EXPECTED
NOTIONAL FACE AVERAGE CAP LOW CAP HIGH CAP CAP EXPENSE
YEAR AMOUNT STRIKE RATE STRIKE RATE STRIKE RATE AMORTIZATION
---- ------ ----------- ----------- ----------- ------------
<S> <C> <C> <C> <C> <C>
1996 (last 9 months) $378,151 7.33% 5.50% 12.00% $ 486
1997 254,957 8.02% 5.50% 12.00% 458
1998 110,657 9.12% 7.13% 12.00% 355
1999 82,400 9.49% 7.50% 12.00% 304
2000 52,889 8.95% 7.50% 10.00% 255
2001 33,082 8.55% 7.50% 9.00% 220
2002 24,616 8.68% 8.00% 9.00% 157
2003 22,634 8.67% 8.00% 9.00% 145
2004 21,834 8.67% 8.00% 9.00% 135
2005 5,216 8.53% 8.50% 9.00% 20
------
Total $2,534
======
</TABLE>
Swap Agreements
The Company had one outstanding Swap Agreement at March 31 1996 and
December 31, 1995. The Swap Agreement outstanding at March 31, 1996 and
December 31, 1995 is as follows:
<TABLE>
<CAPTION>
INTEREST RATE
NOTIONAL FACE -----------------------------------
PAYS FIXED/RECEIVES VARIABLE: AMOUNT (IN THOUSANDS) COMPANY PAYS COMPANY RECEIVES
----------------------------------------------------------------
<S> <C> <C> <C>
April 1996 to April 1997 $ 10,000 6.97% 3 Month LIBOR
April 1997 to April 1998 $ 10,000 7.18% 3 Month LIBOR
</TABLE>
The Company has incurred credit risk to the extent that the
counter-parties to the Interest Rate Agreements do not perform their
obligations under the Interest Rate Agreements. Potential credit write
offs are limited to the amortized cost of the Cap Agreements. In
addition, for both Cap and Swap Agreements, if one of the
counter-parties does not perform, the Company would not receive the
cash to which it would otherwise be entitled under the Interest Rate
Agreement. In order to mitigate this risk, the Company has entered into
Interest Rate Agreements only with counter-parties rated A or better
and has entered into Interest Rate Agreements with eight different
counter-parties in order to reduce the risk of credit exposure to any
one counter-party.
There have been no terminations of Interest Rate Agreements as of March
31, 1996 or December 31, 1995.
NOTE 4. REVERSE REPURCHASE AGREEMENTS AND NOTES PAYABLE
The Company has entered into both reverse repurchase agreements and
notes payable (together "Borrowings") to finance acquisitions of a
portion of its Mortgage Assets. These Borrowings are collateralized by
a portion of the Company's Mortgage Assets. At no time are more than
34% of the Borrowings with any one investment banking firm. At March
31, 1996, Mortgage Assets actually pledged had an estimated fair value
of $539,571,815. At December 31, 1995, Mortgage Assets actually pledged
had an estimated fair value of $386,321,449.
At March 31, 1996 the Company had $508,721,000 of Borrowings
outstanding with a weighted average borrowing rate of 5.62% and a
weighted average maturity of 48 days. At December 31, 1995, the Company
had $370,316,047 of Borrowings outstanding with a weighted average
borrowing rate of 6.01% and a weighted
12
<PAGE> 13
average remaining maturity of 74 days. At March 31, 1996 and December
31, 1994, the Borrowings had the following remaining maturities:
<TABLE>
<CAPTION>
(IN THOUSANDS) MARCH 31, 1996 DECEMBER 31, 1995
-------------- -----------------
<S> <C> <C>
Within 30 days $221,555 $ 75,808
30 to 90 days 227,234 175,921
Over 90 days 59,932 118,587
-------- --------
Total Borrowings $508,721 $370,316
======== ========
</TABLE>
For the three months ended March 31, 1996, the average balance of
Borrowings was $435,978,990 with a weighted average interest cost of
5.72%. For the three months ended March 31, 1995 the average balance of
Borrowings was $102,961,000 with a weighted average interest cost of
6.04%. The maximum balance outstanding during the three months ended
March 31, 1996 was $508,721,000. The maximum balance outstanding during
the three months ended March 31, 1995 was $121,998,000.
NOTE 5. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table presents the carrying amounts and estimated fair
values of the Company's financial instruments at March 31, 1996 and
December 31, 1995 . 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
liquidation sale.
<TABLE>
<CAPTION>
MARCH 31, 1996 DECEMBER 31, 1995
-------------- -----------------
CARRYING FAIR CARRYING FAIR
(IN THOUSANDS) AMOUNT VALUE AMOUNT VALUE
------ ----- ------ -----
Assets
<S> <C> <C> <C> <C>
Mortgage Assets $562,922 $562,922 $429,481 $429,481
IO Strips 2,237 2,237 2,763 2,763
Interest Rate Agreements 1,233 1,233 547 547
</TABLE>
Management bases its fair value estimates primarily on third party bid
price indications, such as bid indications provided by dealers who make
markets in these assets and asset valuations made by collateralized
lenders, when such indications are available. However, the fair value
reported reflects estimates and may not necessarily be indicative of
the amounts the Company could realize in a current market exchange.
Cash and cash equivalents, interest receivable, reverse repurchase
agreements and accrued liabilities are reflected in the financial
statements at their amortized costs, which approximates their fair
value because of the short-term nature of these instruments.
NOTE 6. CLASS A CONVERTIBLE PREFERRED STOCK
Prior to the Initial Public Offering the Company was authorized to
issue up to 12,000,000 shares of Preferred Stock, $.01 par value, in
one or more series and to fix the powers, designations, preferences and
rights of each series. The Preferred Stock ranked senior to the
Company's Common Stock as to dividends and liquidation rights.
Following the closing of the Initial Public Offering, the Company filed
Articles Supplementary to reclassify all authorized and unissued shares
of Preferred Stock and all shares of Preferred Stock received upon
conversion of Preferred Stock into Common Stock as authorized and
unissued shares of Common Stock.
NOTE 7. STOCK PURCHASE WARRANTS
At March 31, 1996 and December 31, 1995 there were 1,665,063 and
1,665,063 Warrants outstanding, respectively. Each Warrant entitles the
holder to purchase 1.000667 share of the Company's common stock at an
exercise price of $15.00 per share. The Warrants remain exercisable
until December 31, 1997.
13
<PAGE> 14
NOTE 8. STOCK OPTION PLAN
The Company has adopted a Stock Option Plan for executive officers, key
employees and non-employee directors (the "Stock Option Plan"). The
Stock Option Plan authorizes the Board of Directors (or a committee
appointed by the Board of Directors) to grant "incentive stock options"
as defined under section 422 of the Code ("ISOs"), options not so
qualified ("NQSOs"), deferred stock, restricted stock, performance
shares, stock appreciation rights and limited stock appreciation rights
("Awards") and dividend equivalent rights ("DERs") to such eligible
recipients other than non-employee directors. Non-employee directors
are automatically provided annual grants of NQSOs with DERs pursuant to
a formula under the Stock Option Plan.
The number of shares of Common Stock available under the Stock Option
Plan for options and Awards, subject to certain anti-dilution
provisions, is 500,000 shares of Common Stock. The exercise price for
ISOs granted under the Stock Option Plan may not be less than the fair
market value of shares of Common Stock at the time the ISO is granted.
No options were granted during the three months ended March 31, 1996.
During the year ended December 31, 1995 each of the four non-employee
directors was automatically granted an additional 2,500 NQSOs at an
exercise price of $7.18 per share and employees were granted 156,972
NQSOs at exercise prices ranging from $17.38 to $21.50 per share. On
July 19, 1995, 47,083 options were exercised at prices ranging from
$0.10 to $0.11 per share resulting in proceeds to the Company of
$5,079. During the year ended December 31, 1994 the Company granted
40,000 options at an exercise price of $0.10 per share, 20,000 of which
were NQSOs and 20,000 of which were ISOs, and 148,333 ISOs at an
exercise price of $0.11 per share. All stock options granted under the
Stock Option Plan vest no earlier than ratably over a four year period
from the date of grant and expire within ten years after the date of
grant.
The Company's Stock Option Plan permits NQSOs granted under the plan to
accrue DERs. The first quarter 1996 dividend resulted in non-cash
charges to general and administrative expenses of $84,919 for DERs
accruing on NQSOs outstanding on the record date of the dividend. The
1995 dividends on common stock resulted in non-cash charges to general
and administrative expenses of $54,513 for DERs accruing on NQSOs
outstanding on the record date of the dividend. DERs represent shares
of stock which are issuable to holders of NQSOs when the holders
exercise the underlying NQSOs based on the price of the stock on the
dividend payment date. A total of 6,540 shares have been granted as
DERs as of March 31, 1996. At March 31, 1996 a total of 361,845 of the
500,000 available options had been granted as options or DERs (47,083
of which had been exercised) leaving 138,155 of the options available
for grant.
In October 1995, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 123 "Accounting for
Stock-Based Compensation." Under the provisions of SFAS No. 123,
compensation cost is measured at the grant date based on the fair value
of the award and is recognized over the service period, which is
usually the vesting period. The Company is required to either recognize
compensation expense under this method or to disclose the pro forma net
income and earnings per share effects based on the SFAS No. 123 fair
value methodology. SFAS No. 123 applies to financial statements for
fiscal years beginning after December 15, 1995. The Company will
implement the requirements of SFAS No. 123 in 1996 and will only adopt
the disclosure provisions of this statement; accordingly, this
statement will have no impact on the financial position and the results
of operations when adopted.
NOTE 9. DIVIDENDS
On March 11, 1996 the Company declared a dividend of $2,539,833, or
$0.46 per common share. This dividend was paid on April 19, 1996 to
shareholders of record as of March 29, 1996.
On March 17, 1995, the Company declared a dividend of $333,213, or
$0.20 per preferred share. This dividend was paid on April 21, 1995 to
preferred shareholders of record as of March 31, 1995. On June 19,
1995, the Company declared a dividend of $499,819, or $0.30 per
preferred share. This dividend was paid on July 21, 1995 to preferred
shareholders of record as of June 30, 1995. On September 15, 1995, the
Company declared a dividend of $1,103,264, or $0.20 per common share.
This dividend was paid on October 20, 1995 to
14
<PAGE> 15
common shareholders of record as of September 29, 1995. On December 13,
1995, the Company declared a dividend of $1,434,500, or $0.26 per
common share. This fourth quarter 1995 dividend was paid on January 19,
1996 to common shareholders of record as of December 29, 1995.
Under the Internal Revenue Code of 1986, a dividend declared by a REIT
in December of a calendar year, payable to shareholders of record as of
a specified date in December, will be deemed to have been paid by the
Company and received by the shareholders on that record date if the
dividend is actually paid before February 1st of the following calendar
year. Therefore, the dividends declared in December 1995 and 1994 which
were paid in January 1996 and 1995, respectively, are considered
taxable income to shareholders in the year declared. The Company's
dividends are not eligible for the dividends received deduction for
corporations.
NOTE 10. COMMITMENTS AND CONTINGENCIES
As of March 31, 1996 the Company had entered into a commitment to
purchase a Federal National Mortgage Association Asset for
approximately $8,000,000 and a commitment to purchase a privately
issued Mortgage Asset for approximately $46,500,000. At March 31, 1996
and December 31, 1995, the Company had no other outstanding commitments
to purchase or sell Mortgage Assets or to purchase, sell or terminate
Interest Rate Agreements. The Company also had no commitments to enter
into additional reverse repurchase agreements or other borrowings.
Rental expense for office properties under operating leases for the
three months ended March 31, 1996 and March 31, 1995 was $24,062 and
$15,724, respectively. Future minimum rental commitments as of March
31, 1996 under noncancelable operating leases with initial or remaining
terms of more than one year, are as follows:
<TABLE>
<CAPTION>
(IN THOUSANDS) MINIMUM RENTAL
YEAR ENDING COMMITMENT
DECEMBER 31, AS OF DECEMBER 31, 1995
------------ -----------------------
<S> <C> <C>
1996 72
1997 88
----
Total $160
====
</TABLE>
Because the lease is in the Company's name, the above amounts represent
100% of the minimum future rental commitments. However, the Company
shares certain office expenses, such as lease payments and utilities,
on a pro rata basis with GB Capital. GB Capital is owned by certain
officers of the Company. This arrangement is covered by an
Administrative Services and Facilities Sharing Agreement. For the three
months ended March 31, 1995, the Company was bearing 70% of the lease
expenses and GB Capital was bearing 30%. For the three months ended
March 31, 1996, the Company was bearing 95% of the lease expenses and
GB Capital was bearing 5%.
15
<PAGE> 16
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
Redwood Trust Inc. (the "Company") commenced operations in
August 1994 following the first closing of its private placement of
equity capital. On August 9, 1995, the Company tripled its equity base
through its Initial Public Offering of Common Stock (IPO). On April 19,
1996 the Company raised an additional $54.5 million in equity through a
secondary offering of Common Stock. The Company has grown since its
inception and intends to continue to grow. The operating results and
financial condition of the Company reflect this growth and should be
interpreted accordingly. Performance may differ should the Company
reach a state wherein its asset size is stable and the Company's equity
capital base is fully utilized as described under the Company's
Risk-Adjusted Capital Policy.
The Company is a portfolio lending company which acquires and
manages both single-family real estate mortgage loans which have been
originated to high-quality underwriting standards and securitized
interests in pools of single family mortgage loans (collectively,
"Mortgage Assets"). To date, the Company has acquired Mortgage Assets
secured by single-family real estate properties throughout the United
States, with an emphasis on properties located in the State of
California. Substantially all of the Company's current Mortgage Assets
have coupon rates which adjust over time (subject to certain
limitations and lag periods) in conjunction with changes in short-term
interest rates. The Company may also acquire fixed-rate single-family
Mortgage Assets, multi-family and commercial Mortgage Assets in the
future.
All of the Company's income to date has been net interest
income generated from its Mortgage Assets and its cash balances
("earning assets"). The Company funds its acquisitions of earning
assets with both borrowings and cash raised from issuance of equity
capital. For that portion of the balance sheet funded with equity
capital ("equity-funded lending"), net interest income is primarily a
function of the yield generated from earning assets. Due to the
adjustable-rate nature of its earning assets, management expects that
income from this source will tend to increase as short-term interest
rates rise and will tend to decrease as short-term interest rates fall.
For the portion of the balance sheet made up of earning assets
funded with borrowings ("spread lending"), the Company generates net
interest income to the extent that there is a positive spread between
the yield on earning assets and the cost of borrowed funds and interest
rate agreements. Net interest income from spread lending is a function
of both the spread and the total volume of spread lending assets.
Income from spread lending may fall following an increase in short-term
interest rates. In these conditions, spread lending income may, after a
lag period, be restored to its former level as earning asset yields
adjust to market conditions. Income from spread lending may increase
following a fall in short-term interest rates; this increase may be
temporary as earning asset yields adjust to the new market conditions
after a lag period.
Management believes that in a rising short-term interest rate
environment the net result of these effects on the equity-funded
lending and spread lending portions of the Company's balance sheet may
be, after a lag period, an overall increase in earnings and dividends
relative to what they would have been otherwise. Similarly, the net
result of a falling interest rate environment may be a decrease in
earnings and dividends relative to what they would have been otherwise.
In each case, however, the Company will seek to maintain, after initial
adjustment lags, a constant or widening relationship between the
earnings and dividend yield of the Company and the level of short-term
interest rates.
The Company seeks to generate secular growth in earnings and
dividends per share in a variety of ways, including through (i) issuing
new Common Stock and increasing the size of the balance sheet when
opportunities in the mortgage market are likely to allow growth in
earnings per share, (ii) seeking to improve productivity by increasing
the size of the balance sheet at a rate faster than operating expenses
increase, (iii) changing the mix of Mortgage Asset types on the balance
sheet in an effort to improve risk-adjusted returns, (iv) seeking to
benefit by an increased market value of assets and lower borrowing
costs should Mortgage Asset quality improve with seasoning, mortgage
principal repayments, and improvements in real estate markets and the
general economy, and (v)
16
<PAGE> 17
increasing the efficiency with which the Company utilizes its equity
capital over time by increasing the Company's use of debt when prudent
and by issuing subordinated debt, preferred stock or other forms of
debt and equity.
The Company intends to seek to increase dividends and earnings
per share by continuing to follow its current business strategy. The
Company intends to acquire Mortgage Assets until the asset base has
reached a size wherein the Company's equity capital base is fully
utilized as described under the Company's Risk-Adjusted Capital Policy.
The Company intends to continue its primary focus on the acquisition of
single-family adjustable-rate Mortgage Assets such as high-quality
whole Mortgage Loans and mortgage securities rated AAA and AA. The
Company will seek to increase participation in its Dividend
Reinvestment Plan.
The Company intends to continue to increase its equity capital
base through various offerings. Management will increase its equity
base when it believes existing shareholders are likely to benefit from
such offerings through earnings and dividends per share that may be
increased as compared to the level of earnings and dividends the
Company would likely generate without such offerings.
RESULTS OF OPERATIONS: FIRST QUARTER 1996 VERSUS FIRST QUARTER 1995
REPORTING PERIODS
The 1994 fiscal year ("fiscal 1994") commenced with the start
of Company operations on August 19, 1994 and finished December 31,
1994. Fiscal year 1995 ("1995"), the four quarters of 1995 and the
first quarter of 1996 correspond to their calendar equivalents.
NET INCOME SUMMARY
From the first quarter of 1995 to the first quarter of 1996,
the Company reported significant increases in total dividends, GAAP and
taxable income. Total dividends declared rose from $0.3 million to $2.5
million. GAAP income rose from $0.4 million to $2.0 million. Taxable
income rose from $0.4 million to $2.5 million.
Dividends, GAAP income and taxable income per share also
increased significantly. Quarterly dividends increased by 130%, from
$0.20 per share of Preferred Stock in the first quarter of 1995 to
$0.46 per Common in the first quarter of 1996. GAAP income per share
rose by 68%, from $0.19 to $0.32 over the same period. Taxable income
per share entitled to a dividend rose 84%, from $0.25 to $0.46.
The primary factors driving this growth in dividends and
profits were an increase in the Company's average equity base from
$21.8 million to $68.7 million and an increase in the returns earned on
this equity.
Return on equity increased as net interest income increased
more rapidly than did credit expenses and general and administrative
expenses. On a GAAP basis for the first quarters of 1995 and 1996, net
interest income as a percent of equity increased from 11.54% to 16.25%.
Credit expenses increased from 0.34% to 1.94% of equity and general and
administrative expenses decreased from 3.74% to 2.88% of equity. The
resulting net GAAP return on equity increased by 3.97%, from 7.46% to
11.43%.
On a taxable income basis for the first quarters of 1995 and
1996, net interest income as a percent of equity increased from 11.26%
to 17.28%, while credit expenses remained at 0.00% of equity and
general and administrative expenses decreased from 3.68% to 2.36% of
equity. The resulting net taxable return on equity increased by 7.34%,
from 7.58% to 14.92%.
Net interest income as a percent of equity from the first
quarter of 1995 to the first quarter of 1996 increased for GAAP income
and for taxable as: (i) the yield on the Company's earning assets
increased, thus increasing returns from the equity-funded lending part
of the balance sheet, (ii) spread lending became more profitable as the
Company increased the spread between the yield on earning assets and
the cost of borrowing
17
<PAGE> 18
and hedging, and (iii) the Company increased the amount of its spread
lending activities relative to its equity base (the Company's capital
was closer to being fully employed).
GAAP INCOME AND TAXABLE INCOME
Income as calculated according to generally accepted
accounting principles (GAAP income) differs from income as calculated
for tax purposes (taxable income) for various reasons. This distinction
is important to the Company's shareholders as dividends are based on
taxable income. While the Company does not pay taxes so long as it
meets the REIT requirements, each year the Company completes a
corporate tax form wherein taxable income is calculated as if the
Company were to be taxed. This taxable income level determines the
amount of dividends the Company will pay out over time.
DIFFERENCES BETWEEN GAAP INCOME AND TAXABLE INCOME
The table below summarizes the differences between GAAP income
and taxable income for the first quarters of 1996 and 1995. Interest
income differs due to different methods of calculating the rate of
amortization into income of the discount created when Mortgage Assets
are acquired at a price below the principal value of the mortgages.
Credit expense differs between tax and GAAP methods because the Company
takes credit provisions in order to build a credit reserve for GAAP
whereas only actual credit losses are deducted in calculating taxable
income. General and administrative expenses differ due to differing
treatment of leasehold amortization, certain stock option expenses, and
other items.
TABLE 1
GAAP INCOME AND TAXABLE INCOME
<TABLE>
<CAPTION>
1996 1996 1996 1995 1995 1995
QUARTER 1 QUARTER 1 QUARTER 1 QUARTER 1 QUARTER 1 QUARTER 1
GAAP TAXABLE GAAP/TAX GAAP TAXABLE GAAP/TAX
INCOME INCOME DIFFERENCES INCOME INCOME DIFFERENCES
------ ------ ----------- ------ ------ -----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Interest Income $9,131 $9,306 $175 $2,170 $2,155 $(15)
Interest Expense 6,202 6,202 0 1,533 1,533 0
Interest Rate Agreement Expense 151 151 0 16 16 0
- ------------------------------- ------ ------ ---- ------ ------ ----
Net Interest Income 2,778 2,953 175 621 606 (15)
Credit Expense 332 0 332 18 0 18
General & Administrative Expense 492 404 88 201 198 3
- -------------------------------- ------ ------ ---- ------ ------ ----
Net Income $1,954 $2,549 $595 $ 402 $ 408 $ 6
</TABLE>
INTEREST INCOME AND THE EARNING ASSET YIELD
On average, the Company had $501.7 million in earning assets
during the first three months of 1996 as compared to the $123.2 million
on average for the same time period in 1995. The Company's sole source
of income to date has been the interest income earned from these
earning assets. As a portfolio lender, the Company expects to continue
to rely on interest income as its primary source of income in the
future.
On a GAAP basis, total interest income for the first quarter
rose from $2.2 million in 1995 to $9.1 million in 1996 as the GAAP
yield on earning assets rose from 7.14% to 7.32%. These yields were
0.53% and 1.99% over the average daily six-month LIBOR rate during
those periods.
On a taxable basis, total interest income rose from $2.2
million in the first quarter of 1995 to $9.3 million in 1996 as the
earning asset based increased and the yield on earning assets rose from
7.09% to 7.46%. These yields were 0.48% and 2.13% higher than the
average daily six-month LIBOR interest rate during those periods. The
table below shows the Company's balances of cash and Mortgage
18
<PAGE> 19
on a taxable income and a GAAP basis, and the weighted average yield on
earning assets as compared to the six-month LIBOR rate.
TABLE 2
EARNING ASSET YIELD
<TABLE>
<CAPTION>
GAAP TAXABLE
DAILY YIELD YIELD
GAAP AVERAGE VERSUS TAXABLE VERSUS
GAAP AVERAGE YIELD ON SIX- AVERAGE TAXABLE YIELD ON AVERAGE
INTEREST EARNING EARNING MONTH SIX-MONTH INTEREST EARNING SIX-MONTH
INCOME ASSETS ASSETS LIBOR LIBOR INCOME ASSETS LIBOR
------ ------ ------ ----- ----- ------ ------ -----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 1,296 $ 56,361 6.31% 6.03% 0.28% $ 1,267 6.17% 0.14%
1995, Quarter 1 2,170 123,196 7.14% 6.61% 0.53% 2,155 7.09% 0.48%
1995, Quarter 2 2,961 161,164 7.37% 6.16% 1.21% 2,996 7.46% 1.30%
1995, Quarter 3 3,985 211,310 7.48% 5.88% 1.60% 4,034 7.57% 1.69%
1995, Quarter 4 6,610 367,448 7.14% 5.74% 1.40% 6,716 7.25% 1.51%
1996, Quarter 1 9,131 501,749 7.32% 5.33% 1.99% 9,306 7.46% 2.13%
</TABLE>
The majority of the Company's Mortgage Assets have coupons
which adjust up and down as a function of changes in the six-month
LIBOR rate, which is the benchmark short-term interest rate the Company
uses when evaluating the yield performance of its assets. LIBOR is the
London Inter-Bank Offered Rate and represents the wholesale funding
rates of international money center banks when they borrow from each
other in U.S. dollars. It is closely related to the rate on large
certificates of deposit (CDs) offered by U.S. domestic banks. For the
first three months of 1995, the average six-month LIBOR rate was 6.61%;
for the first three months of 1996, the average six-month LIBOR rate
was 5.33%
The Company was able to increase its earning asset yield
despite the decrease in short term interest rates as (i) the Company
acquired assets with higher yields during 1995, (ii) the coupon rate on
low-initial-coupon ("teaser") adjustable-rate mortgages acquired during
fiscal 1994 and early 1995 had time to adjust upwards towards the full
potential coupon rate, and (iii) short-term interest rates generally
declined. Declines in short-term interest rates generally have a
temporary positive effect on the earning asset yield relative to LIBOR
as there is a lag in the adjustment of Mortgage Asset coupons to market
conditions.
The mortgage principal repayment rate for the Company was 9%
in the first quarter of 1995 and 26% in the first quarter of 1996. The
principal repayment rate was similar for the Company's assets acquired
at a premium and those acquired at a discount throughout these periods.
Economically, the Company may have benefited from the increase in the
rate of mortgage principal repayment for a variety of reasons,
including that the Company has had a greater balance of discount than
premium. Nevertheless, faster principal repayments had a negative
effect on the Company's earning asset yield due to the Company's
treatment of premium and discount amortization. The Company adjusts its
rate of premium amortization monthly based on actual principal
repayments received. For discounts, however, the Company's amortization
schedules are determined using a fixed principal repayment rate
assumption which would be changed only if the Company believed that
long-term mortgage principal repayment rates had changed. As a result,
premium amortization accelerates as compared to discount amortization
as the rate of principal repayment increases. This lowers the earning
asset yield and reported earnings. Another result of the faster premium
amortization rate in the latter part 1995 and thus far in 1996 is that
the Company has a larger net discount balance on its balance sheet at
this time than it would have otherwise. This discount balance (net of
the effect of any credit losses) will be amortized into income over
time, thus benefiting future income.
The Company may acquire new Mortgage Assets with coupons that
are initially low relative to prevailing short-term interest rates. As
a result, the overall earning asset yield relative to six-month LIBOR
may be temporarily lower during periods of rapid asset growth such as
the Company has experienced following its various equity offerings.
19
<PAGE> 20
In addition to Mortgage Assets with coupons linked to the
six-month LIBOR index, the Company also acquires assets with coupons
linked to the one-year Treasury Bill rate, the one-month LIBOR rate,
the six-month bank CD rate, and other indices. To the extent these
other indices rise or fall relative to six-month LIBOR, the Company's
earning asset yield versus six-month LIBOR would also rise or fall over
time.
INTEREST EXPENSE AND THE COST OF FUNDS
The Company's largest expense is the cost of borrowed funds.
From the first quarter of 1995 and 1996, interest expense increased
from $1.5 million to $6.2 million as average borrowed funds rose from
$103.0 million to $436.0 million. The average cost of funds during
these two periods fell from 6.04% to 5.72%. Interest expense is
calculated in the same manner for GAAP and tax purposes.
The Company's cost of funds was 57 basis points under the
average daily six-month LIBOR rate in the first quarter of 1995 but was
39 basis points over the average six-month LIBOR rate in the first
quarter of 1996. The cost of funds in the first quarter of 1995
benefited from an extension of liabilities in late 1994. In addition,
the cost of funds was higher relative to short-term interest rates in
the first quarter of 1996 due to acquisitions during 1995 and 1996 of
whole Mortgage Loans and other assets with higher funding costs, due to
falling short-term interest rates, and due to a significant increase in
the one-month LIBOR rate relative to the six-month LIBOR rate. The bulk
of the Company's borrowings in 1995 and in the first quarter of 1996
had monthly interest rate resets, so changes in the Company's cost of
funds have been more highly correlated with changes in the one-month
LIBOR rate than with the six-month LIBOR rate. By basing the bulk of
its borrowings on one-month LIBOR, the Company benefited in 1995 and
the first quarter of 1996 relative to a strategy of using longer-term
borrowings.
The following table shows the Company's cost of funds as
compared to the average daily six-month LIBOR rate.
TABLE 3
COST OF FUNDS
<TABLE>
<CAPTION>
GAAP COST OF ONE-MONTH
AND FUNDS AVERAGE LIBOR
AVERAGE TAXABLE VERSUS SIX- RELATIVE TO
BORROWED INTEREST COST OF SIX-MONTH MONTH SIX-MONTH
FUNDS EXPENSE FUNDS LIBOR LIBOR LIBOR
----- ------- ----- ----- ----- -----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 37,910 $ 760 5.50% (0.53%) 6.03% (0.51%)
1995, Quarter 1 102,961 1,533 6.04% (0.57%) 6.61% (0.56%)
1995, Quarter 2 139,979 2,191 6.28% 0.12% 6.16% (0.08%)
1995, Quarter 3 159,794 2,432 6.04% 0.16% 5.88% 0.01%
1995, Quarter 4 295,089 4,452 5.99% 0.25% 5.74% 0.11%
1996, Quarter 1 435,979 6,202 5.72% 0.39% 5.33% 0.10%
</TABLE>
NET INTEREST RATE AGREEMENT EXPENSE
As part of its asset/liability management process, the Company
enters into interest rate agreements such as interest rate caps and
interest rate swaps ("hedges"). These agreements are used solely to
reduce interest rate risk. The agreements are designed to provide
income and capital appreciation to the Company in the event that
short-term interest rates rise quickly (see Footnote 3 to the Financial
Statements).
The net interest rate agreement expense, or hedging expense,
equals income from these agreements less the associated expense and is
calculated in the same manner for GAAP and tax. The net interest rate
agreement expense was $15,592 in the first quarter of 1995 and $151,232
in the first quarter of 1996. As a percentage of average earning
assets, the net hedging expense equaled 0.05% in the first three months
of 1995 and 0.12% for
20
<PAGE> 21
the same period in 1996. As a percentage of average borrowings, the net
hedging expense equaled 0.06% in the first quarter of 1995 and 0.16% in
the first quarter of 1996. The primary reason hedging expenses
increased as a percentage of assets and borrowings was that in early
1995 the Company focused primarily on hedging future periods (as
reflected in higher hedging expenses in mid-1995) while relying on the
extension of borrowings to protect income in the short-term. In early
1996, the Company utilized primarily one-month borrowings and thus
focused on hedging both current and future periods.
Net interest rate agreement expense as a percentage of assets
and borrowings has generally declined since mid-1995 due to a flatter
yield curve and lower levels of interest rate volatility.
TABLE 4
NET INTEREST RATE AGREEMENT EXPENSE
<TABLE>
<CAPTION>
INTEREST RATE INTEREST RATE NET INTEREST NET EXPENSE NET EXPENSE
AGREEMENT AGREEMENT RATE AGREEMENT AS % OF AS % OF AVERAGE
INCOME EXPENSE EXPENSE AVERAGE ASSETS BORROWINGS
------ ------- ------- -------------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Fiscal 1994 $ 0 $ 8 $ 8 0.04% 0.06%
1995, Quarter 1 0 16 16 0.05% 0.06%
1995, Quarter 2 0 82 82 0.20% 0.23%
1995, Quarter 3 0 112 112 0.21% 0.28%
1995, Quarter 4 0 129 129 0.14% 0.17%
1996, Quarter 1 0 151 151 0.12% 0.14%
</TABLE>
NET INTEREST INCOME FROM EQUITY-FUNDED LENDING AND SPREAD LENDING
For the purpose of analyzing net interest income, the Company
has divided its balance sheet activities into two parts: equity-funded
lending and spread lending. Each of these two portions of the Company's
balance sheet has a different dynamic with respect to changes in
interest rates, asset/liability strategy, growth, and other factors.
Spread lending is that part of the Company's business wherein
earning assets are funded with borrowings. Profits from spread lending
are a function of the volume of spread lending assets and the spread
the Company earns between its average earning asset rate and the cost
of borrowed funds and interest rate hedging agreements. In the first
quarter of 1996, the Company earned 57% of its GAAP net interest income
from spread lending.
Equity-funded lending is that part of the Company's business
wherein earning assets are funded with cash received from the issuance
of equity capital. Profits from equity-funded lending are a function of
the average yield on earning assets and the percentage of the Company's
equity base which is invested in earning assets. In the first quarter
of 1996, the Company earned 43% of its GAAP net interest income from
equity-funded lending.
Management believes equity-funded lending has a large
influence on the Company's profitability relative to financial
institutions which have lower equity-to-asset ratios and relative to
financial institutions which have intangible capital or have
significant amounts of non-earning assets or net working capital on
their books. For example, in the first quarter of 1996 approximately
96% of the Company's equity was invested in earning assets.
When analyzing the profitability of equity-funded lending and
spread lending, the Company does not assign specific assets to each
type of lending, but rather assumes that one portion of aggregate
earning assets is funded with equity and another portion of the
aggregate earning assets is funded with borrowings. The Company assigns
all borrowing and hedging costs to spread lending and assigns all
non-earning assets to equity-funded lending.
21
<PAGE> 22
SPREAD LENDING PROFITABILITY
On a GAAP basis, spread lending profits increased from $0.3
million in the first quarter of 1995 to $1.6 million in the first
quarter of 1996. The total amount of spread lending undertaken by the
Company increased from $103.0 million to $436.0 million over this time
frame.
The spread earned, or spread lending profits divided by spread
lending assets, increased from 1.04% in the first quarter of 1995 to
1.46% in the first quarter of 1996. The amount of spread lending
relative to the size of the Company's equity base increased from 4.72
times to 6.34 times. As a result of the increase in spread and the
increase in the relative amount of spread lending, the contribution of
spread lending to the Company's GAAP return on equity increased from
4.92% in the first quarter of 1995 to 9.25% in the first quarter of
1996.
The table below shows the components making up the Company's
spread as calculated on a GAAP basis, the ratio of spread lending
assets to equity, and the contribution made to return on equity from
spread lending net interest income.
TABLE 5
GAAP SPREAD LENDING PROFITABILITY
<TABLE>
<CAPTION>
GAAP
EARNING GAAP GAAP
ASSET COST NET NET SPREAD SPREAD
YIELD FOR OF INTEREST INTEREST LENDING LENDING
SPREAD FUNDS RATE INCOME ASSETS INCOME
LENDING VS. VS. SIX- AGREEMENT SPREAD FROM OVER OVER
SIX-MONTH MONTH EXPENSE/ GAAP LENDING SPREAD AVERAGE AVERAGE
LIBOR LIBOR BORROWINGS SPREAD ASSETS LENDING EQUITY EQUITY
----- ----- ---------- ------ ------ ------- ------ ------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 0.45% (0.53%) (0.06%) 0.92% $ 37,910 $ 127 1.94x 1.78%
1995, Quarter 1 0.53% (0.57%) (0.06%) 1.04% 102,961 265 4.72 4.92%
1995, Quarter 2 1.21% 0.12% (0.23%) 0.86% 139,979 299 6.20 5.32%
1995, Quarter 3 1.60% 0.16% (0.28%) 1.16% 159,794 469 3.08 3.59%
1995, Quarter 4 1.40% 0.25% (0.17%) 0.98% 295,456 727 4.10 4.01%
1996, Quarter 1 1.99% 0.39% (0.14%) 1.46% 435,979 1,581 6.34 9.25%
</TABLE>
On a taxable income basis, the Company's spread widened from
0.99% in the first quarter of 1995 to 1.60% in the first quarter of
1996. The contribution of spread lending to the Company's taxable
return on equity increased from 4.68% to 10.14%.
The table below shows the components making up the Company's
spread as calculated on a taxable income basis, the ratio of spread
lending assets to equity, and the contribution made to return on equity
from spread lending net interest income.
22
<PAGE> 23
TABLE 6
TAXABLE SPREAD LENDING PROFITABILITY
<TABLE>
<CAPTION>
TAXABLE
EARNING TAXABLE SPREAD
ASSET COST NET NET SPREAD LENDING
YIELD FOR OF INTEREST INTEREST LENDING TAXABLE
SPREAD FUNDS RATE INCOME ASSETS INCOME
LENDING VS. VS. SIX- AGREEMENT SPREAD FROM OVER OVER
SIX-MONTH MONTH EXPENSE/ TAXABLE LENDING SPREAD AVERAGE AVERAGE
LIBOR LIBOR BORROWINGS SPREAD ASSETS LENDING EQUITY EQUITY
----- ----- ---------- ------ ------ ------- ------ ------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 0.30% (0.53%) (0.06%) 0.77% $ 37,910 $ 106 1.94x 1.48%
1995, Quarter 1 0.48% (0.57%) (0.06%) 0.99% 102,961 252 4.72 4.68%
1995, Quarter 2 1.30% 0.12% (0.23%) 0.95% 139,979 330 6.20 5.87%
1995, Quarter 3 1.69% 0.16% (0.28%) 1.25% 159,794 505 3.08 3.87%
1995, Quarter 4 1.51% 0.25% (0.17%) 1.09% 295,456 813 4.10 4.48%
1996, Quarter 1 2.13% 0.39% (0.14%) 1.60% 435,979 1,733 6.34 10.14%
</TABLE>
EQUITY-FUNDED LENDING PROFITABILITY
The bulk of the cash the Company has received from its equity
offerings has been invested directly into earning assets. Since the
Company has not borrowed funds to acquire these equity-funded earning
assets, the yield earned goes directly into net interest income. Equity
also funds a small amount of non-earning assets such as leasehold
improvements and net working capital. In the first quarter of 1995, 93%
of equity was invested in earning assets. In the first quarter of 1996,
96% of equity was invested in earning assets.
The contribution to return on equity from equity-funded
lending on a GAAP basis was 6.62% in the first quarter of 1995 and
7.00% in the first quarter of 1996. On a taxable basis, the
contribution to return on equity from equity-funded lending was 6.58%
and 7.14% for these periods, respectively. Equity-funded profitability
increased due to increasing earning asset yields and to an increasing
percentage of equity invested in earning assets. The table below
summarizes the Company's equity-funded lending profitability.
TABLE 7
EQUITY-FUNDED LENDING PROFITABILITY
<TABLE>
<CAPTION>
GAAP TAXABLE
EQUITY- EQUITY-
GAAP FUNDED TAXABLE FUNDED
PERCENT EARNING GAAP NET EARNING TAXABLE NET
OF ASSET EQUITY- INTEREST ASSET EQUITY- INTEREST
EQUITY EQUITY- YIELD FOR FUNDED INCOME YIELD FOR FUNDED INCOME
INVESTED IN FUNDED EQUITY- NET AS % OF EQUITY- NET AS % OF
AVERAGE EARNING EARNING FUNDED INTEREST AVERAGE FUNDED INTEREST AVERAGE
EQUITY ASSETS ASSETS LENDING INCOME EQUITY LENDING INCOME EQUITY
------- ----------- ------- --------- -------- -------- --------- -------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $19,584 94% $18,451 5.96% $ 401 5.62% 5.86% $ 394 5.52%
1995, Quarter 1 21,820 93% 20,236 7.14% 356 6.62% 7.09% 354 6.58%
1995, Quarter 2 22,561 94% 21,185 7.37% 389 6.92% 7.46% 394 7.00%
1995, Quarter 3 51,868 99% 51,516 7.48% 972 7.43% 7.57% 983 7.52%
1995, Quarter 4 71,991 100% 71,991 7.14% 1,301 7.17% 7.25% 1,322 7.28%
1996, Quarter 1 68,743 96% 65,788 7.32% 1,197 7.00% 7.46% 1,220 7.14%
</TABLE>
TOTAL NET INTEREST INCOME
Net interest income equals interest income less interest
expense and net interest rate agreement expense. Net interest income is
the total profit before credit and operating expenses generated both by
equity-funded earning assets and by spread lending. GAAP net interest
income increased from $0.6 million in the first quarter
23
<PAGE> 24
of 1995 to $2.8 million in the first quarter of 1996. Taxable net
interest income increased from $0.6 million to $3.0 million over the
same period.
The net interest margin equals net interest income as a
percentage of average assets. The net interest margin on a GAAP taxable
basis was 2.00% in the first three months of 1995 and 2.20% for the
same period of 1996. The net interest margin on a taxable basis was
1.96% in the first quarter of 1995 and 2.34% in the first quarter of
1996.
Net interest income as a percent of equity on a GAAP basis
increased from 11.54% in the first quarter of 1995 to 16.25% in the
first quarter of 1996. On a taxable basis, net interest income as a
percent of equity increased from 11.26% to 17.28%. These significant
increases in profitability were primarily a result of an increase in
spread lending profitability, although equity-funded lending
profitability increased as well.
TABLE 8
NET INTEREST INCOME
<TABLE>
<CAPTION>
GAAP TAXABLE
GAAP EQUITY- TAXABLE EQUITY-
SPREAD FUNDED GAAP SPREAD FUNDED TAXABLE
LENDING LENDING NET LENDING LENDING NET
GAAP GAAP INCOME INCOME INTEREST TAXABLE TAXABLE INCOME INCOME INTEREST
NET NET AS A % OF AS A % OF INCOME/ NET NET AS % OF AS % OF INCOME/
INTEREST INTEREST AVERAGE AVERAGE AVERAGE INTEREST INTEREST AVERAGE AVERAGE AVERAGE
INCOME MARGIN EQUITY EQUITY EQUITY INCOME MARGIN EQUITY EQUITY EQUITY
-------- -------- --------- --------- -------- -------- -------- ------- ------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 528 2.51% 1.78% 5.62% 7.40% $ 500 2.37% 1.48% 5.52% 7.00%
1995, Quarter 1 621 2.00% 4.92% 6.62% 11.54% 606 1.96% 4.68% 6.58% 11.26%
1995, Quarter 2 688 1.69% 5.32% 6.92% 12.24% 724 1.77% 5.87% 7.00% 12.87%
1995, Quarter 3 1,442 2.67% 3.59% 7.43% 11.02% 1,488 2.76% 3.87% 7.52% 11.39%
1995, Quarter 4 2,029 2.16% 4.01% 7.17% 11.18% 2,135 2.28% 4.48% 7.28% 11.76%
1996, Quarter 1 2,778 2.20% 9.25% 7.00% 16.25% 2,953 2.34% 10.14% 7.14% 17.28%
</TABLE>
GAINS AND LOSSES ON SALE
To date, the Company has not sold Mortgage Assets or interest
rate agreements. Should the Company sell Mortgage Assets in the future,
the difference between the sale price and the historical amortized cost
of the Mortgage Asset would be a realized gain or loss and would
increase or decrease income accordingly. The gain or loss may differ
for GAAP and tax purposes and the sale price may differ from the
asset's carrying value on the Company's balance sheet. Depending on
circumstances, realized gains or losses on the sale of interest rate
agreements may be realized as income immediately or may be amortized
over time. The Company does not expect to sell assets on a frequent
basis, but may sell existing assets and interest rate agreements in
order to acquire new assets that management believes might have higher
risk-adjusted returns or to manage its balance sheet as part of its
asset/liability management process.
CREDIT EXPENSES
In the first quarter of 1995, the Company's GAAP provision for
credit losses was $18,436 and the Company experienced no actual credit
losses. In the first quarter of 1996, credit expenses for GAAP were
$331,516 and the Company experienced no actual credit losses. Since the
Company's inception in 1994, the Company has taken credit provisions of
$825,226 and has experienced $3,997 in actual credit losses.
In 1995, the Company started making regular allowances for
credit losses. The Company has experienced insignificant credit losses
to date, but losses may be experienced on its Mortgage Assets in the
future. This is particularly true for below-BBB rating equivalent
assets and whole Mortgage Loans. The Company regularly evaluates the
potential for future credit losses by analyzing each of its Mortgage
Securities and whole Mortgage Loans. The Company's method for assessing
potential credit loss analyzes both the
24
<PAGE> 25
probability of a default resulting in loss and the loss severity, or
potential amount of such loss. To assess the probability of default,
the Company monitors the delinquency and foreclosure statistics for the
pools of loans underlying its Mortgage Securities and for its Mortgage
Loans. The Company applies certain factors to such statistics,
depending on the characteristics of the loans involved, current and
projected economic conditions and other considerations, to calculate
expected default levels. The Company then applies an expected loss per
default factor to the default levels to produce an aggregate loss
severity, or expected loss per pool of loans. The probability of loss
to each of the Company's Mortgage Assets is then estimated, based on
the credit support available for such asset, the risk of non-pro rata
losses being incurred and any other pertinent factors. Based on such
review, an allowance for credit losses is taken if appropriate in
management's judgment.
The IRS does not allow corporations to reduce taxable income
by taking credit provisions. Only actual realized credit losses are
deducted from taxable income. As a result, the credit expense for GAAP
will exceed the credit expense for taxable income in years when credit
provisions exceed actual charge-offs; actual charge-offs could exceed
credit provisions in the future, in which case the taxable income
credit expense would exceed the GAAP credit expense.
With respect to whole Mortgage Loans (unsecuritized mortgage
loans), the Company's current practice is to maintain a credit reserve
equal to thirty basis points (0.30%) of the historical amortized cost
of the loans. The Company anticipates that reserves will be maintained
at this level unless the credit outlook for the loans deteriorates.
Through March 31, 1996, the Company had experienced no actual credit
losses on whole Mortgage Loans.
With respect to securitized Mortgage Assets rated BBB or
better, the Company takes no GAAP credit provisions unless the credit
quality of an asset has deteriorated to a point where the Company
believes a credit provision would be warranted. The Company has not
taken any GAAP credit provisions for such assets nor have there been
any credit losses.
With respect to securitized Mortgage Assets which have credit
ratings below BBB or, if unrated, an equivalent credit quality, the
Company takes on-going credit provisions against GAAP income. In
reviewing the adequacy of the level of credit reserves for these
assets, the Company reviews the level of 90+ day delinquencies in the
mortgage pools, estimates the likely percentage of delinquencies that
will result in default, and estimates the likely percentage of
principal loss per defaulted loan to determine the aggregate loss
severity. After taking into consideration the benefit of any
third-party credit enhancements and the level of the Company's
historical amortized cost for the asset, the Company makes an estimate
of possible future realized credit losses. In the first quarter of
1995, GAAP credit provisions for these assets were $18,436 while actual
credit losses were zero. In the first quarter of 1996, GAAP credit
provisions for these assets were $336,258 while actual credit losses
were zero. The increase in credit provisions from the first three
months of 1995 to the same period of 1996 was due to an increase in the
amount of these assets the Company owned during these periods.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses ("operating expense" or
"G&A expense") increased from $201,265 in the first quarter of 1995 to
$491,971 in the first quarter of 1996 as measured for GAAP income. For
taxable income, G&A expense increased from $197,987 in the first
quarter of 1995 to $403,958 in the first quarter of 1996. Differences
in the methods of calculating G&A expenses for GAAP and taxable income
arise from the treatment of leasehold expenses, certain stock option
costs, and other expense items. G&A expenses increased from the first
three months of 1995 to the first three months of 1996 as the number of
employees and the scope of the Company's operations increased and as
certain officers' salaries grew as a function of the increase in the
size of the Company's equity base.
25
<PAGE> 26
TABLE 9
GENERAL AND ADMINISTRATIVE EXPENSES
<TABLE>
<CAPTION>
GAAP GAAP TAXABLE TAXABLE
CASH STOCK GAAP TOTAL CASH STOCK TAXABLE TOTAL
COMP AND OPTION OTHER GAAP COMP AND OPTION OTHER TAXABLE
BENEFITS AND DER G&A G & A BENEFITS AND DER G&A G & A
EXPENSE EXPENSE EXPENSE EXPENSE EXPENSE EXPENSE EXPENSE EXPENSE
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 63 $ 0 $ 83 $146 $ 63 $ 0 $ 83 $146
1995, Quarter 1 81 0 120 201 81 0 117 198
1995, Quarter 2 81 0 117 198 81 0 114 195
1995, Quarter 3 197 7 160 364 197 55 156 408
1995, Quarter 4 103 47 218 368 103 0 214 317
1996, Quarter 1 233 85 174 492 233 0 171 404
</TABLE>
The Company has grown rapidly since its inception in 1994 and
the increases in G&A expenses reflect such growth. However, the
Company's operating expenses have not grown as rapidly as its income,
assets, equity or number of employees have increased. From the first
quarter of 1995 to the first quarter of 1996, the Company's efficiency
ratio (G&A expense as a percentage of net interest income) decreased
from 32% to 18% on a GAAP basis and from 33% to 14% on a taxable basis.
The ratio of G&A expenses to average assets declined from 0.65% to
0.39% on a GAAP basis and from 0.64% to 0.32% on a taxable basis over
the same time frame.
From the first quarter of 1995 to the first quarter of 1996,
the ratio of G&A expenses to average equity decreased from 3.74% to
2.88% on a GAAP basis and from 3.68% to 2.36% on a taxable basis.
Management considers this ratio to be the most important measure of the
Company's productivity. Average assets per employee rose from $25
million in the first quarter of 1995 to $69 million in the first
quarter of 1996. The Company had five employees at March 31, 1995 and
nine employees at March 31, 1996.
TABLE 10
OPERATING EXPENSE RATIOS
<TABLE>
<CAPTION>
AVERAGE
GAAP TAXABLE ASSETS PER
GAAP TAXABLE GAAP TAXABLE G&A EXP/ G&A EXP/ AVERAGE # OF
EFFICIENCY EFFICIENCY G&A EXP/ G&A EXP/ AVERAGE AVERAGE EMPLOYEES
RATIO RATIO AVE ASSETS AVE ASSETS EQUITY EQUITY ($MM)
---------- ---------- ---------- ---------- ------- ------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 28% 29% 0.69% 0.69% 2.05% 2.05% $ 12
1995, Quarter 1 32% 33% 0.65% 0.64% 3.74% 3.68% 25
1995, Quarter 2 29% 27% 0.49% 0.48% 3.52% 3.47% 33
1995, Quarter 3 25% 27% 0.67% 0.76% 2.79% 3.12% 39
1995, Quarter 4 18% 15% 0.39% 0.34% 2.03% 1.75% 53
1996, Quarter 1 18% 14% 0.39% 0.32% 2.88% 2.36% 69
</TABLE>
The Company expects its G&A expenses to increase in the
subsequent quarters of 1996. Compensation expenses will rise with the
planned addition of at least one new employee and because certain
compensation expenses will increase automatically as a result of the
Company's April 1996 equity offering. With these salary increases,
certain officers' salaries will have reached their "salary cap" and
will grow in the future only as a function of the consumer price index.
Despite anticipated increases in future operating expenses, management
believes that the Company's operating expenses are likely over time to
continue to grow at a slower rate than its asset or equity base and
thus management believes that the Company's operating expense ratios
are likely to continue to improve over time should the Company grow.
26
<PAGE> 27
NET INCOME AND RETURNS ON EQUITY AND ASSETS
GAAP net income increased from $0.4 million in the first
quarter of 1995 to $2.0 million in the first quarter of 1996. GAAP
return on equity increased from 7.46% to 11.43%. Taxable net income
increased from $0.4 million in the first quarter of 1995 to $2.5
million in the first quarter of 1996. Return on equity as measured for
taxable income increased from 7.58% to 14.92%.
TABLE 11
COMPONENTS OF RETURN ON EQUITY
<TABLE>
<CAPTION>
GAAP GAAP TAXABLE TAXABLE
NET GAAP GENERAL NET TAXABLE GENERAL
INTEREST CREDIT & ADMIN GAAP INTEREST CREDIT & ADMIN TAXABLE
GAAP INCOME/ EXPENSE/ EXPENSE/ RETURN TAXABLE INCOME/ EXPENSE/ EXPENSE/ RETURN
NET AVERAGE AVERAGE AVERAGE ON NET AVERAGE AVERAGE AVERAGE ON
INCOME EQUITY EQUITY EQUITY EQUITY INCOME EQUITY EQUITY EQUITY EQUITY
------ -------- -------- -------- ------ ------- -------- -------- -------- -------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 382 7.40% 0.00% 2.05% 5.35% $ 353 7.00% 0.00% 2.05% 4.95%
1995, Quarter 1 402 11.54% 0.34% 3.74% 7.46% 408 11.26% 0.00% 3.68% 7.58%
1995, Quarter 2 449 12.24% 0.72% 3.52% 8.00% 528 12.87% 0.00% 3.47% 9.40%
1995, Quarter 3 994 11.02% 0.64% 2.79% 7.59% 1,082 11.39% 0.00% 3.12% 8.27%
1995, Quarter 4 1,310 11.18% 1.93% 2.03% 7.22% 1,814 11.76% 0.02% 1.75% 9.99%
1996, Quarter 1 1,954 16.25% 1.94% 2.88% 11.43% 2,549 17.28% 0.00% 2.36% 14.92%
</TABLE>
The Company's GAAP return on assets increased from 1.30% in
the first quarter of 1995 to 1.55% in the first quarter of 1996. The
Company's taxable return on assets increased from 1.32% in the first
three months of 1995 to 2.02% in the first three months of 1996.
TABLE 12
COMPONENTS OF RETURN ON ASSETS
<TABLE>
<CAPTION>
GAAP
COST OF
FUNDS
GAAP AND GAAP GAAP GAAP
INTEREST HEDGING GAAP CREDIT G&A RETURN
INCOME/ EXPENSE NET PRVSN/ EXP./ ON
AVERAGE AVERAGE INTEREST AVERAGE AVERAGE AVERAGE
ASSETS ASSETS MARGIN ASSETS ASSETS ASSETS
-------- ------- -------- ------- ------- -------
<S> <C> <C> <C> <C> <C> <C>
Fiscal 1994 6.15% (3.64%) 2.51% (0.00%) (0.69%) 1.82%
1995, Quarter 1 7.00% (5.00%) 2.00% (0.05%) (0.65%) 1.30%
1995, Quarter 2 7.26% (5.57%) 1.69% (0.10%) (0.49%) 1.10%
1995, Quarter 3 7.38% (4.71%) 2.67% (0.16%) (0.67%) 1.84%
1995, Quarter 4 7.05% (4.89%) 2.16% (0.37%) (0.39%) 1.40%
1996, Quarter 1 7.24% (5.04%) 2.20% (0.26%) (0.39%) 1.55%
<CAPTION>
TAXABLE
COST OF
FUNDS
TAXABLE AND TAXABLE TAXABLE TAXABLE
INTEREST HEDGING TAXABLE CREDIT G&A RETURN
INCOME/ EXPENSE NET PRVSN/ EXP./ ON
AVERAGE AVERAGE INTEREST AVERAGE AVERAGE AVERAGE
ASSETS ASSETS MARGIN ASSETS ASSETS ASSETS
-------- ------- -------- ------- ------- -------
<S> <C> <C> <C> <C> <C> <C>
Fiscal 1994 6.01% (3.64%) 2.37% (0.00%) (0.69%) 1.68%
1995, Quarter 1 6.96% (5.00%) 1.96% (0.00%) (0.64%) 1.32%
1995, Quarter 2 7.34% (5.57%) 1.77% (0.00%) (0.48%) 1.29%
1995, Quarter 3 7.47% (4.71%) 2.76% (0.00%) (0.76%) 2.00%
1995, Quarter 4 7.17% (4.89%) 2.28% (0.00%) (0.34%) 1.94%
1996, Quarter 1 7.38% (5.04%) 2.34% (0.00%) (0.32%) 2.02%
</TABLE>
DIVIDENDS AND TAXABLE INCOME
The Company intends to declare and pay out as dividends 100%
of its taxable income over time. The Company's current practice is to
declare quarterly dividends per share immediately following the regular
March, June, September, and December Board meetings. In general, the
Company has endeavored to declare a quarterly dividend per share which
would result in the distribution of most or all of the taxable income
earned in that quarter. This is not an exact process, however; at the
time of the dividend announcement neither the total level of taxable
income for the quarter nor the number of shares that will be
outstanding and eligible to receive a dividend at quarter end are
known. In addition, considerations other than the desire to pay out
most of the taxable earnings for a quarter may take precedence when the
Board determines the level of dividends. The
27
<PAGE> 28
Company's quarterly dividend payments are likely to be irregular, as
they will rise and fall with trends in taxable income and other
factors.
To date, the Company has been cautious with its dividend per
share declaration for a variety of reasons, including the fact that the
Company does not know at the time of declaration what taxable earnings
for the quarter will be or, due to possible Warrant exercises, how many
share of Common Stock will outstanding at the record date. The result
is that the Company has earned taxable income exceeding dividends
declared. On a cumulative basis through March 31, 1996, this
undistributed taxable income is $472,703.
TABLE 13
DIVIDEND SUMMARY
<TABLE>
<CAPTION>
PREFERRED OR TAXABLE NET
COMMON INCOME PER
SHARES SHARE DIVIDEND CUMULATIVE
TAXABLE ELIGIBLE ELIGIBLE PER DIVIDEND UNDISTRIBTD UNDISTRIBTD
NET TO RECEIVE TO RECEIVE SHARE TOTAL PAY-OUT TAXABLE TAXABLE
INCOME DIVIDENDS DIVIDENDS DECLARED DIVIDEND RATIO INCOME INCOME
------- ------------- ---------- -------- -------- -------- ----------- -----------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 353 1,401,904 $ 0.25 $ 0.25 $ 350 99% $ 3 $ 3
1995, Quarter 1 408 1,666,063 0.25 0.20 333 82% 75 78
1995, Quarter 2 528 1,666,063 0.32 0.30 500 95% 28 106
1995, Quarter 3 1,082 5,516,313 0.20 0.20 1,103 102% (21) 85
1995, Quarter 4 1,814 5,517,299 0.33 0.26 1,435 79% 379 464
1996, Quarter 1 2,548 5,521,376 0.46 0.46 2,540 100% 9 473
</TABLE>
DIFFERENCES BETWEEN PRIMARY EARNINGS PER SHARE AND DIVIDENDS
DECLARED
The Company's earnings per share (EPS) for the first quarter
of 1996 of $0.32 was lower than the Company's dividend declaration of
$0.46 per share. The number of shares used to calculate EPS is larger
than the number of shares entitled to a dividend due to the Company's
warrants and options; this factor accounted for $0.03 of the difference
between EPS and dividends. The remaining gap of $0.11 was caused by
GAAP/taxable income differences in credit expenses ($0.06 per share),
amortization ($0.03 per share), and G&A expenses ($0.02 per share).
The Company's earnings per share for the first quarter of 1995
of $0.19 was lower than the dividends declared of $0.20 per share. The
taxable income earned during the quarter was $0.25 per share entitled
to a dividend; the undistributed taxable income was held by the Company
for distribution at a later date. The gap between the EPS of $0.19 and
the taxable earnings per share of $0.25 during this quarter was caused
by a different number of shares used in the denominator (resulting in a
$0.05 per share difference) and a $0.01 difference between GAAP and
taxable income.
28
<PAGE> 29
<TABLE>
<CAPTION>
TABLE 14
DIFFERENCES BETWEEN GAAP EARNINGS PER SHARE AND DIVIDENDS DECLARED
PER SHARE AVERAGE
--------------------------------------------------------------------------------
UNDIST- GAAP GAAP NUMBER NUMBER
RIBUTED VS. TAX GAAP VS. TAX OF SHARES OF
DIVIDEND TAXABLE TAXABLE G&A VS. TAX CREDIT GAAP RECEIVING PRIMARY
DECLARED EARNINGS EARNINGS EXPENSES AMRTZTN EXPENSES DILUTION EARNINGS DIVIDENDS SHARES
-------- -------- -------- -------- ------- -------- -------- -------- --------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 0.25 $ 0.05 $ 0.25 $ 0.00 $ 0.02 $ 0.00 $ (0.07) $ 0.20 1,401,904 1,916,846
1995, Quarter 1 0.20 0.05 0.25 0.00 0.00 (0.01) (0.05) 0.19 1,666,063 2,061,417
1995, Quarter 2 0.30 0.02 0.32 0.00 (0.02) (0.02) (0.07) 0.21 1,666,063 2,119,667
1995, Quarter 3 0.20 0.00 0.20 0.01 (0.01) (0.02) 0.05 0.23 5,516,313 4,358,309
1995, Quarter 4 0.26 0.07 0.33 (0.01) (0.02) (0.06) (0.02) 0.22 5,517,299 6,079,507
1996, Quarter 1 0.46 0.00 0.46 (0.02) (0.03) (0.06) (0.03) 0.32 5,521,376 6,129,587
</TABLE>
FINANCIAL CONDITION
SUMMARY
Management believes the Company is well capitalized for the
level of risks undertaken. The Company's assets are single-family
mortgages. A substantial majority of these assets are further
credit-enhanced beyond the inherent value of a mortgage secured by a
first lien on a residential property. The liquidity of a substantial
majority of the Company's assets has been enhanced through the
securitization and credit rating process. The interest rate risks of
the Company's assets and liabilities are closely matched; all of the
mortgages are adjustable-rate mortgages financed with equity and
variable-rate borrowings. Interest rate risks which remain on the
balance sheet after this matching program are mitigated through the
Company's interest rate hedging program. The Company has uncommitted
borrowing facilities in excess of its needs and, based on the quality
of its assets, believes it will continue to be able to access borrowed
funds without difficulty. The Company takes credit provisions to
reserve for credit risk. The Company has low operating expenses and a
high percentage of its equity invested in earning assets. The Company's
capital base is tangible capital: all of the Company's earning assets
and interest rate agreements are marked-to-market at liquidation value.
The Company has no intangible assets or goodwill. Nevertheless, the
Company maintains an equity-to-assets ratio that is higher than that of
many banks, savings and loans, insurance companies, and REITs that act
as mortgage portfolio lenders.
MORTGAGE ASSETS
Through March 31, 1996, all of the Company's acquisitions of
Mortgage Assets have been adjustable-rate mortgages on single-family
residential properties or interests in securitized pools of such
mortgages. All of the mortgage loans which underlie the Company's
Mortgage Assets are secured with a first lien position with respect to
the underlying single-family properties. The majority of the Company's
Mortgage Assets are further credit-enhanced by third parties who have
agreed (through insurance, subordination, or other means) to absorb all
credit losses in the pool up to a specified limit (which varies by
Mortgage Asset). As a result, the majority of the Company's Mortgage
Assets are rated AAA by one or more nationally-recognized rating
agencies. The average credit rating equivalent of the Company's
Mortgage Assets at December 31, 1995 and March 31, 1996 was AA+.
The Company acquired $24.1 million Mortgage Assets in the
first quarter of 1995 for an average price of 94.80% of principal
value. The Company acquired $166.9 million in Mortgage Assets in the
first quarter of 1996 for an average price of 102.60% of principal
value. Mortgage principal repayments received were $2.7 million in the
first three months of 1995 for an average annualized principal
repayment rate of 9% and were $32.8 million in the first three months
of 1996 for an average principal repayment rate of 26%. To date, the
Company has not sold Mortgage Assets, although it may do so in the
future.
29
<PAGE> 30
A relatively high percentage of the single-family
adjustable-rate mortgages in the United States are secured by
properties located in California. This is particularly true for
single-family adjustable-rate mortgages within the loan balance range
of $200,000 and $500,000 targeted by the Company. At December 31, 1995
and March 31, 1996, the percentage of the Company's Mortgage Assets
which had mortgaged properties located in California was 65% and 64%,
respectively. Management believes single-family property values in
California were generally stable during 1995 and thus far in 1996.
The table below summarizes the Company's Mortgage Assets, the
average credit rating equivalent and the average California
concentration as well as the Company's Mortgage Assets acquisitions and
monthly principal repayment rates.
TABLE 15
MORTGAGE ASSET SUMMARY
<TABLE>
<CAPTION>
AVERAGE ANNUALIZED
MORTGAGE CREDIT % IN PRINCIPAL
PRINCIPAL AMORTIZED CARRYING RATING CALIF ASSET PRINCIPAL REPAYMENTS
VALUE AT COST AT VALUE AT EQUIV. AT ACQUISITIONS AVE RE- AS A % OF
PERIOD PERIOD PERIOD AT PERIOD PERIOD AT PRICE PAYMENTS AVERAGE
END END END END END COST PAID RECEIVED MTG. ASSETS
--------- --------- -------- --------- ------ ------------ ----- -------- -----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $120,627 $120,135 $117,477 AAA- 72% $121,297 99.53% $ 1,244 7%
1995, Quarter 1 143,393 141,792 141,860 AA+ 73% 24,116 94.80% 2,673 9%
1995, Quarter 2 178,429 174,415 175,242 AA+ 72% 35,355 93.11% 2,934 7%
1995, Quarter 3 298,718 298,894 298,785 AA+ 65% 132,640 103.14% 8,319 16%
1995, Quarter 4 443,625 436,236 432,244 AA+ 65% 162,461 95.78% 24,898 27%
1996, Quarter 1 573,807 569,744 565,159 AA+ 64% 166,852 102.60% 32,814 26%
</TABLE>
At December 31, 1995, the Company had on its balance sheet as
part of the Mortgage Asset account a total of $17.0 million of
unamortized discount (which is the difference between the remaining
principal value and current historical amortized cost of Mortgage
Assets acquired at a price below principal value) and a total of $9.6
million of unamortized premium (which is the difference between the
remaining principal value and the current historical amortized cost of
Mortgage Assets acquired at a price above principal value). The net
discount at December 31, 1995 was $7.4 million, or 1.7% of the total
amortized cost of Mortgage Assets. At March 31, 1996, the Company had a
total of $16.9 million of unamortized discount and $12.8 million of
unamortized premium for a net discount of $4.1 million, or 0.7% of the
total amortized cost of Mortgage Assets.
Discount balances will be amortized as an increase in interest
income over the life of discount Mortgage Assets and premium balances
will be amortized as a decrease in interest income over the life of
premium Mortgage Assets. If mortgage principal repayment rates increase
over the life of these Mortgage Assets, the Company's rate of income
recognition over this entire period should increase, all other factors
being equal, as the average life of the assets will decrease and the
Company will amortize its net discount balance into income over a
shorter time period. Similarly, if mortgage principal repayment rates
decrease over the life these assets, the average life will increase and
the Company's rate of income recognition over this entire period should
decrease. The accounting effects of changes in the rate of mortgage
principal repayment on the Company's rate of income recognition in the
short-term, however, are likely to be the opposite of that described
above due to the Company's treatment of amortization of premium and
discount for accounting purposes (see "Interest Income and Earning
Asset Yield.")
In the second half of 1995, the Company acquired a limited
amount of interest-only strip ("IO") Mortgage Assets (see Footnote 2 to
the Financial Statements). The carrying value of these IOs was $2.8
million at December 31, 1995 and $2.2 million at March 31, 1996. These
IOs receive a fixed rate of interest on a pool of adjustable-rate
mortgages but receive no principal payments. Since IOs have no
principal value, the entire acquisition price is recorded as premium;
the acquisition of the IOs caused the average price paid for Mortgage
Assets in the third quarter of 1995 to be at a premium to principal
value (see Table 15). The potential risks and
30
<PAGE> 31
rewards of owning IO strip Mortgage Assets are similar in many ways to
the mortgage servicing business; IOs are also known as "excess
servicing" strips. The slower the rate of mortgage principal repayment
in the underlying mortgage pool, the more income the IO owner will
receive over time. The faster the rate of mortgage principal repayment,
the less income the IO owner will receive over time. Accounting
convention calls for an IO asset to be written down to market value for
income statement purposes should the future projected cash flow yield
drop below a certain level due to greater-than-expected mortgage
principal repayment rates. The price the Company paid for its IOs
incorporated a rapid principal repayment rate assumption although
principal repayment rates to date have been faster than expected.
Should principal repayment rates accelerate beyond their already rapid
levels, a negative accounting adjustment could become necessary.
Management believes the Company's IOs are potentially attractive
earning assets which also serve to reduce the level of net discount on
the Company's balance sheet. Thus, over longer periods of time, the
IOs may reduce the Company's overall level of sensitivity to changes
in mortgage principal repayment rates.
Since the Company's inception, the majority of the Company's
Mortgage Assets had principal and interest payments that were fully
guaranteed by the government-sponsored agencies FNMA or FHLMC (see
Footnote 2 to the Financial Statements). The Company may lower its
percentage of agency-guaranteed Mortgage Assets in the future.
At December 31, 1995, the Company owned partial interests in
30 pools of residential adjustable-rate mortgage loans which were not
guaranteed by a Federal agency ("privately-issued assets"). The
privately-issued assets owned by the Company had a market value of $165
million. The total principal balance of the mortgages in these pools
was $3.5 billion, the majority of which were located in California, had
original loan balances of $200,000 to $500,000 and were originated in
1993 or later. Each of these privately-issued assets had varying
degrees of credit-enhancement from normal credit losses; most of these
assets were, in turn, providing credit-enhancement to more senior
interests issued from the same pool. On the basis of the quality of the
loans in the pools, the degree of credit-enhancement, and the degree to
which these interests were subordinated to other interests, the
Company's privately-issued assets were rated or had a credit rating
equivalent of A+ on average.
At March 31, 1996, the Company owned partial interests in 35
pools of privately-issued assets. These partial interests had a market
value of $242 million. The total principal balance of the mortgages in
these pools was $3.9 billion, the majority of which were located in
California, had original loan balances of $200,000 to $500,000 and were
originated in 1993 or later. With the exception of $232,124 in "first
loss" interests, each of the Company's interests had varying degrees of
credit-enhancement from normal credit losses; most of these interests
were, in turn, providing credit-enhancement to more senior interests
issued from the same pool. The Company's privately-issued assets at
quarter-end were rated or had a credit rating equivalent of AA on
average.
The single-family mortgage industry uses terms such as
"FNMA/FHLMC" underwriting and "A", "A-", "B", and "C" quality
underwriting to describe the standards used when assessing the credit
and level of documentation of a mortgage loan, although these terms are
not standardized and usage can differ. The Company uses these terms as
follows: (i) "FNMA/FHLMC" underwriting standards are those which have
been developed over the years by the government-sponsored agencies for
the high-quality mortgage loans (generally with balances less than
$207,000) which they acquire and guarantee, (ii) "A" quality
underwriting generally applies to loans with original loan balances
which are larger than the FNMA/FHLMC limits but have been underwritten
to standards which are similar in most respects to FNMA/FHLMC
standards or otherwise would generally be considered by the Company to
meet high-quality standards, (iii) "A-" quality underwriting applies
to loans which do not meet some of the "A" quality credit or
documentation standards but otherwise have one or more positive
compensating factors, and (iv) "B" and "C" quality underwriting
standards generally apply to loans where the borrower has a lower
quality credit history (typically these loans have lower loan-to-value
ratios to compensate for potential increased credit risk) or loans
which otherwise do not meet "A" type underwriting criteria. By
references to "high-quality" whole Mortgage Loans herein, the Company
is referring to its loans underwritten to "FNMA/FHLMC," "A" or "A-"
standards.
A substantial majority of mortgage loans underlying the
Company's Mortgage Assets have been underwritten to high-quality "A" or
"FNMA/FHLMC" underwriting standards. To a lesser degree, the
31
<PAGE> 32
Company owns securitized and credit-enhanced interests in mortgage
pools which contain some loans underwritten to "A-" standards. The
Company does not specifically track the total volume of loans with "A-"
as opposed to "A" or "FNMA/FHLMC" quality underwriting in its pools as
management believes that, for most of its assets, the distinction
between these types of underwriting is likely to be immaterial given
the level of credit-enhancement protection. Of the Company's
privately-issued Mortgage Assets as of December 31, 1995 and March 31,
1996, approximately $30.0 million and $28.8 million, respectively, were
interests in pools of mortgage loans containing a material amount of
loans underwritten to "B" and "C" quality underwriting standards. The
Company only acquires such Mortgage Assets when they have substantial
levels of third-party credit- enhancement and a credit rating of at
least AA. To date, all such Mortgage Assets have been rated AA and
third-party credit enhancement levels have ranged from 7.6% to 23.5% of
such mortgage pools.
In the fourth quarter of 1995, the Company started acquiring
high-quality whole Mortgage Loans generally underwritten to "A" quality
standards. No such loans were acquired in the first quarter of 1996.
These loans have not been pooled, securitized or rated. If whole
Mortgage Loans of the quality acquired to date by the Company were
pooled, securitized and rated, management believes that over 90% of the
pool would receive a rating of AAA or AA.
The table below shows the balance of the Company's whole
Mortgage Loans and the Company's securitized Mortgage Assets segregated
by credit rating. Unrated securitized assets have been assigned a
credit rating equivalent by management.
TABLE 16
MORTGAGE ASSETS BY CREDIT RATING EQUIVALENT
<TABLE>
<CAPTION>
AAA/ A/ BB/ AAA/ A/ BB/
WHOLE AA BBB OTHER AA BBB OTHER
MORTGAGE RATING RATING RATING WHOLE RATING RATING RATING
END LOAN EQUIV. EQUIV. EQUIV. LOAN EQUIV. EQUIV. EQUIV.
OF CARRYING CARRYING CARRYING CARRYING PERCENT PERCENT PERCENT PERCENT
PERIOD VALUE VALUE VALUE VALUE OF TOTAL OF TOTAL OF TOTAL OF TOTAL
------ -------- -------- -------- -------- -------- -------- -------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 0 $109,548 $ 4,761 $ 3,168 0.0% 93.2% 4.1% 2.7%
1995, Quarter 1 0 125,237 10,988 5,635 0.0% 88.3% 7.7% 4.0%
1995, Quarter 2 0 150,846 11,306 13,092 0.0% 86.0% 6.5% 7.5%
1995, Quarter 3 0 263,344 16,338 19,103 0.0% 88.1% 5.5% 6.4%
1995, Quarter 4 26,450 355,784 25,171 24,839 6.1% 82.4% 5.8% 5.7%
1996, Quarter 1 24,861 490,189 26,258 23,852 4.4% 86.8% 4.6% 4.2%
</TABLE>
The following table shows the average characteristics of the
Company's Mortgage Assets at the end of each reporting period. The
index level is the weighted average rate of the various short-term
interest rate indices which determine coupon adjustments. Unless
limited by periodic or lifetime caps, the Mortgage Asset coupons adjust
at the end of each adjustment period to the level of the index plus the
net margin. The fully-indexed rate is the current index plus the net
margin: this is the maximum level to which the coupon could adjust
should interest rates remain unchanged. The rate of adjustment of the
current coupon to the fully-indexed rate is determined by the
adjustment periods and the periodic caps of the Mortgage Loans.
32
<PAGE> 33
TABLE 17
MORTGAGE ASSET CHARACTERISTICS
<TABLE>
<CAPTION>
AVERAGE
MONTHS
FULLY- TO MORTGAGE
END OF COUPON INDEX NET INDEXED NEXT LIFETIME ASSET
PERIOD RATE LEVEL MARGIN RATE ADJUSTMENT CAP YIELD
------ ------ ----- ------ ------- ---------- -------- --------
<S> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 6.00% 6.94% 2.25% 9.19% 3 11.48% 6.60%
1995, Quarter 1 6.53% 6.47% 2.24% 8.71% 3 11.57% 7.23%
1995, Quarter 2 6.94% 5.99% 2.21% 8.20% 3 11.54% 7.74%
1995, Quarter 3 7.35% 5.86% 2.20% 8.06% 4 11.56% 7.81%
1995, Quarter 4 7.50% 5.44% 2.08% 7.52% 3 11.54% 7.74%
1996, Quarter 1 7.59% 5.47% 2.11% 7.58% 3 11.53% 7.67%
</TABLE>
The table below segments the Company's Mortgage Assets by type
of adjustment index, coupon adjustment frequency and periodic cap
adjustment.
TABLE 18
MORTGAGE ASSETS BY INDEX
<TABLE>
<CAPTION>
ELEVENTH
SIX- DISTRICT
SIX- ONE- MONTH ONE- SIX- COST NATIONAL INTEREST-
MONTH MONTH BANK YEAR MONTH OF MORTGAGE ONLY
LIBOR LIBOR CD TREASURY TREASURY FUNDS CONTRACT MORTGAGE
INDEX INDEX INDEX INDEX INDEX INDEX RATE ASSETS
----- ----- ----- -------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Adjustment Frequency/Loan 6 months 1 month 6 months 12 months 6 months 1 month 12 months n/a
Average Adjustment/Pool 3 months 1 month 3 months 6 months 3 months 1 month 6 months n/a
Annualized Periodic Cap 2% none 2% 2% 2% none 2% n/a
</TABLE>
<TABLE>
<CAPTION>
% of Total Mortgage Assets at Period End
----------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 78.2% 3.9% 17.9% 0.0% 0.0% 0.0% 0.0% 0.0%
1995, Quarter 1 78.7% 3.1% 17.3% 0.9% 0.0% 0.0% 0.0% 0.0%
1995, Quarter 2 83.0% 2.5% 13.8% 0.7% 0.0% 0.0% 0.0% 0.0%
1995, Quarter 3 66.8% 1.4% 11.6% 11.5% 7.6% 0.0% 0.0% 1.1%
1995, Quarter 4 59.7% 7.7% 12.8% 12.5% 5.0% 1.7% 0.0% 0.6%
1996, Quarter 1 63.1% 6.5% 8.9% 14.9% 3.6% 1.3% 1.3% 0.4%
</TABLE>
Whole Loan Mortgage Assets
In the fourth quarter of 1995, the Company commenced the
acquisition of individual single-family residential Mortgage Loans
which have not been pooled or securitized (whole Mortgage Loans). The
Company did not purchase additional Mortgage Loans in the first quarter
of 1996. The Company seeks to acquire high-quality single-family
Mortgage Loans ("A" quality underwriting) when management believes the
risk-adjusted returns on equity potentially available to shareholders
from such assets may exceed potential returns from the acquisition of
securitized mortgage loans. While whole Mortgage Loans are expected to
produce higher earning asset yields than the bulk of the Company's
securitized Mortgage Assets, the acquisition of whole Mortgage Loans
also increases the Company's cost of funds versus prevailing LIBOR
rates and exposes the Company to potential credit losses. The Company
may securitize its whole Mortgage Loans in the future in order to lower
borrowing costs. Credit losses will occur in the whole Mortgage Loan
portfolio. The Company has provided for a GAAP credit reserve of
$79,234 as of December 31, 1995, which is thirty basis points (0.30%)
of the amortized cost of its whole Mortgage Loans. As of March 31, 1995
this reserve was reduced to $74,492 reflecting the principal reduction
in the Company's whole Mortgage Loans. No credit losses on whole
Mortgage Loans have been incurred to date.
33
<PAGE> 34
The Company defines Non-Performing Assets ("NPAs") as whole
loans which are delinquent more than 90 days. At December 31, 1995 the
Company had no Non-Performing Assets. As of March 31, 1996, Company's
Non-Performing Assets were $190,252, reflecting one loan in
foreclosure.
TABLE 19
WHOLE MORTGAGE LOAN SUMMARY
<TABLE>
<CAPTION>
AT MARCH 31, 1996 AT DECEMBER 31, 1995
----------------- --------------------
(ALL RATIOS BASED ON % OF TOTAL LOAN
PORTFOLIO BALANCES UNLESS NOTED)
<S> <C> <C>
Face Value $24,830,547 $26,411,412
Amortized Cost 24,865,544 26,450,045
Adjustable-Rate 100% 100%
Single-Family 100% 100%
"A" Quality Underwriting 100% 100%
First Lien 100% 100%
Owner-Occupied 100% 100%
Property Located in Northern California 30% 30%
Property Located in Southern California 46% 44%
Number of Loans 101 109
Average Loan Size $ 245,847 $ 242,307
Original Loan Balance in Excess of $500,000 25% 25%
Average Original Loan to Value Ratio (LTV) 77% 76%
Original LTV greater than 80% 27% 26%
Percent of Original LTV greater than 80% with Mortgage Insurance 100% 100%
1994 Origination 2% 2%
1995 Origination 98% 98%
Non-Performing Assets (90+ days delinq.) $ 190,252 0
Number of non-performing loans (90+ days delinq.) 1 0
Non-Performing Assets as % of Total Loan Balances 0.77% 0.00%
Credit Reserves $ 74,492 $ 79,234
Credit Reserves as % of NPA's 39% N/A
Credit Reserves as % of Total Loan Balances 0.30% 0.30%
</TABLE>
SECURITIZED MORTGAGE ASSETS WITH A CREDIT RATING EQUIVALENT OF AAA
TO BBB
At December 31, 1995 and March 31, 1996, 88% and 91% of the
Company's Mortgage Assets, respectively, were interests in securitized
pools of single-family mortgage loans which had a rating of AAA through
BBB from one or more of the nationally-recognized rating agencies, or,
if not rated, had equivalent credit quality in the view of management.
In addition to including mortgages with first liens on the value of
each of the underlying properties, each of these mortgage pools has an
additional level of credit-enhancement provided by a third party
designed to reduce the risk of credit loss to the Company. In the
event, however, that credit losses in these pools are higher than
expected or in the event of default of FNMA, FHLMC or another third
party guarantor, credit losses to the Company could result. The Company
continuously monitors the credit quality of its assets and will provide
for GAAP credit reserves accordingly; management is comfortable that
GAAP credit provisions are not warranted for these assets at this time.
SECURITIZED MORTGAGE ASSETS WITH A CREDIT RATING EQUIVALENT BELOW
BBB
The Company acquires limited amounts of securitized Mortgage
Assets with a credit rating equivalent of less than BBB when management
believes that the cash flow and return on equity, net of expected
credit losses, over the life of the asset will be attractive. These
assets have high potential yields but also are costly to finance. These
assets may be highly beneficial to the Company over their life,
although any such benefits are likely to be realized chiefly in later
years. Future benefits may include possible credit rating upgrades and
market value improvements as the mortgage interests senior to the
Company's position prepay (this would lead to lower
34
<PAGE> 35
borrowing costs and an expanded equity base for the Company) and the
eventual return of principal (net of credit losses) which was purchased
at a discount. If credit losses exceed management's expectations,
however, net losses on these assets could result.
The bulk of the Company's securitized assets with a credit
rating equivalent below BBB are credit-enhanced and thus credit losses
will not be incurred by the Company until total credit losses in the
related mortgage pool exhaust the credit-enhancement. The level of
credit losses in these pools has been insignificant to date; the full
original levels of credit-enhancement to the Company's positions are
generally intact. Management expects that these pools will experience
credit losses in the future and that in some pools all of the
credit-enhancement will be exhausted, leading to credit losses in the
Company's positions. Any such losses are limited to the Company's
amortized cost in the asset.
In the case of "first loss" assets (subordinated interests
with no credit enhancement), all credit losses in the related pool of
mortgages will reduce the principal value of the "first loss" asset and
will be recognized as a credit loss by the Company. The amortized cost
of the Company's first loss assets at December 31, 1995 and March 31,
1996 was $227,997 and $232,124, respectively; the limit of the
Company's potential credit losses on these assets is equal to the
amortized cost. As the Company's cost basis in "first loss" assets is
low relative to their principal value, the Company's realized credit
loss will equal only 10-15% of the realized credit losses to the pools.
<TABLE>
<CAPTION>
TABLE 20
SUMMARY OF BELOW BBB-RATED SECURITIZED MORTGAGE ASSETS
GAAP GAAP
PRINCIPAL AMORTIZED CREDIT CREDIT
VALUE COST GAAP RESERVES RESERVE/
PERIOD PERIOD CREDIT ACTUAL PERIOD AMORTIZED
END END PROVISION LOSSES END COST
--------- --------- --------- ------ -------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 3,628 $ 3,377 $ 0 $ 0 $ 0 0.00%
1995, Quarter 1 6,779 5,836 18 0 18 0.32%
1995, Quarter 2 17,009 13,351 41 0 59 0.44%
1995, Quarter 3 25,638 19,964 84 0 143 0.72%
1995, Quarter 4 41,290 28,857 271 4 410 1.42%
1996, Quarter 1 39,311 27,429 336 0 747 2.72%
</TABLE>
The Company monitors the delinquent loans and the quality of
mortgage servicing in these pools. Delinquencies and defaults in the
various mortgage pools in which the Company has an interest may have
widely different credit loss implications for the Company due to the
level of credit-enhancement and the level of the Company's amortized
cost in the asset. One of the tools the Company uses to monitor its
possible credit exposure and to assess the adequacy of its GAAP credit
reserves is to calculate the level of realized loss the Company would
incur if most or all of the mortgage loans in these pools which are
more than 90 days delinquent eventually default and if the total loss
to the mortgage pool on defaulted loans equaled 10% to 40% of the loan
balance ("loss severity"). See Table 22.
Over the entire period of time the Company has owned these
pools through March 31, 1996, of a total original balance of $2.2
billion of mortgages in these pools representing over 10,750 loans,
four loans with a total loan balance of $904,717 have defaulted and
resulted in a credit loss to these pools. The average loss severity
realized by the mortgage pools on the default of these four loans was
10% of the loan balance. Based on limited data from other mortgage
pools, however, management believes a loss severity assumption of 20%
to 30% is reasonable; actual experience could be more severe.
Delinquencies have risen in these pools. This increase in
delinquencies as a percent of the current remaining principal balance
is a function of the normal seasoning of the mortgage pools, of
mortgage principal repayments and of a small general increase in
mortgage delinquencies nationwide. For these reasons, management
expects delinquencies as a percent of current remaining principal
balance to continue to rise in 1996.
35
<PAGE> 36
All pools in which the Company owns an interest are performing
within expectations with the exception of three pools issued from one
mortgage conduit. Delinquencies have risen in these pools; mortgage
servicing difficulties related to a servicing transfer and other
factors may be partially responsible for this increase. Management is
monitoring the efforts of the conduit and the servicers to address
these servicing issues.
The table below shows the likely credit loss to the Company
that may result from loans which were part of the Company's securitized
mortgage assets with a credit rating equivalent below BBB and which
were delinquent more than 90 days as of March 31, 1996. The table
assumes a variety of possible default frequencies and loss severities.
For example, if 95% of the over-90-day delinquent loans in those assets
as of March 31, 1996 eventually default with a 25% loss severity, the
Company would likely realize a credit loss of approximately $92,000.
GAAP credit reserves for these assets at March 31, 1996 were $746,738.
The table reflects potential credit loss only for those loans
delinquent more than 90 days at March 31, 1996 and does not purport to
reflect potential losses over the life of the related pools.
<TABLE>
<CAPTION>
TABLE 22
POTENTIAL CREDIT LOSSES DUE TO 90+ DAY DELINQUENCIES AS OF MARCH 31, 1996
FOR SECURITIZED MORTGAGE ASSETS WITH CREDIT RATING EQUIVALENT BELOW BBB
90% 95% 100%
DEFAULT DEFAULT DEFAULT
LOSS SEVERITY FREQUENCY FREQUENCY FREQUENCY
------------- --------- --------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
10% $ 23 $ 24 $ 26
15% 35 36 38
20% 46 49 51
25% 58 92 94
30% 361 488 615
35% 743 982 1,234
40% 1,407 1,771 2,171
</TABLE>
INTEREST RATE AGREEMENTS
The Company's interest rate agreements are assets carried on
the balance sheet at estimated liquidation value. There is a risk that
the counter-parties to the interest rate agreements will not be able to
perform under these contracts. All of the counter-parties to the
Company's interest rate agreements have a credit rating of at least
"A". Potential accounting losses from counter-party risk are limited to
the Company's amortized cost basis in these agreements, which was $2.5
million at December 31, 1995 and $2.5 million at March 31, 1996.
BORROWINGS
To date, the Company's debt has consisted entirely of
borrowings collateralized by a pledge of the Company's Mortgage Assets.
These borrowings appear on the balance sheet as reverse repurchase
agreements and notes payable. The size of the market for borrowings of
this type is measured in the trillions of dollars; institutions with
high-quality pledgable assets such as banks, savings and loans,
brokerage firms, federal agencies and the Federal Reserve Bank are the
largest U.S. borrowers in this market. The Company has established
uncommitted borrowing facilities in this market in amounts in excess of
its needs.
All of the Company's Mortgage Assets are currently accepted as
collateral for such borrowings. On average, the Company could borrow
94% to 96% of the market value of its Mortgage Assets. The Company,
however, limits its borrowings, and thus its potential asset growth, in
order to maintain unused borrowing capacity and thus increase the
liquidity and strength of its balance sheet.
The term to maturity of the Company's borrowings has ranged
from one day to seven months, with a weighted average term to maturity
of 74 days at December 31, 1995 and 48 days at March 31, 1996. Many of
36
<PAGE> 37
the Company's borrowings have a cost of funds which adjusts monthly
based on a fixed spread over or under the one-month LIBOR interest rate
or daily based on the Fed Funds rate. As a result, the average term to
the next rate adjustment for the Company's borrowings is typically
shorter than the term to maturity: at December 31, 1995 and at March
31, 1996, the weighted average term to next rate adjustment was 26 days
and 19 days, respectively. The average rate on the Company's borrowing
at December 31, 1995 was 6.01% and at March 31, 1996 it was 5.62%.
TABLE 22
BORROWING SUMMARY
<TABLE>
<CAPTION>
ESTIMATED
MARKET BORROWING
VALUE OF CAPACITY AVERAGE RATE ON
END PLEDGABLE AS A % OF ESTIMATED AVERAGE TERM TO BORROWINGS
OF MORTGAGE PLEDGABLE BORROWING TOTAL TERM TO RATE OUTSTANDING
PERIOD ASSETS ASSETS CAPACITY BORROWINGS MATURITY ADJUSTMENT AT PERIOD-END
------ --------- --------- --------- ---------- -------- ---------- -------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 117,477 95.6% $ 112,283 $ 100,376 112 days 70 days 5.80%
1995, Quarter 1 141,860 94.3% 133,719 121,998 97 days 27 days 6.25%
1995, Quarter 2 175,242 95.4% 167,192 155,881 64 days 28 days 6.23%
1995, Quarter 3 298,785 94.5% 282,432 228,826 38 days 31 days 5.95%
1995, Quarter 4 432,244 94.6% 408,998 370,316 74 days 26 days 6.01%
1996, Quarter 1 565,159 95.2% 537,783 508,721 48 days 19 days 5.62%
</TABLE>
LIQUIDITY
A financial institution has ample liquidity when it is able to
meet the demands made upon it for cash payments with its cash reserves,
operating cash flow, borrowing capacity, proceeds from asset sales, or
other sources of cash. Liquidity allows the Company to purchase
additional Mortgage Assets and allows the Company to pledge additional
assets to secure existing borrowings should the value of pledged assets
decline. Potential immediate sources of liquidity for the Company
include cash balances and unused borrowing capacity. The Company
typically pledges its least liquid Mortgage Assets for secured
borrowings so that the Company's pool of unpledged Mortgage Assets
consist of its most liquid assets. Unused borrowing capacity will vary
over time as the market value of the Company's Mortgage Assets vary and
due to other factors. Potential immediate sources of liquidity equaled
12% of borrowings at year end 1995 and 8% of borrowings at March 31,
1996. The maintenance of liquidity is one of the goals of the Company's
Risk-Adjusted Capital Policy; under this policy, asset growth is
limited in order to preserve unused borrowing capacity for liquidity
management purposes.
The Company's balance sheet generates liquidity on an on-going
basis through mortgage principal repayments and net earnings held prior
to payment as dividends. Should the Company's needs ever exceed these
on-going sources of liquidity plus the immediate sources of liquidity
discussed above, management believes that the Company's Mortgage Assets
and interest rate agreements could be sold in most circumstances to
raise cash. The table below shows the potential immediate sources of
liquidity available to the Company.
37
<PAGE> 38
TABLE 23
POTENTIAL IMMEDIATE SOURCES OF LIQUIDITY
<TABLE>
<CAPTION>
POTENTIAL
IMMEDIATE POTENTIAL
SOURCES OF IMMEDIATE
LIQUIDITY SOURCES
ESTIMATED (CASH + OF
END UNUSED EST. UNUSED LIQUIDITY
OF CASH BORROWING BORROWING AS % OF
PERIOD BALANCE CAPACITY CAPACITY) BORROWINGS
------ ------- -------- --------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Fiscal 1994 $ 1,027 $ 11,907 $ 12,934 13%
1995, Quarter 1 953 11,721 12,674 10%
1995, Quarter 2 1,620 11,311 12,931 8%
1995, Quarter 3 1,150 53,606 54,756 24%
1995, Quarter 4 4,825 38,682 43,507 12%
1996, Quarter 1 9,705 29,062 38,767 8%
</TABLE>
STOCKHOLDERS' EQUITY
The Company's GAAP equity base as measured on a historical
cost basis decreased slightly in the first quarter of 1996 as
dividends, which are based on taxable earnings, exceeded GAAP earnings.
This created a larger deficit in the "Undistributed Earnings" account,
which is part of stockholders' equity. As measured on a historical cost
basis, the equity base decreased from $73.8 million, or $13.37 per
share, at December 31, 1995 to $73.2 million, or $13.27 per share, at
March 31, 1996.
The Company's GAAP equity base as reported in its financial
statements reflects the mark-to-market of its assets. On this basis,
the equity base decreased from $68.3 million, or $12.38 per share, at
December 31, 1995 to $68.1 million, or $12.35 per share, at March 31,
1996. This change reflects a positive net asset mark-to-market
adjustment of $410,762 offset by the excess of dividends over GAAP
earnings mentioned above.
With the Company's "available-for-sale" accounting treatment,
unrealized fluctuations in market values of assets are reflected on the
balance sheet by changing the carrying value of the asset and
reflecting the change in stockholders' equity under "Net Unrealized
Losses on Assets Available for Sale". Unrealized market value
fluctuations do not impact income. By accounting for its assets in this
manner on its balance sheet, the Company hopes to provide useful
information to shareholders and creditors and to preserve flexibility
to sell assets in the future without having to change accounting
methods.
As a result of this mark-to-market accounting treatment, the
reported book value and book value per share of the Company are likely
to fluctuate far more than if the Company used historical amortized
cost accounting. As a result, comparisons with companies that use
historical cost accounting for some or all of their balance sheet may
be misleading.
Positive mark-to-market changes will increase the Company's
equity base and allow the Company to increase its spread lending
activities while negative changes will tend to limit spread lending
growth under the Company's Risk-Adjusted Capital Policy. A very large
negative change in the net market value of Mortgage Assets and interest
rate agreements might impair the Company's liquidity position,
requiring the Company to sell assets with the likely result of realized
losses upon sale.
An unrealized loss is created each time the Company acquires a
Mortgage Asset or enters into an interest rate agreement; the Company
immediately marks down the asset to reflect the difference between the
acquisition cost and a conservative estimate of bid-side market value.
This mark-down spread can be as much as 5% of acquisition value for
lower-rated Mortgage Assets and interest rate agreements. As a result,
in the absence of other factors, the Company's net unrealized loss is
expected to grow as the balance sheet grows.
38
<PAGE> 39
"Net Unrealized Losses on Assets Available for Sale" was $5.5
million, or 1.2% of assets, at December 31, 1995 and was $5.1 million,
or 0.9% of assets, at March 31, 1996. Despite rising interest rates
during the quarter, the market values of the Company's Mortgage Assets
were generally stable. The market value of the Company's interest rate
hedging agreements rose during the quarter along with rising interest
rates; this increase was sufficient to overcome the negative effect of
the bid/ask spread on Mortgage Assets acquired during the quarter,
resulting in a positive net mark-to-market gain.
The table below shows the Company's equity capital base as
reported and on a historical amortized cost basis. The historical cost
equity capital base is influenced by common stock issuance, the level
of GAAP earnings as compared to dividends declared, and other factors.
The GAAP reported equity capital base is influenced by these factors
plus changes in the "Net Unrealized Losses on Assets Available for
Sale" account.
TABLE 24
STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
NET NET HISTORICAL
UNREALIZED UNREALIZED HISTORICAL AMORTIZED GAAP
LOSSES LOSSES AMORTIZED GAAP COST REPORTED
END ON ASSETS AS % OF COST REPORTED EQUITY EQUITY
OF TOTAL AVAILABLE TOTAL EQUITY EQUITY PER PER
PERIOD ASSETS FOR SALE ASSETS BASE BASE SHARE SHARE
- ------ ------ -------- ------ ---- ---- ----- -----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 121,528 $ (2,557) (2.1%) $ 22,837 $ 20,280 $ 12.18 $ 10.82
1995, Quarter 1 145,440 (549) (0.4%) 22,901 22,352 12.22 11.93
1995, Quarter 2 179,321 (314) (0.2%) 22,847 22,533 12.19 12.02
1995, Quarter 3 303,394 (1,551) (0.5%) 74,024 72,473 13.42 13.14
1995, Quarter 4 441,557 (5,476) (1.2%) 73,766 68,290 13.37 12.38
1996, Quarter 1 581,313 (5,065) (0.9%) 73,211 68,146 13.27 12.35
</TABLE>
WARRANTS
At year end 1995 and March 31, 1996, the Company had 1,665,063
Warrants outstanding. These Warrants currently trade on NASDAQ under
the symbol RWTIW. Each Warrant gives the holder the right until
December 31, 1997 to buy 1.000667 shares of Common Stock at a price per
share of $15.00. If the Company's Common Stock continues to trade at a
price above $15.00 per share, the remaining Warrants are likely to be
exercised sometime in the next two years. If all these Warrants are
exercised, the Company will receive new equity capital of approximately
$25 million. If a significant number of the Warrants were to be
exercised in a short period of time, earnings and dividends per share
may be affected for a period of time as the Company works to employ the
new capital. The impact of Warrant exercises on earnings and dividends
per share in the longer run may or may not be negative, depending on
the incremental return on equity earned on the Warrant exercise
proceeds.
CAPITAL ADEQUACY/RISK-ADJUSTED CAPITAL POLICY
Stockholders' equity as a percent of total assets was 15.5% at
December 31, 1995 and 11.7% at March 31, 1996. The Company's target
equity-to-assets ratio at March 31, 1996 was also 11.7%; the Company
was fully utilizing its equity at the end of the first quarter of 1996.
This level of equity capitalization is higher than that of many banks,
savings and loans, insurance companies, and REITs that act as mortgage
portfolio lenders.
The Company's target equity-to-assets ratio varies over time
as a function of management's opinion of the level of risk of its
assets and liabilities, the Company's liquidity position, the level of
unused borrowing capacity, and the over-collateralization levels
required by lenders when the Company pledges assets to secure
borrowings. The Company currently seeks to maintain an equity-to-assets
ratio of 7% to 10% for assets which have low credit risk, relatively
low interest rate risk, good liquidity, and low lender
over-collateralization requirements. For less liquid assets with credit
risk, the Company currently seeks to maintain an equity-to-
39
<PAGE> 40
assets ratio of 40% to 100%. Thus the overall target equity-to-assets
ratio will vary over time as a function of the asset mix and other
factors. As shown in Table 25, the target equity-to-assets ratio has
been declining since mid-1995 due primarily to a change in asset mix.
In general, the target equity-to-assets ratio is more than double the
over-collateralization amounts required by the Company's secured
lenders.
The target equity-to-assets ratio is determined through a
Board-level process called for in the Company's Risk-Adjusted Capital
("RAC") Policy. Should the actual equity-to-assets ratio of the Company
fall below the target level due to asset acquisitions and/or asset
market value fluctuations, management will cease the acquisition of new
assets. Management will, at that time, present a plan to the Board to
bring the Company back to its target equity-to-assets ratio; in many
circumstances, this would be accomplished in time by waiting for the
balance of Mortgage Assets to reduce through principal repayments.
The table below shows the Company's actual and target
equity-to-assets ratios and the Company's actual asset size as compared
to its full potential asset size given its equity capital base and the
guidelines of the Company's RAC Policy. Management anticipates that the
target equity-to-assets ratio may continue to drop in the future as the
Company shifts its asset mix towards an increased emphasis on
high-quality whole Mortgage Loans and securitized Mortgage Assets rated
AAA and AA.
TABLE 25
EXCESS CAPITAL AND ASSET GROWTH POTENTIAL
<TABLE>
<CAPTION>
POTENTIAL ASSET
ASSET GROWTH
TARGET ACTUAL SIZE POTENTIAL
EQUITY EQUITY WITH WITH
END TO TO SAME ACTUAL SAME
OF EQUITY ASSETS ASSETS EXCESS ASSET ASSET ASSET
PERIOD CAPITAL RATIO RATIO CAPITAL MIX SIZE MIX
------ ------- ------ ------ ------- --------- ------ ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 20,280 10.84% 16.69% $ 6,716 $ 187,050 $ 121,528 $ 65,522
1995, Quarter 1 22,352 12.41% 15.37% 3,970 180,173 145,440 34,733
1995, Quarter 2 22,533 12.95% 12.57% (1,069) 173,989 179,321 (5,332)
1995, Quarter 3 72,473 13.08% 23.89% 32,155 554,183 303,394 250,789
1995, Quarter 4 68,290 12.59% 15.47% 12,028 542,431 441,557 100,874
1996, Quarter 1 68,146 11.72% 11.72% 26 581,540 581,313 227
</TABLE>
In April 1996, the Company successfully completed a secondary
stock offering bringing in an additional $54.5 million in equity. If
the Company utilizes the same 11.72% target equity to assets ratio it
had at March 31, 1996, the potential asset size of the Company
currently exceeds $1.1 billion as a result of the April 1996 equity
offering.
ASSET/LIABILITY MANAGEMENT AND EFFECT OF CHANGES IN INTEREST RATES
Management continually reviews the Company's asset/liability
strategy with respect to interest rate risk, mortgage prepayment risk,
credit risk and the related issues of capital adequacy and liquidity.
The Company seeks attractive risk-adjusted shareholder returns while
seeking to maintain a strong balance sheet and pattern of net income
which is stable and growing over time relative to its competitors in
the banking and savings and loan industries.
The Company seeks to manage the extent to which net income
changes as a function of changes in interest rates by matching
adjustable-rate assets with variable-rate liabilities and by mitigating
the potential impact on net income of periodic and lifetime coupon
adjustment restrictions in the assets through entering into interest
rate agreements.
40
<PAGE> 41
Changes in interest rates also may have an effect on the rate
of mortgage principal repayment; the Company seeks to mitigate the
effect of changes in the mortgage principal repayment rate from an
economic point of view by balancing assets purchased at a premium with
assets purchased at a discount. However, due to the Company's
accounting practices, changes in the rate of mortgage principal
repayment have differing effects on premium and discount amortization
schedules. When the rate of mortgage principal repayments has increased
above expected levels, the Company has increased premium amortization
at a faster rate than discount amortization. This accounting practice
leads to a lower level of accounting income, compared to what it would
have been otherwise, during periods of rapid mortgage principal
repayments.
The net effect of changes in interest rates, relative changes
in one- and six-month LIBOR rates, changes in short-term rates relative
to longer-term interest rates, changes in mortgage principal repayment
rates, changes in the market values of assets and interest rate
agreements, and other factors cannot be determined in advance. In
general, the Company's goal is to stabilize spread lending income over
longer periods of time and allow income from equity-funded lending to
rise as interest rates rise and fall as short-term interest rates fall.
If the Company achieves this goal, the Company's return on equity will
maintain over time a constant or widening spread to the level of
short-term interest rates.
INTEREST RATE SENSITIVITY GAP
The table below shows the Company's cumulative interest rate
sensitivity gap, or maturity gap, for periods of one month to one year
as a percentage of total assets. The interest rate sensitivity gap is a
tool used by financial institutions such as banks and savings and loans
to analyze the possible effects of interest rate changes on net income
over time. This gap analysis ignores many important factors, however.
In the Company's case, it ignores the effect of the Company's hedging
activities, the effect of the periodic and lifetime caps in the
Company's assets, the effect of changes in mortgage principal repayment
rates and other factors. Nevertheless, the gap analysis can provide
some useful information on the interest rate risk profile of a
financial institution.
A negative cumulative gap over a particular period means that
the amount of liabilities that will have an expense rate adjusting to
prevailing market conditions during that period will be greater than
the amount of assets that will have an earning rate adjustment. Thus a
negative gap implies that increasing interest rates would result in a
falling level of net interest income during the time period in
question, as the cost of funds on the liabilities would adjust more
quickly to the interest rate increase than would the interest income
from the assets. A negative gap also implies that falling interest
rates would result in an increasing level of net interest during the
period in question. The table below shows that the Company's two-month
cumulative gap as a percentage of total assets was negative 36.4% at
year end 1995 and negative 47.2% at March 31, 1996. This suggests that
the initial short-term response on the Company's net interest income
would be negative to increasing interest rates and would be positive to
decreasing interest rates, although the Company's interest rate
agreements may mitigate the short-term negative effect of rising rates.
For the Company, the relevant interest rates are short-term interest
rates such as LIBOR.
A positive interest rate sensitivity gap over a particular
period means that a greater amount of assets than liabilities will have
an earning or expense rate adjustment to prevailing market conditions
during that period. The table below shows that the Company had a
positive cumulative six-month gap of 9.3% at the end of 1995 and 4.3%
at the end of the first quarter of 1996. This implies that the impact
on net interest income of increasing interest rates may be positive
within six months even though the initial impact for the first three
months may have been negative. Similarly, this six-month gap analysis
implies that falling interest rates may result in a decrease in net
interest income within six months even though the initial impact for
the first three months may have been positive. Although the Company's
balance sheet does have these tendencies, since a variety of factors
have been ignored it is not possible to assess from this gap analysis
what the actual impact on the Company's net income of such interest
rate changes would be, especially over shorter time periods.
Since virtually all of the Company's assets and liabilities
have income or expense rates which adjust to market conditions within
one year, the Company's cumulative twelve-month interest rate
sensitivity gap, which
41
<PAGE> 42
was 14.7% at year end 1995 and 11.1% at March 31, 1996, applies to time
periods longer than one year as well. The Company has a positive
twelve-month interest rate sensitivity gap, even though virtually all
assets and liabilities adjust within one year, because the Company has
more earning assets than interest-bearing liabilities.
TABLE 27
INTEREST RATE SENSITIVITY GAP
<TABLE>
<CAPTION>
CUMULATIVE CUMULATIVE CUMULATIVE CUMULATIVE CUMULATIVE CUMULATIVE CUMULATIVE CUMULATIVE
1-MONTH 2-MONTH 3-MONTH 4-MONTH 5-MONTH 6-MONTH 9-MONTH 12-MONTH
GAP GAP GAP GAP GAP GAP GAP GAP
END AS A % OF AS A % OF AS A % OF AS A % OF AS A % OF AS A % OF AS A % OF AS A % OF
OF TOTAL TOTAL TOTAL TOTAL TOTAL TOTAL TOTAL TOTAL
PERIOD ASSETS ASSETS ASSETS ASSETS ASSETS ASSETS ASSETS ASSETS
- ------ --------- --------- --------- --------- --------- --------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 (3.0%) (0.1%) 4.6% (0.8%) 1.2% 14.9% 14.9% 14.9%
1995, Quarter 1 (45.7%) (40.5%) (26.9%) (11.7%) 0.1% 13.9% 14.1% 14.3%
1995, Quarter 2 (39.1%) (48.9%) (32.7%) (17.3%) (2.6%) 11.4% 11.6% 11.7%
1995, Quarter 3 (50.6%) (34.3%) (18.8%) (5.6%) 4.2% 17.6% 20.3% 22.6%
1995, Quarter 4 (48.2%) (36.4%) (25.8%) (15.8%) (2.9%) 9.3% 12.2% 14.7%
1996, Quarter 1 (61.9%) (47.2%) (34.1%) (20.7%) (7.9%) 4.3% 7.9% 11.1%
</TABLE>
EQUITY DURATION
The Company uses "equity duration" to measure the stability of
the market value of its assets with respect to the size of its equity
base as interest rates fluctuate. Equity duration is a theoretical
calculation of the projected percentage change in the reported equity
base of the Company that would occur if short-term and long-term
interest rates moved up or down by 1% overnight. The Company's goal is
to maintain an equity duration of less than 15%. In practice, the
Company believes it has maintained an equity duration of less than 10%.
INFLATION
Virtually all of the Company's assets and liabilities are
financial in nature. As a result, interest rates and other factors
drive the Company's performance far more than does inflation. Changes
in interest rates do not necessarily correlate with inflation rates or
changes in inflation rates. The Company's financial statements are
prepared in accordance with generally accepted accounting principals
(GAAP) and the Company's dividends are determined by the Company's net
income as calculated for tax purposes; in each case, the Company's
activities and balance sheet are measured with reference to historical
cost or fair market value without considering inflation.
42
<PAGE> 43
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
At March 31, 1996, there were no pending legal
proceedings to which the Company as a party or of
which any of its property was subject.
Item 2 . Changes in Securities
None
Item 3. Defaults Upon Senior Securities
Not applicable
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit 11 to Part I - Computation of Earnings Per Share for the
three months ended March 31, 1996 and March 31, 1995.
Exhibit 27 - Financial Data Schedule
(b) Reports on Form 8-K
None
43
<PAGE> 44
SIGNATURES
Pursuant to the requirements of the Securities Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
REDWOOD TRUST, INC.
Dated: May 10, 1996 By: /s/ Douglas B. Hansen
----------------------------------------
Douglas B. Hansen
President and Chief Financial Officer
(authorized officer of registrant)
Dated: May 10, 1996 By: /s/ Vickie L. Rath
----------------------------------------
Vickie L. Rath
Vice President, Treasurer and Controller
(principal accounting officer)
44
<PAGE> 45
REDWOOD TRUST, INC.
INDEX TO EXHIBIT
<TABLE>
<CAPTION>
Sequentially
Exhibit Numbered
Number Page
----------- --------------
<S> <C> <C>
11 Computation of Earnings per Share 46
27 Financial Data Schedule 47
</TABLE>
45
<PAGE> 1
EXHIBIT 11
REDWOOD TRUST, INC.
STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS
<TABLE>
<CAPTION>
THREE MONTHS THREE MONTHS
ENDED ENDED
MARCH 31, 1996 MARCH 31, 1995
-------------- --------------
<S> <C> <C>
PRIMARY:
Average common shares outstanding .................................. 5,521,376 208,332
Average preferred shares outstanding (A) ........................... 0 1,666,063
Net effect of dilutive stock options outstanding
during the period -- based on the treasury stock method ........ 164,227 187,022
Net effect of dilutive stock warrants outstanding
during the period -- based on the treasury stock method ........ 443,984 53,744
---------- ----------
Total 6,129,587 2,115,161
========== ==========
Net Income $1,954,190 $ 401,677
========== ==========
Per Share Amount $ 0.32 $ 0.19
========== ==========
FULLY DILUTED:
Average common shares outstanding .................................. 5,521,376 208,332
Average preferred shares outstanding (A) ........................... 0 1,666,063
Net effect of dilutive stock options outstanding
during the period -- based on the treasury stock method ........ 164,548 187,022
Net effect of dilutive stock warrants outstanding
during the period -- based on the treasury stock method ........ 446,724 53,744
---------- ----------
Total 6,132,648 2,115,161
========== ==========
Net Income $1,954,190 $ 401,677
========== ==========
Per Share Amount $ 0.32 $ 0.19
========== ==========
</TABLE>
(A) Preferred shares considered common stock equivalents for all periods as
there is no stated yield and there is an automatic conversion feature to
convert the preferred to common with no additional proceeds to the
company.
46
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM MARCH 31,
1996 QUARTERLY REPORT ON FORM 10-Q AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE
TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<CIK> 0000930236
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