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Filed Pursuant to Rule 424 (b)(1)
Registration Number 333-08363
875,000 SHARES
RWT
REDWOOD TRUST, INC.
CLASS B 9.74% CUMULATIVE CONVERTIBLE PREFERRED STOCK
Redwood Trust, Inc. ("Redwood Trust" or the "Company") is hereby offering
875,000 shares of its Class B 9.74% Cumulative Convertible Preferred Stock (the
"Preferred Stock"). Dividends on the Preferred Stock are cumulative from the
date of issue and are payable quarterly in arrears on January 21, April 21, July
21, and October 21 of each year, commencing October 21, 1996 in an amount per
share equal to the greater of (i) the Base Rate of $0.755 per quarter (equal to
a 9.74% annual dividend rate), or (ii) the quarterly dividend declared on the
number of shares of Common Stock (or portion thereof) into which the Preferred
Stock is convertible.
Each share of Preferred Stock is convertible at any time at the option of
the holder thereof into one share (subject to possible future adjustment in
certain circumstances) of Common Stock. The record date for determination of
shareholders entitled to receive dividends on the Preferred Stock for the period
from the date of issuance through September 30, 1996 is expected to be September
30, 1996. The dividend for the partial period ending September 30, 1996 will be
prorated from the date of issuance and will be determined solely by reference to
the Base Rate.
The Preferred Stock will not be redeemable by the Company prior to October
1, 1999. On and after October 1, 1999, the Preferred Stock will be redeemable by
the Company, in whole or in part, at the option of the Company (i) for one share
(subject to possible future adjustment in certain circumstances) of Common Stock
(plus accumulated, accrued and unpaid dividends through the end of the prior
dividend period, which are to be paid in cash), provided that for 20 trading
days within any period of 30 consecutive trading days, including the last
trading day of such period, the closing price of the Common Stock on the Nasdaq
National Market equals or exceeds the Conversion Price then in effect (initially
equal to the issue price of $31.00 per share (the "Issue Price")) or (ii) for
cash at a redemption price equal to the Issue Price, plus any accumulated,
accrued and unpaid dividends through the date of redemption.
The Company has elected to be subject to tax as a real estate investment
trust ("REIT") under the Internal Revenue Code of 1986, as amended (the "Code"),
and as a result, the dividends on the Preferred Stock are not eligible for the
dividends received deduction for federal income tax purposes.
The shares of Preferred Stock have been approved for quotation on the Nasdaq
National Market (subject to notice of issuance) under the symbol "RWTIP." The
Company's Common Stock is traded on the over-the-counter market and is quoted on
the Nasdaq National Market under the symbol "RWTI." On August 8, 1996, the last
reported sale price per share of Common Stock, as reported by Nasdaq, was
$25 1/2. See "Market Prices and Dividend Data."
SEE "RISK FACTORS" COMMENCING ON PAGE 18 FOR A DISCUSSION OF CERTAIN
FACTORS THAT SHOULD BE CONSIDERED BY PROSPECTIVE PURCHASERS OF THE PREFERRED
STOCK OFFERED HEREBY. THESE RISKS INCLUDE:
- - Risks of Substantial Leverage and Potential Net Interest
and Operating Losses in Connection with Borrowings
- - Risk of Decrease in Net Interest Income Due to
Interest Rate Fluctuations; Prepayment Risks of
Mortgage Assets
- - Risk of Failing to Hedge Against Interest Rate Changes
Effectively; Risk of Losses Associated with Hedging;
Counterparty Risks
- - Risk of Loss on Single-Family Mortgage Assets
- - Risk of Lack of Geographic and Industry Diversification
- - Risk of Future Revisions in Policies and Strategies by
Board of Directors
- - Consequences of Failure to Maintain REIT Status;
Company Subject to Tax as a Regular Corporation
- - Dependence on Key Personnel
------------------------
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE
SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES
COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS
PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A
CRIMINAL OFFENSE.
------------------------
THE ATTORNEY GENERAL OF THE STATE OF NEW YORK HAS NOT PASSED ON OR ENDORSED
THE MERITS OF THIS OFFERING. ANY REPRESENTATION TO THE CONTRARY IS UNLAWFUL.
<TABLE>
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==================================================================================================================
Underwriting
Price to Discounts and Proceeds to
Public Commissions(1) Company(2)
- ---------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<S> <C> <C> <C>
Per Share............................................. $31.00 $1.317 $29.683
Total(3).............................................. $27,125,000 $1,152,375 $25,972,625
==================================================================================================================
</TABLE>
(1) See "Underwriting" for information concerning indemnification of the
Underwriters and other matters.
(2) Before deducting expenses payable by the Company estimated at $300,000.
(3) The Company has granted to the Underwriters a 30-day option to purchase up
to 131,250 additional shares of Preferred Stock solely to cover
over-allotments, if any. If the Underwriters exercise this option in full,
the Price to Public will total $31,193,750, the Underwriting Discount will
total $1,325,231 and the Proceeds to Company will total $29,868,519. See
"Underwriting."
The shares of Preferred Stock are offered by the several Underwriters named
herein, subject to receipt and acceptance by them and subject to their right to
reject any order in whole or in part. It is expected that delivery of the
Preferred Stock will be made in New York, New York on or about August 14, 1996.
------------------------
MONTGOMERY SECURITIES STIFEL, NICOLAUS & COMPANY
Incorporated
August 8, 1996
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IN CONNECTION WITH THIS OFFERING, THE UNDERWRITERS MAY OVER-ALLOT OR EFFECT
TRANSACTIONS WHICH STABILIZE OR MAINTAIN THE MARKET PRICE OF THE PREFERRED STOCK
AND THE COMMON STOCK OF THE COMPANY AT A LEVEL ABOVE THAT WHICH MIGHT OTHERWISE
PREVAIL IN THE OPEN MARKET. SUCH TRANSACTIONS MAY BE EFFECTED ON THE NASDAQ
NATIONAL MARKET, IN THE OVER-THE-COUNTER MARKET OR OTHERWISE. SUCH STABILIZING,
IF COMMENCED, MAY BE DISCONTINUED AT ANY TIME.
IN CONNECTION WITH THIS OFFERING, CERTAIN UNDERWRITERS MAY ENGAGE IN PASSIVE
MARKET MAKING TRANSACTIONS IN THE COMMON STOCK ON THE NASDAQ NATIONAL MARKET IN
ACCORDANCE WITH RULE 10B-6A UNDER THE SECURITIES EXCHANGE ACT OF 1934, AS
AMENDED. SEE "UNDERWRITING."
AVAILABLE INFORMATION
The Company is subject to the informational requirements of the Securities
Exchange Act of 1934, as amended (the "Exchange Act"), and in accordance
therewith files reports and other information with the Securities and Exchange
Commission (the "Commission"). Reports, proxy statements and other information
filed by the Company may be inspected and copied at the public reference
facilities maintained by the Commission at 450 Fifth Street, N.W., Washington,
D.C. 20549, and at the Commission's regional offices located at Seven World
Trade Center, 13th Floor, New York, New York 10048, and at 500 West Madison
Street, Chicago, Illinois 60661. Copies may also be obtained from the Public
Reference section of the Commission at 450 Fifth Street, N.W., Washington, D.C.
20549 at prescribed rates. The Common Stock of the Company is, and the Preferred
Stock is expected to be, quoted on the Nasdaq National Market. Reports, proxy
statements and other information concerning the Company may be inspected at the
National Association of Securities Dealers, Inc., 1735 K Street, N.W.,
Washington, D.C. 20006. In addition, holders of the Capital Stock will receive
annual reports containing audited financial statements with a report thereon by
the Company's independent certified public accountants, and quarterly reports
containing unaudited financial information for each of the first three quarters
of each fiscal year.
The Company has filed with the Commission a Registration Statement on Form
S-11 under the Securities Act of 1933, as amended (the "Securities Act"), with
respect to the Preferred Stock offered hereby. This Prospectus does not contain
all the information set forth in the Registration Statement and the exhibits and
schedules thereto, as certain items are omitted in accordance with the rules and
regulations of the Commission. For further information pertaining to the Company
and the Preferred Stock, reference is made to such Registration Statement and
the exhibits and schedules thereto, which may be inspected without charge at the
office of the Commission at 450 Fifth Street, N.W., Washington, D.C. 20549, and
copies of which may be obtained from the Commission at prescribed rates.
TABLE OF CONTENTS
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AVAILABLE INFORMATION.................................. 2
PROSPECTUS SUMMARY..................................... 3
The Offering......................................... 3
The Company.......................................... 5
Business and Strategy................................ 6
Dividend Policy and Distributions.................... 14
Risk Factors......................................... 14
Summary Financial Information........................ 16
THE COMPANY............................................ 17
USE OF PROCEEDS........................................ 17
RISK FACTORS........................................... 18
Operations Risks..................................... 18
Legal and Other Risks................................ 27
DIVIDEND POLICY AND DISTRIBUTIONS...................... 33
DIVIDEND REINVESTMENT PLAN............................. 34
CAPITALIZATION......................................... 35
MARKET PRICES AND DIVIDEND DATA........................ 36
SELECTED FINANCIAL DATA................................ 37
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.................. 39
Overview............................................. 39
Results of Operations: First Quarter 1996 versus
First Quarter 1995 and Fiscal 1995 Versus Fiscal
1994............................................... 40
Financial Condition.................................. 55
Asset/Liability Management and Effect of Changes in
Interest Rates..................................... 67
BUSINESS AND STRATEGY.................................. 71
Mortgage Assets...................................... 72
Management Policies and Programs..................... 81
Recent Legislation................................... 90
Future Revisions in Policies and Strategies.......... 90
Legal Proceedings.................................... 91
MANAGEMENT............................................. 92
Directors and Executive Officers..................... 92
Executive Compensation............................... 94
Employment Agreements................................ 96
Compensation Committee Interlocks and Insider
Participation in Compensation Decisions............ 97
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Stock Options........................................ 97
Conflict of Interest................................. 99
PRINCIPAL SECURITYHOLDERS.............................. 100
Beneficial Ownership of Common Stock by Large
Securityholders.................................... 100
Beneficial Ownership of Common Stock by Directors and
Management......................................... 101
CERTAIN FEDERAL INCOME TAX CONSIDERATIONS.............. 102
General.............................................. 102
Taxation of the Company.............................. 104
Taxable Subsidiaries................................. 105
Taxation of Stockholders............................. 105
Taxation of Tax-Exempt Entities...................... 107
State and Local Taxes................................ 108
Certain United States Federal Income Tax
Considerations Applicable to Foreign Holders....... 108
ERISA CONSIDERATIONS................................... 110
DESCRIPTION OF WARRANTS................................ 111
DESCRIPTION OF CAPITAL STOCK........................... 112
General.............................................. 112
Preferred Stock...................................... 112
Common Stock......................................... 126
Registration Rights.................................. 127
Repurchase of Shares and Restrictions on Transfer.... 127
Indemnification...................................... 129
Limitation of Liability.............................. 129
Control Share Acquisitions........................... 130
Transfer Agent and Registrar......................... 130
CERTAIN LEGAL ASPECTS OF MORTGAGE LOANS................ 130
Mortgages and Deeds of Trust Generally............... 131
Enforceability of Certain Provisions................. 138
Certain Laws and Regulations......................... 139
UNDERWRITING........................................... 140
LEGAL MATTERS.......................................... 141
EXPERTS................................................ 141
GLOSSARY............................................... 142
INDEX TO FINANCIAL STATEMENTS.......................... F-1
</TABLE>
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PROSPECTUS SUMMARY
The following summary is qualified in its entirety by the more detailed
information appearing in this Prospectus. Certain capitalized and other terms
used herein shall have the meanings assigned to them in the Glossary. Unless
otherwise indicated, all information in this Prospectus assumes that the
over-allotment option described in "Underwriting" is not exercised. See
"Glossary" for the definitions of certain terms used in this Prospectus. This
Prospectus contains forward-looking statements within the meaning of Section 27A
of the Securities Act and Section 21E of the Exchange Act. Such statements
relate to future events or the future financial performance of the Company, and
prospective investors are cautioned that the Company's actual results could
differ materially from those set forth in the forward-looking statements.
Prospective investors should specifically consider the various factors
identified in this Prospectus which could cause actual results to differ,
including those discussed in the section entitled "Risk Factors."
THE OFFERING
Securities Offered......... 875,000 shares of Class B 9.74% Cumulative
Convertible Preferred Stock ("Preferred Stock").(1)
Dividends.................. Cumulative, commencing on the Issue Date in an
amount per share equal to the greater of (i) the
Base Rate of $0.755 per quarter, or (ii) an amount
equal to the quarterly dividend declared on the
number of shares of the Company's Common Stock (or
portion thereof) into which the Preferred Stock is
convertible. Dividends are payable, when and as
declared by the Board of Directors out of funds
legally available for that purpose, with respect to
each calendar quarter in arrears on the following
January 21, April 21, July 21 and October 21 (or
the next succeeding business day) of each year,
commencing October 21, 1996. The dividend for the
partial period ending September 30, 1996 will be
prorated from the date of issuance and will be
determined solely by reference to the Base Rate.
Dividends on the Preferred Stock are determined on
each of the quarterly Common Stock dividend
declaration dates, with record dates and payment
dates the same as for holders of Common Stock.
Dividends on the Preferred Stock are cumulative
from the date of original issuance. No dividends
will be paid or set apart for payment on shares of
Common Stock unless full cumulative dividends have
been paid on the Preferred Stock.
Conversion Rights.......... Each share of the Preferred Stock will be
convertible at the option of the holder at any
time, unless previously redeemed, into one share of
Common Stock, subject to possible future adjustment
in certain circumstances.
Liquidation Preference..... The holders of Preferred Stock will be entitled to
receive out of the assets of the Company or the
proceeds thereof available for distribution to
shareholders, before any distribution is made on
the Common Stock, the Issue Price per share in cash
plus accumulated, accrued but unpaid dividends.
Redemption at Option of the
Company.................. The Preferred Stock will not be redeemable by the
Company prior to October 1, 1999. On and after
October 1, 1999, the Preferred Stock will
- ---------------
(1) Assumes the Underwriters' over-allotment option is not exercised. See
"Underwriting."
3
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be redeemable by the Company, in whole or in part,
at the option of the Company as follows:
(i) for one share of the Common Stock, subject
to adjustment in certain circumstances (plus
accumulated, accrued and unpaid dividends,
which are to be paid in cash through the end
of the prior dividend period), provided that
for 20 trading days within any period of 30
consecutive trading days, including the last
trading day of such period immediately prior
to the announcement of such redemption, the
closing price of the Common Stock on the
Nasdaq National Market equals or exceeds the
Conversion Price (initially equal to the Issue
Price but subject to adjustment upon certain
events). In order to exercise this redemption
option, the Company must issue a press release
announcing the redemption prior to the opening
of business on the second trading day after
the conditions in the preceding sentences
have, from time to time, been met; or
(ii) for cash at the Issue Price per share,
plus any accumulated, accrued and unpaid
dividends through the redemption date.
Voting Rights.............. Except as otherwise expressly required by
applicable law or the Company's Articles of
Incorporation or as described below, the holders of
the Preferred Stock will not be entitled to vote on
any matter and will not be
entitled to notice of any meeting of shareholders
of the Company. If at any time the Company falls in
arrears in the payment of dividends on the
Preferred Stock in an aggregate amount equal to the
full accrued dividends for six quarterly dividend
periods, or upon failure of the Company to maintain
consolidated shareholders' equity (determined in
accordance with generally accepted accounting
principles and giving effect to any adjustment for
the net unrealized gain or loss on assets available
for sale) of at least 150% of the sum of (a) the
aggregate Issue Price of the then outstanding
Preferred Stock and (b) the aggregate original
issue price of any then outstanding Parity Stock
(as defined below), the number of the Company's
directors will be increased (if not already
increased by reason of similar types of provisions
with respect to any Parity Stock) by two and the
holders of the Preferred Stock, together with
holders of all classes of Parity Stock, voting
together as a single class, will have the right to
elect two directors to fill the positions created,
and such right will continue until all dividends in
arrears shall have been paid, or such shareholders'
equity has been restored to at least 150% of the
sum of (a) the aggregate Issue Price of the then
outstanding Preferred Stock and (b) the aggregate
original issue price of any Parity Stock, as the
case may be. If any other class of Parity Stock
with which the Preferred Stock is entitled to vote
as a single class is entitled to elect two
directors as a result of a failure to maintain a
specified level of consolidated shareholders'
equity, then, when such entitlement to vote is
triggered, the separate entitlement of the
Preferred Stock to vote for directors described in
this paragraph shall be suspended.
Ranking.................... The Preferred Stock will rank senior to the Common
Stock with respect to the payment of dividends and
amounts payable upon liquidation, dissolution or
winding up of the Company. The Company may issue
additional classes or series of preferred stock
that rank pari passu with the Preferred Stock as to
the payment of dividends and amounts payable upon
liquidation, dissolution or winding up of the
Company ("Parity
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Stock") without the approval of the holders of the
Preferred Stock. The Company is not permitted to
issue any stock ranking senior to the Preferred
Stock as to the payment of dividends or amounts
upon liquidation without the approval of the
holders of two-thirds of the Preferred Stock.
Nasdaq National Market
Listing.................. The Preferred Stock has been approved for quotation
on the Nasdaq National Market (subject to notice of
issuance) under the symbol "RWTIP."
Use of Proceeds............ The Company intends to use the net proceeds from
the sale of the shares of Preferred Stock, together
with borrowings, to acquire additional Mortgage
Assets as described herein and, pending such use,
to reduce borrowings.
THE COMPANY
Redwood Trust, Inc. ("Redwood Trust" or the "Company") commenced operations
on August 19, 1994. The Company completed its initial public offering of Common
Stock on August 9, 1995. At March 31, 1996 the Company had total Mortgage Assets
of $565 million, total assets of $581 million and shareholders' equity totaling
$68 million. On April 19, 1996 the Company completed its second public offering
for 2,875,000 shares of Common Stock at a price of $20.25 per share. As a result
of the funds raised in the April 19, 1996 offering, the Company was able to
increase total Mortgage Assets and total assets to approximately $1 billion as
of June 30, 1996 and shareholders' equity grew to approximately $125 million as
of that date. While the total dividends paid grew from $2.5 million for first
quarter of 1996 to $3.4 million for the second quarter of 1996, dividends per
share declined from $0.46 per share to $0.40 per share as a result of the
temporary dilution caused by the funds raised in the April 19, 1996 Common Stock
offering not being fully utilized for the full quarter.
The Company specializes in acquiring and managing real estate mortgage
assets ("Mortgage Assets") which may be acquired as whole loans ("Mortgage
Loans") or as mortgage securities representing interests in or obligations
backed by pools of mortgage loans ("Mortgage Securities"). To date, a majority
of the Company's acquisitions have been Mortgage Securities. The Company
acquires Mortgage Assets that are secured by single-family, multifamily and
commercial real estate properties located throughout the United States with a
special emphasis on properties located in the State of California. The Company
has elected to be subject to tax as a real estate investment trust ("REIT")
under the Internal Revenue Code of 1986, as amended (the "Code"), and will
generally not be subject to tax on its Federal income to the extent that it
distributes its earnings to its stockholders and it maintains its qualification
as a REIT. See "Certain Federal Income Tax Considerations." The Company is
self-advised and self-managed.
The goal of the Company is to be an efficient long-term holder of Mortgage
Assets and to seek to benefit from any improvement in the real estate markets in
California and the United States. Substantially all of the Company's Mortgage
Assets are adjustable rate, bearing interest rates that adjust at least annually
based on changes in short-term market interest rates. The Company intends to
acquire additional Mortgage Assets through (i) selected purchases of Mortgage
Securities and (ii) acquisitions of Mortgage Loans from conduits and mortgage
loan originators. The Company also intends to create Mortgage Securities by
using its own assets as collateral. The Company finances its purchases with the
proceeds of equity offerings and borrowings (primarily under reverse repurchase
agreements) whose interest rates also reflect changes in short-term market
interest rates. The Company attempts to structure its borrowings to have
interest rate adjustment indices and interest rate adjustment periods that, on
an aggregate basis, generally correspond (within a range of one to six months)
to the interest rate adjustment indices and interest rate adjustment periods of
the adjustable-rate Mortgage Assets purchased by the Company.
5
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The Company was founded in 1994 by George E. Bull (Chairman and CEO),
Douglas B. Hansen (President and CFO) and Frederick H. Borden (Vice Chairman and
Secretary). This management team has extensive experience in managing portfolios
of Mortgage Assets, arranging collateralized borrowings and utilizing
asset/liability management techniques to hedge balance sheet risks. The members
of this management team have served in various capacities in the banking,
insurance, investment banking and investment management industries and have
managed both healthy and troubled financial institutions as well as both
performing and non-performing Mortgage Assets. The team founded Redwood Trust
with the objective of building a company that could compete favorably with its
competitors by maintaining low operating expenses, utilizing the team's
expertise in managing Mortgage Assets and financial institutions and electing to
be subject to tax on its Federal income as a REIT.
From the commencement of operations on August 19, 1994 through March 31,
1996, the Company acquired Mortgage Assets that had a carrying value at March
31, 1996 of approximately $565.2 million. The Company carries Mortgage Assets on
its books at market value. All Mortgage Assets held at March 31, 1996 were
adjustable rate single-family residential mortgage loans or securitized
interests in pools of such loans. As of March 31, 1996, 90% of the Company's
Mortgage Assets were investment grade equivalent (i.e., one of the four highest
rating levels by one or more nationally recognized mortgage security rating
agencies or the equivalent as determined by the Company), and the Mortgage Asset
portfolio had an average credit rating equivalent of AA+.
All of these assets were acquired in the secondary market for mortgage
loans or directly from mortgage origination firms.
BUSINESS AND STRATEGY
The Company's principal business objective is to produce net interest
income on its Mortgage Assets while maintaining strict cost controls in order to
generate net income for distribution to stockholders. The Company seeks to
distribute dividends to stockholders at levels that generally adjust, following
a lag period, with changes in short-term market interest rates and that may
increase over time in the event of improvements in the single-family,
multifamily and commercial real estate markets. To achieve its business
objective and generate dividend yields that provide a relatively attractive rate
of return for stockholders, the Company's strategy is:
- to purchase Single-Family, Multifamily and Commercial Mortgage Assets,
substantially all of which are currently expected to have adjustable
interest rates based on changes in short-term market interest rates and
the majority of which are expected to represent mortgage interests in
California real estate;
- to manage the credit risk of its Mortgage Assets through, among other
activities, (i) carefully selecting Mortgage Assets to be acquired,
including an underwriting review of Mortgage Loans and lower-rated
Mortgage Securities, (ii) following the Company's policies with respect
to credit risk concentration which, among other things, require the
Company to maintain a Mortgage Asset portfolio with a weighted average
rating level of A- or better, (iii) actively monitoring the ongoing
credit quality and servicing of its Mortgage Assets, and (iv) maintaining
appropriate capital levels and allowances for possible credit losses;
- to finance such purchases with the proceeds of equity offerings and, to
the extent permitted by the Company's capital and liquidity policies, to
utilize leverage to increase potential returns to stockholders through
borrowings (primarily under reverse repurchase agreements) whose interest
rates will also reflect changes in short-term market interest rates;
- to attempt to structure its borrowings to have interest rate adjustment
indices and interest rate adjustment periods that, on an aggregate basis,
generally correspond (within a range of one to six months) to the
interest rate adjustment indices and interest rate adjustment periods of
the adjustable-rate Mortgage Assets purchased by the Company;
6
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- to utilize interest rate caps, swaps and similar instruments to mitigate
the risk of the cost of its variable rate liabilities increasing at a
faster rate than the earnings on its assets during a period of rising
interest rates;
- to seek to minimize prepayment risk by structuring a diversified
portfolio with a variety of prepayment characteristics and through other
means;
- to apply securitization techniques designed to enhance the value and
liquidity of the Company's Mortgage Assets acquired in the form of
Mortgage Loans by securitizing them into Mortgage Securities that are
tailored to the Company's objectives;
- to re-securitize portions of its Mortgage Securities portfolio when the
underlying Mortgage Loans have improved in credit quality through
seasoning or rising underlying property values, or when the credit
quality of a junior class of security improves due to the prepayment of
more senior classes, as such re-securitization transactions may result in
improved credit ratings, higher market values and lowered borrowing
costs; and
- to strive to become more cost-efficient over time.
The Company believes that the current economic environment is favorable for
the Company's business strategy. The Company is located in California and a
majority of its Mortgage Assets currently are and are expected to be represented
by mortgage interests on real property located in California. The Company
believes that there are attractive Mortgage Asset acquisition opportunities in
Northern and Southern California today due to the diversity of the economy and
the size, depth and liquidity of its real estate property markets, and that
there may be significant potential for appreciation in real estate values in
California in the future. At December 31, 1995 and March 31, 1996, approximately
65% and 64%, respectively, of the Company's Mortgage Assets represented
interests in mortgages on residential real property located in California. The
Company expects that any future price appreciation in the real estate property
markets in California and the United States will tend to have a direct and
positive effect on the Company's earnings and dividends. If an increase in
property values occurs, the Company believes that the credit quality and market
value of its Mortgage Assets will rise. Should this occur, the Company expects
that it will be able to reduce its capital allocation to these assets, free its
credit reserves and lower its borrowing costs.
The Company believes that its principal competition in the business of
acquiring and managing Mortgage Assets are financial institutions such as banks,
savings and loans, life insurance companies, institutional investors such as
mutual funds and pension funds, and certain other mortgage REITs. While most of
these entities have significantly greater resources than the Company, the
Company anticipates that it will be able to compete effectively and generate
relatively attractive rates of return for stockholders due to its relatively low
level of operating costs, relative freedom to securitize its assets, ability to
utilize prudent amounts of leverage through accessing the wholesale market for
collateralized borrowings, freedom from certain forms of regulation and the tax
advantages of its REIT status.
The Company believes it is and will continue to be a "low cost producer"
compared to most of its competitors in the business of holding Mortgage Assets.
Accordingly, the Company believes that it will be able to generate relatively
attractive earnings and dividends while holding assets of higher credit quality
and maintaining a lower interest rate risk profile as compared to its principal
competitors. Nevertheless, the Company will strive to become even more
cost-efficient over time. The Company will attempt to do so by: (i) seeking to
raise additional capital from time to time in order to increase its ability to
invest in Mortgage Assets as operating costs are not anticipated to increase as
quickly as assets and because growth will increase the Company's purchasing
influence with suppliers of Mortgage Assets; (ii) striving to lower its
effective borrowing costs over time through seeking direct funding with
collateralized lenders rather than using Wall Street intermediaries and
investigating the possibility of using commercial paper and medium term note
programs; (iii) improving the efficiency of its balance sheet structure by
investigating the issuance of uncollateralized subordinated debt and other forms
of capital; and (iv) utilizing information technology to the fullest extent
possible in its business, which technology the Company believes can be developed
to improve the
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Company's ability to monitor the performance of its Mortgage Assets, improve its
ability to assess credit risk, improve hedge efficiency and lower operating
costs.
MORTGAGE ASSETS
General
The Mortgage Assets to be purchased by the Company will consist primarily
of Single-Family Mortgage Assets (Single-Family Mortgage Loans and Single-Family
Mortgage Securities), Multifamily Mortgage Assets (Multifamily Mortgage Loans
and Multifamily Mortgage Securities) and Commercial Mortgage Assets (Commercial
Mortgage Loans and Commercial Mortgage Securities). Although all of the
Company's Mortgage Assets purchased through March 31, 1996 were Single-Family
Mortgage Assets, the Company expects to acquire Multifamily Mortgage Assets and
Commercial Mortgage Assets from time to time in the future when consistent with
its Asset Acquisition/Capital Allocation Policies. Single-Family Mortgage Loans
are Mortgage Loans secured solely by first mortgages or deeds of trust on
single-family (one- to four-unit) residences and Single-Family Mortgage
Securities are backed by, or evidence interests in, Single-Family Mortgage
Loans. Multifamily Mortgage Loans are Mortgage Loans secured solely by first
mortgages or deeds of trust on multifamily (more than four units) residential
properties and Multifamily Mortgage Securities are backed by, or evidence
interests in, Multifamily Mortgage Loans. Commercial Mortgage Loans are Mortgage
Loans secured by commercial properties and Commercial Mortgage Securities are
backed by, or evidence interests in, Commercial Mortgage Loans. The Company
expects substantially all of its Mortgage Assets to bear adjustable interest
rates. However, fixed rate Mortgage Assets also may be acquired when they
satisfy the Company's Asset Acquisition/Capital Allocation Policies and will
contribute to the Company's business objectives with respect to desired levels
of income and dividend distributions. From time to time, the Company may also
acquire common stock in other REITs that invest primarily in Mortgage Assets if
the Company believes the returns on such common stock are good and such
opportunities are more favorable than investing in Mortgage Assets directly,
provided such common stock is traded on a national securities exchange or quoted
on the Nasdaq National Market. The Company may also acquire its own stock, when
permitted by applicable securities and state corporation laws.
The Company expects that a majority of its Mortgage Assets will have
investment grade ratings (the four highest rating levels) from one or more
nationally recognized mortgage security rating agencies or be deemed by the
Company to be of comparable credit quality. Based upon the Company's investment
strategy and the guidelines under the Company's Asset Acquisition/Capital
Allocation Policies, the Company expects that the weighted average rating of its
Mortgage Assets (including the Company's deemed equivalent ratings for unrated
Mortgage Assets) will be at least an "A-" rating level under the Standard &
Poor's Corporation ("S&P") rating system or at a comparable level under other
rating systems.
The Company will generally not acquire residuals, principal-only strips,
inverse floaters, companion bonds, first loss Subordinated Bonds rated below BBB
or mortgage securities rated below B. On a limited basis only, the Company may
acquire interest-only strips as an investment or to assist in the hedging of
prepayment or other risks. The Company may, however, create a variety of
different types of assets, including the types mentioned in this paragraph,
through the normal process of securitization of the Company's own Mortgage
Assets. In no event will the Company acquire or retain any real estate mortgage
investment conduit ("REMIC") residual interest that may give rise to "excess
inclusion" income as defined under section 860E of the Code. See "Certain
Federal Income Tax Considerations -- Taxation of Tax-Exempt Entities."
For purposes of this Prospectus, "face value" of Mortgage Assets represents
the outstanding principal balance of the Mortgage Loans or Mortgage Securities
comprising the Mortgage Assets, and "amortized cost" means the purchase price
paid for the Mortgage Assets adjusted to reflect (i) amortization of discounts
or premiums embodied in such purchase prices and (ii) principal repayments.
Mortgage Assets are carried on the balance sheet at what is referred to by the
Company as "carrying value." "Carrying value" for the Mortgage Assets is
management's estimate of the bid-side of the market value for such assets.
Management usually bases its estimates on the lowest of third-party bid-side
indications of market value for Mortgage Assets obtained from firms making a
market in or lending against Mortgage Assets. Generally, such
8
<PAGE> 9
indications are solicited by the Company on a monthly basis and from time to
time in connection with the Company's borrowing activities and the lowest of
such indications with respect to a Mortgage Asset generally comes from the
secured lender on that asset. To the extent such bid-side indications typically
are below the amortized cost of Mortgage Assets, the difference is referred to
in this Prospectus as unrealized losses, and, to the extent such indications
exceed the amortized cost, the difference is referred to as unrealized gains.
The net amount of such unrealized gains and losses is reflected on the balance
sheet as a valuation adjustment to Stockholders' Equity under the caption "Net
Unrealized Gain or Loss on Assets Available for Sale."
At March 31, 1996, the Company's Mortgage Assets consisted of the
following:
<TABLE>
<CAPTION>
AS OF MARCH 31, 1996(1)
------------------------------------------------------
PERCENT OF
MORTGAGE ASSETS RATING SCALE(3)
CARRYING VALUE --------------- ---------------
--------------
(DOLLARS IN
THOUSANDS)
<S> <C> <C> <C>
Whole Loans(2)................... $ 24,861 4.4% 1.5
AAA -- Agency.................... 298,354 52.8% 1.0
AAA.............................. 91,304 16.2% 1.0
AA............................... 100,531 17.7% 2.0
A................................ 19,184 3.4% 3.0
BBB.............................. 6,653 1.2% 4.0
BB............................... 11,158 2.0% 5.0
B................................ 12,758 2.2% 6.0
Other............................ 356 0.1% 6.0
-------------- ------ -----
Total/Weighted Average........... $565,159 100.0% 1.50
Weighted Average Rating.......... AA+
Percentage Investment Grade...... 96%
Weighted Average Rating on Non-
agency Portfolio............... AA 2.06
Percentage Investment Grade of
Non-agency Portfolio........... 90%
</TABLE>
- ---------------
(1) All assets are rated by one or more of the four nationally recognized rating
agencies or are assigned a rating deemed equivalent by the Company. When
rating agencies have assigned different ratings to the same asset,
management has assigned that asset to the category it believes is most
appropriate.
(2) If rated, management believes that 90-95% of these loans would receive
investment grade ratings. For inclusion in the overall averages, 94% are
assumed to be investment grade, producing an average rating of AA+.
(3) For purposes of computing a weighted average portfolio rating, management
has assigned a number to each rating level, with AAA being a "1" and B or
below being a "6," as indicated in the table.
A detailed analysis of the Company's initial Mortgage Assets is presented
in "Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Business and Strategy -- Mortgage Assets."
MANAGEMENT POLICIES AND PROGRAMS
Asset Acquisition Policies
The Company only acquires those Mortgage Assets the Company believes it has
the necessary expertise to evaluate and manage and which are consistent with the
Company's balance sheet guidelines and risk management objectives. Since the
intention of the Company is generally to hold its Mortgage Assets until
maturity, the Company generally does not seek to acquire assets whose investment
returns are only attractive in a limited range of scenarios. The Company
believes that future interest rates and mortgage prepayment
9
<PAGE> 10
rates are very difficult to predict. Therefore, the Company seeks to acquire
Mortgage Assets which the Company believes will provide acceptable returns over
a broad range of interest rate and payment scenarios.
Among the asset choices available to the Company, the Company acquires
those Mortgage Assets which the Company believes will generate the highest
returns on capital invested, after considering (i) the amount and nature of the
anticipated cashflows from the asset, (ii) the Company's ability to pledge the
asset to secure collateralized borrowings, (iii) the increase in the Company's
risk-adjusted capital requirement determined by the Company's Risk-Adjusted
Capital Policy resulting from the purchase and financing of the asset, and (iv)
the costs of financing, hedging, managing, securitizing and reserving for the
asset. Prior to acquisition, potential returns on capital employed are assessed
over the life of the asset and in a variety of interest rate, yield spread,
financing cost, credit loss and prepayment scenarios.
Credit Risk Management Policies
The Company reviews credit risk, interest rate risk and other risk of loss
associated with each investment and determines the appropriate allocation of
capital to apply to such investment under its Risk-Adjusted Capital Policy.
Because the risks presented by Single-Family, Multifamily and Commercial
Mortgage Assets are different, the Company analyzes the risk of loss associated
with such Mortgage Assets separately. In addition, the Company attempts to
diversify its investment portfolio to avoid undue geographic, issuer, industry
and certain other types of concentrations. The Company attempts to obtain
protection from sellers and servicers against certain risks through
representations and warranties and other appropriate documentation. The Board of
Directors monitors the overall portfolio risk and determines appropriate levels
of provision for loss.
With respect to its Mortgage Securities, the Company is exposed to various
levels of credit and special hazard risk, depending on the nature of the
underlying Mortgage Assets and the nature and level of credit enhancements
supporting such securities. Most of the Mortgage Assets acquired by the Company
have some degree of protection from normal credit losses. At December 31, 1995
and March 31, 1996, 55.8% and 52.8%, respectively, of the Company's Mortgage
Assets were Mortgage Securities covered by credit protection in the form of a
100% guarantee from a government sponsored entity (GNMA, FNMA and FHLMC)
("Agency Certificates").
An additional 38.1% and 42.8% of the Company's Mortgage Assets at December
31, 1995 and March 31, 1996, respectively, were Privately Issued Certificates
and represented interests in pools of residential mortgage loans with partial
credit enhancement; of these amounts, 85% and 90% were rated investment grade
equivalent, respectively. Credit loss protection for Privately Issued
Certificates is achieved through the subordination of other interests in the
pool to the interest held by the Company, through pool insurance or though other
means. The degree of credit protection varies substantially among the Privately
Issued Certificates held by the Company. While most Privately Issued
Certificates held by the Company have some degree of credit enhancement, the
majority of such assets are, in turn, subordinated to other interests. Thus,
should such a Privately Issued Certificate experience credit losses, such losses
could be greater than the Company's pro rata share of the remaining mortgage
pool, but in no event could exceed the Company's investment in such Privately
Issued Certificate. At March 31, 1996, the amount of realized credit losses a
particular pool of mortgages represented by Privately Issued Certificates would
have to experience before the Company would bear responsibility for any credit
losses ranged from 0% to 37% of the pool balance. The Company has undertaken an
independent underwriting review of a sample of the loans underlying the
Privately Issued Certificates that are rated below BBB.
All of the Company's Mortgage Assets have received a credit rating from one
or more nationally recognized rating agencies or have been assigned a rating
deemed equivalent by the Company. At March 31, 1996, the average rating of the
Company's Mortgage Assets, as adjusted to a single format and weighted by
carrying value, was AA+. At March 31, 1996, the average rating of the non-agency
Mortgage Assets was AA.
At March 31, 1996, the Company owned $24.9 million of whole Mortgage Loans,
which comprised 4.4% of the Company's total Mortgage Assets at such date. In
preparation for purchases of Mortgage Assets in the form of Mortgage Loans, the
Company developed a quality control program to monitor the quality of loan
10
<PAGE> 11
underwriting at the time of acquisition and on an ongoing basis. The Company
will conduct, or cause to be conducted, a legal document review of each Mortgage
Loan acquired to verify the accuracy and completeness of the information
contained in the mortgage notes, security instruments and other pertinent
documents in the file. As a condition of purchase, the Company will select a
sample of Mortgage Loans targeted to be acquired, focusing on those Mortgage
Loans with higher risk characteristics, and submit them to a third party,
nationally recognized underwriting review firm for a compliance check of
underwriting and review of income, asset and appraisal information. In addition,
the Company or its agents will underwrite all Multifamily and Commercial
Mortgage Loans. During the time it holds Mortgage Loans, the Company will be
subject to risks of borrower defaults and bankruptcies and special hazard losses
(such as those occurring from earthquakes or floods) that are not covered by
standard hazard insurance. The Company will generally not obtain credit
enhancements such as mortgage pool or special hazard insurance for its Mortgage
Loans, although individual loans may be covered by FHA insurance, VA guarantees
or private mortgage insurance and, to the extent securitized into Agency
Certificates, by such government sponsored entity obligations or guarantees.
Capital and Leverage Policies
The Company's goal is to strike a balance between the under-utilization of
leverage, which reduces potential returns to stockholders, and the
over-utilization of leverage, which could reduce the Company's ability to meet
its obligations during adverse market conditions. The Company has established a
"Risk-Adjusted Capital Policy" which limits management's ability to acquire
additional assets during times when the actual capital base of the Company is
less than a required amount defined in the policy. In this way, the use of
balance sheet leverage is controlled. The actual capital base as defined for the
purpose of this policy is equal to the market value of total assets less the
book value of total collateralized borrowings. The actual capital base, as so
defined, represents the approximate liquidation value of the Company and
approximates the market value of assets that can be pledged or sold to meet
over-collateralization requirements for the Company's borrowings. The unpledged
portion of the Company's actual capital base is available to be pledged or sold
as necessary to maintain over-collateralization levels for the Company's
borrowings.
Management is prohibited from acquiring additional assets during periods
when the actual capital base of the Company is less than the minimum amount
required amount under the Risk-Adjusted Capital Policy (except when such asset
acquisitions may be necessary to maintain REIT status or the Company's exemption
from the Investment Company Act of 1940). In addition, when the actual capital
base falls below the Risk-Adjusted Capital requirement, management is required
to submit to the Board a plan for bringing the actual capital base into
compliance with the Risk-Adjusted Capital Policy guidelines. It is anticipated
that in most circumstances this goal will be achieved over time without overt
management action through the natural process of mortgage principal repayments
and increases in the market values of Mortgage Assets as their coupon rates
adjust upwards to market levels. Management anticipates that the actual capital
base is likely to exceed the Risk-Adjusted Capital requirement during periods
following new equity offerings and during periods of falling interest rates and
that the actual capital base may fall below the Risk-Adjusted Capital
requirement during periods of rising interest rates.
The first component of the Company's capital requirements is the current
aggregate over-collateralization amount or "haircut" the lenders require the
Company to hold as capital. The haircut for each Mortgage Asset is determined by
the lender based on the risk characteristics and liquidity of that asset.
Haircut levels on individual borrowings range from 3% for Agency Certificates to
20% for certain Privately Issued Certificates, and have averaged 4% to 6% for
the Company as a whole. Should the market value of the pledged assets decline,
the Company will be required to deliver additional collateral to the lenders in
order to maintain a constant over-collateralization level on its borrowings.
The second component of the Company's capital requirement is the "liquidity
capital cushion." The liquidity capital cushion is an additional amount of
capital in excess of the haircut maintained by the Company in order to help the
Company meet the demands of the lenders for additional collateral should the
market value of the Company's Mortgage Assets decline. The aggregate liquidity
capital cushion equals the sum of liquidity cushion amounts assigned under the
Risk-Adjusted Capital Policy to each of the Company's Mortgage Assets. Liquidity
capital cushions are assigned to each Mortgage Asset based on management's
11
<PAGE> 12
assessment of the Mortgage Asset's market price volatility, credit risk,
liquidity and attractiveness for use as collateral by lenders. The process of
assigning liquidity capital cushions relies on management's ability to identify
and weigh the relative importance of these and other factors. Consideration is
also given to hedges associated with the Mortgage Asset and any effect such
hedges may have on reducing net market price volatility, concentration or
diversification of credit and other risks in the balance sheet as a whole and
the net cash flows that can be expected to arise from the interaction of the
various components of the Company's balance sheet. The Board of Directors thus
reviews on a periodic basis various analyses prepared by management of the risks
inherent in the Company's balance sheet, including an analysis of the effects of
various scenarios on the Company's net cash flow, earnings, dividends, liquidity
and net market value. Should the Board of Directors determine that the minimum
required capital base set by the Company's Risk-Adjusted Capital Policy is
either too low or too high, the Board of Directors will raise or lower the
capital requirement accordingly.
The Company expects that its aggregate minimum capital requirement under
the Risk-Adjusted Capital Policy will approximate 10% to 20% of the market value
of the Company's Mortgage Assets. This percentage will fluctuate over time, and
may fluctuate out of the expected range, as the composition of the balance sheet
changes, haircut levels required by lenders change, the market value of the
Mortgage Assets changes and as liquidity capital cushion percentages set by the
Board of Directors are adjusted over time. As of March 31, 1996 the aggregate
Risk-Adjusted Capital Requirement was 11.7% of Mortgage Assets, and the
Company's actual capital base was 11.7% of Mortgage Assets.
The Risk-Adjusted Capital Policy also stipulates that at least 50% of the
capital base maintained to satisfy the liquidity capital cushion shall be
invested in Agency Certificates, AAA-rated adjustable-rate Mortgage Securities
or assets with similar or better liquidity characteristics.
Pursuant to the Company's overall business strategy, a substantial portion
of the Company's borrowings are short term or adjustable-rate. The Company's
borrowings currently are, and are expected to continue to be, implemented
primarily through reverse repurchase agreements (a borrowing device evidenced by
an agreement to sell securities or other assets to a third-party and a
simultaneous agreement to repurchase them at a specified future date and price,
the price difference constituting interest on the borrowing), but in the future
may also be obtained through loan agreements, lines of credit, Dollar-Roll
Agreements (an agreement to sell a security for delivery on a specified future
date and a simultaneous agreement to repurchase the same or a substantially
similar security on a specified future date) and other credit facilities with
institutional lenders and issuance of debt securities such as commercial paper,
medium-term notes, CMOs and senior or subordinated notes. See "Business and
Strategy -- Management Policies and Programs -- Capital and Leverage Policies."
The Company intends to enter into financing transactions only with institutions
that it believes are sound credit risks and to follow other internal policies
designed to limit its credit and other exposure to financing institutions.
ASSET/LIABILITY MANAGEMENT PROGRAMS
Interest Rate Risk Management Program
To the extent consistent with its election to qualify as a REIT, the
Company follows an interest rate risk management program intended to protect
against the effects of major interest rate changes. Specifically, the Company's
interest rate risk management program is formulated with the intent to offset
the potential adverse effects resulting from rate adjustment limitations on its
Mortgage Assets and the differences between interest rate adjustment indices and
interest rate adjustment periods of its adjustable-rate Mortgage Assets and
related borrowings. The Company's interest rate risk management program
encompasses a number of procedures, including: (i) the Company attempts to
structure its borrowings to have interest rate adjustment indices and interest
rate adjustment periods that, on an aggregate basis, generally correspond to the
interest rate adjustment indices and interest rate adjustment periods of the
adjustable-rate Mortgage Assets purchased by the Company, so as to limit
mis-matching of such aggregates to a range of one to six months, and (ii) the
Company attempts to structure its borrowing agreements relating to
adjustable-rate Mortgage Assets to have a range of different maturities and
interest rate adjustment periods (although substantially all will be less than
12
<PAGE> 13
one year). As a result, the Company expects to be able to adjust the average
maturity/adjustment period of such borrowings on an ongoing basis by changing
the mix of maturities and interest rate adjustment periods as borrowings come
due and are renewed. Through use of these procedures, the Company intends to
minimize differences between interest rate adjustment periods of adjustable-rate
Mortgage Assets and related borrowings that may occur.
The Company purchases interest rate caps, interest rate swaps and similar
instruments to attempt to mitigate the risk of the cost of its variable rate
liabilities increasing at a faster rate than the earnings on its assets during a
period of rising rates. In this way, the Company intends generally to hedge as
much of the interest rate risk as management determines is in the best interests
of the stockholders of the Company, given the cost of such hedging transactions
and the need to maintain the Company's status as a REIT, among other factors.
See "Certain Federal Income Tax Considerations -- General -- Gross Income
Tests." This determination may result in management electing to have the Company
bear a level of interest rate risk that could otherwise be hedged when
management believes, based on all relevant facts, that bearing such risk is
advisable. The Company may also, to the extent consistent with its compliance
with the REIT Gross Income Tests, Maryland law and the no-action relief
discussed below, utilize financial futures contracts, options and forward
contracts as a hedge against future interest rate changes. The Company has
obtained no-action relief from the Commodities Futures Trading Commission
permitting the Company to invest a small percentage of the Company's assets in
certain financial futures contracts and options thereon without registering as a
commodity pool operator under the Commodity Exchange Act, provided that the
Company uses such instruments solely for bona fide hedging purposes.
The Company seeks to build a balance sheet and undertake an interest rate
risk management program which is likely, in management's view, to enable the
Company to generate positive earnings and maintain an equity liquidation value
sufficient to maintain operations given a variety of potentially adverse
circumstances. Accordingly, the hedging program addresses both income
preservation, as discussed in the first part of this section, and capital
preservation concerns. With regard to the latter, the Company monitors its
"equity duration." This is the expected percentage change in the Company's
equity (measured as the carrying value of total assets less book value of total
liabilities) that would be caused by a 1% change in short and long term interest
rates. To date, the Company believes that it has met its goal of maintaining an
equity duration of less than 15%. To monitor its equity duration and the related
risks of fluctuations in the liquidation value of the Company's equity, the
Company models the impact of various economic scenarios on the market value of
the Company's Mortgage Assets, liabilities and interest rate agreements. See
"Risk Factors -- Operations Risks -- Risk of Decrease in Net Interest Income Due
to Interest Rate Fluctuations; Prepayment Risks of Mortgage Assets" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Asset/Liability Management and Effect of Changes in Interest
Rates." The Company believes that the existing hedging program will allow the
Company to maintain operations throughout a wide variety of potentially adverse
circumstances without further management action. Nevertheless, in order to
further preserve the Company's capital base (and lower its equity duration)
during periods when management believes a trend of rapidly rising interest rates
has been established, management may decide to increase hedging activities
and/or sell assets. Each of these types of actions may lower the earnings and
dividends of the Company in the short term in order to further the objective of
maintaining attractive levels of earnings and dividends over the long term.
In all of its interest rate risk management transactions, the Company
follows certain procedures designed to limit credit exposure to counterparties,
including dealing only with counterparties whose financial strength meets the
Company's requirements. See "Business and Strategy -- Management Policies and
Programs -- Asset/Liability Management -- Interest Rate Risk Management."
Although the Company believes it has developed a cost-effective
asset/liability management program to provide a level of protection against
interest rate and prepayment risks, no strategy can completely insulate the
Company from the effects of interest rate changes, prepayments and defaults by
counterparties. Further, certain of the Federal income tax requirements that the
Company must satisfy to qualify as a REIT limit the Company's ability to fully
hedge its interest rate and prepayment risks. See "Certain Federal Income Tax
Considerations -- General."
13
<PAGE> 14
Prepayment Risk Program
The Company seeks to minimize the effects of faster or slower than
anticipated prepayment rates through structuring a diversified portfolio with a
variety of prepayment characteristics, investing in Mortgage Assets with
prepayment prohibitions and penalties, investing in certain Mortgage Security
structures which have prepayment protections, and balancing assets purchased at
a premium with assets purchased at a discount. In addition, the Company has
purchased and may in the future purchase additional interest-only strips to a
limited extent as a hedge against prepayment risk. Prepayment risk is monitored
by management and the Board of Directors through periodic review of the impact
of a variety of prepayment scenarios on the Company's revenues, net earnings,
dividends, cash flow and net balance sheet market value.
DIVIDEND POLICY AND DISTRIBUTIONS
The Company intends to distribute to stockholders each year substantially
all of its net taxable income (which does not ordinarily equal net income as
calculated in accordance with GAAP) so as to qualify for the tax benefits
accorded to REITs under the Code. Dividends will be payable on the Preferred
Stock quarterly in the amounts and on the dates set forth herein, and are
cumulative from the date of original issuance. The Company intends to make
dividend distributions on the Common Stock at least quarterly; provided,
however, that no dividends will be paid or set apart for payment on shares of
Common Stock unless full cumulative dividends have been paid on the Preferred
Stock.
The Company has adopted a Dividend Reinvestment Plan ("DRP") that allows
stockholders to have their dividends reinvested automatically in shares of
Common Stock at 97% of the then current market price. The shares of Common Stock
to be acquired for distribution under the DRP will be purchased on the open
market or directly from the Company, at the option of the Company. The holders
of Preferred Stock will be eligible to participate in the DRP in which dividends
would be reinvested in Common Stock. See "Dividend Reinvestment Plan."
RISK FACTORS
The purchase of the Preferred Stock offered hereby is subject to certain
risks. See "Risk Factors." Among such risks are the following:
- The Company employs a strategy of borrowing a substantial portion of the
market value of the Mortgage Assets (approximately 80% to 90%) to finance
the acquisition of such Mortgage Assets, although the percentage may vary
depending on market conditions or other factors deemed relevant by
management. The Company may incur a decrease in net interest income and
may incur net losses if returns on Mortgage Assets are not sufficient to
cover borrowing costs. In addition, various factors may prevent the
Company from attaining the level of leverage it deems optimal, which may
cause the Company to be less profitable than it would be otherwise.
- Interest rate fluctuations may affect the Company's earnings as a result
of potential changes in the spread between the interest rates on its
borrowings and the interest rates on its Mortgage Assets. In addition,
mortgage prepayment rates vary depending on such factors as mortgage
interest rates and market conditions. Changes in anticipated prepayment
rates may affect the Company's earnings by changing the speed of
amortization of purchase discounts and premiums. Any adverse or
anticipated adverse effect on the Company's earnings may negatively
impact the market price and liquidity of the Company's Common Stock and
the Preferred Stock.
- Asset/liability management hedging strategies involve risk and may not be
effective in reducing the Company's exposure to interest rate changes.
Moreover, compliance with the REIT Provisions of the Code may prevent the
Company from effectively implementing the strategies that the Company
determines, absent such compliance, would best insulate the Company from
the risks associated with changing interest rates.
14
<PAGE> 15
- During the time the Company holds Single-Family Mortgage Loans or
Single-Family Mortgage Securities other than Agency Certificates, it will
be subject to the risk of loss on such Mortgage Assets arising from
borrower defaults to the extent not covered by third-party credit
enhancement.
- The Company does not set specific limitations on the aggregate percentage
of its portfolio comprised of Mortgage Assets secured by properties
located in any one area, and a substantial portion of the properties
securing the Company's Mortgage Assets are concentrated in California. To
the extent that properties underlying Mortgage Assets are located in the
same geographical region, such Mortgage Assets may be subject to a
greater risk of default than other comparable Mortgage Assets in the
event of adverse economic, political, or business developments and
natural hazard risks that may affect such region.
- If the Company fails to maintain its qualification as a REIT, the Company
will be subject to Federal income tax as a regular corporation. The
Company intends to conduct its business at all times in a manner
consistent with the REIT Provisions of the Code.
- The investment policies and operating policies and strategies of the
Company set forth in this Prospectus may be modified or waived by the
Board of Directors, subject in certain cases to approval by a majority of
the Independent Directors, without stockholder consent.
- The Company's operations depend in significant part upon the
contributions of its executive officers, many of whom would be difficult
to replace. The loss of any key person may have a material adverse effect
on the Company's business and results of operations.
15
<PAGE> 16
SUMMARY FINANCIAL INFORMATION
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
PERIOD FROM
THREE MONTHS THREE MONTHS AUGUST 19, 1994
ENDED ENDED YEAR ENDED TO
MARCH 31, 1996 MARCH 31, 1995 DECEMBER 31, 1995 DECEMBER 31, 1994
-------------- -------------- ----------------- -----------------
<S> <C> <C> <C> <C>
STATEMENT OF INCOME DATA:
Days in Period............... 91 90 365 133
Interest Income.............. $ 9,131 $ 2,170 $ 15,726 $ 1,296
Interest and Hedge
Expenses................... 6,353 1,549 10,947 768
Net Interest Income.......... 2,778 621 4,779 528
Net Income................... 1,954 402 3,155 382
Primary Earnings per
Share(1)................... $ 0.32 $ 0.19 $ 0.85 $ 0.20
Dividends Declared per Class
A Preferred Share(2)....... $ 0.00 $ 0.20 $ 0.50 $ 0.25
Dividends Declared per Common
Share(3)................... $ 0.46 $ 0.00 $ 0.46 $ 0.00
BALANCE SHEET DATA (AT PERIOD END):
Total Mortgage Assets........ $565,159 $141,859 $ 432,244 $ 117,477
Total Assets................. 581,313 145,440 441,557 121,528
Short-term Borrowings........ 508,721 121,998 370,316 100,376
Stockholders' Equity......... 68,146 22,352 68,290 20,280
</TABLE>
- ---------------
(1) See Note 1 to the Financial Statements for information regarding the
calculation of this item.
(2) All shares of Class A Preferred Stock have been converted into Common Stock.
(3) The level of quarterly dividends is determined by the Board of Directors
based upon its consideration of a number of factors and should not be deemed
indicative of taxable income for the quarter in which declared or future
quarters, or of income calculated in accordance with GAAP. See "Dividend
Policy and Distributions."
RECENT FINANCIAL DATA
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
QUARTER ENDED SIX MONTHS ENDED
JUNE 30, 1996 JUNE 30, 1996
------------------- ----------------------
<S> <C> <C>
STATEMENT OF INCOME DATA:
Interest Income....................................... $ 12,901 $ 21,613
Interest and Hedge Expenses........................... 9,330 15,684
Net Interest Margin................................... 3,571 6,348
Net Income............................................ 2,500 4,454
Primary Earnings per Share(1)......................... $ 0.29 $ 0.60
Dividends Declared per Common Share(2)................ $ 0.40 $ 0.86
</TABLE>
<TABLE>
<CAPTION>
AT JUNE 30, 1996
----------------------------------------
<S> <C>
BALANCE SHEET DATA (AT PERIOD END):
Total Mortgage Assets................................ $1,007,480
Total Assets......................................... 1,028,330
Short-term Borrowings................................ 896,214
Stockholders' Equity................................. 124,295
</TABLE>
- ---------------
(1) See Note 1 to the Financial Statements for information regarding the
calculation of this item.
(2) The level of quarterly dividends is determined by the Board of Directors
based upon its consideration of a number of factors and should not be deemed
indicative of taxable income for the quarter in which declared or future
quarters, or of income calculated in accordance with GAAP. See "Dividend
Policy and Distributions."
Total assets grew 77% during the quarter ending June 30, 1996. The
Company's equity-to-asset ratio at that date was 12.1% as compared to 11.7% at
March 31, 1996. The Company's return on average equity fell to 8.93% during the
second quarter from 11.43% during the first quarter due to the short-term
dilutive effect of the April 1996 equity offering. Substantially all Mortgage
Assets at June 30, 1996 continued to be adjustable-rate single family first
mortgages.
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THE COMPANY
The Company was incorporated in the State of Maryland on April 11, 1994 and
commenced operations on August 19, 1994. It invests in Mortgage Assets financed
by the proceeds of equity offerings and by borrowings. The Company produces net
interest income on Mortgage Assets qualifying as Qualified REIT Real Estate
Assets while maintaining strict cost controls in order to generate net income
for distribution to its stockholders. The Company intends to continue operating
in a manner that will permit it to maintain its qualification as a REIT for
Federal income tax purposes. As a result of its REIT status, the Company is
permitted to deduct dividend distributions to stockholders, thereby effectively
eliminating the "double taxation" that generally results when a corporation
earns income and distributes that income to stockholders in the form of
dividends. See "Certain Federal Income Tax Considerations -- Taxation of the
Company." The principal executive offices of the Company are located at 591
Redwood Highway, Suite 3100, Mill Valley, California 94941, telephone (415)
389-7373.
The Company is self-advised and self-managed. The management of the Company
manages the day-to-day operations of the Company, subject to the supervision of
the Company's Board of Directors. The management team of the Company has
considerable expertise in the acquisition and management of Mortgage Assets,
mortgage finance, asset/liability management and the management of corporations
in the real estate lending business, including banks, savings and loans and life
insurance companies. In addition to working with healthy real estate assets and
healthy real estate lending institutions, the management of the Company also has
experience managing the assets of several failed life insurance companies during
rehabilitation, managing and advising a number of troubled savings and loans and
banks, and overseeing the workout and liquidation process for large portfolios
of troubled commercial real estate mortgages and equity investments. See
"Management -- Directors and Executive Officers." Reference to the "Company"
herein shall include any taxable or Qualified REIT Subsidiaries through which
the Company may conduct its business.
USE OF PROCEEDS
The net proceeds to be received by the Company from the sale of the 875,000
shares of Preferred Stock being offered hereby by the Company are estimated to
be approximately $25,672,625 after deducting underwriting discounts and
commissions and estimated expenses (approximately $29,568,519 if the
Underwriters' over-allotment option is exercised in full). The net proceeds,
together with borrowings, will be used to purchase Mortgage Assets as described
herein. Pending use of the proceeds to purchase such Mortgage Assets, the net
proceeds may be used to reduce borrowings. The Company intends to increase its
investment in Mortgage Assets by borrowing against existing Mortgage Assets (as
described under "Business and Strategy -- Management Policies and
Programs -- Capital and Leverage Policies") and using the proceeds to acquire
additional Mortgage Assets. The Company's borrowings generally are secured by
the Mortgage Assets owned by the Company. Until the proceeds are fully utilized
along with borrowings in this manner, the Company's net earnings are expected to
be lower than would be the case if this financing strategy were fully
implemented.
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RISK FACTORS
In addition to the other information contained in this Prospectus, the
following risk factors should be carefully considered in the evaluating the
Company and its business before purchasing any of the shares of Preferred Stock
offered hereby. This Prospectus contains forward-looking statements within the
meaning of Section 27A of the Securities Act and Section 21E of the Exchange
Act. Discussions containing such forward-looking statements may be found in the
material set forth under "Prospectus Summary," "Use of Proceeds," "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
"Business and Strategy," as well as within the Prospectus generally. Actual
results could differ materially from those discussed in the forward-looking
statements as a result of the risk factors set forth below and the matters set
forth in the Prospectus generally. The Company cautions the reader, however,
that this list of factors may not be exhaustive.
OPERATIONS RISKS
GENERAL
The results of the Company's operations are affected by various factors,
many of which are beyond the control of the Company. The results of the
Company's operations depend on, among other things, the level of net interest
income generated by the Company's Mortgage Assets, the market value of such
Mortgage Assets and the supply of and demand for such Mortgage Assets. The
Company's net interest income varies primarily as a result of changes in
short-term interest rates, borrowing costs and prepayment rates, the behavior of
which involve various risks and uncertainties as set forth below. Prepayment
rates, interest rates, borrowing costs and credit losses depend upon the nature
and terms of the Mortgage Assets, the geographic location of the properties
securing the Mortgage Loans included in or underlying the Mortgage Assets,
conditions in financial markets, the fiscal and monetary policies of the United
States government and the Board of Governors of the Federal Reserve System,
international economic and financial conditions, competition and other factors,
none of which can be predicted with any certainty. Because changes in interest
rates may significantly affect the Company's activities, the operating results
of the Company depend, in large part, upon the ability of the Company to
effectively manage its interest rate and prepayment risks while maintaining its
status as a REIT. See "-- Risk of Failing to Hedge Against Interest Rate Changes
Effectively; Risk of Losses Associated with Hedging; Counterparty Risks,"
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Asset/Liability Management and the Effect of Changes in Interest
Rates" and "Business and Strategy -- Management Policies and Programs -- Asset/
Liability Management -- Interest Rate Risk Management."
RISKS OF SUBSTANTIAL LEVERAGE AND POTENTIAL NET INTEREST AND OPERATING LOSSES
IN CONNECTION WITH BORROWINGS
General
The Company intends to continue to employ its financing strategy to
increase the size of its Mortgage Asset investment portfolio by borrowing a
substantial portion (which may vary depending upon the mix of the Mortgage
Assets in the Company's portfolio and the application of the Risk-Adjusted
Capital Policy requirements to such mix of Mortgage Assets) of the market value
of its Mortgage Assets. The Company expects generally to maintain a ratio of its
total book capital base (book value of capital accounts, retained earnings and
subordinated debt deemed by management to qualify as capital for this purpose,
taking into account valuation adjustments) to book value of total assets of
between 10% and 20%, although the percentage may vary from time to time
depending upon market conditions and other factors deemed relevant by
management. However, the Company is not limited under its Bylaws in respect of
the amount of its borrowings, whether secured or unsecured, and the aggregate
percentage of total equity capital could at times be lower than 10%. If the
returns on the Mortgage Assets purchased with borrowed funds fail to cover the
cost of the borrowings, the Company will experience net interest losses and may
experience net losses. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Financial Condition -- Liquidity" and
"-- Capital Adequacy/Risk-Adjusted Capital Policy," and "Business and
Strategy -- Management Policies and Programs -- Capital and Leverage Policies."
In addition, through increases in haircuts, decreases in the market value of the
Company's Mortgage Assets, increases in interest
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rate volatility, availability of financing in the market, circumstances then
applicable in the lending market and other factors, the Company may not be able
to achieve the degree of leverage it believes to be optimal, which may cause the
Company to be less profitable than it would be otherwise.
Risk of Failure to Refinance Outstanding Borrowings
Additionally, the ability of the Company to achieve its investment
objectives depends not only on its ability to borrow money in sufficient amounts
and on favorable terms but also on the Company's ability to renew or replace on
a continuous basis its maturing short-term borrowings. The Company's business
strategy relies on short-term borrowings to fund Mortgage Assets with
adjustable-rate coupons and long-term maturities. The Company has not at the
present time entered into any commitment agreements under which a lender would
be required to enter into new borrowing agreements during a specified period of
time; however, the Company may enter into one or more of such commitment
agreements in the future if deemed favorable to the Company. In the event the
Company is not able to renew or replace maturing borrowings, the Company could
be required to sell Mortgage Assets under adverse market conditions and could
incur losses as a result. In addition, in such event, the Company may be
required to terminate hedge positions, which could result in further costs to
the Company. An event or development such as a sharp rise in interest rates or
increasing market concern about the value or liquidity of a type or types of
Mortgage Loans or Mortgage Securities in which the Company's portfolio is
concentrated will reduce the market value of the Mortgage Assets, which would
likely to cause lenders to require additional collateral. At the same time, the
market value of the assets in which the Company's liquidity capital is invested
may have decreased. A number of such factors in combination may cause
difficulties for the Company, including a possible liquidation of a major
portion of the Company's Mortgage Assets at disadvantageous prices with
consequent losses, which could have a materially adverse effect on the Company
and its solvency.
A majority of the Company's borrowings are, and are expected to continue to
be, collateralized borrowings, primarily in the form of reverse repurchase
agreements and similar borrowings, the availability of which are based on the
market value of the Mortgage Assets pledged to secure the specific borrowings,
availability of financing in the market, circumstances then applicable in the
lending market and other factors. Additional borrowings may be obtained through
loan agreements, lines of credit, Dollar Roll Agreements and other credit
facilities with institutional lenders or the issuance of debt securities. The
cost of borrowings under reverse repurchase agreements generally correspond to
LIBOR plus or minus a margin, although many of such agreements do not expressly
incorporate a LIBOR index. The cost of borrowings under other sources of funding
which the Company may use may refer or correspond to other short-term indices,
plus or minus a margin. The margins on such borrowings over or under LIBOR or
such other short-term indices vary depending upon the lender, the nature and
liquidity of the underlying collateral, the movement of interest rates, the
availability of financing in the market and other factors. If the actual cash
flow characteristics are other than as expected, the Company may experience
reduced net interest income.
Risk of Decline in Market Value of Mortgage Assets; Margin Calls
Certain of the Company's Mortgage Assets may be cross-collateralized to
secure multiple borrowing obligations of the Company to a single lender. A
decline in the market value of such assets may limit the Company's ability to
borrow or result in lenders initiating margin calls (i.e., requiring a pledge of
cash or additional Mortgage Assets to re-establish the ratio of the amount of
the borrowing to the value of the collateral). In the event that the Company
acquires fixed-rate Mortgage Assets pursuant to its Asset Purchase/Capital
Allocation Policies, such fixed-rate Mortgage Assets may be more susceptible to
margin calls as increases in interest rates tend to more negatively affect the
market value of fixed-rate Mortgage Assets than adjustable-rate Mortgage Assets.
This remains true despite effective hedging against such fluctuations as the
hedging instruments may not be part of the collateral securing the
collateralized borrowings. Additionally, it may be difficult to realize the full
value of the hedging instrument when desired for liquidity purposes due to the
applicable REIT Provisions of the Code. The Company could be required to sell
Mortgage Assets under adverse market conditions in order to maintain liquidity.
Such sales may be effected by management when deemed by it necessary in order to
preserve the capital base of the Company. If
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these sales were made at prices lower than the amortized cost of the Mortgage
Assets, the Company would experience losses. A default by the Company under its
collateralized borrowings could also result in a liquidation of the collateral,
including any cross-collateralized assets, and a resulting loss of the
difference between the value of the collateral and the amount borrowed.
Additionally, in the event of a bankruptcy of the Company, certain reverse
repurchase agreements may qualify for special treatment under the Bankruptcy
Code, the effect of which is, among other things, to allow the creditors under
such agreements to avoid the automatic stay provisions of the Bankruptcy Code
and to liquidate the collateral under such agreements without delay. Conversely,
in the event of the bankruptcy of a party with whom the Company had a reverse
repurchase agreement, the Company might experience difficulty recovering the
collateral under such agreement if it were to be repudiated and the Company's
claim against the bankrupt lender for damages resulting therefrom were to be
treated simply as one of an unsecured creditor. Should this occur, the Company's
claims would be subject to significant delay and recoveries, if and when
received, may be substantially less than the damages actually suffered by the
Company. Although the Company has, and intends to continue to, enter into
reverse repurchase agreements with several different parties and has developed
policies to reduce its exposure to such risks, no assurance can be given that
the Company will be able to avoid such third party risks. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations -- Financial Condition -- Liquidity" and "-- Capital
Adequacy/Risk-Adjusted Capital Policy," and "Business and Strategy -- Management
Policies and Programs -- Capital and Leverage Policies."
To the extent the Company is compelled to liquidate Mortgage Assets
qualifying as Qualified REIT Real Estate Assets to repay borrowings, the Company
may be unable to comply with the REIT Provisions of the Code regarding assets
and sources of income requirements, ultimately jeopardizing the Company's status
as a REIT. The Code does not provide for any mitigating provisions with respect
to the 30% Gross Income Test. Accordingly, if the Company failed to meet the 30%
Gross Income Test, its status as a REIT would terminate automatically. See
"Certain Federal Income Tax Considerations -- General -- Asset Tests" and
"-- Gross Income Tests."
RISK OF DECREASE IN NET INTEREST INCOME DUE TO INTEREST RATE FLUCTUATIONS;
PREPAYMENT RISKS OF MORTGAGE ASSETS
General
The Company's Mortgage Assets bear, and the Company expects that a
substantial portion of the Company's Mortgage Assets in the future will bear,
adjustable interest or pass-through rates based on short-term interest rates,
and substantially all of the Company's borrowings will bear interest at
short-term rates and have and will have maturities of less than one year.
Consequently, changes in short-term interest rates may significantly influence
the Company's net interest income. While increases in short-term interest rates
will generally increase the yields on the Company's adjustable-rate Mortgage
Assets, rising short-term rates will also increase the costs of borrowings by
the Company which will be utilized to fund the Mortgage Assets and, to the
extent such costs rise more rapidly than the yields, the Company's net interest
income may be reduced or a net loss may result. Conversely, decreases in
short-term interest rates may decrease the interest cost on the Company's
borrowings more rapidly than the yields on the Mortgage Assets and hence may
increase the Company's net interest income. No assurance can be given as to the
amount or timing of changes in interest rates or their effect on the Company's
Mortgage Assets or net interest income.
Risks Associated with Differences Between Mortgage Asset and Borrowing
Characteristics
All of the Mortgage Assets owned by the Company at March 31, 1996 were
either adjustable-rate Mortgage Loans ("ARMS") or Mortgage Securities backed by
ARMS. In each case, such ARMS are subject to periodic interest rate adjustments
based on an objective index such as the CD Rate, LIBOR or the Treasury Index.
The Company currently expects that substantially all of the Mortgage Assets the
Company will acquire in the future will be either ARMs or Mortgage Securities
backed by ARMs. Interest rates on the Company's borrowings are and are expected
to continue to be based on short-term indices. To the extent any of the
Company's Mortgage Assets are financed with borrowings bearing interest based on
or varying with an
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index different from that used for the related Mortgage Assets, so-called
"basis" interest rate risk will arise. In such event, if the index used for the
Mortgage Assets is a "lagging" index (such as the 11th District Cost of Funds)
that reflects market interest rate changes on a delayed basis, and the rate
borne by the related borrowings reflects market rate changes more rapidly, the
Company's net interest income will be adversely affected in periods of
increasing market interest rates. Additionally, the Company's adjustable-rate
Mortgage Assets are subject to periodic rate adjustments which may be more or
less frequent than the increases or decreases in rates borne by the borrowings
or financings utilized by the Company. Accordingly, in a period of increasing
interest rates, the Company could experience a decrease in net interest income
or a net loss because the interest rates on borrowings could adjust faster than
the interest rates on the Company's ARMs or Mortgage Securities backed by ARMs.
Moreover, ARMs are typically subject to periodic and lifetime interest rate caps
which limit the amount an ARM interest rate can change during any given period.
The Company's borrowings are not subject to similar restrictions. Hence, in a
period of rapidly increasing interest rates, the Company could also experience a
decrease in net interest income or a net loss in the absence of effective
hedging because the interest rates on borrowings could increase without
limitation while the interest rates on the Company's ARMs and Mortgage
Securities backed by ARMs would be limited by caps. Further, some ARMs may be
subject to periodic payment caps that result in some portion of the interest
accruing on the ARM being deferred and added to the principal outstanding. This
could result in receipt by the Company of less cash income on its ARMs than is
required to pay interest on the related borrowings, which will not have such
payment caps. The Company expects that the net effect of these factors, all
other factors being equal, could be to lower the Company's net interest income
or cause a net loss during periods of rapidly rising market interest rates,
which could negatively impact the level of dividend distributions and the market
price of the Common Stock and the Preferred Stock. However, in such periods the
Company's business strategy is designed to produce increased income and levels
of dividend distributions following a lag period the length of which will depend
on the extent and timing of the market interest rate increases. Conversely, in
periods of declining market interest rates, the Company's net interest income
may be initially increased but following a lag period the Company's income and
levels of dividend distributions may be reduced. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations -- Asset/Liability
Management and Effect of Changes in Interest Rates."
Mortgage Asset Commitment Risks
The Company may issue Commitments to purchase Mortgage Loans, Agency
Certificates and/or Privately Issued Certificates. These Commitments would
obligate the Company to purchase a specific aggregate principal amount of such
Mortgage Assets from the holders of such Commitments from time to time during
the Commitment term at the time a specified amount of Mortgage Assets has been
accumulated for sale. If, during the period from the time the price for the
Mortgage Assets to be acquired by the Company is determined and the date of
delivery of such Mortgage Assets, interest rates on borrowings of the type to be
used to finance the purchase of such Mortgage Assets rise and the interest rates
on the Mortgage Assets do not rise by a corresponding amount, the Company will
nonetheless be required to purchase such Mortgage Assets delivered under the
Commitment and such Mortgage Assets may produce lower than anticipated net
income or a net loss. In addition, if the Mortgage Assets to be purchased under
Commitments are Mortgage Loans, the Company will be subject to the risk that the
Mortgage Loans may not be delivered to the Company due to failure of the
borrower to fund. See "Business and Strategy -- Mortgage Assets."
Mortgage Asset prepayment rates vary from time to time and may cause
changes in the amount of the Company's net interest income. Prepayments of ARMs
and Mortgage Securities backed by ARMs usually can be expected to increase when
mortgage interest rates fall below the then-current interest rates on such ARMs
and decrease when mortgage interest rates exceed the then-current interest rate
on the ARMs, although such effects are not predictable. Prepayment experience
also may be affected by the geographic location of the property securing the
Mortgage Loans, the assumability of the Mortgage Loans, conditions in the
housing and financial markets and general economic conditions. In addition,
prepayments on ARMs are affected by the ability of the borrower to convert an
ARM to a fixed-rate loan and by conditions in the fixed-rate mortgage market. If
the interest rates on ARMs increase at a rate greater than the interest rates on
fixed-rate Mortgage Loans, prepayments on ARMs may tend to increase. In periods
of fluctuating interest rates,
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interest rates on ARMs may exceed interest rates on fixed-rate Mortgage Loans,
which may tend to cause prepayments on ARMs to increase at a rate greater than
anticipated. Single-Family Mortgage Securities are often structured so that
certain classes are provided protection from prepayments for a period of time.
However, in a period of extremely rapid prepayments, during which earlier-paying
classes may be retired faster than expected, the protected classes may receive
unscheduled payments of principal earlier than expected and would have average
lives that, while longer than the average lives of the earlier-paying classes,
would be shorter than originally expected. The Company seeks to minimize
prepayment risk through a variety of means, including structuring a diversified
portfolio with a variety of prepayment characteristics, investing in Mortgage
Assets with prepayment prohibitions and penalties, investing in certain Mortgage
Security structures which have prepayment protection, and balancing assets
purchased at a premium with assets purchased at a discount. In addition, the
Company has purchased and may in the future purchase additional interest-only
strips to a limited extent. However, no strategy can completely insulate the
Company from prepayment risks arising from the effects of interest rate changes.
Certain of the Mortgage Assets may consist of Mortgage Loans that are, and
Mortgage Securities evidencing interests in, ARMs convertible to fixed-rate
loans. Because converted loans are required to be repurchased by the applicable
Agency or servicer, the conversion of a loan results, in effect, in the
prepayment of such loan.
Changes in anticipated prepayment rates of Mortgage Assets could affect the
Company in several adverse ways. A portion of the adjustable-rate Single-Family
Mortgage Loans acquired or to be acquired by the Company (either directly as
Mortgage Loans or through Mortgage Securities backed by ARMs) have or will have
been recently originated and will still bear initial interest rates which are
lower than their "fully-indexed" rates (the applicable index plus margin). In
the event that such an ARM is prepaid faster than anticipated prior to or soon
after the time of adjustment to a fully-indexed rate, the Company will have
experienced an adverse effect on its net interest income during the time it held
such ARM compared with holding a fully-indexed ARM and will have lost the
opportunity to receive interest at the fully-indexed rate over the expected life
of the ARM. These effects may be mitigated to the extent such ARMs were acquired
at a discount. In addition, the faster than anticipated prepayment of any
Mortgage Asset that had been purchased at a premium by the Company would
generally result in a faster than anticipated write-off of any remaining
capitalized premium amount and consequent reduction of the Company's net
interest income by such amount.
Risk of Loss Associated with Servicing Rights
Although the Company's strategy at the present time for its investments in
Mortgage Assets does not contemplate the purchase of Mortgage Assets on a
"servicing released" basis (i.e., the Company would acquire both the Mortgage
Assets and the rights to service them), such purchases may be made in the future
if market conditions make this an attractive strategy. This type of purchase
would require payment of a higher purchase price by the Company for the Mortgage
Assets and, to the extent a premium is paid, the Company would be more exposed
to the adverse effects of early prepayments of the Mortgage Assets, as described
above.
RISK OF FAILING TO HEDGE AGAINST INTEREST RATE CHANGES EFFECTIVELY; RISK OF
LOSSES ASSOCIATED WITH HEDGING; COUNTERPARTY RISKS
The Company's operating strategy subjects it to interest rate risks as
described under "-- Risk of Decrease in Net Interest Income Due to Interest Rate
Fluctuations; Prepayment Risks of Mortgage Assets" above. The Company follows an
asset/liability management program intended to protect against interest rate
changes and prepayments. See "Business and Strategy -- Management Policies and
Programs -- Asset/ Liability Management -- Interest Rate Risk Management."
Nevertheless, developing an effective asset/ liability management strategy is
complex and no strategy can completely insulate the Company from risks
associated with interest rate changes and prepayments. In addition, there can be
no assurance that the Company's hedging activities will have the desired
beneficial impact on the Company's results of operations or financial condition.
Hedging typically involves costs, including transaction costs, which increase
dramatically as the period covered by the hedge increases and which also
increase during periods of rising and volatile interest rates. The Company may
increase its hedging activity, and thus increase its hedging costs, during such
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periods when interest rates are volatile or rising and hedging costs have
increased. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Asset/Liability Management and Effect of Changes in
Interest Rates" and "Business and Strategy -- Management Policies and
Programs -- Asset/Liability Management -- Interest Rate Risk Management."
Moreover, Federal tax laws applicable to REITs may substantially limit the
Company's ability to engage in asset/liability management transactions. Such
Federal tax laws may prevent the Company from effectively implementing hedging
strategies that the Company determines, absent such restrictions, would best
insulate the Company from the risks associated with changing interest rates and
prepayments. See "Certain Federal Income Tax Considerations -- General" and
"-- Taxation of the Company."
The Company purchases from time to time interest rate caps, interest rate
swaps and similar instruments to attempt to mitigate the risk of the cost of its
variable rate liabilities increasing at a faster rate than the earnings on its
assets during a period of rising rates. In this way, the Company intends
generally to hedge as much of the interest rate risk as management determines is
in the best interests of the stockholders of the Company given the cost of such
hedging transactions and the need to maintain the Company's status as a REIT. In
this regard, the amount of income the Company may earn from its interest rate
caps and other hedging instruments is subject to substantial limitations under
the REIT Provisions of the Code. In particular, when the Company earns income
under such instruments, it will seek advice from tax counsel as to whether such
income constitutes qualifying income for purposes of the 95% Gross Income Test
and as to the proper characterization of such arrangements for purposes of the
REIT Asset Tests. See "Certain Federal Income Tax
Considerations -- General -- Gross Income Tests." This determination may result
in management electing to have the Company bear a level of interest rate risk
that could otherwise be hedged when management believes, based on all relevant
facts, that bearing such risk is advisable.
In the event that the Company purchases interest rate caps or other
interest rate agreements to hedge against lifetime and periodic rate or payment
caps, and the provider of interest rate agreements becomes financially unsound
or insolvent, the Company may be forced to unwind its interest rate agreements
with such provider and may take a loss on such interest rate agreements.
Although the Company intends to purchase interest rate agreements only from
financially sound institutions and to monitor the financial strength of such
institutions on a periodic basis, no assurance can be given that the Company can
avoid such third party risks.
RISK OF LOSS ON SINGLE-FAMILY MORTGAGE ASSETS
Ninety-six percent (96%) of the Mortgage Assets the Company had acquired as
of March 31, 1996 were Mortgage Securities. The Company bears risk of loss on
any Mortgage Securities it purchases in the secondary mortgage market or
otherwise. However, such securities, including all Mortgage Securities purchased
as of December 31, 1995, are either Agency Certificates or are generally
structured with one or more types of credit enhancement. To the extent third
parties have been contracted to provide the credit enhancement, the Company is
dependent in part upon the creditworthiness and claims paying ability of the
insurer and the timeliness of reimbursement in the event of a default on the
underlying obligations. Further, the insurance coverage for various types of
losses is limited in amount and losses in excess of the limitation would be
borne by the Company. The Company expects that a substantial portion of its
Single-Family Mortgage Assets in the future may constitute Mortgage Loans and
Mortgage Securities acquired in exchange for such Mortgage Loans as explained
below. See "Business and Strategy -- Mortgage Assets." The Company generally
does not intend to obtain credit enhancements such as mortgage pool or special
hazard insurance for its Single-Family Mortgage Loans, other than FHA insurance,
VA guarantees and private mortgage insurance, in each case relating only to
individual Mortgage Loans. Accordingly, during the time it holds such Mortgage
Loans for which third party insurance is not obtained, the Company will be
subject to risks of borrower defaults and bankruptcies and special hazard losses
that are not covered by standard hazard insurance (such as those occurring from
earthquakes or floods). In the event of a default on any Single-Family Mortgage
Loan held by the Company, including, without limitation, resulting from higher
default levels as a result of declining property values and worsening economic
conditions, among other factors, the Company would bear the risk of loss of
principal to the extent of any deficiency between the value of the related
Mortgage Property, plus any payments from an insurer or guarantor, and the
amount owing on the Mortgage Loan. See "Certain Legal
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Aspects of Mortgage Loans." Defaulted Mortgage Loans would also cease to be
eligible collateral for borrowings and would have to be financed by the Company
out of other funds until ultimately liquidated, resulting in increased financing
costs and reduced net income or a net loss.
The Company expects to pool and exchange a substantial portion of the
Single-Family Mortgage Loans it acquires for Single-Family Mortgage Securities
to achieve better financing rates. To the extent such Mortgage Securities are
Privately Issued Certificates and privately issued CMOs or Agency Certificates
as to which the Company agrees to bear recourse for losses, the Company may
continue to bear the risk of loss on the underlying Mortgage Loans because it
may not obtain third party credit enhancements in forming such Mortgage
Securities. For example, the Company may exchange its Mortgage Loans for
Senior-Subordinated Mortgage Securities and retain some or all of the resulting
classes.
RISK OF LOSS ON MULTIFAMILY MORTGAGE ASSETS
Multifamily Mortgage Loans share many of the characteristics and risks
associated with Commercial Mortgage Loans and are often categorized as
commercial loans rather than residential loans. See "-- Risk of Loss on
Commercial Mortgage Assets" below for a description of these risks. Although all
of the Company's Mortgage Assets purchased through March 31, 1996 were
Single-Family Mortgage Assets, the Company expects to acquire Multifamily
Mortgage Assets and Commercial Mortgage Assets from time to time in the future
when consistent with its Asset Acquisition/Capital Allocation Policies.
The Company currently intends to focus on the acquisition of Multifamily
Mortgage Securities rather than Multifamily Mortgage Loans, although the Company
may purchase Multifamily Mortgage Loans in the future. The Company will only
acquire Multifamily Mortgage Loans when it believes it has the necessary
expertise to evaluate and manage them and only if they are consistent with the
Company's Risk-Adjusted Capital Policy.
RISK OF LOSS ON COMMERCIAL MORTGAGE ASSETS
Risk of Loss on Commercial Mortgage Loans
Commercial Mortgage Loans have certain distinct risk characteristics.
Commercial Mortgage Loans generally lack standardized terms, which may
complicate their structure. Commercial properties themselves tend to be unique
and are more difficult to value than single-family residential properties.
Commercial Mortgage Loans also tend to have shorter maturities than residential
Mortgage Loans and may not be fully amortizing, meaning that they may have a
significant principal balance, or "balloon," due on maturity. Assets underlying
Commercial Mortgage Securities may relate to only a few properties or to a
single property. In order to offset the relatively high risk involved in single
property financings, the relatively small number of such financings thus far
have tended to be limited to extremely desirable properties with excellent
values or extremely creditworthy and reliable tenants such as major
corporations. As the Commercial Mortgage Securities market broadens, these
constraints may lessen. In addition, commercial properties, particularly
industrial and warehouse properties, are generally subject to relatively greater
environmental risks than non-commercial properties and the corresponding burdens
and costs of compliance with environmental laws and regulations. See
"-- Environmental Liabilities," below.
Commercial Mortgage Loans generally are non-recourse to borrowers. In the
event of foreclosure on a Commercial Mortgage Loan, the value at that time of
the collateral under the mortgage may be less than the principal amount
outstanding on the mortgage loan and the accrued but unpaid interest. Also,
there may be costs and delays involved in enforcing rights of a property owner
against tenants in default under the terms of leases with respect to commercial
properties who may seek the protection of the bankruptcy laws which can result
in termination of lease contracts.
Commercial Mortgage Loans are also subject to the effects of: (i) local and
other economic conditions on real estate values, (ii) the ability of tenants to
make lease payments, (iii) the ability of a property to attract and retain
tenants, which may in turn be affected by local conditions such as oversupply of
space or a reduction in demand for rental space in the area, the attractiveness
of properties to tenants, competition from
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other available space, the ability of the owner to pay leasing commissions,
provide adequate maintenance and insurance, pay tenant improvements costs and to
make other tenant concessions, and (iv) increased operating costs, including
energy costs and real estate taxes. While real properties generally will carry
comprehensive liability and casualty coverage, such coverage may not provide
full protection for the value of the underlying property and may not protect
against all casualty losses. If underlying commercial properties do not generate
sufficient income to meet operating expenses, debt service, capital expenditures
and tenant improvements, obligors under Commercial Mortgage Loans may be unable
to make payments of principal and interest in a timely fashion, increasing the
risk of default on a related commercial mortgage-backed security. Income from
and values of commercial properties are also affected by such factors as
applicable laws, including tax laws, interest rate levels, the availability of
financing for owners and tenants, and the impact of and costs of compliance with
environmental controls and regulations.
Risk of Loss on Commercial Mortgage Securities
Many of the risks of investing in Commercial Mortgage Securities reflect
the risks of investing directly in the real estate securing the underlying
Mortgage Loans. This may be especially true in the case of Commercial Mortgage
Securities secured by, or evidencing an interest in, a single commercial
mortgage loan or a relatively small or less diverse pool of Commercial Mortgage
Loans. In the event of a default on the underlying Commercial Mortgage Loan or
Loans, to the extent the Company invests in Mezzanine and Subordinated
Securities, the ultimate extent of the loss, if any, to such securities may only
be determined after a foreclosure of the mortgage encumbering the property and,
if the mortgagee takes title to the property, upon liquidation of the property.
Factors such as the title to the property, its physical condition (including
environmental considerations) and financial performance, as well as governmental
disclosure requirements with respect to the condition of the property, may make
a third party unwilling to purchase the property at a foreclosure sale or for a
price sufficient to satisfy the obligations with respect to the related
Commercial Mortgage Securities. In addition, the condition of a property may
deteriorate during foreclosure proceedings. Certain obligors on underlying
mortgages may become subject to bankruptcy proceedings, in which case the amount
and timing of amounts due under the related Commercial Mortgage-Backed
Securities may be materially adversely affected. In general, any losses on a
given Commercial Mortgage Security will be absorbed first by the equity holder,
then by a third party credit support, if any, and then by the Subordinated
Security holder to the extent of its principal balance and then by the Mezzanine
Security holder to the extent of its principal balance. The Company intends to
invest in Mezzanine Securities, and there can be no assurances that in the event
of default and the exhaustion of equity support, the third party credit support
and any debt classes junior to those in which the Company invests, the Company
will be able to recover all of its investment in the securities it purchases, or
if it does recover its investment, that such recovery will not be substantially
delayed. In addition, if the underlying mortgage portfolio has been overvalued
by the originator, or if the values subsequently decline, the Company may
effectively hold the "first loss" position in certain Commercial Mortgage
Securities even if they are Mezzanine Securities. See "Certain Legal Aspects of
Mortgage Loans."
The Commercial Mortgage Securities market is relatively new. Rating
agencies have not had experiences over a long period through different economic
cycles in assigning ratings to Commercial Mortgage Securities or monitoring
previously rated securities. The process of rating Commercial Mortgage
Securities generally involves a more complicated credit analysis than applies to
ratings of Single-Family Mortgage Securities. The process of servicing
Commercial Mortgage Securities also is more complicated than the servicing of
Single-Family Mortgage Securities, and difficulties encountered in servicing may
cause a rating agency to reevaluate or downgrade the credit quality of an issue
during its life. Certain Commercial Mortgage Securities issued with respect to
pools of Commercial Mortgage Loans originated by failed thrift institutions may
be subject to risks that underlying documentation is incomplete, mortgage
underwriting standards are unclear, the applicable mortgages loan balances are
disproportionately high relative to the value of the applicable properties and
additional information concerning the terms of such loans is unavailable.
The risks of investing in Commercial Mortgage Securities include risks that
the existing credit support will prove to be inadequate, either because of
unanticipated levels of losses or, if such credit support is
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provided by a third party, because of difficulties experienced by such provider.
Delays or difficulties encountered in servicing Commercial Mortgage Securities
may cause greater losses and, therefore, greater resort to credit support than
was originally anticipated, and may cause a rating agency to downgrade a
security.
The Company currently intends to focus on the acquisition of Commercial
Mortgage Securities rather than Commercial Mortgage Loans, although the Company
may purchase Commercial Mortgage Loans in the future. The Company will only
acquire Commercial Mortgage Loans when it believes it has the necessary
expertise to evaluate and manage them and only if they are consistent with the
Company's Risk-Adjusted Capital Policy.
INVESTMENT STRATEGY RISKS
A majority of the Company's Mortgage Assets have and, the Company expects,
will continue to have investment grade ratings (the four highest rating levels)
from one or more nationally recognized mortgage security rating agencies or be
deemed by the Company to be of comparable credit quality. The Company also
invests in Mortgage Assets that do not have investment grade ratings. The
Company's investment strategy seeks to balance the risk and return potential of
its investments in a manner that attempts to maximize return while minimizing
the risk of losses to the Company through defaults on portfolio obligations.
This strategy determines the relative weightings within the Company's portfolio
of Mortgage Assets of different ratings. The Company generally structures its
portfolio to maintain a minimum weighted average rating (including the Company's
deemed comparable ratings for unrated Mortgage Assets based on a comparison to
rated Mortgage Assets with like characteristics) of its Mortgage Assets of at
least single "A" under the S&P rating system and at the comparable level under
the other rating systems. There can be no assurance the Company's deemed
comparable ratings will agree with assessments by others as to how such Mortgage
Assets would be rated. In addition, this strategy operates to limit the
percentage of the Company's assets that may be invested in Mortgage Assets rated
below investment grade, which also tend to carry higher potential returns on
investment but relatively greater risk of loss.
References to ratings of Mortgage Assets (whether assigned by a rating
service or, if unrated by such a service, deemed by the Company to be of
comparable credit quality to rated securities) apply only at the time a
transaction is entered into by the Company. Any subsequent change in a rating
assigned by any rating service to a Mortgage Assets, or change in the percentage
of Company assets invested in certain Mortgage Assets or other instruments
resulting from market fluctuations or other changes in the Company's total
assets will not require the Company to dispose of an investment. In the event
that ratings services assign different ratings to the same Mortgage Asset, the
Company determines which rating it believes most accurately reflects the
Mortgage Asset's quality and risk at that time, which may be the highest of the
several assigned ratings.
RISK OF LACK OF GEOGRAPHIC AND INDUSTRY DIVERSIFICATION
At December 31, 1995 and March 31, 1996, approximately 65% and 64%,
respectively, of the mortgaged properties underlying the Company's Mortgage
Assets were located in California, and the Company expects that in the future
over 50% of the mortgaged properties underlying its Mortgage Assets will be
located in California. Subject to this emphasis, the Company seeks geographic
diversification of the properties underlying its Mortgage Assets, but does not
intend to set specific limitations on the aggregate percentage of its portfolio
comprised of such properties located in any one area (whether by state, zip
code, seismological or other geographic measure). Consequently, properties
underlying such Mortgage Assets may be located in the same or a limited number
of geographical regions. To the extent that properties underlying such Mortgage
Assets are located in the same geographical region, such Mortgage Assets may be
subject to a greater risk of default than other comparable Mortgage Assets in
the event of adverse economic, political or business developments and natural
hazard risks that may affect such region and, ultimately, the ability of
property owners to make payments of principal and interest on the underlying
mortgages. In addition, to the extent that the end use of commercial properties
underlying the Company's Commercial Mortgage Assets tend to be concentrated in
the same or similar industries and such industries suffer adverse economic or
business developments, the ability of property owners to make principal and
interest payments on the underlying mortgages will be impaired.
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ABILITY TO ACQUIRE MORTGAGE ASSETS AT YIELDS WHICH ARE FAVORABLE RELATIVE TO
BORROWING COSTS; COMPETITION AND SUPPLY
The Company's net income depends, in large part, on the Company's ability
to acquire Mortgage Assets at favorable spreads over the Company's borrowing
costs. In acquiring Mortgage Assets, the Company competes with other REITs,
investment banking firms, savings and loan associations, banks, mortgage
bankers, insurance companies, mutual funds, other lenders, GNMA, FNMA, FHLMC and
other entities purchasing Mortgage Assets, many of which have greater financial
resources than the Company. In addition, there are several mortgage REITs
similar to the Company, and others may be organized in the future. The effect of
the existence of additional REITs may be to increase competition for the
available supply of Mortgage Assets suitable for purchase by the Company.
In addition, in fluctuating interest rate environments, the spread between
ARM interest rates and interest rates on fixed-rate Mortgage Loans may decrease,
and may cease to exist or become negative. Under such conditions, mortgagors
tend to favor fixed-rate Mortgage Loans, thereby decreasing the supply of ARMs
available to the Company for purchase. The relative availability of ARMs may
also be diminished by a number of other market and regulatory considerations.
There can be no assurance that the Company will be able to acquire
sufficient Mortgage Assets from mortgage suppliers at spreads above the
Company's cost of funds. The Company will also face competition for financing
sources, and the effect of the existence of additional mortgage REITs may be to
deny the Company access to sufficient funds to carry out its business strategy
and/or to increase the cost of funds to the Company.
ENVIRONMENTAL LIABILITIES
In the event that the Company is forced to foreclose on a defaulted
Mortgage Loan to recover its investment in such Mortgage Loan, the Company may
be subject to environmental liabilities in connection with such real property as
a result of which liabilities the value of the real property may be diminished.
While the Company intends to exercise due diligence to discover potential
environmental liabilities prior to the acquisition of any property through
foreclosure, hazardous substances or wastes, contaminants, pollutants or sources
thereof (as defined by state and federal laws and regulations) may be discovered
on properties during the Company's ownership or after a sale thereof to a third
party. If such hazardous substances are discovered on a property, the Company
may be required to remove those substances or sources and clean up the property.
There can be no assurances that the Company would not incur full recourse
liability for the entire cost of any removal and clean-up, that the cost of such
removal and clean-up would not exceed the value of the property or that the
Company could recoup any of such costs from any third party. The Company may
also be liable to tenants and other users of neighboring properties. In
addition, the Company may find it difficult or impossible to sell the property
prior to or following any such clean-up. See "Certain Legal Aspects of Mortgage
Loans."
RISK OF FUTURE REVISIONS IN POLICIES AND STRATEGIES BY BOARD OF DIRECTORS
The Board of Directors has established the investment policies and
operating policies and strategies set forth in this Prospectus as the investment
policies and operating policies and strategies of the Company. However, these
policies and strategies may be modified or waived by the Board of Directors,
subject in certain cases to approval by a majority of the Independent Directors,
without stockholder consent. The ultimate effect of changes in these policies
and strategies may be positive or negative.
LEGAL AND OTHER RISKS
CONFLICTS OF INTEREST
The Chairman of the Board, President, Vice Chairman of the Board, and the
Treasurer and Controller of the Company are actively involved in managing
portfolios of mortgage loans and securitized mortgages, managing and advising
healthy and troubled financial institutions and structuring workouts of
portfolios of troubled real estate and corporate investments through George E.
Bull, III Capital Management, Inc. ("GB Capital"). These officers of the Company
have performed and will continue to perform such services for GB
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Capital; however, such officers have devoted a majority of their time to the
business of the Company since the Company was founded and will continue to
devote a majority their time to the Company's affairs as long as it remains
necessary for the effective conduct and operation of the Company's business.
These arrangements may create conflicts of interest if such members of
management are presented with corporate opportunities that may benefit both the
Company and clients of GB Capital. Generally, under applicable state corporate
law, a director of a corporation is required to first offer to the company
corporate opportunities learned of solely as a result of his or her service as a
member of the board of directors. Maryland law provides further that in order
for a contract or other transaction between a corporation and any of its
directors or a corporation, firm, or other entity in which a director has a
material financial interest not to be void or voidable: (i) the contract or
transaction must be fair and reasonable to the corporation; or (ii) the fact of
such interest must be disclosed or known to (a) the board or committee that
authorizes, approves or ratifies the contract or transaction and such
authorization, approval or ratification must be by a vote of the majority of
disinterested directors or (b) the stockholders entitled to vote and the
contract or transaction is authorized, approved and ratified by a majority of
the votes cast by disinterested stockholders entitled to vote. See
"Management -- Conflict of Interest."
The Company's policy is that the approval of the Board of Directors (with
any interested director abstaining) is required for any director, officer,
securityholder or affiliate of the Company (a) to engage for their own account
in realizing upon a corporate opportunity learned of solely as a result of their
service to or representation of the Company or (b) to have any direct or
indirect pecuniary interest in any investment to be acquired or disposed of by
the Company or in any transaction to which the Company is a party or has an
interest.
The Company shares with GB Capital office space and certain office
expenses, such as lease payments, utilities charges and ancillary services
performed by office personnel, at cost on a pro rata basis based on the relative
use of such facilities and services by the Company and GB Capital. The
Independent Directors periodically review leases and other arrangements with GB
Capital to ensure that such arrangements are on an arm's-length basis and to
ensure compliance with the REIT Provisions of the Code.
CONSEQUENCES OF FAILURE TO MAINTAIN REIT STATUS; COMPANY SUBJECT TO TAX AS A
REGULAR CORPORATION
In order to maintain its qualification as a REIT for Federal income tax
purposes, the Company must comply with the REIT Provisions of the Code,
including satisfying certain tests with respect to the sources of its income,
the nature and diversification of its assets, the amount of its distributions to
stockholders and the ownership of its stock.
The Company intends, at all times, to operate so as to qualify as a REIT
for Federal income tax purposes. To qualify as a REIT, the Company must satisfy
a series of complicated tests related to the nature of its assets and income and
it must also distribute substantially all of its income (as specially defined
for these purposes) to its stockholders. If the Company fails to qualify as a
REIT in any taxable year and certain relief provisions of the Code do not apply,
the Company would be subject to Federal income tax as a regular, domestic
corporation, and its stockholders would be subject to tax in the same manner as
stockholders of such corporation. Distributions to stockholders in any year in
which the Company fails to qualify as a REIT would not be deductible by the
Company in computing its taxable income. As a result, the Company could be
subject to income tax liability, thereby significantly reducing or eliminating
the amount of cash available for distribution to its stockholders. Further, the
Company could also be disqualified from re-electing REIT status for the four
taxable years following the year during which it became disqualified.
No assurance can be given that future legislation, regulations,
administrative interpretations or court decisions will not significantly change
the tax laws with respect to the Company's qualification as a REIT or the
Federal income tax consequences of such qualification, which changes may reduce
or eliminate the Company's competitive advantage over non-REIT competitors. See
"Certain Federal Income Tax Considerations -- Taxation of the Company."
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POTENTIAL CHARACTERIZATION OF DISTRIBUTIONS AS UBTI; TAXATION OF TAX-EXEMPT
INVESTORS
In the event that (i) the Company is subject to the rules relating to
taxable mortgage pools (discussed below) or the Company is a "pension-held
REIT," or (ii) a tax-exempt stockholder has incurred indebtedness to purchase or
hold its Preferred Stock or Common Stock or is not exempt from Federal income
taxation under certain special sections of the Code, distributions to and, in
the case of a stockholder described in (ii), gains realized on the sale of
Preferred Stock or Common Stock by, such tax-exempt stockholder may be subject
to Federal income tax as UBTI (i.e., "unrelated business taxable income" as
defined in section 512 of the Code). See "Certain Federal Income Tax
Considerations -- Taxation of Tax-Exempt Entities."
TAXABLE MORTGAGE POOL RISK; INCREASED TAXATION
A REIT that incurs debt obligations with two or more maturities and which
are secured by assets such as the Mortgage Assets may be classified as a
"taxable mortgage pool" under the Code if payments required to be made on such
debt obligations bear a relationship to the payments received on such assets. If
the Company or a pool of its assets were to be subject to the taxable mortgage
pool rules, the Company's status as a REIT would not be impaired but a portion
or all of the taxable income (in excess of a specified return to investors)
generated by the Company's Mortgage Assets constituting the taxable mortgage
pool may, under regulations to be issued by the Treasury Department, be
characterized as "excess inclusion" income and allocated to the stockholders.
Any such excess inclusion income (i) would not be allowed to be offset by the
net operating losses of a stockholder, and (ii) would be subject to tax as UBTI
to a tax-exempt stockholder. See "Certain Federal Income Tax
Considerations -- Taxation of Tax-Exempt Entities."
The Company does not intend to issue debt obligations with differing
maturities backed by a single pool of Mortgage Assets, but it does intend to
enter into master reverse repurchase agreements pursuant to which the Company
may borrow funds with differing maturity dates which are cross-collateralized by
specific Mortgage Assets. The Company does not believe that the master reverse
repurchase agreements or that its other financing arrangements should cause the
Mortgage Assets to be treated as a taxable mortgage pool. No assurances can be
given, however, that the IRS might not successfully maintain that the Mortgage
Assets collateralizing such master reverse repurchase agreements constitute a
taxable mortgage pool.
INVESTMENT COMPANY ACT RISK
The Company at all times intends to conduct its business so as not to
become regulated as an investment company under the Investment Company Act.
Accordingly, the Company does not expect to be subject to the restrictive
provisions of the Investment Company Act. The Investment Company Act exempts
entities that are "primarily engaged in the business of purchasing or otherwise
acquiring mortgages and other liens on and interests in real estate"
("Qualifying Interests"). Under the current interpretation of the staff of the
Securities and Exchange Commission, in order to qualify for this exemption, the
Company must maintain at least 55% of its assets directly in Mortgage Loans,
qualifying Pass-Through Certificates and certain other qualifying interests in
real estate. In addition, unless certain Mortgage Securities represent all the
certificates issued with respect to an underlying pool of mortgages, such
Mortgage Securities may be treated as securities separate from the underlying
Mortgage Loans and, thus, may not qualify as Qualifying Interests for purposes
of the 55% requirement. Therefore, the Company's ownership of certain Mortgage
Assets may be limited by the provisions of the Investment Company Act. In
addition, in meeting the 55% requirement under the Investment Company Act, the
Company intends to consider Privately Issued Certificates issued with respect to
an underlying pool as to which the Company holds all issued certificates as
Qualifying Interests. If the Securities and Exchange Commission, or its staff,
adopts a contrary interpretation with respect to such securities, the Company
could be required to restructure its activities to the extent its holdings of
such Privately Issued Certificates did not comply with the interpretation. Such
a restructuring could require the sale of a substantial amount of Privately
Issued Certificates held by the Company at a time it would not otherwise do so,
which sale could occur under adverse market conditions and the Company could
incur losses as a result. Further, in order to insure that the Company at all
times continues to qualify for the above exemption from the Investment Company
Act, the Company may be required at times to adopt less efficient methods of
financing certain of its Mortgage Assets than would otherwise be the case and
may be precluded from
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acquiring certain types of Mortgage Assets whose yield is somewhat higher than
the yield on Mortgage Assets that could be purchased in a manner consistent with
the exemption. The net effect of these factors may be to lower at times the
Company's net interest income, although the Company does not expect any such
effect to be material. If the Company fails to qualify for exemption from
registration as an investment company, its ability to use leverage would be
substantially reduced and it would be unable to conduct its business as
described herein. Any such failure to qualify for such exemption could have a
material adverse effect on the Company.
DEPENDENCE ON KEY PERSONNEL
The Company's operations depend in significant part upon the contributions
of its executive officers many of whom would be difficult to replace. Although
all executive officers currently have employment agreements with the Company,
there can be no assurance of the continued employment of all such officers. The
loss of any key person could have a material adverse effect on the Company's
business and results of operations. See "Management -- Executive Compensation"
and "-- Employment Agreements."
CAPITAL STOCK PRICE VOLATILITY RISK
With respect to the public market for the Common Stock, it is likely that
the market price of the Common Stock will be influenced by any variation between
the net yield on the Company's Mortgage Assets and prevailing market interest
rates and by the market's perception of the Company's ability to achieve
earnings growth. The market price of the Preferred Stock will also be influenced
by those factors and by the market price of the Common Stock into which the
Preferred Stock is convertible. The Company's earnings will be derived primarily
from any positive spread between the yield on the Company's Mortgage Assets and
the cost of the Company's borrowings. The positive spread between the yield on
the Company's Mortgage Assets and the cost of borrowings will not necessarily be
larger in high interest rate environments than in low interest rate environments
regardless of the Company's business strategy to achieve such result.
Accordingly, in periods of high interest rates, the net income of the Company,
and therefore the dividend yield on the Common Stock, may be less attractive
compared with alternative investments, which could negatively impact the price
of the Common Stock. If the anticipated or actual net yield on the Company's
Mortgage Assets declines or if prevailing market interest rates rise, thereby
decreasing the positive spread between the net yield on the Mortgage Assets and
the cost of the Company's borrowings, the market price of the Common Stock may
be adversely affected. In addition, if the market price of other REIT stocks
decline for any reason, or there is a broad-based decline in real estate values
or in the value of the Company's portfolio of Mortgage Assets, the market price
of the Common Stock may be adversely affected. During any period when the market
price of the Common Stock has been adversely affected due to any of the
foregoing reasons, the liquidity of the Common Stock and the Preferred Stock may
be negatively impacted and investors who may desire or be required to sell their
shares may experience losses.
Securities Eligible for Future Sale
On August 9, 1995, the Company successfully completed an underwritten
initial public offering of its Common Stock, resulting in net proceeds to the
Company of approximately $51.1 million. As a result of such offering, all
outstanding shares of the Company's Class A Convertible Preferred Stock, par
value $0.01 per share (the "Class A Preferred Stock"), were converted into
Common Stock and all outstanding Stock Purchase Warrants ("Warrants"), each
Warrant exercisable for 1.000667 shares of the Company's Common Stock, became
exercisable only for shares of Common Stock. For purposes of this Prospectus,
the Common Stock issued upon conversion of the Class A Preferred Stock, the
Warrants and the shares of Common Stock issuable upon the exercise of Warrants
are referred to collectively as the "Securities." The Securities are covered by
a shelf registration statement permitting the holders thereof to sell such
Securities from time to time (the "Shelf Registration Statement"). On April 24,
1996, the Company successfully completed its second underwritten public offering
of Common Stock, resulting in net proceeds of approximately $54.5 million.
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Based on shares outstanding as of June 30, 1996 and giving affect to this
Offering (and assuming that the Underwriters' over-allotment option is not
exercised), there will be outstanding 875,000 shares of Preferred Stock,
8,520,116 shares of Common Stock and 1,563,957 Warrants, of which (i) all of the
shares of the Preferred Stock and 6,597,567 shares of Common Stock will have
been issued in registered or exempt offerings and will be freely tradable
(except for any of such shares held by affiliates of the Company who are subject
to a 90-day "lock-up" period following the closing of this Offering), (ii)
1,667,134 shares of Common Stock and all of the Warrants, together with all of
the shares of Common Stock issuable upon exercise of the outstanding Warrants,
are covered by the Shelf Registration Statement and (iii) 255,415 shares of
Common Stock are not covered by the Shelf Registration Statement. The shares of
Common Stock and Warrants set forth in (ii) above, together with the Common
Stock issuable pursuant to the exercise of the Warrants, may be sold without
restriction pursuant to the Shelf Registration Statement. The 255,415 shares of
Common Stock not covered by the Shelf Registration Statement, are "restricted
securities" within the meaning of Rule 144 ("Rule 144") under the Securities
Act. Such restricted securities will be available for resale pursuant to Rule
144 following a holding period ending two years from the date of issuance,
subject to the volume limitations imposed by Rule 144 and, unless held by
affiliates of the Company, will become unrestricted three years from the date of
issuance. With respect to 208,332 of such currently outstanding shares of Common
Stock, the two year holding period expired on June 23, 1996, and 1,000 shares of
such Common Stock will become unrestricted one year later; with respect to the
remaining 47,073 shares of such Common Stock, such shares are available for
resale, 46,083 of which are subject to lockup agreements expiring 90 days after
the closing of this Offering and to the volume limitations of Rule 144. Future
sales of restricted securities could have an adverse effect on the market price
of the Common Stock and the Preferred Stock. The holders of the currently
restricted shares of Common Stock have certain registration rights with respect
to such shares. See "Description of Capital Stock -- Registration Rights."
As of June 30, 1996, options, exclusive of Dividend Equivalent Rights, to
purchase 318,222 shares of Common Stock were outstanding under the Company's
Stock Option Plan, of which options to purchase 47,083 shares of Common Stock
vest on each of July 18, 1997 and 1998, and options to purchase 38,993 shares of
Common Stock will vest on each of May 4, 1997, 1998 and 1999.
RISK OF POTENTIAL FUTURE OFFERINGS
The Company may in the future increase its capital resources by making
additional offerings of equity and debt securities, including additional classes
or series of preferred stock, Common Stock, commercial paper, medium-term notes,
CMOs and senior or subordinated notes. All debt securities and classes of
preferred stock, including the Preferred Stock offered hereby, will be senior to
the Common Stock in a liquidation of the Company. The effect of additional
equity offerings may be the dilution of the equity of stockholders of the
Company or the reduction of the price of shares of the Company's Capital Stock,
or both. The Company is unable to estimate the amount, timing or nature of
additional offerings as they will depend upon market conditions and other
factors.
In addition, as of the date of this Prospectus, only a small number of the
Warrants have been exercised. The ability of holders of Warrants to acquire
Common Stock at $15.00 per share may tend to adversely impact the ability of the
market price of the Company's Common Stock to rise above $15.00 per share. To
the extent investors purchase Common Stock or Preferred Stock at a price in
excess of $15.00 per share, they will suffer dilution in the event Warrants are
exercised.
During the period immediately following the receipt by the Company of new
proceeds from an offering or other source, prior to the time the Company has
fully implemented its financing strategy to employ those proceeds, the Company's
earnings and levels of dividend distributions may be lower than if the financing
strategy were fully implemented, which may affect the market value of the Common
Stock and the Preferred Stock.
RATING RISK
The Company has not sought to obtain a rating for the Preferred Stock or
other securities or debt obligations of the Company. No assurance can be given,
however, that one or more rating agencies might independently determine to issue
such a rating or that such a rating, if issued, would not adversely affect the
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market price of the Preferred Stock or other securities or debt obligations of
the Company. Furthermore, such a rating may increase the Company's borrowing
costs. In addition, the Company may elect in the future to obtain a rating of
the Preferred Stock or other securities or debt obligations of the Company which
could adversely impact the market price of the Preferred Stock or other
securities or debt obligations of the Company. Ratings only reflect the views of
the rating agency or agencies issuing the ratings and such ratings could be
revised downward or withdrawn entirely at the discretion of the issuing rating
agency if in its judgment circumstances so warrant. Any such downward revision
or withdrawal of a rating could have an adverse effect on the market price of
the Preferred Stock or other securities or debt obligations of the Company or
the Company's borrowing costs.
ILLIQUIDITY OF INVESTMENTS
A substantial portion of the Company's portfolio is invested in Mortgage
Assets for which the secondary trading market is not as well developed as the
market for certain other Mortgage Assets (or which are otherwise considered less
marketable or illiquid). In addition, the Company invests in Mortgage Assets
which have been sold in private placements and have not been registered under
the Securities Act. Unregistered Mortgage Assets may be subject to restrictions
on resale which may limit the ability of the Company to sell them when it might
be most desirable to do so. Although the Company expects that most of the
Company's investments will be in Mortgage Assets for which a resale market
exists, certain of the Company's investments may lack a regular trading market
and may be illiquid. In addition, during turbulent market conditions, the
liquidity of all of the Company's Mortgage Assets may be adversely impacted.
There is no limit in the percentage of the Company's investments that may be
invested in illiquid Mortgage Assets.
RESTRICTIONS ON OWNERSHIP OF CAPITAL STOCK
In order that the Company may meet the requirements for qualification as a
REIT at all times, the Articles of Incorporation prohibit any person from
acquiring or holding, directly or constructively, ownership of a number of
shares of Capital Stock in excess of 9.8% (the "Ownership Limit") of the
outstanding shares. See "Certain Federal Income Tax Considerations." For this
purpose the term "ownership" is defined as either direct ownership or
constructive ownership in accordance with the constructive ownership provisions
of section 544 of the Code. Any transfer of shares of Capital Stock or Warrants
that would result in disqualification of the Company as a REIT or that would (a)
create a direct or constructive ownership of shares of stock in excess of the
Ownership Limit, (b) result in the shares of stock being beneficially owned
(within the meaning section 856(a) of the Code) by fewer than 100 persons
(determined without reference to any rules of attribution), or (c) result in the
Company being "closely held" within the meaning of section 856(h) of the Code,
will be null and void, and the intended transferee will acquire no rights to
such shares or Warrants. Any purported transfer of shares or Warrants that would
result in a person owning (directly or constructively) shares in excess of the
Ownership Limit (except as otherwise waived by the Board of Directors) due to
the unenforceability of the transfer restrictions set forth above will
constitute "Excess Securities," which will be transferred by operation of law to
the Company as trustee for the exclusive benefit of the person or persons to
whom the Excess Securities are ultimately transferred, until such time as the
purported transferee retransfers the Excess Securities. Subject to the Ownership
Limit, Excess Securities may be transferred by the purported transferee to any
person (if such transfer would not result in Excess Securities) at a price not
to exceed the price paid by the purported transferee (or, if no consideration
was paid by the purported transferee, the fair market value of the Excess
Securities on the date of the purported transfer), at which point the Excess
Securities will automatically be exchanged for the stock or Warrants, as the
case may be, to which the Excess Securities are attributable. If a purported
transferee receives a higher price for designating an ultimate transferee, such
purported transferee shall pay, or cause the ultimate transferee to pay, such
excess to the Company. In addition, such Excess Securities held in trust are
subject to purchase by the Company at a purchase price equal to the lesser of
(a) the price per share or per warrant, as the case may be, in the transaction
that created such Excess Securities (or, in the case of a devise or gift, the
market price at the time of such devise or gift), reduced by the amount of any
distributions received in violation of the Articles of Incorporation that have
not been repaid to the Corporation, and (b) the market price as reflected in the
last reported sales price of such shares of stock or Warrants on the trading day
immediately preceding the date of
32
<PAGE> 33
the purchase by the Company as reported on any exchange or quotation system over
which such shares of stock or Warrants may be traded, or if not then traded over
any exchange or quotation system, then the market price of such shares of stock
or Warrants on the date of the purported transfer as determined in good faith by
the Board of Directors of the Company, reduced by the amount of any
distributions received in violation of the Articles of Incorporation that have
not been repaid to the Company. See "Description of Capital Stock -- Repurchase
of Shares and Restrictions on Transfer."
Subject to certain limitations, the Board of Directors may increase or
decrease the Ownership Limit. In addition, to the extent consistent with the
REIT Provisions of the Code, the Board of Directors may waive the Ownership
Limit for and at the request of certain purchasers in this Offering.
The provisions described above may inhibit market activity and the
resulting opportunity for the holders of the Company's Capital Stock and
Warrants to receive a premium for their shares or Warrants that might otherwise
exist in the absence of such provisions. Such provisions also may make the
Company an unsuitable investment vehicle for any person seeking to obtain
ownership of more than 9.8% of the outstanding shares of its Capital Stock. See
"Description of Capital Stock -- Repurchase of Shares and Restrictions on
Transfer."
LIMITED OPERATING HISTORY OF THE COMPANY
The Company began operations in August 1994 following the initial closing
of the private placement of its Units and accordingly has not yet developed an
extensive earnings history or experienced a wide variety of interest rate or
market conditions. Additionally, although management of the Company has
considerable expertise in the acquisition and management of Mortgage Assets,
mortgage finance, asset/liability management and the management of corporations
in real estate lending business, management has limited experience in managing a
REIT.
DIVIDEND POLICY AND DISTRIBUTIONS
The Company intends to distribute substantially all of its taxable income
with respect to each year (which does not ordinarily equal net income as
calculated in accordance with GAAP) to its stockholders so as to comply with the
REIT Provisions of the Code. Dividends will be payable on the Preferred Stock
quarterly in the amounts and on the dates set forth herein, and are cumulative
from the date of original issuance. The Company declares regular quarterly
dividends. The Company intends to make dividend distributions on the Common
Stock at least quarterly; provided, however, that no dividends will be paid or
set apart for payment on shares of Common Stock unless full cumulative dividends
have been paid on the Preferred Stock. Any taxable income remaining after the
distribution of the final regular quarterly dividend each year is distributed
together with the first regular quarterly dividend payment of the following
taxable year or in a special dividend distributed prior thereto. The dividend
policy with respect to the Common Stock is subject to revision at the discretion
of the Board of Directors. All distributions will be made by the Company at the
discretion of the Board of Directors and will depend on the taxable earnings of
the Company, the financial condition of the Company, maintenance of REIT status
and such other factors as the Board of Directors deems relevant. See "Certain
Federal Income Tax Considerations -- General -- Distribution Requirement."
During 1994, the Company declared dividends of $350,576. During 1995, the
Company declared dividends of $333,213 for the first quarter, $499,819 for the
second quarter, $1,103,264 for the third quarter and $1,434,500 for the fourth
quarter. During 1996 to date, the Company has declared dividends of $2,539,833
for the first quarter and $3,408,046 for the second quarter. The level of
quarterly dividends is based on a number of factors referenced in the first
paragraph of this section and should not be deemed indicative of taxable income
for the quarter in which declared or future quarters or of income calculated in
accordance with GAAP. For the period from August 19, 1994 to December 31, 1994
and the year ended December 31, 1995, the primary earnings per share calculated
in accordance with Note 1 to the Financial Statements was $0.20 and $0.85,
respectively.
Distributions to stockholders will generally be subject to tax as ordinary
income, although a portion of such distributions may be designated by the
Company as capital gain or may constitute a tax-free return of
33
<PAGE> 34
capital. The Company does not intend to declare dividends that would result in a
return of capital. The Company will annually furnish to each of its stockholders
a statement setting forth distributions paid during the preceding year and their
characterization as ordinary income, capital gains, or return of capital. For a
discussion of the Federal income tax treatment of distributions by the Company,
see "Certain Federal Income Tax Considerations -- Taxation of Stockholders."
DIVIDEND REINVESTMENT PLAN
The Company has adopted a Dividend Reinvestment Plan (the "Plan" or "DRP")
in order to provide stockholders with a convenient method to automatically
reinvest their cash dividends in shares of the Company's Common Stock. The Plan
is being administered by Chase Mellon Shareholder Services, LLC (the "Plan
Administrator"). The Plan Administrator keeps records, sends statements of
account to each stockholder who participates in the Plan (the "Participant"),
provides safekeeping for the shares, and performs other duties related to the
Plan. The Plan Administrator also acts as the dividend disbursing agent,
transfer agent and registrar for the Capital Stock of the Company.
All of the Company's stockholders (including holders of Preferred Stock)
owning at least 100 shares are eligible to participate in the Plan. Stockholders
whose shares are registered in their own names may participate directly in the
Plan. Stockholders who beneficially own shares that are registered in a name
other than their own (i.e., in the name of a broker, bank or other nominee) must
either make arrangements with their broker, bank or other nominee to participate
in the Plan on their behalf or become the registered owner of the stock by
having such shares transferred into their names. If shares are owned in the
stockholder's own name, the stockholder may elect to participate in the Plan by
requesting from the Company, a Prospectus of the Plan and by completing and
sending an Authorization Form to the Plan Administrator. If the stockholder
beneficially owns shares registered in the name of a broker, bank or other
nominee, the stockholder must contact such broker, bank or other nominee and ask
them to participate in the Plan on the stockholder's behalf.
The Authorization Form provides for the purchase of shares of the Company's
Common Stock through the following investment options: (1) Full Dividend
Reinvestment -- the Plan Administrator will apply cash dividends paid on all the
shares of Common Stock or Preferred Stock registered in the record owner's
name(s) toward the purchase of shares of the Company's Common Stock; or (2)
Partial Dividend Reinvestment -- the Plan Administrator will apply cash
dividends paid on only the number of participating shares specified on the
Authorization Form toward the purchase of shares of the Company's Common Stock.
Shares purchased by the Plan will be automatically enrolled in the Plan so that
the dividends paid on such shares will also be reinvested in additional shares
of the Company's Common Stock.
The Company will pay to the Plan Administrator all dividends payable with
respect to shares of Common Stock or Preferred Stock owned by Participants,
including shares and fractional shares previously acquired under the Plan. The
Plan Administrator will apply such funds towards the purchase of the Company's
Common Stock for the Participant's account either directly from the Company or
on the open market, as instructed by the Company. The price of the shares
purchased by the Plan Administrator directly from the Company will be discounted
by three percent (3%) from the then-current Average Market Price. The "Average
Market Price" is the average of the daily high and low sales prices, computed to
seven decimal places, of the Company's Common Stock on the Nasdaq National
Market, as reported in the Wall Street Journal, during the Pricing Period (the
ten days on which Nasdaq is open and for which trades in the Company's Common
Stock are reported immediately preceding the relevant investment date). In the
case of purchases on the open market, the price will be ninety-seven percent
(97%) of the weighted average purchase price of the Company's Common Stock
purchased for the Plan in respect of the related investment date.
Generally, the Company pays all costs relating to the administration and
maintenance of the Plan. There will be no brokerage commission on shares
purchased directly from the Company. With respect to purchases on the open
market, the Plan Administrator shall pay brokerage commissions, administration
costs and other charges in an amount determined by the prevailing rates at the
time of purchase. Such commissions, administration costs and charges will be
reimbursed by the Company but in no event shall the Company pay commissions,
administration costs or other charges which, when combined with the three
percent (3%)
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<PAGE> 35
discount, exceed five percent (5%) of the fair market value of the stock at the
time of purchase. A Participant pays a $5.00 fee and brokerage commissions in
the event the Participant asks the Plan Administrator to sell all of the
Participant's shares, or a $15.00 fee and brokerage commissions for each partial
sale.
As soon as practical after the purchase of the shares has been completed,
the Plan Administrator will send each Participant a statement of account
confirming the transaction and itemizing the previous reinvestment activity for
the calendar year. Participants will receive tax information annually for their
personal records and to assist in the preparation of their federal income tax
returns. Participants will generally be treated as having received a dividend
distribution equal to the fair value of the Plan shares that are purchased with
the Participant's reinvested dividends generally on the date that the Company
credits such shares to the Participant's account, plus the brokerage
commissions, if any, allocable to be purchase of such shares, and Participants
will have a tax basis in the shares equal to such value. See "Certain Federal
Income Tax Considerations."
CAPITALIZATION
The following table sets forth the capitalization of the Company (i) at
March 31, 1996 and (ii) as adjusted to give effect to the sale by the Company of
2,875,000 shares of Common Stock in April 1996 and 875,000 shares of Preferred
Stock at the public offering price set forth on the cover page.
<TABLE>
<CAPTION>
AT MARCH 31, 1996
-------------------------------------------------
(DOLLARS IN THOUSANDS)
(UNAUDITED) (UNAUDITED) (UNAUDITED)
AS ADJUSTED APRIL AS ADJUSTED
ACTUAL 1996 OFFERING THIS OFFERING
--------- ----------------- -------------
<S> <C> <C> <C>
Stockholders' Equity
Class B Preferred Stock, par value $.01 per
share:
Authorized -- 0 shares (as adjusted
1,006,250 shares)
Outstanding -- 0 shares (as adjusted
875,000 shares)......................... $ 0 $ 0 $ 9
Common Stock, par value $.01 per share:
Authorized -- 50,000,000 shares (as
adjusted 48,993,750 shares)
Outstanding -- 5,521,376 shares (as
adjusted 8,396,376 shares).............. 55 84 84
Additional Paid-in Capital................... 73,926 128,469 154,133
Net Unrealized Loss on Assets Available for
Sale....................................... (5,065) (5,065) (5,065)
Undistributed Income......................... (770) (770) (770)
------- -------- --------
Total.............................. $68,146 $ 122,718 $ 148,391
======= ======== ========
</TABLE>
35
<PAGE> 36
MARKET PRICES AND DIVIDEND DATA
The Preferred Stock has been approved for quotation on the Nasdaq National
Market (subject to notice of issuance) under the symbol "RWTIP." The Common
Stock of the Company is traded on the over-the-counter market and is quoted on
the Nasdaq National Market under the symbol "RWTI." The following table sets
forth, for the periods indicated, the high and low sales prices per share of
Common Stock as reported on the Nasdaq National Market composite tape and the
cash dividends paid per share of outstanding Capital Stock.
<TABLE>
<CAPTION>
COMMON STOCK PRICES
-------------------
1995 HIGH LOW
- ------------------------------ ------ ------
<S> <C> <C>
Third Quarter ended
September 30, 1995(1)....... $22.00 $16.88
Fourth Quarter ended
December 31, 1995........... 22.00 18.00
1996
First Quarter ended
March 31, 1996.............. 21.75 18.75
Second Quarter................ 28.00 19.38
Third Quarter
(through August 8, 1996).... 27.88 23.25
</TABLE>
<TABLE>
<CAPTION>
CASH DIVIDENDS
---------------------------------
DATE DATE PAID AMOUNT
CLASS DECLARED OR PAYABLE PER SHARE
- ------------------- -------- ---------- ---------
<S> <C> <C> <C>
Class A
Preferred Stock 10/3/94 10/31/94 $0.15
12/16/94 1/20/95 0.10
3/17/95 4/21/95 0.20
6/19/95 7/21/95 0.30
Common Stock 9/15/95 10/20/95 0.20
12/13/95 1/19/96 0.26
3/8/96 4/19/96 0.46
6/14/96 7/19/96 0.40
</TABLE>
- ---------------
(1) The Company's Common Stock began trading on August 4, 1995.
On August 8, 1996, the last reported sales price for the Common Stock was
$25 1/2 per share. As of June 30, 1996, the Company's 8,520,116 shares of Common
Stock were held by approximately 150 holders of record.
The Company intends to pay quarterly dividends. The Company intends to make
distributions to its stockholders of all or substantially all of its taxable
income in each year (subject to certain adjustments) so as to qualify for the
tax benefits accorded to a REIT under the Code. All distributions will be made
by the Company at the discretion of the Board of Directors and will depend on
the earnings of the Company, financial condition of the Company, maintenance of
REIT status and such other factors as the Board of Directors may deem relevant
from time to time. See "Dividend Policy and Distributions."
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<PAGE> 37
SELECTED FINANCIAL DATA
The following selected financial data are derived from the audited
financial statements of the Company for the year ended December 31, 1995 and the
period from commencement of operations on August 19, 1994 to December 31, 1994
and from the unaudited financial information at and for the three months ended
March 31, 1996 and March 31, 1995. The unaudited information has been derived
from unaudited financial statements; however, in the opinion of management, such
information reflects all adjustments necessary for a fair statement of the
results of operations for such interim periods. The selected financial data
should be read in conjunction with the more detailed information contained in
the Financial Statements and Notes thereto and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" included elsewhere in
this Prospectus.
<TABLE>
<CAPTION>
THREE MONTHS THREE MONTHS PERIOD FROM
ENDED ENDED YEAR ENDED AUGUST 19, 1994 TO
MARCH 31, MARCH 31, DECEMBER 31, DECEMBER 31,
1996 1995 1995 1994
------------ ------------ ------------ ------------------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Days in period.................... 91 90 365 133
Interest income................... $ 9,131 2,170 $ 15,726 $ 1,296
Interest expense.................. 6,202 1,533 10,608 760
Interest rate agreement expense... 151 16 339 8
------- ------- ------- -------
Net interest income............... 2,778 621 4,779 528
Provision for credit losses....... 332 18 493 0
------- ------- ------- -------
Net interest income after
provision or credit losses..... 2,446 603 4,286 528
General and administrative
expenses....................... 492 201 1,131 146
------- ------- ------- -------
Net income........................ $ 1,954 $ 402 $ 3,155 $ 382
======= ======= ======= =======
Net taxable income................ 2,549 408 $ 3,832 $ 353
Weighted average shares of Common
Stock and Common Stock
equivalents.................... 6,129,587 2,115,161 3,703,803 1,916,846
Primary earnings per share(1)..... $ 0.32 $ 0.19 $ 0.85 $ 0.20
Dividends declared per preferred
share(2)....................... -- $ 0.20 $ 0.50 $ 0.25
Dividends declared per common
share(2)....................... $ 0.46 -- $ 0.46 $ 0.00
Ratio of earnings to combined
fixed charges and Preferred
Stock dividends................ 1.32 1.26 1.30 1.50
BALANCE SHEET DATA:
Mortgage assets................... $ 565,159 $ 141,859 $ 432,244 $ 117,477
Total assets...................... 581,313 145,440 441,557 121,528
Borrowings........................ 508,721 121,998 370,316 100,376
Total liabilities................. 513,167 123,088 373,267 101,248
Stockholders' equity.............. 68,146 22,352 68,290 20,280
Number of preferred shares
outstanding.................... -- 1,666,063 -- 1,666,063
Number of common shares
outstanding(3)................. 5,521,376 208,332 5,517,299 208,332
</TABLE>
37
<PAGE> 38
<TABLE>
<CAPTION>
THREE MONTHS THREE MONTHS PERIOD FROM
ENDED ENDED YEAR ENDED AUGUST 19, 1994 TO
MARCH 31, MARCH 31, DECEMBER 31, DECEMBER 31,
1996 1995 1995 1994
----------- ----------- ------------ ------------------
(UNAUDITED) (UNAUDITED)
<S> <C> <C> <C> <C>
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
OTHER DATA:
Average assets.................... $ 507,046 $ 125,691 $ 219,492 $ 57,862
Average borrowings................ 435,979 102,961 174,942 37,910
Average equity.................... 68,743 21,820 42,224 19,584
Interest rate spread.............. 1.46% 1.04% 1.01% 0.92%
Net interest margin............... 2.20% 2.00% 2.18% 2.51%
Net interest income as a percent
of average equity.............. 16.25% 11.54% 11.32% 7.40%
G&A expenses as a percent of
interest income................ 5.39% 9.28% 7.19% 11.30%
G&A expenses as a percent of net
interest income................ 17.71% 32.39% 23.66% 27.73%
G&A expenses as a percent of
average assets................. 0.39% 0.65% 0.52% 0.69%
G&A expenses as a percent of
average equity................. 2.88% 3.74% 2.68% 2.05%
Return on average assets.......... 1.55% 1.30% 1.44% 1.81%
Average assets/average equity..... 7.38x 5.76x 5.20x 2.95x
Return on average equity.......... 11.43% 7.46% 7.47% 5.35%
Credit reserves................... $ 821 $ 18 $ 490 $ 0
Actual charge-offs................ 0 0 4 0
</TABLE>
- ---------------
(1) See Note 1 to the Financial Statements for information regarding the
calculation of this item.
(2) The level of quarterly dividends is determined by the Board of Directors
based upon its consideration of a number of factors and should not be deemed
indicative of taxable income for the quarter in which declared or future
quarters, or of income calculated in accordance with GAAP. See "Dividend
Policy and Distributions." Dividends include amounts declared in December
but not paid until January of the following year.
(3) As of June 30, 1996, the number of shares of Common Stock outstanding was
8,520,116.
38
<PAGE> 39
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 $54.9 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)
increasing the efficiency with which the Company utilizes its
39
<PAGE> 40
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 AND FISCAL
1995 VERSUS FISCAL 1994
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.
From fiscal 1994 to 1995, the Company reported increases in total
dividends, taxable income, and GAAP income of over 700%. Total dividends
declared rose from $0.4 million to $3.4 million. GAAP income rose from $0.4
million to $3.2 million. Taxable income rose from $0.4 million to $3.8 million.
Dividends, GAAP income and taxable income per share also increased
significantly over these time periods. 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.
From fiscal 1994 to 1995, dividends per share (Preferred Stock prior to the
IPO and Common Stock thereafter) rose from $0.25 to $0.96. GAAP income per share
rose from $0.20 to $0.85 over this period. Taxable income per share rose from
$0.18 to $1.03.
The primary factors driving this growth in dividends and profits were an
increase in the Company's average equity base from $21.8 million in the first
quarter of 1995 to $68.7 million in the first quarter of 1996 and an increase in
the returns earned on this equity. From fiscal 1994 to 1995, growth in dividends
and profits were driven by an increase in the Company's average equity base from
$19.6 million to $42.2 million, an increase in the returns earned on this on
equity and an increase in the length of the operating period from 133 days to
365 days.
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
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<PAGE> 41
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%.
From fiscal 1994 to 1995, on a GAAP basis, net interest income increased by
3.92%, from 7.40% to 11.32%, while credit expenses increased from 0.00% to 1.17%
of equity and general and administrative expenses increased from 2.05% to 2.68%
of equity. On a taxable income basis over the same periods, net interest income
as a percent of equity increased by 4.73%, from 7.00% to 11.73%, while credit
expenses increased from 0.00% to 0.01% of equity and general and administrative
expenses increased from 2.05% to 2.65% of equity.
Net interest income as a percent of equity from the first quarter of 1995
to the first quarter of 1996 and from fiscal 1994 to 1995 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 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 and for 1995 and fiscal 1994.
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>
41
<PAGE> 42
<TABLE>
<CAPTION>
FISCAL FISCAL FISCAL
1995 1995 1995 1994 1994 1994
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.................. $15,726 $15,901 $ 175 $ 1,296 $ 1,267 $ (29)
Interest Expense................. 10,608 10,608 0 760 760 0
Interest Rate Agreement
Expense........................ 339 339 0 8 8 0
------- ------- ---- ------ ------ ---
Net Interest Income.............. 4,779 4,954 175 528 499 (29)
Credit Expense................... 493 4 489 0 0 0
General & Administrative
Expense........................ 1,131 1,118 13 146 146 0
------- ------- ---- ------ ------ ---
Net Income....................... $ 3,155 $ 3,832 $ 677 $ 382 $ 353 $ (29)
</TABLE>
INTEREST INCOME AND THE EARNING ASSET YIELD
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 average earning asset balance for 1995 was $216.4 million as
compared to $56.4 million for fiscal 1994. 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.
Total interest income rose from $1.3 million in fiscal 1994 to $15.7
million in 1995, on a GAAP basis, as the yield on earning assets rose from 6.31%
to 7.27%. These yields were 0.28% and 1.17% over the six month LIBOR rate during
those periods. On a taxable basis, total interest income rose from $1.3 million
in fiscal 1994 to $15.9 million in 1995 as the earning asset based increased and
the yield on earning assets rose from 6.17% to 7.35%. These yields were 0.14%
and 1.25% higher than the average daily six month LIBOR interest rate during
those periods.
The table below shows, on a GAAP and taxable income basis, the Company's
balances of earning assets, the yields earned on earning assets, 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................... 15,726 216,436 7.27% 6.10% 1.17% 15,901 7.35% 1.25%
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>
42
<PAGE> 43
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%. In fiscal 1994, the average six-month LIBOR rate was 6.03; in 1995, the
average six-month LIBOR rate was 6.10%.
The Company was able to increase its earning asset yield despite the
decrease in short term interest rates during these periods 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. In fiscal 1994, the
mortgage principal repayment rate was 7% and in 1995 this rate was 18%. 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.
All the Mortgage Assets acquired by the Company since December 31, 1995
have been acquired at a price representing a premium above the face value of the
mortgage loans. This pricing reflects the high credit quality, attractiveness of
the cash flows, and reduced interest rate risk which these Mortgage Assets may
have relative to Mortgage Assets which are priced at a discount in today's
economic environment. The Company believes this trend towards paying premium
prices on average for its Mortgage Asset acquisitions is likely to continue for
some time. As a result, the Company expects that the level of total premium on
its balance sheet will exceed and continue to grow relative to the level of
discount. As a result of this shift towards a net premium balance, the Company's
sensitivity towards changes in mortgage prepayment rates in both the short and
the long run has been shifting and is expected to continue to shift. More so
than in the past, increases in mortgage prepayment rates should tend to reduce
earnings and decreases in mortgage prepayment rates should tend to increase
earnings, in each case relative to what earnings would have been otherwise.
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.
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.
43
<PAGE> 44
INTEREST EXPENSE AND THE COST OF FUNDS
The Company's largest expense is the cost of borrowed funds. This interest
expense is calculated in the same manner for GAAP and tax purposes. 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%. From fiscal 1994 to 1995, interest expense increased from $0.8 million to
$10.6 million as average borrowed funds rose from $37.9 million to $174.9
million and the average cost of funds rose from 5.50% to 6.06%.
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 daily 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.
In fiscal 1994 the Company's cost of funds was 53 basis points under the
six-month LIBOR index and rose to 4 basis points under the six-month LIBOR index
in 1995. Since management believes changes in the Company's earning asset yield
are likely to be most closely correlated with changes in the six-month LIBOR
rate, the goal of the Company's borrowing program is to minimize costs as
compared to the six-month LIBOR rate. However, through March 1996, the Company
has generally structured its funding to vary with one-month LIBOR rate because
the Company believes that one-month LIBOR may be lower than six-month LIBOR over
time. On average, one-month LIBOR was 0.51% lower than the six-month LIBOR rate
in fiscal 1994 but only 0.13% lower than the six-month LIBOR rate in 1995. The
one-month LIBOR rate rose above the six-month LIBOR rate in June and July and
then again in November and December of 1995.
In April 1996, the Company began lengthening the maturity and repricing
terms of its liabilities. As a result, liability costs are expected to increase
relative to the one- and six-month LIBOR indices but the Company expects that
its earnings sensitivity to rising interest rates and changes in the one- to
six-month LIBOR spread will be reduced.
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>
ONE-MONTH
GAAP COST OF LIBOR
AND FUNDS AVERAGE RELATIVE
AVERAGE TAXABLE VERSUS SIX- 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............................... 174,942 10,608 6.06% (0.04%) 6.10% (0.13%)
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% 0.11%
</TABLE>
44
<PAGE> 45
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 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 0.14% 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.
The net interest rate agreement expense was $7,815 in fiscal 1994 and
$338,512 in 1995. As a percentage of average earning assets, the net expense
equaled 0.04% in fiscal 1994 and 0.15% in 1995. As a percentage of average
borrowings, the net expense equaled 0.06% in fiscal 1994 and 0.19% in 1995. The
primary reason this expense increased as a percentage of assets and borrowings
in 1995 was that the greater utilization of leverage in 1995 required an
increase in interest rate hedging. In addition, the Company increased its
hedging activities in late 1994 and early 1995 as a result of the rapid increase
in interest rates at that time. The amortization of this increased expense over
the effective periods of the interest rate agreements peaked in the second and
third quarters of 1995. As interest rates and interest rate volatility decreased
throughout 1995, the cost of hedging new balance sheet growth declined. As a
result, the net interest rate agreement expense as a percentage of average
assets and borrowings declined in the fourth quarter of 1995 and the first
quarter of 1996.
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............................ 0 339 339 0.15% 0.19%
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
45
<PAGE> 46
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.
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.
In fiscal 1994, spread lending profits were $0.1 million; in 1995 spread
lending profits totaled $1.8 million. During this time periods, the average
amount of spread lending undertaken by the Company increased from $37.9 million
to $174.9 million. The spread earned increased from 0.92% in fiscal 1994 to
1.01% in 1995. The amount of spread lending relative to the size of the
Company's equity base increased from 1.94 times to 4.14 times over these same
time periods. Due to the increase in spread earned 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 1.78% in fiscal 1994 to 4.17% in
1995.
46
<PAGE> 47
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................. 1.16% (0.04%) (0.19%) 1.01% 174,942 1,760 4.14x 4.17%
1995, Quarter 1...... 0.53% (0.57%) (0.06%) 1.04% $102,961 $ 265 4.72x 4.92%
1995, Quarter 2...... 1.21% 0.12% (0.23%) 0.86% 139,979 299 6.20x 5.32%
1995, Quarter 3...... 1.60% 0.16% (0.28%) 1.16% 159,794 469 3.08x 3.59%
1995, Quarter 4...... 1.40% 0.25% (0.17%) 0.98% 295,089 727 4.10x 4.01%
1996, Quarter 1...... 1.99% 0.39% (0.14%) 1.46% 435,979 1,581 6.34x 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%.
From fiscal 1994 to 1995, the Company's spread increased from 0.77% to
1.09%. The contribution of spread lending to the Company's taxable return on
equity increased from 1.48% to 4.50% over the same time period.
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.
TABLE 6
TAXABLE SPREAD LENDING PROFITABILITY
<TABLE>
<CAPTION>
TAXABLE
EARNING TAXABLE
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/ 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.................... 1.24% (0.04%) (0.19%) 1.09% 174,942 1,900 4.14x 4.50%
1995, Quarter 1......... 0.48% (0.57%) (0.06%) 0.99% $102,961 $ 252 4.72x 4.68%
1995, Quarter 2......... 1.30% 0.12% (0.23%) 0.95% 139,979 330 6.20x 5.87%
1995, Quarter 3......... 1.69% 0.16% (0.28%) 1.25% 159,794 505 3.08x 3.87%
1995, Quarter 4......... 1.51% 0.25% (0.17%) 1.09% 295,089 813 4.10x 4.48%
1996, Quarter 1......... 2.13% 0.39% (0.14%) 1.60% 435,979 1,733 6.34x 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
47
<PAGE> 48
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. In fiscal 1994 and 1995,the percentage of equity invested in earning
assets was 94% and 98%, respectively.
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.
In fiscal 1994, the contribution to return on equity on a GAAP basis was
5.62% and increased to 7.15% in 1995. On a taxable basis, the contribution was
5.52% in fiscal 1994 and 7.23% in 1995.
The rising contribution to return on equity of this portion of the balance
sheet over these time periods was largely a function of the rising earning asset
yield and an increase in the 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............... 42,224 98% 41,495 7.27% 3,018 7.15% 7.36% 3,053 7.23%
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.... 71,991 101% 72,358 7.14% 1,301 7.17% 7.25% 1,322 7.28%
1996, Quarter 1.... 68,743 96% 65,770 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 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 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.
From fiscal 1994 to 1995, GAAP net interest income increased from $0.5
million to $4.8 million. Over this same period, taxable net interest income
increased from $0.5 million to $5.0 million. The net interest margin on a GAAP
basis was 2.51% in fiscal 1994 and 2.18% in 1995. On a taxable basis, the net
interest
48
<PAGE> 49
margin was 2.37% in fiscal 1994 and 2.26% in 1995. Due to increases in both
equity-funded lending and spread lending, net interest income as a percent of
equity on a GAAP basis increased from 7.40% in fiscal 1994 to 11.32% in 1995,
and on a taxable basis increased from 7.00% to 11.73% over the same time
periods.
The table below presents GAAP and taxable net interest incomes and margins
and the spread lending and equity-funded incomes as a percent of average equity.
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.............. 4,779 2.18% 4.17% 7.15% 11.32% 4,953 2.26% 4.50% 7.23% 11.73%
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. In fiscal 1994, the Company took no credit
provisions and experienced no actual credit losses. In 1995, credit provisions
were $493,710 while actual losses were $3,997. Since the Company's inception in
1994 through March 1996, 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 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
49
<PAGE> 50
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, have 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. In fiscal 1994, the Company did not take
credit provisions nor did the Company realize credit losses on these assets. In
1995, GAAP credit provisions for these assets were $414,476 while actual credit
losses were $3,977.
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.
For GAAP income, G&A expense increased from $146,498 in fiscal 1994 to
$1,131,078 in 1995. For taxable income, G&A expenses increased from $146,465 in
fiscal 1994 to $1,117,912 in 1995. G&A expenses increased from fiscal 1994 to
1995 for both taxable income and GAAP as the length of the operating period
50
<PAGE> 51
increased, compensation expenses increased pursuant to certain employment
contracts, and the number of employees and the scope of the Company's operations
increased.
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...................... 462 54 615 1,131 462 55 601 1,118
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.
From fiscal 1994 to 1995, the Company's efficiency ratio (G&A expense as a
percentage of net interest income) declined from 28% to 24% on a GAAP basis and
from 29% to 23% on a taxable basis. Over this same time period, the ratio of G&A
expenses to average assets declined from 0.69% to 0.52% on a GAAP basis and from
0.69% to 0.51% on a taxable basis. From fiscal 1994 to 1995, the ratio of G&A
expenses to average equity increased from 2.05% to 2.68% on a GAAP basis and
from 2.05% to 2.65% on a taxable basis. Average assets per employee rose from
$12 million in fiscal 1994 to $39 million in 1995.
TABLE 10
OPERATING EXPENSE RATIOS
<TABLE>
<CAPTION>
AVERAGE
GAAP TAXABLE GAAP TAXABLE ASSETS PER
GAAP TAXABLE G&A EXP/ G&A EXP/ G&A EXP/ G&A EXP/ AVERAGE # OF
EFFICIENCY EFFICIENCY AVE AVE AVERAGE AVERAGE EMPLOYEES
RATIO RATIO ASSETS ASSETS EQUITY EQUITY ($MM)
---------- ---------- -------- -------- -------- -------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994............... 28% 29% 0.69% 0.69% 2.05% 2.05% $ 12
1995...................... 24% 23% 0.52% 0.51% 2.68% 2.65% 39
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>
51
<PAGE> 52
The Company expects its G&A expenses to increase in the subsequent quarters
of 1996. Compensation expenses will rise with the 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 April 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. Such
officers are eligible to receive cash bonuses of up to 100% of their base
salaries; cash bonuses may increase in the future as such bonuses have been very
limited to date. 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.
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%.
From fiscal 1994 to 1995, GAAP net income increased from $0.4 million to
$3.2 million. GAAP return on equity increased from 5.35% to 7.47% over this same
time period. Taxable net income increased from $0.4 million in fiscal 1994 to
$3.8 million in 1995. Return on equity as measured for taxable income increased
from 4.95% to 9.08% from fiscal 1994 to 1995.
The table below presents the components of return on equity for both GAAP
and taxable income.
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................ 3,155 11.32% 1.17% 2.68% 7.47 % 3,832 11.73% 0.01% 2.65% 9.08%
1995, Quarter 1..... $ 401 11.54% 0.34% 3.74% 7.46 % $ 408 11.26% 0.00% 3.68% 7.58%
1995, Quarter 2..... 450 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.
52
<PAGE> 53
From fiscal 1994 to 1995, the Company's GAAP return on assets decreased
from 1.82% to 1.44%. On a taxable basis, the Company's return on assets
increased from 1.68% in fiscal 1994 to 1.75% in 1995.
TABLE 12
COMPONENTS OF RETURN ON ASSETS
<TABLE>
<CAPTION>
GAAP TAXABLE
COST OF COST OF
FUNDS FUNDS
GAAP AND GAAP GAAP GAAP TAXABLE AND TAXABLE TAXABLE TAXABLE
INTEREST HEDGING GAAP CREDIT G&A RETURN INTEREST HEDGING TAXABLE CREDIT G&A RETURN
INCOME/ EXPENSE NET PRVSN/ EXP./ ON INCOME/ EXPENSE NET PRVSN/ EXP./ ON
AVERAGE AVERAGE INTEREST AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE INTEREST AVERAGE AVERAGE AVERAGE
ASSETS ASSETS MARGIN ASSETS ASSETS ASSETS ASSETS ASSETS MARGIN ASSETS ASSETS ASSETS
------- ------- -------- ------- ------- ------- ------- ------- ------- ------- ------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994....... 6.15% (3.64%) 2.51% (0.00%) (0.69%) 1.82% 6.01% (3.64%) 2.37% (0.00%) (0.69%) 1.68%
1995.............. 7.16% (4.98%) 2.18% (0.22%) (0.52%) 1.44% 7.24% (4.98%) 2.26% (0.00%) (0.51%) 1.75%
1995, Quarter 1.. 7.00% (5.00%) 2.00% (0.05%) (0.65%) 1.30% 6.96% (5.00%) 1.96% (0.00%) (0.64%) 1.32%
1995, Quarter 2.. 7.26% (5.57%) 1.69% (0.10%) (0.49%) 1.10% 7.34% (5.57%) 1.77% (0.00%) (0.48%) 1.29%
1995, Quarter 3.. 7.38% (4.71%) 2.67% (0.16%) (0.67%) 1.84% 7.47% (4.71%) 2.76% (0.00%) (0.76%) 2.00%
1995, Quarter 4.. 7.05% (4.89%) 2.16% (0.37%) (0.39%) 1.40% 7.17% (4.89%) 2.28% (0.00%) (0.34%) 1.94%
1996, Quarter 1.. 7.24% (5.04%) 2.20% (0.26%) (0.39%) 1.55% 7.38% (5.04%) 2.34% (0.00%) (0.32%) 2.02%
</TABLE>
DIVIDENDS AND TAXABLE INCOME
The Company currently 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 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.
On June 14, 1996 the Company declared its second quarter dividend of $0.40
per share. This dividend is payable on all shareholders of record as of June 28,
1996, and includes the 2.875 million shares which were issued as the result of
the Company's secondary offering in April 1996. The proceeds from this secondary
offering will allow the Company to grow and benefit from operating efficiencies.
However, in the short-term, the effect of such offerings may a lower per share
dividend as the number of shares eligible to receive a dividend can increase
significantly, while the use of the proceeds cannot be maximized within the same
short time period. It is the Company's goal to grow through such secondary
offerings of equity only if, in the long term, management believes that existing
shareholders will benefit from such additional growth.
53
<PAGE> 54
TABLE 13
DIVIDEND SUMMARY
<TABLE>
<CAPTION>
PREFERRED OR TAXABLE NET
COMMON INCOME PER
SHARES SHARE DIVIDEND CUMULATIVE
TAXABLE ELIGIBLE ELIGIBLE PER DIVIDEND UNDISTRIBUTED UNDISTRIBUTED
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................ 3,832 3,511,242 1.09 0.96 3,371 88% 461 464
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 per share. The
remaining gap of $0.11 per share 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 $0.24 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 $0.24 during this
quarter was caused by a different number of shares used in the denominator
(resulting in a $0.05 per share difference) and no per share difference between
GAAP and taxable income.
The differences between GAAP earnings per share and dividends declared in
fiscal 1994 and 1995 were due to dilution and to the variation in accounting
treatment between GAAP and taxable income with regards to credit provisions and
amortization expenses. The table below presents the various categories which
result in the differences between GAAP earnings per share and dividends
declared.
TABLE 14
DIFFERENCES BETWEEN GAAP EARNINGS PER SHARE AND DIVIDENDS DECLARED
<TABLE>
<CAPTION>
PER SHARE
----------------------------------------------------------------------------- AVERAGE
UNDIS- GAAP GAAP NUMBER NUMBER
TRIBUTED VS. TAX GAAP VS. TAX OF SHARES OF
DIVIDEND TAXABLE TAXABLE G&A VS. TAX CREDIT GAAP RECEIVING PRIMARY
DECLARED EARNINGS EARNINGS EXPENSES AMRTZIN EXPENSES DILUTION EARNINGS DIVIDENDS SHARES
-------- -------- -------- -------- ------- -------- -------- -------- --------- ---------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994...... $ 0.25 $ 0.00 $ 0.25 $ 0.00 $0.02 $ 0.00 $(0.07) $ 0.20 1,401,904 1,916,846
1995............. 0.96 0.13 1.09 0.00 (0.05) (0.14) (0.05) 0.85 3,511,242 3,703,803
1995, Quarter 1.. $ 0.20 $ 0.04 $ 0.24 $ 0.00 $0.01 $(0.01) $(0.05) $ 0.19 1,666,063 2,115,161
1995, Quarter 2.. 0.30 0.02 0.32 0.00 (0.02) (0.02) (0.06) 0.22 1,666,063 2,063,094
1995, Quarter 3.. 0.20 0.00 0.20 0.01 (0.01) (0.02) 0.05 0.23 5,516,313 4,183,138
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>
54
<PAGE> 55
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 was AAA- at December
31, 1994 and was AA+ at December 31, 1995 and March 31, 1996.
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.
In fiscal 1994, the Company acquired $121.3 million in Mortgage Assets for
an average price of 99.53% of principal value. In 1995, the Company acquired
$354.6 million in Mortgage Assets for an average price of 98.05% of principal
value. Mortgage principal repayments received were $1.2 million in fiscal 1994
for an average annualized principal repayment rate of 7% and were $38.8 million
in 1995 for an average principal repayment rate of 18%.
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,
1994, December 31, 1995 and March 31, 1996, the percentage of the Company's
Mortgage Assets which had mortgaged properties located in California was 72%,
65% and 64%, respectively. Management believes single-family property values in
California were generally stable during 1995 and thus far in 1996.
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<PAGE> 56
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>
ANNUALIZED
AVERAGE PRINCIPAL
MORTGAGE CREDIT % IN REPAYMENTS
PRINCIPAL AMORTIZED CARRYING RATING CALIF. AS A % OF
VALUE AT COST AT VALUE AT EQUIV. AT ASSET AVE PRINCIPAL AVERAGE
PERIOD PERIOD PERIOD AT PERIOD PERIOD ACQUISITIONS PRICE REPAYMENTS MTG.
END END END END END AT COST PAID RECEIVED ASSETS
-------- --------- -------- --------- ------ ------------ ------- ---------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <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.............. 443,625 436,236 432,244 AA+ 65% 354 572 98.06% 38,824 18%
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 March 31, 1996, the Company had on its balance sheet as part of the
Mortgage Asset account a total of $16.9 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
$12.8 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) for a net discount of $4.1
million, or 0.7% of the total amortized cost of Mortgage Assets. At December 31,
1995, the Company had a total of $17.0 million of unamortized discount and a
total of $9.6 million of unamortized premium. The net discount at December 31,
1995 was $7.4 million, or 1.7% of the total amortized cost of Mortgage Assets.
At December 31, 1994, the unamortized discount was $1.3 million and the
unamortized premium was $0.8 million for a net unamortized discount of $0.5
million, or 0.4% 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. With a net
discount balance, 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 decreases and the Company would amortize its net discount
balance into income over a shorter time period. Similarly, with a net discount
balance, 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 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
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<PAGE> 57
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). A change in the credit quality or government-agency status of FNMA
and FHLMC may result in adverse consequences for the Company, including a
possible decrease in asset value and an increase in borrowing costs.
At year end 1994, the Company owned partial interests in 7 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 $41 million. The total principal balance of
the mortgages in these pools was $1.1 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. The Company's privately-issued assets were
rated or had a credit rating equivalent of AA- on average.
At December 31, 1995, the Company owned partial interests in 30 pools of
privately-issued assets. These assets 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. On average, the Company's privately-issued
assets at March 31, 1996 were rated or had a credit rating equivalent of AA.
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
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<PAGE> 58
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 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, 1994, December 31, 1995 and March 31, 1996, approximately
$10.0 million, $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
LOAN EQUIV. EQUIV. EQUIV. LOAN EQUIV. EQUIV. EQUIV.
END 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............... 26,450 355,784 25,171 24,839 6.1% 82.4% 5.8% 5.7%
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 25,838 24,272 4.4% 86.8% 4.6% 4.2%
</TABLE>
58
<PAGE> 59
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.
TABLE 17
MORTGAGE ASSET CHARACTERISTICS
<TABLE>
<CAPTION>
AVERAGE
FULLY- MONTHS MORTGAGE
END OF COUPON INDEX NET INDEXED TO 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.................... 7.50% 5.44% 2.08% 7.52% 3 11.54% 7.74%
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>
SIX- ELEVENTH
SIX- ONE- MONTH ONE- SIX- DISTRICT NATIONAL INTEREST-
MONTH MONTH BANK YEAR MONTH COST 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
<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.............................. 59.7% 7.7% 12.8% 12.5% 5.0% 1.7% 0.0% 0.6%
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
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<PAGE> 60
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.
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, AT DECEMBER 31, AT DECEMBER 31,
1996 1995 1994
----------------- --------------- ---------------
(ALL RATIOS BASED ON % OF TOTAL LOAN
PORTFOLIO BALANCES UNLESS NOTED)
<S> <C> <C> <C>
Face Value.................................... $24,830,547 $26,411,412 $ 0
Amortized Cost................................ 24,865,544 26,450,045 0
Adjustable-Rate............................... 100% 100% N/A
Single-Family................................. 100% 100% N/A
"A" Quality Underwriting...................... 100% 100% N/A
First Lien.................................... 100% 100% N/A
Owner-Occupied................................ 100% 100% N/A
Property Located in Northern California....... 30% 30% N/A
Property Located in Southern California....... 46% 44% N/A
Number of Loans............................... 101 109 N/A
Average Loan Size............................. $ 245,847 $ 242,307 N/A
Original Loan Balance in Excess of $500,000... 25% 25% N/A
Average Original Loan to Value Ratio (LTV).... 77% 76% N/A
Original LTV > 80%............................ 27% 26% N/A
Percent of Original LTV > 80% with Mortgage
Insurance................................... 100% 100% N/A
1994 Origination.............................. 2% 2% N/A
1995 Origination.............................. 98% 98% N/A
Non-Performing Assets (90+ days delinq.)...... $ 190,252 0 N/A
Number of non-performing loans
(90+ days delinq.).......................... 1 0 N/A
Non-Performing Assets as % of Total Loan
Balances.................................... 0.77% 0.00% N/A
Credit Reserves............................... $ 74,492 $ 79,234 N/A
Credit Reserves as % of NPA's................. 39% N/A N/A
Credit Reserves as % of Total Loan Balances... 0.30% 0.30% N/A
</TABLE>
SECURITIZED MORTGAGE ASSETS WITH A CREDIT RATING EQUIVALENT OF AAA TO BBB
At December 31, 1994, December 31, 1995 and March 31, 1996, 97%, 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
60
<PAGE> 61
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 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 Company had no "first loss" assets as of December 31,
1994. 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 20
SUMMARY OF BELOW BBB-RATED SECURITIZED MORTGAGE ASSETS
<TABLE>
<CAPTION>
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............................ 41,290 28,857 414 4 410 1.42%
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................. 39,934 28,051 336 0 747 2.66%
</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
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<PAGE> 62
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 21.
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.
The Company owns an interest in three pools issued from one mortgage
conduit which experienced a rapid growth in reported delinquencies through March
1996. 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 21
POTENTIAL CREDIT LOSSES DUE TO 90+ DAY DELINQUENCIES AS OF MARCH 31, 1996
FOR SECURITIZED MORTGAGE ASSETS WITH CREDIT RATING EQUIVALENT BELOW BBB
<TABLE>
<CAPTION>
90% 95% 100%
LOSS SEVERITY DEFAULT FREQUENCY DEFAULT FREQUENCY DEFAULT 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
62
<PAGE> 63
basis in these agreements, which was $1.8 million at December 31, 1994, $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
current requirements.
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 112 days at December
31, 1994, 74 days at December 31, 1995 and 48 days at March 31, 1996. Through
March 1996, many of the Company's borrowings had a cost of funds which adjusted
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 typically has been shorter than the
term to maturity: at December 31, 1994, December 31, 1995 and at March 31, 1996,
the weighted average term to next rate adjustment was 70 days, 26 days and 19
days, respectively The average rate on the Company's borrowing at December 31,
1994 was 5.80%, at December 31, 1995 it was 6.01% and at March 31, 1996 it was
5.62%. The effective rate of increase in the Company's borrowing costs should
short-term interest rates rise will be partially limited by the Company's
interest rate agreements.
TABLE 22
BORROWING SUMMARY
<TABLE>
<CAPTION>
ESTIMATED
MARKET BORROWING
VALUE OF CAPACITY AVERAGE RATE ON
PLEDGABLE AS A % OF ESTIMATED AVERAGE TERM TO BORROWINGS
END 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................... 432,244 94.6% 408,998 370,316 74 days 26 days 6.01%
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>
As a result of the Company's extending the term of its liabilities in the
second quarter of 1996, the average term to maturity and the average term to
next rate adjustments in the second quarter increased from the March 1996
levels.
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
63
<PAGE> 64
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.
TABLE 23
POTENTIAL IMMEDIATE SOURCES OF LIQUIDITY
<TABLE>
<CAPTION>
POTENTIAL
IMMEDIATE
SOURCES OF POTENTIAL
LIQUIDITY IMMEDIATE
ESTIMATED (CASH + SOURCES OF
UNUSED EST. UNUSED LIQUIDITY
END 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............................. 4,825 38,682 43,507 12%
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
increased from year end 1994 to year end 1995 as a result of the Company's
initial public offering in August 1995. As measured on a historical cost basis,
the equity base increased from $22.8 million, or $12.18 per share at December
31, 1994 to $73.8 million, or $13.37 per share, at December 31, 1995. During the
first quarter of 1996, the historical cost basis equity base decreased slightly
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 to $73.2 million, or $13.26 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
increased form $20.3 million, or $10.82 per share, at December 31, 1994 to $68.3
million, or $12.38 per share, at December 31, 1995. This increase was primarily
due to equity raised in the Company's initial public offering in August 1995,
offset by a negative change in the assets' mark-to-market valuation adjustment.
Since the year end 1995, the GAAP equity base has decreased to $68.1 million, or
$12.34 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.
64
<PAGE> 65
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.
"Net Unrealized Losses on Assets Available for Sale" was $2.6 million, or
2.1% of assets, December 31, 1994, $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 first quarter of 1996, 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
UNREALIZED UNREALIZED HISTORICAL HISTORICAL
LOSSES LOSSES AMORTIZED GAAP AMORTIZED GAAP
ON ASSETS AS % OF COST REPORTED COST REPORTED
END OF TOTAL AVAILABLE TOTAL EQUITY EQUITY EQUITY EQUITY
PERIOD ASSETS FOR SALE ASSETS BASE BASE PER SHARE PER 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........................ 441,557 (5,476) (1.2%) 73,766 68,290 13.37 12.38
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 13.26 12.34
</TABLE>
65
<PAGE> 66
The completion of the Company's April 1996 secondary common stock offering
at $20.25 per share resulted in a significant increase in book value per share,
which will be evident at the end of the second quarter of 1996.
WARRANTS
At December 31, 1994, the Company had 1,666,063 Warrants outstanding. At
December 31, 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 on or prior to December 31, 1997.
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 16.7% at December 31,
1994, 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-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
66
<PAGE> 67
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>
ASSET
TARGET ACTUAL POTENTIAL GROWTH
EQUITY EQUITY ASSET SIZE ACTUAL POTENTIAL
END OF EQUITY TO ASSETS TO ASSETS EXCESS WITH SAME ASSET WITH SAME
PERIOD CAPITAL RATIO RATIO CAPITAL ASSET MIX SIZE ASSET 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.......................... 68,290 12.59% 15.47% 12,028 542,431 441,557 100,874
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 common 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. As of June 1996, the Company's asset
size was in excess of $1.0 billion.
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.
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.
67
<PAGE> 68
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 (i.e., interest rate agreements), 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 0.1% at December 31, 1994, negative
36.4% at December 31, 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 14.9% at
December 31, 1994, 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 was 14.9% at year
end 1994, 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.
68
<PAGE> 69
TABLE 26
INTEREST RATE SENSITIVITY GAP EXCLUDING INTEREST RATE AGREEMENTS
<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
AS A % OF AS A % OF AS A % OF AS A % OF AS A % OF AS A % OF AS A % OF AS A % OF
END 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.................. (48.2%) (36.4%) (25.8%) (15.8%) (2.9%) 9.3% 12.2% 14.7%
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>
INTEREST RATE AGREEMENTS
The Company's interest rate agreements alter the interest rate risk profile
suggested by the interest rate sensitivity gap analysis. These interest rate
agreements are described in Footnote 3 of the Financial Statements.
The interest rate agreements are designed to produce income for the Company
as short-term interest rates rise. In effect, these agreements can be thought of
as serving to limit potential increases in the costs of the Company's
liabilities or, alternatively, as serving to remove some of the periodic and
lifetime caps imbedded in the Company's assets.
The tables below show the amount of interest rate agreements that would
serve in such a capacity as compared to the size of the Company's assets and
liabilities. For example, at March 31, 1996 had short-term interest rates risen
immediately by 100 basis points, the amount of interest rate agreements that
would then be in effect would have equaled 31.0% of the Company's assets and
35.1% of the Company's liabilities. As shown in the tables, as short-term
interest rates rise to higher levels, the amount of interest rate agreement
protection generally increases.
These tables do not show how long each interest rate agreement would be in
effect or other factors. Initial maturities of interest rate agreements have
ranged from one year to ten years. Each interest rate agreement references one
month or three month LIBOR on a monthly or quarterly basis, respectively.
TABLE 27
NOTIONAL AMOUNT OF INTEREST RATE AGREEMENTS EFFECTIVE AS A % OF TOTAL ASSETS
ASSUMING AN IMMEDIATE SHIFT IN INTEREST RATES
<TABLE>
<CAPTION>
IMMEDIATE INCREASE IN ONE-MONTH OR THREE-MONTH LIBOR OF:
END OF ------------------------------------------------------------------------------------
PERIOD 0BPS 50BPS 100BPS 150BPS 200BPS 300BPS 400BPS 500BPS 600BPS 700BPS
- --------------------------- ---- ----- ------ ------ ------ ------ ------ ------ ------ ------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994................ 0.0 % 0.0 % 4.1% 4.1% 4.1% 4.1% 4.1% 4.1% 4.1% 4.1%
1995....................... 0.0 % 20.4 % 20.4% 34.0% 50.1% 59.3% 59.3% 66.1% 66.1% 68.4%
1995, Quarter 1............ 0.0 % 25.4 % 25.4% 28.9% 28.9% 28.9% 28.9% 28.9% 28.9% 28.9%
1995, Quarter 2............ 0.0 % 0.0 % 38.5% 41.3% 41.3% 52.4% 58.0% 58.0% 63.6% 63.6%
1995, Quarter 3............ 0.0 % 0.0 % 0.0% 35.4% 37.1% 43.7% 45.3% 48.6% 48.6% 51.9%
1995, Quarter 4............ 0.0 % 20.4 % 20.4% 34.0% 50.1% 59.3% 59.3% 66.1% 66.1% 68.4%
1996, Quarter 1............ 0.0 % 17.2 % 31.0% 37.8% 42.1% 58.6% 62.0% 67.2% 67.2% 68.9%
</TABLE>
The table above show the notional amounts of effective interest rate
agreements as a percent of assets; the following table presents the same
information but as a percentage of liabilities.
69
<PAGE> 70
TABLE 28
NOTIONAL AMOUNT OF INTEREST RATE AGREEMENTS EFFECTIVE AS A % OF TOTAL
LIABILITIES
ASSUMING AN IMMEDIATE SHIFT IN INTEREST RATES
<TABLE>
<CAPTION>
IMMEDIATE INCREASE IN ONE-MONTH OR THREE-MONTH LIBOR OF:
END OF -----------------------------------------------------------------------------
PERIOD 0BPS 50BPS 100BPS 150BPS 200BPS 300BPS 400BPS 500BPS 600BPS 700BPS
- ---------------------- ----- ----- ----- ----- ----- ----- ----- ----- ----- -----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994........... 0.0% 0.0% 4.9% 4.9% 4.9% 4.9% 4.9% 4.9% 4.9% 4.9%
1995.................. 0.0% 24.1% 24.1% 40.2% 59.2% 70.2% 70.2% 78.2% 78.2% 80.9%
1995, Quarter 1....... 0.0% 30.1% 30.1% 34.1% 34.1% 34.1% 34.1% 34.1% 34.1% 34.1%
1995, Quarter 2....... 0.0% 0.0% 44.0% 47.2% 47.2% 60.0% 66.3% 66.3% 72.7% 72.7%
1995, Quarter 3....... 0.0% 0.0% 0.0% 46.6% 48.7% 57.4% 59.5% 63.9% 63.9% 68.2%
1995, Quarter 4....... 0.0% 24.1% 24.1% 40.2% 59.2% 70.2% 70.2% 78.2% 78.2% 80.9%
1996, Quarter 1....... 0.0% 19.5% 35.1% 42.9% 47.7% 66.4% 70.2% 76.1% 76.1% 78.0%
</TABLE>
INTEREST RATE FUTURES AND OPTIONS
In the second half of 1996, the Company intends to commence the limited use
of interest rate futures and listed options on interest rate futures as part of
its on-going interest rate risk management process. These instruments are in
some ways similar to the interest rate agreements currently in use by the
Company; the Company intends to use them in a similar manner and for hedging
purposes only. The Company currently plans to limit the aggregate amount of
funds that the Company will deposit as original margin on futures plus premiums
on listed options to less than 1% of the Company's total assets, after taking
into account unrealized profits and unrealized losses on any such contracts.
Unless federal legislation changing REIT hedging restrictions with respect to
futures and options is enacted, the Company currently plans to limit its use of
futures and listed options so that its net profits from such instruments will be
limited to 5% or less of the Company's gross taxable income on an annual basis.
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.
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<PAGE> 71
BUSINESS AND STRATEGY
The Company's principal business objective is to produce net interest
income on its Single-Family, Multifamily and Commercial Mortgage Assets while
maintaining strict cost controls in order to generate net income for
distribution to stockholders. The Company's business strategy, as described
below, was formulated with the intention of distributing dividends to
stockholders at levels that generally adjust, following a lag period, with
changes in short-term market interest rates and that may increase over time in
the event of improvements in the single-family, multifamily and commercial real
estate markets. In order to preserve its status as a REIT under the Code,
substantially all of the assets of the Company will consist of Qualified REIT
Real Estate Assets. To achieve its business objective and generate dividend
yields that provide a relatively attractive rate of return for stockholders, the
Company's strategy is:
- to purchase Single-Family, Multifamily and Commercial Mortgage Assets,
substantially all of which are currently expected to have adjustable
interest rates based on changes in short-term market interest rates and
the majority of which are expected to represent mortgage interests in
California real estate;
- to manage the credit risk of its Mortgage Assets through, among other
activities, (i) carefully selecting Mortgage Assets to be acquired,
including an underwriting review of Mortgage Loans and lower-rated
Mortgage Securities, (ii) following the Company's policies with respect
to credit risk concentration which, among other things, require the
Company to maintain a Mortgage Asset portfolio with a weighted average
rating level of A- or better, (iii) actively monitoring the ongoing
credit quality and servicing of its Mortgage Assets, and (iv) maintaining
appropriate capital levels and allowances for possible credit losses;
- to finance such purchases with the proceeds of equity offerings and, to
the extent permitted by the Company's capital and liquidity policies, to
utilize leverage to increase potential returns to stockholders through
borrowings (primarily under reverse repurchase agreements) whose interest
rates will also reflect changes in short-term market interest rates;
- to attempt to structure its borrowings to have interest rate adjustment
indices and interest rate adjustment periods that, on an aggregate basis,
generally correspond (within a range of one to six months) to the
interest rate adjustment indices and interest rate adjustment periods of
the adjustable-rate Mortgage Assets purchased by the Company;
- to utilize interest rate caps, swaps and similar instruments to mitigate
the risk of the cost of its variable rate liabilities increasing at a
faster rate than the earnings on its assets during a period of rising
interest rates;
- to seek to minimize prepayment risk by structuring a diversified
portfolio with a variety of prepayment characteristics and through other
means;
- to apply securitization techniques designed to enhance the value and
liquidity of the Company's Mortgage Assets acquired in the form of
Mortgage Loans by securitizing them into Mortgage Securities that are
tailored to the Company's objectives;
- to re-securitize portions of its Mortgage Securities portfolio when the
underlying Mortgage Loans have improved in credit quality through
seasoning or rising underlying property values, or when the credit
quality of a junior class of security improves due to the prepayment of
more senior classes, as such re-securitization transactions may result in
improved credit ratings, higher market values and lowered borrowing
costs; and
- to strive to become more cost-efficient over time.
The Company believes that the current economic environment is favorable for
the Company's business strategy. The Company is located in California and a
majority of its Mortgage Assets currently are and are expected to be represented
by mortgage interests on real property located in California. The Company
believes that there are attractive Mortgage Asset acquisition opportunities in
Northern and Southern California today due to the diversity of the economy and
the size, depth and liquidity of its real estate property markets, and
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<PAGE> 72
that there may be significant potential for appreciation in real estate values
in California in the future. At December 31, 1995 and March 31, 1996,
approximately 65% and 64%, respectively, of the Company's Mortgage Assets
represented interests in mortgages on residential real property located in
California. The Company expects that any future price appreciation in the real
estate property markets in California and the United States will tend to have a
direct and positive effect on the Company's earnings and dividends. If an
increase in property values occurs, the Company believes that the credit quality
and market value of its Mortgage Assets will rise. Should this occur, the
Company expects that it will be able to reduce its capital allocation to these
assets, free its credit reserves and lower its borrowing costs.
The Company believes that its principal competition in the business of
acquiring and holding Mortgage Assets are financial institutions such as banks,
savings and loans, life insurance companies, institutional investors such as
mutual funds and pension funds, and certain other mortgage REITs. While most of
these entities have significantly greater resources than the Company, the
Company anticipates that it will be able to compete effectively and generate
relatively attractive rates of return for stockholders due to its relatively low
level of operating costs, relative freedom to securitize its assets, ability to
utilize prudent amounts of leverage through accessing the wholesale market for
collateralized borrowings, freedom from certain forms of regulation and the tax
advantages of its REIT status.
The Company believes it is and will continue to be a "low cost producer"
compared to most of its competitors in the business of holding Mortgage Assets.
Accordingly, the Company believes that it will be able to generate attractive
earnings and dividends while holding assets of higher credit quality and
maintaining a lower interest rate risk profile as compared to its principal
competitors. Nevertheless, the Company will strive to become even more
cost-efficient over time. The Company will attempt to do so by: (i) seeking to
raise additional capital from time to time in order to increase its ability to
invest in Mortgage Assets as operating costs are not anticipated to increase as
quickly as assets and because growth will increase the Company's purchasing
influence with suppliers of Mortgage Assets; (ii) striving to lower its
effective borrowing costs over time through seeking direct funding with
collateralized lenders rather than using Wall Street intermediaries and
investigating the possibility of using collateralized commercial paper and
medium term note programs; (iii) improving the efficiency of its balance sheet
structure by investigating the issuance of uncollateralized subordinated debt
and other forms of capital; and (iv) utilizing information technology to the
fullest extent possible in its business, which technology the Company believes
can be developed to improve the Company's ability to monitor the performance of
its Mortgage Assets, improve its ability to assess credit risk, improve hedge
efficiency and lower operating costs. For example, the Company is presently able
to access electronically large volumes of data on estimated current market
values of residential properties in California and other parts of the United
States (categorized by zip code or smaller geographic unit), as well as data
relating to specific mortgage loans and borrowers. Such information is used to
evaluate prospective acquisitions of Mortgage Assets and to monitor performance
and risk in existing investments. The growth of available data and services
interpreting this data in creative ways is expected to continue.
MORTGAGE ASSETS
GENERAL
The Mortgage Assets to be purchased by the Company will consist of
Single-Family Mortgage Assets (Single-Family Mortgage Loans and Single-Family
Mortgage Securities), Multifamily Mortgage Assets (Multifamily Mortgage Loans
and Multifamily Mortgage Securities) and Commercial Mortgage Assets (Commercial
Mortgage Loans and Commercial Mortgage Securities). Although all of the
Company's Mortgage Assets purchased through March 31, 1996 were Single-Family
Mortgage Assets, the Company expects to acquire Multi-Family Mortgage Assets and
Commercial Mortgage Assets from time to time in the future when consistent with
its Asset Acquisition/Capital Allocation Policies. Single-Family Mortgage Loans
are Mortgage Loans secured solely by first mortgages or deeds of trust on
single-family (one- to four-unit) residences and Single-Family Mortgage
Securities are backed by, or evidence interests in, Single-Family Mortgage
Loans. Multifamily Mortgage Loans are Mortgage Loans secured solely by first
mortgages or deeds of trust on multifamily (more than four units) residential
properties and Multifamily Mortgage Securities are backed by, or evidence
interests in, Multifamily Mortgage Loans. Commercial Mortgage Loans are Mortgage
72
<PAGE> 73
Loans secured by commercial properties and Commercial Mortgage Securities are
backed by, or evidence interests in, Commercial Mortgage Loans. The Company
expects substantially all of its Mortgage Assets to bear adjustable interest
rates. However, fixed-rate Mortgage Assets also may be acquired when they
satisfy the Company's Asset Acquisition/Capital Allocation Policies and will
contribute to the Company's business objectives with respect to desired levels
of income and dividend distributions. From time to time, the Company may also
acquire common stock in other REITs that invest primarily in Mortgage Assets if
the Company believes the returns on such common stock are good and such
opportunities are more favorable than investing in Mortgage Assets directly,
provided such common stock is traded on a national securities exchange or quoted
on the Nasdaq National Market. The Company may also acquire its own stock, when
permitted by applicable securities and state corporation laws.
The Company expects that a majority of its Mortgage Assets will continue to
have investment grade ratings (the four highest rating levels) from one or more
nationally recognized mortgage security rating agencies or be deemed by the
Company to be of comparable credit quality. Based upon the Company's investment
strategy and the guidelines under the Company's Asset Acquisition/Capital
Allocation Policies, the Company expects that the weighted average rating of its
Mortgage Assets (including the Company's deemed equivalent ratings for unrated
Mortgage Assets) will continue to be at least at the single "A" rating level
under S&P's rating system and at the comparable level under other rating
systems. See "Certain Federal Income Tax Considerations -- Taxation of
Tax-Exempt Entities."
The Company generally will not acquire residuals, principal-only strips,
inverse floaters, companion bonds, first loss Subordinated Bonds rated below
BBB, or mortgage securities rated below B. The Company may acquire, however,
interest-only mortgage strips as an investment or to assist in the hedging of
prepayment or other risks, to the extent that the aggregate amortized cost of
the Company's Mortgage Assets does not exceed 102.5% of the aggregate face value
of such Mortgage Assets at the time of purchase. For this purpose, the amortized
cost of interest-only mortgage strips would be approximately equal the price
paid therefor less accrued amortization. In addition, the Company may create a
variety of different types of assets, including the types mentioned in this
paragraph, through the normal process of securitization of the Company's own
Mortgage Assets. In no event will the Company acquire or retain any REMIC
residual interest that may give rise to "excess inclusion" income as defined
under Section 860E of the Code.
The Company's Asset Acquisition/Capital Allocation Policies utilize a
return on equity calculation that includes adjustments for credit risk,
borrowing costs, the cost of associated interest rate agreements (caps and
swaps) and the Risk-Adjusted Capital Policy requirements. The relative
attractiveness of various asset types will vary over time. The Company may
acquire its Mortgage Assets in the secondary mortgage market or upon origination
pursuant to arrangements with loan originators. Purchases of Mortgage Assets in
the secondary market generally are from national broker/dealer firms or other
large financial institutions. The Company may issue Commitments to originators
and other sellers of Mortgage Loans who it believes follow prudent origination
policies and procedures and comply with all applicable federal and state laws
and regulations for origination of Mortgage Loans. In addition, the Company may
issue Commitments for Mortgage Securities. These Commitments will obligate the
Company to purchase Mortgage Assets from the holders of the Commitment for a
specific period of time, in a specific aggregate principal amount and at a
specified price and margin over an index. Although the Company may commit to
acquire Mortgage Loans prior to funding, all loans are to be fully funded prior
to their acquisition by the Company. Following the issuance of Commitments, the
Company will be exposed to risks of interest rate fluctuations similar to those
risks on the Company's adjustable-rate Mortgage Assets. As described below under
"-- Management Policies and Programs -- Asset/Liability Management -- Mortgage
Loan Securitization Techniques," the Company works with loan originators,
conduits, other issuers of Mortgage Securities and their investment bankers to
acquire and securitize Mortgage Loans in a manner that best meets the needs of
the Company. Such activity may involve the issuance of Commitments by the
Company. See "Risk Factors -- Operations Risks -- Risk of Decrease in Net Income
Due to Interest Rate Fluctuations; Prepayment Risks of Mortgage Assets."
For purposes of this Prospectus, "face value" of Mortgage Assets represents
the outstanding principal balance of the Mortgage Loans or Mortgage Securities
comprising the Mortgage Assets, and "amortized cost" means the purchase prices
paid for the Mortgage Assets adjusted to reflect (i) amortization of discounts
or
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<PAGE> 74
premiums and (ii) principal repayments. Mortgage Assets are carried on the
balance sheet at what is referred to by the Company as "carrying value."
"Carrying value" for the Mortgage Assets is management's estimate of the bid
side of the market value for such assets. Management usually bases its estimates
on the lowest of third-party bid-side indications of market value for Mortgage
Assets obtained from firms making a market in or lending against Mortgage
Assets. Generally, such indications are solicited by the Company on a monthly
basis and from time to time in connection with the Company's borrowing
activities and the lowest of such indications with respect to a Mortgage Asset
generally comes from the secured lender on that asset. To the extent such
bid-side indications typically are below the amortized cost of Mortgage Assets,
the difference is referred to in this Prospectus as unrealized losses, and, to
the extent such indications exceed the amortized cost, the difference is
referred to as unrealized gains. The net amount of such unrealized gains and
losses is reflected on the balance sheet as a valuation adjustment to
Stockholders' Equity under the caption "Net Unrealized Loss on Assets Available
for Sale."
Following commencement of operations on August 19, 1994, the Company began
to accumulate its Mortgage Asset portfolio. Mortgage Assets were acquired during
the fiscal years ending December 31, 1994 and December 31, 1995 and such
acquisitions have continued during the first two quarters of 1996.
At December 31, 1995 and March 31, 1996, the Company's Mortgage Assets,
excluding interest only mortgage strips, consisted of the following:
<TABLE>
<CAPTION>
AT DECEMBER 31, 1995
------------------------------------------------------
FEDERAL FEDERAL
HOME LOAN NATIONAL PRIVATELY TOTAL
MORTGAGE MORTGAGE ISSUED MORTGAGE MORTGAGE
CORPORATION ASSOCIATION ASSETS ASSETS
----------- ----------- --------------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Mortgage Assets, Face Value.............. $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
Reserve for Credit Losses................ 0 0 (490) (490)
Unrealized Gains*........................ 334 1,033 874 2,241
Unrealized Losses*....................... (110) (458) (4,345) (4,913)
------- -------- -------- --------
Carrying Value*.......................... $47,291 $ 193,931 $ 188,259 $429,481
</TABLE>
- ---------------
* Estimate based on bid-side market value of Mortgage Assets.
<TABLE>
<CAPTION>
AT MARCH 31, 1996
------------------------------------------------------
(UNAUDITED)
FEDERAL FEDERAL
HOME LOAN NATIONAL PRIVATELY TOTAL
MORTGAGE MORTGAGE ISSUED MORTGAGE MORTGAGE
CORPORATION ASSOCIATION ASSETS ASSETS
----------- ----------- --------------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Mortgage Assets, Face Value.............. $ 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
Reserve for Credit Losses................ 0 0 (821) (821)
Unrealized Gains*........................ 265 970 613 1,848
Unrealized Losses*....................... (217) (487) (3,926) (4,630)
------- -------- -------- -------
Carrying Value*.......................... $ 83,872 $ 214,483 $ 264,567 $562,922
</TABLE>
- ---------------
* Estimate based on bid-side market value of Mortgage Assets.
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All of the Company's Mortgage Assets at December 31, 1995 and March 31,
1996 were ARMs or Mortgage Securities evidencing interests in pools of ARMs. The
weighted average December 1995 coupon rate for the Company's Mortgage Assets at
December 31, 1995 was 7.50% and the weighted average March 1996 coupon at March
31, 1996 was 7.59%. The coupons on the Company's Mortgage Assets adjust relative
to several indices; the weighted average level of these underlying indices at
December 31, 1995 and March 1996 was 5.44% and 5.47%, respectively. The coupon
rates on the Company's Mortgage Assets adjust to the underlying index plus a
margin; the weighted average margin in December 1995 and March 1996 was
approximately 2.08% and 2.11%, respectively. The Company's Mortgage Assets as a
whole have scheduled coupon adjustment dates that are well distributed through
the months of the year; the approximate weighted average period to next
adjustment was three months at December 31, 1995 and March 31, 1996. The
weighted average life cap at December 31, 1995 and March 31, 1996 was 11.54% and
11.53%, respectively.
The weighted average "fully indexed" rate at December 31, 1995 and March
31, 1996 was 7.52% and 7.58%, respectively. The fully indexed rate is equal to
the current average index level plus the weighted average margin. If interest
rates and the Company's balance sheet remained unchanged at March 31, 1996
levels, the Company's average coupon rate at March 31, 1996 of 7.59% would
remain relatively stable.
All of the mortgage loans underlying the Company's Mortgage Assets at March
31, 1996 were being serviced by third-party servicers unrelated to the Company.
The Company's Mortgage Securities are held by its custodian, Mellon Bank, N.A.,
pursuant to a Custody Agreement dated August 22, 1994.
TYPES OF MORTGAGE ASSETS
The various types of Mortgage Assets the Company may purchase are
summarized below.
Single-Family and Multifamily Mortgage Assets
Single-Family Mortgage Loans
The Company may acquire both Conforming Mortgage Loans and Nonconforming
Mortgage Loans. Conventional Conforming Mortgage Loans will comply with the
requirements for inclusion in a loan guarantee program sponsored by either FHLMC
or FNMA. The Company also may acquire FHA Loans or VA Loans, which qualify for
inclusion in a pool of Mortgage Loans guaranteed by GNMA. Under current
regulations, the maximum principal balance allowed on Conforming Mortgage Loans
ranges from $207,000 ($310,500 for Mortgage Loans secured by Mortgaged
Properties located in either Alaska or Hawaii) for one-unit to $397,800
($596,700 for Mortgage Loans secured by Mortgaged Properties located in either
Alaska or Hawaii) for four-unit residential loans. Nonconforming Single-Family
Mortgage Loans are Single-Family Mortgage Loans that do not qualify in one or
more respects for purchase by FNMA or FHLMC. The Company expects that a majority
of the Nonconforming Mortgage Loans it purchases will be nonconforming because
they have original principal balances which exceed the requirements for FHLMC or
FNMA programs or generally because they vary in certain other respects from the
requirements of such programs other than the requirements relating to
creditworthiness of the mortgagors. A substantial portion of the Company's
Nonconforming Mortgage Loans are expected to meet the requirements for sale to
national private mortgage conduit programs in the secondary mortgage market.
The Company currently expects that substantially all of the Single-Family
Mortgage Loans acquired by it will be ARMs. The interest rate on an ARM is
typically tied to an index (such as LIBOR or the interest rate on United States
Treasury Bills), and is adjustable periodically at various intervals. Such
Mortgage Loans are typically subject to lifetime interest rate caps and periodic
interest rate and/or payment caps.
Multifamily Mortgage Loans
Multifamily Mortgage Loans generally involve larger principal amounts per
loan than Single-Family Mortgage Loans and require more complex credit and
property evaluation analysis. Multifamily Mortgage Loans share many of the
characteristics and risks associated with Commercial Mortgage Loans and are
often categorized as commercial loans rather than residential loans. For
example, the credit quality of a Multifamily Mortgage Loan typically depends
upon the existence and terms of underlying leases, tenant credit quality and
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<PAGE> 76
the historical and anticipated level of vacancies and rents on the mortgaged
property and on the competitive market condition of the mortgaged property
relative to other competitive properties in the same region, among other
factors. See "Risk Factors -- Operations Risks -- Risk of Loss on Multifamily
Mortgage Assets." Multifamily Mortgage Loans, however, constitute "qualified
mortgages" for purposes of the REMIC regulations and the favorable tax treatment
associated therewith and, when securitized, certain of the resulting rated
classes of Multifamily Mortgage Securities qualify as "mortgage-related
securities" and for the favorable treatment awarded such securities under the
Secondary Mortgage Market Enhancement Act of 1984 ("SMMEA").
Single-Family and Multifamily Mortgage Securities
The Mortgage Assets purchased by the Company are expected to include
Single-Family Mortgage Securities. In addition, the Company expects to pool and
exchange a substantial portion of its Single-Family and Multifamily Mortgage
Loans for Single-Family and Multifamily Mortgage Securities, respectively, which
it may then hold for investment, sell or pledge to secure borrowings. The types
of Single-Family and Multifamily Mortgage Securities that the Company may
purchase or receive in exchange for its Single-Family and Multifamily Mortgage
Loans are described below.
Single-Family and Multifamily Privately Issued Certificates. Single-Family
and Multifamily Privately Issued Certificates are Pass-Through Certificates that
are not issued by one of the Agencies and that are backed by a pool of
conventional Single-Family or Multifamily Mortgage Loans, respectively.
Single-Family and Multifamily Privately Issued Certificates are issued by
originators of, investors in, and other owners of Mortgage Loans, including
savings and loan associations, savings banks, commercial banks, mortgage banks,
investment banks and special purpose "conduit" subsidiaries of such
institutions.
While Agency Certificates are backed by the express obligation or guarantee
of one of the Agencies, as described below, Single-Family and Multifamily
Privately Issued Certificates are generally covered by one or more forms of
private (i.e., nongovernmental) credit enhancements. Such credit enhancements
provide an extra layer of loss coverage in the event that losses are incurred
upon foreclosure sales or other liquidations of underlying mortgaged properties
in amounts that exceed the holder's equity interest in the property and result
in Realized Losses. Forms of credit enhancements include, but are not limited
to, limited issuer guarantees, reserve funds, private mortgage guaranty pool
insurance, over-collateralization and subordination.
Subordination is a form of credit enhancement frequently used and involves
the issuance of multiple classes of Senior-Subordinated Mortgage Securities.
Such classes are structured into a hierarchy of levels for purposes of
allocating Realized Losses and also for defining priority of rights to payment
of principal and interest. Typically, one or more classes of Senior Securities
are created which are rated in one of the two highest rating levels by one or
more nationally recognized rating agencies and which are supported by one or
more classes of Mezzanine Securities and Subordinated Securities that bear
Realized Losses prior to the classes of Senior Securities. Mezzanine Securities
for purposes of this Prospectus will refer to any classes that are rated below
the two highest levels but no lower than a single "B" level under the S&P rating
system (or comparable level under other rating systems) and are supported by one
or more classes of Subordinated Securities which bear Realized Losses prior to
the classes of Mezzanine Securities. For purposes of this Prospectus,
Subordinated Securities will refer to any class that bears the "first loss" from
Realized Losses or that is rated below a single "B" level (or, if unrated, is
deemed by the Company to be below such level based on a comparison of
characteristics of such class with other rated Subordinated Securities with like
characteristics). In some cases, only classes of Senior Securities and
Subordinated Securities are issued. By adjusting the priority of interest and
principal payments on each class of a given series of Senior-Subordinated
Mortgage Securities, issuers are able to create classes of Mortgage Securities
with varying degrees of credit exposure, prepayment exposure and potential total
return, tailored to meet the needs of sophisticated institutional investors.
The Company may purchase Single-Family and Multifamily Privately Issued
Certificates in the secondary market. The Company may also acquire Single-Family
and Multifamily Privately Issued Certificates by pooling and exchanging some of
its Single-Family and Multifamily Mortgage Loans, respectively, for
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<PAGE> 77
such securities. In connection with exchanging its Single-Family and Multifamily
Mortgage Loans for Single-Family and Multifamily Privately Issued Certificates,
the Company may retain some or all classes resulting therefrom, including
Mezzanine and Subordinated Securities. In cases where the Company retains such
junior classes, the Company will continue to be exposed to the various risks of
loss associated with the entire pool of underlying Mortgage Loans.
GNMA Certificates. GNMA is a wholly owned corporate instrumentality of the
United States within the Department of Housing and Urban Development ("HUD").
Section 306(g) of Title III of the National Housing Act of 1934, as amended (the
"Housing Act"), authorizes GNMA to guarantee the timely payment of the principal
of and interest on certificates which represent an interest in a pool of
mortgages insured by the FHA under the Housing Act or Title V of the Housing Act
of 1949, or partially guaranteed by the VA under the Servicemen's Readjustment
Act of 1944, as amended, or Chapter 37 of Title 38, United States Code and other
loans eligible for inclusion in mortgage pools underlying GNMA Certificates.
Section 306(g) of the Housing Act provides that "the full faith and credit of
the United States is pledged to the payment of all amounts which may be required
to be paid under any guaranty under this subsection." An opinion, dated December
12, 1969, of an Assistant Attorney General of the United States provides that
such guarantees under section 306(g) of GNMA Certificates of the type which may
be purchased or received in exchange by the Company are authorized to be made by
GNMA and "would constitute general obligations of the United States backed by
its full faith and credit."
At present, all GNMA Certificates are backed by Single-Family Mortgage
Loans. The interest rate paid on GNMA Certificates may be fixed rate or
adjustable rate. The interest rate on GNMA Certificates issued under GNMA's
standard ARM program adjusts annually in relation to the Treasury Index.
Interest rates paid on GNMA ARM Certificates typically equal the index rate plus
150 basis points. Adjustments in the interest rate are generally limited to an
annual increase or decrease of 1% and to a lifetime cap of 5%.
FNMA Certificates. FNMA is a privately owned, federally chartered
corporation organized and existing under the Federal National Mortgage
Association Charter Act (12 U.S.C. sec. 1716 et seq.). FNMA provides funds to
the mortgage market primarily by purchasing home Mortgage Loans from local
lenders, thereby replenishing their funds for additional lending. FNMA
guarantees to the registered holder of a FNMA Certificate that it will
distribute amounts representing scheduled principal and interest (at the rate
provided by the FNMA Certificate) on the Mortgage Loans in the pool underlying
the FNMA Certificate, whether or not received, and the full principal amount of
any such mortgage loan foreclosed or otherwise finally liquidated, whether or
not the principal amount is actually received. The obligations of FNMA under its
guarantees are solely those of FNMA and are not backed by the full faith and
credit of the United States. If FNMA were unable to satisfy such obligations,
distributions to holders of FNMA Certificates would consist solely of payments
and other recoveries on the underlying Mortgage Loans and, accordingly, monthly
distributions to holders of FNMA Certificates would be affected by delinquent
payments and defaults on such Mortgage Loans.
FNMA Certificates may be backed by pools of Single-Family or Multifamily
Mortgage Loans. The original terms to maturities of the Mortgage Loans generally
do not exceed 40 years. FNMA Certificates may pay interest at a fixed rate or
adjustable rate. Each series of FNMA ARM Certificates bears an initial interest
rate and margin tied to an index based on all loans in the related pool, less a
fixed percentage representing servicing compensation and FNMA's guarantee fee.
The specified index used in each such series has included the Treasury Index,
the 11th District Cost of Funds Index published by the Federal Home Loan Bank of
San Francisco, LIBOR and other indices. In addition, the majority of series of
FNMA ARM Certificates issued to date have evidenced pools of Mortgage Loans with
monthly, semi-annual or annual interest rate adjustments. Certain FNMA programs
include Mortgage Loans which allow the borrower to convert the adjustable
mortgage interest rate of its ARM to a fixed rate. ARMs which are converted into
fixed rate Mortgage Loans are repurchased by FNMA or by the seller of such loans
to FNMA at the unpaid principal balance thereof plus accrued interest to the due
date of the last adjustable rate interest payment. Adjustments to the interest
rates on FNMA ARM Certificates are typically subject to lifetime caps and
periodic rate or payment caps.
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FHLMC Certificates. FHLMC is a privately owned government-sponsored
enterprise created pursuant to an Act of Congress (Title III of the Emergency
Home Finance Act of 1970, as amended, 12 U.S.C. sec.sec. 1451-1459), on July 24,
1970. The principal activity of FHLMC currently consists of the purchase of
conventional Conforming Mortgage Loans or participation interests therein and
the resale of the loans and participations so purchased in the form of
guaranteed mortgage securities. FHLMC guarantees to each holder of FHLMC
Certificates the timely payment of interest at the applicable pass-through rate
and ultimate collection of all principal on the holder's pro rata share of the
unpaid principal balance of the related Mortgage Loans, but does not guarantee
the timely payment of scheduled principal of the underlying Mortgage Loans. The
obligations of FHLMC under its guarantees are solely those of FHLMC and are not
backed by the full faith and credit of the United States. If FHLMC were unable
to satisfy such obligations, distributions to holders of FHLMC Certificates
would consist solely of payments and other recoveries on the underlying Mortgage
Loans and, accordingly, monthly distributions to holders of FHLMC Certificates
would be affected by delinquent payments and defaults on such Mortgage Loans.
FHLMC Certificates may be backed by pools of Single-Family Mortgage Loans
or Multifamily Mortgage Loans. Such underlying Mortgage Loans may have original
terms to maturity of up to 40 years. FHLMC Certificates may be issued under Cash
Programs (composed of Mortgage Loans purchased from a number of sellers) or
Guarantor Programs (composed of Mortgage Loans purchased from one seller in
exchange for participation certificates representing interests in the Mortgage
Loans purchased). FHLMC Certificates may pay interest at a fixed rate or
adjustable rate. The interest rate paid on FHLMC ARM Certificates adjusts
periodically within 60 days prior to the month in which the interest rates on
the underlying Mortgage Loans adjust. The interest rates paid on FHLMC ARM
Certificates issued under FHLMC's standard ARM programs adjust in relation to
the Treasury Index. Other specified indices used in FHLMC ARM programs include
the 11th District Cost of Funds Index published by the Federal Home Loan Bank of
San Francisco, LIBOR and other indices. Interest rates paid on fully-indexed
FHLMC ARM Certificates equal the applicable index rate plus a specified number
of basis points ranging typically from 125 to 250 basis points. In addition, the
majority of series of FHLMC ARM Certificates issued to date have evidenced pools
of Mortgage Loans with monthly, semi-annual or annual interest adjustments.
Adjustments in the interest rates paid are generally limited to an annual
increase or decrease of either 1% or 2% and to a lifetime cap of 5% or 6% over
the initial interest rate. Certain FHLMC programs include Mortgage Loans which
allow the borrower to convert the adjustable mortgage interest rate to a fixed
rate. ARMs which are converted into fixed rate Mortgage Loans are repurchased by
FHLMC or by the seller of such loans to FHLMC at the unpaid principal balance
thereof plus accrued interest to the due date of the last adjustable rate
interest payment.
Single-Family and Multifamily CMOs. The Company may, from time to time,
invest in adjustable-rate Single-Family and Multifamily CMOs. Single-Family and
Multifamily CMOs ordinarily are issued in series, each of which consists of
several serially maturing classes ratably secured by a single pool of
Single-Family or Multifamily Mortgage Loans or Single-Family or Multifamily
Privately Issued Certificates. Generally, principal payments received on the
mortgage-related assets securing a series of CMOs, including prepayments on such
mortgage-related assets, are applied to principal payments on one or more
classes of the CMOs of such series on each principal payment date for such CMOs.
Scheduled payments of principal and interest on the mortgage-related assets and
other collateral securing a series of CMOs are intended to be sufficient to make
timely payments of interest on such CMOs and to retire each class of such CMOs
by its stated maturity. By allocating the principal and interest cash flows from
the underlying collateral among the separate CMO classes, different classes
(referred to as "tranches") of bonds are created, each with its own stated
maturity, estimated average life, coupon rate and prepayment characteristics.
Principal prepayments on the mortgage-related assets underlying a CMO issue
may cause different tranches of a CMO issue to be retired substantially earlier
than their stated maturities or final distribution dates. Interest generally is
paid or accrues on interest-bearing classes of CMOs on a monthly, quarterly or
semi-annual basis. The principal of and interest on the underlying
mortgage-related assets may be allocated among the several classes of a CMO
issue in a variety of ways. One type of CMO issue is one in which payments of
principal, including any principal prepayments, on the mortgage-related assets
are applied to the classes of CMOs in order of their respective stated
maturities or final distribution dates, so that no payment of
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principal will be made on any class of the series until all other classes having
an earlier stated maturity or final distribution date have been paid in full.
Other types of CMO issues include classes such as parallel pay CMOs, some
of which, such as Planned Amortization Class CMOs ("PAC Bonds"), provide
protection against prepayment uncertainty. Parallel pay CMOs are structured to
provide payments of principal on certain payment dates to more than one class.
These simultaneous payments are taken into account in calculating the stated
maturity date or final distribution date of each class which, as with other CMO
structures, must be retired by its stated maturity date or final distribution
date but may be retired earlier. PAC Bonds generally require payment of a
specified amount of principal on each payment date so long as prepayment speeds
on the underlying collateral fall within a specified range. PAC Bonds are always
parallel pay CMOs with the required principal payment on such securities having
the highest priority after interest has been paid to all classes.
Other types of CMO issues include Targeted Amortization Class CMOs ("TAC
Bonds"), which are similar to PAC Bonds. While PAC Bonds maintain their
amortization schedule within a specified range of prepayment speeds, TAC Bonds
are generally targeted to a narrow range of prepayment speeds or a specified
pricing speed. TAC Bonds can provide protection against prepayment uncertainty
since cash flows generated from higher prepayments of the underlying
mortgage-related assets are applied to the various other pass-through tranches
so as to allow the TAC Bonds to maintain their amortization schedule.
CMOs may be subject to certain rights of issuers thereof to redeem such
CMOs prior to their stated maturity dates, which may have the effect of
diminishing the Company's anticipated return on its investment. Privately issued
Single-Family and Multifamily CMOs are supported by private credit enhancements
similar to those used for Privately Issued Certificates and are often issued as
Senior-Subordinated Mortgage Securities. The Company will only acquire CMOs that
constitute beneficial ownership in grantor trusts holding Mortgage Loans, or
regular interests in REMICs, or that otherwise constitute Qualified REIT Real
Estate Assets (provided that the Company has obtained a favorable opinion of
counsel or a ruling from the IRS to that effect).
Commercial Mortgage Assets
Commercial Mortgage Loans
Commercial Mortgage Loans are secured by commercial properties, such as
industrial and warehouse properties, office buildings, retail space and shopping
malls, hotels and motels, hospitals, nursing homes and senior living centers.
Commercial Mortgage Loans have certain distinct risk characteristics: existing
Commercial Mortgage Loans generally lack standardized terms, which may
complicate their structure (although certain of the new conduits are introducing
standard form documents for use in their programs); Commercial Mortgage Loans
tend to have shorter maturities than Single-Family Mortgage Loans; they may not
be fully amortizing, meaning that they may have a significant principal balance
or "balloon" due on maturity; and commercial properties, particularly industrial
and warehouse properties, are generally subject to relatively greater
environmental risks than non-commercial properties and the corresponding burdens
and costs of compliance with environmental laws and regulations. See "Risk
Factors -- Operations Risks -- Risk of Loss on Commercial Mortgage Assets" and
"-- Environmental Liabilities."
Unlike most Single-Family Mortgage Loans, Commercial Mortgage Loans
generally utilize yield maintenance agreements to impose penalties on
prepayments of principal that compensate mortgagees, in part or in full, for the
possibility of lower interest lending rates that may be applicable at the time
of repayment. Commercial Mortgage Loans may also contain prohibitions, at least
for a period of time following origination, on principal prepayments. Such
prepayment penalties and prohibitions tend to reduce the likelihood of
prepayments on Commercial Mortgage Loans as compared to Single-Family Mortgage
Loans.
The credit quality of a Commercial Mortgage Loan may depend on, among other
factors, the existence and structure of underlying leases, deferred maintenance
on the property or physical condition of the property, the creditworthiness of
tenants, the historical and anticipated level of vacancies and rents on the
property and on other comparable properties located in the same region,
potential or existing environmental risks and the local and regional economic
climate in general. Primary indicators of credit quality on a Commercial
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Mortgage Loan are the debt service coverage, i.e., the ratio of current net
operating income on a commercial property to the current debt service obligation
on the same property, and the loan-to-value ratio, both of which generally are
examined by the rating agencies from the perspective of a variety of worst-case
scenarios. Loan-to-value analysis is particularly important in the case of
Commercial Mortgages Loans because many are nonrecourse to the borrower and
therefore the value of the property will determine the amount of loss in the
event of default. Foreclosures of defaulted Commercial Mortgage Loans are
generally subject to a number of complicating factors not present in
foreclosures of Single-Family Mortgage Loans. See "Risk Factors -- Operations
Risks -- Risk of Loss on Commercial Mortgage Assets."
To the extent the Company seeks to acquire Commercial Mortgage Assets, the
Company intends to focus on the acquisition of Commercial Mortgage Securities
rather than Commercial Mortgage Loans. The Company will only acquire Commercial
Mortgage Loans when it believes it has the necessary expertise to evaluate and
manage them and only if they are consistent with the Company's Risk-Adjusted
Capital Policy.
Commercial Mortgage Securities
Commercial Mortgage Securities are securities that represent an interest
in, or are secured by, Commercial Mortgage Loans. Commercial Mortgage Securities
generally have been structured as Pass-Through Certificates with private (i.e.,
nongovernmental) credit enhancements ("Commercial Privately Issued
Certificates") or as CMOs ("Commercial CMOs"). Commercial Mortgage Securities
may pay adjustable rates of interest. Because of the great diversity in
characteristics of the Commercial Mortgage Loans that secure or underlie
Commercial Mortgage Securities, however, such securities will also have diverse
characteristics. Although many Commercial Mortgage Securities are backed by
large pools of Commercial Mortgage Loans with relatively small individual
principal balances, Commercial Mortgage Securities may be backed by Commercial
Mortgage Loans collateralized by only a few commercial properties or a single
commercial property. Because the risk involved in single commercial property
financings is highly concentrated, single-property Commercial Mortgage
Securities to date have tended to be limited to extremely desirable commercial
properties with excellent values and/or lease agreements with extremely
creditworthy and reliable tenants, such as major corporations.
Commercial Mortgage Securities generally are structured with some form of
private credit enhancement to protect against potential Realized Losses on the
underlying Mortgage Assets. As with Single-Family Mortgage Securities, such
credit enhancements provide an extra layer of loss coverage in cases where the
equityholder's equity interest in the underlying mortgaged property has been
completely extinguished. Because of the particular risks that accompany
Commercial Mortgage Securities, the required amount and corresponding cost of
such credit support may be significant. Credit supports used in the Commercial
Mortgage Securities market have included, but have not been limited to, limited
issuer guarantees, reserve funds, Subordinated Securities (which bear the risks
of default before more senior classes of securities of the same issuer),
cross-collateralization, over-collateralization, cross-default provisions,
subordination and letters of credit. The Company expects that multiple-class
structures, featuring Senior-Subordinated Mortgage Securities, will continue to
be the most common form of credit enhancement used in the Commercial Mortgage
Securities markets. In addition to credit support, Commercial Mortgage
Securities may be structured with liquidity protections intended to provide
assurance of timely payment of principal and interest. Such protections may
include surety bonds, letters of credit and payment advance agreements. The
process used to rate commercial mortgage-backed securities may focus on, among
other factors, the structure of the security, the quality and adequacy of
collateral and insurance, and the creditworthiness of the originators, servicing
companies and providers of credit support.
Commercial Mortgage Securities have been issued in public and private
transactions by a variety of public and private issuers. The RTC has issued more
than $16 billion of Commercial and Multifamily Mortgage Securities. Neither the
U.S. Government nor the RTC guarantees securities issued under RTC programs.
Non-governmental entities that have issued or sponsored Commercial Mortgage
Securities offerings include owners of commercial properties, originators of and
investors in Mortgage Loans, savings and loan associations, mortgage banks,
commercial banks, insurance companies, investment banks and special purpose
subsidiaries of the foregoing.
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The Commercial Mortgage Securities market is newer and in terms of total
outstanding principal amount of issues is relatively small compared to the total
size of the market for Single-Family Mortgage Securities. Securitization of the
commercial mortgage market has accelerated in recent years, however, in part as
a result of new risk-based capital rules imposed on insurance companies, banks
and thrift institutions that have required many such institutions to reduce
positions in Commercial Mortgage Loans in their investment portfolios. The
establishment by the rating agencies of ratings criteria for Commercial Mortgage
Securities and the resulting assignment of ratings by the rating agencies to
such securities has made such securities more attractive to potential investors
and has increased their potential investor base. As Commercial Mortgage Loans
with balloon payments become due, such loans will have to be re-financed or the
underlying commercial properties will have be to sold. In either case, there
will be a significant need for new Commercial Mortgage Loans. In addition, to
the extent financial institutions seek to reduce their portfolio holdings of
Commercial Mortgage Loans, the supply of Commercial Mortgage Loans available for
securitization with increase. Demand for new commercial real estate financings
and the reluctance of financial institutions to assume long-term portfolio risk
with respect to such financings also should encourage securitization. The
Company believes that an increased supply of Commercial Mortgage Securities may
present attractive investment opportunities for the Company.
MANAGEMENT POLICIES AND PROGRAMS
ASSET ACQUISITION POLICIES
The Company only acquires those Mortgage Assets the Company believes it has
the necessary expertise to evaluate and manage and which are consistent with the
Company's balance sheet guidelines and risk management objectives. Since the
intention of the Company is generally to hold its Mortgage Assets until
maturity, the Company generally does not seek to acquire assets whose investment
returns are only attractive in a limited range of scenarios. The Company
believes that future interest rates and mortgage prepayment rates are very
difficult to predict. Therefore, the Company seeks to acquire Mortgage Assets
which the Company believes will provide acceptable returns over a broad range of
interest rate and prepayment scenarios.
Among the asset choices available to the Company, the Company acquires
those Mortgage Assets which the Company believes will generate the highest
returns on capital invested, after considering (i) the amount and nature
anticipated cashflows from the asset, (ii) the Company's ability to pledge the
asset to secure collateralized borrowings, (iii) the increase in the Company's
risk-adjusted capital requirement determined by the Company's Risk-Adjusted
Capital Policy resulting from the purchase and financing of the asset, and (iv)
the costs of financing, hedging, managing, securitizing, and reserving for the
asset. Prior to acquisition, potential returns on capital employed are assessed
over the life of the asset and in a variety of interest rate, yield spread,
financing cost, credit loss and prepayment scenarios.
Management also gives consideration to balance sheet management and risk
diversification issues. A specific asset which is being evaluated for potential
acquisition is deemed more or less valuable to the Company to the extent it
serves to increase or decrease certain interest rate or prepayment risks which
may exist in the balance sheet, to diversify or concentrate credit risk, and to
meet the cash flow and liquidity objectives management may establish for the
balance sheet from time to time. Accordingly, an important part of the asset
evaluation process is a simulation, using the Company's risk management model,
of the addition of a potential asset and its associated borrowings and hedges to
the balance sheet and an assessment of the impact this potential asset
acquisition would have on the risks in and returns generated by the Company's
balance sheet as a whole over a variety of scenarios.
The Company focuses primarily on the acquisition of floating-rate and
adjustable-rate assets, and believes that currently such products are more
attractive for the Company's purposes than are fixed-rate assets.
In the event that the Company acquires fixed-rate Mortgage Assets pursuant
to its Asset Acquisition/ Capital Allocation Policies, the Company's
Risk-Adjusted Capital Policy will allocate a high liquidity capital cushion to
such fixed-rate assets due to their greater market price volatility, so it is
difficult for fixed-rate product to generate high returns on capital employed
under the Company's asset acquisition criteria. In
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addition, the cost of hedging a fixed-rate asset to meet the Company's
asset/liability management goals is usually significant. The Company may,
however, purchase fixed-rate assets in the future should the potential returns
on capital invested, after hedging and all other costs, clearly exceed the
returns available from other assets or if the purchase of such assets would
serve to reduce or diversify the risks of the Company's balance sheet.
The Company's strategy is to focus primarily on the acquisition of
adjustable-rate Mortgage Assets, including Single-Family Mortgage Loans,
Single-Family Mortgage Securities, Multifamily Mortgage Loans and Multifamily
Mortgage Securities. To date, all Mortgage Assets purchased have been
Single-Family Mortgage Securities. In addition, the Company will seek to acquire
Commercial Mortgage Securities which, except for securities created through the
normal process of securitization of its own Mortgage Assets, will generally be
limited initially to investment grade securities with a rating of BBB- or
better. The Company's asset acquisition strategy will change over time as market
conditions change and as the Company evolves.
The Company may also purchase stock in other mortgage REITs or stock in
similar companies when the Company believes that such purchases will yield
attractive returns on capital employed. When the stock market valuations of such
companies are low in relation to the market value of their assets, such stock
purchases can be a way for the Company to acquire an interest in a pool of
Mortgage Assets at an attractive price. The Company does not, however, presently
intend to invest in the securities of other issuers for the purpose of
exercising control or to underwrite securities of other issuers.
The Company intends to acquire new Mortgage Assets, and will also seek to
expand its capital base in order to further increase the Company's ability to
acquire new assets, when the potential returns from new investments appear
attractive relative to the return expectations of stockholders (as expressed
principally by the effective dividend yield of the Company's stock). The Company
may in the future acquire Mortgage Assets by offering its debt or equity
securities in exchange for such Mortgage Assets.
The Company generally intends to hold Mortgage Assets to maturity. In
addition, the REIT Provisions of the Code limit in certain respects the ability
of the Company to sell Mortgage Assets. See "Certain Federal Income Tax
Considerations -- General -- Gross Income Tests" and "-- Taxation of the
Company." Management may decide to sell assets from time to time, however, for a
number of reasons including, without limitation, to dispose of an asset as to
which credit risk concerns have arisen, to reduce interest rate risk, to
substitute one type of Mortgage Asset for another to improve yield or to
maintain compliance with the 55% requirement under the Investment Company Act,
and generally to re-structure the balance sheet when management deems such
action advisable. Management will select any Mortgage Assets to be sold
according to the particular purpose such sale will serve. The Board of Directors
has not adopted a policy that would restrict management's authority to determine
the timing of sales or the selection of Mortgage Assets to be sold.
As a requirement for maintaining REIT status, the Company will distribute
to stockholders aggregate dividends equaling at least 95% of its taxable income.
See "Certain Federal Income Tax Considerations -- General -- Distribution
Requirement." The Company will make additional distributions of capital when the
return expectations of the stockholders (as expressed principally by the
effective dividend yield of the Company's stock) appear to exceed returns
potentially available to the Company through making new investments in Mortgage
Assets. Subject to the limitations of applicable securities and state
corporation laws, the Company can distribute capital by making purchases of its
own Capital Stock, through paying down or re-purchasing any outstanding
uncollateralized debt obligations, or through increasing the Company's dividend
to include a return of capital.
CREDIT RISK MANAGEMENT POLICIES
The Company reviews credit risk and other risk of loss associated with each
investment and determines the appropriate allocation of capital to apply to such
investment under its Risk-Adjusted Capital Policy. Because the risks presented
by Single-Family, Multifamily and Commercial Mortgage Assets are different, the
Company analyzes the risk of loss associated with such Mortgage Assets
separately. In addition, the Company attempts to diversify its investment
portfolio to avoid undue geographic, issuer, industry and certain
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other types of concentrations. The Company attempts to obtain protection against
some risks from sellers and servicers through representations and warranties and
other appropriate documentation. The Board of Directors monitors the overall
portfolio risk and determines appropriate levels of provision for loss.
With respect to its Mortgage Securities, the Company is exposed to various
levels of credit and special hazard risk, depending on the nature of the
underlying Mortgage Assets and the nature and level of credit enhancements
supporting such securities. Most of the Mortgage Assets acquired by the Company
have some degree of protection from normal credit losses. At December 31, 1995
and March 31, 1996, 55.8% and 52.8%, respectively, of the Company's Mortgage
Assets were Agency Certificates.
An additional 38.1% and 42.8% of the Company's Mortgage Assets at December
31, 1995 and March 31, 1996, respectively, were Privately Issued Certificates
and represented interests in pools of residential mortgage loans with partial
credit enhancement; of these amounts, 85% and 90% were rated invest grade,
respectively. Credit loss protection for Privately Issued Certificates is
achieved through the subordination of other interests in the pool to the
interest held by the Company, through pool insurance or though other means. The
degree of credit protection varies substantially among the Privately Issued
Certificates held by the Company. While all the Privately Issued Certificates
held by the Company have some degree of credit enhancement, the majority of such
assets are, in turn, subordinated to other interests. Thus, should such a
Privately Issued Certificate experience credit losses, such losses could be
greater than the Company's pro rata share of the remaining mortgage pool, but in
no event could exceed the Company's investment in such Privately Issued
Certificate. At March 31, 1996, the amount of realized credit losses a
particular pool of mortgages represented by Privately Issued Certificates would
have to experience before the Company would bear responsibility for any credit
losses ranged from 0% to 37% of the pool balance. The Company has undertaken an
independent underwriting review of a sample of the loans underlying the
Privately Issued Certificates that are rated below BBB.
All of the Company's Mortgage Assets have received a credit rating from one
or more nationally recognized rating agencies or have been assigned a rating
deemed equivalent by the Company. At December 31, 1995, the average rating of
the Company's Mortgage Assets, as adjusted to a single format and weighted by
carrying value, was AA+. At March 31, 1996, the average rating of the non-agency
Mortgage Assets was AA.
At March 31, 1996, the Company owned $24.9 million of whole Mortgage Loans,
which comprised 4.4% of the Company's total Mortgage Assets at such date. In
preparation for purchases of Mortgage Assets in the form of Mortgage Loans, the
Company developed a quality control program to monitor the quality of loan
underwriting at the time of acquisition and on an ongoing basis. The Company
will conduct, or cause to be conducted, a legal document review of each Mortgage
Loan acquired to verify the accuracy and completeness of the information
contained in the mortgage notes, security instruments and other pertinent
documents in the file. As a condition of purchase, the Company will select a
sample of Mortgage Loans targeted to be acquired, focusing on those Mortgage
Loans with higher risk characteristics, and submit them to a third party,
nationally recognized underwriting review firm for a compliance check of
underwriting and review of income, asset and appraisal information. In addition,
the Company or its agents will underwrite all Multifamily and Commercial
Mortgage Loans. During the time it holds Mortgage Loans, the Company will be
subject to risks of borrower defaults and bankruptcies and special hazard losses
(such as those occurring from earthquakes or floods) that are not covered by
standard hazard insurance. The Company will generally not obtain credit
enhancements such as mortgage pool or special hazard insurance for its Mortgage
Loans, although individual loans may be covered by FHA insurance, VA guarantees
or private mortgage insurance and, to the extent securitized into Agency
Certificates, by such government sponsored entity obligations or guarantees.
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The following table details the ratings of the Company's Mortgage Assets
and illustrates the rating scale used to determine the average rating as
weighted by carrying value.
<TABLE>
<CAPTION>
AT MARCH 31, 1996(1) AT DECEMBER 31, 1995(1)
------------------------------- -------------------------------
(UNAUDITED)
CARRYING CARRYING
VALUE PERCENT RATING VALUE PERCENT RATING
RATING CATEGORY ($000) OF ASSETS SCALE ($000) OF ASSETS SCALE
------------------------------ -------- --------- ------ -------- --------- ------
<S> <C> <C> <C> <C> <C> <C>
Whole Mortgage Loans(2)....... $ 24,861 4.4% 1.5 $ 26,450 6.1% 1.5
AAA -- Agency................. 298,354 52.8% 1.0 241,222 55.8% 1.0
AAA -- Privately Issued....... 91,304 16.2% 1.0 7,913 1.8% 1.0
AA............................ 100,531 17.7% 2.0 106,649 24.7% 2.0
A............................. 19,184 3.4% 3.0 18,073 4.2% 3.0
BBB........................... 6,653 1.2% 4.0 7,098 1.6% 4.0
BB............................ 11,158 2.0% 5.0 12,049 2.8% 5.0
B............................. 12,758 2.2% 6.0 12,303 2.9% 6.0
Other......................... 356 0.1% 6.0 487 0.1% 6.0
-------- --------- ------ -------- --------- ------
Total/Weighted Average........ $565,159 100.0% 1.50 $432,244 100.0% 1.67
Weighted Average Rating....... AA+ AA+
Percentage Investment Grade... 96% 94%
</TABLE>
- ---------------
(1) All assets are rated by one or more of the four nationally recognized rating
agencies or are assigned a rating deemed equivalent by the Company. When
rating agencies have assigned different ratings to the same asset,
management has assigned that asset to the category it believes is the most
appropriate.
(2) If rated, management believes that 90-95% of these loans would receive
investment grade ratings. For inclusion in the overall averages, 94% are
assumed to be investment grade, producing an average rating of AA+.
(3) For purposes of computing a weighted average portfolio rating, management
has assigned a number to each rating level, with AAA being a "1" and B or
below being a "6," as indicated in the table.
CAPITAL AND LEVERAGE POLICIES
The Company's goal is to strike a balance between the under-utilization of
leverage, which reduces potential returns to stockholders, and the
over-utilization of leverage, which could reduce the Company's ability to meet
its obligations during adverse market conditions. The Company has established a
"Risk-Adjusted Capital Policy" which limits management's ability to acquire
additional assets during times when the actual capital base of the Company is
less than a required amount defined in the policy. In this way, the use of
balance sheet leverage is controlled. The actual capital base as defined for the
purpose of this policy is equal to the market value of total assets less the
book value of total collateralized borrowings. The actual capital base, as so
defined, represents the approximate liquidation value of the Company and
approximates the market value of assets that can be pledged or sold to meet
over-collateralization requirements for the Company's borrowings. The unpledged
portion of the Company's actual capital base is available to be pledged or sold
as necessary to maintain over-collateralization levels for the Company's
borrowings.
Management is prohibited from acquiring additional assets during periods
when the actual capital base of the Company is less than the minimum amount
required amount under the Risk-Adjusted Capital Policy (except when such asset
acquisitions may be necessary to maintain REIT status or the Company's exemption
from the Investment Company Act of 1940). In addition, when the actual capital
base falls below the Risk-Adjusted Capital requirement, management is required
to submit to the Board a plan for bringing the actual capital base into
compliance with the Risk-Adjusted Capital Policy guidelines. It is anticipated
that in most circumstances this goal will be achieved over time without overt
management action through the natural process of mortgage principal repayments
and increases in the market values of Mortgage Assets as their coupon rates
adjust upwards to market levels. Management anticipates that the actual capital
base is likely to
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exceed the Risk-Adjusted Capital requirement during periods following new equity
offerings and during periods of falling interest rates and that the actual
capital base is likely to fall below the Risk-Adjusted Capital requirement
during periods of rising interest rates.
The first component of the Company's capital requirements is the current
aggregate over-collateralization amount or "haircut" the lenders require the
Company to hold as capital. The haircut for each Mortgage Asset is determined by
the lender based on the risk characteristics and liquidity of that asset.
Haircut levels on individual borrowings range from 3% for Agency Certificates to
20% for certain Privately Issued Certificates, and average 5% to 10% for the
Company as a whole. Should the market value of the pledged assets decline, the
Company will be required to deliver additional collateral to the lenders in
order to maintain a constant over-collateralization level on its borrowings.
The second component of the Company's capital requirement is the "liquidity
capital cushion." The liquidity capital cushion is an additional amount of
capital in excess of the haircut maintained by the Company in order to help the
Company meet the demands of the lenders for additional collateral should the
market value of the Company's Mortgage Assets decline. The aggregate liquidity
capital cushion equals the sum of liquidity cushion amounts assigned under the
Risk-Adjusted Capital Policy to each of the Company's Mortgage Assets. Liquidity
capital cushions are assigned to each Mortgage Asset based on management's
assessment of the Mortgage Asset's market price volatility, credit risk,
liquidity and attractiveness for use as collateral by lenders. The process of
assigning liquidity capital cushions relies on management's ability to identify
and weigh the relative importance of these and other factors. Consideration is
also given to hedges associated with the Mortgage Asset and any effect such
hedges may have on reducing net market price volatility, concentration or
diversification of credit and other risks in the balance sheet as a whole and
the net cash flows that can be expected to arise from the interaction of the
various components of the Company's balance sheet. The Board of Directors thus
reviews on a periodic basis various analyses prepared by management of the risks
inherent in the Company's balance sheet, including an analysis of the effects of
various scenarios on the Company's net cash flow, earnings, dividends, liquidity
and net market value. Should the Board of Directors determine that the minimum
required capital base set by the Company's Risk-Adjusted Capital Policy is
either too low or too high, the Board of Directors will raise or lower the
capital requirement accordingly.
The Company expects that its aggregate minimum capital requirement under
the Risk-Adjusted Capital Policy will approximate 10% to 20% of the market value
of the Company's Mortgage Assets. This percentage will fluctuate over time, and
may fluctuate out of the expected range, as the composition of the balance sheet
changes, haircut levels required by lenders change, the market value of the
Mortgage Assets changes and as liquidity capital cushion percentages set by the
Board of Directors are adjusted over time. As of March 31, 1996, the aggregate
Risk-Adjusted Capital Requirement was 11.7% of Mortgage Assets, and the
Company's actual capital base was 11.7% of Mortgage Assets.
The Risk-Adjusted Capital Policy also stipulates that at least 50% of the
capital base maintained to satisfy the liquidity capital cushion shall be
invested in Agency Certificates, AAA-rated adjustable-rate Mortgage Securities
or assets with similar or better liquidity characteristics.
Pursuant to the Company's overall business strategy, a substantial portion
of the Company's borrowings are short-term or adjustable-rate. The Company's
borrowings currently are, and are expected to continue to be, implemented
primarily through reverse repurchase agreements (a borrowing device evidenced by
an agreement to sell securities or other assets to a third-party and a
simultaneous agreement to repurchase them at a specified future date and price,
the price difference constituting interest on the borrowing), but in the future
may also be obtained through loan agreements, lines of credit, Dollar-Roll
Agreements (an agreement to sell a security for delivery on a specified future
date and a simultaneous agreement to repurchase the same or a substantially
similar security on a specified future date) and other credit facilities with
institutional lenders and issuance of debt securities such as commercial paper,
medium-term notes, CMOs and senior or subordinated notes. The Company intends to
enter into financing transactions only with institutions that it believes are
sound credit risks and to follow other internal policies designed to limit its
credit and other exposure to financing institutions.
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Mortgage Assets are currently financed at short-term borrowing rates
primarily through reverse repurchase agreements, but future borrowings may be
obtained through lines of credit, Dollar-Roll Agreements and other financings
which the Company may establish with approved institutional lenders. It is
expected that reverse repurchase agreements will continue to be the principal
financing devices utilized by the Company to leverage its Mortgage Assets
portfolio. The Company anticipates that, upon repayment of each borrowing in the
form of a reverse repurchase agreement, the collateral will immediately be used
for borrowing in the form of a new reverse repurchase agreement. The Company has
not at the present time entered into any commitment agreements under which the
lender would be required to enter into new reverse repurchase agreements during
a specified period of time, nor does the Company presently plan to have
liquidity facilities with commercial banks. The Company, however, may enter into
such commitment agreements in the future if deemed favorable to the Company. See
"Risk Factors -- Operations Risks -- Risks of Substantial Leverage and Potential
Net Interest and Operating Losses in Connection with Borrowings." The Company
enters into reverse repurchase agreements primarily with national
broker/dealers, commercial banks and other lenders which typically offer such
financing. The Company enters into the collateralized borrowings only with
financial institutions meeting credit standards approved by the Company's Board
of Directors, including approval by a majority of Independent Directors, and
monitors the financial condition of such institutions on a regular basis.
A reverse repurchase agreement, although structured as a sale and
repurchase obligation, acts as a financing under which the Company effectively
pledges its Mortgage Assets as collateral to secure a short-term loan.
Generally, the other party to the agreement will make the loan in an amount
equal to a percentage of the market value of the pledged collateral. At the
maturity of the reverse repurchase agreement, the Company is required to repay
the loan and correspondingly receives back its collateral. While used as
collateral, Mortgage Assets continue to pay principal and interest which inure
to the benefit of the Company. In the event of the insolvency or bankruptcy of
the Company, certain reverse repurchase agreements may qualify for special
treatment under the Bankruptcy Code, the effect of which is, among other things,
to allow the creditor under such agreements to avoid the automatic stay
provisions of the Bankruptcy Code and to foreclose on the collateral agreements
without delay. In the event of the insolvency or bankruptcy of a lender during
the term of a reverse repurchase agreement, the lender may be permitted, under
applicable insolvency laws, to repudiate the contract, and the Company's claim
against the lender for damages therefrom may be treated simply as one of the
unsecured creditor. In addition, if the lender is a broker or dealer subject to
the Securities Investor Protection Act of 1970, or an insured depositary
institution subject to the Federal Deposit Insurance Act, the Company's ability
to exercise its rights to recover its securities under a reverse repurchase
agreement or to be compensated for any damages resulting from the lender's
insolvency may be further limited by those statutes. These claims would be
subject to significant delay and, if and when received, may be substantially
less than the damages actually suffered by the Company.
The Company expects that substantially all of its borrowing agreements will
require the Company to deposit additional collateral in the event the market
value of existing collateral declines, which may require the Company to sell
assets to reduce the borrowings. The Company's liquidity management policy is
designed to maintain a cushion of equity sufficient to provide required
liquidity to respond to the effects under its borrowing arrangements of interest
rate movements and changes in market value of its Mortgage Assets, as described
above. However, a major disruption of the reverse repurchase or other market
relied on by the Company for short-term borrowings would have a material adverse
effect on the Company unless the Company were able to arrange alternative
sources of financing on comparable terms. See "Risk Factors -- Operations
Risks -- Risks of Substantial Leverage and Potential Net Interest and Operating
Losses in Connection with Borrowings" and "-- Risk of Decrease in Net Interest
Income Due to Interest Rate Fluctuations; Prepayment Risks of Mortgage Assets."
The Company's Bylaws do not limit its ability to incur borrowings, whether
secured or unsecured.
At December 31, 1995 and March 31, 1996, total borrowings outstanding were
$370 million and $509 million, respectively, supported by Mortgage Assets with a
market value of $386 million and $540 million, respectively, pledged to secure
such borrowings. These borrowings are carried on the balance sheet at historical
cost, which approximates market. All of the borrowings were pursuant to reverse
repurchase agreements except for $37.35 million outstanding at March 31, 1996
under one secured loan agreement with
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terms similar to reverse repurchase agreements. At December 31, 1995 and March
31, 1996, the weighted average term to maturity was 74 days and 48 days,
respectively, and the weighted average borrowing rate was 6.01% and 5.62%,
respectively. Several of the borrowing agreements provide for adjustments of the
interest rate to market levels prior to maturity. The weighted average period to
the earlier of maturity or interest rate adjustment was 26 days and 19 days at
December 31, 1995 and March 31, 1996, respectively.
The aggregate "haircut," or the percentage by which the market value of the
pledged collateral must exceed the borrowing amount, was 5.33% and 5.17% at
December 31, 1995 and March 31, 1996, respectively. The total haircut of
approximately $20.8 million and $27.8 million at December 31, 1995 and March 31,
1996, respectively, represented the capital the Company was required to hold at
period end to satisfy the requirements of its secured lenders.
ASSET/LIABILITY MANAGEMENT
Interest Rate Risk Management
To the extent consistent with its election to qualify as a REIT, the
Company follows an interest rate risk management program intended to protect
against the effects of major interest rate changes. Specifically, the Company's
interest rate risk management program is formulated with the intent to offset
the potential adverse effects resulting from rate adjustment limitations on its
Mortgage Assets and the differences between interest rate adjustment indices and
interest rate adjustment periods of its adjustable-rate Mortgage Assets and
related borrowings. The Company's interest rate risk management program
encompasses a number of procedures, including: (i) the Company attempts to
structure its borrowings to have interest rate adjustment indices and interest
rate adjustment periods that, on an aggregate basis, generally correspond to the
interest rate adjustment indices and interest rate adjustment periods of the
adjustable-rate Mortgage Assets purchased by the Company, so as to limit any
mis-matching of such aggregates to a range of one to six months, and (ii) the
Company attempts to structure its borrowing agreements relating to
adjustable-rate Mortgage Assets to have a range of different maturities and
interest rate adjustment periods (although substantially all will be less than
one year). As a result, the Company expects to be able to adjust the average
maturity/adjustment period of such borrowings on an ongoing basis by changing
the mix of maturities and interest rate adjustment periods as borrowings come
due and are renewed. Through use of these procedures, the Company intends to
minimize any differences between interest rate adjustment periods of
adjustable-rate Mortgage Assets and related borrowings that may occur.
The Company purchases from time to time interest rate caps, interest rate
swaps and similar instruments to attempt to mitigate the risk of the cost of its
variable rate liabilities increasing at a faster rate than the earnings on its
assets during a period of rising rates. In this way, the Company intends
generally to hedge as much of the interest rate risk as management determines is
in the best interests of the stockholders of the Company, given the cost of such
hedging transactions and the need to maintain the Company's status as a REIT.
See "Certain Federal Income Tax Considerations -- General -- Gross Income
Tests." This determination may result in management electing to have the Company
bear a level of interest rate risk that could otherwise be hedged when
management believes, based on all relevant facts, that bearing such risk is
advisable. The Company may also, to the extent consistent with its compliance
with the REIT Gross Income Tests, Maryland law and the no-action relief
discussed below, utilize financial futures contracts, options and forward
contracts as a hedge against future interest rate changes. The Company has
obtained no-action relief from the Commodities Futures Trading Commission
permitting the Company to invest a small percentage of the Company's assets in
certain financial futures contracts and options thereon without registering as a
commodity pool operator under the Commodity Exchange Act, provided that the
Company uses such instruments solely for bona fide hedging purposes.
The Company seeks to build a balance sheet and undertake an interest rate
risk management program which is likely, in management's view, to enable the
Company to generate positive earnings and maintain an equity liquidation value
sufficient to maintain operations given a variety of potentially adverse
circumstances. Accordingly, the hedging program addresses both income
preservation, as discussed in the first part of this section, and capital
preservation concerns. With regard to the latter, the Company monitors its
"equity
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duration." This is the expected percentage change in the Company's equity
(measured as the carrying value of total assets less the book value of total
liabilities) that would be caused by a 1% change in short and long term interest
rates. To date, the Company believes that it has met its goal of maintaining an
equity duration of less than 15%. To monitor its equity duration and the related
risks of fluctuations in the liquidation value of the Company's equity, the
Company models the impact of various economic scenarios on the market value of
the Company's Mortgage Assets, liabilities and interest rate agreements. See
"Risk Factors -- Operations Risks -- Risk of Decrease in Net Interest Income Due
to Interest Rate Fluctuations; Prepayment Risks of Mortgage Assets." The Company
believes that the existing hedging program will allow the Company to maintain
operations throughout a wide variety of potentially adverse circumstances
without further management action. Nevertheless, in order to further preserve
the Company's capital base (and lower its equity duration) during periods when
management believes a trend of rapidly rising interest rates has been
established, management may decide to increase hedging activities and/or sell
assets. Each of these types of actions may lower the earnings and dividends of
the Company in the short term in order to further the objective of maintaining
attractive levels of earnings and dividends over the long term.
Each interest rate cap agreement is a legal contract between the Company
and a third party firm (the "counter-party"). The Company makes an up-front cash
payment to the counter-party and the counter-party agrees to make payments to
the Company in the future should the one or three month LIBOR interest rate rise
above the "strike" rate specified in the contract. Each contract has a "notional
face" amount. Should the reference LIBOR interest rate rise above the
contractual strike rate, the Company will earn cap income. Payments on an
annualized basis will equal the contractual notional face amount times the
difference between actual LIBOR and the strike rate. In all of its interest rate
risk management transactions, the Company follows certain procedures designed to
limit credit exposure to counterparties, including dealing only with
counterparties whose financial strength meets the Company's requirements. See
"Risk Factors -- Operations Risks -- Risk of Failing to Hedge Against Interest
Rate Changes Effectively; Risk of Losses Associated with Hedging; Counterparty
Risks."
The Company may elect to conduct a portion of its hedging operations
through one or more subsidiary corporations which would not be a Qualified REIT
Subsidiary and would be subject to Federal and state income taxes. In order to
comply with the nature of asset tests applicable to the Company as a REIT, the
value of the securities of any such subsidiary held by the Company must be
limited to less than 5% of the value of the Company's total assets as of the end
of each calendar quarter and no more than 10% of the voting securities of any
such subsidiary may be owned by the Company. See "Certain Federal Income Tax
Considerations -- General -- Asset Tests." A taxable subsidiary would not elect
REIT status and would distribute any net profit after taxes to the Company and
its other stockholders. Any dividend income received by the Company from any
such taxable subsidiary (combined with all other income generated from the
Company's assets, other than Qualified REIT Real Estate Assets) must not exceed
25% of the gross income of the Company. See "Certain Federal Income Tax
Considerations -- General -- Gross Income Tests." Before the Company forms any
such taxable subsidiary corporation for its hedging activities, the Company will
obtain an opinion of counsel to the effect that the formation and contemplated
method of operation of such corporation will not cause the Company to fail to
satisfy the nature of assets and sources of income tests applicable to it as a
REIT.
The carrying value of the interest rate cap agreements on December 31, 1995
and March 31, 1996 was $0.55 million and $1.23 million, respectively. Cap
premium is amortized over the effective period of the cap. During the first
quarter 1995, the cap amortization expense was $15,592 and during the first
quarter 1996 was $151,232. There was no significant income from the caps during
1995 or first quarter 1996 and there were no sales or terminations of caps.
During first quarter 1995 and first quarter 1996, net cap expense equaled 0.05%
and 0.12%, respectively, of the average balance of the Company's Mortgage Assets
and 0.06% and 0.14%, respectively, of the average balance of the Company's
interest-bearing liabilities. For such periods, the net cap expense was 2.45%
and 5.16%, respectively, of net interest earnings before such cap expense.
At December 31, 1995 and March 31, 1996, the total notional face amount of
interest rate cap agreements in effect was $302 million and $401 million,
respectively. At March 31, 1996, the range of strike rates was 5.50% to 12.00%
and the weighted average strike rate was 7.36%. Some of the Company's interest
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rate cap agreements have strike rates and/or notional face amounts which vary
over time. Some of the existing cap agreements do not become effective until
1997. All of the interest rate caps reference either one or three month LIBOR.
The Company had one outstanding Swap Agreement at December 31, 1995 and
March 31, 1996 for a notional face amount of $10 million pursuant to which the
Company receives a LIBOR based rate and pays a fixed rate that adjusts annually.
At December 31, 1995 and March 31, 1996, the Company's weighted average
assets and liabilities were matched within a six-month period in terms of
adjustment frequency and speed of adjustment to market conditions. Looking at
these two factors only (and thus ignoring periodic and life caps), the Company's
net interest spread should be stable over time periods greater than six months.
Substantially all of the Company's Mortgage Assets at December 31, 1995 and
March 31, 1996 had coupon rates that adjust to market levels at least every six
months, with a weighted average term to reset of approximately three months. All
of the Company's borrowings at December 31, 1995 and March 31, 1996 will either
mature or adjust to a market interest rate level within six months of such date.
The borrowings had a weighted average term to rate reset of 26 days and 19 days
at December 31, 1995 and March 31, 1996, respectively. Both changes in coupon
rates earned on assets and in the rates paid on borrowings are expected to be
highly correlated with changes in LIBOR rates (subject to the effects of
periodic and lifetime caps).
The Company believes that it has developed a cost-effective asset/liability
management program to provide a level of protection against interest rate and
prepayment risks. However, no strategy can completely insulate the Company from
interest rate changes, prepayment risks and defaults by counterparties. Further,
as noted above, certain of the Federal income tax requirements that the Company
must satisfy to qualify as a REIT limit the Company's ability to fully hedge its
interest rate and prepayment risks. The Company monitors carefully, and may have
to limit, its asset/liability management program to assure that it does not
realize excessive hedging income, or hold hedging assets having excess value in
relation to total assets, which would result in the Company's disqualification
as a REIT or, in the case of excess hedging income, the payment of a penalty tax
for failure to satisfy certain REIT income tests under the Code, provided such
failure was for reasonable cause. See "Certain Federal Income Tax
Considerations -- General." In addition, asset/liability management involves
transaction costs which increase dramatically as the period covered by the
hedging protection increases. Therefore, the Company may be prevented from
effectively hedging its interest rate and prepayment risks.
PREPAYMENT RISK
The Company seeks to minimize the effects of faster or slower than
anticipated prepayment rates through structuring a diversified portfolio with a
variety of prepayment characteristics, investing in Mortgage Assets with
prepayment prohibitions and penalties, investing in certain Mortgage Security
structures which have prepayment protections, and balancing assets purchased at
a premium with assets purchased at a discount. In addition, the Company has
purchased and may in the future purchase additional interest-only strips to a
limited extent as a hedge against prepayment risks. Prepayment risk is monitored
by management and the Board of Directors through periodic review of the impact
of a variety of prepayment scenarios on the Company's revenues, net earnings,
dividends, cash flow and net balance sheet market value.
A majority of the Company's non-agency Mortgage Assets are structured so
that for several years they receive less than a pro rata share of principal
repayments experienced in the underlying mortgage pool as a whole. In such
Mortgage Securities, one or more classes of Senior Securities are ordinarily
entitled to receive all principal prepayments on the underlying pool of loans
until such Senior Securities have been paid down to a specified amount
determined by formula. To illustrate, if (i) the Company owned a Mezzanine
Security with a face value of $2 million representing a partial interest in a
pool of ARMs totaling $100 million of aggregate principal balance, (ii)
Subordinated Securities with a face value of $6 million were held by other
investors and provided credit support for the Mezzanine Securities, (iii) $92
million face value of Senior Securities were also held by other investors
supported by the Mezzanine Securities and Subordinated Securities, and (iv) the
$100 million face value of Senior Securities, Mezzanine Securities and
Subordinated
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Securities had been issued in this format, the Company's $2 million face value
of Mezzanine Securities would receive no principal prepayments on the underlying
loans until the $92 million face value of Senior Securities had been paid down
to a formula-determined amount, which would normally be expected to occur within
a range of three to ten years depending on the rate of prepayments and other
factors.
During the first quarter of 1995, the Company received $2.7 million in
principal payments on its Mortgage Assets. The annualized rate of principal
repayment the Company experienced was 9%. During the first quarter of 1996,
$32.8 million in principal repayments was received, and the annualized rate of
principal repayment was 26%. The amortized cost of the Company's Mortgage Assets
at December 31, 1995 and March 31, 1996 was equal to 98.33% and 99.29%,
respectively, of the face value of the assets; the net discount was 1.67% and
0.71%, respectively. The smaller the level of net discount or premium, the less
risk there is that fluctuations in prepayment rates will affect earnings in the
long run.
MORTGAGE LOAN SECURITIZATION TECHNIQUES
The Company expects to contract with conduits, financial institutions,
mortgage bankers, investment banks and others to purchase Mortgage Loans which
they are originating. The Company anticipates that it will have sufficient
purchasing power in some circumstances to induce origination firms to originate
Mortgage Loans to the Company's specifications. The Company intends to enhance
the value and liquidity of all the Mortgage Loans it acquires by securitizing
the loans into Mortgage Securities in the manner which will best meet its own
needs.
In addition to creating Mortgage Securities from the Mortgage Loans in its
portfolio, the Company also plans from time to time to "re-securitize" portions
of its Mortgage Securities portfolio. In a re-securitization transaction,
Mortgage Securities rather than Mortgage Loans are used as collateral to create
new Mortgage Securities. This would typically be done as the Mortgage Loans
underlying the securities improve in credit quality through seasoning, as values
rise on the underlying properties or when the credit quality of a junior class
of mortgage security improves due to prepayment of more senior classes. Such
transactions can result in improved credit ratings, higher market values and
lowered borrowing costs. The Company believes that this built-in tendency of
securitized mortgage bonds to improve in credit quality even if real estate
prices remain level could be one of the most attractive aspects of the markets
in which the Company will invest.
The Company may conduct its securitization activities through one or more
taxable or REIT-qualifying subsidiaries formed for such purpose. Prior to
engaging in any securitization activities, the Company will receive an opinion
of counsel that the proposed method of such activities will not jeopardize the
Company's status as a REIT.
RECENT LEGISLATION
On September 23, 1994, the Riegle Community Development and Regulatory
Improvement Act of 1994 (the "Riegle Act") was enacted which, among other
things, amended SMMEA to confer upon commercial mortgage securities the benefit
of SMMEA treatment and to remove certain impediments to trading and investing in
commercial mortgage securities. However, such amendments do not become effective
until certain final regulations are promulgated by the Comptroller of the
Currency with respect to such amendments. Proposed regulations were issued in
December 1995 but no final regulations have as yet been adopted. It is still
unclear what effect, if any, the amendments to SMMEA will have on institutions
governed by such regulations or on the commercial mortgage securities market.
Furthermore, the Riegle Act specifically allows the various states to prohibit
or limit the benefits of such amendments.
FUTURE REVISIONS IN POLICIES AND STRATEGIES
The Board of Directors has established the investment policies and
operating policies and strategies set forth in this Prospectus. The Board of
Directors has the power to modify or waive such policies and strategies without
the consent of the stockholders to the extent that the Board of Directors
determines that such modification or waiver is in the best interests of
stockholders. However, if such modification or waiver relates to the
relationship of, or any transaction between, the Company and GB Capital or any
affiliated person of GB
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Capital, the approval of a majority of the Independent Directors is also
required. Among other factors, developments in the market which affect the
policies and strategies mentioned herein or which change the Company's
assessment of the market may cause the Board of Directors to revise the
Company's policies and strategies.
LEGAL PROCEEDINGS
There are no material pending legal proceedings to which the Company is a
party or to which any property of the Company is subject.
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MANAGEMENT
DIRECTORS AND EXECUTIVE OFFICERS
The directors and executive officers of the Company are as follows:
<TABLE>
<CAPTION>
NAME POSITION
- ----------------------------------- ------------------------------------------------
<S> <C>
George E. Bull(1).................. Chairman of the Board and Chief Executive
Officer
Douglas B. Hansen(1)............... President, Chief Financial Officer and Director
Frederick H. Borden(1)............. Vice Chairman of the Board and Secretary
Dan A. Emmett(2)(3)................ Director
Thomas F. Farb(2)(4)............... Director
Nello Gonfiantini(2)(4)............ Director
Charles J. Toeniskoetter(2)(3)..... Director
Vickie L. Rath..................... Vice President, Treasurer and Controller
</TABLE>
- ---------------
(1) Founder of the Company
(2) Independent Director
(3) Member of the Audit Committee
(4) Member of the Compensation Committee
GEORGE E. BULL, age 47, was elected to serve as Chairman of the Board and
Chief Executive Officer of the Company in April, 1994. Mr. Bull is the President
of GB Capital, and has served in such capacity since he founded the predecessor
of GB Capital in 1983. GB Capital assists banks, insurance companies, and
savings and loans in managing portfolios of securitized and unsecuritized
Mortgage Loans, in arranging collateralized borrowings, in hedging balance sheet
risks, and with other types of capital markets transactions. In addition, GB
Capital manages and advises troubled commercial real estate and corporate
investments. In 1991 and 1992, Mr. Bull served as Acting Chief Investment
Officer of First Capital Life Insurance Company, managing its $4 billion
securities portfolio and over $200 million in commercial real estate loans. He
also worked during this period in various aspects of fixed income portfolio
management with Wood Island Associates, Inc. From 1991 through 1993, Mr. Bull
oversaw the management of the $350 million portfolio of commercial real estate
investments and the $8 billion securities portfolio of Executive Life Insurance
Company (in Rehabilitation) ("Executive Life") on behalf of the California
Department of Insurance. Mr. Bull and GB Capital continue to oversee portions of
the remaining assets of Executive Life. Prior to 1983, Mr. Bull worked at A. G.
Becker and Kidder Peabody in their fixed income and mortgage-backed securities
departments. In the early 1970's, Mr. Bull was a fixed income portfolio manager
for the California Public Employees Retirement System, and was one of the first
large investors in the emerging GNMA securities market. Mr. Bull is presently a
director of EurekaBank in San Francisco and formerly served as a director of
Home Federal Savings Bank in Nevada. Mr. Bull has a BA in Economics from
University of California, Davis.
DOUGLAS B. HANSEN, age 38, was elected to serve as President, Chief
Financial Officer and a Director of the Company in April, 1994. Mr. Hansen
joined GB Capital in 1990 as a Principal, assisting GB Capital's financial
institution clients with securities portfolio management, asset/liability
management, and balance sheet hedging. From 1991 to 1993, Mr. Hansen also served
as a Special Deputy Insurance Commissioner of the State of California and as the
Acting Chief Investment Officer of Executive Life, managing its $8 billion
portfolio of securities and its Investment Department. In 1991 and 1992, Mr.
Hansen worked in various aspects of fixed income portfolio management with Wood
Island Associates, Inc. From 1992 to 1994, Mr. Hansen served as the Acting Chief
Investment Officer of Old Colony Life Insurance Company, a failed insurance
company conserved by the State of Georgia. Prior to joining GB Capital, Mr.
Hansen worked from 1987 through 1990 at Merrill Lynch as a specialist in
mortgage loans and securities and hedging instruments. Prior to 1987, he worked
on the turnaround team of a savings and loan as a Senior Vice President
(including work on commercial real estate loan work-out and mortgage
securitization), provided strategic management consulting for European companies
while working for Bain & Company in London, and worked on mergers
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and acquisitions and some of the first interest rate swaps in the Corporate
Finance Department at Citibank in New York. Mr. Hansen formerly served as a
director of Industrial Coatings Group, Inc., Applause Enterprises, Concurrent
Computer and the San Francisco Merola Opera Center. Mr. Hansen has a BA in
Economics from Harvard College and an MBA from Harvard Business School.
FREDERICK H. BORDEN, age 50, was elected to serve as Vice Chairman of the
Board and Secretary of the Company in April, 1994. Mr. Borden joined GB Capital
as a Principal in 1992 to assist GB Capital with portfolio management and
marketing. Prior to joining GB Capital, Mr. Borden was Senior Vice President of
Douglas, Emmett & Company, where he organized an institutional capital raising
effort to fund debt and equity investments in West Los Angeles commercial real
estate properties. From 1985 to 1990, Mr. Borden worked as a specialist in
raising capital for financial institutions and as a high yield bond salesman for
Drexel Burnham Lambert. In 1984, Mr. Borden was the sales manager for the
mortgage loan trading department of Farmer's Savings Bank. Mr. Borden was one of
the founding members of Salomon Brothers' mortgage securities department in 1978
and was manager of the West Coast mortgage sales department until 1984. Mr.
Borden has a BA in History from the University of California, Berkeley and an
MBA from Stanford Business School.
DAN A. EMMETT, age 56, was elected to serve as a Director of the Company in
June, 1994. Mr. Emmett is the co-founder and President of Douglas, Emmett and
Company and Douglas Emmett Realty Advisors, leading commercial and multifamily
real estate development, investment, management and asset management businesses
in Los Angeles. Mr. Emmett is the co-founder and a substantial shareholder of
the Jon Douglas Company and its mortgage brokerage, title and escrow affiliates.
Jon Douglas Company is the largest independent residential brokerage firm in
California. Mr. Emmett has been associated with such companies since 1971. Mr.
Emmett has a BA from Stanford University and a JD from Harvard University.
THOMAS F. FARB, age 39, was elected to serve as Director of the Company in
June, 1994. Mr. Farb is the Senior Vice President of Finance, Chief Financial
Officer, and Treasurer of Interneuron Pharmaceuticals, Inc., a publicly-held
pharmaceutical company. From 1992 to 1994, Mr. Farb was the Vice President of
Finance and Corporate Development, Chief Financial Officer, and Controller of
Cytyc Corporation, a medical device/diagnostics company. From 1989 to 1992, Mr.
Farb was Senior Vice President, Chief Financial Officer, and Director of AIRFUND
Corporation, where he closed numerous international aircraft financing
transactions involving various interest rate hedges and multiple layers of debt
and equity. From 1983 to 1989, as Chief Financial Officer and General Manager,
Eastern Operations, Mr. Farb was part of a successful turnaround team for
Symbolics, Inc., a publicly-traded computer company and defense contractor. In
1982, Mr. Farb founded and later sold Language Technology, a programmer
productivity software company. Mr. Farb is currently a director of HNC Software,
Inc. and AIRFUND Corporation. Mr. Farb has a BA in Quantitative Sociology from
Harvard College.
NELLO GONFIANTINI, age 41, was elected to serve as Director of the Company
in June, 1994. Mr. Gonfiantini manages a private mortgage finance and real
estate development business in Reno, Nevada. From 1986 until 1994, Mr.
Gonfiantini was the Chairman, CEO, and President of Home Federal Savings Bank of
Nevada, where he oversaw the commercial and residential real estate lending
operations. Prior to taking that position in 1986, Mr. Gonfiantini was the
Executive Vice President of Home Mortgage Company, a mortgage banking firm and
predecessor to Home Federal Bank. Mr. Gonfiantini has a BA and an MBA from
University of Denver.
CHARLES J. TOENISKOETTER, age 51, was elected to serve as Director of the
Company in June, 1994. Mr. Toeniskoetter is the President of Toeniskoetter &
Breeding, Inc. Development, a company which has developed, and owns and manages,
over $60 million of commercial and industrial real estate properties, and is the
President of Toeniskoetter & Breeding, Inc. Construction, a commercial and
industrial construction company that has completed over $185 million of
construction contracts since its founding. Mr. Toeniskoetter co-founded both of
these companies in 1983. From 1975 to 1983, Mr. Toeniskoetter worked with Carl
N. Swenson Company, Inc. as manager of the Real Estate Development Group,
Division Vice President, and Director. From 1973 to 1975, he worked as a
management consultant with McKinsey & Co., Inc. Mr. Toeniskoetter serves on the
Boards of the San Jose Water Company and a number of non-profit
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<PAGE> 94
foundations and other community entities. Mr. Toeniskoetter has a B.S. in
Mechanical Engineering from Notre Dame University and an MBA from Stanford
Business School.
VICKIE L. RATH, age 36, was elected to serve as Vice President, Treasurer
and Controller of the Company in April, 1994. Ms. Rath has acted as an
independent consultant to GB Capital since February 1994 and was elected Vice
President of GB Capital in 1994. From 1993 to 1994, Ms. Rath served as Principal
and Controller of Wells Fargo Nikko Investment Advisors. From 1988 to 1993, Ms.
Rath was Vice President, Controller of TIS Mortgage Investment Company, a
NYSE-listed REIT and served as its Treasurer from 1989 to 1993. In addition, Ms.
Rath served as the Principal Financial Officer of TIS Financial Services, Inc.
(formerly Thrift Investment Services) (1988 to 1993), Vice President, Secretary
and Treasurer of TIS Asset Management (1991 to 1993) and Assistant Treasurer of
INVG Mortgage Securities Corp., a REIT traded on Nasdaq (1992 to 1993). Ms. Rath
was a Senior Tax Manager at Arthur Andersen & Co., where she worked from 1981 to
1988. Ms. Rath has a BA in Accounting from the University of Colorado at Boulder
and an MBA in Taxation from Golden Gate University. Ms. Rath is a Certified
Public Accountant.
The Directors of the Company are divided into three classes, designated
Class I, Class II and Class III. Messrs. Borden and Gonfiantini are Class I
directors, Messrs. Hansen, Farb and Toeniskoetter are Class II directors and
Messrs. Bull and Emmett are Class III directors. Class I, Class II and Class III
directors will stand for reelection at the annual meetings of stockholders held
in 1998, 1999 and 1997, respectively. Successors to the directors whose terms
expire at the respective annual meetings will be elected for three-year terms.
The Company pays an annual director's fee to each Independent Director equal to
$6,000, and options to purchase 5,000 shares of Common Stock at the fair market
value of the Common Stock upon becoming a director and options to purchase 2,500
shares at the fair market value of the Common Stock on the day after each Annual
Meeting of Stockholders, plus a fee of $500 for each meeting of the Board of
Directors attended by the director in person and $250 for each meeting attended
telephonically and reimbursement of the director's costs and expenses for
attending such meetings. All officers are appointed by and serve at the
discretion of the Board of Directors. There are no family relationships between
any executive officers or directors.
The Bylaws of the Company provide that, except in the case of a vacancy, a
majority of the members of the Board of Directors and of any committee of the
Board of Directors will at all times be Independent Directors. Vacancies
occurring on the Board of Directors among the Independent Directors will be
filled by a vote of a majority of the directors, including a majority of the
Independent Directors.
The Articles of Incorporation of the Company provide for the
indemnification of the directors and officers of the Company to the fullest
extent permitted by Maryland law. See "Description of Capital Stock --
Indemnification." The Articles of Incorporation of the Company also provide that
the personal liability of any director or officer of the Company to the Company
or its stockholders for money damages is limited to the fullest extent allowed
by the statutory or decisional law of the State of Maryland as amended or
interpreted. See "Description of Capital Stock -- Limitation of Liability."
EXECUTIVE COMPENSATION
Management of the Company receives annual base salaries. Messrs. Bull,
Hansen and Borden each currently receive annual base salaries of $184,580. Ms.
Rath currently receives an annual base salary of $123,053. The base salaries
will grow with the consumer price index and may be raised at the discretion of
the Compensation Committee. In addition, the Board of Directors has established
a bonus incentive compensation plan for executive officers of the Company. This
program permits the Board of Directors, in their discretion, to award cash
bonuses annually to executive officers of the Company.
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<PAGE> 95
The following Summary Compensation Table sets forth information concerning
compensation earned in the years ended December 31, 1994 and 1995 by the
Company's Chief Executive Officer and its three other executive officers serving
at the end of the last completed fiscal year (the "Named Executive Officers").
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION AWARDS
---------------------------
ANNUAL COMPENSATION DIVIDEND SECURITIES OTHER
------------------------- EQUIVALENT UNDERLYING COMPENSATION
NAME AND PRINCIPAL POSITION YEAR SALARY ($) BONUS ($)(1) RIGHTS (#)(2) OPTIONS (#) ($)(3)
- ----------------------------------- ---- ---------- ------------ ------------- ----------- ------------
<S> <C> <C> <C> <C> <C> <C>
George E. Bull..................... 1995 $ 75,408 $ -- 590 46,528 $7,688
Chairman of the Board and Chief 1994 9,998 -- -- 49,445 --
Executive Officer
Douglas B. Hansen.................. 1995 $ 75,408 $ -- 590 46,528 $7,688
President and Chief Financial 1994 9,998 -- -- 49,444 --
Officer
Frederick H. Borden................ 1995 $ 75,408 $ -- 367 28,905 $7,688
Vice Chairman of the Board and 1994 9,998 -- -- 49,444 --
Secretary
Vickie L. Rath..................... 1995 $ 66,217 $ 33,108 190 15,000 $6,327
Vice President, Treasurer and 1994 16,667 2,083 -- 16,000 --
Controller
</TABLE>
- ---------------
(1) Amounts stated include bonus amounts accrued during the fiscal year and paid
in the following year.
(2) Represents the number of shares of stock which are accrued under Dividend
Equivalent Rights ("DERs") and are issuable to holders upon the exercise of
the related stock options.
(3) Annual Company contributions to the Company's Profit Sharing Plan.
OPTION GRANTS
The following table sets forth information concerning stock options granted
during the 1995 fiscal year to each of the Named Executive Officers. Each of the
stock options is exercisable to purchase Common Stock of the Company.
OPTION/SAR GRANTS IN LAST FISCAL YEAR
<TABLE>
<CAPTION>
POTENTIAL REALIZABLE
INDIVIDUAL GRANTS VALUE AT ASSUMED
------------------------------------------------------------- ANNUAL RATES OF
NUMBER OF % OF TOTAL STOCK PRICE
SECURITIES OPTIONS/SARS APPRECIATION
UNDERLYING GRANTED TO EXERCISE OR FOR OPTION TERM (2)
OPTIONS/SARS EMPLOYEES IN BASE PRICE ---------------------
NAME GRANTED (#)(1) FISCAL YEAR ($/SH) EXPIRATION DATE 5% ($) 10% ($)
- ----------------------- -------------- ------------ ----------- --------------- -------- ----------
<S> <C> <C> <C> <C> <C> <C>
George E. Bull......... 46,528 29.6% $ 18.25 12/15/05 $534,017 $1,353,304
Douglas B. Hansen...... 46,528 29.6% 18.25 12/15/05 534,017 1,353,304
Frederick H. Borden.... 28,905 18.4% 18.25 12/15/05 331,752 840,725
Vickie L. Rath......... 15,000 9.6% 18.25 12/15/05 172,760 436,487
</TABLE>
- ---------------
(1) All options were granted with related DERs.
(2) Excludes any value relative to the DERs associated with the stock options.
95
<PAGE> 96
OPTION EXERCISES AND FISCAL YEAR END VALUES
The following table sets forth certain information regarding exercise of
options during 1995 and the number and value of options to acquire Common Stock
of the Company held by each Named Executive Officer as of December 31, 1995.
AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND
FISCAL YEAR-END OPTION/SAR VALUE
<TABLE>
<CAPTION>
NUMBER OF SECURITIES VALUE OF UNEXERCISED
UNDERLYING UNEXERCISED IN-THE-MONEY
OPTIONS AT OPTIONS AT
SHARES ACQUIRED ON VALUE FISCAL YEAR-END (#) FISCAL YEAR-END ($)(2)
NAME EXERCISE (#) REALIZED ($)(1) EXERCISABLE/UNEXERCISABLE EXERCISABLE/UNEXERCISABLE
- ----------------------- ------------------ --------------- ------------------------- -------------------------
<S> <C> <C> <C> <C>
George E. Bull......... 12,361 $ 134,859 0/83,612 $0/$672,704
Douglas B. Hansen...... 12,361 134,859 0/83,611 0/ 672,685
Frederick H. Borden.... 12,361 134,859 0/65,988 0/ 672,685
Vickie L. Rath......... 4,000 43,680 0/27,000 0/ 217,800
</TABLE>
- ---------------
(1) The value realized is based on the market value of underlying securities at
exercise date, minus the exercise price.
(2) The value of unexercised options is based on the market value of the
underlying securities at fiscal year end, minus the exercise price. It
excludes any value relative to the DERs associated with the stock options.
EMPLOYMENT AGREEMENTS
The Company entered into employment agreements with Messrs. Bull, Hansen
and Borden. Each agreement provides for a term through December 31, 1999 and
will be automatically extended for an additional year at the end of each year of
the agreement, unless either party provides a prescribed prior written notice to
the contrary. Each agreement provides for the annual base salary set forth under
the caption "-- Executive Compensation" above and for participation by the
subject officer in the bonus incentive compensation plan. Each employment
agreement provides for the subject officer to receive his base salary and bonus
compensation to the date of the termination of employment by reason of death,
disability or resignation and to receive base compensation to the date of the
termination of employment by reason of a termination of employment for cause as
defined in the agreement. Each employment agreement also provides for the
subject officer to receive, in the event that the Company terminates the subject
officer's employment without cause, or if the subject officer resigns for "good
reason" (as defined in the agreement, including the occurrence of a "Change of
Control" of the Company as defined in the agreement), an amount, 50% payable
immediately and 50% payable in monthly installments over the succeeding twelve
months, equal to three times the greater of such officer's combined maximum base
salary and actual bonus compensation for the preceding fiscal year or the
average for the three preceding years of such officer's combined actual base
salary and bonus compensation, subject in each case to a maximum amount of 1% of
the Company's book equity value (exclusive of valuation adjustments) and a
minimum amount of $250,000. Section 280G of the Code may limit the deductibility
of such payments by the Company for Federal income tax purposes. Each employment
agreement also contains a "non-compete" provision prohibiting the subject
officer from competing with the Company for a period of one year following
termination of employment following the Company's termination of the subject
officer without cause or resignation of the subject officer for "good reason"
(including a "Change of Control"). Providing services to GB Capital is expressly
excluded from operation of the "non-compete" provision. In addition, all
outstanding options and Awards (see "-- Stock Options" below) granted to the
subject officer under the Stock Option Plan shall immediately vest upon his
termination without cause or termination for "good reason" (including upon a
"Change of Control"). "Change of Control" for purposes of the agreements would
include a merger or consolidation of the Company, a sale of all or substantially
all of the assets of the Company, changes in the identity of a majority of the
members of the Board of Directors of the Company (other than due to the death,
disability or age of a director) or acquisitions of more than 9.8% of
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<PAGE> 97
the combined voting power of the Company's capital stock, subject to certain
limitations. Mr. Bull's employment agreement also restricts the Company from
entering into a separate management agreement or arrangement, without Mr. Bull's
consent, pursuant to which another entity would perform all or a substantial
portion of Mr. Bull's duties. Additionally, each agreement requires that the
subject officer act as described under the caption "-- Conflict of Interest,"
below.
The Company has entered into an employment agreement with Ms. Rath on
substantially the same terms as for the executive officers set forth in the
immediately preceding paragraph with the following exceptions: Ms. Rath's
employment agreement provides for a term through December 31, 1996 and will be
automatically extended for an additional year at the end of each year of the
agreement unless either party provides a prescribed prior written notice to the
contrary; the base salary is subject to a maximum as set forth under
"-- Executive Compensation," above; and the payment to Ms. Rath in the event the
Company terminates her employment without cause is six months of compensation
(based on base salary and bonus compensation for the last fiscal year),
calculated and payable as set forth above.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION IN COMPENSATION
DECISIONS
On August 10, 1994, the Company elected a compensation committee comprised
of Thomas Farb and Nello Gonfiantini. The compensation committee establishes the
compensation of the officers of the Company and also administers the Company's
Stock Option Plan. None of the compensation committee members or other directors
or officers of the Company have any relationships which must be disclosed under
this caption.
STOCK OPTIONS
The Company has adopted its Amended and Restated 1994 Executive and
Non-Employee Director Stock Option Plan (the "Stock Option Plan") which provides
for the grant of qualified incentive stock options ("ISOs") which meet the
requirements of section 422 of the Code, stock options not so qualified
("NQSOs"), deferred stock, restricted stock, performance shares, stock
appreciation and limited stock appreciation rights awards ("Awards") and
dividend equivalent rights ("DERs"). At a meeting on March 8, 1996, the
Company's Board of Directors adopted, subject to approval of the stockholders,
amendments to the Stock Option Plan which would provide for an increase in the
maximum aggregate number of shares of the Company's Common Stock available for
grant under the Stock Option Plan and certain other changes. Such amendments
were approved at the Annual Meeting of Stockholders on June 14, 1996 and became
effective on such date.
The purpose of the Stock Option Plan is to provide a means of
performance-based compensation in order to attract and retain qualified
personnel and to provide an incentive to others whose job performance affects
the Company. The Stock Option Plan is administered by the Compensation
Committee, which shall, at all times when the Company is subject to the
reporting requirements of the Securities Exchange Act of 1934, as amended, be
composed solely of "disinterested persons" as required by Rule 16b-3 under the
Exchange Act. Members of the Compensation Committee are eligible to receive only
NQSOs pursuant to automatic grants of stock options discussed below. ISOs may be
granted to the officers and key employees of the Company. NQSOs and Awards may
be granted to the directors, officers, key employees and agents and consultants
of the Company or any of its subsidiaries.
The Plan provides for granting of DERs in tandem with NQSOs. Such DERs
accrue for the account of the optionee shares of Common Stock upon the payment
of cash dividends on outstanding shares of Common Stock. The number of shares
accrued is determined by a formula and such shares are currently transferred to
the optionee only upon exercise of the related option. The amendments adopted
permit DERs to be issued in tandem with all options granted under the Plan (not
just NQSOs) and effect the following changes to DERs granted under the Plan.
First, DERs can be issued in "current-pay" form so that payments can be made to
the optionee at the same time as dividends are paid to holders of outstanding
Common Stock. Second, DERs can be made eligible to participate not only in cash
distributions but also distributions of stock or other property made to holders
of outstanding Common Stock. Shares of Common Stock accrued for the account of
the optionee pursuant to a DER grant may also be made eligible to receive
dividends and distributions. Finally,
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<PAGE> 98
DERs can be made "performance based" by conditioning the right of the holder of
the DER to receive any dividend equivalent payment or accrual upon the
satisfaction of specified performance objectives. Under the prior Plan, DER
accrual was automatic.
Subject to anti-dilution provisions for stock splits, stock dividends and
similar events, the Stock Option Plan currently authorizes the grant of options
to purchase, and Awards of, an aggregate of up to 15% of the Company's total
outstanding shares at any time, provided that no more than 500,000 shares of
Common Stock shall be cumulatively available for grant as Incentive Stock
Options. If an option granted under the Stock Option Plan expires or terminates,
or an Award is forfeited, the shares subject to any unexercised portion of such
option or Award will again become available for the issuance of further options
or Awards under the Stock Option Plan.
Unless previously terminated by the Board of Directors, the Stock Option
Plan will terminate on June 23, 2004, and no options or Awards may be granted
under the Stock Option Plan thereafter.
Options granted under the Stock Option Plan will become exercisable in
accordance with the terms of the grant made by the Committee. Awards will be
subject to the terms and restrictions of the Award made by the Committee. The
Committee has discretionary authority to select participants from among eligible
persons and to determine at the time an option or Award is granted when and in
what increments shares covered by the option may be purchased and, in the case
of options, whether it is intended to be an ISO or a NQSO provided, however,
that certain restrictions applicable to ISOs are mandatory, including a
requirement that ISOs not be issued for less than 100% of the then fair market
value of the Common Stock (110% in the case of a grantee who holds more than 10%
of the outstanding Common Stock) and a maximum term of ten years (five years in
the case of a grantee who holds more than 10% of the outstanding Common Stock).
Under current law, ISOs may not be granted to any director of the Company
who is not also an employee, or to directors, officers and other employees of
entities unrelated to the Company. No options or Awards may be granted under the
Stock Option Plan to any person who, assuming exercise of all options held by
such person, would own or be deemed to own more than 9.8% of the outstanding
shares of equity stock of the Company.
Each option must terminate no more than 10 years from the date it is
granted (or five years in the case of ISOs granted to an employee who is deemed
to own in excess of 10% of the combined voting power of the Company's
outstanding equity stock). Options may be granted on terms providing for
exercise either in whole or in part at any time or times during their respective
terms, or only in specified percentages at stated time periods or intervals
during the term of the option.
The exercise price of any option granted under the Stock Option Plan is
payable in full in cash, or its equivalent as determined by the Committee. The
Company may make loans available to option holders to exercise options evidenced
by a promissory note executed by the optionholder and secured by a pledge of
Common Stock with fair market value at least equal to the principal of the
promissory note unless otherwise determined by the Committee.
Each non-employee director of the Company is automatically granted an NQSO
to purchase 5,000 shares of Common Stock with DERs upon becoming a director of
the Company, and is also automatically granted an NQSO to purchase 2,500 shares
of Common Stock (with DERs) the day after each annual meeting of stockholders.
Such automatic grants of stock options vest 25% on each anniversary of the date
of grant. The exercise price for such automatic grants of stock options is the
fair market value of the Common Stock on the date of grant, and is required to
be paid in cash.
The Board of Directors may, without affecting any outstanding options or
Awards, from time to time revise or amend the Stock Option Plan, and may suspend
or discontinue it at any time. However, no such revision or amendment may,
without stockholder approval, increase the number of shares subject to the Stock
Option Plan, modify the class of participants eligible to receive options or
Awards granted under the Stock Option Plan or extend the maximum option term
under the Stock Option Plan.
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<PAGE> 99
CONFLICT OF INTEREST
The Chairman of the Board, the President, the Vice Chairman of the Board
and the Treasurer and Controller of the Company are actively involved in the
management of GB Capital. GB Capital assists banks, insurance companies and
savings and loans in managing portfolios of securitized and unsecuritized
Mortgage Loans, in arranging collateralized borrowings, in hedging balance sheet
risks and with other types of capital markets transactions. In addition, GB
Capital manages and advises troubled commercial real estate and corporate
investments. Although these members of management have been and will be involved
with GB Capital to the extent described above, they have devoted a majority of
their time to the business of the Company since the Company was founded and will
continue to devote a majority of their time to the Company's affairs as long as
it remains necessary for the effective conduct and operation of the Company's
business. These arrangements may create conflicts of interest if such members of
management are presented with corporate opportunities that may benefit both the
Company and clients of GB Capital. See "Risk Factors -- Legal and Other
Risks -- Conflicts of Interest."
Generally, under applicable state corporate law, a director of a
corporation is required to first offer to the company corporate opportunities
learned of solely as a result of his or her service as a member of the board of
directors. Maryland law provides that in order for a contract or other
transaction between a corporation and any of its directors or a corporation,
firm, or other entity in which a director has a material financial interest not
to be void or voidable: (i) the contract or transaction must be fair and
reasonable to the corporation; or (ii) the fact of such interest must be
disclosed or known to the board or committee that authorizes, approves or
ratifies the contract or transaction and such authorization, approval or
ratification must be by a vote of the majority of disinterested directors.
The Company's policy is that the approval of the Board of Directors (with
any interested director abstaining) is required for any director, officer,
securityholder or affiliate of the Company (a) to engage for their own account
in realizing upon a corporate opportunity learned of solely as a result of their
service to or representation of the Company or (b) to have any direct or
indirect pecuniary interest in any investment to be acquired or disposed of by
the Company or in any transaction to which the Company is a party or has an
interest.
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<PAGE> 100
PRINCIPAL SECURITYHOLDERS
BENEFICIAL OWNERSHIP OF COMMON STOCK BY LARGE SECURITYHOLDERS
The following table sets forth certain information known to the Company
with respect to beneficial ownership of the Company's Common Stock as of June
30, 1996 by each person other than members of management known to the Company to
beneficially own more than five percent of the Company's Common Stock. Unless
otherwise indicated in the footnotes to the table, the beneficial owners named
have, to the knowledge of the Company, sole voting and investment power with
respect to the shares beneficially owned, subject to community property laws
where applicable.
<TABLE>
<CAPTION>
BENEFICIAL
OWNERSHIP
OF COMMON STOCK(1)
-------------------
NAME AND ADDRESS OF BENEFICIAL OWNER SHARES PERCENT\
- ----------------------------------------------------------------------- ------- -------
<S> <C> <C>
Wallace R. Weitz & Company(2)..................................... 975,682 11.1
1125 South 103rd Street, Suite 600
Omaha, NE 68124-6008
Wellington Management Company(3).................................. 885,879 10.1
75 State Street
Boston, MA 02109
Weitz Series Fund, Inc.(4)........................................ 597,301 6.9
c/o Wallace R. Weitz & Company
1125 South 103rd Street, Suite 600
Omaha, NE 68124-6008
First Financial Fund, Inc.(5)..................................... 449,557 5.2
c/o Wellington Management Company
75 State Street
Boston, MA 02109
</TABLE>
- ---------------
(1) Assuming no exercise Warrants (except by entities named, separately) and no
purchases by listed stockholders in the Offering.
(2) Consists of: 108,518 shares of Common Stock held of record by Weitz Partners
III Limited Partnership, 72,048 shares of Common Stock issuable upon the
exercise of Warrants held of record by Weitz Partners III Limited
Partnership; 147,782 shares of Common Stock held of record by Weitz
Partners, Inc., 50,033 shares of Common Stock issuable upon the exercise of
Warrants held of record by Weitz Partners, Inc.; and 443,698 shares of
Common Stock held of record by Weitz Series Fund, Inc. and 153,603 shares of
Common Stock issuable upon the exercise of Warrants held of record by Weitz
Series Fund, Inc. Wallace R. Weitz, as general partner of Weitz Partners III
Limited Partnership and as President of Weitz Partners, Inc. and Weitz
Series Fund, Inc., may be deemed to beneficially own such shares of Common
Stock.
(3) Includes: 288,574 shares of Common Stock currently outstanding, and 160,983
shares of Common Stock issuable upon the exercise of Warrants, in each case
beneficially owned by First Financial Fund, Inc., for whom Wellington
Management Company ("WMC") acts as investment advisor and over which WMC has
shared investment power; 205,094 shares of Common Stock currently
outstanding, and 60,894 shares of Common Stock issuable upon the exercise of
Warrants, in each case beneficially owned by Bay Pond Partners L.P., for
whom WMC acts as investment advisor and over which WMC has shared voting and
investment power; 18,012 shares of Common Stock currently outstanding, and
18,012 shares of Common Stock issuable upon the exercise of Warrants, in
each case beneficially owned by Pocantico Fund, for whom WMC acts as
investment advisor and over which WMC has shared investment power; and 8,705
shares of Common Stock currently outstanding, and 8,705 shares of Common
Stock issuable upon the exercise of Warrants, in each case beneficially
owned by 5500 Fund, for whom WMC acts as investment advisor and over which
WMC has shared investment power.
(4) Includes 153,603 shares of Common Stock issuable upon exercise of Warrants.
Wallace R. Weitz & Company has sole voting and investment power with respect
to these shares.
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<PAGE> 101
(5) Includes 160,983 shares of Common Stock issuable upon the exercise of
Warrants. First Financial Fund, Inc. has sole voting and shared investment
power with respect to the shares it beneficially owns. See footnote 3.
BENEFICIAL OWNERSHIP OF COMMON STOCK BY DIRECTORS AND MANAGEMENT
The following table sets forth certain information known to the Company
with respect to beneficial ownership of the Company's Common Stock as of June
30, 1996, by (i) each director and nominee for director, (ii) the Company's
Named Executive Officers and (iii) all directors and executive officers as a
group. Unless otherwise indicated in the footnotes to the table, the beneficial
owners named have, to the knowledge of the Company, sole voting and investment
power with respect to the shares beneficially owned, subject to community
property laws where applicable.
<TABLE>
<CAPTION>
BENEFICIAL
OWNERSHIP
OF COMMON STOCK(1)
-------------------
NAME OF BENEFICIAL OWNER SHARES PERCENT
- ---------------------------------------------------------------------- ------- -------
<S> <C> <C>
George E. Bull(2)(3).............................................. 128,333 1.5
Douglas B. Hansen(2)(4)........................................... 99,129 1.2
Frederick H. Borden(2)(5)......................................... 103,045 1.2
Dan A. Emmett(6).................................................. 9,795 *
Thomas F. Farb(7)................................................. 3,125 *
Nello Gonfiantini(8).............................................. 23,237 *
Charles J. Toeniskoetter(9)....................................... 4,845 *
Vickie L. Rath(2)(10)............................................. 12,000 *
All Directors and Executive Officers as a group (8 persons)
(11)............................................................ 383,509 4.5
</TABLE>
- ---------------
* Less than one percent.
(1) Assuming no exercise of Warrants or Stock Options (except by individuals
named, separately).
(2) Address: 591 Redwood Highway, Suite 3100, Mill Valley, CA 94941.
(3) Includes 97,662 shares of Common Stock currently outstanding held of record
by the Bull Trust, 15,310 shares of Common Stock issuable upon the exercise
of Warrants held of record by the Bull Trust, 1,500 shares of Common Stock
currently outstanding held of record by Mr. Bull's children, 1,500 shares
of Common Stock issuable upon the exercise of Warrants held of record by
Mr. Bull's children and 12,361 shares of Common Stock issuable upon the
exercise of stock options exercisable within 60 days.
(4) Includes 3,315 shares and 12,361 shares of Common Stock issuable upon the
exercise of Warrants and stock options exercisable within 60 days,
respectively.
(5) Includes 140 shares of Common Stock issuable upon the exercise of Warrants,
5,003 shares of Common Stock currently outstanding held of record by the
Borden Living Trust, 5,003 shares of Common Stock issuable upon the
exercise of Warrants held of record by the Borden Living Trust, 130 shares
of Common Stock currently outstanding held of record by Mr. Borden's
children, 130 shares of Common Stock issuable upon the exercise of Warrants
held of record by Mr. Borden's children and 12,361 shares of Common Stock
issuable upon the exercise of stock options exercisable within 60 days. Mr.
Borden has shared voting and investment power with his wife with respect to
shares of Common Stock he beneficially owns through the Borden Living Trust
and Mr. Borden's children.
(6) Includes 3,335 shares and 1,875 shares of Common Stock issuable upon the
exercise of Warrants and stock options exercisable within 60 days,
respectively.
(7) Includes 1,875 shares of Common Stock issuable upon the exercise of stock
options exercisable within 60 days.
(8) Includes 10,056 shares and 1,875 shares of Common Stock issuable upon the
exercise of Warrants and stock options exercisable within 60 days,
respectively.
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(9) Includes 660 shares and 1,875 shares of Common Stock issuable upon the
exercise of Warrants and stock options exercisable within 60 days,
respectively. Also includes 400 shares which Mr. Toeniskoetter has voting
and investment power in the TBI Construction Profit Sharing Trust.
(10) Includes 4,000 shares of Common Stock issuable upon the exercise of stock
options exercisable within 60 days.
(11) Includes 39,449 shares and 48,583 shares of Common Stock issuable upon the
exercise of Warrants and stock options exercisable within 60 days,
respectively.
CERTAIN FEDERAL INCOME TAX CONSIDERATIONS
The following discussion summarizes certain Federal income tax
considerations to the Company and the purchasers of the Preferred Stock. This
discussion is based on existing Federal income tax law, which is subject to
change, possibly retroactively. This discussion does not address all aspects of
Federal income taxation that may be relevant to a particular investor in light
of its personal investment circumstances or to certain types of investors
subject to special treatment under the Federal income tax laws (including
financial institutions, insurance companies, broker-dealers and, except to the
extent discussed below, tax-exempt entities and foreign taxpayers) and it does
not discuss any aspects of state, local or foreign tax law. This discussion
assumes that investors will hold their Preferred Stock as a "capital asset"
(generally, property held for investment) under the Code. Prospective investors
are advised to consult their tax advisors as to the specific tax consequences to
them of purchasing, holding and disposing of the Preferred Stock, including the
application and effect of Federal, state, local and foreign income and other tax
laws.
GENERAL
The Company has elected to become subject to tax as a REIT, for Federal
income tax purposes, commencing with the taxable year ending December 31, 1994.
The Board of Directors of the Company currently expects that the Company will
continue to operate in a manner that will permit the Company to maintain its
qualifications as a REIT for the taxable year ending December 31, 1996, and in
each taxable year thereafter. This treatment will permit the Company to deduct
dividend distributions to its stockholders for Federal income tax purposes, thus
effectively eliminating the "double taxation" that generally results when a
corporation earns income and distributes that income to its stockholders.
In the opinion of Giancarlo & Gnazzo, A Professional Corporation, special
tax counsel to the Company ("Special Tax Counsel"), the Company has been
organized and operated in a manner which qualifies it as a REIT under the Code
since the commencement of its operations on August 19, 1994, and the Company's
current and contemplated methods of operation, as described in this Prospectus
and as represented by the Company, will enable it to continue to so qualify.
This opinion is based on various assumptions relating to the organization and
operation of the Company to date and in the future and is conditioned upon
certain representations made by the Company as to certain factual matters. The
continued qualification and taxation of the Company as a REIT will depend upon
the Company's ability to meet, on a continuing basis, distribution levels and
diversity of stock ownership, and the various qualification tests imposed by the
Code as discussed below. This opinion is based on the law existing and in effect
on the date hereof which is subject to change, possibly retroactively.
There can be no assurance that the Company will continue to qualify as a
REIT in any particular taxable year, given the highly complex nature of the
rules governing REITs, the ongoing importance of factual determinations and the
possibility of future changes in the circumstances of the Company. If the
Company were not to qualify as a REIT in any particular year, it would be
subject to Federal income tax as a regular, domestic corporation, and its
stockholders would be subject to tax in the same manner as stockholders of such
corporation. In this event, the Company could be subject to potentially
substantial income tax liability in respect of each taxable year that it fails
to qualify as a REIT, and the amount of earnings and cash available for
distribution to its stockholders could be significantly reduced or eliminated.
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The following is a brief summary of certain technical requirements that the
Company must meet on an ongoing basis in order to qualify, and remain qualified,
as a REIT under the Code:
STOCK OWNERSHIP TESTS
The capital stock of the Company must be held by at least 100 persons and
no more than 50% of the value of such capital stock may be owned, directly or
indirectly, by five or fewer individuals at all times during the last half of
the taxable year. Under recent revisions to the Code, tax-exempt entities, other
than private foundations and certain unemployment compensation trusts, are
generally not treated as individuals for these purposes. These stock ownership
requirements must be satisfied in the Company's second taxable year and in each
subsequent taxable year. The Articles of Incorporation provide restrictions
regarding the transfer of the Company's shares in order to aid in meeting the
stock ownership requirements. See "Description of Capital Stock -- Repurchase of
Shares and Restrictions on Transfer."
ASSET TESTS
The Company must generally meet the following asset tests (the "REIT Asset
Tests") at the close of each quarter of each taxable year:
(a) at least 75% of the value of the Company's total assets must
consist of Qualified REIT Real Estate Assets, Government securities, cash,
and cash items (the "75% Asset Test"); and
(b) the value of securities held by the Company but not taken into
account for purposes of the 75% Asset Test must not exceed (i) 5% of the
value of the Company's total assets in the case of securities of any one
non-government issuer, or (ii) 10% of the outstanding voting securities of
any such issuer.
The Company expects that substantially all of its assets will be Qualified
REIT Real Estate Assets. In addition, the Company does not expect that the value
of any security of any one entity would ever exceed 5% of the Company's total
assets, and the Company does not expect to own more than 10% of any one issuer's
voting securities.
The Company intends to monitor closely the purchase, holding and
disposition of its assets in order to comply with the REIT Asset Tests. In
particular, the Company intends to limit and diversify its ownership of any
assets not qualifying as Qualified REIT Real Estate Assets to less than 25% of
the value of the Company's assets and to less than 5%, by value, of any single
issuer. If it is anticipated that these limits would be exceeded, the Company
intends to take appropriate measures, including the disposition of
non-qualifying assets, to avoid exceeding such limits.
GROSS INCOME TESTS
The Company must generally meet the following gross income tests (the "REIT
Gross Income Tests") for each taxable year:
(a) at least 75% of the Company's gross income must be derived from
certain specified real estate sources including interest income and gain
from the disposition of Qualified REIT Real Estate Assets or "qualified
temporary investment income" (i.e., income derived from "new capital"
within one year of the receipt of such capital) (the "75% Gross Income
Test");
(b) at least 95% of the Company's gross income for each taxable year
must be derived from sources of income qualifying for the 75% Gross Income
Test, or from dividends, interest, and gains from the sale of stock or
other securities (including certain interest rate swap and cap agreements
entered into to hedge variable rate debt incurred to acquire Qualified REIT
Real Estate Assets) not held for sale in the ordinary course of business
(the "95% Gross Income Test"); and
(c) less than 30% of the Company's gross income must be derived from
the sale of Qualified REIT Real Estate Assets held for less than four
years, stock or securities held for less than one year (including certain
interest rate swap and cap agreements entered into to hedge variable rate
debt incurred to acquire Qualified Real Estate Assets) and certain "dealer"
property (the "30% Gross Income Test").
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The Company intends to maintain its REIT status by carefully monitoring its
income, including income from hedging transactions and sales of Mortgage Assets,
to comply with the REIT Gross Income Tests. In particular, when the Company
earns income under its interest rate caps and other hedging instruments, it will
seek advice from tax counsel as to whether such income constitutes qualifying
income for purposes of the 95% Gross Income Test and as to the proper
characterization of such arrangements for purposes of the REIT Asset Tests.
Under certain circumstances, for example, (i) the sale of a substantial amount
of Mortgage Assets to repay borrowings in the event that other credit is
unavailable or (ii) unanticipated decrease in the qualifying income of the
Company which may result in the nonqualifying income exceeding 5% of gross
income, the Company may be unable to comply with certain of the REIT Gross
Income Tests. See "-- Taxation of the Company" for a discussion of the tax
consequences of failure to comply with the REIT Provisions of the Code.
DISTRIBUTION REQUIREMENT
The Company must generally distribute to its stockholders an amount equal
to at least 95% of the Company's REIT taxable income before deductions of
dividends paid and excluding net capital gain.
The IRS has ruled that if a REIT's dividend reinvestment plan allows
stockholders of the REIT to elect to have cash distributions reinvested in
shares of the REIT at a purchase price equal to at least 95% of the fair market
value of such shares on the distribution date, then such distributions qualify
under the 95% distribution requirement. The terms of the Company's DRP comply
with this ruling. See "Dividend Reinvestment Plan."
TAXATION OF THE COMPANY
In any year in which the Company qualifies as a REIT, the Company will
generally not be subject to Federal income tax on that portion of its REIT
taxable income or capital gain which is distributed to its stockholders. The
Company will, however, be subject to Federal income tax at normal corporate
income tax rates upon any undistributed taxable income or capital gain.
Notwithstanding its qualification as a REIT, the Company may also be
subject to tax in certain other circumstances. If the Company fails to satisfy
either the 75% or the 95% Gross Income Test, but nonetheless maintains its
qualification as a REIT because certain other requirements are met, it will
generally be subject to a 100% tax on the greater of the amount by which the
Company fails either the 75% or the 95% Gross Income Test. The Company will also
be subject to a tax of 100% on net income derived from any "prohibited
transaction," and if the Company has (i) net income from the sale or other
disposition of "foreclosure property" which is held primarily for sale to
customers in the ordinary course of business or (ii) other non-qualifying income
from foreclosure property, it will be subject to Federal income tax on such
income at the highest corporate income tax rate. In addition, if the Company
fails to distribute during each calendar year at least the sum of (i) 85% of its
REIT ordinary income for such year and (ii) 95% of its REIT capital gain net
income for such year, the Company would be subject to a 4% Federal excise tax on
the excess of such required distribution over the amounts actually distributed
during the taxable year, plus any undistributed amount of ordinary and capital
gain net income from the preceding taxable year. The Company may also be subject
to the corporate alternative minimum tax, as well as other taxes in certain
situations not presently contemplated.
If the Company fails to qualify as a REIT in any taxable year and certain
relief provisions of the Code do not apply, the Company would be subject to
Federal income tax (including any applicable alternative minimum tax) on its
taxable income at the regular corporate income tax rates. Distributions to
stockholders in any year in which the Company fails to qualify as a REIT would
not be deductible by the Company, nor would they generally be required to be
made under the Code. Further, unless entitled to relief under certain other
provisions of the Code, the Company would also be disqualified from re-electing
REIT status for the four taxable years following the year during which it became
disqualified.
The Company intends to monitor on an ongoing basis its compliance with the
REIT requirements described above. In order to maintain its REIT status, the
Company will be required to limit the types of assets that the Company might
otherwise acquire, or hold certain assets at times when the Company might
otherwise have determined that the sale or other disposition of such assets
would have been more prudent.
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TAXABLE SUBSIDIARIES
Hedging activities and the creation of Mortgage Securities through
securitization may be done through a taxable subsidiary of the Company. The
Company and one or more other entities may form and capitalize one or more
taxable subsidiaries. In order to ensure that the Company would not violate the
more than 10% voting stock of a single issuer limitation described above, the
Company would own only nonvoting preferred and nonvoting Common Stock or 10% or
less of the voting Common Stock and the other entities would own all of the
remaining voting Common Stock. The value of the Company's investment in such a
subsidiary must also be limited to less than 5% of the value of the Company's
total assets at the end of each calendar quarter so that the Company can also
comply with the 5% of value, single issuer asset limitation described above
under "-- General -- Asset Tests." The taxable subsidiary would not elect REIT
status and would distribute only net after-tax profits to its stockholders,
including the Company. Before the Company engages in any hedging or
securitization activities or forms any such taxable subsidiary corporation, the
Company will obtain an opinion of counsel to the effect that such activities or
the formation and contemplated method of operation of such corporation will not
cause the Company to fail to satisfy the REIT Asset and REIT Gross Income Tests.
TAXATION OF STOCKHOLDERS
COMMON STOCK AND PREFERRED STOCK GENERALLY
Distributions (including constructive distributions) made to holders of
Common Stock or Preferred Stock, other than tax-exempt entities, will generally
be subject to tax as ordinary income to the extent of the Company's current and
accumulated earnings and profits as determined for Federal income tax purposes.
If the amount distributed exceeds a stockholder's allocable share of such
earnings and profits, the excess will be treated as a return of capital to the
extent of the stockholder's adjusted basis in its shares, which will not be
subject to tax, and thereafter as a taxable gain from the sale or exchange of a
capital asset.
Distributions designated by the Company as capital gain dividends will
generally be subject to tax as long-term capital gain to stockholders, to the
extent that the distribution does not exceed the Company's actual net capital
gain for the taxable year. Distributions by the Company, whether characterized
as ordinary income or as capital gain, are not eligible for the corporate
dividends received deduction. In the event that the Company realizes a loss for
the taxable year, stockholders will not be permitted to deduct any share of that
loss. Further, if the Company (or a portion of its assets) were to be treated as
a taxable mortgage pool, any "excess inclusion income" that is allocated to a
stockholder would not be allowed to be offset by a net operating loss of such
stockholder. See "Risk Factors -- Legal and Other Risks -- Taxable Mortgage Pool
Risk; Increased Taxation." Future Treasury Department regulations may require
that the stockholders take into account, for purposes of computing their
individual alternative minimum tax liability, certain tax preference items of
the Company.
Dividends declared during the last quarter of a taxable year and actually
paid during January of the following taxable year are generally treated as if
received by the stockholder on the record date of the dividend payment and not
on the date actually received. In addition, the Company may elect to treat
certain other dividends distributed after the close of the taxable year as
having been paid during such taxable year, but stockholders will be treated as
having received such dividend in the taxable year in which the distribution is
made.
Upon a sale or other disposition of either Common Stock or Preferred Stock,
a stockholder will generally recognize a capital gain or loss in an amount equal
to the difference between the amount realized and the stockholder's adjusted
basis in such stock, which gain or loss will be long-term if the stock has been
held for more than one year. Any loss on the sale or exchange of shares held by
a stockholder for six months or less will generally be treated as a long-term
capital loss to the extent of any long-term capital gain dividends received by
such stockholder. If either Common Stock or Preferred Stock is sold after a
record date but before a payment date for declared dividends on such stock, a
stockholder will nonetheless be required to include such dividend in income in
accordance with the rules above for distributions, whether or not such dividend
is required to be paid over to the purchaser.
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DRP Participants will generally be treated as having received a dividend
distribution equal to the fair value of the Plan Shares that are purchased with
the Participant's reinvested dividends generally on the date that the Company
credits such shares to the Participant's account, plus the brokerage
commissions, if any, allocable to the purchase of such shares, and participants
will have a tax basis in the shares equal to such value. DRP Participants may
not, however, receive any cash with which to pay the resulting tax liability.
Shares received pursuant to the DRP will have a holding period beginning on the
day after their purchase by the Plan Administrator.
The Company is required under Treasury Department regulations to demand
annual written statements from the record holders of designated percentages of
its Capital Stock disclosing the actual and constructive ownership of such stock
and to maintain permanent records showing the information it has received as to
the actual and constructive ownership of such stock and a list of those persons
failing or refusing to comply with such demand.
In any year in which the Company does not qualify as a REIT, distributions
made to its stockholders would be taxable in the same manner discussed above,
except that no distributions could be designated as capital gain dividends,
distributions would be eligible for the corporate dividends received deduction,
the excess inclusion income rules would not apply, and stockholders would not
receive any share of the Company's tax preference items. In such event, however,
the Company could be subject to potentially substantial Federal income tax
liability, and the amount of earnings and cash available for distribution to its
stockholders could be significantly reduced or eliminated.
CASH REDEMPTION OF PREFERRED STOCK
A cash redemption of shares of the Preferred Stock will be treated under
Section 302 of the Code as a distribution taxable as a dividend (to the extent
of the Company's current and accumulated earnings and profits) at ordinary
income rates unless the redemption satisfies one of the tests set forth in
Section 302(b) of the Code and is therefore treated as a sale or exchange of the
redeemed shares. The cash redemption will be treated as a sale or exchange if it
(i) is "substantially disproportionate" with respect to the holder, (ii) results
in a "complete termination" of the holder's stock interest in the Company, or
(iii) is not essentially equivalent to a "dividend" with respect to the holder,
all within the meaning of Section 302(b) of the Code. In determining whether any
of these tests have been met, shares of capital stock (including Common Stock
and other equity interests in the Company) considered to be owned by the holder
by reason of certain constructive ownership rules set forth in the Code, as well
as shares of capital stock actually owned by the holder, must generally be taken
into account. Because the determination as to whether any of the alternative
tests of Section 302(b) of the Code will be satisfied with respect to any
particular holder of the Preferred Stock depends upon the facts and
circumstances at the time that the determination must be made, prospective
holders of the Preferred Stock are advised to consult their own tax advisors to
determine such tax treatment at the time of the redemption.
If a cash redemption of shares of the Preferred Stock is not treated as a
distribution taxable as a dividend to a particular holder, it will be treated as
to that holder as a taxable sale or exchange. As a result, such holder will
recognize gain or loss for federal income tax purposes in an amount equal to the
difference between (i) the amount of cash and the fair market value of any
property received (less any portion thereof attributable to accumulated and
declared but unpaid dividends, which will be taxable as a dividend to the extent
of the Company's current and accumulated earnings and profits), and (ii) the
holder's adjusted basis in the shares of the Preferred Stock for tax purposes.
Such gain or loss will be capital gain or loss if the shares of the Preferred
Stock have been held as a capital asset, and will be long-term gain or loss if
such shares have been held for more than one year.
If a cash redemption of shares of the Preferred Stock is treated as a
distribution taxable as a dividend, the amount of the distribution will be
measured by the amount of cash and the fair market value of any property
received by the holder. The holder's adjusted basis in the redeemed shares of
the Preferred Stock for tax purposes will be transferred to the holder's
remaining shares of capital stock in the Company, if any.
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A redemption of shares of the Preferred Stock for shares of Common Stock
will be treated as a conversion of the Preferred Stock into Common Stock. See
"-- Conversion of Preferred Stock into Common Stock."
CONVERSION OF PREFERRED STOCK INTO COMMON STOCK
In general, no gain or loss will be recognized for federal income tax
purposes upon conversion of the Preferred Stock solely into shares of Common
Stock. The basis that a holder will have for tax purposes in the shares of
Common Stock received upon conversion will be equal to the adjusted basis for
the holder in the shares of Preferred Stock so converted, and, provided that the
shares of Preferred Stock were held as a capital asset, the holding period for
the shares of Common Stock received would include the holding period for the
shares of Preferred Stock converted. A holder will, however, generally recognize
gain or loss on the receipt of cash in lieu of fractional shares of Common Stock
in an amount equal to the difference between the amount of cash received and the
holder's adjusted basis for tax purposes in the Preferred Stock for which cash
was received. Furthermore, under certain circumstances, a holder of shares of
Preferred Stock will recognize dividend income to the extent of proceeds
received with respect to dividends in arrears on the shares at the time of
conversion into Common Stock.
ADJUSTMENTS TO CONVERSION PRICE
Adjustments in the Conversion Price (or failure to make such adjustments)
pursuant to the antidilution provisions of the Preferred Stock or otherwise may
result in constructive distributions to the holders of Preferred Stock that
could, under certain circumstances, be taxable to them as dividends pursuant to
Section 305 of the Code. If such a constructive distribution were to occur, a
holder of Preferred Stock could be required to recognize ordinary income for tax
purposes without receiving a corresponding distribution of cash.
TAXATION OF TAX-EXEMPT ENTITIES
Subject to the discussion below regarding a "pension-held REIT," a
tax-exempt stockholder is generally not subject to tax on distributions from the
Company or gain realized on the sale of the Capital Stock, provided that such
stockholder has not incurred indebtedness to purchase or hold its Securities,
that its shares are not otherwise used in an unrelated trade or business of such
stockholder, and that the Company, consistent with its present intent, does not
hold a residual interest in a REMIC that gives rise to "excess inclusion" income
as defined under section 860E of the Code. If the Company were to be treated as
a "taxable mortgage pool," however, a substantial portion of the dividends paid
to a tax-exempt stockholder may be subject to tax as UBTI. Although the Company
does not believe that the Company, or any portion of its assets, will be treated
as a taxable mortgage pool, no assurance can be given that the IRS might not
successfully maintain that such a taxable mortgage pool exists. See "Risk
Factors -- Legal and Other Risks -- Taxable Mortgage Pool Risk; Increased
Taxation."
If a qualified pension trust (i.e., any pension or other retirement trust
that qualifies under section 401(a) of the Code) holds more than 10% by value of
the interests in a "pension-held REIT" at any time during a taxable year, a
substantial portion of the dividends paid to the qualified pension trust by such
REIT may constitute UBTI. For these purposes, a "pension-held REIT" is any REIT
(i) that would not have qualified as a REIT but for the provisions of the Code
which look through qualified pension trust stockholders in determining ownership
of stock of the REIT and (ii) in which at least one qualified pension trust
holds more than 25% by value of the interests of such REIT or one or more
qualified pension trusts (each owning more than a 10% interest by value in the
REIT) hold in the aggregate more than 50% by value of the interests in such
REIT. Assuming compliance with the Ownership Limit provisions described in
"Description of Capital Stock -- Repurchase of Shares and Restrictions on
Transfer," it is unlikely that pension plans will accumulate sufficient stock to
cause the Company to be treated as a pension-held REIT.
Distributions to certain types of tax-exempt stockholders exempt from
Federal income taxation under sections 501(c)(7), (c)(9), (c)(17), and (c)(20)
of the Code may also constitute UBTI, and such
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prospective investors should consult their tax advisors concerning the
applicable "set aside" and reserve requirements.
STATE AND LOCAL TAXES
The Company and its stockholders may be subject to state or local taxation
in various jurisdictions, including those in which it or they transact business
or reside. The state and local tax treatment of the Company and its stockholders
may not conform to the Federal income tax consequences discussed above.
Consequently, prospective stockholders should consult their own tax advisors
regarding the effect of state and local tax laws on an investment in the Common
Stock.
CERTAIN UNITED STATES FEDERAL INCOME TAX CONSIDERATIONS APPLICABLE TO FOREIGN
HOLDERS
The following discussion summarizes certain United States Federal tax
consequences of the acquisition, ownership and disposition of Common Stock or
Preferred Stock by an initial purchaser that, for United States Federal income
tax purposes, is not a "United States person" (a "Non-United States Holder").
For purposes of this discussion, a "United States person" means: a citizen or
resident of the United States; a corporation, partnership, or other entity
created or organized in the United States or under the laws of the United States
or of any political subdivision thereof; or an estate or trust whose income is
includible in gross income for United States Federal income tax purposes
regardless of its source. This discussion does not consider any specific facts
or circumstances that may apply to a particular Non-United States Holder.
Prospective investors are urged to consult their tax advisors regarding the
United States Federal tax consequences of acquiring, holding and disposing of
Common Stock or Preferred Stock, as well as any tax consequences that may arise
under the laws of any foreign, state, local or other taxing jurisdiction.
DIVIDENDS
Dividends paid by the Company out of earnings and profits, as determined
for United States Federal income tax purposes, to a Non-United States Holder
will generally be subject to withholding of United States Federal income tax at
the rate of 30%, unless reduced or eliminated by an applicable tax treaty or
unless such dividends are treated as effectively connected with a United States
trade or business. Distributions paid by the Company in excess of its earnings
and profits will be treated as a tax-free return of capital to the extent of the
holder's adjusted basis in his shares, and thereafter as gain from the sale or
exchange of a capital asset as described below. If it cannot be determined at
the time a distribution is made whether such distribution will exceed the
earnings and profits of the Company, the distribution will be subject to
withholding at the same rate as dividends. Amounts so withheld, however, will be
refundable or creditable against the Non-United States Holder's United States
Federal tax liability if it is subsequently determined that such distribution
was, in fact, in excess of the earnings and profits of the Company. If the
receipt of the dividend is treated as being effectively connected with the
conduct of a trade or business within the United States by a Non-United States
Holder, the dividend received by such holder will be subject to the United
States Federal income tax on net income that applies to United States persons
generally (and, with respect to corporate holders and under certain
circumstances, the branch profits tax).
For any year in which the Company qualifies as a REIT, distributions to a
Non-United States Holder that are attributable to gain from the sales or
exchanges by the Company of "United States real property interests" will be
treated as if such gain were effectively connected with a United States business
and will thus be subject to tax at the normal capital gain rates applicable to
United States stockholders (subject to applicable alternative minimum tax) under
the provisions of the Foreign Investment in Real Property Tax Act of 1980
("FIRPTA"). Also, distributions subject to FIRPTA may be subject to a 30% branch
profits tax in the hands of a foreign corporate stockholder not entitled to a
treaty exemption. The Company is required to withhold 35% of any distribution
that could be designated by the Company as a capital gains dividend. This amount
may be credited against the Non-United States Holder's FIRPTA tax liability. It
should be noted that Mortgage Loans without substantial equity or shared
appreciation features generally would not be classified as "United States real
property interests."
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GAIN ON DISPOSITION
A Non-United States Holder will generally not be subject to United States
Federal income tax on gain recognized on a sale or other disposition of its
shares of either Common or Preferred Stock unless (i) the gain is effectively
connected with the conduct of a trade or business within the United States by
the Non-United States Holder, (ii) in the case of a Non-United States Holder who
is a nonresident alien individual and holds such shares as a capital asset, such
holder is present in the United States for 183 or more days in the taxable year
and certain other requirements are met, or (iii) the Non-United States Holder is
subject to tax under the FIRPTA rules discussed below. Gain that is effectively
connected with the conduct of a United States Holder will be subject to the
United States Federal income tax on net income that applies to United States
persons generally (and, with respect to corporate holders and under certain
circumstances, the branch profits tax) but will not be subject to withholding.
Non-United States Holders should consult applicable treaties, which may provide
for different rules.
Gain recognized by a Non-United States Holder upon a sale of either Common
Stock or Preferred Stock will generally not be subject to tax under FIRPTA if
the Company is a "domestically controlled REIT," which is defined generally as a
REIT in which at all times during a specified testing period less than 50% in
value of its shares were held directly or indirectly by non-U.S. persons.
Because only a minority of the Company's stockholders are expected to be
Non-United States Holders, the Company anticipates that it will qualify as a
"domestically controlled REIT." Accordingly, a Non-United States Holder should
not be subject to U.S. tax from gains recognized upon disposition of its shares.
INFORMATION REPORTING AND BACKUP WITHHOLDING
Under temporary United States Treasury regulations, United States
information reporting requirements and backup withholding tax will generally not
apply to dividends paid on either the Common Stock or Preferred Stock to a
Non-United States Holder at an address outside the United States. Payments by a
United States office of a broker of the proceeds of a sale of either the Common
Stock or Preferred Stock is subject to both backup withholding at a rate of 31%
and information reporting unless the holder certifies its Non-United States
Holder status under penalties of perjury or otherwise establishes an exemption.
Information reporting requirements (but not backup withholding) will also apply
to payments of the proceeds of sales of such shares by foreign offices of United
States brokers, or foreign brokers with certain types of relationships to the
United States, unless the broker has documentary evidence in its records that
the holder is a Non-United States Holder and certain other conditions are met,
or the holder otherwise establishes an exemption.
Backup withholding is not an additional tax. Any amounts withheld under the
backup withholding rules will be refunded or credited against the Non-United
States Holder's United States Federal income tax liability, provided that the
required information is furnished to the Internal Revenue Service.
These information reporting and backup withholding rules are under review
by the United States Treasury and their application to the Common Stock or
Preferred Stock could be changed by future regulations.
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ERISA CONSIDERATIONS
In considering an investment in the Preferred Stock, a fiduciary of a
profit-sharing, pension stock bonus plan, or individual retirement account,
including a plan for self-employed individuals and their employees or any other
employee benefit plan subject to prohibited transaction provisions of the Code
or the fiduciary responsibility provisions of ERISA (an "ERISA Plan") should
consider (a) whether the ownership of Preferred Stock is in accordance with the
documents and instruments governing such ERISA Plan; (b) whether the ownership
of Preferred Stock is consistent with the fiduciary's responsibilities and
satisfies the requirements of Part 4 of Subtitle B of Title I of ERISA (where
applicable) and, in particular, the diversification, prudence and liquidity
requirements of Section 404 of ERISA; (c) ERISA's prohibitions in improper
delegation of control over, or responsibility for, "plan assets" and ERISA's
imposition of co-fiduciary liability on a fiduciary who participates in, permits
(by action or inaction) the occurrence of, or fails to remedy a known breach of
duty by another fiduciary; and (d) the need to value the assets of the ERISA
Plan annually.
In regard to the "plan assets" issue noted in clause (c) above, the Company
believes that the Preferred Stock should qualify as a "publicly-offered
security," and therefore the acquisition of such Preferred Stock by ERISA Plans
should not cause the Company's assets to be treated as assets of such investing
ERISA Plans for purposes of the fiduciary responsibility provisions of ERISA or
the prohibited transaction provisions of the Code. The Department of Labor has
issued final regulations (the "DOL Regulations") as to what constitutes an asset
of an ERISA Plan. Under the DOL Regulations, if an ERISA Plan acquires an equity
interest in an entity, which interest is neither a "publicly-offered security"
nor a security issued by an investment company registered under the Investment
Company Act of 1940, as amended, the ERISA Plan's assets would include, for
purposes of the fiduciary responsibility provisions of ERISA and the prohibited
transaction provisions of the Code, both the equity interest and an undivided
interest in each of the entity's underlying assets, unless certain specified
exemptions apply. The DOL Regulations define a publicly-offered security as a
security that is "widely held," "freely transferable" and either part of a class
of securities registered under the Exchange Act, or sold pursuant to an
effective registration statement under the Securities Act (provided the
securities are registered under the Exchange Act within 120 days after the end
of the fiscal year of the issuer during which the offering occurred). The
Preferred Stock offered hereby is being sold in an offering registered under the
Securities Act and will be registered under the Exchange Act.
The DOL Registrations provide that a security is "widely held" only if it
is part of a class of securities that is owned by 100 or more investors
independent of the issuer and of one another. The Company's Stock satisfies this
"widely held" requirement. A security will not fail to be "widely held" because
the number of independent investors falls below 100 subsequent to the initial
public offering as a result of events beyond the issuer's control.
The DOL Regulations provide that whether a security is "freely
transferable" is a factual question to be determined on the basis of all
relevant facts and circumstances. The DOL Regulations further provide that when
a security is part of an offering in which the minimum investment is $10,000 or
less, as is the case with this Offering, certain restrictions ordinarily will
not, alone or in combination, affect the finding that such securities are freely
transferable. The Company believes that the restrictions imposed under the
Company's Articles of Incorporation on the transfer of the Preferred Stock are
limited to the restrictions on transfer generally permitted under the DOL
Regulations and are not likely to result in the failure of the Preferred Stock
to be "freely transferable." The DOL Regulations only establish a presumption in
favor of the finding of free transferability, and, therefore, no assurance can
be given that the Department of Labor and the Treasury Department will not reach
a contrary conclusion.
Fiduciaries of ERISA Plans and IRAs should consult with and rely upon their
own advisors in evaluating the consequences under the fiduciary provisions of
ERISA and the Code of an investment in Preferred Stock in light of their own
circumstances.
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DESCRIPTION OF WARRANTS
The Warrants were originally issued as part of the Units, each Unit
consisting of one share of Preferred Stock and one Warrant. At such time the
Warrants were represented by a Class A Preferred Stock certificate which bore an
endorsement representing beneficial ownership of the related Warrants on deposit
with the Warrant Agent as custodian for the registered holders of the Warrants.
The Warrants became detachable from the Class A Preferred Stock on July 20,
1995, and all preferred shares were automatically converted to common shares
upon the closing of the initial public offering. Separate Common Stock
certificates and Warrant certificates will be issued upon the tender by holders
of Units of their Class A Preferred Stock certificates bearing the Warrant
legend. As of June 30, 1996, 1,563,957 Warrants were outstanding.
The Warrants were issued pursuant to a warrant agreement (the "Warrant
Agreement") dated as of August 19, 1994 between the Company and the warrant
agent (the "Warrant Agent"). Chase Mellon Shareholder Services, LLC is the
Warrant Agent. The following summary of certain provisions of the Warrant
Agreement does not purport to be complete and is qualified in its entirety by
reference to the Warrant Agreement including the definitions therein of certain
terms used below. A copy of the Warrant Agreement has been filed with the
Commission as an exhibit to the Registration Statement of which this Prospectus
is a part.
Each Warrant, when exercised, will entitle the holder thereof to receive
1.000667 shares of Common Stock upon the payment of the $15.00 exercise price.
The exercise price per Warrant was established at the time of the Company's
initial private placement of Units, prior to its commencement of operations, and
was fixed by management at the per Unit offering price. The number of shares to
be issued upon exercise of the Warrants is subject to adjustment in certain
cases referred to below. The Warrants are exercisable immediately and unless
exercised, the Warrants will automatically expire at 5:00 p.m. New York City
time on December 31, 1997.
The Warrants may be exercised by surrendering to the Company or the Warrant
Agent the definitive Warrant Certificates evidencing such Warrants, if any (or
if a Warrant Certificate has not been issued in respect of such Warrant, the
related Class A Preferred Stock certificate, with the accompanying form of
election to purchase properly completed and executed, together with payment of
the exercise price (the "Exercise Price"). Payment of the Exercise Price may be
made by certified check, cashier's bank check or United States postal money
order payable to the order of the Company. Upon surrender of the Warrant
Certificate or related Class A Preferred Stock certificate and payment of the
Exercise Price and any other applicable amounts, the Warrant Agent will deliver
or cause to be delivered, to or upon the written order of such holder, stock
certificates representing the number of whole shares of Common Stock or other
securities or property to which such holder is entitled. If less than all of the
Warrants evidenced by a Warrant Certificate (or related Class A Preferred Stock
certificate) are to be exercised, a new Warrant Certificate will be issued for
the remaining number of Warrants.
No fractional shares of Common Stock will be issued upon exercise of the
Warrants; holders exercising Warrants will receive cash in lieu of fractional
shares of Common Stock. The holders of the Warrants have no right to vote on
matters submitted to the stockholders of the Company and have no right to
receive dividends with respect to the shares of Common Stock issuable upon the
exercise of the Warrants. The holders of the Warrants not yet exercised are not
entitled to share in the assets of the Company in the event of liquidation,
dissolution or the winding up of the affairs of the Company.
If the Company (i) pays a dividend or makes a distribution on its Common
Stock in shares of its Common Stock, (ii) subdivides its outstanding shares of
Common Stock into a greater number of shares, (iii) combines its outstanding
shares of Common Stock into a smaller number of shares or (iv) issues by
reclassification of its Common Stock any shares of its capital stock, then the
number of shares of Common Stock issuable upon exercise of the Warrant
immediately prior to such action shall be proportionately adjusted so that the
holder of any Warrant thereafter exercised may receive the aggregate number and
kind of shares of Common Stock that such holder would have owned immediately
following such action if such Warrant had been exercised immediately prior to
such action.
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In case of certain consolidations or mergers of the Company, or the sale of
all or substantially all of the assets of the Company to another corporation,
each Warrant will thereafter be exercisable for the right to receive the kind
and amount of shares of stock or other securities or property to which such
holder would have been entitled as a result of such consolidation, merger or
sale had the Warrants been exercised immediately prior thereto.
DESCRIPTION OF CAPITAL STOCK
GENERAL
The authorized capital stock of the Company consists of 50,000,000 shares
of Capital Stock, $0.01 par value ("Capital Stock"), classified into 48,993,750
authorized shares of Common Stock and 1,006,250 authorized shares of Preferred
Stock.
All of such shares of Capital Stock were initially classified as Common
Stock. The Articles of Incorporation authorize the Board of Directors to
reclassify any of the unissued shares of authorized Capital Stock into a class
or classes of preferred stock. On August 11, 1994, the Company supplemented its
Articles of Incorporation to divide and classify 12,000,000 shares of the
Capital Stock of the Company into a series of preferred stock designated as the
Class A Preferred Stock. The Class A Preferred Stock had the rights and
privileges and was subject to the conditions set forth in the Articles
Supplementary establishing the terms of the Class A Preferred Stock. Pursuant to
the terms of the Class A Preferred Stock, all Class A Preferred Stock was
converted into Common Stock upon the closing of the initial public offering on
August 9, 1995. Following such conversion, Articles Supplementary were filed to
reclassify all authorized and unissued shares as Common Stock.
On or prior to the date of this prospectus, Articles Supplementary were
filed to divide and classify shares of the Capital Stock of the Company into
shares of the Preferred Stock. Additional preferred stock may be issued from
time to time in one or more classes or series, with such distinctive
designations, rights and preferences as shall be determined by the Board of
Directors, subject to the Articles of Incorporation and applicable laws.
Additional series of preferred stock would be available for possible future
financing of, or acquisitions by, the Company and for general corporate purposes
without any legal requirement that further stockholder authorization for
issuance be obtained. The issuance of additional series of preferred stock could
have the effect of making an attempt to gain control of the Company more
difficult by means of a merger, tender offer, proxy contest or otherwise.
Additional series of preferred stock, if issued, could have a preference over
Common Stock as to dividend payments which could affect the ability of the
Company to make dividend distributions to the holders of Common Stock.
The following summary of the respective rights of the Preferred and Common
Stock is qualified in its entirety by reference to the Company's Articles of
Incorporation and Articles Supplementary, copies of which have been filed with
the Commission as exhibits to a Registration Statement of which this Prospectus
is a part.
PREFERRED STOCK
General
When issued and delivered against payment pursuant to the Underwriting
Agreement between the Company and the Underwriters, the Preferred Stock will be
validly issued, fully paid and non assessable. The holders of the Preferred
Stock will have no preemptive rights with respect to any shares of Capital Stock
of the Company or any other securities of the Company convertible into or
carrying rights or options to purchase any such shares. The Preferred Stock will
not be subject to any sinking fund or other obligation of the Company to redeem
or retire the Preferred Stock. Unless converted into shares of Common Stock or
redeemed by the Company, the Preferred Stock will have a perpetual term, with no
maturity. The Company has obtained approval of the Preferred Stock for quotation
on the Nasdaq National Market (subject to notice of issuance) under symbol
"RWTIP."
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Definitions
For purposes of the description of the terms of the Preferred Stock as
provided in this Prospectus, the following terms shall have the meanings
indicated:
"Act" shall mean the Securities Act of 1933, as amended.
"affiliate" of a person means a person that directly, or indirectly through
one or more intermediaries, controls or is controlled by, or is under common
control with, the person specified.
"Board of Directors" shall mean the Board of Directors of the Company or
any committee authorized by such Board of Directors to perform any of its
responsibilities with respect to the Preferred Stock.
"Business Day" shall mean any day other than a Saturday, Sunday or a day on
which state or federally chartered banking institutions in New York, New York
are not required to be open.
"Call Date" shall have the meaning set forth under "Redemption at the
Option of the Company" below.
"Common Stock" shall mean the common stock, $.01 par value per share, of
the Company or such shares of the Company's Capital Stock into which outstanding
shares of Common Stock shall be reclassified.
"Conversion Price" shall mean the conversion price per share of Common
Stock for which each share of Preferred Stock is convertible, as such Conversion
Price may be adjusted as described under "Conversion" below. The initial
Conversion Price shall be $31.00 (equivalent to an initial conversion rate of
one share of Common Stock for each share of Preferred Stock).
"Current Market Price" of publicly traded shares of Common Stock or any
other class or series of Capital Stock or other security of the Company or of
any similar security of any other issuer for any day shall mean the closing
price, regular way on such day, or, if no sale takes place on such day, the
average of the reported closing bid and asked prices regular way on such day, in
either case as reported on the Nasdaq National Market of the National
Association of Securities Dealers, Inc. Automated Quotations System ("Nasdaq")
or, if such security is not quoted on the Nasdaq National Market, on the
principal national securities exchange on which such securities are listed or
admitted for trading, or if not so quoted, listed or admitted, the average of
the closing bid and asked prices on such day in the over-the-counter market as
reported by Nasdaq or, if bid and asked prices for such security on such day
shall not have been reported by Nasdaq, the average of the bid and asked prices
on such day as furnished by any New York Stock Exchange or National Association
of Securities Dealers, Inc. member firm regularly making a market in such
security selected for such purpose by the Chief Executive Officer or the Board
of Directors or if any class or series of securities are not publicly traded,
the fair value of the shares of such class as determined reasonably and in good
faith by the Board of Directors of the Company.
"Distribution" shall have the meaning set forth under "Conversion" below.
"Dividend Payment Date" shall mean, with respect to each Dividend Period,
the twenty-first (21st) day of January, April, July and October, in each year,
commencing on October 21, 1996 with respect to the period commencing on the
Issue Date and ending September 30, 1996; provided, however, that if any
Dividend Payment Date falls on any day other than a Business Day, the dividend
payment payable on such Dividend Payment Date shall be paid on the Business Day
immediately following such Dividend Payment Date.
"Dividend Periods" shall mean quarterly dividend periods commencing on
January 1, April 1, July 1 and October 1 of each year and ending on and
including the day preceding the first day of the next succeeding Dividend Period
(other than the initial Dividend Period, which shall commence on the Issue Date
and end on and include September 30, 1996).
"Fair Market Value" shall mean the average of the daily Current Market
Prices of a share of Common Stock during five (5) consecutive Trading Days
selected by the Company commencing not more than twenty (20) Trading Days
before, and ending not later than, the earlier of the day in question and the
day before the "ex" date with respect to the issuance or distribution requiring
such computation. The term "ex" date, when used with respect to any issuance or
distribution, means the first day on which the share of Common Stock
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trades regular way, without the right to receive such issuance or distribution,
on the exchange or in the market, as the case may be, used to determine that
day's Current Market Price.
"Issue Date" shall mean August 14, 1996.
"Junior Stock" shall mean the Common Stock and any other class or series of
Capital Stock of the Company over which the shares of Preferred Stock have
preference or priority in the payment of dividends or in the distribution of
assets on any liquidation, dissolution or winding up of the Company.
"Parity Stock" shall have the meaning set forth under "Ranking" below.
"Person" shall mean any individual, firm, partnership, corporation or other
entity and shall include any successor (by merger or otherwise) of such entity.
"Press Release" shall have the meaning set forth under "Redemption at the
Option of the Company" below.
"set apart for payment" shall be deemed to include, without any action
other than the following, the recording by the Company in its accounting ledgers
of any accounting or bookkeeping entry which indicates, pursuant to a
declaration of dividends or other distribution by the Board of Directors, the
allocation of funds to be so paid on any series or class of capital stock of the
Company; provided, however, that if any funds for any class or series of Junior
Stock or any class or series of Parity Stock are placed in a separate account of
the Company or delivered to a disbursing, paying or other similar agent, then
"set apart for payment" with respect to the Preferred Stock shall mean placing
such funds in a separate account or delivering such funds to a disbursing,
paying or other similar agent.
"Trading Day", as to any securities, shall mean any day on which such
securities are traded on the Nasdaq National Market or, if such securities are
not listed or admitted for trading on the Nasdaq National Market, on the
principal national securities exchange on which such securities are listed or
admitted or, if such securities are not listed or admitted for trading on any
national securities exchange, in the securities market in which such securities
are traded.
"Transaction" shall have the meaning set forth under "Conversion" below.
"Transfer Agent" means Chase Mellon Shareholder Services, L.L.C., or such
other transfer agent as may be designated by the Board of Directors or their
designee as the transfer agent for the Preferred Stock.
"Voting Preferred Stock" shall have the meaning set forth under "Voting
Rights" below.
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Ranking
Any class or series of Capital Stock of the Company shall be deemed to
rank:
(a) prior or senior to the Preferred Stock, as to the payment of
dividends and as to distribution of assets upon liquidation, dissolution or
winding up, if the holders of such class or series shall be entitled to the
receipt of dividends or of amounts distributable upon liquidation,
dissolution or winding up, as the case may be, in preference or priority to
the holders of Preferred Stock;
(b) on a parity with the Preferred Stock, as to the payment of
dividends and as to distribution of assets upon liquidation, dissolution or
winding up, whether or not the dividend rates, dividend payment dates or
redemption or liquidation prices per share thereof be different from those
of the Preferred Stock, if the holders of such class of stock or series and
the Preferred Stock shall be entitled to the receipt of dividends and of
amounts distributable upon liquidation, dissolution or winding up in
proportion to their respective amounts of accrued and unpaid dividends per
share or liquidation preferences, without preferences or priority one over
the other ("Parity Stock"); and
(c) junior to the Preferred Stock, as to the payment of dividends or
as to the distribution of assets upon liquidation, dissolution or winding
up, if such stock or series shall be Common Stock or if the holders of
Preferred Stock shall be entitled to receipt of dividends or of amounts
distributable upon liquidation, dissolution or winding up, as the case may
be, in preference or priority to the holders of shares of such class or
series ("Junior Stock").
Dividends
The holders of Preferred Stock shall be entitled to receive, when and as
declared by the Board of Directors out of funds legally available for that
purpose, cumulative dividends payable in cash in an amount per share of
Preferred Stock equal to the greater of (i) the base dividend of $0.755 per
quarter (the "Base Rate") or (ii) the cash dividends declared on the number of
shares of Common Stock, or portion thereof, into which a share of Preferred
Stock is convertible. The initial Dividend Period shall commence on the Issue
Date and end on September 30, 1996. The dividends payable with respect to the
portion of the initial Dividend Period commencing on the Issue Date and ending
on September 30, 1996, shall be determined solely by reference to the Base Rate.
The amount referred to in clause (ii) above with respect to each succeeding
Dividend Period shall be determined as of the applicable Dividend Payment Date
by multiplying the number of shares of Common Stock, or portion thereof
calculated to the fourth decimal point, into which a share of Preferred Stock
would be convertible at the opening of business on such Dividend Payment Date
(based on the Conversion Price then in effect) by the aggregate cash dividends
payable or paid for such Dividend Period in respect of a share of Common Stock
outstanding as of the record date for the payment of dividends on the Common
Stock with respect to such Dividend Period or, if different, with respect to the
most recent quarterly period for which dividends with respect to the Common
Stock have been declared. Such dividends shall be cumulative from the Issue
Date, whether or not in any Dividend Period or Periods such dividends shall be
declared or there shall be funds of the Company legally available for the
payment of such dividends, and shall be payable quarterly in arrears on the
Dividend Payment Dates, commencing on the first Dividend Payment Date after the
Issue Date. Each such dividend shall be payable in arrears to the holders of
record of the Preferred Stock, as they appear on the stock records of the
Company at the close of business on a record date fixed by the Board of
Directors which shall be not more than 60 days prior to the applicable Dividend
Payment Date and, within such 60-day period, shall be the same date as the
record date for the regular quarterly dividend payable with respect to the
Common Stock for the Dividend Period to which such Dividend Payment Date relates
(or, if there is no such record date for Common Stock, then such date as the
Board of Directors may fix). Accumulated, accrued and unpaid dividends for any
past Dividend Periods may be declared and paid at any time, without reference to
any regular Dividend Payment Date, to holders of record on such date, which date
shall not precede by more than 45 days the payment date thereof, as may be fixed
by the Board of Directors.
Upon a final administrative determination by the Internal Revenue Service
that the Company does not qualify as a real estate investment trust in
accordance with Section 856 of the Internal Revenue Code of 1986
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(the "Code"), the Base Rate will be increased to $0.794 until such time as the
Company regains its status as a real estate investment trust; provided, however,
that if the Company contests its loss of real estate investment trust status in
Federal Court, following its receipt of any opinion of nationally recognized tax
counsel to the effect that there is a reasonable basis to contest such loss of
status, the Base Rate shall not be increased during the pendency of such
judicial proceeding; provided further, however, that upon a final judicial
determination in Federal Tax Court, Federal District Court or the Federal Claims
Court that the Company does not qualify as a real estate investment trust, the
Base Rate will be increased as stated above.
The amount of dividends payable per share of Preferred Stock for the
portion of the initial Dividend Period commencing on the Issue Date and ending
and including September 30, 1996, or any other period shorter than a full
Dividend Period, shall be computed ratably on the basis of twelve 30-day months
and a 360-day year. Holders of Preferred Stock shall not be entitled to any
dividends, whether payable in cash, property or stock, in excess of cumulative
dividends, as herein provided, on the Preferred Stock. No interest, or sum of
money in lieu of interest, shall be payable in respect of any dividend payment
or payments on the Preferred Stock that may be in arrears.
So long as any of the shares of Preferred Stock are outstanding, except as
described in the immediately following sentence, no dividends shall be declared
or paid or set apart for payment by the Company and no other distribution of
cash or other property shall be declared or made directly or indirectly by the
Company with respect to any class or series of Parity Stock for any period
unless dividends equal to the full amount of accumulated, accrued and unpaid
dividends have been or contemporaneously are declared and paid or declared and a
sum sufficient for the payment thereof has been or contemporaneously is set
apart for such payment on the Preferred Stock for all Dividend Periods
terminating on or prior to the Dividend Payment Date with respect to such class
or series of Parity Stock. When dividends are not paid in full or a sum
sufficient for such payment is not set apart, as aforesaid, all dividends
declared upon the Preferred Stock and all dividends declared upon any other
class or series of Parity Stock shall be declared ratably in proportion to the
respective amounts of dividends accumulated, accrued and unpaid on the Preferred
Stock and accumulated, accrued and unpaid on such Parity Stock.
So long as any of the shares of Preferred Stock are outstanding, no
dividends (other than dividends or distributions paid in shares of or options,
warrants or rights to subscribe for or purchase shares of Junior Stock) shall be
declared or paid or set apart for payment by the Company and no other
distribution of cash or other property shall be declared or made directly or
indirectly by the Company with respect to any shares of Junior Stock, nor shall
any shares of Junior Stock be redeemed, purchased or otherwise acquired (other
than a redemption, purchase or other acquisition of Common Stock made for
purposes of any employee incentive or benefit plan of the Company or any
subsidiary) for any consideration (or any moneys be paid to or made available
for a sinking fund for the redemption of any shares of any such stock) directly
or indirectly by the Company (except by conversion into or exchange for Junior
Stock), nor shall any other cash or other property otherwise be paid or
distributed to or for the benefit of any holder of shares of Junior Stock in
respect thereof, directly or indirectly, by the Company unless in each case (i)
the full cumulative dividends (including all accumulated, accrued and unpaid
dividends) on all outstanding shares of Preferred Stock and any other Parity
Stock of the Company shall have been paid or such dividends have been declared
and set apart for payment for all past Dividend Periods with respect to the
Preferred Stock and all past dividend periods with respect to such Parity Stock
and (ii) sufficient funds shall have been paid or set apart for the payment of
the full dividend for the current Dividend Period with respect to the Preferred
Stock and the current dividend period with respect to such Parity Stock.
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Redemption at the Option of the Company
Shares of Preferred Stock shall not be redeemable by the Company prior to
October 1, 1999. On and after October 1, 1999, the Company, at its option, may
redeem shares of Preferred Stock, in whole or from time to time in part, subject
to the provisions described below:
(i) Shares of Preferred Stock may be redeemed, in whole or in part, at the
option of the Company, at any time on or after October 1, 1999 by issuing and
delivering to each holder for each share of Preferred Stock to be redeemed such
number of authorized but previously unissued shares of Common Stock as equals
the Liquidation Preference (excluding any accumulated, accrued and unpaid
dividends which are to be paid in cash as provided below) per share of Preferred
Stock divided by the Conversion Price as in effect as of the opening of business
on the Call Date (as defined below); provided, however, that the Company may
redeem shares of Preferred Stock pursuant to this provision only if for twenty
(20) Trading Days, within any period of thirty (30) consecutive Trading Days,
including the last Trading Day of such 30-day Trading Day period, the Current
Market Price of the Common Stock on each of such 20 Trading Days equals or
exceeds the Conversion Price in effect on such Trading Day. In order to exercise
its redemption option pursuant to this provision, the Company must issue a press
release announcing the redemption (the "Press Release") prior to the opening of
business on the second Trading Day after the condition in the preceding sentence
has, from time to time, been satisfied. The Company may not issue a Press
Release prior to August 31, 1999. The Press Release shall announce the
redemption and set forth the number of shares of Preferred Stock that the
Company intends to redeem.
(ii) Shares of Preferred Stock may also be redeemed, in whole or in part,
at the option of the Company at any time on or after October 1, 1999 out of
funds legally available therefor at a redemption price payable in cash equal to
$31.00 per share of Preferred Stock (plus all accumulated, accrued and unpaid
dividends as provided below).
In the event of a redemption pursuant to paragraph (i) above, the Company
shall pay in cash all accumulated, accrued and unpaid dividends for all Dividend
Periods ending prior to the Dividend Period in which the redemption occurs; but
no dividend shall accrue or be payable on the Preferred Stock to be redeemed for
the Dividend Period in which the redemption occurs unless the Call Date is after
the record date for the dividend payable on the Common Stock for such Dividend
Period in which event each holder of Preferred Stock at the close of business on
such dividend record date shall be entitled to the dividend payable on such
shares on the corresponding Dividend Payment Date notwithstanding the redemption
of such shares prior to such Dividend Payment Date. In the event of a redemption
pursuant to paragraph (ii) above, the Company shall pay in cash all cumulative,
accrued and unpaid dividends for all Dividend Periods ending prior to the
Dividend Period in which the redemption occurs, plus the dividend (determined by
reference to the Base Rate if the Call Date precedes the date which the dividend
on the Common Stock is declared for such Dividend Period) accrued from the
beginning of the Dividend Period in which the redemption occurs and ending on
the Call Date, provided, however, that if such Call Date is after the record
date for such Dividend Period, each holder of Preferred Stock at the close of
business on such dividend record date shall be entitled to the dividend payable
on such shares on the corresponding Dividend Payment Date notwithstanding the
redemption of such shares prior to such Dividend Payment Date. Except as
provided above, the Company shall make no payment or allowance for accumulated
or accrued dividends on shares of Preferred Stock called for redemption or on
the shares of Common Stock issued upon such redemption.
Shares of Preferred Stock shall be redeemed by the Company on the date
specified in the required notice to holders (the "Call Date"). The Call Date
shall be selected by the Company, shall be specified in the notice of redemption
and shall be not less than 30 days nor more than 60 days after (i) the date on
which the Company issued the Press Release, if such redemption is pursuant to
paragraph (i) above, and (ii) the date notice of redemption is sent by the
Company, if such redemption is pursuant to paragraph (ii) above.
If full cumulative dividends on all outstanding shares of Preferred Stock
and any other class or series of Parity Stock of the Company have not been paid
or declared and set apart for payment, no shares of Preferred Stock may be
redeemed unless all outstanding shares of Preferred Stock are simultaneously
redeemed and neither the Company nor any affiliate of the Company may purchase
or acquire shares of Preferred Stock,
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otherwise than pursuant to a purchase or exchange offer made on the same terms
to all holders of shares of Preferred Stock.
If the Company shall redeem shares of Preferred Stock, notice of such
redemption shall be given to each holder of record of the shares to be redeemed
and, if such redemption is pursuant to paragraph (i) above, such notice shall be
given not more than ten (10) Business Days after the date on which the Company
issues the Press Release. Such notice shall be provided by first class mail,
postage prepaid, at such holder's address as the same appears on the stock
records of the Company, or by publication in The Wall Street Journal or The New
York Times, or if neither such newspaper is then being published, any other
daily newspaper of national circulation not less than 30 nor more than 60 days
prior to the Call Date. If the Company elects to provide such notice by
publication, it shall also promptly mail notice of such redemption to the
holders of the shares of Preferred Stock to be redeemed. Neither the failure to
mail any required notice, nor any defect therein or in the mailing thereof to
any particular holder, shall affect the sufficiency of the notice or the
validity of the proceedings for redemption with respect to the other holders.
Any notice which was mailed in the manner herein provided shall be conclusively
presumed to have been duly given on the date mailed whether or not the holder
receives the notice. Each mailed or published notice shall state, as
appropriate: (1) the Call Date; (2) the number of shares of Preferred Stock to
be redeemed and, if fewer than all such shares held by such holder are to be
redeemed, the number of such shares to be redeemed from such holder; (3) whether
redemption will be for shares of Common Stock pursuant to paragraph (i) above or
for cash pursuant to paragraph (ii) above, and, if redemption will be for Common
Stock, the number of shares of Common Stock to be issued with respect to each
share of Preferred Stock to be redeemed; (4) the place or places at which
certificates for such shares are to be surrendered for certificates representing
shares of Common Stock; and (5) the then-current Conversion Price. Notice having
been published or mailed as aforesaid, from and after the Call Date (unless the
Company shall fail to issue and make available the number of shares of Common
Stock and/or amount of cash necessary to effect such redemption), (i) except as
otherwise provided herein, dividends on the shares of Preferred Stock so called
for redemption shall cease to accumulate or accrue on the shares of Preferred
Stock called for redemption (except that, in the case of a Call Date after a
dividend record date and prior to the related Dividend Payment Date, holders of
Preferred Stock on the dividend record date will be entitled on such Dividend
Payment Date to receive the dividend payable on such shares), (ii) said shares
shall no longer be deemed to be outstanding, and (iii) all rights of the holders
thereof as holders of Preferred Stock of the Company shall cease (except the
rights to receive the shares of Common Stock and/or cash payable upon such
redemption, without interest thereon, upon surrender and endorsement of their
certificates if so required and to receive any dividends payable thereon). The
Company's obligation to provide shares of Common Stock and/or cash in accordance
with the preceding sentence shall be deemed fulfilled if, on or before the Call
Date, the Company shall deposit with a bank or trust company (which may be an
affiliate of the Company) that has, or is an affiliate of a bank or trust
company that has, a capital and surplus of at least $50,000,000, such number of
shares of Common Stock and such amount of cash as is necessary for such
redemption, in trust, with irrevocable instructions that such shares of Common
Stock and/or cash be applied to the redemption of shares of Preferred Stock so
called for redemption. In the case of any redemption pursuant to paragraph (i)
above, at the close of business on the Call Date, each holder of shares of
Preferred Stock to be redeemed (unless the Company defaults in the delivery of
the shares of Common Stock or cash payable on such Call Date) shall be deemed to
be the record holder of the number of shares of Common Stock into which such
shares of Preferred Stock are to be converted at a redemption, regardless of
whether such holder has surrendered the certificates representing the shares of
Preferred Stock to be so redeemed. No interest shall accrue for the benefit of
the holders of shares of Preferred Stock to be redeemed on any cash so set aside
by the Company. Subject to applicable escheat laws, any such cash unclaimed at
the end of two years from the Call Date shall revert to the general funds of the
Company, after which reversion the holders of shares of Preferred Stock so
called for redemption shall look only to the general funds of the Company for
the payment of such cash.
As promptly as practicable after the surrender in accordance with said
notice of the certificates for any such shares so redeemed (properly endorsed or
assigned for transfer, if the Company shall so require and if the notice shall
so state), such certificates shall be exchanged for certificates representing
shares of Common Stock and/or any cash (without interest thereon) for which such
shares have been redeemed in accordance
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with such notice. If fewer than all the outstanding shares of Preferred Stock
are to be redeemed, shares to be redeemed shall be selected by the Company from
outstanding shares of Preferred Stock not previously called for redemption by
lot or, with respect to the number of shares of Preferred Stock held of record
by each holder of such shares, pro rata (as nearly as may be) or by any other
method as may be determined by the Board of Directors in its discretion to be
equitable. If fewer than all the shares of Preferred Stock represented by any
certificate are redeemed, then a new certificate representing the unredeemed
shares shall be issued without cost to the holders thereof.
No fractional shares of Common Stock or scrip representing fractions of
shares of Common Stock shall be issued upon redemption of the shares of
Preferred Stock. Instead of any fractional interest in a share of Common Stock
that would otherwise be deliverable upon redemption of shares of Preferred
Stock, the Company shall pay to the holder of such share an amount in cash
(rounded to the nearest cent) based upon the Current Market Price of the Common
Stock on the Trading Day immediately preceding the Call Date. If more than one
share shall be surrendered for redemption at one time by the same holder, the
number of full shares of Common Stock issuable upon redemption thereof shall be
computed on the basis of the aggregate number of shares of Preferred Stock so
surrendered.
Any shares of Common Stock issued upon redemption of shares of Preferred
Stock shall be validly issued, fully paid and non-assessable. The Company shall
list, subject to official notice of issuance, the shares of Common Stock
required to be delivered upon any such redemption of shares of Preferred Stock,
prior to such redemption, upon the Nasdaq National Market or each national
securities exchange, if any, upon which the outstanding shares of Common Stock
are listed at the time of such delivery.
The Company shall take any action necessary to ensure that any shares of
Common Stock issued upon the redemption of Preferred Stock are freely
transferable and not subject to any resale restrictions under the Act, or any
applicable state securities or blue sky laws (other than any shares of Common
Stock issued upon redemption of any Preferred Stock which are held by an
"affiliate" (as defined in Rule 144 under the Act) of the Company).
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Liquidation Preference
In the event of any liquidation, dissolution or winding up of the Company,
whether voluntary or involuntary, before any payment or distribution of the
Company (whether capital or surplus) shall be made to or set apart for the
holders of Junior Stock, the holders of shares of Preferred Stock shall be
entitled to receive Thirty-One Dollars ($31.00) per share of Preferred Stock
(the "Liquidation Preference"), plus an amount equal to all dividends (whether
or not earned or declared) accumulated, accrued and unpaid thereon to the date
of final distribution to such holders, but such holders shall not be entitled to
any further payment. Until the holders of the Preferred Stock have been paid the
Liquidation Preference in full, plus an amount equal to all dividends (whether
or not earned or declared) accumulated, accrued and unpaid thereon to the date
of final distribution to such holders, no payment will be made to any holder of
Junior Stock upon the liquidation, dissolution or winding up of the Company. If,
upon any liquidation, dissolution or winding up of the Company, the assets of
the Company, or proceeds thereof, distributable among the holders of Preferred
Stock shall be insufficient to pay in full the preferential amount aforesaid and
liquidating payments on any other shares of any class or series of Parity Stock,
then such assets, or the proceeds thereof, shall be distributed among the
holders of Preferred Stock and any such other Parity Stock ratably in the same
proportion as the respective amounts that would be payable on such Preferred
Stock and any such other Parity Stock if all amounts payable thereon were paid
in full. For the purposes of this provision, (i) a consolidation or merger of
the Company with one or more corporations, (ii) a sale or transfer of all or
substantially all of the Company's assets, or (iii) a statutory share exchange
shall not be deemed to be a liquidation, dissolution or winding up, voluntary or
involuntary, of the Company.
Subject to the rights of the holders of any shares of Parity Stock, upon
any liquidation, dissolution or winding up of the Company, after payment shall
have been made in full to the holders of Preferred Stock and any Parity Stock,
any other series or class or classes of Junior Stock shall, subject to the
respective terms thereof, be entitled to receive any and all assets remaining to
be paid or distributed, and the holders of the Preferred Stock and any Parity
Stock shall not be entitled to share therein.
Voting Rights
(a) If and whenever (i) six quarterly dividends (whether or not
consecutive) payable on the Preferred Stock or any series or class of Parity
Stock shall be in arrears (which shall, with respect to any such quarterly
dividend, mean that any such dividend has not been paid in full), whether or not
earned or declared, or (ii) the consolidated shareholders' equity of the Company
(determined in accordance with generally accepted accounting principles and
giving effect to any adjustment for the net unrealized gain or loss on assets
available for sale) at the end of any calendar quarter is less than 150% of the
sum of (a) the aggregate Liquidation Preference (excluding any accumulated,
accrued and unpaid dividends) of the then outstanding Preferred Stock and (b)
the aggregate liquidation preference (excluding any accumulated, accrued and
unpaid dividends) of any then outstanding Parity Stock, the number of directors
then constituting the Board of Directors shall be increased by two (if not
already increased by reason of similar types of provisions with respect to
Voting Preferred Stock (as defined below)) and the holders of shares of
Preferred Stock, together with the holders of shares of every other class or
series of Parity Stock (any other such series, the "Voting Preferred Stock"),
voting as a single class regardless of series, shall be entitled to elect the
two additional directors to serve on the Board of Directors at any annual
meeting of stockholders or special meeting held in place thereof, or at a
special meeting of the holders of the Preferred Stock and the Voting Preferred
Stock called as hereinafter provided. Notwithstanding anything herein to the
contrary, if any class or series of Voting Preferred Stock (with which the
Preferred Stock is entitled to vote as a single class) is entitled to elect two
directors as a result of a failure to maintain a specified level of consolidated
shareholders' equity required by the terms of such Voting Preferred Stock, then
when such entitlement is triggered, the separate entitlement to elect two
directors shall be suspended. Whenever the entitlement of the Preferred Stock
(together with holders of Voting Preferred Stock voting as a single class
regardless of series) to vote is suspended as described in the preceding
sentence, the terms of office of all persons elected as directors shall
terminate upon the election of the two directors elected pursuant to a vote of
the Preferred Stock and Voting Preferred Stock voting as a single class as a
result of a failure to maintain a specified level of consolidated shareholders'
equity
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required by the terms of such class or series of Voting Preferred Stock.
Whenever (1) in the case of an arrearage in dividends described in clause (i),
all arrears in dividends on the Preferred Stock and the Voting Preferred Stock
then outstanding shall have been paid and dividends thereon for the current
quarterly dividend period shall have been paid or declared and set apart for
payment, or (2) in the case of a shortfall in the Company's consolidated
shareholders' equity described in clause (ii), the consolidated shareholders'
equity of the Company (determined in accordance with generally accepted
accounting principles and giving effect to any adjustment for the net unrealized
gain or loss on assets available for sale) at the end of any subsequent calendar
quarter equals or exceeds 150% of the sum of (a) the aggregate Liquidation
Preference (excluding any accumulated, accrued and unpaid dividends) of the then
outstanding Preferred Stock and (b) the aggregate liquidation preference
(excluding any accumulated, accrued and unpaid dividends) of the then
outstanding Parity Stock, then the right of the holders of the Preferred Stock
and the Voting Preferred Stock to elect such additional two directors shall
cease (but subject always to the same provision for the vesting of such voting
rights in the case of any similar future arrearages in six quarterly dividends
or shortfall in consolidated shareholders' equity), and the terms of office of
all persons elected as directors by the holders of the Preferred Stock and the
Voting Preferred Stock shall forthwith terminate and the number of the Board of
Directors shall be reduced accordingly. At any time after such voting power
shall have been so vested in the holders of Preferred Stock and the Voting
Preferred Stock, if applicable, the Secretary of the Company may, and upon the
written request of any holder of Preferred Stock (addressed to the Secretary at
the principal office of the Company) shall, call a special meeting of the
holders of the Preferred Stock and of the Voting Preferred Stock for the
election of the two Directors to be elected by them as herein provided, such
call to be made by notice similar to that provided in the Bylaws of the Company
for a special meeting of the stockholders or as required by law. If any such
special meeting required to be called as above provided shall not be called by
the Secretary within 20 days after receipt of any such request, then any holder
of Preferred Stock may call such meeting, upon the notice above provided, and
for that purpose shall have access to the stock books of the Company. The
Directors elected at any such special meeting shall hold office until the next
annual meeting of the stockholders or special meeting held in lieu thereof if
such office shall not have previously terminated as above provided. If any
vacancy shall occur among the Directors elected by the holders of the Preferred
Stock and the Voting Preferred Stock, a successor shall be elected by the Board
of Directors, upon the nomination of the then-remaining Director elected by the
holders of the Preferred Stock and the Voting Preferred Stock or the successor
of such remaining Director, to serve until the next annual meeting of the
stockholders or special meeting held in place thereof if such office shall not
have previously terminated as provided above.
(b) So long as any shares of Preferred Stock are outstanding, in addition
to any other vote or consent of stockholders required by law or by the Articles
of Incorporation of the Company, as amended, the affirmative vote of at least
66 2/3% of the votes entitled to be cast by the holders of the Preferred Stock,
given in person or by proxy, either in writing without a meeting or by vote at
any meeting called for the purpose, shall be necessary for effecting or
validating:
(i) Any amendment, alteration or repeal or any of the provisions of
the Articles Supplementary to the Articles of Incorporation of the Company
creating the Preferred Stock, the Articles of Incorporation of the Company
or the Bylaws of the Company that materially adversely affects the voting
powers, rights or preferences of the holders of the Preferred Stock;
provided, however, that the amendment of the provisions of the Articles of
Incorporation so as to authorize or create, or to increase the authorized
amount of, any Junior Stock or any shares of any class ranking on a parity
with the Preferred Stock shall not be deemed to materially adversely affect
the voting powers, rights or preferences of the holders of Preferred Stock;
or
(ii) The authorization or creation of, or the increase in the
authorized amount of, any shares of any class or any security convertible
into shares of any class ranking prior or senior to the Preferred Stock in
the distribution of assets on any liquidation, dissolution or winding up of
the Company or in the payment of dividends; provided, however, that no such
vote of the holders of Preferred Stock shall be required if, at or prior to
the time when such amendment, alteration or repeal is to take effect, or
when the issuance of
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any such prior shares or convertible security is to be made, as the case
may be, provision is made for the redemption of all shares of Preferred
Stock at the time outstanding.
For purposes of the foregoing provisions and all other voting rights under
the Articles Supplementary, each share of Preferred Stock shall have one (1)
vote per share, except that when any other class or series of preferred stock
shall have the right to vote with the Preferred Stock as a single class on any
matter, then the Preferred Stock and such other class or series shall have with
respect to such matters one (1) vote per $31.00 of the stated Liquidation
Preference. Except as otherwise required by applicable law or as set forth
herein, the Preferred Stock shall not have any relative, participating, optional
or other special voting rights and powers other than as set forth herein, and
the consent of the holders thereof shall not be required for the taking of any
corporate action.
Conversion
Holders of shares of Preferred Stock shall have the right to convert all or
a portion of such shares into shares of Common Stock, as follows:
A holder of shares of Preferred Stock shall have the right, at such
holder's option, at any time to convert such shares, in whole or in part, into
the number of fully paid and non-assessable shares of authorized but previously
unissued shares of Common Stock per each share of Preferred Stock obtained by
dividing the Liquidation Preference (excluding any accumulated, accrued and
unpaid dividends) per share of Preferred Stock by the Conversion Price and by
surrendering such shares to be converted; provided, however, that the right to
convert shares of Preferred Stock called for redemption shall terminate at the
close of business on the Call Date fixed for such redemption, unless the Company
shall default in making payment of shares of Common Stock and/or cash payable
upon such redemption.
In order to exercise the conversion right, the holder of each share of
Preferred Stock to be converted shall surrender the certificate representing
such share, duly endorsed or assigned to the Company or in blank, at the office
of the Transfer Agent, accompanied by written notice to the Company that the
holder thereof elects to convert such share of Preferred Stock. Unless the
shares issuable on conversion are to be issued in the same name as the name in
which such share of Preferred Stock is registered, each share surrendered for
conversion shall be accompanied by instruments of transfer, in form satisfactory
to the Company, duly executed by the holder or such holder's duly authorized
attorney and an amount sufficient to pay any transfer or similar tax (or
evidence reasonably satisfactory to the Company demonstrating that such taxes
have been paid).
Holders of shares of Preferred Stock at the close of business on a dividend
payment record date shall be entitled to receive the dividend payable on such
shares on the corresponding Dividend Payment Date notwithstanding the conversion
thereof following such dividend payment record date and prior to such Dividend
Payment Date. Except as provided above, the Company shall make no payment or
allowance for unpaid dividends, whether or not in arrears, on converted shares
or for dividends on the shares of Common Stock issued upon such conversion.
As promptly as practicable after the surrender of certificates for shares
of Preferred Stock as aforesaid, the Company shall issue and shall deliver at
such office to such holder, or send on such holder's written order, a
certificate or certificates for the number of full shares of Common Stock
issuable upon the conversion of such shares of Preferred Stock, and any
fractional interest in respect of a share of Common Stock arising upon such
conversion shall be settled as provided herein.
Each conversion shall be deemed to have been effected immediately prior to
the close of business on the date on which the certificates for shares of
Preferred Stock shall have been surrendered and such notice received by the
Company as aforesaid, and the person or persons in whose name or names any
certificate or certificates for shares of Common Stock shall be issuable upon
such conversion shall be deemed to have become the holder or holders of record
of the shares represented thereby at such time on such date and such conversion
shall be at the Conversion Price in effect at such time on such date unless the
stock transfer books of the Company shall be closed on that date, in which event
such person or persons shall be deemed to have become such holder or holders of
record at the close of business on the next succeeding day on which such
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stock transfer books are open, but such conversion shall be at the Conversion
Price in effect on the date on which such shares shall have been surrendered and
such notice received by the Company. If the dividend record date for the
Preferred Stock and Common Stock do not coincide, and the preceding sentence
does not operate to ensure that a holder of shares of Preferred Stock whose
shares are converted into Common Stock does not receive dividends on both the
shares of Preferred Stock and the Common Stock into which such shares are
converted for the same Dividend Period, then notwithstanding anything herein to
the contrary, it is the intent, and the Transfer Agent is authorized to ensure
that no conversion after the earlier of such record dates will be accepted until
after the latter of such record dates; conversely, if the dividend record date
for the Preferred Stock and the Common Stock do not coincide, and a holder of
shares of Preferred Stock whose shares are converted into Common Stock would
receive a dividend on neither the Preferred Stock nor the Common Stock for the
related Dividend Period, the Transfer Agent is likewise authorized to defer
giving effect to the conversion until after the latter of such record dates.
No fractional share of Common Stock or scrip representing fractions of a
share of Common Stock shall be issued upon conversion of the shares of Preferred
Stock. Instead of any fractional interest in a share of Common Stock that would
otherwise be deliverable upon the conversion of shares of Preferred Stock, the
Company shall pay to the holder of such share an amount in cash based upon the
Current Market Price of the Common Stock on the Trading Date immediately
preceding the date of conversion. If more than one share shall be surrendered
for conversion at one time by the same holder, the number of full shares of
Common Stock issuable upon conversion thereof shall be computed on the basis of
the aggregate number of shares of Preferred Stock so surrendered.
The Conversion Price shall be adjusted from time to time as follows:
(i) If the Company shall after the Issue Date (A) pay a dividend or make a
distribution on its capital stock in shares of Common Stock, (B) subdivide its
outstanding Common Stock into a greater number of shares, (C) combine its
outstanding Common Stock into a smaller number of shares or (D) issue any shares
of capital stock by reclassification of its outstanding Common Stock, the
Conversion Price in effect at the opening of business on the day following the
date fixed for the determination of stockholders entitled to receive such
dividend or distribution or at the opening of business on the day following the
day on which such subdivision, combination or reclassification becomes
effective, as the case may be, shall be adjusted so that the holder of any share
of Preferred Stock thereafter surrendered for conversion shall be entitled to
receive the number of shares of Common Stock (or fraction of a share of Common
Stock) that such holder would have owned or have been entitled to receive after
the happening of any of the events described above had such share of Preferred
Stock been converted immediately prior to the record date in the case of a
dividend or distribution or the effective date in the case of a subdivision,
combination or reclassification. An adjustment shall become effective
immediately after the opening of business on the day next following the record
date (except as provided below) in the case of a dividend or distribution and
shall become effective immediately after the opening of business on the day next
following the effective date in the case of a subdivision, combination or
reclassification.
(ii) If the Company shall issue after the Issue Date rights, options or
warrants to all holders of Common Stock entitling them (for a period expiring
within 45 days after the record date described below) to subscribe for or
purchase Common Stock at a price per share less than the Fair Market Value per
share of the Common Stock on the record date for the determination of
stockholders entitled to receive such rights, options or warrants, then the
Conversion Price in effect at the opening of business on the day next following
such record date shall be adjusted to equal the price determined by multiplying
(A) the Conversion Price in effect immediately prior to the opening of business
on the day following the date fixed for such determination by (B) a fraction,
the numerator of which shall be the sum of (X) the number of shares of Common
Stock outstanding on the close of business on the date fixed for such
determination and (Y) the number of shares that could be purchased at such Fair
Market Value from the aggregate proceeds to the Company from the exercise of
such rights or warrants for Common Stock, and the denominator of which shall be
the sum of (XX) the number of shares of Common Stock outstanding on the close of
business on the date fixed for such determination and (YY) the number of
additional shares of Common Stock offered for subscription or purchase pursuant
to such rights or warrants. Such adjustment shall become effective immediately
after the
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opening of business on the date next following such record date (except as
provided below). In determining whether any rights, options or warrants entitle
the holders of Common Stock to subscribe for or purchase Common Stock at less
than such Fair Market Value, there shall be taken into account any consideration
received by the Company upon issuance and upon exercise of such rights, options
or warrants, the value of such consideration, if other than cash, to be
determined in good faith by the Board of Directors.
(iii) If the Company shall after the Issue Date make a distribution on its
Common Stock other than in cash or shares of Common Stock (including any
distribution in securities other than rights, options or warrants as set forth
below) (each of the foregoing being referred to herein as a "distribution"),
then the Conversion Price in effect at the opening of business on the next day
following the record date for the determination of stockholders entitled to
receive such distribution shall be adjusted to equal the price determined by
multiplying (A) the Conversion Price in effect immediately prior to the opening
of business on the day following the record date by (B) a fraction, the
numerator of which shall be the difference between (X) the number of shares of
Common Stock outstanding on the close of business on the record date and (Y) the
number of shares determined by dividing (aa) the aggregate value of the property
being distributed by (bb) the Fair Market Value per share of Common Stock on the
record date, and the denominator of which shall be the number of shares of
Common Stock outstanding on the close of business on the record date. Such
adjustment shall become effective immediately after the opening of business on
the day next following such record date (except as provided below). The value of
the property being distributed shall be as determined in good faith by the Board
of Directors. Neither the issuance by the Company of rights, options or warrants
to subscribe for or purchase securities of the Company nor the exercise thereof
shall be deemed a distribution under this paragraph. Notwithstanding the
foregoing provisions of this paragraph, the Company will not make any
distribution that, when taken together with all prior distributions after the
Issue Date, would result in an aggregate adjustment constituting 50% or more of
the Conversion Price on the Issue Date without obtaining prior consent by the
affirmative vote of at least 66 2/3% of the votes entitled to be cast by the
holders of Preferred Stock and any other class or series of preferred stock at
the time outstanding that constitutes Parity Stock, voting together as a single
class, given in person or by proxy, either in writing without a meeting or by
vote at any meeting called for the purpose.
(iv) No adjustment in the Conversion Price shall be required unless such
adjustment would require a cumulative increase or decrease of at least 1% in
such price; provided, however, that any adjustments that by reason of this
paragraph are not required to be made shall be carried forward and taken into
account in any subsequent adjustment until made; and provided, further, that any
adjustment shall be required and made not later than such time as may be
required in order to preserve the tax-free nature of a distribution to the
holders of shares of Common Stock. Notwithstanding any other provision, the
Company shall not be required to make any adjustment of the Conversion Price for
the issuance of (A) any shares of Common Stock pursuant to any plan providing
for the reinvestment of dividends or interest payable on securities of the
Company and the investment of optional amounts in shares of Common Stock under
such plan or (B) any options, rights or shares of Common Stock pursuant to any
stock option, stock purchase or other stock-based plan maintained by the
Company. All calculations shall be made to the nearest cent (with $.005 being
rounded upward) or to the nearest one-tenth of a share (with .05 of a share
being rounded upward), as the case may be. Anything to the contrary
notwithstanding, the Company shall be entitled, to the extent permitted by law,
to make such reductions in the Conversion Price, in addition to those required,
as it in its discretion shall determine to be advisable in order that any stock
dividends, subdivision of shares, reclassification or combination of shares,
distribution of rights or warrants to purchase stock or securities, or a
distribution of other assets (other than cash dividends) hereafter made by the
Company to its stockholders shall not be taxable, or if that is not possible, to
diminish any income taxes that are otherwise payable because of such event.
If the Company shall be a party to any transaction (including without
limitation a merger, consolidation, statutory share exchange, issuer or self
tender offer for all or a substantial portion of the shares of Common Stock
outstanding, sale of all or substantially all of the Company's assets or
recapitalization of the Common Stock, but excluding any transaction as to which
the Conversion Price adjustment provision applies) (each of the foregoing being
referred to herein as a "Transaction"), in each case as a result of which shares
of Common Stock shall be converted into the right to receive stock, securities
or other property (including cash or any combination thereof), each share of
Preferred Stock which is not converted into the right to receive stock,
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securities or other property in connection with such Transaction shall thereupon
be convertible into the kind and amount of shares of stock, securities and other
property (including cash or any combination thereof) receivable upon such
consummation by a holder of that number of shares of Common Stock into which one
share of Preferred Stock was convertible immediately prior to such Transaction.
The Company shall not be a party to any Transaction unless the terms of such
Transaction are consistent with the provisions of this paragraph, and it shall
not consent or agree to the occurrence of any Transaction until the Company has
entered into an agreement with the successor or purchasing entity, as the case
may be, for the benefit of the holders of the Preferred Stock that will contain
provisions enabling the holders of the Preferred Stock that remain outstanding
after such Transaction to convert into the consideration received by holders of
Common Stock at the Conversion Price in effect immediately prior to such
Transaction. The provisions of this paragraph shall similarly apply to
successive Transactions.
If:
(i) the Company shall declare a dividend (or any other distribution)
on the Common Stock (other than cash dividends and cash distributions); or
(ii) the Company shall authorize the granting to all holders of the
Common Stock of rights or warrants to subscribe for or purchase any shares
of any class or series of capital stock or any other rights or warrants; or
(iii) there shall be any reclassification of the outstanding Common
Stock or any consolidation or merger to which the Company is a party and
for which approval of any stockholders of the Company is required, or a
statutory share exchange, or an issuer or self tender offer by the Company
for all or a substantial portion of its outstanding shares of Common Stock
(or an amendment thereto changing the maximum number of shares sought or
the amount or type of consideration being offered therefor) or the sale or
transfer of all or substantially all of the assets of the Company as an
entirety; or
(iv) there shall occur the voluntary or involuntary liquidation,
dissolution or winding up of the Company,
then the Company shall cause to be filed with the Transfer Agent and shall cause
to be mailed to each holder of shares of Preferred Stock at such holder's
address as shown on the stock records of the Company, as promptly as possible,
but at least 15 days prior to the applicable date hereinafter specified, a
notice stating (A) the record date for the payment of such dividend,
distribution or rights or warrants, or, if a record date is not established, the
date as of which the holders of Common Stock of record to be entitled to such
dividend, distribution or rights or warrants are to be determined or (B) the
date on which such reclassification, consolidation, merger, statutory share
exchange, sale, transfer, liquidation, dissolution or winding up is expected to
become effective, and the date as of which it is expected that holders of Common
Stock of record shall be entitled to exchange their shares of Common Stock for
securities or other property, if any, deliverable upon such reclassification,
consolidation, merger, statutory share exchange, sale, transfer, liquidation,
dissolution or winding up or (C) the date on which such tender offer commenced,
the date on which such tender offer is scheduled to expire unless extended, the
consideration offered and the other material terms thereof (or the material
terms of any amendment thereto). Failure to give or receive such notice or any
defect therein shall not affect the legality or validity of the proceedings
described herein.
Whenever the Conversion Price is adjusted as herein described, the Company
shall promptly file with the Transfer Agent an officer's certificate setting
forth the Conversion Price after such adjustment and setting forth a brief
statement of the facts requiring such adjustment which certificate shall be
conclusive evidence of the correctness of such adjustment absent manifest error.
Promptly after delivery of such certificate, the Company shall prepare a notice
of such adjustment of the Conversion Price setting forth the adjusted Conversion
Price and the effective date such adjustment becomes effective and shall mail
such notice of such adjustment of the Conversion Price to each holder of shares
of Preferred Stock at such holder's last address as shown on the stock records
of the Company.
In any case in which these provisions provide that an adjustment shall
become effective on the day next following the record date for an event, the
Company may defer until the occurrence of such event (A) issuing to the holder
of any share of Preferred Stock converted after such record date and before the
occurrence of such event of the additional Common Stock issuable upon such
conversion by reason of the adjustment
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required by such event over and above the Common Stock issuable upon such
conversion before giving effect to such adjustment and (B) paying to such holder
any amount of cash in lieu of any fraction.
There shall be no other adjustment of the Conversion Price in case of the
issuance of any capital stock of the Company in a reorganization, acquisition or
other similar transaction.
If the Company shall take any action affecting the Common Stock, other than
action described in this provision, that in the opinion of the Board of
Directors would materially adversely affect the conversion rights of the holders
of Preferred Stock, the Conversion Price for the Preferred Stock may be
adjusted, to the extent permitted by law, in such manner, if any, and at such
time as the Board of Directors, in its sole discretion, may determine to be
equitable under the circumstances.
The Company shall at all times reserve and keep available, free from
preemptive rights, out of the aggregate of its authorized but unissued Common
Stock solely for the purpose of effecting conversion of the Preferred Stock, the
full number of shares of Common Stock deliverable upon the conversion of all
outstanding shares of Preferred Stock not theretofore converted into Common
Stock. For purposes of this provision, the number of shares of Common Stock that
shall be deliverable upon the conversion of all outstanding shares of Preferred
Stock shall be computed as if at the time of computation all such outstanding
shares were held by a single holder (and without regard to the Ownership Limit
set forth in the Charter of the Company).
The Company covenants that any shares of Common Stock issued upon
conversion of the shares of Preferred Stock shall be validly issued, fully paid
and nonassessable.
The Company shall take any action necessary to ensure that any shares of
Common Stock issued upon conversion of shares of Preferred Stock are freely
transferable and not subject to any resale restrictions under the Act, or any
applicable state securities or blue sky laws (other than any shares of Common
Stock which are held by an "affiliate" (as defined in Rule 144 under the Act)).
The Company will pay any and all documentary stamp or similar issue or
transfer taxes payable in respect of the issue or delivery of shares of Common
Stock or other securities or property on conversion or redemption of shares of
Preferred Stock pursuant hereto; provided, however, that the Company shall not
be required to pay any tax that may be payable in respect of any transfer
involved in the issue or delivery of shares of Common Stock or other securities
or property in a name other than that of the holder of the shares of Preferred
Stock to be converted or redeemed, and no such issue or delivery shall be made
unless and until the person requesting such issue or delivery has paid to the
Company the amount of any such tax or established, to the reasonable
satisfaction of the Company, that such tax has been paid.
Dividend Reinvestment Plan
The Company has established a Dividend Reinvestment Plan (the "Plan" or
"DRP") pursuant to which each holder of the Preferred Stock whose shares are
registered in his own name may elect to have dividends reinvested automatically
in shares of the Common Stock of the Company. See "Dividend Reinvestment Plan."
Restrictions on Ownership and Transfer
With certain exceptions, no person may own, or be deemed to own by virtue
of the attribution provisions of the Code, more than 9.8% of the Company's
Capital Stock. See "Repurchase of Shares and Restrictions on Transfers," below.
COMMON STOCK
Voting
Each holder of Common Stock is entitled to one vote for each share held of
record on each matter submitted to a vote of holders of Capital Stock of the
Company. The Company's Articles of Incorporation do
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not provide for cumulative voting and, accordingly, the holders of a majority of
the outstanding shares of Capital Stock have the power to elect all directors to
be elected each year.
The Company's bylaws provide that annual meetings of the stockholders of
the Company are to be held within 180 days of the last day of the Company's
fiscal year, and special meetings may be called by a majority of the Board of
Directors, by the Chairman of the Board of Directors, by a majority of the
Independent Directors, by the President or generally by stockholders entitled to
cast at least 25% of the votes which all stockholders are entitled to cast at
the meeting. The Articles of Incorporation of the Company may be amended in
accordance with Maryland law, subject to certain limitations set forth in the
Articles of Incorporation.
Dividends; Liquidation; Other Rights
The holders of shares of Common Stock are entitled to receive dividends
when, as, and if declared by the Board of Directors out of funds legally
available therefor, subject to the rights of the holders of Preferred Stock and
any other class or series of preferred stock that may be issued in the future.
In the event of liquidation, dissolution or winding up of the Company, the
holders of Common Stock will share ratably in all assets of the Company
remaining after the payment of liabilities and after payment of the liquidation
preference of outstanding Preferred Stock and any other class or series of
preferred stock that may be issued in the future. There are no preemptive or
other subscription rights, conversion rights, or redemption or sinking fund
provisions with respect to shares of Common Stock.
REGISTRATION RIGHTS
Purchasers of Units in the Company's private placement in 1994 are entitled
to certain rights with respect to registration under the Securities Act.
Pursuant to a Registration Rights Agreement between the Company and the
Placement Agent, the Company agreed to (i) file with the Commission a shelf
registration statement (the "Shelf Registration Statement") with respect to the
securities comprising the Units or issuable upon conversion or exercise thereof,
and (ii) use its best efforts to have such securities approved for quotation on
the Nasdaq National Market or listed on a stock exchange and/or to qualify such
securities under the various state securities laws. The Company is required to
keep the Shelf Registration Statement effective until the earlier to occur of
(i) December 31, 1997 or (ii) such time as all of the Warrants have been
exercised and, in the opinion of counsel to the Company, such registration is
not required for the unrestricted resale of shares entitled to registration
rights under the Registration Rights Agreement. Under the Registration Rights
Agreement, the holders of the Securities may be restricted from selling or
distributing the Company's securities during certain underwritten offerings by
the Company. See "Underwriting."
Certain existing holders of the Common Stock are entitled to certain rights
with respect to registration under the Securities Act of such Common Stock.
Under the terms of a registration rights agreement with such holders, such
holders are entitled to include within any registration statement under the
Securities Act proposed by the Company with respect to a firm commitment
underwritten public offering of Common Stock (either for its own account or for
the account of other security holders) shares of Common Stock held by such
holders, subject to certain conditions.
REPURCHASE OF SHARES AND RESTRICTIONS ON TRANSFER
In order that the Company may meet the requirements for qualification as a
REIT at all times, the Articles of Incorporation prohibit any person from
acquiring or holding, directly or constructively, ownership of a number of
shares of Capital Stock in excess of 9.8% (the "Ownership Limit") of the
outstanding shares. See "Certain Federal Income Tax Considerations." For this
purpose the term "ownership" generally means either direct ownership or
constructive ownership in accordance with the constructive ownership provisions
of section 544 of the Code.
Under the constructive ownership provisions of section 544 of the Code, a
holder of a Warrant will be treated as owning the number of shares of Capital
Stock into which such Warrant may be converted. In addition, the constructive
ownership rules generally attribute ownership of securities owned by a
corporation, partnership, estate or trust proportionately to its stockholders,
partners or beneficiaries, attribute ownership of securities owned by family
members to other members of the same family, and set forth rules as to when
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securities constructively owned by a person are considered to be actually owned
for the application of such attribution provisions (i.e., "reattribution"). For
purposes of determining whether a person holds or would hold Capital Stock in
excess of the Ownership Limit, a person will thus be treated as owning not only
shares of Capital Stock actually owned, but also any shares of Capital Stock
attributed to such person under the attribution rules described above (including
any shares of Capital Stock attributed to such person by reason of such person's
ownership of Warrants). Accordingly, a person who individually owns less than
9.8% of the shares outstanding may nevertheless be in violation of the Ownership
Limit.
Any transfer of shares of Capital Stock or Warrants that would result in
disqualification of the Company as a REIT or that would (a) create a direct or
constructive ownership of shares of stock in excess of the Ownership Limit, (b)
result in the shares of stock being beneficially owned (within the meaning of
section 856(a) of the Code) by fewer than 100 persons (determined without
reference to any rules of attribution), or (c) result in the Company being
"closely held" within the meaning of section 856(h) of the Code, will be null
and void, and the intended transferee will acquire no rights to such shares or
Warrants. The foregoing restrictions on transferability and ownership will not
apply if the Board of Directors determines that it is no longer in the best
interests of the Company to continue to qualify as a REIT. The Company's Board
of Directors, upon receipt of a ruling from the IRS, an opinion of counsel or
other evidence satisfactory to the Board of Directors, may also waive the
Ownership Limit with respect to a purported transferee. As a condition to such
waiver the intended transferee must give written notice to the Company of the
proposed transfer no later than the fifteenth day prior to any transfer which,
if consummated, would result in the intended transferee owning shares in excess
of the Ownership Limit. The Board of Directors may also take such other action
as it deems necessary or advisable to protect the Company's status as a REIT.
Any purported transfer of shares or Warrants that would result in a person
owning (directly or constructively) shares in excess of the Ownership Limit
(except as otherwise waived by the Board of Directors as set forth above) due to
the unenforceability of the transfer restrictions set forth above will
constitute "Excess Securities," which will be transferred by operation of law to
the Company as trustee for the exclusive benefit of the person or persons to
whom the Excess Securities are ultimately transferred, until such time as the
purported transferee retransfers the Excess Securities. While the Excess
Securities are held in trust, a holder of such securities will not be entitled
to vote or to share in any dividends or other distributions with respect to such
securities and will not be entitled to exercise or convert such securities into
shares of Capital Stock. Subject to the Ownership Limit, Excess Securities may
be transferred by the purported transferee to any person (if such transfer would
not result in Excess Securities) at a price not to exceed the price paid by the
purported transferee (or, if no consideration was paid by the purported
transferee, the fair market value of the Excess Securities on the date of the
purported transfer), at which point the Excess Securities will automatically be
exchanged for the stock or Warrants, as the case may be, to which the Excess
Securities are attributable. If a purported transferee receives a higher price
for designating an ultimate transferee, such purported transferee shall pay, or
cause the ultimate transferee to pay, such excess to the Company. In addition,
such Excess Securities held in trust are subject to purchase by the Company at a
purchase price equal to the lesser of (a) the price per share or per warrant, as
the case may be, in the transaction that created such Excess Securities (or, in
the case of a devise or gift, the market price at the time of such devise or
gift), reduced by the amount of any distributions received in violation of the
Articles of Incorporation that have not been repaid to the Company, and (b) the
market price as reflected in the last reported sales price of such shares of
stock or Warrants on the trading day immediately preceding the date of the
purchase by the Company as reported on any exchange or quotation system over
which such shares of stock or Warrants may be traded, or if not then traded over
any exchange or quotation system, then the market price of such shares of stock
or Warrants on the date of the purported transfer as determined in good faith by
the Board of Directors of the Company, reduced by the amount of any
distributions received in violation of the Articles of Incorporation that have
not been repaid to the Company.
From and after a purported transfer to the transferee of the Excess
Securities, the purported transferee shall cease to be entitled to
distributions, voting rights and other benefits with respect to such shares of
the stock or Warrants except the right to payment of the purchase price for the
shares of stock or Warrants or the retransfer of securities as provided above.
Any dividend or distribution paid to a purported transferee on
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Excess Securities prior to the discovery by the Company that such shares of
stock or Warrants have been transferred in violation of the provisions of the
Company's Articles of Incorporation shall be repaid to the Company upon demand.
If the foregoing transfer restrictions are determined to be void, invalid or
unenforceable by a court of competent jurisdiction, then the purported
transferee of any Excess Securities may be deemed, at the option of the Company,
to have acted as an agent on behalf of the Company in acquiring such Excess
Securities and to hold such Excess Securities on behalf of the Company.
All certificates representing shares of stock and Warrants will bear a
legend referring to the restrictions described above.
Any person who acquires shares or Warrants in violation of the Articles of
Incorporation, or any person who is a purported transferee such that Excess
Securities results, must immediately give written notice or, in the event of a
proposed or attempted transfer that would be void as set forth above, give at
least 15 days prior written notice to the Company of such event and shall
provide to the Company such other information as the Company may request in
order to determine the effect, if any, of such transfer on the Company's status
as a REIT. In addition, every record owner of more than 5.0% (during any period
in which the number of stockholders of record is 2,000 or more) or 1.0% (during
any period in which the number of stockholders of record is greater than 200 but
less than 2,000) or 1/2% (during any period in which the number of stockholders
is 200 or less) of the number or value of the outstanding shares of Capital
Stock of the Company must give an annual written notice to the Company by
January 31, stating the name and address of the record owner, the number of
shares held and describing how such shares are held. Further, each stockholder
shall upon demand be required to disclose to the Company in writing such
additional information as the Board of Directors deems reasonably necessary to
comply with the REIT Provisions of the Code, to comply with the requirements of
any taxing authority or governmental agency or to determine any such compliance.
Subject to certain limitations, the Board of Directors may increase or
decrease the Ownership Limit. In addition, to the extent consistent with the
REIT Provisions of the Code, the Board of Directors may waive the Ownership
Limit for and at the request of certain purchasers in this Offering.
The provisions described above may inhibit market activity and the
resulting opportunity for the holders of the Company's Capital Stock and
Warrants to receive a premium for their shares or Warrants that might otherwise
exist in the absence of such provisions. Such provisions also may make the
Company an unsuitable investment vehicle for any person seeking to obtain
ownership of more than 9.8% of the outstanding shares of its Capital Stock.
INDEMNIFICATION
The Company's Articles of Incorporation obligate the Company to indemnify
its directors and officers, and other employees and agents, and to pay or
reimburse expenses for such individuals in advance of the final disposition of a
proceeding to the maximum extent permitted from time to time by Maryland law.
The Maryland General Corporation Law (the "Maryland GCL") permits a corporation
to indemnify its present and former directors and officers, among others,
against judgments, penalties, fines, settlements and reasonable expenses
actually incurred by them in connection with any proceeding to which they may be
made a party by reason of their service in those or other capacities, unless it
is established that (a) the act or omission of the director or officer was
material to the matter giving rise to the proceeding and (i) was committed in
bad faith, or (ii) was the result of active and deliberate dishonesty, or (b)
the director or officer actually received an improper personal benefit in money,
property or services, or (c) in the case of any criminal proceeding, the
director or officer had reasonable cause to believe that the act or omission was
unlawful.
LIMITATION OF LIABILITY
The Maryland GCL permits the charter of a Maryland corporation to include a
provision limiting the liability of its directors and officers to the
corporation and its stockholders for money damages, except to the extent that
(i) it is proved that the person actually received an improper benefit or profit
in money, property or services, or (ii) a judgment or other final adjudication
is entered in a proceeding based on a finding that the
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person's action, or failure to act, was the result of active and deliberate
dishonesty and was material to the cause of action adjudicated in the
proceeding. The Company's Articles of Incorporation contain a provision
providing for elimination of the liability of its directors and officers to the
Company or its stockholders for money damages to the maximum extent permitted by
Maryland law from time to time.
CONTROL SHARE ACQUISITIONS
The Maryland GCL provides that "control shares" of a Maryland corporation
acquired in a "control share acquisition" have no voting rights except to the
extent approved by a vote of two-thirds of the votes entitled to be cast on the
matter, excluding shares of stock owned by the acquiror or by officers or
directors who are employees of the corporation. "Control shares" are voting
shares of stock which, if aggregated with all other shares of stock previously
acquired by such a person, would entitle the acquiror to exercise voting power
in electing directors within one of the following ranges of voting power: (i)
one-fifth or more but less than one-third, (ii) one-third or more but less than
a majority, or (iii) a majority or more of all voting power. "Control shares" do
not include shares of stock the acquiring person is then entitled to vote as a
result of having previously obtained stockholder approval. A "control share
acquisition" means, subject to certain exceptions, the acquisition of, ownership
of, or the power to direct the exercise of voting power with respect to, control
shares.
A person who has made or proposes to make a "control share acquisition,"
upon satisfaction of certain conditions (including an undertaking to pay
expenses), may compel the Board of Directors to call a special meeting of
stockholders to be held within 50 days of demand to consider the voting rights
of the shares. If no request for a meeting is made, the corporation may itself
present the question at any stockholders' meeting. If voting rights are not
approved at the meeting or if the acquiring person does not deliver an acquiring
person statement as permitted by the statute, then, subject to certain
conditions and limitations, the corporation may redeem any or all of the
"control shares" (except those for which voting rights have previously been
approved) for fair value determined, without regard to the absence of voting
rights, as of the date of the last control share acquisition or of any meeting
of stockholders at which the voting rights of such shares are considered and not
approved. If voting rights for "control shares" are approved at a stockholders
meeting and the acquiror becomes entitled to vote a majority of the shares
entitled to vote, all other stockholders may exercise appraisal rights. The fair
value of the stock as determined for purposes of such appraisal rights may not
be less than the highest price per share paid in the control share acquisition,
and certain limitations and restrictions otherwise applicable to the exercise of
dissenters' rights do not apply in the context of "control share acquisitions."
The "control share acquisition" statute does not apply to stock acquired in
a merger, consolidation or share exchange if the corporation is a party to the
transaction, or to acquisitions approved or exempted by a provision of the
Articles of Incorporation or bylaws of the corporation adopted prior to the
acquisition of the shares.
TRANSFER AGENT AND REGISTRAR
Chase Mellon Shareholder Services, LLC acts as the transfer agent and
registrar with respect to the Preferred Stock, the Common Stock and the
Warrants.
CERTAIN LEGAL ASPECTS OF MORTGAGE LOANS
The following discussion contains summaries of certain legal aspects of
Mortgage Loans which are general in nature. Because many of the legal aspects of
Mortgage Loans are governed by applicable state laws (which may vary
substantially), the following summaries do not purport to be complete, to
reflect the laws of any particular state, to reflect all the laws applicable to
any particular mortgage loan or to encompass the laws of all states in which the
properties securing Mortgage Loans in which the Company might invest (directly
or through acquisitions of Single-Family and Multifamily or Commercial Mortgage
Securities) are situated. The summaries are qualified in their entirety by
reference to the applicable federal and state laws governing Mortgage Loans. The
risks and other considerations summarized below may affect the Company both as a
direct acquiror of Mortgage Loans or through its indirect acquisition of
interests in Mortgage Loans through Mortgage Securities.
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MORTGAGES AND DEEDS OF TRUST GENERALLY
Mortgage Loans are secured by either mortgages or deeds of trust or other
similar security instruments, depending upon the prevailing practice in the
state in which the related mortgaged property is located. There are two parties
to a mortgage, the mortgagor, who is the borrower and owner of the mortgaged
property, and the mortgagee, who is the lender. In a mortgage transaction, the
mortgagor delivers to the mortgagee a note, bond or other written evidence of
indebtedness and a mortgage. A mortgage creates a lien upon the real property
encumbered by the mortgage as security for the obligation evidenced by the note,
bond or other evidence of indebtedness. Although a deed of trust is similar to a
mortgage, a deed of trust has three parties, the borrower-property owner called
the trustor (similar to a mortgagor), a lender called the beneficiary (similar
to a mortgagee), and a third-party grantee called the trustee. Under a deed of
trust, the borrower grants the property, until the debt is paid, in trust for
the benefit of the beneficiary to the trustee to secure payment of the
obligation generally with a power of sale. The trustee's authority under a deed
of trust and the mortgagee's authority under a mortgage are governed by
applicable law, the express provisions of the deed of trust or mortgage, and, in
some cases, the directions of the beneficiary.
The real property covered by a mortgage is most often the fee estate in
land and improvements. However, a mortgage may encumber other interests in real
property such as a tenant's interest in a lease of land and improvements and the
leasehold estate created by such lease. A mortgage covering an interest in real
property other than the fee estate requires special provisions in the instrument
creating such interest or in the mortgage to protect the mortgagee against
termination of such interest before the mortgage is paid.
Priority of liens on mortgaged property created by mortgages and deeds of
trust depends on their terms and, generally, on the order of filing with a
state, county or municipal office, although such priority may in some states be
altered by the mortgagee's or beneficiary's knowledge of unrecorded liens
against the mortgaged property. However, filing or recording does not establish
priority over governmental claims for real estate taxes and assessments. In
addition, the Internal Revenue Code of 1986, as amended, provides priority to
certain tax liens over the lien of the mortgage.
FORECLOSURE
Foreclosure of a mortgage is generally accomplished by judicial action
initiated by the service of legal pleadings upon all necessary parties having an
interest in the real property. Delays in completion of foreclosure may
occasionally result from difficulties in locating necessary parties defendant.
When the mortgagee's right to foreclose is contested, the legal proceedings
necessary to resolve the issue can be time-consuming. A judicial foreclosure may
be subject to most of the delays and expenses of other litigation, sometimes
requiring up to several years to complete. At the completion of the judicial
foreclosure proceedings, if the mortgagee prevails, the court ordinarily issues
a judgment of foreclosure and appoints a referee or other designated official to
conduct the sale of the property. Such sales are made in accordance with
procedures which vary from state to state. The purchaser at such sale acquires
the estate or interest in real property covered by the mortgage.
Foreclosure of a deed of trust is generally accomplished by a non-judicial
trustee's sale under a specific provision in the deed of trust and/or applicable
statutory requirements which authorizes the trustee, generally following a
request from the beneficiary/lender, to sell the property to a third party upon
any default by the borrower under the terms of the note or deed of trust. A
number of states may also require that a lender provide notice of acceleration
of a note to the borrower. Notice requirements under a trustee's sale vary from
state to state. In some states, the trustee must record a notice of default and
send a copy to the borrower-trustor and to any person who has recorded a request
for a copy of a notice of default and notice of sale. In addition, the trustee
must provide notice in some states to any other individual having an interest in
the real property, including any junior lienholders. In some states, the
borrower, or any other person having a junior encumbrance on the real estate,
may, during a reinstatement period, cure the default by paying the entire amount
in arrears plus the costs and expenses incurred in enforcing the obligation.
Generally, state law controls the amount of foreclosure expenses and costs,
including attorneys' fees, which may be covered by a lender. If the deed of
trust is not reinstated, a notice of sale must be posted in a public place and,
in most states, published for a specific period of time in one or more
newspapers. In addition, some state laws require
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that a copy of the notice of sale be posted on the property and sent to all
parties having an interest in the real property.
In case of foreclosure under either a mortgage or deed of trust, the sale
by the referee or other designated official or by the trustee is often a public
sale. However, because of the difficulty a potential buyer at the sale might
have in determining the exact status of title to the property subject to the
lien of the mortgage or deed of trust and the redemption rights that may exist
(see "-- Statutory Rights of Redemption" below), and because the physical
condition and financial performance of the property may have deteriorated during
the foreclosure proceedings and/or for a variety of other reasons (including
exposure to potential fraudulent transfer allegations), a third party may be
unwilling to purchase the property at the foreclosure sale. For these and other
reasons, it is common for the lender to purchase the property from the trustee,
referee or other designated official for an amount equal to the outstanding
principal amount of the indebtedness secured by the mortgage or deed of trust,
together with accrued and unpaid interest and the expenses of foreclosure, in
which event, if the amount bid by the lender equals the full amount of such
debt, interest and expenses, the mortgagee's debt will be extinguished.
Thereafter, the lender will assume the burdens of ownership, including paying
operating expenses and real estate taxes and making repairs. The lender is then
obligated as an owner until it can arrange a sale of the property to a third
party. Frequently, the lender employs a third party management company to manage
and operate the property. The costs of operating and maintaining commercial
property may be significant and may be greater than the income derived from the
property. The costs of management and operation of those mortgaged properties
which are hotels, motels or nursing or convalescent homes or hospitals may be
particularly significant because of the expertise, knowledge and, with respect
to nursing or convalescent homes or hospitals, regulatory compliance, required
to run such operations and the effect which foreclosure and a change in
ownership may have on the public's and the industry's (including franchisors')
perception of the quality of such operations. The lender will commonly obtain
the services of a real estate broker and pay the broker's commission in
connection with the sale of the property. Depending upon market conditions, the
ultimate proceeds of the sale of the property may not equal the lender's
investment in the property. Moreover, a lender commonly incurs substantial legal
fees and court costs in acquiring a mortgaged property through contested
foreclosure and/or bankruptcy proceedings. Furthermore, an increasing number of
states require that any environmental hazards be eliminated before a property
may be resold. In addition, a lender may be responsible under federal or state
law for the cost of cleaning up a mortgaged property that is environmentally
contaminated. See "-- Environmental Risks" below. As a result, a lender could
realize an overall loss on a mortgage loan even if the related mortgaged
property is sold at foreclosure or resold after it is acquired through
foreclosure for an amount equal to the full outstanding principal amount of the
mortgage loan, plus accrued interest.
In foreclosure proceedings, some courts have applied general equitable
principles. These equitable principles are generally designed to relieve the
borrower from the legal effect of his defaults under the loan documents.
Examples of judicial remedies that have been fashioned include judicial
requirements that the lender undertake affirmative and expensive actions to
determine the causes of the borrower's default and the likelihood that the
borrower will be able to reinstate the loan. In some cases, courts have
substituted their judgment for the lender's judgment and have required that
lenders reinstate loans or recast payment schedules in order to accommodate
borrowers who are suffering from temporary financial disability. In other cases,
courts have limited the right of the lender to foreclose if the default under
the mortgage instrument is not monetary, such as the borrower's failing to
maintain adequately the property or the borrower's executing a second mortgage
or deed of trust affecting the property. Finally, some courts have been faced
with the issue of whether or not federal or state constitutional provisions
reflecting due process concerns for adequate notice require that borrowers under
mortgages receive notices in addition to the statutorily-prescribed minimum. For
the most part, these cases have upheld the notice provisions as being reasonable
or have found that the sale under a deed of trust, or under a mortgage having a
power of sale, does not involve sufficient state action to afford constitutional
protection to the borrower.
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ENVIRONMENTAL RISKS
Real property pledged as security to a lender may be subject to potential
environmental risks. Of particular concern may be those mortgaged properties
which are, or have been, the site of manufacturing, industrial or disposal
activity. Such environmental risks may give rise to a diminution in value of
property securing any mortgage loan or, as more fully described below, liability
for clean-up costs or other remedial actions, which liability could exceed the
value of such property or the principal balance of the related mortgage loan. In
certain circumstances, a lender may choose not to foreclose on contaminated
property rather than risk incurring liability for remedial actions.
Under the laws of certain states, the owner's failure to perform remedial
actions required under environmental laws may in certain circumstances give rise
to a lien on mortgaged property to ensure the reimbursement of remedial costs
incurred by the state. In some states such lien has priority over the lien of an
existing mortgage against such property. Because the costs of remedial action
could be substantial, the value of a mortgaged property as collateral for a
mortgage loan could be adversely affected by the existence of an environmental
condition giving rise to a lien.
The state of the law is currently unclear as to whether and under what
circumstances clean-up costs, or the obligation to take remedial actions, can be
imposed on a secured lender. Under the laws of some states and under the federal
Comprehensive Environmental Response, Compensation, and Liability Act of 1980,
as amended ("CERCLA"), current ownership or operation of a property provides a
sufficient basis for imposing liability for the costs of addressing releases or
threatened releases of hazardous substances on that property. Under such laws, a
secured lender who holds indicia of ownership primarily to protect its interest
in a property could under certain circumstances fall within the literal terms of
the definition of "owner or operator"; consequently, such laws often
specifically exclude such a secured lender, provided that the lender does not
participate in the facility's management of environmental matters.
In 1992, the United States Environmental Protection Agency (the "EPA")
issued a rule interpreting and delineating CERCLA's secured creditor exemption.
This rule defined and specified the range of permissible actions that may be
undertaken by a lender who holds a contaminated facility as collateral without
exceeding the bounds of the secured creditor exemption. In February 1994,
however, the United States Court of Appeals for the D.C. Circuit struck down the
EPA's lender liability rule on the grounds that it exceeded EPA's rule-making
authority under CERCLA. A petition for writ of certiorari to the United States
Supreme Court appealing the D.C. Circuit's decision was denied in January 1995.
At the present time, the future status of the rule and similar legislation now
pending in Congress is unclear, although the EPA has stated that it will
continue to adhere to the rule as a matter of policy and is in the process of
preparing guidance to this effect. Certain courts that have addressed the issue
of lender liability under CERCLA have, in some cases without relying on any EPA
rule or policy, nonetheless interpreted the secured creditor exemption
consistent with the EPA rule. In any event, the EPA rule does not or would not
necessarily affect the potential for liability under state law or federal laws
other than CERCLA. Furthermore, it is not clear at the present time whether any
such lender protections would be binding in actions brought by a party other
than the federal government.
At the time Mortgage Loans were originated, it is possible that no
environmental assessment or a very limited environmental assessment of the
mortgaged properties was conducted. The Company does not intend to acquire title
to, or possession of, a mortgaged property underlying a mortgage loan, take over
its operation or take any other action that might subject the Company to
liability under CERCLA or comparable laws unless it has previously been
determined, based upon a "Phase I" or other specified environmental assessment
prepared by a person who regularly conducts such environmental assessments, that
the mortgaged property is in compliance with applicable environmental laws and
that there are no circumstances relating to use, management or disposal of any
hazardous substances for which investigation, monitoring, containment, clean-up
or remediation could be required under applicable environmental laws, or that it
would be in the best economic interest of the Company to take such actions as
are necessary to bring the mortgaged property into compliance therewith or as
may be required under such laws. In addition, the Company does not intend to
invest in Mortgage Loans serviced or held by others on behalf of the Company,
whether in the form of Mortgage Securities or otherwise, and other investors
unless the servicer, trustee or other third party is
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required to make the determinations specified in the preceding sentence prior to
taking action that might subject the Company to liability under CERCLA or
comparable laws. The Company also does not intend to acquire Mortgage Securities
unless the servicer of the Mortgage Loans underlying the Mortgage Securities is
required to follow a substantially similar policy. This policy effectively
precludes enforcement of the security for the related note until a satisfactory
environmental assessment is obtained or any required remedial action is taken,
reducing the likelihood that the Company will become liable for any
environmental conditions affecting a mortgaged property, but making it more
difficult to realize on the security for the mortgage loan. However, there can
be no assurance that any environmental assessment obtained by the Company or by
a servicer, trustee or other third party on behalf of the Company will detect
all possible environmental conditions or that other precautions will in fact
insulate the Company from liability for environmental conditions.
"Hazardous substances" are generally defined as any dangerous, toxic or
hazardous pollutants, chemicals, wastes or substances, including, without
limitation, those so identified pursuant to CERCLA or any other environmental
laws now existing, and specifically including, without limitation, asbestos and
asbestos containing materials, polychlorinated biphenyls, radon gas, petroleum
and petroleum products, and urea formaldehyde.
If a lender is or becomes liable for clean-up costs, it may bring an action
for contribution against the current owners or operators, the owners or
operators at the time of on-site disposal activity or any other party who
contributed to the environmental hazard, but such persons or entities may be
bankrupt or otherwise judgment proof. Furthermore, such action against the
borrower may be adversely affected by the limitations on recourse in the loan
documents. Similarly, in some states anti-deficiency legislation and other
statutes requiring the lender to exhaust its security before bringing a personal
action against the borrower (see "-- Anti-Deficiency Legislation" below) may
curtail the lender's ability to recover from its borrower the environmental
clean-up and other related costs and liabilities incurred by the lender.
JUNIOR MORTGAGE AND DEEDS OF TRUST; RIGHTS OF SENIOR MORTGAGEES OR BENEFICIARIES
Priority of liens on mortgaged property created by mortgages or deeds of
trust depends on their terms and, generally, on the order of filing with a
state, county or municipal office, although such priority may in some states be
altered by the mortgagee's or beneficiary's knowledge of unrecorded liens,
leases or encumbrances against the mortgaged property. However, filing or
recording does not establish priority over governmental claims for real estate
taxes and assessments or, in some states, for reimbursement of remediation costs
of certain environmental conditions. See "-- Environmental Risks," above. In
addition, the Code provides priority to certain tax liens over the lien of a
mortgage.
The Company does not presently intend to acquire junior mortgages or deeds
of trust which are subordinate to senior mortgages or deeds of trust held by the
other lenders or institutional investors but may from time to time hold such
junior mortgages or Mortgage Securities in which some or all of the underlying
mortgages are junior mortgages. The rights of the Company (or the Mortgage
Securities vehicle in which the Company has acquired an interest) as mortgagee
or beneficiary under a junior mortgage or deed of trust will be subordinate to
those of the mortgagee as beneficiary under the senior mortgage or deeds of
trust, including the prior rights of the senior mortgagee as beneficiary to
receive rents, hazard insurance and condemnation proceeds and to cause the
property securing the mortgage loan to be sold upon default of the mortgagor,
thereby extinguishing the junior mortgagee's or beneficiary's lien unless the
Company (or the mortgage loan servicer in a Mortgage Securities issue) asserts
its subordinate interest in foreclosure litigation or satisfies the defaulted
senior loan. As discussed more fully below, in many states a junior mortgagee
may satisfy a defaulted senior loan in full, or may cure such default and bring
the senior loan current, in either event adding the amounts expended to the
balance due on the junior loan. Absent a provision in the senior mortgage, no
notice of default is required to be given to the junior mortgagee or
beneficiary.
The form of mortgage or deed of trust used by many institutional lenders
confers on the mortgagee or beneficiary the right both to receive proceeds
collected under any hazard insurance policy and awards made in connection with
any condemnation proceedings, and to apply such proceeds and awards to any
indebtedness secured by the mortgage or deed of trust, in such order as the
mortgagee may determine. Thus, in the event
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improvements on the property are damaged or destroyed by fire or other casualty,
or in the event the property is taken by condemnation, the mortgagee or
beneficiary under the senior mortgage or deed of trust will have the prior right
to collect any insurance proceeds payable under a hazard insurance policy and
any award of damages in connection with the condemnation and to apply the same
to the indebtedness secured by the senior mortgage or deed of trust. Proceeds in
excess of the amount of senior indebtedness will, in most cases, be applied to
the indebtedness secured by a junior mortgage or deed of trust. The laws of
certain states may limit the ability of mortgagees or beneficiaries to apply the
proceeds of hazard insurance and partial condemnation awards to the secured
indebtedness. In such states, the mortgagor or trustor must be allowed to use
the proceeds of hazard insurance to repair the damage unless the security of the
mortgagee or beneficiary has been impaired. Similarly, in certain states, the
mortgagee or beneficiary is entitled to the award for a partial condemnation of
the real property security only to the extent that its security is impaired.
The form of mortgage or deed of trust used by many institutional lenders
typically contains a "future advance" clause, which provides that additional
amounts advanced to or on behalf of the mortgagor or trustor by the mortgagee or
beneficiary are to be secured by the mortgage or deed of trust. While such a
clause is valid under the laws of most states, the priority of any advance made
under the clause depends, in some states, on whether the advance was an
"obligatory" or "optional" advance. If the mortgagee or beneficiary is obligated
to advance the additional amounts, the advance may be entitled to receive the
same priority as amounts initially made under the mortgage or deed of trust,
notwithstanding that there may be intervening junior mortgages or deeds of trust
and other liens between the date of recording of the mortgage or deed of trust
and the date of the future advance, and notwithstanding that the mortgagee or
beneficiary had actual knowledge of such intervening junior mortgages or deeds
of trust and other liens at the time of the advance. Where the mortgagee or
beneficiary is not obligated to advance the additional amounts and has actual
knowledge of the intervening junior mortgages or deeds of trust and other liens,
the advance may be subordinate to such intervening junior mortgages or deeds of
trust and other liens. Priority of advances under a "future advance" clause
rests, in other states, on state law giving priority to advances made under the
loan agreement up to a "credit limit" amount stated in the recorded mortgage or
deed of trust.
Another provision typically found in the forms of mortgage and deed of
trust used by many institutional lenders obligates the mortgagor or trustor to
pay before delinquency all taxes and assessments on the property and, when due,
all encumbrances, charges and liens on the property which appear prior to the
mortgage, to provide and maintain fire insurance on the property, to maintain
and repair the property and not to commit or permit any waste thereof, and to
appear in and defend any action or proceeding purporting to affect the property
or the rights of the mortgagee under the mortgage. Upon a failure of the
mortgagor or trustor to perform any of these obligations, the mortgagee or
beneficiary is given the right under the mortgage or deed of trust to perform
the obligation itself, at its election, with the mortgagor or trustor agreeing
to reimburse the mortgagee or beneficiary for any sums expended by the mortgagee
or beneficiary on behalf of the mortgagor or trustor. All sums so expended by
the mortgagee or beneficiary become part of the indebtedness secured by the
mortgage.
The forms of mortgage and deed of trust used by many institutional lenders
typically require the mortgagor or trustor to obtain the consent of the
mortgagee or beneficiary in respect of actions affecting the mortgaged property,
including, without limitation, leasing activities (including new leases and
termination or modification of existing leases), alterations and improvements to
buildings forming a part of the mortgaged property and management and leasing
agreements for the mortgaged property. Tenants will often refuse to execute a
lease unless the mortgagee or beneficiary executes a written agreement with the
tenant not to disturb the tenant's possession of its premises in the event of a
foreclosure. A senior mortgagee or beneficiary may refuse to consent to matters
approved by a junior mortgagee or beneficiary with the result that the value of
the security for the junior mortgage or deed of trust is diminished.
STATUTORY RIGHTS OF REDEMPTION
In some states, after a foreclosure sale pursuant to a mortgage or deed of
trust, the borrower and certain foreclosed junior lienors are given a statutory
period in which to redeem the property from the foreclosure sale. In some
states, redemption may occur only upon payment of the entire principal balance
of the loan, accrued
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interest and expenses of foreclosure. In other states, redemption may be
authorized if the borrower pays only a portion of the sums due. The effect of a
statutory right of redemption is to diminish the ability of the lender to sell
the foreclosed property. The right of redemption may defeat the title of any
purchaser at a foreclosure sale or any purchaser from the lender subsequent to a
foreclosure sale. Certain states permit a lender to avoid a post-sale redemption
by waiving its right to a deficiency judgment. Consequently, the practical
effect of the redemption right is often to force the lender to retain the
property and pay the expenses of ownership until the redemption period has run.
ANTI-DEFICIENCY LEGISLATION
The Company may acquire interests (either directly or through Mortgage
Securities) in Mortgage Loans which are nonrecourse loans as to which, in the
event of default by a borrower, recourse may be had only against the specific
property pledged to secure the related Mortgage Loan and not against the
borrower's other assets. Even if recourse is available pursuant to the terms of
the Mortgage Loan against the borrower's assets in addition to the mortgaged
property, certain states have imposed statutory prohibitions which impose
prohibitions against or limitations on such recourse. Some state statutes limit
the right of the mortgagee or beneficiary to obtain a deficiency judgment
against the borrower following foreclosure. A deficiency judgment is a personal
judgment against the former borrower equal in most cases to the difference
between the net amount realized upon the public sale of the security and the
amount due to the lender. Other statutes require the mortgagee or beneficiary to
exhaust the security afforded under a mortgage by foreclosure in an attempt to
satisfy the full debt before bringing a personal action against the borrower. In
certain states, the lender has the option of bringing a personal action against
the borrower on the debt without first exhausting such security; however, in
some of these states, the lender, following judgment on such personal action,
may be deemed to have elected a remedy and may be precluded from exercising
remedies with respect to the security. The practical effect of such an election
requirement is that lenders will usually proceed first against the security
rather than bringing personal action against the borrower. Other statutory
provisions limit any deficiency judgment against the former borrower following a
judicial sale to the excess of the outstanding debt over the fair market value
of the property at the time of the public sale. The purpose of these statutes is
generally to prevent a mortgagee from obtaining a large deficiency judgment
against the borrower as a result of low bids or the absence of bids at the
judicial sale.
BANKRUPTCY LAWS
Statutory provisions, including the Bankruptcy Code and state laws
affording relief to debtors, may interfere with and delay the ability of the
secured mortgage lender to obtain payment of the loan, to realize upon
collateral and/or to enforce a deficiency judgment. Under the Bankruptcy Code,
virtually all actions (including foreclosure actions and deficiency judgment
proceedings) are automatically stayed upon the filing of the bankruptcy
petition, and, often, no interest or principal payments are made during the
course of the bankruptcy proceeding. The delay and consequences thereof caused
by such automatic stay can be significant. Also, under the Bankruptcy Code, the
filing of a petition in bankruptcy by or on behalf of a junior lienor,
including, without limitation, any junior mortgagee, may stay the senior lender
from taking action to foreclose out such junior lien. Mortgaged properties may
have a junior "wraparound" mortgage or deed of trust encumbering such mortgaged
property. In general terms, a "wraparound" mortgage or deed of trust is a junior
mortgage or deed of trust where the full amount of the mortgage or deed of trust
is increased by an amount equal to the principal balance of the senior mortgage
or deed of trust and where the junior lender agrees to pay the senior mortgage
or deed of trust out of the payments received from the mortgagor or trustor
under the "wraparound" mortgage. As with other junior mortgages or deeds of
trust, the filing of a petition under the Bankruptcy Code by or on behalf of
such a "wrap" mortgagee may stay the senior lender from taking action to
foreclose upon the subject property.
Under the Bankruptcy Code, provided certain substantive and procedural
safeguards for the lender are met, the amount and terms of a mortgage secured by
property of the debtor may be modified under certain circumstances. The
outstanding amount of the loan secured by the real property may be reduced to
the then current value of the property (with a corresponding partial reduction
of the amount of the lender's security
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interest) pursuant to a confirmed plan or lien avoidance proceeding, thus
leaving the lender a general unsecured creditor for the difference between such
value and the outstanding balance of the loan. Other modifications may include
the reduction in the amount of each monthly payment, which reduction may result
from a reduction in the rate of interest and/or the alteration of the repayment
schedule (with or without affecting the unpaid principal balance of the loan),
and/or an extension (or reduction) of the final maturity date. Some courts with
federal bankruptcy jurisdiction have approved plans, based on the particular
facts of the reorganization case, that effected the curing of a mortgage loan
default by paying arrearage over a number of years. Also, under the Bankruptcy
Code, a bankruptcy court may permit a debtor through its rehabilitative plan to
deaccelerate a secured loan and to reinstate the loan even though the lender
accelerated the mortgage loan and final judgment of foreclosure had been entered
in state court (provided no sale of the property had yet occurred) prior to the
filing of the debtor's petition. This may be done even if the full amount due
under the original loan is never repaid. Other types of significant
modifications to the terms of the mortgage or deed of trust may be acceptable to
the bankruptcy court, often depending on the particular facts and circumstances
of the specific case.
Federal bankruptcy law may also interfere with or affect the ability of the
secured mortgage lender to enforce an assignment by a mortgagor of rents and
leases related to the mortgaged property if the related mortgagor or trustor is
in a bankruptcy proceeding. The mortgagee will be stayed from enforcing the
assignment to the extent rent and lease payments are deemed to be proceeds of
operating a business rather than owned property that can be pledged to a secured
lender, and the legal proceedings necessary to resolve the issue can be
time-consuming and may result in significant delays in the receipt of the rents.
Rents may also escape an assignment thereof if the assignment is not fully
perfected under state law prior to commencement of the bankruptcy proceeding, to
the extent such rents are used by the borrower to maintain the mortgaged
property or for other court authorized expenses, or to the extent other
collateral may be substituted for the rents.
To the extent a mortgagor's or trustor's ability to make payment on a
mortgage loan is dependent on payments under a lease of the related property,
such ability may be impaired by the commencement of a bankruptcy proceeding
relating to a lessee under such lease. Under the Bankruptcy Code, the filing of
a petition in bankruptcy by or on behalf of a lessee results in a stay in
bankruptcy against the commencement or continuation of any state court
proceeding for past due rent, for accelerated rent, for damages or for a summary
eviction order with respect to a default under the lease that occurred prior to
the filing of the lessee's petition. In addition, federal bankruptcy law
generally provides that a trustee or debtor in possession in a bankruptcy or
reorganization case under the Bankruptcy Code may, subject to approval of the
court, either assume the lease and retain it or assign it to a third party, or
reject the lease. If the lease is assumed, the trustee or debtor in possession
(or assignee, if applicable) must cure any defaults under the lease, compensate
the lessor for its losses and provide the lessor with "adequate assurance" of
future performance. Such remedies may be insufficient, however, as the lessor
may be forced to continue under the lease with a lessee that is a poor credit
risk or an unfamiliar tenant if the lease was assigned, and any assurances
provided to the lessor may, in fact, be inadequate. Furthermore, there is likely
to be a period of time between the date upon which a lessee files a bankruptcy
petition and the date upon which the lease is assumed or rejected. Although the
lessee is obligated to make all lease payments currently with respect to the
post-petition period, there is a risk that such payments will not be made due to
the lessee's poor financial condition. If the lease is rejected, the lessor will
be treated as an unsecured creditor with respect to its claim for damages for
termination of the lease and the mortgagor or trustor must relet the mortgaged
property before the flow of lease payments will recommence. In addition,
pursuant to section 502(b)(6) of the Bankruptcy Code, a lessor's damages for
lease rejection are limited.
In a bankruptcy or similar proceeding action may be taken seeking the
recovery as a preferential transfer of any payments made by the mortgagor under
the related mortgage loan to the lender. Payments on long-term debt may be
protected from recovery as preferences if they are payments in the ordinary
course of business made on debts incurred in the ordinary course of business.
Whether any particular payment would be protected depends upon the facts
specific to a particular transaction.
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ENFORCEABILITY OF CERTAIN PROVISIONS
PREPAYMENT PROVISIONS
In the absence of state statutory provisions prohibiting prepayment fees
(e.g., in the case of single-family residential loans), courts generally enforce
claims requiring prepayment fees unless enforcement would be unconscionable.
However, the laws of certain states may render prepayment fees unenforceable for
certain residential loans or after a mortgage loan has been outstanding for a
certain number of years, or may limit the amount of any prepayment fee to a
specified percentage of the original principal amount of the mortgage loan, to a
specified percentage of the outstanding principal balance of a mortgage loan, or
to a fixed number of months' interest on the prepaid amount. In certain states,
prepayment fees payable on default or other involuntary acceleration of a
mortgage loan may not be enforceable against the mortgagor or trustor. Some
state statutory provisions may also treat certain prepayment fees as usurious if
in excess of statutory limits. See "-- Certain Laws and Regulations --
Applicability of Usury Laws." The Company may invest in Mortgage Loans that do
not require the payment of specified fees as a condition to prepayment or the
requirements of which have expired, and to the extent Mortgage Loans do require
such fees, such fees generally may not be a material deterrent to the prepayment
of Mortgage Loans by the borrowers.
DUE-ON-SALE PROVISIONS
The enforceability of due-on-sale clauses has been the subject of
legislation or litigation in many states, and in some cases, typically involving
single family residential mortgage transactions, their enforceability has been
limited or denied. The Garn-St Germain Depository Institutions Act of 1982 (the
"Garn-St Germain Act") preempts state constitutional, statutory and case law
that prohibits the enforcement of due-on-sale clauses and permits lenders to
enforce these clauses in accordance with their terms, subject to certain
exceptions. As a result, due-on-sale clauses have become generally enforceable
except in those states whose legislatures exercised their authority to regulate
the enforceability of such clauses with respect to certain mortgage loans. The
Garn-St Germain Act does "encourage" lenders to permit assumption of loans at
the original rate of interest or at some other rate less than the average of the
original rate and the market rates.
Under federal bankruptcy law, due-on-sale clauses may not be enforceable in
bankruptcy proceedings and may, under certain circumstances, be eliminated in
any modified mortgage resulting from such bankruptcy proceeding.
ACCELERATION ON DEFAULT
The Company may invest in Mortgage Loans which contain a
"debt-acceleration" clause, which permits the lender to accelerate the full debt
upon a monetary or nonmonetary default of the borrower. The courts of most
states will enforce clauses providing for acceleration in the event of a
material payment default after giving effect to any appropriate notices. The
equity courts of any state, however, may refuse to foreclose a mortgage or deed
of trust when an acceleration of the indebtedness would be inequitable or unjust
or the circumstances would render the acceleration unconscionable. Furthermore,
in some states, the borrower may avoid foreclosure and reinstate an accelerated
loan by paying only the defaulted amounts and the costs and attorneys' fees
incurred by the lender in collecting such defaulted payments.
State courts also are known to apply various legal and equitable principles
to avoid enforcement of the forfeiture provisions of installment contracts. For
example, a lender's practice of accepting late payments from the borrower may be
deemed a waiver of the forfeiture clause. State courts also may impose equitable
grace periods for payment of arrearage or otherwise permit reinstatement of the
contract following a default. Not infrequently, if a borrower under an
installment contract has significant equity in the property, equitable
principles will be applied to reform or reinstate the contract or to permit the
borrower to share the proceeds upon a foreclosure sale of the property if the
sale price exceeds the debt.
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LEASES AND RENTS
Mortgage Loans may be secured by an assignment of leases and rents, either
through a separate document of assignment or as incorporated in the mortgage or
deed of trust. Under such assignments, the borrower typically assigns its right,
title and interest as landlord under each lease and the income derived therefrom
to the lender, while retaining a license to collect the rents for so long as
there is no default. The manner of perfecting the lender's interest in rents may
depend on whether the borrower's assignment was absolute or one granted as
security for the loan. Failure to perfect the lender's interest in rents
properly may result in the loss of a substantial pool of funds which could
otherwise serve as a source of repayment for the loan. In the event the borrower
defaults, the license terminates and the lender may be entitled to collect
rents. Some state laws may require that to perfect its interest in rents, the
lender must take possession of the property and/or obtain judicial appointment
of a receiver before becoming entitled to collect rents. Lenders that actually
take possession of the property, however, may incur potentially substantial
risks attendant to being a mortgagee or beneficiary in possession. Such risks
include liability for environmental clean-up costs and other risks inherent to
property ownership. In addition, if bankruptcy or similar proceedings are
commenced by or in respect of the borrower, the lender's ability to collect the
rents may be adversely affected. In the event of default, the amount of rent the
lender is able to collect from the tenants can significantly affect the value of
the security interest.
SECONDARY FINANCING: DUE-ON-ENCUMBRANCE PROVISIONS
Some Mortgage Loans may have no restrictions on secondary financing,
thereby permitting the borrower to use the mortgaged property as security for
one or more additional loans. Some mortgage loans may preclude secondary
financing (often by permitting the first lender to accelerate the maturity of
its loan if the borrower further encumbers the mortgaged property) or may
require the consent of the senior lender to any junior or substitute financing;
however, such provisions may be unenforceable in certain jurisdictions under
certain circumstances.
Where the borrower encumbers the mortgaged property with one or more junior
liens, the senior lender is subjected to additional risk. First, the borrower
may have difficulty servicing and repaying multiple loans. Second, acts of the
senior lender which prejudice the junior lender or impair the junior lender's
security may create a superior equity in favor of the junior lender. Third, if
the borrower defaults on the senior loan and/or any junior loan or loans, the
existence of junior loans and actions taken by junior lenders can impair the
security available to the senior lender and can interfere with, delay and in
certain circumstances even prevent the taking of action by the senior lender.
Fourth, the bankruptcy of a junior lender may operate to stay foreclosure or
similar proceedings by the senior lender.
CERTAIN LAWS AND REGULATIONS
Mortgaged properties may be subject to compliance with various federal,
state and local statutes and regulations. Failure to comply (together with an
inability to remedy any such failure) could result in material diminution in the
value of a mortgaged property which could, together with the possibility of
limited alternative uses for a particular mortgaged property (i.e., a nursing or
convalescent home or hospital), result in a failure to realize the full
principal amount of the related mortgage loan.
APPLICABILITY OF USURY LAWS
State and federal usury laws limit the interest that lenders are entitled
to receive on a mortgage loan. In determining whether a given transaction is
usurious, courts may include charges in the form of "points" and "fees" as
"interest," but may exclude payments in the form of "reimbursement of
foreclosure expenses" or other charges found to be distinct from "interest." If,
however, the amount charged for the use of the money loaned is found to exceed a
statutorily established maximum rate, the form employed and the degree of
overcharge are both immaterial. Statutes differ in their provision as to the
consequences of a usurious loan. One group of statutes requires the lender to
forfeit the interest above the applicable limit or imposes a specified penalty.
Under this statutory scheme, the borrower may have the recorded mortgage or deed
of trust
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cancelled upon paying its debt with lawful interest, or the lender may
foreclose, but only for the debt plus lawful interest. Under a second, more
severe type of statute, a violation of the usury law results in the invalidation
of the transaction, thereby permitting the borrower to have the recorded
mortgage or deed of trust cancelled without any payment and prohibiting the
lender from foreclosing.
AMERICANS WITH DISABILITIES ACT
Under Title III of the Americans with Disabilities Act of 1990 and rules
promulgated thereunder (collectively, the "ADA"), in order to protect
individuals with disabilities, public accommodations (such as hotels,
restaurants, shopping centers, hospitals, schools and social service center
establishments) must remove architectural and communication barriers which are
structural in nature from existing places of public accommodation to the extent
"readily achievable." In addition, under the ADA, alterations to a place of
public accommodation or a commercial facility are to be made so that, to the
maximum extent feasible, such altered portions are readily accessible to and
usable by disabled individuals. The "readily achievable" standard takes into
account, among other factors, the financial resources of the affected site,
owner, landlord or other applicable person. In addition to imposing a possible
financial burden on the borrower in its capacity as owner or landlord, the ADA
may also impose such requirements on a foreclosing lender who succeeds to the
interest of the borrower as owner or landlord. Furthermore, since the "readily
achievable" standard may vary depending on the financial condition of the owner
or landlord, a foreclosing lender who is financially more capable than the
borrower of complying with the requirements of the ADA may be subject to more
stringent requirements than those to which the borrower is subject.
UNDERWRITING
The underwriters named below (the "Underwriters"), represented by
Montgomery Securities and Stifel, Nicolaus & Company, Incorporated (the
"Representatives"), have severally agreed to purchase, and the Company has
agreed to sell, subject to the terms and conditions set forth in an underwriting
agreement (the "Underwriting Agreement"), the respective number of shares of
Preferred Stock set forth opposite their names below. The Underwriting Agreement
provides that the obligations of the Underwriters are subject to certain
conditions precedent and that the Underwriters will be obligated to purchase all
of the shares if any are purchased.
<TABLE>
<CAPTION>
NUMBER OF SHARES
UNDERWRITER TO BE PURCHASED
--------------------------------------------------------------------- ----------------
<S> <C>
Montgomery Securities................................................ 371,875
Stifel, Nicolaus & Company, Incorporated............................. 371,875
EVEREN Securities, Inc. ............................................. 65,625
Sutro & Co. Incorporated............................................. 65,625
-------
Total...................................................... 875,000
=======
</TABLE>
The Underwriters, through the Representatives, have advised the Company
that they propose to offer the shares to the public at the public offering price
set forth on the cover page of this Prospectus. The Underwriters may allow to
selected dealers a concession of not more than $0.62 per share, and the
Underwriters may allow, and such dealers may reallow, a concession of not more
than $0.10 per share to certain other dealers. After the initial public
offering, the public offering price, concession and reallowance may be changed.
The Preferred Stock is offered subject to receipt and acceptance by the
Underwriters, and to certain other conditions, including the right to reject
orders in whole or in part.
The Company has granted the Underwriters an option exercisable for 30 days
after the date hereof to purchase up to 131,250 additional shares to cover
over-allotments, if any, at the initial public offering price less the
underwriting discount. If the Underwriters exercise this option, each of the
Underwriters will have a firm commitment, subject to certain conditions, to
purchase approximately the same percentage of such additional shares as the
number of shares to be purchased by it shown in the foregoing table bears to the
shares initially offered hereby. The Underwriters may purchase such shares only
to cover over-allotments in connection with this Offering.
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The Representatives have informed the Company that they do not expect to
make sales to accounts over which they exercise discretionary authority in
excess of 5% of the number of shares of Preferred Stock offered hereby.
In connection with this Offering, the Underwriters may engage in passive
market-making transactions in the Common Stock on the Nasdaq National Market
immediately prior to the commencement of sales in this Offering, in accordance
with Rule 10b-6A under the Exchange Act. Passive market-making consists of
displaying bids on the Nasdaq National Market limited by the bid prices of
independent market-makers and purchases limited by such prices and effected in
response to order flow. Net purchases by a passive market-maker on each day are
limited to a specified percentage of the passive market-maker's average daily
trading volume in the Common Stock during a specified prior period and must be
discontinued when such limit is reached. Passive market-making may stabilize the
market price of the Common Stock at a level above that which might otherwise
prevail and, if commenced, may be discontinued at any time.
The Company and the officers and directors of the Company have agreed that,
for a period of ninety days from the date of this Prospectus, they will not,
without the prior written consent of Stifel, Nicolaus & Company, Incorporated,
directly or indirectly, sell, offer to sell, grant any option for the sale of,
or otherwise dispose of any shares of Common Stock or any security convertible
into Common Stock, except upon exercise of the Warrants or pursuant to the DRP
or the Company's Stock Option Plan.
Certain of the Underwriters have in the past performed, and may continue to
perform, investment banking, broker-dealer and financial advisory services for
the Company and have received customary compensation therefor.
Out of the 875,000 shares to be sold by the Company pursuant to this
Offering (not including the Underwriters' over-allotment option), the
Underwriters have accepted the Company's request to sell up to 5% of such shares
at the public offering price set forth on the cover page hereof to employees and
other persons designated by the Company.
Certain of the Underwriters have entered into or may enter into reverse
repurchase agreements or other financing arrangements with the Company to
finance the purchase of Mortgage Assets. Certain personnel of Montgomery
Securities acquired in excess of 250,000 units of Class A Preferred Stock with
Warrants in the Company's private placement in 1994 for a purchase price of
$15.00 per share. The lead analyst from Montgomery Securities primarily
responsible for following the Company purchased 205,500 units of Class A
Preferred Stock and Warrants at the Company's private placement in August and
October of 1994 and continues to own 102,250 shares of Common Stock and 101,750
Warrants.
LEGAL MATTERS
The validity of the Preferred Stock offered hereby will be passed on for
the Company by Tobin & Tobin, a professional corporation, San Francisco,
California. Certain tax matters will be passed on by Giancarlo & Gnazzo, A
Professional Corporation, San Francisco, California. Certain legal matters will
be passed upon for the Underwriters by O'Melveny & Myers LLP, San Francisco,
California. Tobin & Tobin, a professional corporation, Giancarlo & Gnazzo, A
Professional Corporation, and O'Melveny & Myers LLP will rely as to all matters
of Maryland law upon the opinion of special Maryland counsel to the Company,
Piper & Marbury L.L.P., Baltimore, Maryland.
EXPERTS
The Balance Sheets as of December 31, 1995 and 1994 and the Statements of
Operations, Stockholders' Equity and Cash Flows for the year ended December 31,
1995 and the period from August 19, 1994 (Commencement of Operations) to
December 31, 1994 included in this Prospectus have been included herein in
reliance on the report of Coopers & Lybrand L.L.P., independent accountants,
given on the authority of that firm as experts in accounting and auditing.
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GLOSSARY
As used in this Prospectus, the capitalized and other terms listed below
have the meanings indicated.
"A" means that quality of underwriting which generally applies to loans
which are larger than the FNMA/FHLMC limits but which 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.
"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.
"Act" means the Securities Act of 1933, as amended.
"affiliate" of a person means a person that directly, or indirectly through
one or more intermediaries, controls or is controlled by, or is under common
control with, the person specified.
"Agency" means GNMA, FNMA or FHLMC.
"Agency Certificates" means GNMA ARM Certificates, FNMA ARM Certificates
and FHLMC ARM Certificates.
"amortized cost" means, with respect to Mortgage Assets, the purchase price
as adjusted for subsequent amortization of discount or premium and for principal
repayments.
"ARM" means a Mortgage Loan or any mortgage loan underlying a Mortgage
Security that features adjustments of the underlying interest rate at
predetermined times based on an agreed margin to an established index. An ARM is
usually subject to periodic interest rate and/or payment caps and a lifetime
interest rate cap.
"Asset Acquisition/Capital Allocation Policies" means the policies
established by the Board of Directors, including a majority of the Independent
Directors, establishing the guidelines for management in the type and quantity
of Mortgage Assets that may be purchased by the Company, which policies include,
without limitation, the asset acquisition policies, the credit risk management
policies and the capital and leverage policies.
"Board of Directors" means the Board of Directors of the Company.
"Business Day" means any day other than a Saturday, Sunday or a day on
which state or federally chartered banking institutions in New York, New York
are not required to be open.
"Call Date" means the date Preferred Stock may be redeemed by the Company
as specified in the required notice to holders. See "Capital Stock -- Preferred
Stock -- Redemption at the Option of the Company."
"Capital Stock" means the Common Stock, the Preferred Stock, and any
additional classes of capital stock authorized by the Board of Directors in the
future.
"carrying value" means the value placed on an asset or liability for
balance sheet presentation purposes. With respect to Mortgage Assets and
Interest Rate Cap Agreements, the carrying value equals management's estimate of
the bid-side market value of that asset. Management generally bases its estimate
on the lowest of third-party bid-side indications of market value obtained on a
regular basis from firms making a market in or lending against such assets. With
respect to all other balance sheet items, carrying value equals amortized cost.
"CD Rate" means the weekly average of secondary market interest rates on
six-month negotiable certificates of deposit, as published by the Federal
Reserve Board in its Statistical Release H.15(519), Selected Interest Rates.
"Class A Preferred Stock" means the Class A Convertible Preferred Stock,
par value $0.01 per share, offered as part of the Units in the 1994 private
placement.
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"CMOs" or "Collateral Mortgage Obligations" means adjustable- or fixed-rate
debt obligations (bonds) that are collateralized by Mortgage Loans or mortgage
certificates. CMOs are structured so that principal and interest payments
received on the collateral are sufficient to make principal and interest
payments on the bonds. Such bonds may be issued by United States government
sponsored entities or private issuers in one or more classes with fixed or
adjustable interest rates, maturities and degrees of subordination which are
characteristics designed for the investment objectives of different bond
purchasers.
"Code" means the Internal Revenue Code of 1986, as amended.
"Commercial CMOs" means CMOs collateralized by Commercial Mortgage Loans.
"Commercial Mortgage Assets" means Commercial Mortgage Loans and Commercial
Mortgage Securities.
"Commercial Mortgage Loans" means Mortgage Loans secured by commercial
property.
"Commercial Mortgage Securities" means Mortgage Securities representing an
interest in, or secured by, Commercial Mortgage Loans.
"Commercial Privately Issued Certificates" means Pass-Through Certificates
representing an interest in Commercial Mortgage Loans.
"Commitments" means commitments issued by the Company which will obligate
the Company to purchase Mortgage Assets from the holders of the commitment for a
specified period of time, in a specified aggregate principal amount and at a
specified price.
"Commodity Exchange Act" means the Commodity Exchange Act, as amended (7
U.S.C. sec. sec. 1 et seq.).
"Common Stock" means the Company's shares of Common Stock, $0.01 par value
per share, or such shares of the Company's Capital Stock into which outstanding
shares of Common Stock shall be reclassified.
"Company" means Redwood Trust, Inc., a Maryland corporation.
"Compensation Committee" means the committee of the Board of Directors
appointed to review compensation issues and, among other things, administer the
Stock Option Plan.
"Conforming Mortgage Loans" means Single-Family Mortgage Loans that either
comply with requirements for inclusion in credit support programs sponsored by
FHLMC or FNMA or are FHA or VA Loans.
"Conversion Price" means the conversion price per share of Common Stock for
which each share of Preferred Stock is convertible.
"coupon rate" means, with respect to Mortgage Assets, the annualized cash
interest income actually received from the asset, expressed as a percentage of
the face value of the asset.
"DERs" means dividend equivalent rights under the Company's Stock Option
Plan.
"DRP" or the "Plan" means the dividend reinvestment plan adopted by the
Company.
"Current Market Price" of publicly traded shares of Common Stock or any
other class or series of Capital Stock or other security of the Company or of
any similar security of any other issuer for any day means the closing price,
regular way on such day, or, if no sale takes place on such day, the average of
the reported closing bid and asked prices regular way on such day, in either
case as reported on the Nasdaq National Market of the National Association of
Securities Dealers, Inc. Automated Quotations System ("Nasdaq") or, if such
security is not quoted on the Nasdaq National Market, on the principal national
securities exchange on which such securities are listed or admitted for trading,
or if not so quoted, listed or admitted, the average of the closing bid and
asked prices on such day in the over-the-counter market as reported by Nasdaq
or, if bid and asked prices for such security on such day shall not have been
reported by Nasdaq, the average of the bid and asked prices on such day as
furnished by any New York Stock Exchange or National Association of Securities
Dealers, Inc. member firm regularly making a market in such security selected
for such purpose by the Chief Executive Officer or the Board of Directors or if
any class or series of securities are not publicly
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traded, the fair value of the shares of such class as determined reasonably and
in good faith by the Board of Directors of the Company.
"Distribution" means a distribution by the Company, after the Issue Date,
on its Common Stock other than in cash or shares of Common Stock (including any
distribution in securities other than rights, options or warrants).
"Dividend Payment Date" shall mean, with respect to each Dividend Period,
the twenty-first (21st) day of January, April, July and October, in each year,
commencing on October 21, 1996 with respect to the period commencing on the
Issue Date and ending September 30, 1996; provided, however, that if any
Dividend Payment Date falls on any day other than a Business Day, the dividend
payment payable on such Dividend Payment Date shall be paid on the Business Day
immediately following such Dividend Payment Date.
"Dividend Periods" shall mean quarterly dividend periods commencing on
January 1, April 1, July 1 and October 1 of each year and ending on and
including the day preceding the first day of the next succeeding Dividend Period
(other than the initial Dividend Period, which shall commence on the Issue Date
and end on and include September 30, 1996).
"Dollar-Roll Agreement" means an agreement to sell a security for delivery
on a specified future date and a simultaneous agreement to repurchase the same
or a substantially similar security on a specified future date.
"11th District Cost of Funds Index" means the index made available monthly
by the Federal Home Loan Bank Board of the cost of funds to members of the
Federal Home Loan Bank 11th District.
"ERISA" means the Employee Retirement Income Security Act of 1974.
"ERISA Plan" means a pension, profit-sharing, retirement or other employee
benefit plan or account which is subject to ERISA.
"Excess Securities" means shares of Capital Stock or Warrants representing
ownership, directly or constructively, in excess of 9.8%, in number of shares or
value, of any class of shares of the outstanding Capital Stock (except as
otherwise waived by the Board of Directors).
"Exchange Act" means the Securities Exchange Act of 1934, as amended.
"Exercise Price" means the price payable to the Company to exercise a
Warrant ($15.00) multiplied by the number of Warrants being exercised.
"face value" means, with respect to Mortgage Assets, the outstanding
principal balance of Mortgage Loans or Mortgage Securities comprising the
Mortgage Assets. In the absence of credit losses, the face value equals the sum
of the principal repayments that will be received by the Company over the life
of the Mortgage Asset.
"Fair Market Value" shall mean the average of the daily Current Market
Prices of a share of Common Stock during five (5) consecutive Trading Days
selected by the Company commencing not more than twenty (20) Trading Days
before, and ending not later than, the earlier of the day in question and the
day before the "ex" date with respect to the issuance or distribution requiring
such computation. The term "ex" date, when used with respect to any issuance or
distribution, means the first day on which the shares of Common Stock trade
regular way, without the right to receive such issuance or distribution, on the
exchange or in the market, as the case may be, used to determine that day's
Current Market Price.
"Federal Reserve Board" means the Board of Governors of the Federal Reserve
System.
"FHA" means the United States Federal Housing Administration.
"FHA Loans" means Mortgage Loans insured by the FHA.
"FHLMC" means the Federal Home Loan Mortgage Corporation.
"FHLMC ARM Certificates" means adjustable-rate mortgage participation
certificates issued by FHLMC, either in certificated or book-entry form.
"FNMA" means the Federal National Mortgage Association.
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"FNMA ARM Certificates" means adjustable-rate mortgage participation
certificates issued by FNMA, either in certificated or book-entry form.
"FNMA/FHLMC" means those underwriting standards 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.
"fully-indexed rate" means, with respect to ARMs, the rate that would be
paid by the borrower ("gross") or received by the Company as owner of the
Mortgage Asset ("net") if the coupon rate on the ARM were able to adjust
immediately to a market rate without being subject to adjustment periods,
periodic caps, or life caps. It is equal to the current yield of the ARM index
plus the gross or net margin.
"GB Capital" means George E. Bull, III Capital Management, Inc.
"GNMA" means the Government National Mortgage Association.
"GNMA ARM Certificates" means fully modified pass-through adjustable-rate
mortgage-backed certificates guaranteed by GNMA and issued either in
certificated or book-entry form.
"gross margin" means, with respect to ARMs, of the coupon rate to be paid
by the borrower. The term "gross" is used to differentiate payments made by the
borrower from the lower "net" payments actually received by the Company after
the acquisition of a Mortgage Asset. The difference between the gross margin and
the net margin reflects loan servicing fees and other pre-determined contractual
deductions. The fully-indexed gross coupon rate equals the current yield on the
ARM index (six month LIBOR, one year Treasury, etc.) plus the gross margin. The
actual coupon rate paid by the borrower may be lower than the fully-indexed
gross rate at the initiation of the loan if originated at a "teaser rate" or
during periods of rising interest rates due to the limitations of the ARM
adjustment schedule and the periodic and life caps. If so, the coupon rate paid
by the borrower would move towards the fully-indexed gross rate over time.
"haircut" means the over-collateralization amount required by a lender in
connection with a collateralized borrowing.
"high quality underwriting standards" means "FNMA/FHLMC," "A" or "A-"
underwriting standards.
"Housing Act" means the National Housing Act of 1934, as amended.
"HUD" means the Department of Housing and Urban Development.
"Independent Director" means a director of the Company who is not an
officer or employee of the Company and who is not affiliated with GB Capital.
"interest-only strip" or "IO" means a type of mortgage security which
receives a portion of the interest payments from an underlying pool of mortgage
loans but will receive little or no principal payments and hence will have
little or no face value. The market value and yield of an IO are unusually
sensitive to the prepayment rates experienced on and anticipated for the
underlying pool of mortgage loans. The market values and yields of IOs may
increase as interest rates increase and, in certain conditions, IOs may act in a
counter-cyclical manner as compared to other Mortgage Assets.
"interest rate adjustment indices" means, in the case of Mortgage Assets,
any of the objective indices based on the market interest rates of a specified
debt instrument (such as United States Treasury Bills in the case of the
Treasury Index and United States dollar deposits in London in the case of LIBOR)
or based on the average interest rate of a combination of debt instruments (such
as the 11th District Cost of Funds Index), used as a reference base to reset the
interest rate for each adjustment period on the Mortgage Asset, and in the case
of borrowings, is used herein to mean the market interest rates of a specified
debt instrument (such as reverse repurchase agreements for Mortgage Securities)
as well as any of the objective indices described above that are used as a
reference base to reset the interest rate for each adjustment period under the
related borrowing instrument.
"interest rate adjustment period" means, in the case of Mortgage Assets,
the period of time set forth in the debt instrument that determines when the
interest rate is adjusted and, with respect to borrowings, is used
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to mean the term to maturity of a short-term, fixed-rate debt instrument (such
as a 30-day reverse repurchase agreement) as well as the period of time set
forth in a long-term, adjustable-rate debt instrument that determines when the
interest rate is adjusted.
"Investment Company Act" means the Investment Company Act of 1940, as
amended.
"IRS" means the United States Internal Revenue Service.
"ISOs" means qualified incentive stock options granted under the Stock
Option Plan which meet the requirements of section 422 of the Code.
"Issue Date" means August 14, 1996.
"Junior Stock" means the Common Stock and any other class or series of
Capital Stock of the Company over which the shares of Preferred Stock have
preference or priority in the payment of dividends or in the distribution of
assets on any liquidation, dissolution or winding up of the Company.
"LIBOR" means London Inter-bank Offered Rate as it may be defined, and for
a period of time specified, in a Mortgage Asset or borrowing of the Company.
"lifetime interest rate cap" or "life cap" means, with respect to
adjustable rate Mortgage Assets, in the case of a Mortgage Loan that is an ARM,
the maximum coupon rate that may accrue during any period over the term of such
Mortgage Loan as stated in the governing instruments evidencing such Mortgage
Loan, and in the case of a Mortgage Security evidencing ARMs, the maximum
weighted average coupon rate that may accrue during any period over the term of
such Mortgage Security as stated in the governing instruments thereof.
"liquidity capital cushion" is a term defined in the Company's
Risk-Adjusted Capital Policy. It represents a portion of the capital the Company
is required to maintain as part of this policy in order to continue to make
asset acquisitions. The liquidity capital cushion is that part of the required
capital base which is in excess of the Company's haircut requirements.
"Mezzanine Securities" means Mortgage Securities rated below the two
highest levels but no lower than a single "B" level under the S&P rating system
(or comparable level under other rating systems) and are supported by one or
more classes of Subordinated Securities which bear Realized Losses prior to the
classes of Mezzanine Securities.
"Mortgage Assets" means (i) Single-Family Mortgage Assets, (ii) Multifamily
Mortgage Assets, and (iii) Commercial Mortgage Assets.
"Mortgage Loans" means Single-Family Mortgage Loans, Multifamily Mortgage
Loans and Commercial Mortgage Loans.
"Mortgage Note" means a promissory note evidencing a Mortgage Loan.
"Mortgage Securities" means (i) Pass-Through Certificates and (ii) CMOs.
"Mortgaged Property" means a one- to four-unit residential property which
may be a detached home, townhouse, condominium or other dwelling unit, or
multifamily or commercial property, securing a Mortgage Note.
"Multifamily CMOs" means CMOs backed by Multifamily Mortgage Loans.
"Multifamily Mortgage Assets" means Multifamily Mortgage Loans and
Multifamily Mortgage Securities.
"Multifamily Mortgage Loans" means Mortgage Loans secured by multifamily
(in excess of four units) residential property.
"Multifamily Mortgage Securities" means Mortgage Securities representing an
interest in, or secured by, Multifamily Mortgage Loans.
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"Multifamily Privately Issued Certificates" means Pass-Through Certificates
evidencing ownership in a pool of Multifamily Mortgage Loans issued by private
institutions.
"Net Income" is the income of the Company as calculated using Generally
Accepted Accounting Principles (GAAP); Net Income may differ from taxable
income.
"net margin" is part of the calculation of the coupon rate to be received
by the Company as owner of an ARM. The term "net" is used to differentiate
payments actually received by the Company from a Mortgage Asset from the higher
"gross" payment made by the borrower. The difference between the gross margin
and the net margin reflects loan servicing fees and other pre-determined
contractual deductions. The fully-indexed net rate equals the current yield on
the ARM index (six month LIBOR, one year Treasury, etc.) plus the net margin.
The actual coupon rate received by the Company may be lower than the
fully-indexed net rate at the initiation of the loan if originated at a "teaser
rate" or during periods of rising interest rates due to the limitations of the
ARM adjustment schedule and the periodic and life caps. If so, the coupon rate
received by the Company would move towards the fully-indexed net coupon rate
over time.
"Nonconforming Mortgage Loans" means conventional Single-Family and
Multifamily Mortgage Loans that do not conform to one or more requirements of
FHLMC or FNMA for participation in one or more of such agencies' mortgage loss
credit support programs.
"NQSOs" means options to acquire Company Common Stock granted pursuant to
the Stock Option Plan which do not meet the requirements of section 422 of the
Code.
"Offering" means the offering of the Preferred Stock covered by this
Prospectus.
"Ownership Limit" means 9.8% of the outstanding shares of Capital Stock, as
may be increased or reduced by the Board of Directors of the Company.
"Parity Stock" means such future stock that shall be on a parity with the
Preferred Stock, as to the payment of dividends and as to distribution of assets
upon liquidation, dissolution or winding up, whether or not the dividend rates,
dividend payment dates or redemption or liquidation prices per share thereof be
different from those of the Preferred Stock, if the holders of such class of
stock or series and the Preferred Stock shall be entitled to the receipt of
dividends and of amounts distributable upon liquidation, dissolution or winding
up in proportion to their respective amounts of accrued and unpaid dividends per
share or liquidation preferences, without preferences or priority one over the
other.
"Pass-Through Certificates" means securities (or interests therein)
evidencing undivided ownership interests in a pool of Mortgage Loans, the
holders of which receive a "pass-through" of the principal and interest paid in
connection with the underlying Mortgage Loans in accordance with the holders'
respective, undivided interests in the pool.
"periodic interest rate cap" or "periodic cap" means, with respect to ARMs,
the maximum change in the coupon rate permissible under the terms of the loan at
each coupon adjustment date. Periodic caps limit both the speed by which the
coupon rate can adjust upwards in a rising interest rate environment and the
speed by which the coupon rate can adjust downwards in a falling rate
environment.
"Person" means any individual, firm, partnership, company or other entity
and shall include any successor (by merger or otherwise) of such entity.
"Preferred Stock" means the Class B 9.74% Cumulative Convertible Preferred
Stock, par value $.01 per share.
"Plan" or "DRP" means the dividend reinvestment plan adopted by the
Company.
"Press Release" means an announcement by the Company, not prior to August
31, 1999, announcing the Company's intent to redeem a given number of shares of
Preferred Stock that the Company intends to redeem.
"Privately-Issued Certificates" means privately-issued ARM Pass-Through
Certificates issued by the Company or an affiliate of the Company or other third
party issuer.
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"Qualified Hedges" means bona fide interest rate swap or cap agreements
entered into by the Company solely to hedge adjustable-rate indebtedness that
the Company incurred to acquire or carry Qualified REIT Real Estate Assets and
any futures and options, or other investments (other than Qualified REIT Real
Estate Assets) made by the Company to hedge its Mortgage Assets or borrowings
that have been determined by a favorable opinion of counsel to generate
qualified income for purposes of the 95% Gross Income Test applicable to REITs.
"Qualified REIT Real Estate Assets" means Pass-Through Certificates,
Mortgage Loans, Agency Certificates, and other assets of the type described in
section 856(c) (6)(B) of the Code.
"Qualified REIT Subsidiary" means a corporation whose stock is entirely
owned by the REIT at all times during such corporation's existence.
"Qualifying Interests" means "mortgages and other liens on and interests in
real estate," as defined in section 3(c)(5)(C) under the Investment Company Act.
"rating" means (i) the rating assigned to an asset by one or more of the
four nationally recognized rating agencies as adjusted to the rating scale under
the S&P rating system, (ii) in the case of assets rated differently by such
rating agencies, the rating deemed by management to most appropriately reflect
such asset's credit quality or (iii) for unrated assets, the Company's deemed
comparable rating.
"Realized Losses" means losses incurred in respect of Mortgage Assets upon
foreclosure sales and other liquidations of underlying mortgaged properties that
result in failure to recover all amounts due on the loans secured thereby.
"Registration Rights Agreement" means the agreement between the Company and
Montgomery Securities pursuant to which the Company agreed to (i) file with the
Commission by May 22, 1995, and use its best efforts to cause to become
effective by July 22, 1995, the Shelf Registration Statement with respect to the
securities comprising the Units or issuable upon the conversion or exercise
thereof, and (ii) use its best efforts to have such securities approved for
quotation on the Nasdaq National Market or listed on a stock exchange and/or to
qualify such securities under the various state securities laws.
"REIT" means Real Estate Investment Trust.
"REIT Provisions of the Code" means sections 856 through 860 of the Code.
"REMIC" means Real Estate Mortgage Investment Conduit.
"residuals" means the right to receive the remaining or residual cash flows
from a pool of Mortgage Loans or Mortgage Securities after distributing required
amounts to the holders of interests in or obligations backed by such loans or
securities and after payment of any required pool expenses.
"reverse repurchase agreement" means a borrowing device evidenced by an
agreement to sell securities or other assets to a third-party and a simultaneous
agreement to repurchase them at a specified future date and price, the price
difference constituting the interest on the borrowing.
"Risk-Adjusted Capital Policy" means the policy established by the Company
which limits management's ability to acquire additional assets during such times
that the actual capital base of the Company is less than a required amount
defined in the policy. The required amount is the sum of the haircuts required
by the Company's secured lenders (the required haircut) and the additional
capital levels called for under the policy which are determined with reference
to the various risks inherent in the Company's Mortgage Assets (the liquidity
capital cushion).
"RTC" means the Resolution Trust Corporation.
"Rule 144" means Rule 144 promulgated under the Securities Act.
"S&P" means Standard & Poor's Corporation.
"SEC" means the United States Securities and Exchange Commission.
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"Securities" means the Common Stock issued upon conversion of the Class A
Preferred Stock, the Warrants and the Common Stock issuable pursuant to the
exercise of Warrants.
"Securities Act" means the Securities Act of 1933, as amended.
"Senior Securities" means a class of Mortgage Security that has a prior
right to receive principal and/or interest from the underlying pool of Mortgage
Loans.
"Senior-Subordinated Mortgage Securities" means a series of Pass-Through
Certificates or CMOs in which one or more classes have a prior right to receive
principal and/or interest payments from the underlying pool of Mortgage Loans.
"Servicer" means a servicer or subservicer of the Mortgage Loans pursuant
to a servicing agreement with the Company.
"Shelf Registration Statement" means each shelf registration statement
filed pursuant to the Registration Rights Agreement to register the Securities.
"Short-Term Investments" means the short-term bank certificates of deposit,
short-term United States treasury securities, short-term United States
government agency securities, commercial paper, repurchase agreements,
short-term CMOs, short-term asset-backed securities and other similar types of
short-term investment instruments, all of which will have maturities or average
lives of less than one year.
"Single-Family CMOs" means CMOs backed by Single-Family Mortgage Loans.
"Single-Family Mortgage Assets" means Single-Family Mortgage Loans and
Single-Family Mortgage Securities.
"Single-Family Mortgage Loans" means Mortgage Loans secured by
single-family (one- to four-units) residential property.
"Single-Family Mortgage Securities" means Mortgage Securities representing
an interest in, or secured by, Single-Family Mortgage Loans.
"Single-Family Privately Issued Certificates" means Pass-Through
Certificates evidencing ownership in a pool of Single-Family Mortgage Loans
issued by private institutions.
"SMMEA" means the Secondary Mortgage Market Enhancement Act of 1984.
"Special Tax Counsel" means the law firm of Giancarlo & Gnazzo, A
Professional Corporation.
"Stock Option Plan" means the Amended and Restated 1994 Executive and
Non-Employee Stock Option Plan adopted by the Company.
"Subordinated Interests" means a class of Mortgage Securities that is
subordinated to one or more other classes of Mortgage Securities, all of which
classes share the same collateral.
"Subordinated Securities" means any class that bears the "first loss" from
Realized Losses or that is rated below a single "B" level (or, if unrated, is
deemed by the Company to be below such level).
"Tax-Exempt Entity" means a qualified pension, profit-sharing or other
employee retirement benefit plan, Keogh plans, bank commingled trust funds for
such plans, individual retirement accounts and other similar entities intended
to be exempt from Federal income taxation.
"Trading Day", as to any securities, shall mean any day on which such
securities are traded on the Nasdaq National Market or, if such securities are
not listed or admitted for trading on the Nasdaq National Market, on the
principal national securities exchange on which such securities are listed or
admitted or, if such securities are not listed or admitted for trading on any
national securities exchange, in the securities market in which such securities
are traded.
"Transaction" shall mean any transaction to which the Company is a party,
including without limitation a merger, consolidation, statutory share exchange,
issuer or self tender offer for all or a substantial portion of the
149
<PAGE> 150
shares of Common Stock outstanding, sale of all or substantially all of the
Company's assets or recapitalization of the Common Stock, but excluding any
transaction as to which the Conversion Price adjustment provision applies.
"Transfer Agent" means Chase Mellon Shareholder Services, L.L.C., or such
other transfer agent as may be designated by the Board of Directors or their
designee as the transfer agent for the Preferred Stock.
"Treasury Department" means the United States Department of the Treasury.
"Treasury Index" means the weekly average yield of U.S. Treasury
securities, adjusted to a constant maturity of one year, as published by the
Board of Governors of the Federal Reserve System.
"UBTI" means "unrelated business taxable income" as defined in section 512
of the Code.
"Unit" means one share of Class A Preferred Stock and a Warrant issued
together as a unit in the private placement of units in multiple closings, the
first of which occurred on August 19, 1994 and the last of which occurred on
October 19, 1994.
"VA" means the United States Department of Veterans Affairs.
"VA Loans" means Mortgage Loans partially guaranteed by the VA under the
Servicemen's Readjustment Act of 1944, as amended.
"Voting Preferred Stock" means the Preferred Stock and any Parity Stock
including voting rights which the Company may issue in the future.
"Warrant Certificate" means a certificate received from the Warrant Agent
evidencing a Warrant separately transferable from the Class A Preferred Stock.
"Warrants" means the stock purchase Warrants offered as part of the Units,
which Warrants became exercisable on July 20, 1995 and will remain exercisable
until December 31, 1997.
150
<PAGE> 151
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Report of Independent Accountants..................................................... F-2
Financial Statements:
Balance Sheets...................................................................... F-3
Statements of Operations............................................................ F-4
Statements of Stockholders' Equity.................................................. F-5
Statements of Cash Flows............................................................ F-6
Notes to Financial Statements....................................................... F-7
</TABLE>
F-1
<PAGE> 152
REPORT OF INDEPENDENT ACCOUNTANTS
Board of Directors
Redwood Trust, Inc.
Mill Valley, California
We have audited the accompanying balance sheets of Redwood Trust, Inc. (the
Company) as of December 31, 1995 and 1994 and the related statements of
operations, stockholders' equity and cash flows for the year ended December 31,
1995 and for the period from August 19, 1994 to December 31, 1994. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of the Company as of December
31, 1995 and 1994, and the results of its operations and its cash flows for the
year ended and for the period from August 19, 1994 to December 31, 1994 in
conformity with generally accepted accounting principles.
COOPERS & LYBRAND L.L.P.
San Francisco, California
March 1, 1996
F-2
<PAGE> 153
REDWOOD TRUST, INC.
BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
MARCH 31, DECEMBER 31,
--------------------------- ---------------------
1996 1995 1995 1994
----------- ----------- -------- --------
(UNAUDITED) (UNAUDITED)
<S> <C> <C> <C> <C>
ASSETS
Cash and cash equivalents............... $ 9,705 $ 953 $ 4,825 $ 1,027
Mortgage assets......................... 565,159 141,859 432,244 117,477
Interest rate agreements................ 1,233 1,434 547 1,892
Accrued interest receivable............. 4,496 855 3,270 743
Other assets............................ 720 339 671 389
-------- -------- -------- --------
$ 581,313 $ 145,440 $441,557 $121,528
======== ======== ======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Reverse repurchase agreements........... $ 471,372 $ 116,071 $346,335 $100,376
Notes payable........................... 37,349 5,927 23,981 0
Accrued interest payable................ 1,616 665 1,290 676
Accrued expenses and other
liabilities........................... 290 92 227 29
Dividends payable....................... 2,540 333 1,434 167
-------- -------- -------- --------
513,167 123,088 373,267 101,248
-------- -------- -------- --------
Commitments and contingencies (see Note 10)
STOCKHOLDERS' EQUITY
Class A convertible preferred stock, par
value $.01 per share; Authorized 0,
12,000,000, 0 and 12,000,000 shares,
issued and outstanding 0, 1,666,063, 0
and 1,666,063 shares.................. 0 22,781 0 22,785
Common stock, par value $.01 per share;
Authorized 50,000,000, 38,000,000,
50,000,000 and 38,000,000 shares,
issued and outstanding 5,521,376,
208,332, 5,517,299 and 208,332
shares................................ 55 2 55 2
Additional paid-in capital.............. 73,926 19 73,895 19
Net unrealized loss on assets available
for sale.............................. (5,065) (549) (5,476) (2,557)
Undistributed income (deficit).......... (770) 99 (184) 31
-------- -------- -------- --------
68,146 22,352 68,290 20,280
-------- -------- -------- --------
$ 581,313 $ 145,440 $441,557 $121,528
======== ======== ======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-3
<PAGE> 154
REDWOOD TRUST, INC.
STATEMENT OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
FOR THE PERIOD
AUGUST 19, 1994
(DATE OF
THREE MONTHS ENDED COMMENCEMENT
--------------------------------- YEAR ENDED OF OPERATIONS) TO
MARCH 31, 1996 MARCH 31, 1995 DECEMBER 31, 1995 DECEMBER 31, 1994
-------------- -------------- ----------------- -----------------
(UNAUDITED) (UNAUDITED)
<S> <C> <C> <C> <C>
INTEREST INCOME
Mortgage assets............. $ 8,914 $ 2,155 $ 15,494 $ 1,183
Cash and investments........ 217 15 232 113
-------------- -------------- ----------------- -----------------
9,131 2,170 15,726 1,296
INTEREST EXPENSE.............. 6,202 1,533 10,608 760
INTEREST RATE AGREEMENTS
Interest rate agreement
expense..................... 151 16 339 8
-------------- -------------- ----------------- -----------------
NET INTEREST INCOME........... 2,778 621 4,779 528
Provision for credit losses... 332 18 493 0
-------------- -------------- ----------------- -----------------
Net interest income after
provision for credit
losses...................... 2,446 603 4,286 528
General and administrative
expenses.................... 492 201 1,131 146
-------------- -------------- ----------------- -----------------
NET INCOME.................... $ 1,954 $ 402 $ 3,155 $ 382
=========== =========== ============= =============
Net income per share
Primary..................... $ 0.32 $ 0.19 $ 0.85 $ 0.20
Fully diluted............... $ 0.32 $ 0.19 $ 0.83 $ 0.20
Weighted average shares of
common stock and common
stock equivalents:
Primary..................... 6,129,587 2,115,161 3,703,803 1,916,846
Fully diluted............... 6,132,648 2,115,161 3,780,882 1,916,846
Dividends declared per
preferred share............. $ 0.00 $ 0.20 $ 0.50 $ 0.25
Dividends declared per common
share....................... $ 0.46 $ 0.00 $ 0.46 $ 0.00
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-4
<PAGE> 155
REDWOOD TRUST, INC.
STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE THREE MONTHS ENDED MARCH 31, 1996,
THE YEAR ENDED DECEMBER 31, 1995 AND
THE PERIOD FROM AUGUST 19, 1994 (DATE OF COMMENCEMENT OF
OPERATIONS) TO DECEMBER 31, 1994
(UNAUDITED WITH RESPECT TO INFORMATION AS OF
AND FOR THE THREE MONTHS ENDED MARCH 31, 1996)
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
NET
UNREALIZED
CLASS A LOSS ON
PREFERRED STOCK COMMON STOCK ADDITIONAL ASSETS
--------------------- ------------------ PAID-IN AVAILABLE UNDISTRIBUTED
SHARES AMOUNT SHARES AMOUNT CAPITAL FOR SALE INCOME TOTAL
---------- -------- --------- ------ ---------- ---------- ------------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance, August 19, 1994... 0 $ 0 208,332 $ 2 $ 19 $ 0 $ 0 $ 21
Issuances of preferred
stock in a private
placement, net of
offering costs........... 1,666,063 22,785 -- -- -- -- -- 22,785
Net income................. -- -- -- -- -- -- 382 382
Preferred stock dividends
declared................. -- -- -- -- -- -- (351) (351)
Fair value adjustment on
assets available for
sale..................... -- -- -- -- -- (2,557) -- (2,557)
---------- -------- --------- ------ ---------- ---------- ------------- -------
Balance, December 31,
1994..................... 1,666,063 22,785 208,332 2 19 (2,557) 31 20,280
Additional private
placement closing costs
paid..................... -- (8) -- -- -- -- -- (8)
Exercise of stock
options.................. -- -- 47,083 -- 5 -- -- 5
Conversion of stock
warrants................. -- -- 1,000 -- 15 -- -- 15
Initial public offering
Preferred conversion..... (1,666,063) (22,777) 1,667,134 17 22,760 -- -- 0
Issuance of new shares... 3,593,750 36 51,096 -- -- 51,132
Net income................. -- -- -- -- -- -- 3,155 3,155
Preferred stock dividends
declared................. -- -- -- -- -- -- (833) (833)
Common stock dividends
declared................. -- -- -- -- -- -- (2,537) (2,537)
Fair value adjustment on
assets available for
sale..................... -- -- -- -- -- (2,919) -- (2,919)
---------- -------- --------- ------ ---------- ---------- ------------- -------
Balance, December 31,
1995..................... 0 0 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.... 0 $ 0 5,521,376 $ 55 $ 73,926 $ (5,065) $ (770) $68,146
========== ========= ========= ======= ========= ========== ============ ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-5
<PAGE> 156
REDWOOD TRUST, INC.
STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
FOR THE PERIOD
AUGUST 19, 1994
(DATE OF
THREE MONTHS ENDED COMMENCEMENT
------------------------------- YEAR ENDED OF OPERATIONS) TO
MARCH 31, 1996 MARCH 31, 1995 DECEMBER 31, 1995 DECEMBER 31, 1994
------------- ------------- ----------------- -----------------
(UNAUDITED) (UNAUDITED)
<S> <C> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income............................. $ 1,954 $ 402 $ 3,155 $ 382
Adjustments to reconcile net income to
net cash provided by operating
activities:
Amortization of mortgage asset
premiums and discounts, net....... 530 (215) (356) (82)
Depreciation and amortization....... 17 4 64 13
Provision for credit losses on
mortgage assets................... 332 18 493 0
Amortization of interest rate cap
agreements........................ 151 16 339 8
Increase in accrued interest
receivable........................ (1,226) (111) (2,527) (743)
Decrease (increase) in other
assets............................ (66) 45 (346) (402)
Increase (decrease) in accrued
interest payable.................. 326 (11) 614 676
Increase (decrease) in accrued
expenses and other................ 63 63 198 29
--------- -------- --------- ---------
Net cash provided by (used in)
operating activities......... 2,081 211 1,634 (119)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of mortgage assets............ (166,852) (24,115) (354,572) (121,297)
Principal payments on mortgage
assets.............................. 32,814 2,673 38,824 1,244
Purchase of interest rate cap
agreements.......................... (165) (294) (1,069) (1,799)
--------- -------- --------- ---------
Net cash used in investing
activities................... (134,203) (21,736) (316,817) (121,852)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings from reverse repurchase
agreements.......................... 125,037 15,695 245,959 100,376
Net borrowings from notes payable...... 13,368 5,927 23,981 0
Proceeds from private placement........ 0 0 0 24,991
Private placement issuance costs....... 0 (4) (8) (2,206)
Proceeds from stock issued pursuant to
dividend reinvestment plan.......... 79 0 0 0
Proceeds from common stock issued...... 0 0 55,703 0
Common stock issuance costs............ (48) 0 (4,571) 0
Exercise of stock options.............. 0 0 5 0
Conversion of stock warrants........... 0 0 15 0
Dividends paid......................... (1,434) (167) (2,103) (184)
--------- -------- --------- ---------
Net cash provided by financing
activities................... 137,002 21,451 318,981 122,977
Net increase in cash and cash
equivalents............................ 4,880 (74) 3,798 1,006
Cash and cash equivalents at beginning of
period................................. 4,825 1,027 1,027 21
--------- -------- --------- ---------
Cash and cash equivalents at end of
period................................. $ 9,705 $ 953 $ 4,825 $ 1,027
========= ======== ========= =========
Supplemental disclosure of cash flow
information:
Cash paid for interest................. $ 5,876 $ 1,544 $ 9,994 $ 84
========= ======== ========= =========
</TABLE>
The accompanying notes are an integral part of these financial statements
F-6
<PAGE> 157
REDWOOD TRUST, INC.
NOTES TO FINANCIAL STATEMENTS
(UNAUDITED WITH RESPECT TO INFORMATION AS OF AND FOR THE
THREE MONTH PERIODS ENDED MARCH 31, 1996 AND MARCH 31, 1995)
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 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 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
F-7
<PAGE> 158
REDWOOD TRUST, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
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, 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
F-8
<PAGE> 159
REDWOOD TRUST, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
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, $62,103 at
March 31, 1995, $113,515 at December 31, 1995 and $44,269 at December 31, 1994.
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. Depreciation expense and leasehold improvements amortization for
the year ended December 31, 1995 and for the period from August 19, 1994 to
December 31, 1994 totaled $30,255 and $1,112, respectively. Accumulated
depreciation and leasehold improvement amortization totaled $37,297 at March 31,
1996, $5,170 at March 31, 1995, $31,367 at December 31, 1995 and $1,112 at
December 31, 1994.
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 March 31, 1995, the privately issued
Mortgage Assets held by the Company had rating equivalents ranging from AA to B,
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
F-9
<PAGE> 160
REDWOOD TRUST, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
equivalent of all the Company's Mortgage Assets was AA+. At December 31, 1994,
the privately issued Mortgage Assets held by the Company had rating equivalents
ranging from AA to B, with a weighted average of A-; the weighted average rating
equivalent of all the Company's Mortgage Assets was AAA-.
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. During the year ended December 31,
1995 the Company provided for $493,710 in credit losses and incurred $3,997 in
charge-offs. The reserve balance at March 31, 1996, March 31, 1995 and December
31, 1995 was $821,229, $18,436 and $489,713, respectively. During the period
from August 19, 1994 to December 31, 1994, there were no provisions made for
credit losses and the Company incurred no charge-offs.
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 FEDERAL NATIONAL PRIVATELY ISSUED
LOAN MORTGAGE MORTGAGE MORTGAGE
CORPORATION ASSOCIATION ASSETS TOTAL
------------- ---------------- ---------------- --------
(IN THOUSANDS)
(UNAUDITED)
<S> <C> <C> <C> <C>
Mortgage Assets, Gross............. $81,985 $210,041 $281,782 $573,808
Unamortized Discount............... 0 (294) (16,560) (16,854)
Unamortized Premium................ 1,839 4,253 3,480 9,572
------- -------- -------- --------
Amortized Cost..................... 83,824 214,001 268,702 566,526
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 $264,568 $562,922
======= ======== ======== ========
</TABLE>
F-10
<PAGE> 161
REDWOOD TRUST, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
At March 31, 1995, Mortgage Assets, excluding IO Strips, consisted of the
following:
<TABLE>
<CAPTION>
FEDERAL HOME FEDERAL NATIONAL PRIVATELY ISSUED
LOAN MORTGAGE MORTGAGE MORTGAGE
CORPORATION ASSOCIATION ASSETS TOTAL
------------- ---------------- ---------------- --------
(IN THOUSANDS)
(UNAUDITED)
<S> <C> <C> <C> <C>
Mortgage Assets, Gross............. $25,501 $ 54,126 $ 63,766 $143,393
Unamortized Discount............... 0 (487) (2,028) (2,515)
Unamortized Premium................ 268 460 186 914
------- ------- -------- --------
Amortized Cost..................... 25,769 54,099 61,924 141,792
Allowance for Credit Losses........ 0 0 (18) (18)
Gross Unrealized Gains............. 82 781 125 988
Gross Unrealized Losses............ (56) (20) (827) (903)
------- ------- -------- --------
Estimated Fair Value............... $25,795 $ 54,860 $ 61,204 $141,859
======= ======= ======== ========
</TABLE>
At December 31, 1995, Mortgage Assets, excluding IO Strips, consisted of
the following:
<TABLE>
<CAPTION>
FEDERAL HOME FEDERAL NATIONAL PRIVATELY ISSUED
LOAN MORTGAGE MORTGAGE MORTGAGE
CORPORATION ASSOCIATION ASSETS TOTAL
------------- ---------------- ---------------- --------
(IN THOUSANDS)
<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>
At December 31, 1994, Mortgage Assets, excluding IO Strips, consisted of
the following:
<TABLE>
<CAPTION>
FEDERAL HOME FEDERAL NATIONAL PRIVATELY ISSUED
LOAN MORTGAGE MORTGAGE MORTGAGE
CORPORATION ASSOCIATION ASSETS TOTAL
------------- ---------------- ---------------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Mortgage Assets, Gross............. $25,966 $ 51,854 $ 42,807 $120,627
Unamortized Discount............... 0 (623) (696) (1,319)
Unamortized Premium................ 275 365 187 827
------- ------- ------- --------
Amortized Cost..................... 26,241 51,596 42,298 120,135
Allowance for Credit Losses........ 0 0 0 0
Gross Unrealized Gains............. 0 30 0 30
Gross Unrealized Losses............ (699) (547) (1,442) (2,688)
------- ------- ------- --------
Estimated Fair Value............... $25,542 $ 51,079 $ 40,856 $117,477
======= ======= ======= ========
</TABLE>
At March 31, 1996, March 31, 1995, December 31, 1995 and December 31, 1994
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
F-11
<PAGE> 162
REDWOOD TRUST, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
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 March 31, 1995, the average annualized effective yield was 7.23%
based on the amortized cost of the assets and 7.23% 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. At December 31, 1994, the average
annualized effective yield on the Mortgage Assets was 6.45% based on the
amortized cost of the assets and 6.60% 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 March 31, 1995 the
weighted average lifetime cap was 11.53% and 11.57%, respectively. At December
31, 1995 and December 31, 1994 the weighted average lifetime cap was 11.54% and
11.48%, respectively.
IO Strips
The amortized cost and fair value of the Company's IO Strips are summarized
as follows:
<TABLE>
<CAPTION>
MARCH 31, 1996 DECEMBER 31, 1995
-------------- -----------------
(UNAUDITED)
(IN THOUSANDS)
<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>
There were no IO Strips held by the Company at March 31, 1995 or December
31, 1994. 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>
MARCH 31, DECEMBER 31,
------------------ ------------------
1996 1995 1995 1994
------- ------ ------- ------
(UNAUDITED)
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Amortized Cost................................ $ 2,534 $2,069 $ 2,521 $1,791
Gross Unrealized Gains........................ 0 25 0 397
Gross Unrealized Losses....................... (1,302) (660) (1,974) (296)
------- ------- ------- -------
Estimated Fair Value.......................... $ 1,233 $1,434 $ 547 $1,892
======= ======= ======= =======
</TABLE>
Cap Agreements
The Company had twenty-seven outstanding Cap Agreements at March 31, 1996,
seven outstanding Cap Agreements at March 31, 1995, twenty-three outstanding Cap
Agreements at December 31, 1995 and six outstanding Cap Agreements at December
31, 1994. Potential future earnings from each of these Cap
F-12
<PAGE> 163
REDWOOD TRUST, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
Agreements are based on variations in the London Interbank Offered Rate
("LIBOR"). Three of the Cap Agreements at March 31, 1996, March 31, 1995 and
December 31, 1995 and two of the Cap Agreements at December 31, 1994 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 $62,000,000 at March 31, 1996 and March 31, 1995,
respectively. The sum of the notional amounts of the Company's Cap Agreements in
effect was $302,000,000 and $25,000,000 at December 31, 1995 and December 31,
1994, respectively. The weighted average cap strike rate during the three month
periods ended March 31, 1996 and March 31, 1995 was 7.36% and 7.85%,
respectively. The weighted average cap strike rate during the year ended
December 31, 1995 was 7.35%. The weighted average cap strike rate during the
period from August 19, 1994 to December 31, 1994 was 7.50%. Under these Cap
Agreements the Company will receive 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>
AVERAGE CAP EXPECTED
NOTIONAL FACE AVERAGE CAP LOW CAP HIGH CAP CAP EXPENSE
YEAR AMOUNT STRIKE RATE STRIKE RATE STRIKE RATE AMORTIZATION
------------------------------- ------------- ----------- ----------- ----------- -----------
(DOLLARS IN THOUSANDS)
(UNAUDITED)
<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 and no outstanding Swap Agreements at March 31, 1995 or
December 31, 1994. The Swap Agreement outstanding at March 31, 1996 and December
31, 1995 is as follows:
<TABLE>
<CAPTION>
INTEREST RATE
--------------------------------
NOTIONAL FACE COMPANY
PAYS FIXED/RECEIVES VARIABLE: AMOUNT COMPANY PAYS RECEIVES
-------------------------------- -------------------- ------------ ---------------
(IN THOUSANDS)
<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
F-13
<PAGE> 164
REDWOOD TRUST, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
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.
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 and March 31, 1995, Mortgage
Assets actually pledged had an estimated fair value of $539,571,815 and
$130,138,011, respectively. At December 31, 1995 and December 31, 1994, Mortgage
Assets actually pledged had an estimated fair value of $386,321,449 and
$105,570,337, respectively.
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 March 31, 1995 the Company had $121,998,000 of Borrowings
outstanding with a weighted average borrowing rate of 6.25% and a weighted
average maturity of 97 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 average remaining maturity of 74 days. At December 31, 1994, the
Company had $100,376,000 of Borrowings outstanding with a weighted average
borrowing rate of 5.80% and a weighted average remaining maturity of 112 days.
At these dates, the Borrowings had the following remaining maturities:
<TABLE>
<CAPTION>
MARCH 31, DECEMBER 31,
--------------------- ---------------------
1996 1995 1995 1994
-------- -------- -------- --------
(IN THOUSANDS)
(UNAUDITED)
<S> <C> <C> <C> <C>
Within 30 days.......................... $221,555 $ 35,752 $ 75,808 $ 4,953
30 to 90 days........................... 227,234 41,613 175,921 30,054
Over 90 days............................ 59,932 44,623 118,587 65,369
-------- -------- -------- --------
Total Borrowings........................ $508,721 $121,988 $370,316 $100,376
======== ======== ======== ========
</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%. For the year ended
December 31, 1995, the average balance of Borrowings was $174,942,000 with a
weighted average interest cost of 6.06%. For the period from August 19, 1994 to
December 31, 1994, the average balance of Borrowings was $37,910,000 with a
weighted average interest cost of 5.50%. The maximum balance outstanding during
the three month periods ended March 31, 1996 and March 31, 1995 was $508,721,000
and $121,988,000, respectively. The maximum balance outstanding during the year
ended December 31, 1995 and during the period from August 19, 1994 to December
31, 1994 was $370,316,000 and $100,376,000, respectively.
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
F-14
<PAGE> 165
REDWOOD TRUST, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
instrument could be exchanged in a current transaction between willing parties,
other than in a forced liquidation sale.
<TABLE>
<CAPTION>
MARCH 31, 1996 MARCH 31, 1995 DECEMBER 31, 1995 DECEMBER 31, 1994
------------------- ------------------- ------------------- -------------------
CARRYING FAIR CARRYING FAIR CARRYING FAIR CARRYING FAIR
AMOUNT VALUE AMOUNT VALUE AMOUNT VALUE AMOUNT VALUE
-------- -------- -------- -------- -------- -------- -------- --------
(IN THOUSANDS)
(UNAUDITED) (UNAUDITED)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Assets
Mortgage
Assets........ $562,922 $562,922 $141,859 $141,859 $429,481 $429,481 $117,477 $117,477
IO Strips....... 2,237 2,237 0 0 2,763 2,763 0 0
Interest Rate
Agreements.... 1,233 1,233 1,434 1,434 547 547 1,892 1,892
</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. The Warrants were not detachable from the
Preferred Stock prior to July 22, 1995. 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.
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
F-15
<PAGE> 166
REDWOOD TRUST, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
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 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.
On October 3, 1994, the Company declared a dividend of $183,970, or $0.15
per preferred share. This dividend was paid on October 31, 1994 to preferred
shareholders of record as of October 18, 1994. On December 16, 1994, the Company
declared a dividend of $166,606, or $0.10 per preferred share. This dividend was
paid on January 20, 1995 to preferred shareholders of record as of December 30,
1994.
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
F-16
<PAGE> 167
REDWOOD TRUST, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
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, March 31, 1995, December 31, 1995 and December
31, 1994 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. Rental expense for office properties under operating leases for
the year ended December 31, 1995 and for the period from August 19, 1994 to
December 31, 1994 was $64,082 and $8,612, 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>
MINIMUM RENTAL
YEAR ENDING COMMITMENT
DECEMBER 31, AS OF MARCH 31, 1996
------------- --------------------
(IN THOUSANDS)
(UNAUDITED)
<S> <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 year ended December
31, 1994 and for the period from August 19, 1994 to December 31, 1994 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%.
F-17
<PAGE> 168
- ------------------------------------------------------
- ------------------------------------------------------
No dealer, salesperson or other person has been authorized to give any
information or to make any representations in connection with this Offering
other than those contained in this Prospectus, and, if given or made, such
information or representations must not be relied upon as having been authorized
by the Company or any of the Underwriters. This Prospectus does not constitute
an offer to sell or a solicitation of any offer to buy any securities other than
the shares of Preferred Stock to which it relates or an offer to, or a
solicitation of, any person in any jurisdiction in which such an offer or
solicitation would be unlawful. Neither the delivery of this Prospectus nor any
offer or sale made hereunder shall, under any circumstances, create any
implication that there has been no change in the affairs of the Company or that
the information contained herein is correct as of any time subsequent to the
date hereof.
------------------------------------
TABLE OF CONTENTS
------------------------------------
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Available Information.................. 2
Prospectus Summary..................... 3
The Company............................ 17
Use of Proceeds........................ 17
Risk Factors........................... 18
Dividend Policy and Distributions...... 33
Dividend Reinvestment Plan............. 34
Capitalization......................... 35
Market Prices and Dividend Data........ 36
Selected Financial Data................ 37
Management's Discussion and Analysis of
Financial Condition and Results of
Operations........................... 39
Business and Strategy.................. 71
Management............................. 92
Principal Securityholders.............. 100
Certain Federal Income Tax
Considerations....................... 102
ERISA Considerations................... 110
Description of Warrants................ 111
Description of Capital Stock........... 112
Certain Legal Aspects of Mortgage
Loans................................ 130
Underwriting........................... 140
Legal Matters.......................... 141
Experts................................ 141
Glossary............................... 142
Index to Financial Statements.......... F-1
</TABLE>
- ------------------------------------------------------
- ------------------------------------------------------
- ------------------------------------------------------
- ------------------------------------------------------
875,000 SHARES
RWT
REDWOOD TRUST, INC.
CLASS B 9.74% CUMULATIVE
CONVERTIBLE PREFERRED STOCK
------------------------
PROSPECTUS
------------------------
MONTGOMERY SECURITIES
STIFEL, NICOLAUS & COMPANY
Incorporated
August 8, 1996
- ------------------------------------------------------
- ------------------------------------------------------
