<PAGE> 1
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED: SEPTEMBER 30, 1996
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
------------- -------------
COMMISSION FILE NUMBER: 0-26436
REDWOOD TRUST, INC.
(Exact name of Registrant as specified in its Charter)
MARYLAND 68-0329422
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
591 REDWOOD HIGHWAY, SUITE 3100
MILL VALLEY, CALIFORNIA 94941
(Address of principal executive offices) (Zip Code)
(415) 389-7373
(Registrant's telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all
documents and reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such
shorter period that the Registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days.
Yes X No
------- -------
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's
classes of stock, as of the last practicable date.
Class B Preferred Stock ($.01 par value) 1,006,250 as of November 8,1996
Common Stock ($.01 par value) 9,138,872 as of November 8,1996
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REDWOOD TRUST, INC.
FORM 10-Q
INDEX
<TABLE>
<CAPTION>
Page
----
<S> <C> <C>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Balance Sheets at September 30, 1996 and December 31, 1995 ....... 3
Statements of Operations for the three and nine months
ended September 30, 1996 and September 30, 1995 .................. 4
Statements of Stockholders' Equity for the three and nine months
ended September 30, 1996 and September 30, 1995 .................. 5
Statements of Cash Flows for the three and nine months
ended September 30, 1996 and September 30, 1995 .................. 6
Notes to Financial Statements .................................... 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations .................... 19
PART II. OTHER INFORMATION
Item 1. Legal Proceedings ................................................ 46
Item 2. Changes in Securities ............................................ 46
Item 3. Defaults Upon Senior Securities .................................. 46
Item 4. Submission of Matters to a Vote of Security Holders .............. 46
Item 5. Other Information ................................................ 46
Item 6. Exhibits and Reports on Form 8-K ................................. 46
SIGNATURES ................................................................ 47
</TABLE>
2
<PAGE> 3
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
REDWOOD TRUST, INC.
BALANCE SHEETS
(In thousands, except share data)
<TABLE>
<CAPTION>
September 30, 1996 December 31, 1995
------------------ -----------------
<S> <C> <C>
ASSETS
Cash and cash equivalents $ 14,599 $ 4,825
Mortgage assets 1,375,870 432,244
Interest rate agreements 873 547
Accrued interest receivable 10,781 3,270
Other assets 1,355 671
----------- -----------
$ 1,403,478 $ 441,557
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Short-term borrowings $ 1,225,094 $ 370,316
Accrued interest payable 10,379 1,290
Accrued expenses and other liabilities 472 227
Dividends payable 4,016 1,434
----------- -----------
1,239,961 373,267
----------- -----------
Commitments and contingencies (See Note 11)
STOCKHOLDERS' EQUITY
Preferred stock, par value $0.01 per share:
Class B 9.74% Cumulative Convertible
1,006,250 and 0 shares authorized;
1,006,250 and 0 shares issued and outstanding
($31,582 aggregate liquidation preference) 29,712 0
Common stock, par value $0.01 per share;
48,993,750 and 50,000,000 shares authorized;
9,069,653 and 5,517,299 shares issued and outstanding 91 55
Additional paid-in capital 138,081 73,895
Net unrealized loss on assets available for sale (2,060) (5,476)
Dividends in excess of net income (2,307) (184)
----------- -----------
163,517 68,290
----------- -----------
$ 1,403,478 $ 441,557
=========== ===========
</TABLE>
The accompanying notes are an integral part of these financial statements
3
<PAGE> 4
REDWOOD TRUST, INC.
STATEMENTS OF OPERATIONS
(In thousands, except share data)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
1996 1995 1996 1995
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
INTEREST INCOME
Mortgage assets $ 19,121 $ 3,936 $ 40,734 $ 9,031
Cash and investments 250 50 669 85
----------- ----------- ----------- -----------
19,371 3,986 41,403 9,116
INTEREST EXPENSE 14,447 2,432 29,724 6,155
INTEREST RATE AGREEMENTS
Interest rate agreement expense 349 112 756 210
----------- ----------- ----------- -----------
NET INTEREST INCOME 4,575 1,442 10,923 2,751
Provision for credit losses 516 84 1,324 143
----------- ----------- ----------- -----------
Net interest income after provision for credit losses 4,059 1,358 9,599 2,608
Operating expenses 672 364 1,758 763
----------- ----------- ----------- -----------
NET INCOME $ 3,387 $ 994 $ 7,841 $ 1,845
=========== =========== =========== ===========
Net income 3,387 994 7,841 1,845
Less cash dividends on Class B preferred stock (388) -- (388) --
----------- ----------- ----------- -----------
Net income available to common stockholders 2,999 994 7,453 1,845
=========== =========== =========== ===========
NET INCOME PER SHARE
Primary $ 0.32 $ 0.24 $ 0.90 $ 0.67
Fully diluted $ 0.31 $ 0.24 $ 0.89 $ 0.67
Weighted average shares of common stock and
common stock equivalents:
Primary 9,516,174 4,183,138 8,246,815 2,747,642
Fully diluted 9,657,395 4,183,138 8,402,542 2,747,642
Dividends declared per Class A preferred share $ -- $ -- $ -- $ 0.50
Dividends declared per Class B preferred share $ 0.386 $ -- $ 0.386 $ --
Dividends declared per common share $ 0.40 $ 0.20 $ 1.26 $ 0.20
</TABLE>
The accompanying notes are an integral part of these financial statements
4
<PAGE> 5
REDWOOD TRUST, INC.
STATEMENTS OF STOCKHOLDERS' EQUITY
For the Nine Months Ended September 30, 1996
(In thousands, except share data)
<TABLE>
<CAPTION>
Net Unrealized
Class B Additional Loss on Assets Undistributed
Preferred Common Paid-in Available Income /
Stock Stock Capital for Sale (Deficit) Total
----------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Balance, December 31, 1995 -- $ 55 $ 73,895 ($ 5,476) ($ 184) $ 68,290
Net income -- -- -- -- 1,954 1,954
Issuance of common stock -- -- 79 -- -- 79
Offering costs -- -- (48) -- -- (48)
Dividends declared -- -- -- -- (2,540) (2,540)
Fair value adjustment on
assets available for sale -- -- -- 411 -- 411
--------- ------ --------- --------- --------- ---------
Balance, March 31, 1996 -- 55 73,926 (5,065) (770) 68,146
Net income -- -- -- -- 2,500 2,500
Issuance of common stock -- 29 55,303 -- -- 55,332
Offering costs -- -- (304) -- -- (304)
Conversion of stock warrants -- 1 1,516 -- -- 1,517
Dividends declared -- -- -- -- (3,408) (3,408)
Fair value adjustment on
assets available for sale -- -- -- 512 -- 512
--------- ------ --------- --------- --------- ---------
Balance, June 30, 1996 -- 85 130,441 (4,553) (1,678) 124,295
Net income -- -- -- -- 3,387 3,387
Issuance of common stock -- 1 495 -- -- 496
Issuance of Class B preferred stock 29,868 -- -- -- -- 29,868
Offering costs (156) -- (163) -- -- (319)
Conversion of stock warrants -- 5 7,308 -- -- 7,313
Dividends declared:
Common -- -- -- -- (3,628) (3,628)
Class B Preferred -- -- -- -- (388) (388)
Fair value adjustment on
assets available for sale -- -- -- 2,493 -- 2,493
--------- ------ --------- --------- --------- ---------
Balance, September 30, 1996 $ 29,712 $ 91 $ 138,081 ($ 2,060) ($ 2,307) $ 163,517
</TABLE>
The accompanying notes are an integral part of these financial statements
5
<PAGE> 6
REDWOOD TRUST, INC.
STATEMENTS OF CASH FLOWS
(In thousands, except share data)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
1996 1995 1996 1995
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 3,387 $ 994 $ 7,841 $ 1,845
Adjustments to reconcile net income to net cash
provided by operating activities:
Amortization of mortgage asset premium and discount, net 1,435 (157) 2,989 (575)
Depreciation and amortization 25 18 60 43
Provision for credit losses on mortgage assets 516 84 1,324 143
Amortization of interest rate cap agreements 208 112 548 210
(Increase) in accrued interest receivable (3,489) (753) (7,511) (1,265)
(Increase) decrease in other assets 420 (282) (744) (296)
Increase in accrued interest payable 6,327 493 9,089 135
Increase in accrued expenses and other 111 92 245 152
----------- ----------- ----------- -----------
Net cash provided by operating activities 8,940 601 13,841 392
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of mortgage assets (443,860) (132,640) (1,106,896) (192,111)
Principal payments on mortgage assets 76,942 8,319 162,814 13,927
Purchases of interest rate cap agreements (660) (481) (1,314) (813)
----------- ----------- ----------- -----------
Net cash used in investing activities (367,578) (124,802) (945,396) (178,997)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings from reverse repurchase agreements 328,880 72,945 854,778 128,450
Net proceeds from issuance of Class B preferred stock 29,712 -- 29,712 --
Net proceeds from issuance of common stock 7,646 51,286 64,221 51,278
Dividends paid (3,408) (500) (7,382) (1,000)
----------- ----------- ----------- -----------
Net cash provided by financing activities 362,830 123,731 941,329 178,728
Net increase (decrease) in cash and cash equivalents 4,192 (470) 9,774 123
Cash and cash equivalents at beginning of period 10,407 1,620 4,825 1,027
----------- ----------- ----------- -----------
Cash and cash equivalents at end of period $ 14,599 $ 1,150 $ 14,599 $ 1,150
=========== =========== =========== ===========
Supplemental disclosure of cash flow information:
Cash paid for interest $ 8,120 $ 2,432 $ 20,635 $ 6,514
=========== =========== =========== ===========
</TABLE>
The accompanying notes are an integral part of these financial statements
6
<PAGE> 7
REDWOOD TRUST, INC.
NOTES TO FINANCIAL STATEMENTS
SEPTEMBER 30, 1996
NOTE 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Redwood Trust, Inc. (the "Company") was incorporated in Maryland on
April 11, 1994. At incorporation 208,332 shares of the Company's common
stock, par value $.01 per share ("Common Stock") were issued to various
officers and employees of the Company.
On August 19, 1994, upon receipt of the net proceeds from the first
closing of its private placement of Units, the Company commenced its
operations of acquiring and managing mortgage assets. Each Unit
consisted of one share of Class A Convertible Preferred Stock, par
value $.01 per share ("Preferred Stock") and one Stock Purchase Warrant
("Warrant"). In this first closing, the Company issued 1,226,465 Units
at a price of $15 per Unit. The Company received proceeds of $17
million, net of an underwriting discount of $1.05 per share and other
offering costs.
In October 1994, the Company completed a second closing of its private
placement of Units. The Company issued an additional 439,598 Units at a
price of $15 per Unit. The Company received proceeds of $6 million, 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 million, 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.
On April 19, 1996, the Company completed its second public offering of
2,875,000 shares of common stock at $20.25 per share. The Company
received proceeds of $55 million, net of an underwriting discount of
$1.164 per share and other offering costs.
On August 8, 1996, the Company completed its public offering of
1,006,250 shares of Class B 9.74% Cumulative Convertible Preferred
stock ("Class B preferred stock") at $31.00 per share. The Company
received proceeds of $30 million, net of an underwriting discount of
$1.317 per share and other offering costs.
During September, 1996, the Company completed a Universal Shelf
Registration. With this Registration Statement, the Company may offer
Common Stock, Preferred Stock, Warrants and Shareholder Rights from
time to time. The aggregate maximum offering price of all securities to
be issued pursuant to this Registration Statement is $200,000,000.
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 real estate properties throughout the
United 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.
7
<PAGE> 8
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 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 expected
cash flow from the Mortgage Assets, including an
other-than-temporary deterioration of the credit quality of the
underlying mortgages and/or the credit protection available to
the related mortgage 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
8
<PAGE> 9
Agreements, which include interest rate cap agreements (the "Cap
Agreements"), interest rate swap agreements (the "Swap
Agreements") and interest rate collar agreements (the "Collar
Agreements"), entered into by the Company are intended to provide
income 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 and the net cost or payment
received on each Collar Agreement is amortized over the effective
period of that Cap or Collar 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 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 serious 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 $233,244 at September 30, 1996 and $113,515
at December 31, 1995. Depreciation expense and leasehold
improvements amortization for the three and nine months ended
September 30, 1996 totaled $16,514 and $35,066, respectively.
Depreciation expense and leasehold improvements amortization for
the three and nine months ended September 30, 1995 totaled $9,879
and $17,995, respectively. Accumulated depreciation and leasehold
improvement amortization totaled $66,433 at September 30, 1996
and $31,367 at December 31, 1995.
Income Taxes
The Company has elected to be taxed as a Real Estate Investment
Trust ("REIT") and intends to comply with the REIT provisions of
the Internal Revenue Code (the "Code") and the corresponding
provisions of State law. Accordingly, the Company will not be
subject to Federal or state income tax to the extent of its
distributions to stockholders. In order to maintain its status as
a REIT, the Company is required, among other requirements, to
distribute at least 95% of its taxable income.
Earnings per Share
Earnings per share are based on the weighted average shares of
common stock outstanding plus common equivalent shares 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.
9
<PAGE> 10
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 September
30, 1996, the privately issued Mortgage Assets held by the
Company had rating equivalents ranging from AAA to unrated, with
a weighted average of AA; the weighted average rating equivalent
of all the Company's Mortgage Assets was AA+. At December 31,
1995, the privately issued Mortgage Assets held by the Company
had rating equivalents ranging from AAA to unrated, with a
weighted average of A+; the weighted average rating equivalent of
all the Company's Mortgage Assets was AA+.
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 and nine months ended
September 30, 1996 the Company provided for $515,895 and
$1,324,080 in credit losses, respectively. During the three and
nine months ended September 30, 1995 the Company provided for
$84,044 and $143,079 in credit losses, respectively. During the
three and nine months ended September 30, 1996 and September 30,
1995 the Company incurred no charge-offs. The reserve balance at
September 30, 1996 and December 31, 1995 was $1,813,794 and
$489,713, respectively.
NOTE 2. MORTGAGE ASSETS
Mortgage Assets Excluding IO Strip
At September 30, 1996, Mortgage Assets, excluding IO Strips, consisted
of the following:
<TABLE>
<CAPTION>
FEDERAL HOME LOAN FEDERAL NATIONAL NON-AGENCY
MORTGAGE MORTGAGE MORTGAGE
(IN THOUSANDS) CORPORATION ASSOCIATION ASSETS TOTAL
----------------- ---------------- ---------- -----------
<S> <C> <C> <C> <C>
Mortgage Assets, Gross $ 259,831 $ 595,497 $ 505,734 $ 1,361,062
Unamortized Discount 0 (243) (16,095) (16,338)
Unamortized Premium 7,243 15,650 6,980 29,873
----------- ----------- ----------- -----------
Amortized Cost 267,074 610,904 496,619 1,374,597
Allowance for Credit Losses 0 0 (1,814) (1,814)
Gross Unrealized Gains 752 1,683 2,679 5,114
Gross Unrealized Losses (212) (691) (3,397) (4,300)
----------- ----------- ----------- -----------
Estimated Fair Value $ 267,614 $ 611,896 $ 494,087 $ 1,373,597
=========== =========== =========== ===========
</TABLE>
10
<PAGE> 11
At December 31, 1995, Mortgage Assets, excluding IO Strips, consisted
of the following:
<TABLE>
<CAPTION>
FEDERAL HOME FEDERAL NATIONAL NON-AGENCY
LOAN MORTGAGE MORTGAGE MORTGAGE
(IN THOUSANDS) CORPORATION ASSOCIATION ASSETS TOTAL
------------- ---------------- ---------- ---------
<S> <C> <C> <C> <C>
Mortgage Assets, Gross $ 46,160 $ 190,061 $ 207,404 $ 443,625
Unamortized Discount 0 (313) (16,719) (17,032)
Unamortized Premium 907 3,608 1,535 6,050
--------- --------- --------- ---------
Amortized Cost 47,067 193,356 192,220 432,643
Allowance for Credit Losses 0 0 (490) (490)
Gross Unrealized Gains 334 1,033 874 2,241
Gross Unrealized Losses (110) (458) (4,345) (4,913)
--------- --------- --------- ---------
Estimated Fair Value $ 47,291 $ 193,931 $ 188,259 $ 429,481
========= ========= ========= =========
</TABLE>
At September 30, 1996 and December 31, 1995, all investments in
Mortgage Assets consisted of interests in adjustable rate mortgages on
residential properties. A majority of the Non-Agency Mortgage Asset
properties are located in the State of California. The securitized
interests in pools of adjustable rate mortgages from the Federal Home
Loan Mortgage Corporation and the Federal National Mortgage Association
are guaranteed as to principal and interest by those US government
agencies. The original maturity of the vast majority of the Mortgage
Assets is over a period of thirty years; the actual maturity is subject
to change based on the prepayments of the underlying mortgage loans.
At September 30, 1996, the average annualized effective yield was 6.97%
based on the amortized cost of the assets and 6.97% based on the fair
value of the assets. At December 31, 1995, the average annualized
effective yield on the Mortgage Assets was 7.66% based on the amortized
cost of the assets and 7.74% based on the fair value of the assets.
Most of the adjustable rate mortgage securities and loans are limited
by periodic caps (generally interest rate adjustments are limited to no
more than 1% every six months) and lifetime caps. At September 30, 1996
and December 31, 1995 the weighted average lifetime cap was 11.69% and
11.54%, respectively.
IO Strips
The amortized cost and fair value of the Company's IO Strips are
summarized as follows:
<TABLE>
<CAPTION>
(IN THOUSANDS) SEPTEMBER 30, 1996 DECEMBER 31, 1995
------------------ -----------------
<S> <C> <C>
Amortized Cost $ 2,734 $ 3,593
Gross Unrealized Gains 42 0
Gross Unrealized Losses (503) (830)
------- -------
Estimated Fair Value $ 2,273 $ 2,763
======= =======
</TABLE>
The average annualized effective yield at September 30, 1996 on the IO
Strips was 11.10% based on the amortized cost of the assets and 13.35%
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.
11
<PAGE> 12
NOTE 3. INTEREST RATE AGREEMENTS
The amortized cost and fair value of the Company's Interest Rate
Agreements are summarized as follows:
<TABLE>
<CAPTION>
(IN THOUSANDS) SEPTEMBER 30, 1996 DECEMBER 31, 1995
------------------ -----------------
<S> <C> <C>
Amortized Cost $ 3,286 $ 2,521
Gross Unrealized Gains 54 0
Gross Unrealized Losses (2,467) (1,974)
------- -------
Estimated Fair Value $ 873 $ 547
======= =======
</TABLE>
Cap Agreements
The Company had forty outstanding Cap Agreements at September 30, 1996
and twenty-three outstanding Cap Agreements at December 31, 1995.
Potential future earnings from each of these Cap Agreements are based
on variations in the London Interbank Offered Rate ("LIBOR"). Three of
the Cap Agreements at September 30, 1996 and December 31, 1995 had
contractually stated notional amounts which vary over the life of the
Cap Agreement. The sum of the notional amounts of the Company's Cap
Agreements in effect was $482,500,000 and $302,000,000 at September 30,
1996 and December 31, 1995, respectively. The weighted average cap
strike rate during the three and nine months ended September 30, 1996
was 7.11% and 7.18%. The weighted average cap strike rate during the
three and nine months ended September 30, 1995 was 7.86% and 7.64%.
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 September 30, 1996 are as follows:
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS) AVERAGE CAP EXPECTED
NOTIONAL FACE AVERAGE CAP LOW CAP HIGH CAP CAP EXPENSE
YEAR AMOUNT STRIKE RATE STRIKE RATE STRIKE RATE AMORTIZATION
---- ------ ----------- ----------- ----------- ------------
<S> <C> <C> <C> <C> <C>
1996 (last 3 months) $421,571 7.29% 5.50% 12.00% $ 193
1997 547,392 8.04% 5.50% 12.00% 822
1998 269,657 8.73% 6.94% 12.00% 703
1999 176,197 9.32% 6.94% 12.00% 529
2000 97,889 9.06% 7.50% 10.00% 362
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 $ 3,286
========
</TABLE>
Collar Agreement
At September 30, 1996, the Company had entered into one outstanding
collar agreement, consisting of the purchase of a cap agreement
subsidized by the sale of a floor agreement. On the cap portion, the
Company will receive net hedge income to the extent that three month
LIBOR exceeds 7.50%. On the floor portion, the Company will incur a net
hedge expense to the extent that three month LIBOR falls below 5.91%
12
<PAGE> 13
The Collar Agreement outstanding at September 30, 1996 is as follows:
<TABLE>
<CAPTION>
NOTIONAL FACE EXPECTED
AMOUNT CAP STRIKE FLOOR COLLAR EXPENSE
EFFECTIVE PERIOD: (IN THOUSANDS) INDEX RATE STRIKE RATE AMORTIZATION
----------------- -------------- ----- ---- ----------- ------------
<S> <C> <C> <C> <C> <C>
October 1996 to July 1999 $20,000 3 mo LIBOR 7.50% 5.91% $0
</TABLE>
Swap Agreements
The Company has entered into three types of Interest Rate Swap
Agreements summarized as follows:
Fixed vs. Floating Rate Swap Agreements:
The Company had six outstanding Fixed vs. Floating Rate Swap Agreements
("Fixed Pay Rate Swaps") at September 30, 1996 and one outstanding
Fixed Pay Rate Swap at December 31, 1995. The sum of the notional
amounts of the Company's Fixed Pay Rate Swaps in effect was $70,000,000
and $10,000,000 at September 30, 1996 and December 31, 1995,
respectively. Under these swap agreements, the Company receives the 3
month LIBOR rate and pays the fixed rate shown below.
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS) AVERAGE SWAP
NOTIONAL FACE AVERAGE LOW HIGH
YEAR AMOUNT PAY RATE PAY RATE PAY RATE
---- ------ -------- -------- --------
<S> <C> <C> <C> <C>
1996 (last 3 months) $ 82,554 6.30% 6.01% 6.97%
1997 109,699 6.27% 6.01% 7.18%
1998 (first 5 months) 25,828 6.59% 6.40% 7.18%
</TABLE>
Periodic Swap Agreements:
As of September 30, 1996, the Company had entered into three Periodic
Swap Agreements designed to produce income to the Company in the event
that the three month LIBOR rate rises sharply. In each of these swaps,
the Company receives income on the notional face at a rate equal to
three month LIBOR less 0.230% to 0.265% and pays income on the notional
face on the lesser of (a) three month LIBOR or (b) the prior period's
LIBOR plus 0.50%. The average notional face of these swaps is $110
million, with $90 million maturing in August 1999 and $20 million
maturing in September 1999.
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS) AVERAGE SWAP
NOTIONAL FACE AVERAGE SPREAD LOW SPREAD HIGH SPREAD
YEAR AMOUNT RECEIVED RECEIVED RECEIVED
---- ------ -------- -------- --------
<S> <C> <C> <C> <C>
1996 (last 3 months) $110,000 -0.255% -0.265% -0.230%
1997 110,000 -0.255% -0.265% -0.230%
1998 110,000 -0.255% -0.265% -0.230%
1999 (first 9 months) 98,242 -0.257% -0.265% -0.230%
</TABLE>
Basis Swap Agreements:
As of September 30, 1996, the Company had entered into five
LIBOR/Treasury bill Basis Swap Agreements totaling $160 million. These
Basis Swap Agreements, in conjunction with the Company's other swap and
cap agreements, are designed to reduce the potential risks in that
portion of the Company's balance sheet wherein Treasury-based assets
are funded with LIBOR-based liabilities. The Basis Swap Agreements will
produce net hedge income for the Company to the extent that three month
LIBOR exceeds the average three month Treasury bill rate by 0.440% to
0.465% and will produce a net hedge expense for the Company to the
extent that the spread between these two indices is narrower than
0.440% to 0.465%. Half of the Company's $160 million in Basis Swap
Agreements were effective at the end of the third quarter of 1996; the
remainder will be effective by
13
<PAGE> 14
December 31, 1996. The maturities of these Basis Swap Agreements are as
follows: $30 million in June 1998, $50 million in December 1998, $30
million in June 1999 and $50 million in December 1999.
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS) AVERAGE SWAP
NOTIONAL FACE AVERAGE SPREAD LOW SPREAD HIGH SPREAD
YEAR AMOUNT PAID PAID PAID
---- ------ ---- ---- ----
<S> <C> <C> <C> <C>
1996 (last 3 months) $ 61,087 0.450% 0.440% 0.465%
1997 160,000 0.453% 0.440% 0.465%
1998 144,877 0.455% 0.440% 0.465%
1999 64,712 0.464% 0.460% 0.465%
</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 Cap, Swap and Collar Agreements, if one of the
counter-parties does not perform, the Company would not receive the
cash to which it would otherwise be entitled under the Interest Rate
Agreement. In order to mitigate this risk, the Company has entered into
Interest Rate Agreements only with counter-parties rated A or better
and has entered into Interest Rate Agreements with twelve 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
September 30, 1996 or December 31, 1995.
NOTE 4. SHORT-TERM BORROWINGS
The Company has entered into reverse repurchase agreements, notes
payable and a revolving line of credit (together "Short-Term
Borrowings") to finance acquisitions of a portion of its Mortgage
Assets. These Short-Term Borrowings are collateralized by a portion of
the Company's Mortgage Assets.
In September 1996, the Company entered into a $20 million, one-year
revolving line of credit agreement with a financial institution. The
agreement requires that the Company maintain certain financial ratios.
The Company is in compliance with all requirements. Interest rates on
borrowings under this facility are based on LIBOR. At September 30,
1996, borrowings under this facility totaled $19,943,000 and were
committed through October 15, 1996.
At September 30, 1996 the Company had $1,225,094,000 of Short-Term
Borrowings outstanding with a weighted average borrowing rate of 5.782%
and a weighted average maturity of 102 days. These borrowings were
collateralized with $1,289,471,000 of Mortgage Assets. At December 31,
1995, the Company had $370,316,047 of Short-Term Borrowings outstanding
with a weighted average borrowing rate of 6.01% and a weighted average
remaining maturity of 74 days. These borrowing were collateralized with
$386,321,000 of Mortgage Assets.
At September 30, 1996 and December 31, 1995, the Short-Term Borrowings
had the following remaining maturities:
<TABLE>
<CAPTION>
(IN THOUSANDS) SEPTEMBER 30, 1996 DECEMBER 31, 1995
------------------ -----------------
<S> <C> <C>
Within 30 days $ 221,265 $ 75,808
30 to 90 days 253,477 175,921
Over 90 days 750,352 118,587
---------- ----------
Total Borrowings $1,225,094 $ 370,316
========== ==========
</TABLE>
14
<PAGE> 15
For the three and nine months ended September 30, 1996, the average
balance of Short-Term Borrowings was $999,229,000 and $696,725,000,
respectively with a weighted average interest cost of 5.78% and 5.69%.
For the three and nine months ended September 30, 1995 the average
balance of Short-Term Borrowings was $159,794,000 and $134,431,000,
respectively with a weighted average interest cost of 6.09% and 6.10%.
The maximum balance outstanding during the nine months ended September
30, 1996 was $1,225,094,000. The maximum balance outstanding during the
year ended December 31, 1995 was $370,316,000.
NOTE 5. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table presents the carrying amounts and estimated fair
values of the Company's financial instruments at September 30, 1996 and
December 31, 1995. FASB statement No. 107, Disclosures about Fair Value
of Financial Instruments, defines the fair value of a financial
instrument as the amount at which the instrument could be exchanged in
a current transaction between willing parties, other than in a forced
liquidation sale.
<TABLE>
<CAPTION>
SEPTEMBER 30, 1996 DECEMBER 31, 1995
------------------------- -------------------------
CARRYING FAIR CARRYING FAIR
(IN THOUSANDS) AMOUNT VALUE AMOUNT VALUE
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Assets
Mortgage Assets $1,373,597 $1,373,597 $ 429,481 $ 429,481
IO Strips 2,273 2,273 2,763 2,763
Interest Rate Agreements 873 873 547 547
</TABLE>
Management bases its fair value estimates primarily on third party bid
price indications, such as bid indications provided by dealers who make
markets in these assets and asset valuations made by collateralized
lenders, when such indications are available. However, the fair value
reported reflects estimates and may not necessarily be indicative of
the amounts the Company could realize in a current market exchange.
Cash and cash equivalents, interest receivable, reverse repurchase
agreements and accrued liabilities are reflected in the financial
statements at their amortized costs, which approximates their fair
value because of the short-term nature of these instruments.
NOTE 6. CLASS A CONVERTIBLE PREFERRED STOCK
In 1994 the Company issued 1,666,063 shares of Class A Convertible
Preferred Stock. The Class A Preferred Stock ranked senior to the
Company's Common Stock as to dividends and liquidation rights.
Concurrent with the completion of the Initial Public Offering on August
9, 1995, all 1,666,063 outstanding shares of Class A Convertible
Preferred Stock converted into 1,667,134 shares of Common Stock.
NOTE 7. CLASS B CONVERTIBLE PREFERRED STOCK
On August 8, 1996, the Company issued 1,006,250 shares of Class B 9.74%
Cumulative Convertible Preferred Stock. Each share of the Class B
Preferred Stock is convertible at the option of the holder at any time
into one share of Common Stock. The Class B Preferred Stock will be
redeemable by the Company after September 30, 1999. The Class B
Preferred Stock pays a dividend equal to the greater of (i) $0.755 per
quarter or (ii) an amount equal to the quarterly dividend declared on
the number of shares of the Common Stock into which the Class B
Preferred Stock is convertible. The Class B Preferred Stock ranks
senior to the Company's Common Stock as to the payment of dividends and
liquidation rights.
NOTE 8. STOCK PURCHASE WARRANTS
At September 30, 1996 and December 31, 1995 there were 1,076,431 and
1,665,063 Warrants outstanding, respectively. Each Warrant entitles the
holder to purchase 1.000667 shares of the Company's common stock at an
exercise price of $15.00 per share. The Warrants remain exercisable
until December 31, 1997.
15
<PAGE> 16
NOTE 9. 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 15% of the Company's total outstanding shares of Common
Stock. At September 30, 1996 and December 31, 1995, 983,097 and 142,060
shares of Common Stock, respectively, were available for grant. Of the
shares of Common Stock available for grant, no more than 500,000 shares
of Common Stock shall be cumulatively available for grant as ISOs. At
September 30, 1996 and December 31, 1995, 168,333 ISOs had been
granted. The exercise price for ISOs granted under the Stock Option
Plan may not be less than the fair market value of shares of Common
Stock at the time the ISO is granted. 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 stock options granted under the
plan to accrue DERs. For the three and nine months ended September 30,
1996, the DERs accrued on NQSOs resulted in non-cash charges to general
and administrative expenses of $80,592 and $244,916, respectively.
These non-cash charges were $7,200 for both the three and nine months
ended September 30, 1995. DERs represent shares of stock which are
issuable to holders of stock options when the holders exercise the
underlying stock options. The number of DER shares accrued are based on
the level of the Company's dividends and on the price of the stock on
the related dividend payment date.
Information with respect to stock option and DER activity is as
follows:
<TABLE>
<CAPTION>
NINE MONTHS ENDED YEAR ENDED
SEPTEMBER 30, 1996 DECEMBER 31, 1995
------------------ -----------------
<S> <C> <C>
Outstanding options at beginning of period: 310,857 188,333
Options granted 10,000 166,972
Options exercised (42,083) (47,083)
Dividend equivalent rights earned 9,411 2,635
------- -------
Outstanding options at end of period 288,185 310,857
======= =======
Exercise price per share:
For options exercised during period $0.10 - $0.11 $0.10 - $0.11
For options outstanding end of period $0.10 - $24.63 $0.10 - $21.50
</TABLE>
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.
16
<PAGE> 17
NOTE 10. 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 June 14, 1996 the
Company declared a dividend of $3,408,046, or $0.40 per common share.
This dividend was paid on July 18, 1996 to shareholders of record as of
June 28, 1996. On September 16, 1996 the Company declared a dividend of
$388,413 and $3,627,861, or $0.386 per Class B preferred share and
$0.40 per common share, respectively. These dividends were paid on
October 21, 1996 to shareholders of record as of September 30, 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
Under the Internal Revenue Code of 1986, a dividend declared by a REIT
in December of a calendar year, payable to shareholders of record as of
a specified date in December, will be deemed to have been paid by the
Company and received by the shareholders on that record date if the
dividend is actually paid before February 1st of the following calendar
year. Therefore, the dividend declared in December 1995 which was paid
in January 1996 is considered taxable income to shareholders in the
year declared. The Company's dividends are not eligible for the
dividends received deduction for corporations.
NOTE 11. COMMITMENTS AND CONTINGENCIES
As of September 30, 1996 the Company had entered into a commitment to
purchase $23 million of Mortgage Assets for settlement in October 1996.
At September 30, 1996 and December 31, 1995, the Company had no other
outstanding commitments to purchase or sell Mortgage Assets or to
purchase, sell or terminate Interest Rate Agreements. The Company also
had no commitments to enter into additional reverse repurchase
agreements or other borrowings.
Rental expense for office properties under operating leases for the
three and nine months ended September 30, 1996 was $28,647 and $79,108,
respectively. Rental expense for office properties under operating
leases for the three and nine months ended September 30, 1995 was
$16,098 and $47,920, respectively.
Future minimum rental commitments as of September 30, 1996 under
noncancelable operating leases with initial or remaining terms of more
than one year, are as follows:
<TABLE>
<CAPTION>
MINIMUM RENTAL
COMMITMENT
YEAR ENDING AS OF SEPTEMBER 30, 1996
DECEMBER 31, (IN THOUSANDS)
------------ --------------
<S> <C>
1996 30
1997 121
1998 121
1999 121
2000 121
2001 40
---- ----
Total $554
====
</TABLE>
17
<PAGE> 18
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
and nine months ended September 30, 1996, the Company was bearing 95%
of the lease expenses and GB Capital was bearing 5%. For the three and
nine months ended September 30, 1995, the Company was bearing 70% of
the lease expenses and GB Capital was bearing 30%.
18
<PAGE> 19
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the
Financial Statements and Notes.
SAFE HARBOR STATEMENT
"Safe Harbor" Statement under the Private Securities Litigation Reform
Act of 1995: Statements in this discussion regarding Redwood Trust,
Inc. (the "Company") and its business which are not historical facts
are "forward-looking statements" that involve risks and uncertainties.
For a discussion of such risks and uncertainties, which could cause
actual results to differ from those contained in the forward-looking
statements, see "Risk Factors" commencing on Page 18 of the Company's
preferred stock offering prospectus, dated August 8, 1996 (Registration
Statement No. 333-08363).
OVERVIEW
Redwood Trust, Inc. is a mortgage finance company which acquires and
manages mortgage assets using its equity and borrowed funds. The
Company's source of earnings is net interest income, or the interest
income earned on mortgages less the interest expense paid on borrowed
funds. The Company believes its primary competitors are other financial
institutions, such as banks and savings and loan institutions, which
seek to earn spread income from managing mortgage assets. Compared to
most of its competitors, the Company believes it benefits from a lower
cost of operations and from its status as a Real Estate Investment
Trust ("REIT"). As a REIT, the Company does not pay corporate Federal
income taxes so long as the Company pays out as dividends an amount
equal to at least 95% of its taxable income and satisfies certain other
conditions.
The Company's strategy is to focus solely on being a highly efficient
spread lender. Instead of maintaining an in-house mortgage origination
staff, the Company acquires mortgage assets from mortgage origination
companies and from the secondary mortgage market. The Company
out-sources mortgage servicing functions. Rather than build a retail
branch banking system to gather deposits, the Company accesses borrowed
funds in the capital markets. This strategy enables the Company to keep
its operating costs low. In the third quarter of 1996, the Company's
operating expenses to assets ratio was 0.23% and its efficiency ratio
(operating expenses to net interest income) was 15%.
As of September 30, 1996, all of the Company's mortgage assets
consisted of adjustable-rate, first-lien mortgages on single-family
properties or mortgage securities evidencing an interest in such
mortgages. In the future, the Company may acquire fixed-rate
single-family mortgage loans as well as mortgage loans on multi-family
or commercial properties.
The Company acquires individual whole mortgage loans (9% of total
mortgage assets as of September 30, 1996), mortgage securities
evidencing an interest in pools of mortgage loans which have been fully
insured against credit losses by one of the Federal government mortgage
agencies (64%), mortgage securities which have partial private-sector
credit-enhancement through insurance, subordination, or other means
sufficient to warrant an investment-grade credit rating from one of the
nationally-recognized credit rating firms (25%), and mortgage
securities which are subordinated and have higher levels of credit risk
such that they have received a rating below BBB (2%). The average
credit rating equivalent of the Company's mortgage assets is AA+.
The Company is an "A" quality mortgage lending company: the Company
does not own mortgages originated to "B", "C", or "D" quality
origination or documentation standards except in limited circumstances
when the Company has a degree of credit protection sufficient to
eliminate most of the potential credit risk from such loans.
In general, the Company seeks to acquire "A" quality single-family
mortgage assets consisting of mortgages with loan balances between
$207,000 and $500,000, with a target average loan balance of $250,000
to $300,000. Because of their size, these "jumbo" loans are not
eligible to be acquired or guaranteed by the Federal government
mortgage agencies (FNMA, FHLMC). The Company also acquires FNMA and
FHLMC mortgage securities.
19
<PAGE> 20
As of September 30, 1996, 69% of the non-FNMA, non-FHLMC mortgage
assets owned by the Company were secured by single-family residential
properties located in California. Management believes that the economy
and the trend of residential housing values in California have been
generally stable to improving in the first nine months of 1996.
The coupon rate the Company earns on its mortgage assets increases or
falls in conjunction with changes in short-term interest rates, as does
the rate the Company pays on its borrowings. The coupon rate on each
mortgage generally adjusts on a one, six or twelve month cycle; the
average term-to-next-adjustment for all of the Company's mortgage
assets was 4 months as of September 30, 1996. Borrowings have
maturities ranging from one to twelve months; the average
term-to-next-adjustment for borrowings was 2.4 months as of September
30, 1996. Coupon rate adjustments on the Company's mortgages are
limited by periodic and lifetime caps; the Company's hedging program
seeks to mitigate the negative effects such coupon caps may have on
spread income should short-term interest rates increase rapidly.
Because the Company's adjustable-rate earning assets exceed its
liabilities, the Company believes that rising short-term interest rates
may lead to higher net earnings after a lag period, all other factors
being equal. Similarly, falling short-term interest rates may lead to
reduced net earnings after a lag period.
The Company seeks to generate secular growth in earnings and dividends
per share in a variety of ways, including through (i) issuing new
equity 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 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.
To date, the Company has grown rapidly by issuing new capital and
acquiring new mortgage assets. While the Company believes such growth
has significantly increased its long-term earnings per share potential,
the near-term effect has been a reduction in reported earnings per
share as compared to what earnings likely would have been without such
growth. The Company intends to continue to pursue growth when
management believes that such growth is likely to be additive to
earnings per share potential.
In the third quarter of 1996, the Company issued 1,006,250 shares of
Class B 9.74% Cumulative Convertible Preferred Stock. For purposes of
calculating net income available to common shareholders, the dividends
payable on these preferred shares is deducted. Given the
characteristics of this preferred stock, the Company includes it in its
equity base for determining selected performance ratios.
RESULTS OF OPERATIONS: THREE MONTHS ENDING SEPTEMBER 30, 1996 VERSUS
THREE MONTHS ENDING SEPTEMBER 30, 1995 AND FIRST NINE MONTHS OF 1996
VERSUS FIRST NINE MONTHS OF 1995
REPORTING PERIODS
The 1994 fiscal year ("fiscal 1994") commenced with the start of
Company operations on August 19, 1994 and finished December 31, 1994.
All subsequent reporting periods correspond to their calendar
equivalents.
CHANGE IN CALCULATION METHOD FOR CERTAIN PREVIOUSLY REPORTED YIELDS AND
RATIOS
Certain previously reported yields and ratios have been changed for
this report due to a number of changes in calculation methods,
including a change in the "day-count" convention used by the Company
and an adjustment to average daily balance figures. These changes are
not material, however, management has made these changes in an effort
to make the presentation of these figures more useful and consistent.
20
<PAGE> 21
NET INCOME SUMMARY
Net earnings in the third quarter of 1996 were $3.0 million, an
increase of 200% over the $1.0 million the Company earned in the third
quarter of 1995. The primary reason total earnings increased was that
average assets increased by nearly $1 billion, or 438%, from the 1995
period to the 1996 period. For a similar reason, net earnings in the
first nine months of 1996 of $7.5 million represent a more than
fourfold increase over net earnings of $1.8 million in the first nine
months of 1995. The table below presents the Company's quarterly net
income by major income and expense category.
TABLE 1
NET INCOME
<TABLE>
<CAPTION>
Interest
Rate Net Credit
Interest Interest Agreement Interest Provision Operating
Income Expense Expense Income Expense Expenses
------ ------- ------- ------ ------- --------
(dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
1995, 1st Nine Months $ 9,116 $ 6,155 $ 210 $ 2,751 $ 143 $ 763
1996, 1st Nine Months 41,403 29,724 756 10,923 1,324 1,758
Fiscal 1994 $ 1,296 $ 760 $ 8 $ 528 $ 0 $ 146
1995, Quarter 1 2,170 1,533 16 621 19 201
1995, Quarter 2 2,961 2,191 82 688 40 198
1995, Quarter 3 3,986 2,432 112 1,442 84 364
1995, Quarter 4 6,610 4,453 129 2,029 350 368
1996, Quarter 1 9,131 6,202 151 2,777 331 492
1996, Quarter 2 12,901 9,075 255 3,571 477 594
1996, Quarter 3 19,371 14,447 349 4,575 516 672
</TABLE>
<TABLE>
<CAPTION>
Net Income Net Income
Before After
Preferred Preferred Preferred
Dividends Dividends Dividends
--------- --------- ---------
(dollars in thousands)
<S> <C> <C> <C>
1995, 1st Nine Months $ 1,845 $ 0 $ 1,845
1996, 1st Nine Months 7,841 388 7,453
Fiscal 1994 $ 382 $ 0 $ 382
1995, Quarter 1 401 0 401
1995, Quarter 2 450 0 450
1995, Quarter 3 994 0 994
1995, Quarter 4 1,311 0 1,311
1996, Quarter 1 1,954 0 1,954
1996, Quarter 2 2,500 0 2,500
1996, Quarter 3 3,387 388 2,999
</TABLE>
Earnings per share in the third quarter of 1996 were $0.32,
representing an increase of 33% over the $0.24 per share earned in the
third quarter of 1995. Earnings per share increased due to an increase
in return on average equity from 7.66% to 9.41% and an increase in the
equity per share the Company had available with which to generate
earnings from $13.14 to $16.23. Equity (or book value) per share
increased due to accretive stock offerings at prices in excess of book
value in April 1996 (common stock) and August 1996 (preferred stock).
Third quarter 1996 earnings per share were 10% higher than the $0.29
reported in the second quarter of 1996. This quarterly EPS increase
also resulted from an increase in return on average equity and an
increase in the book value per share.
Two factors served to limit the Company's return on average equity
during the third quarter of 1996. The Company was under-invested in
mortgage assets relative to its equity base and capital policy
guidelines, with 84% of the Company's capital base employed in earning
assets on average during the quarter. In addition, the Company
estimates that the average coupon during the period of 7.52% was 0.47%
below the average fully-indexed coupon level for this period. This
lower-than-full-potential coupon was primarily a result of the rapid
pace of acquisitions of mortgages during the second and third quarter.
The newly acquired mortgages had coupons which were less than
fully-indexed. As of September 30, 1996, the average coupon rate on the
Company's assets was 0.36% below the fully-indexed level.
For the first nine months of 1996, earnings per share were $0.90, an
increase of 34% versus the comparable period in 1995. Return on average
equity for the two nine month periods increased from 7.64% to 9.63% and
book value per share increased from $13.14 to $16.23.
The table below presents information on shares outstanding, earnings
per share, book value per share and return on average equity (ROE).
21
<PAGE> 22
TABLE 2
EARNINGS PER SHARE, BOOK VALUE PER SHARE
AND RETURN ON AVERAGE EQUITY
<TABLE>
<CAPTION>
BOOK VALUE RETURN
BOOK VALUE PER COMMON ON
AVERAGE POTENTIAL PER COMMON AND PREFERRED RETURN AVERAGE EARNINGS
NUMBER OF DILUTION TOTAL SHARE SHARE ON COMMON PER
COMMON DUE TO NUMBER OF OUTSTANDING OUTSTANDING AVERAGE AND PRIMARY
SHARES WARRANTS PRIMARY AT AT COMMON PREFERRED SHARE
OUTSTANDING AND OPTIONS SHARES END OF PERIOD END OF PERIOD EQUITY EQUITY ("EPS")
----------- ----------- ------ ------------- ------------- ------ ------ -------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
1995, 1st Nine Months 2,571,888 175,754 2,747,642 $13.14 $ 13.14 7.64% 7.64% $ 0.67
1996, 1st Nine Months 7,360,916 885,899 8,246,815 14.75 16.23 9.60% 9.63% 0.90
Fiscal 1994 1,676,080 240,766 1,916,846 $10.82 $ 10.82 5.40% 5.40% $ 0.20
1995, Quarter 1 1,874,395 240,766 2,115,161 11.93 11.93 7.36% 7.36% 0.19
1995, Quarter 2 1,874,395 188,699 2,063,094 12.02 12.02 7.97% 7.97% 0.22
1995, Quarter 3 3,944,129 239,009 4,183,138 13.14 13.14 7.66% 7.66% 0.24
1995, Quarter 4 5,516,310 563,197 6,079,507 12.38 12.38 7.28% 7.28% 0.22
1996, Quarter 1 5,521,376 608,211 6,129,587 12.34 12.34 11.37% 11.37% 0.32
1996, Quarter 2 7,813,974 786,258 8,600,232 14.59 14.59 8.88% 8.88% 0.29
1996, Quarter 3 8,732,326 783,848 9,516,174 14.75 16.23 9.32% 9.41% 0.32
</TABLE>
DIVIDEND SUMMARY
Dividends paid to common shareholders for the third quarter of 1996
were $0.40 per share, which was twice the $0.20 dividend paid in the
same quarter one year earlier. Dividends paid to preferred shareholders
were $0.386 per share, reflecting the minimum quarterly preferred
dividend of $0.755 pro-rated for the partial period from the preferred
stock issuance date to the end of the quarter. No such preferred stock
was outstanding a year earlier. Total dividends (common plus preferred)
paid for the third quarter of 1996 were $4.0 million versus $1.1
million paid for the same time period in 1995.
Dividends in the first nine months of 1996 were $1.26 per share, an
increase of 80% over the $0.70 per share dividend paid in the first
nine months of 1995. Total dividends paid for the first nine months of
1996 were $10.0 million; total dividends paid for the same period the
prior year were $1.9 million.
22
<PAGE> 23
TABLE 3
DIVIDENDS
<TABLE>
<CAPTION>
TAXABLE
INCOME
AFTER
PREFERRED TOTAL
COMMON DIVIDENDS PREFERRED COMMON
SHARES PER COMMON SHARES PREFERRED AND
OUTSTANDING COMMON DIVIDEND TOTAL OUTSTANDING DIVIDEND TOTAL PREFERRED
EARNING SHARE DECLARED COMMON EARNING DECLARED PREFERRED DIVIDENDS
DIVIDEND OUTSTANDING PER SHARE DIVIDEND DIVIDEND PER SHARE DIVIDEND DECLARED
-------- ----------- --------- -------- -------- --------- -------- --------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
1995, 1st Nine Months 2,766,134 $0.73 $0.70 $1,936 0 $0.000 $ 0 $1,936
1996, 1st Nine Months 7,599,794 1.28 1.26 9,576 1,006,250 0.386 388 9,964
Fiscal 1994 1,401,904 $0.25 $0.25 $ 350 0 $0.000 $ 0 $ 350
1995, Quarter 1 1,666,063 0.25 0.20 333 0 0.000 0 333
1995, Quarter 2 1,666,063 0.32 0.30 500 0 0.000 0 500
1995, Quarter 3 5,516,313 0.20 0.20 1,103 0 0.000 0 1,103
1995, Quarter 4 5,517,299 0.33 0.26 1,435 0 0.000 0 1,435
1996, Quarter 1 5,521,376 0.46 0.46 2,540 0 0.000 0 2,540
1996, Quarter 2 8,520,116 0.37 0.40 3,408 0 0.000 0 3,408
1996, Quarter 3 9,069,653 0.40 0.40 3,628 1,006,250 0.386 388 4,016
</TABLE>
The Company's policy is to distribute over time as dividends 100% of
its earnings as calculated for tax purposes. Through September 30,
1996, cumulative taxable income has exceeded cumulative dividends paid
or declared by $0.2 million; the Company intends to distribute this
excess taxable income as part of the Company's regular quarterly
dividend in the future.
Taxable income currently exceeds income as calculated according to
generally accepted accounting principles (GAAP income) because (i)
taxable income credit expense equals actual credit losses rather than
credit provisions (actual credit losses through September 30, 1996 have
been minor), (ii) amortization methods differ for discount that has
been created when mortgages have been acquired at a price below
principal value, (iii) dividend equivalent rights which accrue on stock
options are deducted from GAAP income as an operating expense but are
not deducted from taxable income, and (iv) operating expenses differ in
certain other aspects. Management believes taxable income is a closer
approximation of current cash flow generation than is GAAP income.
Dividends per share have exceeded earnings per share because taxable
income has exceeded GAAP income and because the number of shares
eligible at quarter end to receive a dividend has generally been
smaller than the number of primary shares used to calculate earnings
per share. The table below presents the major differences between GAAP
and taxable income.
23
<PAGE> 24
TABLE 4
TAXABLE INCOME
<TABLE>
<CAPTION>
TAXABLE
OPERATING
GAAP EXPENSES TAXABLE TAXABLE TAXABLE TAXABLE
NET INCOME TAXABLE AND INCOME INCOME INCOME INCOME
BEFORE CREDIT MORTGAGE BEFORE AFTER RETURN RETURN
PREFERRED EXPENSE AMORTIZATION PREFERRED PREFERRED ON COMMON ON TOTAL
DIVIDENDS DIFFERENCES DIFFERENCES DIVIDENDS DIVIDENDS EQUITY EQUITY
--------- ----------- ----------- --------- --------- ------ ------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
1995, 1st Nine Months $ 1,845 $ 143 $ 31 $ 2,019 $ 2,019 8.36% 8.36%
1996, 1st Nine Months 7,841 1,324 574 9,739 9,351 12.05% 11.96%
Fiscal 1994 $382 $ 0 $ (28) $ 354 $ 354 4.99% 4.99%
1995, Quarter 1 401 19 (12) 408 408 7.48% 7.48%
1995, Quarter 2 450 40 38 528 528 9.37% 9.37%
1995, Quarter 3 994 84 5 1,082 1,082 8.35% 8.35%
1995, Quarter 4 1,311 347 156 1,814 1,814 10.08% 10.08%
1996, Quarter 1 1,954 331 264 2,549 2,549 14.83% 14.83%
1996, Quarter 2 2,500 477 165 3,142 3,142 11.16% 11.16%
1996, Quarter 3 3,387 516 145 4,048 3,660 11.37% 11.25%
</TABLE>
COUPON INCOME ON MORTGAGE ASSETS
The average coupon on the Company's mortgage assets was 7.52% during
the third quarter of 1996, an increase from the 7.47% average coupon
rate in the second quarter of 1996. The coupon rate in the third
quarter rose because (i) the short-term interest rate indices which
determine coupons on mortgage assets increased (as approximated in the
table below by the increase in the six month average of the six-month
LIBOR rate) and (ii) towards the end of the third quarter, coupons on
the mortgage assets which the Company acquired in the second and third
quarters began to adjust towards their fully-indexed levels.
In the second and third quarter of 1996, the Company acquired $940
million in mortgage assets; these new assets represented a substantial
portion of the Company's total mortgage assets as of September 30,
1996. These assets were generally acquired with initial coupon rates
below their fully-indexed rate and, as of the end of the third quarter,
many of these new mortgage assets had not yet had a coupon adjustment
since being acquired by the Company.
In the last few quarters the Company has generally been acquiring
mortgages at a premium price to the face value of the mortgages. In the
third quarter of 1996, the average historical amortized cost of the
mortgages on the Company's books moved above par. As a result, the
average coupon yield (coupon income divided by the adjusted average
mortgage acquisition price) in the third quarter of 1996 of 7.44% was
lower than the average coupon rate of 7.52%.
In the third quarter of 1995, the coupon rate was 7.29%, or 0.77% lower
than the estimated average fully-indexed rate during the quarter. This
gap between the coupon rate and the fully-indexed rate was due
primarily to the acquisition of mortgages in late 1994 and early 1995
that had low initial coupon rates. Since many of these mortgage
acquisitions were made at a discount price, the yield on the mortgages
was higher than the low coupon would suggest due to the Company's low
basis in the assets and the boost to income from discount amortization.
The table below presents the Company's average coupon rates and coupon
yields on its mortgage assets as compared to the fully-indexed rates
and a benchmark of the six month average of the six-month LIBOR rate.
24
<PAGE> 25
TABLE 5
COUPON INCOME ON MORTGAGE ASSETS
<TABLE>
<CAPTION>
AVERAGE
COUPON AVERAGE AVERAGE
AVERAGE VERSUS FULLY- COUPON
AVERAGE COUPON SIX MONTH SIX MONTH INDEXED VERSUS
PRINCIPAL RATE AVERAGE OF AVERAGE OF RATE FULLY AVERAGE AVERAGE
COUPON VALUE OF DURING SIX-MONTH SIX-MONTH DURING INDEXED BOOK COUPON
INCOME MORTGAGES PERIOD LIBOR LIBOR PERIOD RATE PRICE YIELD
------ --------- ------ ----- ----- ------ ---- ----- -----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
1995, 1st Nine Months $ 8,457 $ 163,880 6.88% 6.28% 0.60% 8.32% (1.44%) 98.84% 6.96%
1996, 1st Nine Months 43,724 773,571 7.54% 5.59% 1.95% 7.82% (0.28%) 100.21% 7.52%
Fiscal 1994 $ 1,102 $ 50,070 6.09% 5.07% 1.02% 8.68% (2.59%) 100.02% 6.09%
1995, Quarter 1 1,940 122,835 6.32% 6.25% 0.07% 8.75% (2.44%) 99.47% 6.35%
1995, Quarter 2 2,738 160,537 6.82% 6.48% 0.34% 8.33% (1.51%) 98.53% 6.92%
1995, Quarter 3 3,779 207,338 7.29% 6.10% 1.19% 8.06% (0.77%) 98.71% 7.39%
1995, Quarter 4 6,682 352,251 7.59% 5.82% 1.77% 7.74% (0.16%) 99.27% 7.64%
1996, Quarter 1 9,445 488,762 7.73% 5.62% 2.11% 7.43% 0.30% 98.85% 7.82%
1996, Quarter 2 13,722 734,347 7.47% 5.49% 1.98% 7.82% (0.35%) 99.95% 7.48%
1996, Quarter 3 20,557 1,094,081 7.52% 5.65% 1.87% 7.99% (0.47%) 100.98% 7.44%
</TABLE>
AMORTIZATION OF PREMIUM AND DISCOUNT AND EFFECTS OF CHANGES IN MORTGAGE
PRINCIPAL REPAYMENT RATES
The average annualized principal repayment rate of the Company's
mortgage assets in the third quarter was 28%. The comparable rate was
16% for the third quarter of 1995. Annualized mortgage principal
repayments averaged 28% for the first nine months of 1996 and 11% for
the first nine months of 1995.
The primary direct earnings impact of changes in the rate of mortgage
principal repayment is the effect on the rate at which the Company
amortizes (as an expense) premium balances paid on the acquisition of
mortgage assets. The Company writes off premium at a rate equal to the
actual monthly mortgage principal repayment rate of the associated
mortgage assets. Due to the increase in mortgage principal repayment
speeds, the average annualized rate of premium amortization was 25% of
the premium balance in the third quarter of 1996 versus 15% in the same
quarter a year earlier.
The amortization of discount into income serves to partially offset the
effects of premium amortization. The rate at which the Company
amortizes discount balances into income, however, is far less sensitive
to short-term changes in the rate of mortgage principal repayment.
The Company recognizes two types of discount. When the Company is able
to acquire high-credit-quality mortgage assets at a discount due to
very low initial coupon rates, the Company amortizes the associated
discount into income in the short-term to offset the effect of the low
coupon. In early 1995, most of the Company's discount balances were of
this type. Accordingly, the Company took its discount balances into
income at a rapid rate. Virtually all of this type of discount had been
taken into income by the end of the third quarter of 1995.
When the Company acquires discount mortgage assets that have a material
amount of credit risk, the Company uses what management believes to be
conservative assumptions regarding the future cash flows of such
mortgages to determine a discount amortization schedule for that asset.
The result is that such discount is amortized into income at a
relatively slow rate which does not fluctuate significantly with
short-term changes in the actual rate of mortgage principal repayment
even though more rapid principal repayments may benefit the long-term
economics of owning these discount mortgages. As shown in the table
below, despite rapid principal repayment rates, the annualized discount
amortization rate was 7% of the discount balance in third quarter and
was 6% for the first nine months of 1996.
25
<PAGE> 26
As a result of the Company's methods of amortizing premium and
discount, faster mortgage principal repayment speeds have led to lower
earnings in 1996 than would otherwise have been reported. In
calculating its interest income for the third quarter of 1996, the
Company added $0.27 million in discount amortization to its coupon
income and then deducted $1.71 million in premium amortization. As
shown in Table 7, the net effect in the third quarter of premium and
discount amortization was a reduction in net mortgage yield of 0.49%.
In the third quarter of 1995, the net effect of amortization was to add
0.30% to the net mortgage yield. For the first nine months of 1996, the
reduction in net mortgage yield due to amortization was 0.47%; for the
same period in 1995, amortization added 0.48% to the net mortgage
yield.
The Company's earnings sensitivity to changes in the mortgage principal
repayment rate has been increasing as the Company continues to acquire
mortgage assets at premium prices. Management believes that the
sensitivity of earnings to a one percentage point change in the
mortgage principal repayment rate, all other factors being equal, was
approximately $0.01 per share per quarter as of September 30, 1996.
TABLE 6
AMORTIZATION ON MORTGAGE ASSETS
<TABLE>
<CAPTION>
NET NET NET
ANNUAL ANNUAL AVERAGE NET MORTGAGE MORTGAGE
AVERAGE RATE OF AVERAGE RATE OF PREMIUM/ AMORT PRINCIPAL PRINCIPAL
DISCOUNT DISCOUNT DISCOUNT PREMIUM PREMIUM PREMIUM (DISC) INCOME/ REPAYMTS REPAYMT
BALANCE AMORT AMORT BALANCE AMORT AMORT BALANCE (EXPENSE) RECEIVED RATE
------- ----- ----- ------- ----- ----- ------- --------- -------- ----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
1995, 1st Nine Months $ 3,678 $751 27% $ 1,779 $ 176 13% $ (1,899) $ 575 $ 13,927 11%
1996, 1st Nine Months 16,716 693 6% 18,344 3,682 27% 1,628 (2,989) 162,814 28%
Fiscal 1994 $440 $101 63% $ 450 $ 19 12% $ 10 $ 82 $ 1,244 7%
1995, Quarter 1 1,440 234 65% 785 19 10% (655) 215 2,673 9%
1995, Quarter 2 3,528 237 27% 1,175 34 12% (2,353) 203 2,934 7%
1995, Quarter 3 6,017 280 19% 3,351 123 15% (2,666) 157 8,319 16%
1995, Quarter 4 10,889 210 8% 8,314 429 21% (2,575) (219) 24,898 28%
1996, Quarter 1 16,941 177 4% 11,299 707 25% (5,642) (530) 32,814 27%
1996, Quarter 2 16,739 245 6% 16,402 1,268 31% (337) (1,023) 53,058 29%
1996, Quarter 3 16,471 271 7% 27,233 1,706 25% 10,762 (1,435) 76,942 28%
</TABLE>
EARNING ASSET YIELD
The Company's earning assets consist of its mortgage assets and its
cash balances. The mortgage asset yield is a function of the coupon
yield and the amortization of premium and discount. The cash yield is a
function of short-term interest rates and other factors. The earning
asset yield in the third quarter of 1996 was 6.92%, or 1.27% over the
six month average of six-month LIBOR. The margin between the earning
asset yield and the level of short-term interest rates narrowed in this
quarter, for the most part due to the Company's rapid growth. The
earning asset yield was 7.64%, or 1.54% over the six month average of
six-month LIBOR, in the third quarter of 1995. For the first nine
months of 1996, the earning asset yield was 7.02% (1.43% over average
LIBOR) and in the first nine months of 1995 the earning asset yield was
7.41% (1.13% over average LIBOR).
26
<PAGE> 27
TABLE 7
EARNING ASSET YIELD
<TABLE>
<CAPTION>
EFFECT OF YIELD VS.
NET SIX-MONTH SIX-MONTH
DISCOUNT/ NET EARNING AVERAGE OF AVERAGE OF
COUPON (PREMIUM) MORTGAGE CASH ASSET SIX-MONTH SIX-MONTH
YIELD AMORTIZATION YIELD YIELD YIELD LIBOR LIBOR
----- ------------ ----- ----- ----- ----- -----
<S> <C> <C> <C> <C> <C> <C> <C>
1995, 1st Nine Months 6.96% 0.48% 7.44% 5.41% 7.41% 6.28% 1.13%
1996, 1st Nine Months 7.52% (0.47%) 7.05% 5.58% 7.02% 5.59% 1.43%
Fiscal 1994 6.09% 0.53% 6.62% 4.73% 6.40% 5.07% 1.33%
1995, Quarter 1 6.35% 0.77% 7.12% 4.96% 7.09% 6.25% 0.84%
1995, Quarter 2 6.92% 0.49% 7.42% 5.57% 7.40% 6.48% 0.92%
1995, Quarter 3 7.39% 0.30% 7.68% 5.53% 7.64% 6.10% 1.54%
1995, Quarter 4 7.64% (0.24%) 7.40% 5.48% 7.34% 5.82% 1.52%
1996, Quarter 1 7.82% (0.37%) 7.45% 5.93% 7.40% 5.62% 1.78%
1996, Quarter 2 7.48% (0.51%) 6.97% 5.61% 6.94% 5.49% 1.45%
1996, Quarter 3 7.44% (0.49%) 6.95% 5.30% 6.92% 5.65% 1.27%
</TABLE>
COST OF BORROWED FUNDS AND HEDGING AND THE INTEREST RATE SPREAD
From the second to the third quarter of 1996, the cost of borrowed
funds increased from 5.57% to 5.78%. This increase was due primarily to
an increase in short-term interest rates (as shown in Table 8 by an
increase in the six month average of six-month LIBOR) and to an
increase in the percentage of the balance sheet consisting of whole
loans (which, on average, are more costly to fund than securitized
mortgage assets). The cost of hedging declined slightly, from 0.16% of
average borrowed funds in the second quarter to 0.14% in the third
quarter. The all-in cost of funds and hedging was 5.92% for the third
quarter of 1996. The all-in cost of funds and hedging in the third
quarter of 1995 was 6.37%. In the third quarter of both of these years,
the all-in cost of funds and hedging was 0.27% over the average LIBOR
rate.
For the first nine months of 1995 and 1996, the all-in cost of funds
and hedging was 6.31% and 5.83%, respectively. The all-in cost of funds
for these periods was 0.03% and 0.24% over the six month average of
six-month LIBOR.
Hedging costs, or interest rate agreement expenses, consist of the
amortization of premium paid for interest rate cap agreements, net of
any income received, plus the net on-going expense or income from
interest rate swap and collar agreements. In an interest rate cap
agreement, the Company pays an up-front premium to a counter-party; the
counter-party will make payments to the Company if LIBOR rises above a
certain level. In an interest rate swap agreement, the Company
typically does not make an up-front payment. The Company agrees to pay
a fixed rate of interest to a counter-party on a certain notional
amount; the counter-party in turn pays to the Company a floating rate
of interest on the same notional amount. In a collar agreement, the
Company generally does not make an initial payment, will incur a hedge
expense if the index falls below the floor strike rate and will have
hedge income if the index exceeds the cap strike rate. The Company has
also entered into a periodic cap designed to serve as a hedge against
short-term interest rates rising faster than 0.50% per quarter. In
addition, the Company has entered into Treasury versus LIBOR basis
swaps to reduce potential risks arising from Treasury-based mortgage
assets funded with LIBOR-based borrowings. These basis swaps will
provide increased income to the Company should short-term LIBOR rates
increase relative to short-term Treasury rates and will increase
hedging expense for the Company should that spread narrow. See "Note 3.
Interest Rate Agreements" to the Notes to Financial Statements for
further details.
Hedging costs in the third quarter of 1996 and the first nine months of
1996 were lower relative to the size of the balance sheet than in the
same time periods of 1995 due to a flatter yield curve and lower levels
of interest rate volatility in 1996. In addition, the Company reduced
its hedging activities somewhat in the second and third quarters of
1996 in conjunction with the extension of the maturities of its
borrowings.
27
<PAGE> 28
The interest rate spread is the difference between the earning asset
yield and the all-in cost of funds and hedging; it measures the
profitability of that portion of the balance sheet wherein earning
assets are funded with borrowings. The interest rate spread for the
third quarter of 1996 was 1.00%. This was lower than the 1.21% earned
in the second quarter of 1996 and the 1.27% earned in the third quarter
of 1995. As discussed above, the compression of the spread in the third
quarter is primarily a product of the Company's rapid growth in the
second and third quarters.
The interest rate spread in the first nine months of 1996 of 1.19% was
slightly wider than the spread in the first nine months of 1995 of
1.10%. Relative to 1995, increased asset yields (relative to short-term
interest rates) and lower hedging costs in 1996 offset a higher cost of
funds (relative to short-term interest rates).
TABLE 8
COST OF BORROWED FUNDS AND HEDGING
<TABLE>
<CAPTION>
COST OF
COST OF FUNDS AND
FUNDS VS. COST HEDGING VS.
SIX MONTH SIX-MONTH OF SIX-MONTH
AVERAGE OF AVERAGE OF FUNDS AVERAGE OF EARNING INTEREST
COST OF SIX-MONTH SIX-MONTH COST OF AND SIX-MONTH ASSET RATE
FUNDS LIBOR LIBOR HEDGING HEDGING LIBOR YIELD SPREAD
----- ----- ----- ------- ------- ----- ----- ------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
1995, 1st Nine Months 6.10% 6.28% (0.17%) 0.21% 6.31% 0.03% 7.41% 1.10%
1996, 1st Nine Months 5.69% 5.59% 0.10% 0.14% 5.83% 0.24% 7.02% 1.19%
Fiscal 1994 5.55% 5.07% 0.48% 0.06% 5.61% 0.54% 6.40% 0.79%
1995, Quarter 1 5.96% 6.25% (0.29%) 0.06% 6.02% (0.23%) 7.09% 1.07%
1995, Quarter 2 6.26% 6.48% (0.22%) 0.23% 6.49% 0.01% 7.40% 0.91%
1995, Quarter 3 6.09% 6.10% (0.01%) 0.28% 6.37% 0.27% 7.64% 1.27%
1995, Quarter 4 6.04% 5.82% 0.22% 0.18% 6.22% 0.40% 7.34% 1.12%
1996, Quarter 1 5.69% 5.62% 0.07% 0.14% 5.83% 0.21% 7.40% 1.57%
1996, Quarter 2 5.57% 5.49% 0.08% 0.16% 5.73% 0.24% 6.94% 1.21%
1996, Quarter 3 5.78% 5.65% 0.13% 0.14% 5.92% 0.27% 6.92% 1.00%
</TABLE>
CREDIT PROVISIONS
Credit provisions for the third quarter of 1996 were $0.52 million, or
0.18% of average assets and 1.43% of average equity during the quarter.
In the third quarter of 1995, credit provisions were $0.08 million, or
0.16% of average assets and 0.65% of average equity. Credit provisions
were lower in the third quarter of 1995 as the Company had not yet
acquired its whole loans or many of the mortgage securities rated below
BBB which it currently owns. These credit expenses represent provisions
only; there were no actual credit losses in either of these periods.
For similar reasons, the credit provisions for the first nine months of
1996 of $1.32 million (equaling 0.22% of average assets and 1.63% of
average equity) were higher than the credit provisions for the same
time period in 1995 of $0.14 million (which equaled 0.11% of average
assets and 0.59% of average equity). There were no actual credit losses
in either of these periods.
The Company takes on-going quarterly credit provisions to build a
credit reserve for possible future losses from its mortgage assets.
Such credit provisions were taken at a rate of approximately $113,000
per month during the third quarter of 1996. In addition, each quarter
the Company takes a provision of 0.30% of the balance of whole loans
acquired during that quarter plus the amount of any interest accrued on
non-performing assets. In the third quarter, this portion of the
provision totaled $178,000. The rate at which the Company takes credit
provisions may be adjusted in the future based on the Company's review
of credit reserve adequacy.
28
<PAGE> 29
The table below summarizes the Company's credit provisions and actual
credit losses. Please also see "Financial Condition -- Credit Reserves"
below.
TABLE 9
CREDIT PROVISIONS AND ACTUAL CREDIT LOSSES
<TABLE>
<CAPTION>
CREDIT CREDIT ACTUAL ACTUAL ANNUALIZED ANNUALIZED
PROVISIONS PROVISIONS CREDIT CREDIT TOTAL CREDIT CREDIT
ON ON TOTAL LOSSES ON LOSSES ON ACTUAL PROVISIONS PROVISIONS
WHOLE SECURITIZED CREDIT WHOLE SECURITIZED CREDIT TO AVERAGE TO AVERAGE
LOANS ASSETS PROVISIONS LOANS ASSETS LOSSES ASSETS EQUITY
----- ------ ---------- ----- ------ ------ ------ ------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
1995, 1st Nine months $ 0 $ 143 $ 143 $ 0 $ 0 $ 0 0.11% 0.59%
1996, 1st Nine months 313 1,011 1,324 0 0 0 0.22% 1.63%
Fiscal 1994 $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 0.00% 0.00%
1995, Quarter 1 0 19 19 0 0 0 0.06% 0.34%
1995, Quarter 2 0 40 40 0 0 0 0.10% 0.72%
1995, Quarter 3 0 84 84 0 0 0 0.16% 0.65%
1995, Quarter 4 79 271 350 0 4 4 0.38% 1.95%
1996, Quarter 1 (5) 336 331 0 0 0 0.26% 1.93%
1996, Quarter 2 140 337 477 0 0 0 0.25% 1.69%
1996, Quarter 3 178 338 516 0 0 0 0.18% 1.43%
</TABLE>
OPERATING EXPENSES
Operating expenses were $0.67 million in the third quarter of 1996.
This was an increase from the $0.36 million of operating expenses
incurred in the same quarter in 1995. Nevertheless, the Company was
significantly more productive in the third quarter of 1996 as compared
to the third quarter of 1995, as measured by the efficiency ratio
(operating expenses to net interest income) dropping from 25% to 15%,
the operating-expenses-to-average-assets ratio dropping from 0.68% to
0.23% and the operating-expenses-to-average-equity ratio dropping from
2.81% to 1.87%. Average assets per employee increased from $39 million
to $115 million.
For the first nine months of 1995 to the first nine months of 1996,
operating expenses increased from $0.76 million to $1.76 million.
Nevertheless, measures of operating expense productivity improved over
that time period as well.
The table below presents the Company's operating expenses and selected
ratios measuring the Company's operating efficiency.
29
<PAGE> 30
TABLE 10
OPERATING EXPENSES
<TABLE>
<CAPTION>
NON-CASH OPERATING AVERAGE
CASH STOCK OTHER OTHER EXPENSE/ OPERATING OPERATING ASSETS PER
COMP AND OPTION NON-CASH CASH TOTAL NET EXPENSE/ EXPENSE/ AVE. # OF
BENEFITS AND DER OPERATING OPERATING OPERATING INTEREST AVERAGE AVERAGE EMPLOYEES
EXPENSE EXPENSE EXPENSE EXPENSE EXPENSE INCOME ASSETS EQUITY ($MM)
------- ------- ------- ------- ------- ------ ------ ------ -----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
1995, 1st Nine Months $359 $ 7 $ 43 $354 $ 763 28% 0.61% 3.16% $ 33
1996, 1st Nine Months 848 245 17 648 1,758 16% 0.29% 2.16% 92
Fiscal 1994 $ 63 $ 0 $ 42 $ 41 $ 146 28% 0.70% 2.07% $ 12
1995, Quarter 1 81 0 37 83 201 32% 0.64% 3.69% 25
1995, Quarter 2 81 0 (20) 137 198 29% 0.48% 3.51% 33
1995, Quarter 3 197 7 26 134 364 25% 0.68% 2.81% 39
1995, Quarter 4 103 48 96 120 368 18% 0.40% 2.04% 53
1996, Quarter 1 233 85 (3) 177 492 18% 0.39% 2.86% 69
1996, Quarter 2 305 79 (5) 214 594 17% 0.31% 2.11% 84
1996, Quarter 3 310 81 25 256 672 15% 0.23% 1.87% 115
</TABLE>
COMPONENTS OF RETURN ON AVERAGE EQUITY
Table 11 below shows elements of the Company's income statement
expressed as a percentage of average equity.
TABLE 11
COMPONENTS OF RETURN ON AVERAGE EQUITY
(EQUITY-BASED METHOD)
<TABLE>
<CAPTION>
EQUITY- NET RETURN ON
SPREAD FUNDED INTEREST AVERAGE
LENDING LENDING INCOME CREDIT OPERATING COMMON RETURN ON
INTEREST DEBT/ RETURN ON RETURN ON RETURN ON PROVISIONS/ EXPENSE/ AND AVERAGE
RATE EQUITY AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE PREFERRED COMMON
SPREAD RATIO EQUITY EQUITY EQUITY EQUITY EQUITY EQUITY EQUITY
------ ----- ------ ------ ------ ------ ------ ------ ------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
1995, 1st Nine months 1.10% 4.18x 4.56% 6.83% 11.39% 0.59% 3.16% 7.64% 7.64%
1996, 1st Nine months 1.19% 6.42x 7.59% 5.83% 13.42% 1.63% 2.16% 9.63% 9.60%
Fiscal 1994 0.79% 1.94x 1.82% 5.65% 7.47% 0.00% 2.07% 5.40% 5.40%
1995, Quarter 1 1.07% 4.72x 5.07% 6.32% 11.39% 0.34% 3.69% 7.36% 7.36%
1995, Quarter 2 0.91% 6.20x 5.61% 6.59% 12.20% 0.72% 3.51% 7.97% 7.97%
1995, Quarter 3 1.27% 3.08x 3.92% 7.20% 11.12% 0.65% 2.81% 7.66% 7.66%
1995, Quarter 4 1.12% 4.10x 4.61% 6.66% 11.27% 1.95% 2.04% 7.28% 7.28%
1996, Quarter 1 1.57% 6.34x 9.99% 6.17% 16.16% 1.93% 2.86% 11.37% 11.37%
1996, Quarter 2 1.21% 5.78x 7.02% 5.66% 12.68% 1.69% 2.11% 8.88% 8.88%
1996, Quarter 3 1.00% 6.94x 6.94% 5.77% 12.71% 1.43% 1.87% 9.41% 9.32%
</TABLE>
Net interest income as a percentage of equity of 12.71% in the third
quarter of 1996 was similar to the 12.68% earned in the second quarter
of 1996. The Company earned a narrower spread but maintained its net
interest income earnings rate through better capital utilization. The
overall return on equity (ROE) rose as a result of decreased credit
provisions and operating expenses as a percentage of equity.
As compared to the third quarter of 1995, ROE in the third quarter of
1996 was higher due to greater net interest income earnings as a
percentage of equity and a significantly improved operating expense
ratio. For similar reasons, the ROE for the first nine months of 1996
exceeded that earned in the same period the year before.
30
<PAGE> 31
The table below shows the components of the Company's income statement
expressed as a percentage of average assets.
TABLE 12
COMPONENTS OF RETURN ON AVERAGE EQUITY
(ASSET-BASED METHOD)
<TABLE>
<CAPTION>
COST OF AVERAGE
FUNDS ASSETS TO RETURN ON
AND AVERAGE AVERAGE
INTEREST HEDGING CREDIT OPERATING RETURN COMMON COMMON RETURN ON
INCOME/ EXPENSE/ NET PROVISION/ EXPENSE/ ON AND AND AVERAGE
AVERAGE AVERAGE INTEREST AVERAGE AVERAGE AVERAGE PREFERRED PREFERRED COMMON
ASSETS ASSETS MARGIN ASSETS ASSETS ASSETS EQUITY EQUITY EQUITY
------ ------ ------ ------ ------ ------ ------ ------ ------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
1995, 1st Nine Months 7.23% 5.05% 2.18% 0.11% 0.61% 1.46% 5.22x 7.64% 7.64%
1996, 1st Nine Months 6.82% 5.02% 1.80% 0.22% 0.29% 1.29% 7.46x 9.63% 9.60%
Fiscal 1994 6.20% 3.68% 2.53% 0.00% 0.70% 1.83% 2.95x 5.40% 5.40%
1995, Quarter 1 6.91% 4.93% 1.98% 0.06% 0.64% 1.28% 5.76x 7.36% 7.36%
1995, Quarter 2 7.24% 5.55% 1.69% 0.10% 0.48% 1.10% 7.25x 7.97% 7.97%
1995, Quarter 3 7.44% 4.75% 2.69% 0.16% 0.68% 1.86% 4.13x 7.66% 7.66%
1995, Quarter 4 7.11% 4.93% 2.18% 0.38% 0.40% 1.41% 5.16x 7.28% 7.28%
1996, Quarter 1 7.20% 5.01% 2.19% 0.26% 0.39% 1.54% 7.38x 11.37% 11.37%
1996, Quarter 2 6.73% 4.87% 1.86% 0.25% 0.31% 1.30% 6.81x 8.88% 8.88%
1996, Quarter 3 6.73% 5.14% 1.59% 0.18% 0.23% 1.18% 8.00x 9.41% 9.32%
</TABLE>
As compared to the second quarter of 1996, the net interest margin and
the return on average assets in the third quarter of 1996 narrowed due
to the compression of the interest rate spread (as discussed above) and
the greater utilization of leverage. Partially offsetting the effects
of spread compression were improved credit provision and operating
expense ratios. With the greater utilization of the Company's capital,
ROE increased despite a lower return on assets (ROA). Similarly, the
ROA was lower and the ROE was higher in the third quarter and first
nine months of 1996 as compared to the same periods in 1995.
FINANCIAL CONDITION
SUMMARY
Management believes the Company is well capitalized for the level of
risk 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. The Company takes credit provisions to reserve for
potential future credit losses. 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
estimated 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.
31
<PAGE> 32
END OF PERIOD BALANCE SHEET
The table below shows the components of the Company's balance sheet over time.
TABLE 13
END OF PERIOD BALANCE SHEET
<TABLE>
<CAPTION>
RECEIVABLES COMMON
INTEREST AND AND
MORTGAGE RATE OTHER TOTAL PREFERRED PREFERRED COMMON
END OF PERIOD CASH ASSETS AGREEMENTS ASSETS ASSETS BORROWINGS PAYABLES EQUITY EQUITY EQUITY
- ------------- ---- ------ ---------- ------ ------ ---------- -------- ------ ------ ------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 1,027 $ 117,477 $1,892 $ 1,132 $ 121,528 $ 100,376 $ 871 $ 20,281 $ 0 $ 20,281
1995, Quarter 1 953 141,860 1,434 1,193 145,440 121,998 1,090 22,352 0 22,352
1995, Quarter 2 1,620 175,242 825 1,634 179,321 155,881 907 22,533 0 22,533
1995, Quarter 3 1,150 298,785 809 2,650 303,394 228,826 2,095 72,473 0 72,473
1995, Quarter 4 4,825 432,244 547 3,941 441,557 370,316 2,951 68,290 0 68,290
1996, Quarter 1 9,705 565,159 1,233 5,216 581,313 508,721 4,447 68,145 0 68,145
1996, Quarter 2 10,407 1,007,480 1,351 9,092 1,028,330 896,214 7,821 124,295 0 124,295
1996, Quarter 3 14,599 1,375,870 873 12,136 1,403,478 1,225,094 14,867 163,517 29,712 133,805
</TABLE>
AVERAGE DAILY BALANCE SHEET
The table below shows the estimated average daily balances over time of the
components of the Company's balance sheet.
TABLE 14
AVERAGE DAILY BALANCE SHEET
<TABLE>
<CAPTION>
RECEIVABLES COMMON
INTEREST AND AND
MORTGAGE RATE OTHER TOTAL PREFERRED PREFERRED COMMON
END OF PERIOD CASH ASSETS AGREEMENTS ASSETS ASSETS BORROWINGS PAYABLES EQUITY EQUITY EQUITY
- ------------- ---- ------ ---------- ------ ------ ---------- -------- ------ ------ ------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
1995, 1st Nine Months $ 2,102 $ 161,881 $1,082 $ 3,123 $ 168,188 $134,431 $ 1,564 $ 32,193 $ 0 $ 32,193
1996, 1st Nine Months 15,975 770,830 1,388 21,628 809,821 696,725 4,523 108,572 5,097 103,475
Fiscal 1994 $ 6,627 $ 49,498 $ 790 $ 948 $ 57,862 $ 37,910 $ 368 $ 19,584 $ 0 $ 19,584
1995, Quarter 1 1,217 121,116 1,399 1,958 125,691 102,894 977 21,820 0 21,820
1995, Quarter 2 1,466 158,606 1,020 2,559 163,651 139,979 1,111 22,561 0 22,561
1995, Quarter 3 3,597 204,999 831 4,819 214,247 159,794 2,585 51,868 0 51,868
1995, Quarter 4 10,709 349,296 730 10,999 371,734 295,089 4,653 71,991 0 71,991
1996, Quarter 1 14,639 478,645 667 13,095 507,046 435,979 2,324 68,743 0 68,743
1996, Quarter 2 14,402 729,143 1,658 21,566 766,768 651,643 2,472 112,653 0 112,653
1996, Quarter 3 18,854 1,101,074 1,833 30,129 1,151,890 999,229 8,728 143,933 15,179 128,754
</TABLE>
MORTGAGE ASSET ACQUISITIONS
The two principal criteria the Company uses when acquiring mortgage assets are:
(i) the mortgages must be "A" quality in terms of underwriting and documentation
standards, or must be credit-enhanced to the AAA or AA credit-rating level, and
(ii) the risk-adjusted returns on equity the Company anticipates earning on such
assets must be attractive across a variety of economic scenarios relative to the
Company's cost of capital and relative to other available mortgage assets.
During the third quarter of 1996, the Company acquired mortgage assets of $444
million, thereby increasing the Company's net total mortgage balance by 37%.
Whole mortgage loans represented 14% of the acquisitions in the third quarter of
1996. FHLMC- and FNMA-guaranteed mortgages represented 70% and private-label
32
<PAGE> 33
mortgage securities represented 16% of the quarter's acquisitions. The average
price paid for mortgage assets acquired during the quarter was 102.74% of
principal value. The pricing in excess of face value for these assets as
compared to past acquisitions reflects, on average, the higher credit ratings,
higher initial coupons and higher net margins of these recently acquired assets.
The average initial coupon of the acquired mortgages was 7.53%, which was 0.49%
lower than the fully-indexed coupon rate toward which these coupons will adjust
over time based on the index levels at the time of acquisition. The table below
summarizes the characteristics of the Company's mortgage asset acquisitions.
TABLE 15
MORTGAGE ASSET ACQUISITIONS
<TABLE>
<CAPTION>
AVERAGE AAA A & BELOW
ASSET PRICE "A" FHLMC &AA BBB BBB
ACQUISITIONS VERSUS AVERAGE QUALITY & FNMA RATED RATED RATED
AT PRINCIPAL INITIAL WHOLE GUARANTEED MORTGAGE MORTGAGE MORTGAGE
COST VALUE COUPON LOANS MORTGAGES SECURITIES SECURITIES SECURITIES
---- ----- ------ ----- --------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
1995, 1st Nine Months $ 192,111 100.05% 7.14% 0.0% 54.7% 30.8% 5.9% 8.6%
1996, 1st Nine Months 1,106,896 102.55% 7.44% 10.2% 67.3% 22.5% 0.0% 0.0%
Fiscal 1994 $ 121,297 99.53% 5.87% 0.0% 64.8% 28.1% 4.3% 2.8%
1995, Quarter 1 24,116 94.80% 6.78% 0.0% 15.1% 49.1% 25.6% 10.2%
1995, Quarter 2 35,355 93.11% 6.42% 0.0% 65.8% 13.1% 0.0% 21.1%
1995, Quarter 3 132,640 103.14% 7.40% 0.0% 59.0% 32.3% 3.8% 4.9%
1995, Quarter 4 162,461 95.78% 7.39% 16.5% 52.4% 20.1% 5.5% 5.5%
1996, Quarter 1 166,852 102.60% 7.60% 0.0% 47.6% 52.4% 0.0% 0.0%
1996, Quarter 2 496,184 102.36% 7.30% 9.9% 71.5% 18.6% 0.0% 0.0%
1996, Quarter 3 443,860 102.74% 7.53% 14.4% 69.9% 15.7% 0.0% 0.0%
</TABLE>
SUMMARY OF MORTGAGE ASSET CHARACTERISTICS
As of September 30, 1996, all the Company's mortgage assets were single-family,
adjustable-rate, first-lien mortgages or securitized interests in pools of such
loans. The average historical amortized cost of these assets (before credit
provision write-downs) was 101.20% of principal value. The estimated bid-side
market value of these assets (which the Company uses as the carrying value of
mortgages on its balance sheet) was 101.09% of principal value. The average
credit rating equivalent at September 30, 1996 was AA+. For all the mortgage
assets owned by the Company, 45% of the underlying properties were located in
California. Excluding the FHLMC- and FNMA-guaranteed mortgages, 69% of the
properties underlying the Company's mortgage assets were located in California.
The table below summarizes the Company's mortgage asset balances.
33
<PAGE> 34
TABLE 16
MORTGAGE ASSET SUMMARY
<TABLE>
<CAPTION>
ESTIMATED PERCENT IN
BID-SIDE CALIFORNIA
AMORTIZED ESTIMATED MARKET AVERAGE EXCLUDING
MORTGAGE COST TO BID-SIDE VALUE TO CREDIT FHLMC
PRINCIPAL AMORTIZED PRINCIPAL MARKET PRINCIPAL RATING PERCENT IN & FNMA
END OF PERIOD VALUE COST VALUE VALUE VALUE EQUIV. CALIFORNIA MORTGAGES
- ------------- ----- ---- ----- ----- ----- ------ ---------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 120,627 $ 120,135 99.59% $ 117,477 97.39% AA+ 72% 82%
1995, Quarter 1 143,393 141,792 98.88% 141,860 98.93% AA+ 73% 80%
1995, Quarter 2 178,429 174,415 97.75% 175,242 98.21% AA+ 72% 80%
1995, Quarter 3 298,718 298,894 100.06% 298,785 100.02% AA+ 65% 77%
1995, Quarter 4 443,625 436,236 98.33% 432,244 97.43% AA+ 65% 71%
1996, Quarter 1 573,807 569,744 99.29% 565,159 98.49% AA+ 64% 69%
1996, Quarter 2 1,005,765 1,011,847 100.60% 1,007,480 100.17% AA+ 51% 67%
1996, Quarter 3 1,361,062 1,377,331 101.20% 1,375,870 101.09% AA+ 45% 69%
</TABLE>
The following table shows the average characteristics of the Company's mortgage
assets at the end of each reporting period. The index level is the weighted
average rate of the various short-term interest rate indices which determine
coupon adjustments. Unless limited by periodic or lifetime caps, the mortgage
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 over time
should interest rates remain unchanged. The rate of adjustment of the current
coupon to the fully-indexed rate is determined by the length of the adjustment
periods and the periodic caps of the mortgage loans.
TABLE 17
AVERAGE MORTGAGE ASSET CHARACTERISTICS
<TABLE>
<CAPTION>
COUPON AVERAGE
INTEREST MORTGAGE RATE VS. NUMBER
MORTGAGE RATE MORTGAGE FULLY- FULLY- OF MONTHS MORTGAGE
COUPON INDEX NET INDEXED INDEXED TO NEXT LIFETIME ASSET
END OF PERIOD RATE LEVEL MARGIN RATE RATE ADJUSTMENT CAP YIELD
- ------------- ---- ----- ------ ---- ---- ---------- --- -----
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 6.00% 6.94% 2.25% 9.19% (3.19%) 3 11.48% 6.60%
1995, Quarter 1 6.53% 6.47% 2.24% 8.71% (2.18%) 3 11.57% 7.23%
1995, Quarter 2 6.94% 5.99% 2.21% 8.20% (1.26%) 3 11.54% 7.74%
1995, Quarter 3 7.35% 5.86% 2.20% 8.06% (0.71%) 4 11.56% 7.81%
1995, Quarter 4 7.50% 5.44% 2.08% 7.52% (0.02%) 3 11.54% 7.74%
1996, Quarter 1 7.59% 5.47% 2.11% 7.58% 0.01% 3 11.53% 7.67%
1996, Quarter 2 7.42% 5.72% 2.21% 7.93% (0.51%) 4 11.71% 6.98%
1996, Quarter 3 7.55% 5.70% 2.21% 7.91% (0.36%) 4 11.69% 6.99%
</TABLE>
As of the end of the third quarter of 1996, 50% of the Company's mortgage assets
had coupon rates which adjusted as a function of changes in the wholesale cost
of funds of money-center banks (the LIBOR and CD indices), 49% adjusted as a
function of short-term U.S. Treasury interest rates and 1% adjusted off other
indices. The coupon adjustment cycle is every six months for 51% of total
mortgages, every twelve months for 46% of total mortgages and monthly for 2% of
total mortgages. Approximately 1% of mortgages have other re-pricing terms. The
periodic caps for 97% of the mortgage assets were either 1% per six months or 2%
per year; 2% of the mortgages had no periodic caps and 1% had other cap
structures. The table below segments the Company's mortgage assets by adjustment
index, coupon adjustment frequency and periodic cap adjustment
34
<PAGE> 35
TABLE 18
MORTGAGE ASSETS BY INDEX
<TABLE>
<CAPTION>
SIX-
SIX- ONE- MONTH ONE- SIX-
MONTH MONTH BANK YEAR MONTH
LIBOR LIBOR CD TREASURY TREASURY
INDEX INDEX INDEX INDEX INDEX OTHER
----- ----- ----- ----- ----- -----
<S> <C> <C> <C> <C> <C> <C>
Adjustment Frequency/Loan 6 months 1 month 6 months 12 months 6 months various
Average Adjustment/Pool 3 months 1 month 3 months 6 months 3 months various
Annualized Periodic Cap 2% none 2% 2% 2% various
</TABLE>
<TABLE>
<CAPTION>
% OF TOTAL MORTGAGE ASSETS AT PERIOD END
----------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Fiscal 1994 78.2% 3.9% 17.9% 0.0% 0.0% 0.0%
1995, Quarter 1 78.7% 3.1% 17.3% 0.9% 0.0% 0.0%
1995, Quarter 2 83.0% 2.5% 13.8% 0.7% 0.0% 0.0%
1995, Quarter 3 66.8% 1.4% 11.6% 11.5% 7.6% 1.1%
1995, Quarter 4 59.7% 7.7% 12.8% 12.5% 5.0% 2.3%
1996, Quarter 1 63.1% 6.5% 8.9% 14.9% 3.6% 3.0%
1996, Quarter 2 54.1% 3.2% 3.4% 33.3% 4.4% 1.6%
1996, Quarter 3 45.5% 2.2% 2.4% 45.7% 3.0% 1.2%
</TABLE>
At the end of the third quarter of 1996, whole mortgage loans were $127.7
million, or 9.3% of total mortgage assets. Due to the "A" quality underwriting
and documentation standards the Company requires for these loans, management
believes that over 90% of the balance of these loans would receive a credit
rating of AAA or AA should the Company securitize these loans and seek a credit
rating from the credit rating agencies in the future. Securitized loans with a
credit rating equivalent of BBB or better were $1.2 billion, or 88.8% of the
Company's total mortgage assets and securitized mortgage loans with a credit
rating equivalent of below BBB represented 1.9% of the total as of September 30,
1996. Unrated securitized assets have been assigned a credit rating equivalent
by management. The table below shows the balance of the Company's whole mortgage
loans and the Company's securitized mortgage assets segregated by credit rating.
TABLE 19
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.
CARRYING CARRYING CARRYING CARRYING PERCENT PERCENT PERCENT PERCENT
END OF PERIOD VALUE VALUE VALUE VALUE OF TOTAL OF TOTAL OF TOTAL OF TOTAL
- ------------- ----- ----- ----- ----- -------- -------- -------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 0 $ 109,548 $ 4,761 $ 3,168 0.0% 93.2% 4.1% 2.7%
1995, Quarter 1 0 125,237 10,988 5,635 0.0% 88.3% 7.7% 4.0%
1995, Quarter 2 0 150,846 11,306 13,092 0.0% 86.0% 6.5% 7.5%
1995, Quarter 3 0 263,344 16,338 19,103 0.0% 88.1% 5.5% 6.4%
1995, Quarter 4 26,450 355,784 25,171 24,839 6.1% 82.4% 5.8% 5.7%
1996, Quarter 1 24,861 490,189 25,838 24,272 4.4% 86.8% 4.6% 4.2%
1996, Quarter 2 69,666 886,990 25,753 25,070 6.9% 88.0% 2.6% 2.5%
1996, Quarter 3 127,695 1,196,887 25,748 25,540 9.3% 86.9% 1.9% 1.9%
</TABLE>
WHOLE MORTGAGE LOANS
As of September 30, 1996, the Company owned 478 whole loans with a total loan
balance of $126.4 million. All of these loans were adjustable-rate,
single-family loans underwritten to "A" quality standards. The average loan size
was $264,490. California loans represent 85% of the total outstanding balance.
Loans with original loan-to-
35
<PAGE> 36
value ratios in excess of 80% represent 32% of the total outstanding balance;
each of these loans is credit-enhanced with primary mortgage insurance which
served to bring the effective original loan-to-value ratio to 75% or less. After
giving effect to this mortgage insurance, the average original loan-to-value
ratio of the Company's whole loans was 73%. In addition, for $11.7 million of
these loans the Company has recourse to an "A"-rated third party for any losses
which may occur prior to August 2001. The table below presents selected
characteristics of the Company's whole loan mortgage assets.
TABLE 20
WHOLE MORTGAGE LOAN SUMMARY
<TABLE>
<CAPTION>
AT SEPTEMBER 30, 1996 AT DECEMBER 31,1995
--------------------- -------------------
(ALL RATIOS BASED ON % OF TOTAL LOAN PORTFOLIO BALANCES (ALL DOLLARS IN THOUSANDS)
UNLESS NOTED)
<S> <C> <C>
Face Value $126,426 $26,411
Amortized Cost 127,809 26,449
Adjustable-Rate 100% 100%
Single-Family 100% 100%
"A" Quality Underwriting 100% 100%
First Lien 100% 100%
Primary Residence 99% 100%
Property Located in Northern California 34% 30%
Property Located in Southern California 51% 44%
Top Ten States as of 9/30/96
California 84.8% 74.5%
Minnesota 2.5% 0.0%
Colorado 1.5% 3.2%
Oregon 1.3% 2.3%
Ohio 1.3% 0.7%
Michigan 1.3% 0.0%
Utah 1.1% 0.5%
Washington 1.0% 3.8%
Texas 1.0% 3.9%
Connecticut 0.6% 1.3%
Number of Loans 478 109
Average Loan Size $ 264 $ 242
Loan Balance in Excess of $500,000 12% 23%
Average Original Loan to Value Ratio (LTV) 78% 76%
Original LTV greater than 80% 32% 26%
Percent of Original LTV greater than 80% with
Mortgage Insurance 100% 100%
Effective Original LTV including Primary Mortgage 73% 72%
Insurance
1993 Origination 7% 0%
1994 Origination 43% 2%
1995 Origination 32% 98%
1996 Origination 18% 0%
Non-Performing Assets (90+ days delinquent) $ 404 $ 0
Number of Non-Performing Loans (90+ days delinquent) 3 0
Non-Performing Assets as % of Total Loan Balances 0.3% 0.0%
</TABLE>
The Company defines non-performing assets ("NPAs") as whole loans which are
delinquent more than 90 days. As of September 30, 1996, the Company's NPAs were
$403,606, reflecting three loans in foreclosure. At December 31, 1995 the
Company had no non-performing assets. The Company has experienced no actual
whole loan credit losses through September 30, 1996.
SECURITIZED MORTGAGES RATED AAA TO BBB
At September 30, 1996, 89% of the Company's mortgage assets were securitized
interests in pools of single-family mortgage loans which had an investment-grade
credit rating of AAA through BBB from one or more of the
36
<PAGE> 37
nationally-recognized rating agencies, or, if not rated, had equivalent credit
quality in the view of management. At December 31, 1995, these types of mortgage
securities represented 88% of the Company's mortgage assets.
Each of these securitized interests in mortgage pools has credit-enhancement
from a third-party which provides the Company with partial protection from
credit losses in addition to the protection afforded by the value of the
properties underlying the individual mortgages and any primary mortgage
insurance on individual loans. Given the quality of the mortgage loans in these
pools and the levels of additional credit-enhancement, management believes the
level of credit risk for these mortgage assets is low. In the event, however,
that credit losses in these pools exhaust the credit-enhancement or in the event
of default of FNMA, FHLMC or another third party guarantor, credit losses to the
Company could result. To date, the Company has experienced no actual credit
losses from these mortgage assets.
SECURITIZED MORTGAGES RATED 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 average equity, net of expected credit losses, over the life
of the asset will be attractive. Such assets had an estimated bid-side market
value at September 30, 1996 of $25.5 million, or 1.9% of the Company's total
mortgage assets. At December 31, 1995, the estimated market value of such assets
was $24.8 million. These assets have high potential yields but also have higher
levels of credit risk, are costly to finance and require a large allocation of
capital under the Company's risk-adjusted capital system.
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, an expanded equity base for the
Company and a lower internal risk-adjusted capital allocation. Another potential
benefit is the eventual return of principal (net of credit losses) which was
purchased at a discount, increasing the rate at which the Company's amortizes
its discount balance into income.
The bulk of the Company's securitized assets with a credit rating equivalent
below BBB are credit-enhanced, although to a lesser degree than higher-rated
assets. Credit losses will not be incurred by the Company on these assets until
total credit losses in the related mortgage pool exhaust the credit-enhancement.
At that point, however, the rate of loss to the Company's interest may be
significant as these interests are subordinated to and provide
credit-enhancement for other, more senior, interests issued from the same
mortgage pool.
For several of these interests owned by the Company, the underlying pools
currently have levels of mortgage delinquencies in excess of management's
original expectations. Delinquency levels in these pools appeared to have
stabilized in the second and third quarters of 1996.
Actual pool credit losses which serve to reduce the credit-enhancement
protection to the Company's below BBB-rated interests have occurred as of
September 30, 1996, but a substantial majority of the aggregate original credit
enhancement in these pools is still intact. The Company has experienced no
credit losses from these assets.
At September 30, 1996 and December 31, 1995, the Company also owned $0.2 million
of "first loss" assets. These are subordinated interests with no
credit-enhancement. All credit losses in the related pools of mortgages will
reduce the principal value of the Company's "first loss" asset and will be
recognized as an actual credit loss by the Company. The limit of the Company's
potential credit losses on these assets is equal to the amortized cost of $0.2
million. As the Company's cost basis in "first loss" assets is low relative to
the mortgage principal value, the Company's realized credit loss will equal only
10-20% of the principal value of any mortgage credit losses in the pools. Total
credit losses realized by the Company on "first loss" assets have been $3,997
through September 30, 1996.
37
<PAGE> 38
CREDIT RESERVES
Through its quarterly credit provisions, the Company is building a credit
reserve for future credit losses. The first step the Company takes in its
on-going review of the adequacy of its credit reserve is to assess potential
credit risk arising from seriously delinquent (90+ days) whole loans and
seriously delinquent loans in the mortgage pools underlying the Company's
securitized mortgage assets. Future credit losses from these loans will depend
on the number of these loans actually defaulting, the loss severity experienced
on default of the loan, the level of credit-enhancement at the pool level, and
the Company's amortized cost basis in that asset. The table below shows the
credit losses that could be incurred by the Company if all the seriously
delinquent mortgage loans in which the Company owned an interest at September
30, 1996 were to default and result in a loss. For example, if all these loans
were to default and the loss severity experienced was 25% of the loan balance,
credit losses to the Company would be $703,000 (39% of the current credit
reserve.) The amount of actual credit losses that will be incurred from these
loans is unknown; management expects that some losses will be realized in the
near future. This table addresses the potential credit risk arising from current
serious delinquencies only; it does not purport to reflect potential losses that
may occur over the life of these assets.
TABLE 21
POTENTIAL FUTURE CREDIT LOSSES ESTIMATED BASED ON
CURRENT 90+ DAY DELINQUENCIES ONLY
<TABLE>
<CAPTION>
POTENTIAL POTENTIAL POTENTIAL POTENTIAL POTENTIAL POTENTIAL
CUMULATIVE FUTURE FUTURE FUTURE FUTURE FUTURE FUTURE
ESTIMATED LOSSES LOSSES LOSSES LOSSES LOSSES LOSSES
ACTUAL ASSUMING ASSUMING ASSUMING ASSUMING ASSUMING ASSUMING
CREDIT REALIZED LOSS LOSS LOSS LOSS LOSS LOSS
LOSS LOSS SEVERITY SEVERITY SEVERITY SEVERITY SEVERITY SEVERITY
END OF PERIOD RESERVE SEVERITY OF 10% OF 15% OF 20% OF 25% OF 30% OF 35%
- ------------- ------- -------- ------ ------ ------ ------ ------ ------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 0 0% $ 0 $ 0 $ 0 $ 0 $ 0 $ 0
1995, Quarter 1 19 0% 0 0 0 0 0 0
1995, Quarter 2 59 0% 0 0 0 0 0 0
1995, Quarter 3 143 0% 0 0 0 0 0 0
1995, Quarter 4 490 9% 15 22 29 37 103 435
1996, Quarter 1 821 10% 39 58 78 227 655 1,280
1996, Quarter 2 1,298 16% 68 102 147 715 1,449 2,215
1996, Quarter 3 1,814 22% 102 154 205 703 1,254 2,196
</TABLE>
In order to complete the evaluation of the adequacy of its reserve levels, the
Company then considers additional credit losses that may arise from future
delinquencies.
INTEREST RATE AGREEMENTS
The Company's interest rate agreements are 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 income losses from counter-party
risk are limited to the Company's amortized cost basis in these agreements,
which was $3.3 million at September 30, 1996 and $2.5 million at December 31,
1995. The Company has experienced no credit losses on interest rate agreements.
See "Note 3: Interest Rate Agreements" in the Notes to Financial Statements for
additional information.
BORROWINGS
Through the end of the third quarter of 1996, the Company's debt has consisted
entirely of borrowings collateralized by a pledge of the Company's mortgage
assets. 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
38
<PAGE> 39
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 believes that total borrowing capacity
has been 94% to 97% of the market value of its mortgage assets. The Company,
however, has limited 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 have ranged from one day to one
year. For some borrowings, the cost of funds adjusts to market levels on a
regular schedule during the term of the borrowing, so the
term-to-next-rate-adjustment may be shorter than the term-to-maturity. The
weighted average term-to-maturity was 102 days and the weighted average
term-to-next-rate-adjustment was 71 days at September 30, 1996. At December 31,
1995, the average term-to-maturity was 74 days and the average
term-to-next-rate-adjustment was 26 days. The Company lengthened the
term-to-next-rate-adjustment for its borrowings beginning in the second quarter
of 1996 and correspondingly reduced its level of short-term interest rate
hedging.
TABLE 22
BORROWING SUMMARY
<TABLE>
<CAPTION>
ESTIMATED
MARKET BORROWING
VALUE OF CAPACITY AVERAGE RATE ON
PLEDGABLE AS A % OF ESTIMATED AVERAGE TERM TO BORROWINGS
MORTGAGE PLEDGABLE BORROWING TOTAL TERM TO RATE OUTSTANDING
END OF PERIOD ASSETS ASSETS CAPACITY BORROWINGS MATURITY ADJUSTMENT AT PERIOD-END
- ------------- ------ ------ -------- ---------- -------- ---------- -------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 117,477 95.6% $ 112,283 $ 100,376 112 days 70 days 5.80%
1995, Quarter 1 141,860 94.3% 133,719 121,998 97 days 27 days 6.25%
1995, Quarter 2 175,242 95.4% 167,192 155,881 64 days 28 days 6.23%
1995, Quarter 3 298,785 94.5% 282,432 228,826 38 days 31 days 5.95%
1995, Quarter 4 432,244 94.6% 408,998 370,316 74 days 26 days 6.01%
1996, Quarter 1 565,159 95.2% 537,783 508,721 48 days 19 days 5.62%
1996, Quarter 2 1,007,480 95.9% 965,735 896,214 72 days 72 days 5.70%
1996, Quarter 3 1,375,870 96.1% 1,322,091 1,225,094 102 days 71 days 5.78%
</TABLE>
LIQUIDITY
A financial institution has ample liquidity when it is able to meet the demands
made upon it for cash payments with its cash reserves, operating cash flow,
borrowing capacity, proceeds from asset sales, or other sources of cash.
Liquidity allows the Company to purchase additional mortgage assets and allows
the Company to pledge additional assets to secure existing borrowings should the
value of pledged assets decline. Potential immediate sources of liquidity for
the Company include cash balances and unused borrowing capacity. Unused
borrowing capacity is defined as estimated borrowing capacity (as shown in Table
22) less total borrowings and is based on the market value of the Company's
assets at period-end. Unused borrowing capacity will vary over time as the
market value of the Company's mortgage assets fluctuate and due to other
factors. Potential immediate sources of liquidity as a percent of total
borrowings equaled 9% at September 30, 1996 and 12% at December 31, 1995. 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
39
<PAGE> 40
(although such sales could cause realized losses). 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 POTENTIAL
SOURCES OF IMMEDIATE
LIQUIDITY SOURCES
ESTIMATED (CASH + OF
UNUSED EST. UNUSED LIQUIDITY
CASH BORROWING BORROWING AS % OF
END OF PERIOD BALANCE CAPACITY CAPACITY) BORROWINGS
------------- ------- -------- --------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C>
Fiscal 1994 $ 1,027 $11,907 $ 12,934 13%
1995, Quarter 1 953 11,721 12,674 10%
1995, Quarter 2 1,620 11,311 12,931 8%
1995, Quarter 3 1,150 53,606 54,756 24%
1995, Quarter 4 4,825 38,682 43,507 12%
1996, Quarter 1 9,705 29,062 38,767 8%
1996, Quarter 2 10,407 69,521 79,928 9%
1996, Quarter 3 14,599 96,997 111,596 9%
</TABLE>
STOCKHOLDERS' EQUITY
During the first nine months of 1996 the Company's equity base grew $95.2
million, from $68.3 million to $163.5 million. This growth was the result of the
Company's April 1996 common stock offering ($54.5 million), the August 1996
preferred stock offering ($29.6 million), proceeds from the issuance of common
stock upon the exercise of warrants ($8.8 million), positive mark-to-market
adjustments on the Company's assets ($3.4 million), common stock sold pursuant
to the Company's Dividend Reinvestment Plan ($1.0 million) and a negative
adjustment (- $2.1 million) because dividends have exceeded GAAP income.
Dividends generally track income as calculated for tax purposes.
Over this nine month period, book value per share grew from $12.38 to $16.23, an
increase of 31%. Management believes that book value per share growth helps the
Company in its efforts to generate future earnings per share growth; as book
value per share increases, the Company has more equity capital per share to
invest in its business.
For balance sheet purposes, the Company values all of its mortgage assets and
interest rate agreements at their estimated bid-side liquidation market value.
As a result, the Company's equity base and book value per share will fluctuate.
The difference between market value and historical amortized cost, or "Net
Unrealized Loss on Assets Available for Sale", was $2.1 million, or 0.1% of
assets, as of September 30, 1996. The net unrealized loss at December 31, 1995
was $5.5 million, or 1.2% of assets. Net unrealized loss includes both
mark-downs on assets taken immediately upon acquisition (as liquidation values
are generally estimated to be lower than acquisition prices) and the effect of
subsequent market value fluctuations.
40
<PAGE> 41
TABLE 24
STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
NET NET NET HISTORICAL
UNREALIZED UNREALIZED UNREALIZED HISTORICAL AMORTIZED GAAP
LOSSES LOSSES ON TOTAL LOSSES AMORTIZED GAAP COST REPORTED
ON INTEREST NET AS % OF COST REPORTED EQUITY EQUITY
MORTGAGE RATE UNREALIZED TOTAL EQUITY EQUITY PER PER
END OF PERIOD ASSETS AGREEMENTS LOSSES ASSETS BASE BASE SHARE SHARE
- ------------- ------ ---------- ------ ------ ---- ---- ----- -----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $(2,657) $ 101 $(2,556) (2.1%) $ 22,837 $ 20,280 $12.18 $10.82
1995, Quarter 1 86 (635) (549) (0.4%) 22,901 22,352 12.22 11.93
1995, Quarter 2 886 (1,200) (314) (0.2%) 22,847 22,533 12.19 12.02
1995, Quarter 3 34 (1,585) (1,551) (0.5%) 74,024 72,473 13.42 13.14
1995, Quarter 4 (3,502) (1,974) (5,476) (1.2%) 73,766 68,290 13.37 12.38
1996, Quarter 1 (3,763) (1,302) (5,065) (0.9%) 73,211 68,146 13.26 12.34
1996, Quarter 2 (3,068) (1,485) (4,553) (0.4%) 128,847 124,295 15.12 14.59
1996, Quarter 3 353 (2,413) (2,060) (0.1%) 165,578 163,517 16.43 16.23
</TABLE>
CAPITAL ADEQUACY/RISK-ADJUSTED CAPITAL POLICY
Stockholders' equity as a percent of total assets was 11.7% at September 30,
1996 and 15.5% at December 31, 1995. The Company's target equity-to-assets ratio
at September 30, 1996 was 10.3%. This target level of equity capitalization is
higher than that of many banks, savings and loans, Federal government mortgage
agencies, 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
the Company's asset mix, liquidity position, the level of unused borrowing
capacity, the level of interest rates as compared to the periodic and life caps
in the Company's assets, and the over-collateralization levels required by the
Company's lenders. The Company has sought 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 has sought to maintain an
equity-to-assets ratio of 40% to 100%.
Through September 30, 1996, the Company's per-asset capital requirements have
not changed significantly since the founding of the Company, although the
overall target equity-to-assets ratio has varied over time as a function of the
asset mix and other factors. As shown in the table below, the target
equity-to-assets ratio has been declining since mid-1995 as the Company has
increased its focus on the acquisition of mortgage assets with relatively low
credit risk and relatively good liquidity.
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
most circumstances, this would be accomplished over time by waiting for the
balance of mortgage assets to reduce through mortgage principal repayments.
The table below shows the Company's actual and target equity-to-assets ratios
and the Company's actual asset size as compared to its full potential asset size
given its equity capital base and the guidelines of the Company's RAC Policy.
Management anticipates that the target equity-to-assets ratio may continue to
drop in the future as the Company shifts its asset mix with a continued emphasis
on the acquisition of high-quality whole mortgage loans and securitized mortgage
assets rated AAA and AA.
With excess capital of $18.7 million as compared to its risk-adjusted capital
guideline at September 30, 1996, the Company had asset growth potential of
approximately $181 million assuming acquired mortgage assets have the same mix
as existing mortgage assets. The Company estimates it employed approximately 84%
of its capital base on average during the third quarter of 1996.
41
<PAGE> 42
TABLE 25
EXCESS CAPITAL AND ASSET GROWTH POTENTIAL
<TABLE>
<CAPTION>
POTENTIAL ASSET ESTIMATED
ASSET GROWTH PERCENT
TARGET ACTUAL SIZE POTENTIAL OF
EQUITY EQUITY WITH WITH CAPITAL
TO TO SAME ACTUAL SAME EMPLOYED
EQUITY ASSETS ASSETS EXCESS ASSET ASSET ASSET DURING
END OF PERIOD CAPITAL RATIO RATIO CAPITAL MIX SIZE MIX PERIOD
- ------------- ------- ----- ----- ------- --- ---- --- ------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 20,280 10.84% 16.69% $ 6,716 $ 187,048 $ 121,528 $ 65,520 30%
1995, Quarter 1 22,352 12.41% 15.37% 3,970 180,173 145,440 34,733 70%
1995, Quarter 2 22,533 12.95% 12.57% (1,069) 173,989 179,321 (5,332) 94%
1995, Quarter 3 72,473 13.08% 23.89% 32,155 554,183 303,394 250,789 55%
1995, Quarter 4 68,290 12.59% 15.47% 12,028 542,431 441,557 100,874 69%
1996, Quarter 1 68,146 11.72% 11.72% 26 581,540 581,313 227 87%
1996, Quarter 2 124,295 10.77% 12.09% 13,566 1,154,303 1,028,330 125,973 74%
1996, Quarter 3 163,517 10.32% 11.65% 18,664 1,584,315 1,403,478 180,837 84%
</TABLE>
WARRANTS
At September 30, 1996, the Company had 1,076,431 warrants outstanding; at
December 31, 1995 the Company had 1,665,063 warrants outstanding. In the first
nine months of 1996, 588,632 warrants were exercised, thus generating additional
equity proceeds to the Company of $8.8 million. 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 additional new equity capital of approximately $16.1 million.
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 principal repayment 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 hedging through the use of interest rate
agreements to mitigate the potential impact on net income of periodic and
lifetime caps (coupon adjustment restrictions) in the assets.
A primary goal of the Company's asset/liability strategy is to preserve
liquidity by managing the volatility of the net market value of the Company's
balance sheet as shown in the stockholders' equity account. In the event of an
increase in short-term interest rates, the market value of the Company's
mortgage assets would likely fall, particularly in the short-term. The Company
anticipates that, in such an event, the market value of its interest rate
agreements would likely rise and partially offset decreases in mortgage values.
See "Asset/Liability Management and Effect of Changes in Interest Rates --
Equity Duration" below.
Changes in interest rates also may have an effect on the rate of mortgage
principal repayment; the Company generally 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.
Such balancing may not always be possible, however. As discussed earlier, the
Company has purchased assets in 1996 at prices
42
<PAGE> 43
in excess of par value, and thus has significantly increased the net unamortized
premium balance. In addition, 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
repayment increases, the Company accelerates premium amortization at a faster
rate than discount amortization. This accounting practice leads to a lower level
of accounting income, compared to what it otherwise would have been, during
periods of rapid mortgage principal repayments. See "Results of Operations --
Amortization of Premium and Discount and Effect of Changes in Principal
Repayment Rates" above.
Although the net effects on earnings of changes in interest rates, mortgage
prepayment rates, and other factors cannot be determined in advance, management
believes, given the balance sheet as of September 30, 1996, that some of the
following effects may occur in an environment of rising short-interest rates:
(i) earnings on that portion of the balance sheet funded with equity may rise
over time as the coupons on adjustable rate mortgages adjust upwards, (ii)
earnings on that portion of the balance sheet funded with borrowings (spread
lending) may be initially reduced as borrowing costs rise more quickly than the
coupons on adjustable rate mortgages, although most or all of the spread might
be restored over time as the mortgage coupons fully adjust to the rate change,
(iii) earnings may benefit from net hedge income or reduced net hedge expense
from interest rate agreements, (iv) premium amortization expenses may be reduced
if the rate of mortgage principal repayment diminishes. All other factors being
equal, the net effect of an increase in short-term interest rates may be an
initial drop in earnings followed by increased earnings after a lag period. The
length of any such lag period would likely be determined by the speed and extent
of the change in interest rates. Management believes each of these effects would
likely be reversed in an environment of falling short-term interest rates. All
other factors being equal, therefore, the net effect of falling short-term
interest rates could be an initial increase in earnings followed by decreased
earnings after a lag period.
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
short-term interest rates rise and fall as short-term interest rates fall. If
the Company achieves this goal, the Company's return on average equity, earnings
and dividends would maintain a constant or widening spread to the level of
short-term interest rates over time.
INTEREST RATE SENSITIVITY GAP BEFORE HEDGING
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. The gap measures the amount of
assets that mature or have a coupon adjustment in a particular period as
compared to the amount of liabilities similarly adjusting during that time. A
negative gap implies that rising interest rates will lead to lower earnings,
while a positive gap implies that rising interest rates will lead to higher
earnings. Lower interest rates would have the opposite effect. In each case,
these effects are limited to the particular time period for which the gap is
calculated.
As applied to the Company, this gap analysis ignores the effect of the Company's
hedging activities (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 Company's interest rate risk profile.
The Company's two-month cumulative gap as a percentage of total assets was
negative 16% at September 30, 1996. This suggests that the initial impact on the
Company's earnings of rising interest rates would be negative. Falling interest
rates would have the opposite effect. The Company had a cumulative nine-month
gap of positive 3% at September 30, 1996. This implies that the impact on net
interest income of increasing interest rates may be positive within nine months
even though the initial impact could have been negative. Falling interest rates
would likely have the opposite effect.
Although the Company's balance sheet does have these characteristics, since a
variety of factors (such as interest rate agreements) have not been taken into
account in the gap analysis, it is not possible to assess, solely on this
43
<PAGE> 44
basis, what the actual impact of such interest rate changes on the Company's net
income 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 positive 12% at
September 30, 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 (a portion of the
Company's earning assets are funded with equity).
The negative short-term interest rate sensitivity gap was reduced at the end of
the second and third quarter of 1996 compared to earlier periods because the
Company extended the average maturity of its liabilities beginning in the second
quarter of 1996.
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
TOTAL TOTAL TOTAL TOTAL TOTAL TOTAL TOTAL TOTAL
END OF PERIOD ASSETS ASSETS ASSETS ASSETS ASSETS ASSETS ASSETS ASSETS
- ------------- ------ ------ ------ ------ ------ ------ ------ ------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 (3%) (0%) 5% (1%) 1% 15% 15% 15%
1995, Quarter 1 (46%) (41%) (27%) (12%) 0% 14% 14% 14%
1995, Quarter 2 (39%) (49%) (33%) (17%) (3%) 11% 12% 12%
1995, Quarter 3 (51%) (34%) (19%) (6%) 4% 18% 20% 23%
1995, Quarter 4 (48%) (36%) (26%) (16%) (3%) 9% 12% 15%
1996, Quarter 1 (62%) (47%) (34%) (21%) (8%) 4% 8% 11%
1996, Quarter 2 (13%) (10%) (3%) (6%) (6%) (2%) 5% 12%
1996, Quarter 3 (21%) (16%) (9%) (10%) (8%) (4%) 3% 12%
</TABLE>
INTEREST RATE AGREEMENTS
The Company's interest rate agreements materially alter the interest rate risk
profile suggested by the interest rate sensitivity gap analysis. See "Results of
Operations -- Cost of Borrowed Funds and Hedging and the Interest Rate Spread"
above and "Note 3. Interest Rate Agreements" of the Notes to Financial
Statements for further detail and information.
The interest rate agreements are designed to produce income for the Company as
short-term interest rates rise to partially or fully offset possible losses of
net interest income from the spread lending portion of the Company's balance
sheet. These agreements can be thought of as serving to limit potential
increases in the costs of the Company's borrowings or, alternatively, as serving
to remove some of the periodic and lifetime caps imbedded in the Company's
assets. In addition, the interest rate agreements are designed to appreciate in
market value in most circumstances in which short-term interest rates rise
sharply, thereby partially offsetting likely concurrent declines in the market
value of the Company's mortgage assets.
The Company has also entered into Treasury/LIBOR basis swaps designed, in
conjunction with the Company's other interest rate agreements, to partially
offset potential negative effects on the Company's earnings and mark-to-market
equity balances should LIBOR interest rates materially increase as compared to
U.S. Treasury interest rates. A portion of the Company's balance sheet consists
of mortgages with coupons set as a function of short-term U.S. Treasury interest
rates; these assets are funded with borrowings with a cost of funds more closely
linked to short-term LIBOR rates.
44
<PAGE> 45
INTEREST RATE FUTURES AND OPTIONS
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
gains and unrealized losses on any such contracts. The Company currently plans
to seek 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%.
Should interest rates increase by more than 1%, the Company believes its equity
duration would increase.
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.
45
<PAGE> 46
PART II OTHER INFORMATION
Item 1. Legal Proceedings
At September 30, 1996, there were no pending legal proceedings to which
the Company as a party or of which any of its property was subject.
Item 2. Changes in Securities
On August 8, 1996, the Company issued its Class B 9.74% Cumulative
Convertible Preferred Stock (the "Preferred Stock"). Under the terms of
the Preferred Stock, no dividends may be paid on shares of Common Stock
unless full cumulative dividends have been paid on the Preferred Stock.
Item 3. Defaults Upon Senior Securities
Not applicable
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit 3.4* - Articles Supplementary of the Registration
relating to the Preferred Stock, filed August 9, 1996.
Exhibit 4.3* - Preferred Stock Certificate.
Exhibit 11 to Part I - Computation of Earnings Per Share for
the three and six months ended September 30, 1996 and
September 30, 1995.
Exhibit 27 - Financial Data Schedule
* Incorporated by reference to the correspondingly numbered exhibit to
the Registration Statement on Form S-11 (333-08363) filed by the
Registrant on July 18, 1996.
(b) Reports
No filings on Form 8-K were made.
46
<PAGE> 47
SIGNATURES
Pursuant to the requirements of the Securities Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
REDWOOD TRUST, INC.
Dated: November 8, 1996 By: /s/ Douglas B. Hansen
-----------------------------------------
Douglas B. Hansen
President and Chief Financial Officer
(authorized officer of registrant)
Dated: November 8, 1996 By: /s/ Vickie L. Rath
----------------------------------------
Vickie L. Rath
Vice President, Treasurer and Controller
(principal accounting officer)
47
<PAGE> 48
REDWOOD TRUST, INC.
INDEX TO EXHIBIT
Sequentially
Exhibit Numbered
Number Page
- ------ --------
11 Computation of Earnings per Share...... 49
27 Financial Data Schedule................ 51
48
<PAGE> 49
EXHIBIT 11.1
REDWOOD TRUST, INC.
STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS
<TABLE>
<CAPTION>
Three Months Nine Months
Ended Ended
September 30, 1996 September 30, 1996
------------------ ------------------
<S> <C> <C>
PRIMARY:
Average common shares outstanding ........................... 8,732,326 7,360,916
Net effect of dilutive stock options outstanding
during the period -- based on the treasury stock method.. 162,393 186,576
Net effect of dilutive stock warrants outstanding
during the period -- based on the treasury stock method.. 621,455 699,324
---------- ----------
Total 9,516,174 8,246,815
========== ==========
Net Income $2,999,205 $7,453,284
========== ==========
Per Share Amount $ 0.32 $ 0.90
========== ==========
FULLY DILUTED:
Average common shares outstanding ........................... 8,732,326 7,360,916
Net effect of dilutive stock options outstanding
during the period -- based on the treasury stock method.. 180,891 204,202
Net effect of dilutive stock warrants outstanding
during the period -- based on the treasury stock method.. 744,178 837,425
---------- ----------
Total 9,657,395 8,402,542
========== ==========
Net Income $2,999,205 $7,453,284
========== ==========
Per Share Amount $ 0.31 $ 0.89
========== ==========
</TABLE>
49
<PAGE> 50
EXHIBIT 11.1
REDWOOD TRUST, INC.
STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS
<TABLE>
<CAPTION>
Three Months Nine Months
Ended Ended
September 30, 1995 September 30, 1995
------------------ ------------------
<S> <C> <C>
Primary:
Average common shares outstanding .............................. 3,219,754 1,223,170
Average preferred shares outstanding (A) ....................... 724,375 1,348,718
Net effect of dilutive stock options outstanding
during the period -- based on the treasury stock method .... 154,886 175,754
Net effect of dilutive stock warrants outstanding
during the period -- based on the treasury stock method .... 84,123 N/A
---------- ----------
Total 4,183,138 2,747,642
========== ==========
Net Income $ 993,815 $1,845,134
========== ==========
Per Share Amount $ 0.24 $ 0.67
========== ==========
Fully Diluted:
Average common shares outstanding .............................. 3,219,754 1,223,170
Average preferred shares outstanding (A) ....................... 724,375 1,348,718
Net effect of dilutive stock options outstanding
during the period -- based on the treasury stock method .... 154,886 175,754
Net effect of dilutive stock warrants outstanding
during the period -- based on the treasury stock method .... 84,123 N/A
---------- ----------
Total 4,183,138 2,747,642
========== ==========
Net Income $ 993,815 $1,845,134
========== ==========
Per Share Amount $ 0.24 $ 0.67
========== ==========
</TABLE>
(A) Preferred shares considered common stock equivalents for all periods as
there is no stated yield and there is an automatic conversion feature
to convert the preferred to common with no additional proceeds to the
company.
50
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM SEPTEMBER
30, 1996 QUARTERLY REPORT ON FORM 10-Q AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<CIK> 0000930236
<NAME> REDWOOD TRUST
<MULTIPLIER> 1,000
<CURRENCY> U.S. DOLLARS
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> SEP-30-1996
<EXCHANGE-RATE> 1,000
<CASH> 14,599
<SECURITIES> 1,376,743
<RECEIVABLES> 10,781
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 1,403,478
<PP&E> 0
<DEPRECIATION> 0
<TOTAL-ASSETS> 1,403,478
<CURRENT-LIABILITIES> 1,239,961
<BONDS> 0
0
29,712
<COMMON> 138,172
<OTHER-SE> (4,367)
<TOTAL-LIABILITY-AND-EQUITY> 1,403,478
<SALES> 0
<TOTAL-REVENUES> 41,403
<CGS> 0
<TOTAL-COSTS> 0
<OTHER-EXPENSES> 2,514
<LOSS-PROVISION> 1,324
<INTEREST-EXPENSE> 29,724
<INCOME-PRETAX> 7,841
<INCOME-TAX> 0
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 7,841
<EPS-PRIMARY> 0.90
<EPS-DILUTED> 0.89
</TABLE>
