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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K/A
Amendment No. 2 to
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended: December 31, 1996
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
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COMMISSION FILE NUMBER: 0-26436
REDWOOD TRUST, INC.
(Exact name of Registrant as specified in its Charter)
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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)
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(415) 389-7373
(Registrant's telephone number, including area code)
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Securities registered pursuant to Section 12(b) of the Act: Securities registered pursuant to Section 12(g) of the Act:
NONE CLASS B 9.74 % CUMULATIVE CONVERTIBLE PREFERRED STOCK,
PAR VALUE $0.01 PER SHARE
(Title of Class)
COMMON STOCK, PAR VALUE $0.01 PER SHARE
(Title of Class)
STOCK PURCHASE WARRANTS, EXPIRING DECEMBER 31, 1997
(Title of Class)
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Indicate by check mark whether the Registrant (1) has filed all 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 [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
At March 17, 1997 the aggregate market value of the voting stock held by
non-affiliates of the Registrant was $479,425,809.
The number of shares of the Registrant's Common Stock outstanding on March 17,
1997 was 11,797,753.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement issued in connection
with the 1997 Annual Meeting of Stockholders are incorporated by reference into
Part III.
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REDWOOD TRUST, INC.
1996 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
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Page
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PART I
Item 1. BUSINESS..................................................................................... 3
Item 2. PROPERTIES................................................................................... 30
Item 3. LEGAL PROCEEDINGS............................................................................ 30
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.......................................... 30
PART II
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY
AND RELATED STOCKHOLDER MATTERS.............................................................. 31
Item 6. SELECTED FINANCIAL DATA...................................................................... 32
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS................................................ 33
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.................................................. 65
Item 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE....................................................... 65
PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT........................................... 65
Item 11. EXECUTIVE COMPENSATION....................................................................... 65
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
OWNERS AND MANAGEMENT........................................................................ 65
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS............................................... 65
PART IV
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND
REPORTS ON FORM 8-K.......................................................................... 66
FINANCIAL STATEMENTS....................................................................................... F-1
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PART I
ITEM 1. BUSINESS
THE COMPANY
Redwood Trust, Inc. (the "Company") was incorporated in the State of Maryland on
April 11, 1994 and commenced operations on August 19, 1994. It invests in
Mortgage Assets financed by the proceeds of equity offerings and by borrowings.
The Company produces net interest income on Mortgage Assets qualifying as
Qualified REIT Real Estate Assets while maintaining strict cost controls in
order to generate net income for distribution to its stockholders. The Company
intends to continue operating in a manner that will permit it to maintain its
qualification as a REIT for Federal income tax purposes. As a result of its REIT
status, the Company is permitted to deduct dividend distributions to
stockholders, thereby effectively eliminating the "double taxation" that
generally results when a corporation earns income and distributes that income to
stockholders in the form of dividends. See "Certain Federal Income Tax
Considerations - Taxation of the Company." The principal executive offices of
the Company are located at 591 Redwood Highway, Suite 3100, Mill Valley,
California 94941, telephone (415) 389-7373. The Company is self-advised and
self-managed.
Statements in this report regarding the Company's business which are not
historical facts are "forward-looking statements" as contemplated in the Private
Securities Litigation Reform Act of 1995. Such statements should be read in
light of the risks and uncertainties attendant to the business of the Company,
including, without limitation, risks of substantial leverage and potential net
interest and operating losses in connection with borrowings, risk of decrease in
net interest income due to interest rate fluctuations, prepayment risks of
Mortgage Assets, risk of failing to hedge against interest rate changes
effectively, risk of loss associated with hedging, counterparty risks, risk of
loss due to default on Mortgage Assets and risk of failure to maintain REIT
status and being subject to tax as a regular corporation. For a complete
description of these and other risks associated with the business of the
Company, see "Risk Factors" commencing on page 26.
Reference is made to the Glossary commencing on page 67 of this report for
definitions of terms used in the following description of the Company's business
and elsewhere in this report.
BUSINESS AND STRATEGY
The Company's principal business objective is to produce net interest income on
its Mortgage Assets while maintaining strict cost controls in order to generate
net income for distribution to stockholders. The Company seeks to distribute
dividends to stockholders at levels that generally adjust, following a lag
period, with changes in short-term market interest rates and that may increase
over time in the event of improvements in the real estate markets. To achieve
its business objective and generate dividend yields that provide a relatively
attractive rate of return for stockholders, the Company's strategy is:
- to purchase Single-Family Mortgage Assets, the majority of which are
currently expected to have adjustable interest rates based on changes in
short-term market interest rates, with an emphasis on mortgage
interests on residential properties located in California;
- to manage the credit risk of its Mortgage Assets through, among other
activities, (i) carefully selecting Mortgage Assets to be acquired,
including an underwriting review of Mortgage Loans and lower-rated
Mortgage Securities, (ii) following the Company's policies with respect
to credit risk concentration which, among other things, require the
Company to maintain a Mortgage Asset portfolio with a weighted average
rating level of A- or better, (iii) actively monitoring the ongoing
credit quality and servicing of its Mortgage Assets, and (iv)
maintaining appropriate capital levels and reserves for possible credit
losses;
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- to finance such purchases with the proceeds of equity offerings and, to
the extent permitted by the Company's capital and liquidity policies, to
utilize leverage to increase potential returns to stockholders through
borrowings. When possible the interest rates on these borrowings will be
structured to match the interest rate characteristics of the Mortgage
Assets;
- to attempt to structure its borrowings to have interest rate adjustment
indices and interest rate adjustment periods that, on an aggregate
basis, generally correspond (within a range of one to six months) to the
interest rate adjustment indices and interest rate adjustment periods of
the adjustable-rate Mortgage Assets purchased by the Company;
- to utilize interest rate caps, swaps and similar instruments to mitigate
the risk of the cost of its variable rate liabilities increasing at a
faster rate than the earnings on its Mortgage Assets during a period of
rising interest rates;
- to seek to minimize prepayment risk by structuring a diversified
portfolio with a variety of prepayment characteristics and through other
means;
- to apply securitization techniques designed to enhance the value and
liquidity of the Company's Mortgage Assets acquired in the form of
Mortgage Loans by securitizing them into Mortgage Securities that are
tailored to the Company's objectives;
- to re-securitize portions of its Mortgage Securities portfolio when the
underlying Mortgage Loans have improved in credit quality through
seasoning or rising underlying property values, or when the credit
quality of a junior class of security improves due to the prepayment of
more senior classes, as such re-securitization transactions may result
in improved credit ratings, higher market values and lowered borrowing
costs;
- to use Mortgage Assets to collateralize the issuance of long term
collateralized mortgage bonds;
- to broaden the scope of its mortgage acquisitions over time to include
fixed rate single-family mortgages, multifamily mortgages and commercial
mortgages when management deems such purchases to be in the best
interests of shareholders; and
- to strive to become more cost-efficient over time.
The Company believes that its principal competition in the business of acquiring
and managing Mortgage Assets are financial institutions such as banks, savings
and loans, life insurance companies, institutional investors such as mutual
funds and pension funds, and certain other mortgage REITs. While many of these
entities have significantly greater resources than the Company, the Company
anticipates that it will be able to compete effectively due to its relatively
low level of operating costs, relative freedom to securitize its assets, ability
to utilize prudent amounts of leverage through accessing the wholesale market
for collateralized borrowings, freedom from certain forms of regulation and the
tax advantages of its REIT status.
The Company believes it is and plans to continue to be a "low cost producer"
compared to most of its competitors in the business of holding Mortgage Assets.
Accordingly, the Company plans to generate relatively attractive earnings and
dividends while holding Mortgage Assets of higher credit quality and maintaining
a lower interest rate risk profile as compared to its principal competitors. The
Company will attempt to be increasingly cost-efficient by: (i) seeking to raise
additional capital from time to time in order to increase its ability to invest
in Mortgage Assets as operating costs are not anticipated to increase as quickly
as Mortgage Assets and because growth will increase the Company's purchasing
influence with suppliers of Mortgage Assets; (ii) striving to lower its
effective borrowing costs over time through seeking direct funding with
collateralized lenders rather than using Wall Street intermediaries and
investigating the possibility of using commercial paper and medium term note
programs; (iii) improving the efficiency of its balance sheet structure by
investigating the issuance of various forms of debt and capital; and (iv)
utilizing information technology to the fullest extent possible in its
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business, which technology the Company believes can be developed to improve the
Company's ability to monitor the performance of its Mortgage Assets, improve its
ability to assess credit risk, improve hedge efficiency and lower operating
costs.
MORTGAGE ASSETS
GENERAL
The Mortgage Assets purchased by the Company may consist of Single-Family,
Multifamily and Commercial Mortgage Assets. Although all of the Company's
Mortgage Assets purchased through December 31, 1996 were Single-Family Mortgage
Assets, the Company may acquire Multifamily Mortgage Assets and Commercial
Mortgage Assets from time to time in the future when consistent with its Asset
Acquisition/Capital Allocation Policies. For the near future, the Company
expects a majority of its Mortgage Assets to bear adjustable interest rates.
However, fixed-rate Mortgage Assets also may be acquired when they satisfy the
Company's Asset Acquisition/Capital Allocation Policies and management believes
they will contribute to the Company's business objectives with respect to
desired levels of income and dividend distributions. From time to time, the
Company may also acquire common stock in other REITs that invest primarily in
Mortgage Assets if the Company believes the potential returns on such common
stock are good and such opportunities are as favorable or more favorable than
investing in Mortgage Assets directly. The Company may also acquire its own
stock, when permitted by applicable securities and state corporation laws.
The Company expects that a majority of its Mortgage Assets will continue to have
investment grade ratings (the four highest rating levels) from one or more
nationally recognized mortgage security rating agencies or be deemed by the
Company to be of comparable credit quality. Based upon the Company's investment
strategy and the guidelines under the Company's Asset Acquisition/Capital
Allocation Policies, the Company expects that the weighted average rating of its
Mortgage Assets (including the Company's deemed equivalent ratings for unrated
Mortgage Assets) will be at the "A-" rating level under Standard and Poor's
Corporation ("S&P") rating system and at the comparable level under other rating
systems. See "Certain Federal Income Tax Considerations - Taxation of Tax-Exempt
Entities."
The Company generally will not acquire residuals, principal-only strips, inverse
floaters, companion bonds, first loss Subordinated Bonds rated below BBB or
mortgage securities rated below B. On a limited basis only, the Company may
acquire interest-only strips as an investment or to assist in the hedging of
prepayment or other risks. The Company may, however, create a variety of
different types of assets, including the types mentioned in this paragraph,
through the normal process of securitization of the Company's own Mortgage
Assets. In no event will the Company acquire or retain any REMIC residual
interest that may give rise to "excess inclusion" income as defined under
Section 860E of the Code.
The Company's Asset Acquisition/Capital Allocation Policies utilize a return on
equity calculation that includes adjustments for credit risk, borrowing costs,
the cost of associated interest rate agreements (caps and swaps) and the
Risk-Adjusted Capital Policy requirements. The relative attractiveness of
various asset types will vary over time. The Company may acquire its Mortgage
Assets in the secondary mortgage market or upon origination pursuant to
arrangements with loan originators. Purchases of Mortgage Assets in the
secondary market generally are from national broker/dealer firms or other large
financial institutions. The Company may issue Commitments to originators and
other sellers of Mortgage Loans who it believes follow prudent origination
policies and procedures and comply with all applicable federal and state laws
and regulations for origination of Mortgage Loans. In addition, the Company may
issue Commitments for Mortgage Securities. These Commitments will obligate the
Company to purchase Mortgage Assets from the holders of the Commitment for a
specific period of time, in a specific aggregate principal amount and at a
specified price and margin over an index. Although the Company may commit to
acquire Mortgage Loans prior to funding, all loans are to be fully funded prior
to their acquisition by the Company. Following the issuance of Commitments, the
Company will be exposed to risks of interest rate fluctuations similar to those
risks on the Company's adjustable-rate Mortgage Assets. As described below under
"Management Policies and Programs - Asset/Liability Management - Mortgage Loan
Securitization Techniques," the Company works with loan originators, conduits
and other issuers of Mortgage Securities and their investment bankers to acquire
and securitize Mortgage Loans in a
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manner that best meets the needs of the Company. Such activity may involve the
issuance of Commitments by the Company.
The "face value" of Mortgage Assets represents the outstanding principal balance
of the Mortgage Loans or Mortgage Securities comprising the Mortgage Assets, and
"amortized cost" means the purchase prices paid for the Mortgage Assets adjusted
to reflect (i) amortization of discounts or premiums and (ii) principal
repayments. Mortgage Assets are carried on the balance sheet at what is referred
to by the Company as "carrying value." "Carrying value" for the Mortgage Assets
is management's estimate of the bid side of the market value for such assets.
Management usually bases its estimates on the lowest of third-party bid-side
indications of market value for Mortgage Assets obtained from firms making a
market in or lending against Mortgage Assets. Generally, such indications are
solicited by the Company on a monthly basis and from time to time in connection
with the Company's borrowing activities and the lowest of such indications with
respect to a Mortgage Asset generally comes from the secured lender on that
asset. To the extent that such bid-side indications typically are below the
amortized cost of Mortgage Assets (net of any specific credit reserves on such
Mortgage Assets), the difference is referred to as unrealized losses, and, to
the extent that such indications exceed the amortized cost (net of any specific
credit reserves), the difference is referred to as unrealized gains. The net
amount of such unrealized gains and losses is reflected on the balance sheet as
a valuation adjustment to Stockholders' Equity under the caption "Net Unrealized
Gain or Loss on Assets Available for Sale."
All of the mortgage loans underlying the Company's Mortgage Assets at December
31, 1996 were being serviced by third-party servicers unrelated to the Company.
The Company's Mortgage Securities are held by either Mellon Bank, N.A., pursuant
to a Custody Agreement dated August 22, 1994 or by Bankers Trust, pursuant to a
Clearance Agreement dated December 1, 1996.
TYPES OF MORTGAGE ASSETS
The various types of Mortgage Assets the Company may purchase are summarized
below.
Single-Family and Multifamily Mortgage Assets
Single-Family Mortgage Loans. The Company may acquire both Conforming Mortgage
Loans and Nonconforming Mortgage Loans. Conventional Conforming Mortgage Loans
will comply with the requirements for inclusion in a loan guarantee program
sponsored by either FHLMC or FNMA. The Company also may acquire FHA Loans or VA
Loans, which qualify for inclusion in a pool of Mortgage Loans guaranteed by
GNMA. Under current regulations, the maximum principal balance allowed on
Conforming Mortgage Loans ranges from $214,600 ($321,900 for Mortgage Loans
secured by Mortgaged Properties located in either Alaska or Hawaii) for one-unit
to $412,450 ($618,675 for Mortgage Loans secured by mortgaged properties located
in either Alaska or Hawaii) for four-unit residential loans. Nonconforming
Single-Family Mortgage Loans are Single-Family Mortgage Loans that do not
qualify in one or more respects for purchase by FNMA or FHLMC. The Company
expects that a majority of the Nonconforming Mortgage Loans it purchases will be
nonconforming because they have original principal balances which exceed the
requirements for FHLMC or FNMA programs or generally because they vary in
certain other respects from the requirements of such programs other than the
requirement relating to creditworthiness of the mortgagors. A substantial
portion of the Company's Nonconforming Mortgage Loans are expected to meet the
requirements for sale to national private mortgage conduit programs in the
secondary mortgage market.
The Company currently expects that substantially all of the Single-Family
Mortgage Loans acquired by it will be ARMs. The interest rate on an ARM is
typically tied to an index (such as LIBOR or the interest rate on United States
Treasury Bills), and is adjustable periodically at various intervals. Such
Mortgage Loans are typically subject to lifetime interest rate caps and periodic
interest rate and/or payment caps.
Multifamily Mortgage Loans. Multifamily Mortgage Loans generally involve larger
principal amounts per loan than Single-Family Mortgage Loans and require more
complex credit and property evaluation analysis. Multifamily Mortgage Loans
share many of the characteristics and risks associated with Commercial Mortgage
Loans and are often categorized as commercial loans rather than residential
loans. For example, the credit quality of a Multifamily Mortgage Loan typically
depends upon the existence and terms of underlying leases, tenant credit quality
and the historical and anticipated level of vacancies and rents on the mortgaged
property and on the competitive market condition of the mortgaged property
relative to other competitive properties in the
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same region, among other factors. Multifamily Mortgage Loans, however,
constitute `qualified mortgages" for purposes of the REMIC regulations and the
favorable tax treatment associated therewith and, when securitized, certain of
the resulting rated classes of Multifamily Mortgage Securities qualify as
"mortgage-related securities" and for the favorable treatment awarded such
securities under the Secondary Mortgage Market Enhancement Act of 1984
("SMMEA").
Single-Family and Multifamily Mortgage Securities. The Mortgage Assets purchased
by the Company are expected to include Single-Family Mortgage Securities. In
addition, the Company expects to pool and exchange a substantial portion of its
Single-Family and Multifamily Mortgage Loans for Single-Family and Multifamily
Mortgage Securities, respectively, which it may then hold for investment, sell
or pledge to secure borrowings. The types of Single-Family and Multifamily
Mortgage Securities that the Company may purchase or receive in exchange for its
Single-Family and Multifamily Mortgage Loans are described below.
Single-Family and Multifamily Privately-Issued Certificates. Single-Family and
Multifamily Privately-Issued Certificates are Pass-Through Certificates that are
not issued by one of the Agencies and that are backed by a pool of conventional
Single-Family or Multifamily Mortgage Loans, respectively. Single-Family and
Multifamily Privately-Issued Certificates are issued by originators of,
investors in, and other owners of Mortgage Loans, including savings and loan
associations, savings banks, commercial banks, mortgage banks, investment banks
and special purpose "conduit" subsidiaries of such institutions.
While Agency Certificates are backed by the express obligation of guarantee of
one of the Agencies, as described below, Single-Family and Multifamily
Privately-Issued Certificates are generally covered by one or more forms of
private (i.e,. nongovernmental) credit enhancements. Such credit enhancements
provide an extra layer of loss coverage in the event that losses are incurred
upon foreclosure sales or other liquidations of underlying mortgaged properties
in amounts that exceed the holder's equity interest in the property and result
in Realized Losses. Forms of credit enhancements include, but are not limited
to, limited issuer guarantees, reserve funds, private mortgage guaranty pool
insurance, over-collateralization and subordination.
Subordinantion is a form of credit enhancement frequently used and involves the
issuance of multiple classes of Senior-Subordinated Mortgage Securities. Such
classes are structured into a hierarchy of levels for purposes of allocating
Realized Losses and also for defining priority of rights to payment of principal
and interest. Typically, one or more classes of Senior Securities are created
which are rated in one of the two highest rating levels by one or more
nationally recognized rating agencies and which are supported by one or more
classes of Mezzanine Securities and Subordinated Securities that bear Realized
Losses prior to the classes of Senior Securities. Mezzanine Securities refer to
any classes that are rated below the two highest levels but no lower than a
single "B" level under the S&P rating system (or comparable level under other
rating systems) and are supported by one or more classes of Subordinated
Securities which bear Realized Losses prior to the classes of Mezzanine
Securities. As used herein, Subordinated Securities will refer to any class that
bears the "first loss" from Realized Losses or that is rated below a single "B"
level (or, if unrated, is deemed by the Company to be below such level based on
a comparison of characteristics of such class with other rated Subordinated
Securities with like characteristics). In some cases, only classes of Senior
Securities and Subordinated Securities are issued. By adjusting the priority of
interest and principal payments on each class of a given series of
Senior-Subordinated Securities, issuers are able to create classes of Mortgage
Securities with varying degrees of credit exposure, prepayment exposure and
potential total return, tailored to meet the needs of sophisticated
institutional investors.
The Company may purchase Single-Family and Multifamily Privately-Issued
Certificates in the secondary market. The Company may also acquire Single-Family
and Multifamily Privately-Issued Certificates by pooling and exchanging some of
its Single-Family and Multifamily Mortgage Loans, respectively, for such
securities. In connection with exchanging its Single-Family and Multifamily
Mortgage Loans for Single-Family and Multifamily Privately-Issued Certificates,
the Company may retain some or all classes resulting therefrom, including
Mezzanine Securities and Subordinated Securities. In cases where the Company
retains such junior classes, the Company will continue to be exposed to the
various risks of loss associated with the entire pool of underlying Mortgage
Loans.
GNMA Certificates. GNMA is a wholly-owned corporate instrumentality of the
United States within the Department of Housing and Urban Development ("HUD").
Section 306(g) of Title III of the National Housing
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Act of 1934, as amended (the "Housing Act"), authorizes GNMA to guarantee the
timely payment of the principal and interest on certificates which represent an
interest in a pool of mortgages insured by the VA under the Servicemen's
Readjustment Act of 1944, as amended, or Chapter 37 of Title 38, United States
Code and other loans eligible for inclusion in mortgage pools underlying GNMA
Certificates. Section 306(g) of the Housing Act provides that "the full faith
and credit of the United States is pledged to the payment of all amounts which
may be required to be paid under any guaranty under this subsection." An
opinion, dated December 12, 1969, of an Assistant Attorney General of the United
States provides that such guarantees under section 306(g) of GNMA Certificates
of the type which may be purchased or received in exchange by the Company are
authorized to be made by GNMA and "would constitute general obligations of the
United States backed by its full faith and credit."
At present, all GNMA Certificates are backed by Single-Family Mortgage Loans.
The interest rate paid on GNMA Certificates may be fixed rate or adjustable
rate. The interest rate on GNMA Certificates issued under GNMA's standard ARM
program adjusts annually in relation to the Treasury Index. Interest rates paid
on GNMA ARM Certificates typically equal the index rate plus 150 basis points.
Adjustments in the interest rate are generally limited to an annual increase or
decrease of 1% and to a lifetime cap of 5% over the initial interest rate.
FNMA Certificates. FNMA is a privately-owned, federally-chartered corporation
organized and existing under the Federal National Mortgage Association Charter
Act (12 U.S.C. 1716 et seq.). FNMA provides funds to the mortgage market
primarily by purchasing home Mortgage Loans from local lenders, thereby
replenishing their funds for additional lending. FNMA guarantees to the
registered holder of a FNMA Certificate that it will distribute amounts
representing scheduled principal and interest (at the rate provided by the FNMA
Certificate) on the Mortgage Loans in the pool underlying the FNMA Certificate,
whether or not received, and the full principal amount of any such mortgaged
loan foreclosed or otherwise finally liquidated, whether or not the principal
amount is actually received. The obligations of FNMA under its guarantees are
solely those of FNMA and are not backed by the full faith and credit of the
United States. If FNMA were unable to satisfy such obligations, distributions to
holders of FNMA Certificates would consist solely of payments and other
recoveries on the underlying Mortgage Loans and, accordingly, monthly
distributions to holders of FNMA Certificates would be affected by delinquent
payments and defaults on such Mortgage Loans.
FNMA Certificates may be backed by pools of Single-Family or Multifamily
Mortgage Loans. The original terms to maturities of the Mortgage Loans generally
do not exceed 40 years. FNMA Certificates may pay interest at a fixed rate or
adjustable rate. Each series of FNMA ARM Certificates bears an initial interest
rate and margin tied to an index based on all loans in the related pool, less a
fixed percentage representing servicing compensation and FNMA's guarantee fee.
The specified index used in each such series has included the Treasury Index,
the 11th District Cost of Funds Index published by the Federal Home Loan Bank of
San Francisco, LIBOR and other indices. In addition, the majority of series of
FNMA ARM Certificates issued to date have evidenced pools of Mortgage Loans with
monthly, semi-annual or annual interest rate adjustments. Certain FNMA programs
include Mortgage Loans which allow the borrower to convert the adjustable
mortgage interest rate to a fixed rate. ARMs which are converted into fixed rate
Mortgage Loans are repurchased by FNMA or by the seller of such loans to FNMA at
the unpaid principal balance thereof plus accrued interest to the due date of
the last adjustable rate interest payment. Adjustments to the interest rates on
FNMA ARM Certificates are typically subject to lifetime interest rate caps and
periodic interest rate and/or payment caps.
FHLMC Certificates. FHLMC is a privately-owned government-sponsored enterprise
created pursuant to an Act of Congress (Title III of the Emergency Home Finance
Act of 1970, as amended, 12 U.S.C. 1451-1459), on July 24, 1970. The principal
activity of FHLMC currently consists of the purchase of conventional Conforming
Mortgage Loans or participation interests therein and the resale of the loans
and participations so purchased in the form of guaranteed mortgage securities.
FHLMC guarantees to each holder of FHLMC Certificates the timely payment of
interest at the applicable pass-through rate and ultimate collection of all
principal on the holder's pro rata share of the unpaid principal balance of the
related Mortgage Loans, but does not guarantee the timely payment of scheduled
principal of the underlying Mortgage Loans. The obligations of FHLMC under its
guarantees are solely those of FHLMC and are not backed by the full faith and
credit of the United States. If FHLMC were unable to satisfy such obligations,
distributions to holders of FHLMC Certificates would consist solely of payments
and other recoveries on the underlying Mortgage Loans and, accordingly, monthly
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distributions to holders of FHLMC Certificates would be affected by delinquent
payments and defaults on such Mortgage Loans.
FHLMC Certificates may be backed by pools of Single-Family Mortgage Loans or
Multifamily Mortgage Loans. Such underlying Mortgage Loans may have original
terms to maturity of up to 40 years. FHLMC Certificates may be issued under cash
programs (composed of Mortgage Loans purchased from a number of sellers) or
guarantor programs (composed of Mortgage Loans purchased from one seller in
exchange for participation certificates representing interests in the Mortgage
Loans purchased). FHLMC Certificates may pay interest at a fixed rate or
adjustable rate. The interest rate paid on FHLMC ARM Certificates adjusts
periodically within 60 days prior to the month in which the interest rates on
the underlying Mortgage Loans adjust. The interest rates paid on FHLMC ARM
Certificates issued under FHLMC's standard ARM programs adjust in relation to
the Treasury Index. Other specified indices used in FHLMC ARM Programs include
the 11th District Cost of Funds Index published by the Federal Home Loan Bank of
San Francisco, LIBOR and other indices. Interest rates paid on fully-indexed
FHLMC ARM Certificates equal the applicable index rate plus a specified number
of basis points ranging typically from 125 to 250 basis points. In addition, the
majority of series of FHLMC ARM Certificates issued to date have evidenced pools
of Mortgage Loans with monthly, semi-annual or annual interest adjustments.
Adjustments in the interest rates paid are generally limited to an annual
increase or decrease of either 1% or 2% and to a lifetime cap of 5% or 6% over
the initial interest rate. Certain FHLMC programs include Mortgage Loans which
allow the borrower to convert the adjustable mortgage interest rate to a fixed
rate. ARMs which are converted into fixed rate Mortgage Loans are repurchased by
FHLMC or by the seller of such loans to FHLMC at the unpaid principal balance
thereof plus accrued interest to the due date of the last adjustable rate
interest payment.
Single-Family and Multifamily CMOs. The Company may, from time to time, invest
in adjustable-rate Single-Family and Multifamily CMOs. Single-Family and
Multifamily CMOs ordinarily are issued in series, each of which consists of
several serially maturing classes ratably secured by a single pool of
Single-Family or Multifamily Mortgage Loans or Single-Family or Multifamily
Privately-Issued Certificates. Generally, principal payments received on the
mortgage-related assets securing a series of CMOs, including prepayments on such
mortgage-related assets, are applied to principal payments on one or more
classes of the CMOs of such series on each principal payment date for such CMOs.
Scheduled payments of principal and interest on the mortgage-related assets and
other collateral securing a series of CMOs are intended to be sufficient to make
timely payments of interest on such CMOs and to retire each class of such CMOs
by its stated maturity. By allocating the principal and interest cash flows from
the underlying collateral among the separate CMO classes, different classes
(referred to as "tranches") of bonds are created, each with its own stated
maturity, estimated average life, coupon rate and prepayment characteristics.
Principal prepayments on the mortgage-related assets underlying a CMO issue may
cause different tranches of a CMO issue to be retired substantially earlier than
their stated maturities or final distribution dates. Interest generally is paid
or accrues on interest-bearing classes of CMOs on a monthly, quarterly or
semi-annual basis. The principal of and interest on the underlying
mortgage-related assets may be allocated among the several classes of a CMO
issue in a variety of ways. One type of CMO issue is one in which payments of
principal, including any principal prepayments, on the mortgage-related asset
are applied to the classes of CMOs in order of their respective stated
maturities or final distribution dates, so that no payment of principal will be
made on any class of the series until all other classes having an earlier stated
maturity or final distribution date have been paid in full.
Other types of CMO issues include classes such as parallel pay CMO's some of
which, such as Planned Amortization Class CMOs ("PAC Bonds"), provide protection
against prepayment uncertainty. Parallel pay CMOs are structured to provide
payments of principal on certain payment dates to more than one class. These
simultaneous payments are taken into account in calculating the stated maturity
date or final distribution date of each class which, as with other CMO
structures, must be retired by its stated maturity date or final distribution
date but may be retired earlier. PAC Bonds generally require payment of a
specified amount of principal on each payment date so long as prepayment speeds
on the underlying collateral fall within a specified range. PAC Bonds are always
parallel pay CMOs with the required principal payment on such securities having
the highest priority after interest has been paid to all classes.
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Other types of CMO issues include Targeted Amortization Class CMOs ("TAC
Bonds"), which are similar to PAC Bonds. While PAC Bonds maintain their
amortization schedule within a specified range of prepayment speeds, TAC Bonds
are generally targeted to a narrow range of prepayment speeds or a specified
pricing speed. TAC Bonds can provide protection against prepayment uncertainty
since cash flows generated from higher prepayments of the underlying
mortgage-related assets are applied to the various other pass-through tranches
so as to allow the TAC Bonds to maintain their amortization schedule.
CMOs may be subject to certain rights of issuers thereof to redeem such CMOs
prior to their stated maturity dates, which may have the effect of diminishing
the Company's anticipated return on its investment. Privately-Issued
Single-Family and Multifamily CMOs are supported by private credit enhancements
similar to those used for Privately-Issued Certificates and are often issued as
Senior-Subordinated Mortgage Securities. The Company will only acquire CMOs that
constitute beneficial ownership in grantor trusts holding Mortgage Loans, or
regular interests in REMICs, or that otherwise constitute Qualified REIT Real
Estate Assets (provided that the Company has obtained a favorable opinion of
counsel or a ruling from the IRS to that effect).
Commercial Mortgage Assets
Commercial Mortgage Loans. Commercial Mortgage Loans are secured by commercial
properties, such as industrial and warehouse properties, office buildings,
retail space and shopping malls, hotels and motels, hospitals, nursing homes and
senior living centers. Commercial Mortgage Loans have certain distinct risk
characteristics: existing Commercial Mortgage Loans generally lack standardized
terms, which may complicate their structure (although certain of the new
conduits are introducing standard form documents for use in their programs);
Commercial Mortgage Loans tend to have shorter maturities than Single-Family
Mortgage Loans; they may not be fully amortizing, meaning that they may have a
significant principal balance or "balloon" due on maturity; and commercial
properties, particularly industrial and warehouse properties, are generally
subject to relatively greater environmental risks than non-commercial properties
and the corresponding burdens and costs of compliance with environmental laws
and regulations.
Unlike most Single-Family Mortgage Loans, Commercial Mortgage Loans generally
utilize yield maintenance agreements to impose penalties on prepayments of
principal that compensate mortgagees, in part or in full, for the possibility of
lower interest lending rates that may be applicable at the time of prepayment.
Commercial Mortgage Loans may also contain prohibitions, at least for a period
of time following origination, on principal prepayments. Such prepayment
penalties and prohibitions tend to reduce the likelihood of prepayments on
Commercial Mortgage Loans as compared to Single-Family Mortgage Loans.
The credit quality of a Commercial Mortgage Loan may depend on, among other
factors, the existence and structure of underlying leases, deferred maintenance
on the property or physical condition of the property, the creditworthiness of
tenants, the historical and anticipated level of vacancies and rents on the
property and on other comparable properties located in the same region,
potential or existing environmental risks and the local and regional economic
climate in general. Primary indicators of credit quality on a Commercial
Mortgage Loan are the debt service coverage, i.e., the ratio of current net
operating income on a commercial property to the current debt service obligation
on the same property, and the loan-to-value ratio, both of which generally are
examined by the rating agencies from the perspective of a variety of worst-case
scenarios. Loan-to-value analysis is particularly important in the case of
Commercial Mortgage Loans because many are nonrecourse to the borrower and
therefore the value of the property will determine the amount of loss in the
event of default. Foreclosures of defaulted Commercial Mortgage Loans are
generally subject to a number of complicating factors not present in
foreclosures of Single-Family Mortgage Loans.
To the extent the Company seeks to acquire Commercial Mortgage Assets, the
Company intends to focus on the acquisition of Commercial Mortgage Securities
rather than Commercial Mortgage Loans. The Company will only acquire Commercial
Mortgage Loans when it believes it has the necessary expertise to evaluate and
manage them and only if they are consistent with the Company's Asset
Acquisition/Capital Allocation Policies.
Commercial Mortgage Securities. Commercial Mortgage Securities are securities
that represent an interest in, or are secured by, Commercial Mortgage Loans.
Commercial Mortgage Securities generally have been structured as Pass-Through
Certificates with private (i.e., nongovernmental) credit enhancements
("Commercial Privately-Issued Certificates") or as CMOs ("Commercial CMOs").
Commercial Mortgage Securities may pay
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adjustable rates of interest. Because of the great diversity in characteristics
of the Commercial Mortgage Loans that secure or underlie Commercial Mortgage
Securities, however, such securities will also have diverse characteristics.
Although many Commercial Mortgage Securities are backed by large pools of
Commercial Mortgage Loans with relatively small individual principal balances,
Commercial Mortgage Securities may be backed by Commercial Mortgage Loans
collateralized by only a few commercial properties or a single commercial
property. Because the risk involved in single commercial property financings is
highly concentrated, single-property Commercial Mortgage Securities to date have
tended to be limited to extremely desirable commercial properties with excellent
values and/or lease agreements with extremely creditworthy and reliable tenants,
such as major corporations.
Commercial Mortgage Securities generally are structured with some form of
private credit enhancement to protect against potential Realized Losses on the
underlying Mortgage Assets. As with Single-Family Mortgage Securities, such
credit enhancements provide an extra layer of loss coverage in cases where the
equityholder's equity interest in the underlying mortgaged property has been
completely extinguished. Because of the particular risks that accompany
Commercial Mortgage Securities, the required amount and corresponding cost of
such credit support may be significant. Credit supports used in the Commercial
Mortgage Securities market have included, but have not been limited to, limited
issuer guarantees, reserve funds, Subordinated Securities (which bear the risks
of default before more senior classes of securities of the same issuer),
cross-collateralization, over-collateralization, cross-default provisions,
subordination and letters of credit. The Company expects that multiple-class
structures, featuring Senior-Subordinated Mortgage Securities, will continue to
be the most common form of credit enhancement used in the Commercial Mortgage
Securities markets. In addition to credit support, Commercial Mortgage
Securities may be structured with liquidity protections intended to provide
assurance of timely payment of principal and interest. Such protections may
include surety bonds, letters of credit and payment advance agreements. The
process used to rate Commercial Mortgage Securities may focus on, among other
factors, the structure of the security, the quality and adequacy of collateral
and insurance, and the creditworthiness of the originators, servicing companies
and providers of credit support.
Commercial Mortgage Securities have been issued in public and private
transactions by a variety of public and private issuers. The RTC has issued more
than $16 billion of Commercial and Multifamily Mortgage Securities. Neither the
U.S. Government nor the RTC guarantees securities issued under RTC programs.
Non-governmental entities that have issued or sponsored Commercial Mortgage
Securities include owners of commercial properties, originators of and investors
in Mortgage Loans, savings and loan associations, mortgage banks, commercial
banks, insurance companies, investment banks and special purpose subsidiaries of
the foregoing.
The Commercial Mortgage Securities market is newer and in terms of total
outstanding principal amount of issues is relatively small compared to the total
size of the market for Single-Family Mortgage Securities. Securitization of the
commercial mortgage market has accelerated in recent years, however, in part as
a result of new risk-based capital rules imposed on insurance companies, banks
and thrift institutions that have required many such institutions to reduce
positions in Commercial Mortgage Loans in their investment portfolios. The
establishment by the rating agencies of rating criteria for Commercial Mortgage
Securities and the resulting assignment of ratings by the rating agencies to
such securities has made such securities more attractive to potential investors
and has increased their potential investor base. As Commercial Mortgage Loans
with balloon payments become due, such loans will have to be re-financed or the
underlying commercial properties will have to be sold. In either case, there
will be a significant need for new Commercial Mortgage Loans. In addition, to
the extent financial institutions continue to seek to reduce their portfolio
holdings of Commercial Mortgage Loans, the supply of Commercial Mortgage Loans
available for securitization will increase. Demand for new commercial real
estate financings and the reluctance of financial institutions to assume
long-term portfolio risk with respect to such financings also should encourage
securitization. The Company believes that an increased supply of Commercial
Mortgage Securities may present attractive investment opportunities for the
Company.
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MANAGEMENT POLICIES AND PROGRAMS
ASSET ACQUISITION POLICIES
The Company only acquires those Mortgage Assets the Company believes it has the
necessary expertise to evaluate and manage and which are consistent with the
Company's balance sheet guidelines and risk management objectives. Since the
intention of the Company is generally to hold its Mortgage Assets until
maturity, the Company generally does not seek to acquire assets whose investment
returns are only attractive in a limited range of scenarios. The Company
believes that future interest rates and mortgage prepayment rates are very
difficult to predict. Therefore, the Company seeks to acquire Mortgage Assets
which the Company believes will provide acceptable returns over a broad range of
interest rate and prepayment scenarios.
Among the asset choices available to the Company, the Company acquires those
Mortgage Assets which the Company believes will generate the highest returns on
capital invested, after considering (i) the amount and nature of anticipated
cash flows from the asset, (ii) the Company's ability to pledge the asset to
secure collateralized borrowings, (iii) the increase in the Company's
risk-adjusted capital requirement determined by the Company's Risk-adjusted
Capital Policy resulting from the purchase and financing of the asset, and (iv)
the costs of financing, hedging, managing, securitizing, and reserving for the
asset. Prior to acquisition, potential returns on capital employed are assessed
over the life of the asset and in a variety of interest rate, yield spread,
financing cost, credit loss and prepayment scenarios.
Management also gives consideration to balance sheet management and risk
diversification issues. A specific asset which is being evaluated for potential
acquisition is deemed more (or less) valuable to the Company to the extent it
serves to decrease (or increase) certain interest rate or prepayment risks which
may exist in the balance sheet, to diversify (or concentrate) credit risk, and
to meet (or not meet) the cash flow and liquidity objectives management may
establish for the balance sheet from time to time. Accordingly, an important
part of the evaluation process is a simulation, using the Company's risk
management model, of the addition of a potential asset and its associated
borrowings and hedges to the balance sheet and an assessment of the impact this
potential asset acquisition would have on the risks in and returns generated by
the Company's balance sheet as a whole over a variety of scenarios.
The Company focuses primarily on the acquisition of floating-rate and
adjustable-rate assets, and believes that currently such products are more
attractive for the Company's purposes than are fixed-rate assets.
In the event that the Company acquires fixed-rate Mortgage Assets pursuant to
its Asset Acquisition/Capital Allocation Policies, the Company's Risk-Adjusted
Capital Policy will allocate a high liquidity capital cushion to such fixed-rate
assets due to their greater market price volatility, so it is difficult for
fixed-rate products to generate high returns on capital employed under the
Company's asset acquisition criteria. In addition, the cost of hedging a
fixed-rate asset to meet the Company's asset/liability management goals is
usually significant. The Company may, however, purchase fixed-rate assets in the
future should the potential returns on capital invested, after hedging and all
other costs, clearly exceed the returns available from other assets or if the
purchase of such assets would serve to reduce or diversify the risks of the
Company's balance sheet.
The Company's strategy is to focus primarily on the acquisition of
adjustable-rate Mortgage Assets, including Single-Family Mortgage Loans,
Single-Family Mortgage Securities, Multifamily Mortgage Loans and Multifamily
Mortgage Securities. To date, all Mortgage Assets purchased have been
Single-Family Mortgage Assets. In addition, the Company will seek to acquire
Commercial Mortgage Securities which, except for securities created through the
normal process of securitization of its own Mortgage Assets, will generally be
limited initially to investment grade securities with a rating of BBB- or
better. The Company's asset acquisition strategy may change over time as market
conditions change and as the Company evolves.
The Company may also purchase the stock of other mortgage REITs or similar
companies when the Company believes that such purchases will yield attractive
returns on capital employed. When the stock market valuations of such companies
are low in relation to the market value of their assets, such stock purchases
can be a way for the Company to acquire an interest in a pool of Mortgage Assets
at an attractive price. The Company does not, however, presently intend to
invest in the securities of other issuers for the purpose of exercising control
or to underwrite securities of other issuers.
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The Company intends to acquire new Mortgage Assets, and will also seek to expand
its capital base in order to further increase the Company's ability to acquire
new assets, when the potential returns from new investments appear attractive
relative to the return expectations of stockholders (as expressed principally by
the effective dividend yield of the Company's stock). The Company may in the
future acquire Mortgage Assets by offering its debt or equity securities in
exchange for such Mortgage Assets.
The Company generally intends to hold Mortgage Assets to maturity. In addition,
the REIT provisions of the Code limit in certain respects the ability of the
Company to sell Mortgage Assets. See "Certain Federal Income Tax Considerations
- - - General - Gross Income Tests" and " - Taxation of the Company." However,
management may decide to sell assets from time to time for a number of reasons
including, without limitation, to dispose of an asset as to which credit risk
concerns have risen beyond levels the Company wishes to manage, to reduce
interest rate risk, to substitute one type of Mortgage Asset for another; to
improve yield, to maintain compliance with the 55% requirement under the
Investment Company Act, or generally to re-structure the balance sheet when
management deems such action advisable. Management will select any Mortgage
Asset to be sold according to the particular purpose such sale will serve. The
Board of Directors has not adopted a policy that would restrict management's
authority to determine the timing of sales or the selection of Mortgage Assets
to be sold.
As a requirement for maintaining REIT status, the Company, will distribute to
stockholders aggregate dividends equaling at least 95% of its taxable income.
See "Certain Federal Income Tax Considerations - General - Distribution
Requirement." The Company will make additional distributions of capital when the
return expectations of the stockholders (as expressed principally by the
effective dividend yield of the Company's stock) appear to exceed returns
potentially available to the Company through making new investments in Mortgage
Assets. Subject to the limitations of applicable securities and state
corporation laws, the Company can distribute capital by making purchases of its
own Capital Stock, through paying down or repurchasing any outstanding
uncollateralized debt obligations, or through increasing the Company's dividend
to include a return of capital.
CREDIT RISK MANAGEMENT POLICIES
The Company reviews credit risk, interest rate risk and other risk of loss
associated with each investment and determines the appropriate allocation of
capital to apply to such investment under its Risk-Adjusted Capital Policy. In
addition, the Company attempts to diversify its investment portfolio to avoid
undue geographic and other types of concentrations. The Board of Directors
monitors the overall portfolio risk and determines appropriate levels of
provision for credit loss.
With respect to its Mortgage Securities, the Company is exposed to various
levels of credit and special hazard risk, depending on the nature of the
underlying Mortgage Assets and the nature and level of credit enhancements
supporting such securities. Most of the Mortgage Assets acquired by the Company
have some degree of protection from normal credit losses. At December 31, 1996
and December 31, 1995, 45% and 56%, respectively, of the Company's Mortgage
Assets were Mortgage Securities covered by credit protection in the form of a
100% guarantee from a government-sponsored entity (GNMA, FNMA and FHLMC)
("Agency Certificates").
An additional 31% and 38% of the Company's Mortgage Assets at December 31, 1996
and December 31, 1995, respectively, were Privately-Issued Certificates and
represented interests in pools of residential mortgage loans with partial credit
enhancement; of these amounts, 96% and 85% were rated investment grade,
respectively. Credit loss protection for Privately-Issued Certificates is
achieved through the subordination of other interests in the pool to the
interest held by the Company, through pool insurance or through other means. The
degree of credit protection varies substantially among the Privately-Issued
Certificates held by the Company. While the Privately-Issued Certificates held
by the Company have some degree of credit enhancement, many of such Mortgage
Assets are, in turn, subordinated to other interests. Thus, should such a
Privately-Issued Certificate experience credit losses, such losses could be
greater than the Company`s pro rata share of the remaining mortgage pool, but in
no event could exceed the Company's investment in such Privately-Issued
Certificate. At December 31, 1996, the amount of Realized Losses a particular
pool of mortgages represented by Privately- Issued Certificates would have to
experience before the Company would bear responsibility for any credit losses
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ranged from 0% to 48% of the pool balance. The Company has undertaken an
independent underwriting review of a sample of the loans underlying the
Privately-Issued Certificates that are rated below BBB.
Beginning in the fourth quarter of 1995, the Company began purchasing Mortgage
Assets in the form of unsecuritized Mortgage Loans. The Company has developed a
quality control program to monitor the quality of loan underwriting at the time
of acquisition and on an ongoing basis. The Company may conduct, or cause to be
conducted, a legal document review of each Mortgage Loan acquired to verify the
accuracy and completeness of the information contained in the mortgage notes,
security instruments and other pertinent documents in the file. As a condition
of purchase, the Company will select a sample of Mortgage Loans targeted to be
acquired, focusing on those Mortgage Loans with higher risk characteristics, and
submit them to a third party, nationally recognized underwriting review firm for
a compliance check of underwriting and review of income, asset and appraisal
information. In addition, the Company or its agents will underwrite all
Multifamily and Commercial Mortgage Loans. During the time it holds Mortgage
Loans, the Company will be subject to risks of borrower defaults and
bankruptcies and special hazard losses (such as those occurring from earthquakes
or floods) that are not covered by standard hazard insurance. The Company will
generally not obtain credit enhancements such as mortgage pool or special hazard
insurance for its Mortgage Loans, although individual loans may be covered by
FHA insurance, VA guarantees or private mortgage insurance and, to the extent
securitized into Agency Certificates, by such government-sponsored entity
obligations or guarantees.
CAPITAL AND LEVERAGE POLICIES
The Company's goal is to strike a balance between the under-utilization of
leverage, which reduces potential returns to stockholders, and the
over-utilization of leverage, which could reduce the Company's ability to meet
its obligations during adverse market conditions. The Company has established a
Risk-Adjusted Capital Policy which limits management's ability to acquire
additional assets during times when the actual capital base of the Company is
less than a required amount defined in the policy. In this way, the use of
balance sheet leverage is controlled. The actual capital base as defined for the
purpose of the Risk Adjusted Capital Policy is equal to the market value of
total assets less the book value of total collateralized borrowings. The actual
capital base, as so defined, represents the approximate liquidation value of the
Company and approximates the market value of assets that can be pledged or sold
to meet over-collateralization requirements for the Company's borrowings. The
unpledged portion of the Company's actual capital base is available to be
pledged or sold as necessary to maintain over-collateralization levels for the
Company's borrowings.
Prior to the fourth quarter of 1996, under its Risk-Adjusted Capital Policy,
management was prohibited from acquiring additional Mortgage Assets during
periods when the actual capital base of the Company was less than the minimum
amount required under the Risk-Adjusted Capital Policy (except when such
Mortgage Asset acquisitions may have been necessary to maintain REIT status or
the Company's exemption from the Investment Company Act of 1940). As a result,
the Company has generally grown in the past by issuing equity and then seeking
to acquire Mortgage Assets over time in order to fully employ the capital
raised. In order to employ new capital more efficiently, the Board of Directors
approved a permanent modification to the Company's Risk-Adjusted Capital Policy
on October 31, 1996. Management is now able to acquire Mortgage Assets when
attractive opportunities present themselves in excess of the level at which the
Company's capital base would have been fully employed under the pre-modified
Risk-Adjusted Capital Policy within certain limitations and in certain
circumstances. As a result, when additional equity is raised, some or all of the
assets necessary to fully employ this capital will have been pre-acquired. Such
excess asset acquisitions are subject to a variety of limitations, including (i)
that additional asset growth not increase the balance sheet size by more than
10% beyond the point at which capital would have been fully employed under the
pre-modified Risk-Adjusted Capital Policy guidelines, and (ii) that the Company
seek to issue additional equity to bring the Company into compliance with the
pre-modified Risk-Adjusted Capital Policy guidelines.
The first component of the Company's capital requirements is the current
aggregate over-collateralization amount or "haircut" the lenders require the
Company to hold as capital. The haircut for each Mortgage Asset is determined by
the lender based on the risk characteristics and liquidity of that asset.
Haircut levels on individual borrowings range from 3% for Agency Certificates to
25% for certain Privately-Issued Certificates, and average 5% to 10% for the
Company as a whole. Should the market value of the pledged assets decline, the
Company
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will be required to deliver additional collateral to the lenders in order to
maintain a constant over-collateralization level on its borrowings.
The second component of the Company's capital requirement is the "liquidity
capital cushion." The liquidity capital cushion is an additional amount of
capital in excess of the haircut maintained by the Company in order to help the
Company meet the demands of the lenders for additional collateral should the
market value of the Company's Mortgage Assets decline. The aggregate liquidity
capital cushion equals the sum of liquidity cushion amounts assigned under the
Risk-Adjusted Capital Policy to each of the Company's Mortgage Assets. Liquidity
capital cushions are assigned to each Mortgage Asset based on management's
assessment of the Mortgage Asset's market price volatility, credit risk,
liquidity and attractiveness for use as collateral by lenders. The process of
assigning liquidity capital cushions relies on management's ability to identify
and weigh the relative importance of these and other factors. Consideration is
also given to hedges associated with the Mortgage Asset and any effect such
hedges may have on reducing net market price volatility, concentration or
diversification of credit and other risks in the balance sheet as a whole and
the net cash flows that can be expected to arise from the interaction of the
various components of the Company's balance sheet. The Board of Directors thus
reviews on a periodic basis various analyses prepared by management of the risks
inherent in the Company's balance sheet, including an analysis of the effects of
various scenarios on the Company's net cash flow, earnings, dividends, liquidity
and net market value. Should the Board of Directors determine that the minimum
required capital base set by the Company's Risk-Adjusted Capital Policy is
either too low or too high, the Board of Directors may raise or lower the
capital requirement accordingly.
The Company expects that its aggregate minimum capital requirement under the
Risk-Adjusted Capital Policy will approximate 5% to 15% of the market value of
the Company's Mortgage Assets. This percentage will fluctuate over time, and may
fluctuate out of the expected range, as the composition of the balance sheet
changes, haircut levels required by lenders change, the market value of the
Mortgage Assets changes and as liquidity capital cushions set by the Board of
Directors are adjusted over time. As of December 31, 1996, the aggregate
Risk-Adjusted Capital Requirement was 10.0% of Mortgage Assets, and the
Company's actual capital base was 9.7% of Mortgage Assets. At December 31,
1996, the Company had acquired excess assets in anticipation of its January
1997 stock offering.
The Risk-Adjusted Capital Policy also stipulates that at least 50% of the
capital base maintained to satisfy the liquidity capital cushion shall be
invested in Agency Certificates, AAA-rated adjustable-rate Mortgage Securities
or Mortgage Assets with similar or better liquidity characteristics.
Pursuant to the Company's overall business strategy, a substantial portion of
the Company's borrowings are short-term or adjustable-rate. The Company's
borrowings currently are implemented through reverse repurchase agreements (a
borrowing device evidenced by an agreement to sell securities or other assets to
a third party and a simultaneous agreement to repurchase them at a specified
future date and price, the price difference constituting interest on the
borrowing) and one revolving line of credit agreement. In the future, however,
the Company's borrowings may also be obtained through loan agreements,
Dollar-Roll Agreements (an agreement to sell a security for delivery on a
specified future date and a simultaneous agreement to repurchase the same or a
substantially similar security on a specified future date) and other credit
facilities with institutional lenders and issuance of debt securities such as
commercial paper, medium term notes, collateralized mortgage bonds and senior
or subordinated notes.
It is expected that reverse repurchase agreements will continue to be a
principal financing device utilized by the Company to leverage its Mortgage
Assets portfolio. The Company anticipates that, upon repayment of each borrowing
in the form of a reverse repurchase agreement, the collateral will immediately
be used for borrowing in the form of a new reverse repurchase agreement. The
Company has not at the present time entered into any commitment agreements under
which the lender would be required to enter into new reverse repurchase
agreements during a specified period of time, nor does the Company presently
plan to have liquidity facilities with commercial banks. The Company, however,
may enter into such commitment agreements in the future if deemed favorable to
the Company. The Company enters into reverse repurchase agreements primarily
with national broker/dealers, commercial banks and other lenders which typically
offer such financing. The Company enters into collateralized borrowings only
with financial institutions meeting credit standards approved by the Company's
Board of Directors, including approval by a majority of Independent Directors,
and monitors the financial condition of such institutions on a regular basis.
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A reverse repurchase agreement, although structured as a sale and repurchase
obligation, acts as a financing vehicle under which the Company effectively
pledges its Mortgage Assets as collateral to secure a short-term loan.
Generally, the other party to the agreement will make the loan in the amount
equal to a percentage of the market value of the pledged collateral. At the
maturity of the reverse repurchase agreement, the Company is required to repay
the loan and correspondingly receives back its collateral. While used as
collateral, Mortgage Assets continue to pay principal and interest which inure
to the benefit of the Company. In the event of the insolvency or bankruptcy of
the Company, certain reverse repurchase agreements may qualify for special
treatment under the Bankruptcy Code, the effect of which is, among other things,
to allow the creditor under such agreements to avoid the automatic stay
provisions of the Bankruptcy Code and to foreclose on the collateral agreements
without delay. In the event of the insolvency or bankruptcy of a lender during
the term of a reverse repurchase agreement, the lender may be permitted, under
applicable insolvency laws, to repudiate the contract, and the Company's claim
against the lender for damages therefrom may be treated simply as one of
unsecured creditor. In addition, if the lender is a broker or dealer subject to
the Securities Investor Protection Act of 1970, or an insured depository
institution subject to the Federal Deposit Insurance Act, the Company's ability
to exercise its rights to recover its securities under a reverse repurchase
agreement or to be compensated for any damages resulting from the lender's
insolvency may be further limited by those statutes. These claims would be
subject to significant delay and, if and when received, may be substantially
less than the damages actually suffered by the Company.
The Company expects that some of its borrowing agreements will continue to
require the Company to deposit additional collateral in the event the market
value of existing collateral declines, which may require the Company to sell
assets to reduce the borrowings. The Company's liquidity management policy is
designed to maintain a cushion of equity sufficient to provide required
liquidity to respond to the effects under its borrowing arrangements of interest
rate movements and changes in market value of its Mortgage Assets, as described
above. However, a major disruption of the reverse repurchase or other markets
relied on by the Company for short-term borrowings would have a material adverse
effect on the Company unless the Company were able to arrange alternative
sources of financing on comparable terms. The Company's Bylaws do not limit its
ability to incur borrowings, whether secured or unsecured.
ASSET/LIABILITY MANAGEMENT
Interest Rate Risk Management
To the extent consistent with its election to qualify as a REIT, the Company
follows an interest rate risk management program intended to protect against the
effects of major interest rate changes. Specifically, the Company's interest
rate risk management program is formulated with the intent to offset the
potential adverse effects resulting from rate adjustment limitations on its
Mortgage Assets and the differences between interest rate adjustment indices and
interest rate adjustment periods of its adjustable-rate Mortgage Assets and
related borrowings. The Company's interest rate risk management program
encompasses a number of procedures, including: (i) the Company attempts to
structure its borrowings to have interest rate adjustment indices and interest
rate adjustment periods that, on an aggregate basis, generally correspond to the
interest rate adjustment indices and interest rate adjustment periods of the
adjustable-rate Mortgage Assets purchased by the Company, so as to limit
mis-matching of such aggregates to a range of one to six months, and (ii) the
Company attempts to structure its borrowing agreements relating to
adjustable-rate Mortgage Assets to have a range of different maturities and
interest rate adjustment periods (although substantially all reverse repurchase
agreements will be less than one year). As a result, the Company expects to be
able to adjust the average maturity/adjustment period of such borrowings on an
ongoing basis by changing the mix of maturities and interest rate adjustment
periods as borrowings come due and are renewed. Through use of these procedures,
the Company intends to minimize differences between interest rate adjustment
periods of adjustable-rate Mortgage Assets and related borrowings that may
occur.
The Company purchases, from time to time, interest rate caps, interest rate
swaps and similar instruments to attempt to mitigate the risk of the cost of its
variable rate liabilities increasing at a faster rate than the earnings on its
Mortgage Assets during a period of rising rates. In this way, the Company
intends generally to hedge as much of the interest rate risk as management
determines is in the best interest of the stockholders of the Company, given the
cost of such hedging transactions and the need to maintain the Company's status
as a REIT.
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See "Certain Federal Income Tax Considerations General - Gross Income Tests."
This determination may result in management electing to have the Company bear a
level of interest rate risk that could otherwise be hedged when management
believes, based on all relevant facts, that bearing such risk is prudent. The
Company also, to the extent consistent with its compliance with the REIT Gross
Income Tests, Maryland law and the no-action relief discussed below, utilizes
financial futures contracts, options and forward contracts as a hedge against
future interest rate changes. The Company obtained no-action relief from the
Commodities Futures Trading Commission permitting the Company to invest a small
percentage of the Company's total assets in certain financial futures contracts
and options thereon without registering as a commodity pool operator under the
Commodity Exchange Act, provided that the Company uses such instruments solely
for bona fide hedging purposes.
The Company seeks to build a balance sheet and undertake an interest rate risk
management program which is likely, in management's view, to enable the Company
to generate positive earnings and maintain an equity liquidation value
sufficient to maintain operations given a variety of potentially adverse
circumstances. Accordingly, the hedging program address both income
preservation, as discussed in the first part of this section, and capital
preservation concerns. With regard to the latter, the Company monitors its
"equity duration." This is the expected percentage change in the Company's
equity (measured as the carrying value of total assets less the book value of
total liabilities) that would be caused by a 1% change in short and long term
interest rates. To date, the Company believes that it has met its goal of
maintaining an equity duration of less than 15%. To monitor its equity duration
and the related risks of fluctuations in the liquidation value of the Company's
equity, the Company models the impact of various economic scenarios on the
market value of the Company's Mortgage Assets, liabilities and interest rate
agreements. The Company believes that the existing hedging program will allow
the Company to maintain operations throughout a wide variety of potentially
adverse circumstances without further management action. Nevertheless, in order
to further preserve the Company's capital base (and lower its equity duration)
during periods when management believes a trend of rapidly rising interest rates
has been established, management may decide to increase hedging activities
and/or sell assets. Each of these types of actions may lower the earnings and
dividends of the Company in the short term in order to further the objective of
maintaining attractive levels of earnings and dividends over the long term.
Each interest rate cap agreement is a legal contract between the Company and a
third party firm (the "counter-party"). The Company makes an up-front cash
payment to the counter-party and the counter-party agrees to make payments to
the Company in the future should the one or three month LIBOR interest rate rise
above the "strike" rate specified in the contract. Each contract has a "notional
face" amount. Should the reference LIBOR interest rates rise above the
contractual strike rate, the Company will earn cap income. Payments on an
annualized basis will equal the contractual notional face amount times the
difference between actual LIBOR and the strike rate. In all of its interest rate
risk management transactions, the Company follows certain procedures designed to
limit credit exposure to counterparties, including dealing only with
counterparties whose financial strength meets the Company's requirements.
The Company may elect to conduct a portion of its hedging operations through one
or more subsidiary corporations which would not be a Qualified REIT Subsidiary
and would be subject to Federal and state income taxes. In order to comply with
the nature of asset tests applicable to the Company as a REIT, the value of the
securities of any such subsidiary held by the Company must be limited to less
than 5% of the value of the Company's total assets as of the end of each
calendar quarter and no more than 10% of the voting securities of any such
subsidiary may be owned by the Company. See "Certain Federal Income Tax
Considerations - General - Asset Tests." A taxable subsidiary would not elect
REIT status and would distribute any net profit after taxes to the Company and
its other stockholders. Any dividend income received by the Company from any
such taxable subsidiary (combined with all other income generated from the
Company's assets, other than Qualified REIT Real Estate Assets) must not exceed
25% of the gross income of the Company. See "Certain Federal Income Tax
Considerations - General - Gross Income Tests." Before the Company forms any
such taxable subsidiary corporation for its hedging activities, the Company will
obtain an opinion of counsel to the effect that the formation and contemplated
method of operation of such corporation will not cause the Company to fail to
satisfy the nature of assets and sources of income tests applicable to it as a
REIT.
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At December 31, 1996, the company's weighted average assets and liabilities were
matched within a twelve-month period in terms of adjustment frequency and speed
of adjustment to market conditions. Looking at these two factors only (and thus
ignoring periodic and life caps), the Company's net interest spread should be
stable over time periods greater than twelve months. Substantially all of the
Company's' Mortgage Assets at December 31, 1996 had coupon rates that adjust to
market levels at least every twelve months, with a weighted average term to
reset of approximately five months. All of the Company's borrowings at December
31, 1996 will either mature or adjust to a market interest rate level within six
months of such date. The borrowings had a weighted average term to rate reset of
55 days at December 31, 1996. Both changes in coupon rates earned on assets and
in the rates paid on borrowings are expected to be highly correlated with
changes in LIBOR rates (subject to the effects of periodic and lifetime caps).
Although the Company believes it has developed a cost-effective asset/liability
management program to provide a level of protection against interest rate and
prepayment risks, no strategy can completely insulate the Company from the
effect of interest rate changes, prepayment risks and defaults by
counterparties. Further, certain of the Federal income tax requirements that the
Company must satisfy to qualify as a REIT limit the Company's ability to fully
hedge its interest rate and prepayment risks. The Company monitors carefully,
and may have to limit, its asset/liability management program to assure that it
does not realize excessive hedging income, or hold hedging assets having excess
value in relation to total assets, which would result in the Company's
disqualification as a REIT or, in case of excess hedging income, the payment of
a penalty tax for failure to satisfy certain REIT income tests under the Code,
provided such failure was for reasonable cause. See "Certain Federal Income Tax
Considerations - General." In addition, asset/liability management involves
transaction costs which increase dramatically as the period covered by the
hedging protection increases. Therefore, the Company may be prevented from
effectively hedging its interest rate and prepayment risks.
PREPAYMENT RISK MANAGEMENT
The Company seeks to minimize the effects of faster or slower than anticipated
prepayment rates through structuring a diversified portfolio with a variety of
prepayment characteristics, investing in Mortgage Assets with prepayment
prohibitions and penalties, investing in certain Mortgage Securities structures
which have prepayment protections, and balancing Mortgage Assets purchased at a
premium with Mortgage Assets purchased at a discount. In certain operating
environments, however, it may not be possible for the Company to acquire assets
with a net balance of discount and premium. In such circumstances, the risk of
earnings variability resulting from changes in prepayment rates may rise. In
addition, the Company has purchased and may in the future purchase additional
interest-only strips to a limited extent as a hedge against prepayment risks.
Prepayment risk is monitored by management and the Board of Directors through
periodic review of the impact of a variety of prepayment scenarios on the
Company's revenues, net earnings, dividends, cash flow and net balance sheet
market value.
The Company owns a variety of non-agency Mortgage Assets which are structured so
that for several years they receive less than or a pro rata share of principal
repayments experienced in the underlying mortgage pool as a whole. In such
Mortgage Securities, one or more classes of Senior Securities are ordinarily
entitled to receive all principal prepayments on the underlying pool of loans
until such Senior Securities have been paid down to a specified amount
determined by formula. To illustrate, a Mortgage Security totaling $100 million
of aggregate principal balance may be structured so that there is (i) $92
million face value of Senior Securities, (ii) Mezzanine Securities with a face
value of $2 million providing credit support for the Senior Securities, (iii)
Subordinated Securities with a face value of $6 million providing credit support
for the Mezzanine Securities and the Senior Securities, and (iv) the $100
million face value of Senior Securities, Mezzanine Securities and Subordinated
Securities had been issued in this format, the Mezzanine Securities or the
Subordinated Securities would receive no principal prepayments on the underlying
loans until the $92 million face value of Senior Securities had been paid down
to a formula-determined amount, which would normally be expected to occur within
a range of three to ten years depending on the rate of prepayments and other
factors. The Company owns interests which are similar to the Senior Securities,
Mezzanine Securities and Subordinated Securities in this example.
During 1996, the Company received $258.4 million in principal payments on its
Mortgage Assets. The annualized rate of principal repayment the Company
experienced was 27%. The amortized cost of the
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Company's Mortgage Assets at December 31, 1996 was equal to 101.81% of the face
value of the assets; the net premium was 1.81%. The smaller the level of net
discount or premium, the less risk there is that fluctuations in prepayment
rates will affect earnings in the long run.
MORTGAGE LOAN SECURITIZATION TECHNIQUES
The Company expects to contract with conduits, financial institutions, mortgage
bankers, investment banks and others to purchase Mortgage Loans which they are
originating. The Company anticipates that it will have sufficient purchasing
power in some circumstances to induce origination firms to originate Mortgage
Loans to the Company's specifications. The Company intends to enhance the value
and liquidity of all the Mortgage Loans it acquires by securitizing the loans
into Mortgage Securities in the manner which will best meet its own needs.
In addition to creating Mortgage Securities from the Mortgage Loans in its
portfolio, the Company also plans from time to time to "re-securitize" portions
of its Mortgage Securities portfolio. In a re-securitization transaction,
Mortgage Securities rather than Mortgage Loans are used as collateral to create
new Mortgage Securities. This would typically be done as the Mortgage Loans
underlying the securities improve in credit quality through seasoning, as values
rise on the underlying properties or when the credit quality of a junior class
of mortgage security improves due to prepayment of more senior classes. Such
transactions can result in improved credit ratings, higher market values and
lowered borrowing costs. The Company believes that this built-in tendency of
securitized mortgage bonds to improve in credit quality even if real estate
prices remain level could be one of the most attractive aspects of the markets
in which the Company will invest.
The Company may conduct its securitization activities through one or more
taxable or REIT-qualifying subsidiaries formed for such purpose. Prior to
engaging in any securitization activities, the Company will receive an opinion
of counsel that the proposed method of such activities will not jeopardize the
Company's status as a REIT.
CERTAIN FEDERAL INCOME TAX CONSIDERATIONS
The following discussion summarizes certain Federal income tax considerations to
the Company and its stockholders. This discussion is based on existing Federal
income tax law, which is subject to change, possibly retroactively. This
discussion does not address all aspects of Federal income taxation that may be
relevant to a particular stockholder in light of its personal investment
circumstances or to certain types of investors subject to special treatment
under the Federal income tax laws (including financial institutions, insurance
companies, broker-dealers and, except to the extent discussed below, tax-exempt
entities and foreign taxpayers) and it does not discuss any aspects of state,
local or foreign tax law. This discussion assumes that stockholders will hold
their Common Stock as a "capital asset" (generally, property held for
investment) under the Code. Stockholders are advised to consult their tax
advisors as to the specific tax consequences to them of purchasing, holding and
disposing of the Common Stock, including the application and effect of Federal,
state, local and foreign income and other tax laws.
GENERAL
The Company has elected to become subject to tax as a REIT, for Federal income
tax purposes, commencing with the taxable year ending December 31, 1994.
Management currently expects that the Company will continue to operate in a
manner that will permit the Company to maintain its qualifications as a REIT.
This treatment will permit the Company to deduct dividend distributions to its
stockholders for Federal income tax purposes, thus effectively eliminating the
"double taxation" that generally results when a corporation earns income and
distributes that income to its stockholders.
There can be no assurance that the Company will continue to qualify as a REIT in
any particular taxable year, given the highly complex nature of the rules
governing REITs, the ongoing importance of factual determinations and the
possibility of future changes in the circumstances of the Company. If the
Company were not to qualify as a REIT in any particular year, it would be
subject to Federal income tax as a regular, domestic corporation, and its
stockholders would be subject to tax in the same manner as stockholders of such
corporation. In this event, the Company could be subject to potentially
substantial income tax liability in respect of each taxable year
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that it fails to qualify as a REIT, and the amount of earnings and cash
available for distribution to its stockholders could be significantly reduced or
eliminated.
The following is a brief summary of certain technical requirements that the
Company must meet on an ongoing basis in order to qualify, and remain qualified,
as a REIT under the Code.
STOCK OWNERSHIP TESTS
The capital stock of the Company must be held by at least 100 persons and no
more than 50% of the value of such capital stock may be owned, directly or
indirectly, by five or fewer individuals at all times during the last half of
the taxable year. Under the Code, most tax-exempt entities including employee
benefit trusts and charitable trusts (but excluding trusts described in 401(a)
and exempt under 501(a)) are generally treated as individuals for these
purposes. These stock ownership requirements must be satisfied in the Company's
second taxable year and in each subsequent taxable year. The Articles of
Incorporation provide restrictions regarding the transfer of the Company's
shares in order to aid in meeting the stock ownership requirements.
ASSET TESTS
The Company must generally meet the following asset tests (the "REIT Asset
Tests") at the close of each quarter of each taxable year:
(a) at least 75% of the value of the Company's total assets must consist
of Qualified REIT Real Estate Assets, government securities, cash, and
cash items (the "75% Asset Test"); and
(b) the value of securities held by the Company but not taken into
account for purposes of the 75% Asset Test must not exceed (i) 5% of the
value of the Company's total assets in the case of securities of any one
non-government issuer, or (ii) 10% of the outstanding voting securities
of any such issuer.
The Company expects that substantially all of its assets will be Qualified REIT
Real Estate Assets. In addition, the Company does not expect that the value of
any security of any one entity would ever exceed 5% of the Company's total
assets, and the Company does not expect to own more than 10% of any one issuer's
voting securities.
The Company intends to monitor closely the purchase, holding and disposition of
its assets in order to comply with the REIT Asset Tests. In particular, the
Company intends to limit and diversify its ownership of any assets not
qualifying as Qualified REIT Real Estate Assets to less than 25% of the value of
the Company's assets and to less than 5%, by value, of any single issuer. If it
is anticipated that these limits would be exceeded, the Company intends to take
appropriate measures, including the disposition of non-qualifying assets, to
avoid exceeding such limits.
GROSS INCOME TESTS
The Company must generally meet the following gross income tests (the "REIT
Gross Income Tests") for each taxable year:
(a) at least 75% of the Company's gross income must be derived from
certain specified real estate sources including interest income and gain
from the disposition of Qualified REIT Real Estate Assets or "qualified
temporary investment income" (i.e., income derived from "new capital"
within one year of the receipt of such capital) (the "75% Gross Income
Test");
(b) at least 95% of the Company's gross income for each taxable year
must be derived from sources of income qualifying for the 75% Gross
Income Test, or from dividends, interest, and gains from the sale of
stock or other securities (including certain interest rate swap and cap
agreements entered into to hedge variable rate debt incurred to acquire
Qualified REIT Real Estate Assets) not held for sale in the ordinary
course of business (the "95% Gross Income Test"); and
(c) less than 30% of the Company's gross income must be derived from the
sale of Qualified REIT Real Estate Assets held for less than four years,
stock or securities held for less than one year (including certain
interest rate swaps and cap agreements entered into to hedge variable
rate debt incurred to acquire Qualified REIT Real Estate Assets) and
certain "dealer" property (the "30% Gross Income Test").
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The Company intends to maintain its REIT status by carefully monitoring its
income, including income from hedging transactions and sales of Mortgage Assets,
to comply with the REIT Gross Income Tests. In particular, the Company will
treat income generated by its interest rate caps and other hedging instruments
as non-qualifying income for purposes of the 95% Gross Income Tests unless it
receives advice from counsel that such income constitutes qualifying income for
purposes of such test. Under certain circumstances, for example, (i) the sale of
a substantial amount of Mortgage Assets to repay borrowings in the event that
other credit is unavailable or (ii) unanticipated decrease in the qualifying
income of the Company which may result in the non-qualifying income exceeding 5%
of gross income, the Company may be unable to comply with certain of the REIT
Gross Income Tests. See " - Taxation of the Company" for a discussion of the tax
consequences of failure to comply with the REIT Provisions of the Code.
DISTRIBUTION REQUIREMENT
The Company must generally distribute to its stockholders an amount equal to at
least 95% of the Company's REIT taxable income before deductions of dividends
paid and excluding net capital gain.
The IRS has ruled that if a REIT's dividend reinvestment plan allows
stockholders of the REIT to elect to have cash distributions reinvested in
shares of the REIT at a purchase price equal to at least 95% of the fair market
value of such shares on the distribution date, then such distributions qualify
under the 95% distribution requirement. The Company maintains a Dividend
Reinvestment and Stock Purchase Plan ("DRP") and intends that the terms of its
DRP will comply with this ruling.
TAXATION OF THE COMPANY
In any year in which the Company qualifies as a REIT, the Company will generally
not be subject to Federal income tax on that portion of its REIT taxable income
or capital gain which is distributed to its stockholders. The Company will,
however, be subject to Federal income tax at normal corporate income tax rates
upon any undistributed taxable income or capital gain.
Notwithstanding its qualification as a REIT, the Company may also be subject to
tax in certain other circumstances. If the Company fails to satisfy either the
75% or the 95% Gross Income Test, but nonetheless maintains its qualification as
a REIT because certain other requirements are met, it will generally be subject
to a 100% tax on the greater of the amount by which the Company fails either the
75% or the 95% Gross Income Test. The Company will also be subject to a tax of
100% on net income derived from any "prohibited transaction," and if the Company
has (i) net income from the sale or other disposition of "foreclosure property"
which is held primarily for sale to customers in the ordinary course of business
or (ii) other non-qualifying income from foreclosure property, it will be
subject to Federal income tax on such income at the highest corporate income tax
rate. In addition, if the Company fails to distribute during each calendar year
at least the sum of (i) 85% of its REIT ordinary income for such year and (ii)
95% of its REIT capital gain net income for such year, the Company would be
subject to a 4% Federal excise tax on the excess of such required distribution
over the amounts actually distributed during the taxable year, plus any
undistributed amount of ordinary and capital gain net income from the preceding
taxable year. The Company may also be subject to the corporate alternative
minimum tax, as well as other taxes in certain situations not presently
contemplated.
If the Company fails to qualify as a REIT in any taxable year and certain relief
provisions of the Code do not apply, the Company would be subject to Federal
income tax (including any applicable alternative minimum tax) on its taxable
income at the regular corporate income tax rates. Distributions to stockholders
in any year in which the Company fails to qualify as a REIT would not be
deductible by the company, nor would they generally be required to be made under
the Code. Further, unless entitled to relief under certain other provisions of
the Code, the Company would also be disqualified from re-electing REIT status
for the four taxable years following the year in which it became disqualified.
The Company intends to monitor on an ongoing basis its compliance with the REIT
requirements described above. In order to maintain its REIT status, the Company
will be required to limit the types of assets that the Company might otherwise
acquire, or hold certain assets at times when the Company might otherwise have
determined that the sale or other disposition of such assets would have been
more prudent.
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TAXABLE SUBSIDIARIES
Hedging activities and the creation of Mortgage Securities through
securitization may be done through a taxable subsidiary of the Company. The
Company and one or more other entities may form and capitalize one or more
taxable subsidiaries. In order to ensure that the Company would not violate the
more than 10% voting stock of a single issuer limitation described above, the
Company would own only nonvoting preferred and nonvoting common stock or 10% or
less of the voting common stock and the other entities would own all of the
remaining voting common stock. The value of the Company's investment in such a
subsidiary must also be limited to less than 5% of the value of the Company's
total assets at the end of each calendar quarter so that the Company can also
comply with the 5% of value, single issuer asset limitation described above
under " - General - Asset Tests." The taxable subsidiary would not elect REIT
status and would distribute only net after-tax profits to its stockholders,
including the Company. Before the Company engages in any hedging or
securitization activities or forms any such taxable subsidiary corporation, the
Company will obtain an opinion of counsel to the effect that such activities or
the formation and contemplated method of operation of such corporation will not
cause the Company to fail to satisfy the REIT Asset and REIT Gross Income Tests.
TAXATION OF STOCKHOLDERS
COMMON STOCK
Distributions (including constructive distributions) made to holders of Common
Stock, other than tax-exempt entities, will generally be subject to tax as
ordinary income to the extent of the Company's current and accumulated earnings
and profits as determined for Federal income tax purposes. If the amount
distributed exceeds a stockholder's allocable share of such earnings and
profits, the excess will be treated as a return of capital to the extent of the
stockholder's adjusted basis in the Common Stock, which will not be subject to
tax, and thereafter as a taxable gain from the sale or exchange of a capital
asset.
Distributions designated by the Company as capital gain dividends will generally
be subject to tax as long-term capital gain to stockholders, to the extent that
the distribution does not exceed the Company's actual net capital gain for the
taxable year. Distributions by the Company, whether characterized as ordinary
income or as capital gain, are not eligible for the corporate dividends received
deduction. In the event that the Company realizes a loss for the taxable year,
stockholders will not be permitted to deduct any share of that loss. Further, if
the Company (or a portion of its assets) were to be treated as a taxable
mortgage pool, any "excess inclusion income" that is allocated to a stockholder
would not be allowed to be offset by a net operating loss of such stockholder.
Future Treasury Department regulations may require that the stockholders take
into account, for purposes of computing their individual alternative minimum tax
liability, certain tax preference items of the Company.
Dividends declared during the last quarter of a taxable year and actually paid
during January of the following taxable year are generally treated as if
received by the stockholder on the record date of the dividend payment and not
on the date actually received. In addition, the Company may elect to treat
certain other dividends distributed after the close of the taxable year as
having been paid during such taxable year, but stockholders will be treated as
having received such dividend in the taxable year in which the distribution is
made.
Upon a sale or other disposition of the Common Stock, a stockholder will
generally recognize a capital gain or loss in an amount equal to the difference
between the amount realized and the stockholder's adjusted basis in such stock,
which gain or loss will be long-term if the stock has been held for more than
one year. Any loss on the sale or exchange of Common Stock held by a stockholder
for six months or less will generally be treated as a long-term capital loss to
the extent of designated capital gain dividends received by such stockholder.
DRP participants will generally be treated as having received a dividend
distribution, subject to tax as ordinary income, in an amount equal to the fair
value of the Common Stock purchased with the reinvested dividends generally on
the date the Company credits such Common Stock to the DRP participant's account.
The Company is required under Treasury Department regulations to demand annual
written statements from the record holders of designated percentages of its
Capital Stock disclosing the actual and constructive ownership of such stock and
to maintain permanent records showing the information it has received as to the
actual and constructive ownership of such stock and a list of those persons
failing or refusing to comply with such demand.
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In any year in which the Company does not qualify as a REIT, distributions made
to its stockholders would be taxable in the same manner discussed above, except
that no distributions could be designated as capital gain dividends,
distributions would be eligible for the corporate dividends received deduction,
the excess inclusion income rules would not apply, and stockholders would not
receive any share of the Company's tax preference items. In such event, however,
the Company would be subject to potentially substantial Federal income tax
liability, and the amount of earnings and cash available for distribution to its
stockholders could be significantly reduced or eliminated.
TAXATION OF TAX-EXEMPT ENTITIES
Subject to the discussion below regarding a "pension-held REIT," a tax-exempt
stockholder is generally not subject to tax on distributions from the Company or
gain realized on the sale of the Securities, provided that such stockholder has
not incurred indebtedness to purchase or hold its Securities, that its shares
are not otherwise used in an unrelated trade or business of such stockholder,
and that the Company, consistent with its present intent, does not hold a
residual interest in a REMIC that gives rise to "excess inclusion" income as
defined under section 860E of the Code. If the Company or a pool of its assets
were to be treated as a "taxable mortgage pool," however, a substantial portion
of the dividends paid to a tax-exempt stockholder may be subject to tax as UBTI.
Although the Company does not believe that the Company, or any portion of its
assets, will be treated as a taxable mortgage pool, no assurance can be given
that the IRS might not successfully maintain that such a taxable mortgage pool
exists.
If a qualified pension trust (i.e., any pension or other retirement trust that
qualifies under section 401 (a) of the Code) holds more than 10% by value of the
interests in a "pension-held REIT" at any time during a taxable year, a
substantial portion of the dividends paid to the qualified pension trust by such
REIT may constitute UBTI. For these purposes, a "pension-held REIT" is a REIT
(i) that would not have qualified as a REIT but for the provisions of the Code
which look through qualified pension trust stockholders in determining ownership
of stock of the REIT and (ii) in which at least one qualified pension trust
holds more than 25% by value of the interest of such REIT or one or more
qualified pension trusts (each owning more than a 10% interest by value in the
REIT) hold in the aggregate more than 50% by value of the interests in such
REIT. Assuming compliance with the Ownership Limit provisions in the Company's
Articles of Incorporation it is unlikely that pension plans will accumulate
sufficient stock to cause the Company to be treated as a pension-held REIT.
Distributions to certain types of tax-exempt stockholders exempt from Federal
income taxation under sections 501 (c)(7), (c)(9), (c)(17), and (c)(20) of the
Code may also constitute UBTI, and such prospective investors should consult
their tax advisors concerning the applicable "set aside" and reserve
requirements.
STATE AND LOCAL TAXES
The Company and its stockholders may be subject to state or local taxation in
various jurisdictions, including those in which it or they transact business or
reside. The state and local tax treatment of the Company and its stockholders
may not conform to the Federal income tax consequences discussed above.
Consequently, prospective stockholders should consult their own tax advisors
regarding the effect of state and local tax laws on an investment in the Common
Stock.
CERTAIN UNITED STATES FEDERAL INCOME TAX CONSIDERATIONS APPLICABLE TO FOREIGN
HOLDERS
The following discussion summarizes certain United States Federal tax
consequences of the acquisition, ownership and disposition of Common Stock or
Preferred Stock by an initial purchaser that, for United States Federal income
tax purposes, is a "Non-United States Holder". "Non-United States Holder" means:
not a citizen or resident of the United States; not a corporation, partnership,
or other entity created or organized in the United States or under the laws of
the United States or of any political subdivision thereof; or not an estate or
trust whose income is includible in gross income for United States Federal
income tax purposes regardless of its source. This discussion does not consider
any specific facts or circumstances that may apply to particular non-United
states Federal tax consequences of acquiring, holding and disposing of Common
Stock or Preferred Stock, as well as any tax consequences that may arise under
the laws of any foreign, state, local or other taxing jurisdiction.
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DIVIDENDS
Dividends paid by the Company out of earnings and profits, as determined for
United States Federal income tax purposes, to a Non-United States Holder will
generally be subject to withholding of United States Federal income tax at the
rate of 30%, unless reduced or eliminated by an applicable tax treaty or unless
such dividends are treated as effectively connected with a United States trade
or business. Distributions paid by the Company in excess of its earnings and
profits will be treated as a tax-free return of capital to the extent of the
holder's adjusted basis in his shares, and thereafter as gain from the sale or
exchange of a capital asset as described below. If it cannot be determined at
the time a distribution is made whether such distribution will exceed the
earnings and profits of the Company, the distribution will be subject to
withholding at the same rate as dividends. Amounts so withheld, however, will be
refundable or creditable against the Non-United States Holder's United States
Federal tax liability if it is subsequently determined that such distribution
was, in fact, in excess of the earnings and profits of the Company. If the
receipt of the dividend is treated as being effectively connected with the
conduct of a trade or business within the United States by a Non-United States
Holder, the dividend received by such holder will be subject to the United
States Federal income tax on net income that applies to United States persons
generally (and, with respect to corporate holders and under certain
circumstances the branch profits tax).
For any year in which the Company qualifies as a REIT, distributions to a
Non-United States Holder that are attributable to gain from the sales or
exchanges by the Company of "United States real property interests" will be
treated as if such gain were effectively connected with a United States business
and will thus be subject to tax at the normal capital gain rates applicable to
United States stockholders (subject to applicable alternative minimum tax) under
the provisions of the Foreign Investment in Real Property Tax Act of 1980
("FIRPTA"). Also, distributions subject to FIRPTA may be subject to a 30% branch
profits tax in the hands of a foreign corporate stockholder not entitled to a
treaty exemption. The Company is required to withhold 35% of any distribution
that could be designated by the Company as a capital gains dividend. This amount
may be credited against the Non-United States Holder's FIRPTA tax liability. It
should be noted that Mortgage Loans without substantial equity or shared
appreciation features generally would not be classified as "United States real
property interests."
GAIN ON DISPOSITION
A Non-United States Holder will generally not be subject to United States
Federal income tax on gain recognized on a sale or other disposition of its
shares of either Common or Preferred Stock unless (i) the gain is effectively
connected with the conduct of a trade or business within the United States by
the Non-United States Holder, (ii) in the case of a Non-United Stated Holder who
is a nonresident alien individual and holds such shares as a capital asset, such
holder is present in the United States for 183 or more days in the taxable year
and certain other requirements are met, or (iii) the Non-United States Holder is
subject to tax under the FIRPTA rules discussed below. Gain that is effectively
connected with the conduct of a United States Holder will be subject to the
United States Federal income tax on net income that applies to United States
persons generally (and, with respect to corporate holders and under certain
circumstances, the branch profits tax) but will not be subject to withholding.
Non-United States Holders should consult applicable treaties, which may provide
for different rules.
Gain recognized by a Non-United States Holder upon a sale of either Common Stock
or Preferred Stock will generally not be subject to tax under FIRPTA if the
Company is a "domestically-controlled REIT," which is defined generally as a
REIT in which at all times during a specified testing period less than 50% in
value of its shares were held directly or indirectly by non-U.S. persons.
Because only a minority of the Company's stockholders are expected to be
Non-United States Holders, the Company anticipates that it will qualify as a
"domestically-controlled REIT." Accordingly, a Non-United States Holder should
not be subject to U.S. tax from gains recognized upon disposition of its shares.
INFORMATION REPORTING AND BACKUP WITHHOLDING
Under temporary United States Treasury regulations, United States information
reporting requirements and backup withholding tax will generally not apply to
dividends paid on either the Common Stock or Preferred Stock to a Non-United
States Holder at an address outside the United States. Payments by a United
States office
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<PAGE> 25
of a broker of the proceeds of a sale of either the Common Stock or Preferred
Stock is subject to both backup withholding at a rate of 31% and information
reporting unless the holder certifies its Non-United States Holder status under
penalties of perjury or otherwise establishes an exemption. Information
reporting requirements (but not backup withholding) will also apply to payments
of the proceeds of sales of such shares by foreign offices of United States
brokers, or foreign brokers with certain types of relationships to the United
States, unless the broker has documentary evidence in its records that the
holder is a Non-United States Holder and certain other conditions are met, or
the holder otherwise establishes an exemption.
Backup withholding is not an additional tax. Any amounts withheld under the
backup withholding rules will be refunded or credited against the Non-United
States Holder's United States Federal income tax liability, provided that the
required information is furnished to the Internal Revenue Service.
These information reporting and backup withholding rules are under review by the
United States Treasury and their application to the Common Stock or Preferred
Stock could be changed by future regulations.
COMPETITION
The Company believes that its principal competition in the business of acquiring
and holding Mortgage Assets are financial institutions such as banks, savings
and loans, life insurance companies, institutional investors such as mutual
funds and pension funds, and certain other mortgage REITs. While most of these
entities have significantly greater resources than the Company, the Company
anticipates that it will be able to compete effectively and generate relatively
attractive rates of return for stockholders due to its relatively low level of
operating costs, relative freedom to securitize its assets, ability to utilize
prudent amounts of leverage through accessing the wholesale market for
collateralized borrowings, freedom from certain forms of regulation and the tax
advantages of its REIT status. The existence of these competitive entities, as
well as the possibility of additional entities forming in the future, may
increase the competition for the acquisition of adjustable-rate mortgage assets
resulting in higher prices and lower yields on such mortgage assets.
POLICIES AND STRATEGIES
The Board of Directors has established the investment policies and strategies
summarized in this report. The Board of Directors has the power to modify or
waive such policies and strategies without the consent of the stockholders to
the extent that the Board of Directors determines that such modification or
waiver is in the best interests of stockholders. However, if such modification
or waiver relates to the relationship of, or any transaction between, the
Company and GB Capital or any affiliated person of GB Capital, the approval of a
majority of the Independent Directors is also required. Among other factors,
developments in the market which affect the policies and strategies mentioned
herein or which change the Company's assessment of the market may cause the
Board of Directors to revise the Company's policies and strategies.
The Company at all times intends to conduct its business so as not to become
regulated as an investment company under the Investment Company Act.
Accordingly, the Company does not expect to be subject to the restrictive
provisions of the Investment Company Act. The Investment Company Act exempts
entities that are "primarily engaged in the business of purchasing or otherwise
acquiring mortgages and other liens on and interests in real estate"
("Qualifying Interests"). Under the current interpretation of the staff of the
Securities and Exchange Commission, in order to qualify for this exemption, the
Company must maintain at least 55% of its assets directly in Mortgage Loans,
qualifying pass-though Certificates and certain other qualifying interests in
real estate. In addition, unless certain Mortgage Securities represent all the
Certificates issued with respect to an underlying pool of mortgages, such
Mortgage Securities may be treated as securities separate from the underlying
Mortgage Loans and, thus, may not qualify as Qualifying Interests for purposes
of the 55% requirement. Therefore, the Company's ownership of certain Mortgage
Assets may be limited by the provisions of the Investment Company Act.
EMPLOYEES
As of March 17, 1997, the Company had eleven employees.
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<PAGE> 26
RISK FACTORS
In addition to the other information contained in this Form 10-K, the following
risk factors should be carefully considered in evaluating the Company and its
business.
OPERATIONS RISKS
GENERAL
The results of the Company's operations are affected by various factors, many of
which are beyond the control of the Company. The results of the Company's
operations depend on, among other things, the level of net interest income
generated by the Company's Mortgage Assets, the market value of such Mortgage
Assets and the supply of and demand for such Mortgage Assets. The Company's net
interest income varies primarily as a result of changes in short-term interest
rates, borrowing costs and prepayment rates, the behavior of which involve
various risks and uncertainties as set forth below. Prepayment rates, interest
rates, borrowing costs and credit losses depend upon the nature and terms of the
Mortgage Assets, the geographic location of the properties securing the Mortgage
Loans included in or underlying the Mortgage Assets, conditions in financial
markets, the fiscal and monetary policies of the United States government and
the Board of Governors of the Federal Reserve System, international economic and
financial conditions, competition and other factors, none of which can be
predicted with any certainty. Because changes in interest and prepayment rates
may significantly affect the Company's activities, the operating results of the
Company depend, in large part, upon the ability of the Company to effectively
manage its interest rate and prepayment risks while maintaining its status as a
REIT.
RISKS OF SUBSTANTIAL LEVERAGE AND POTENTIAL NET INTEREST AND
OPERATING LOSSES IN CONNECTION WITH BORROWINGS
General
The Company intends to continue to employ its financing strategy to increase the
size of its Mortgage Asset investment portfolio by borrowing a substantial
portion (which may vary depending upon the mix of the Mortgage Assets in the
Company's portfolio and the application of the Risk-Adjusted Capital Policy
requirements to such mix of Mortgage Assets) of the market value of its Mortgage
Assets. The Company expects generally to maintain a ratio of its total book
capital base (book value of capital accounts, retained earnings and subordinated
debt deemed by management to qualify as capital for this purpose, taking into
account valuation adjustments) to book value of total Mortgage Assets of between
5% and 15%, although the percentage may vary from time to time depending upon
market conditions and other factors deemed relevant by management. However, the
Company is not limited under its Bylaws in respect of the amount of its
borrowings, whether secured or unsecured, and the aggregate percentage of total
equity capital could at times be outside of this range. If the returns on the
Mortgage Assets purchased with borrowed funds fail to cover the cost of the
borrowings, the Company will experience net interest losses and may experience
net income losses. In addition, through increases in haircuts, decreases in the
market value of the Company's Mortgage Assets, increases in interest rate
volatility, availability of financing in the market, circumstances then
applicable in the lending market and other factors, the Company may not be able
to achieve the degree of leverage it believes to be optimal, which may cause the
Company to be less profitable than it would be otherwise.
Risk of Failure to Refinance Outstanding Borrowings
Additionally, the ability of the Company to achieve its investment objectives
depends not only on its ability to borrow money in sufficient amounts and on
favorable terms but also on the Company's ability to renew or replace on a
continuous basis its maturing short-term borrowings. The Company currently
relies on short-term borrowings to fund Mortgage Assets with adjustable-rate
coupons and long-term maturities. The Company has not, at the present time,
entered into any long-term commitment agreements under which a lender would be
required to enter into new borrowing agreements during a specified period of
time; however, the Company may enter into one or more of such commitment
agreements in the future if deemed favorable to the Company. In addition, the
Company is currently exploring various options with regard to the issuance of
long term debt. In the event the Company is not able to renew or replace
maturing borrowings, the Company could be required to
26
<PAGE> 27
sell Mortgage Assets under adverse market conditions and could incur losses as a
result. In addition, in such event, the Company may be required to terminate
hedge agreements, which could result in further costs to the Company. An event
or development such as a sharp rise in interest rates or increasing market
concern about the value or liquidity of a type or types of Mortgage Loans or
Mortgage Securities in which the Company's portfolio is concentrated will reduce
the market value of the Mortgage Assets, which would likely cause lenders to
require additional collateral. At the same time, the market value of the
Mortgage Assets in which the Company's liquidity capital is invested may have
decreased. A number of such factors in combination may cause difficulties for
the Company, including a possible liquidation of a major portion of the
Company's Mortgage Assets at disadvantageous prices with consequent losses,
which could have a materially adverse effect on the Company and its solvency.
Risk of Decline in Market Value of Mortgage Assets; Margin Calls
Certain of the Company's Mortgage Assets may be cross-collateralized to secure
multiple borrowing obligations of the Company to a single lender. A decline in
the market value of such Mortgage Assets may limit the Company's ability to
borrow or result in lenders initiating margin calls (i.e., requiring a pledge of
cash or additional Mortgage Assets to re-establish the ratio of the amount of
the borrowing to the value of the collateral). In the event that the Company
acquires fixed-rate Mortgage Assets pursuant to its Asset Allocation/Capital
Allocation Policies, such fixed-rate Mortgage Assets may be more susceptible to
margin calls as increases in interest rates tend to more negatively affect the
market value of fixed-rate Mortgage Assets than adjustable-rate Mortgage Assets.
This remains true despite effective hedging against such fluctuations as the
hedging instruments may not be part of the collateral securing the
collateralized borrowings. Additionally, it may be difficult to realize the full
value of the hedging instrument when desired for liquidity purposes due to the
applicable REIT Provisions of the Code. The Company could be required to sell
Mortgage Assets under adverse market conditions in order to maintain liquidity.
Such sales may be effected by management when deemed necessary in order to
preserve the capital base of the Company. If these sales were made at prices
lower than the amortized cost of the Mortgage Assets, the Company would
experience losses. A default by the Company under its collateralized borrowings
could also result in a liquidation of the collateral, including any
cross-collateralized assets, and a resulting loss of the difference between the
value of the collateral and the amount borrowed. Additionally, in the event of a
bankruptcy of the Company, certain reverse repurchase agreements may qualify for
special treatment under the Bankruptcy code, the effect of which is, among other
things, to allow the creditors under such agreements to avoid the automatic stay
provisions of the Bankruptcy Code and to liquidate the collateral under such
agreements without delay.
To the extent the Company is compelled to liquidate Mortgage Assets qualifying
as Qualified REIT Real Estate Assets to repay borrowings, the Company may be
unable to comply with the REIT provisions of the Code regarding assets and
sources of income requirements, ultimately jeopardizing the Company's status as
a REIT.
RISK OF DECREASE IN NET INTEREST INCOME DUE TO INTEREST RATE FLUCTUATIONS;
PREPAYMENT RISKS OF MORTGAGE ASSETS
The Company's Mortgage Assets bear, and the Company expects that a majority of
the Company's Mortgage Assets in the future will bear, adjustable interest or
pass-through rates based on short-term interest rates, and substantially all of
the Company's borrowings will bear interest at short-term rates and currently
have maturities of less than one year. Consequently, changes in short-term
interest rates may significantly influence the Company's net interest income.
While increases in short-term interest rates will generally increase the yields
on the Company's adjustable-rate Mortgage Assets, rising short-term rates will
also increase the costs of borrowings by the Company which will be utilized to
fund the Mortgage Assets and, to the extent such costs rise more rapidly than
the yields, the Company's net interest income, in the short-term, may be reduced
or a net loss may result. Conversely, decreases in short-term interest rates may
decrease the interest cost on the Company's borrowings more rapidly than the
yields on the Mortgage Assets and hence may increase the Company's net interest
income in the short-term. In the longer-term, lower short-term interest rates
would generally lead to lower net income, all other factors being equal. No
assurance can be given as to the amount or timing of changes in interest rates
or their effect on the Company's Mortgage Assets or net interest income.
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<PAGE> 28
Mortgage Asset prepayment rates vary from time to time and may cause changes in
the amount of the Company's net interest income. Prepayments of ARMs and
Mortgage Securities backed by ARMs usually can be expected to increase when
mortgage interest rates fall below the then-current interest rates on such ARMs
and decrease when mortgage interest rates exceed the then-current interest rates
on the ARMs, although such effects are not predictable. Prepayment experience
also may be affected by the geographic location of the property securing the
Mortgage Loans, the assumability of the Mortgage Loans, conditions in the
housing and financial markets and general economic conditions. In addition,
prepayments on ARMs are affected by the ability of the borrower to convert an
ARM to a fixed-rate loan and by conditions in the fixed-rate mortgage market. If
the interest rates on ARMs increase at a rate greater than the interest rates on
fixed-rate Mortgage Loans, prepayments on ARMs may tend to increase. In periods
of fluctuating interest rates, interest rates on ARMs may exceed interest rates
on fixed-rate Mortgage Loans, which may tend to cause prepayments on ARMs to
increase at a rate greater than anticipated. The Company seeks to minimize
prepayment risk through a variety of means, including structuring a diversified
portfolio with a variety of prepayment characteristics, investing in Mortgage
Assets with prepayment prohibitions and penalties, investing in certain Mortgage
Securities structures which have prepayment protection, and balancing Mortgage
Assets purchased at a premium with Mortgage Assets purchased at a discount. In
certain operating environments, however, it may not be possible for the Company
to acquire assets with a net balance of discount and premium. In such
circumstances, the risk of earning variability resulting from changes in
prepayment rates may rise. In addition, the Company has purchased and may in the
future purchase additional interest-only strips to a limited extent. However, no
strategy can completely insulate the Company from prepayment risks arising from
the effects of interest rate changes.
Changes in anticipated prepayment rates of Mortgage Assets could affect the
Company in several adverse ways. The faster than anticipated prepayment of any
Mortgage Asset that had been purchased at a premium by the Company would
generally result in a faster than anticipated write-off any remaining
unamortized premium amount and consequent reduction of the Company's net
interest income by such amount. In addition, a, portion of the adjustable-rate
Single-Family Mortgage Loans acquired or to be acquired by the Company (either
directly as Mortgage Loans or through Mortgage Securities backed by ARMs) have
or will have been recently originated and may still bear initial interest rates
which are lower than their "fully-indexed" rates (the applicable index plus
margin). In the event that such an ARM is prepaid faster than anticipated prior
to or soon after the time of adjustment to a fully-indexed rate, the Company
will have experienced an adverse effect on its net interest income during the
time it held such ARM compared with holding a fully-indexed ARM and will have
lost the opportunity to receive interest at the fully-indexed rate over the
expected life of the ARM. These effects may be mitigated to the extent such ARMs
were acquired at a discount to face value.
RISK OF FAILING TO HEDGE AGAINST INTEREST RATE CHANGES EFFECTIVELY;
RISK OF LOSSES ASSOCIATED WITH HEDGING; COUNTERPARTY RISKS
The Company's operating strategy subjects it to interest and prepayment rate
risks as described above. The Company follows an asset/liability management
program intended to partially protect against interest rate changes and
prepayments. Nevertheless, developing an effective asset/liability management
strategy is complex and no strategy can completely insulate the Company from
risks associated with interest rate changes and prepayments and the Company does
not attempt to hedge away all such risks. In addition, there can be no assurance
that the Company's hedging activities will have the desired beneficial impact on
the Company's results of operations or financial condition. Hedging typically
involves costs, including transaction costs, which increase dramatically as the
period covered by the hedge increases and which also increase during periods of
rising and volatile interest rates. The Company may increase its hedging
activity, and thus increase its hedging costs, during such periods when interest
rates are volatile or rising and hedging costs have increased. Moreover, Federal
tax laws applicable to REITs may substantially limit the Company's ability to
engage in asset/liability management transactions. Such Federal tax laws may
prevent the Company from effectively implementing hedging strategies that the
Company determines, absent such restrictions, would best insulate the Company
from the risks associated with changing interest rates and prepayments.
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<PAGE> 29
The Company purchases from time to time interest rate caps, interest rate swaps
and similar instruments to attempt to mitigate the risk of the cost of its
variable-rate liabilities increasing at a faster rate than the earnings on its
assets during a period of rising rates. In this way, the Company intends
generally to hedge as much of the interest rate risk as management determines is
in the best interests of the stockholders of the Company given the cost of such
hedging transactions and the need to maintain the Company's status as a REIT. In
this regard, the amount of income the Company may earn from its interest rate
caps and other hedging instruments is subject to substantial limitations under
the REIT Provisions of the Code. In particular, when the Company earns income
under such instruments, it will seek advice from tax counsel as the whether such
income constitutes qualifying income for purposed of the 95% Gross Income Test
and as to the proper characterization of such arrangements for purposes of the
REIT Asset Tests. This determination may result in management electing to have
the Company bear a level of interest rate risk that could otherwise be hedged
when management believes, based on all relevant facts, that bearing such risk is
prudent.
In the event that the Company purchases interest rate caps or other interest
rate agreements to hedge against lifetime and periodic rate or payment caps, and
the provider of interest rate agreements becomes financially unsound or
insolvent, the Company may be forced to unwind its interest rate agreements with
such provider and may take a loss on such interest rate agreements. Although the
Company intends to purchase interest rate agreements only from financially sound
institutions and to monitor the financial strength of such institutions on a
periodic basis, no assurance can be given that the Company can avoid such third
party risks.
RISK OF LOSS ON SINGLE-FAMILY MORTGAGE ASSETS
Seventy-six percent (76%) of the Mortgage Assets the Company had acquired as of
December 31, 1996 were Mortgage Securities. The Company bears the risk of loss
on any Mortgage Securities it purchases in the secondary mortgage market or
otherwise. However, such Mortgage Securities, including all Mortgage Securities
purchased as of December 31, 1996, are either Agency Certificates or are
generally structured with one or more types of credit enhancement. To the extent
third parties have been contracted to provide the credit enhancement, the
Company is dependent in part upon the creditworthiness and claims paying ability
of the insurer and the timeliness of reimbursement in the event of a default on
the underlying obligations. Further, the insurance coverage for various types of
losses is limited in amount and losses in excess of the limitation may be borne
by the Company. The Company expects that a substantial portion of its
Single-Family Mortgage Assets in the future may constitute Mortgage Loans and
Mortgage Securities acquired in exchange for such Mortgage Loans. The Company
generally does not intend to obtain credit enhancements such as mortgage pool or
special hazard insurance for its Single-Family Mortgage Loans, other than FHA
insurance, VA guarantees and private mortgage insurance, in each case relating
only to individual Mortgage Loans. Accordingly, during the time it holds such
Mortgage Loans for which third party insurance is not obtained, the Company will
be subject to risks of borrower defaults and bankruptcies and special hazard
losses that are not covered by standard hazard insurance (such as those
occurring from earthquakes or floods). In the event of a default on any
Single-Family Mortgage Loan held by the Company, including, without limitation,
any event of default resulting from higher default levels as a result of
declining property values and worsening economic conditions, among other
factors, the Company would bear the risk of loss of principal to the extent of
any deficiency between the value of the related mortgage property, plus any
payments from an insurer or guarantor, and the amount owing on the Mortgage
Loan. Defaulted Mortgage Loans would also cease to be eligible collateral for
borrowings and would have to be financed by the Company out of other funds or
funded with equity until ultimately liquidated, resulting in increased financing
costs and reduced net income or a net loss.
RISK OF FUTURE REVISIONS IN POLICIES AND STRATEGIES BY BOARD OF DIRECTORS
The Board of Directors has established the investment policies and operation
policies and strategies set forth in this Form 10-K as the investment policies
and operating policies and strategies of the Company. However, these policies
and strategies may be modified or waived by the Board of Directors, subject in
certain cases to approval by a majority of the Independent Directors, without
stockholder consent. The ultimate effect of changes in these policies and
strategies may be positive or negative.
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<PAGE> 30
The Company is building a credit reserve for future credit losses through its
credit provisions. To the extent credit losses experienced in the future exceed
anticipated levels, the amount of credit provisions may be increased, negatively
impacting the Company's income under GAAP. Moreover, for tax purposes, credit
losses are not covered by the GAAP reserve for future losses. Rather, credit
losses reduce the Company's taxable income in the period in which they are
realized and hence could reduce the dividends payable for such period.
OTHER RISKS
DEPENDENCE ON KEY PERSONNEL
The Company's operations depend significantly upon the contributions of its
executive officers, many of whom would be difficult to replace. Although all
executive officers currently have employment agreements with the Company, there
can be no assurance of the continued employment of all such officers. The loss
of any key person could have a material adverse effect on the Company's business
and results of operations.
CAPITAL STOCK PRICE VOLATILITY RISK
With respect to the public market for the Common Stock, it is likely that the
market price of the Common Stock will be influenced by any variation between the
net yield on the Company's Mortgage Assets and prevailing market interest rates
and by the market's perception of the Company's ability to achieve earnings
growth. The Company's earnings will be derived primarily from any positive
spread between and yield on the Company's Mortgage Assets and the cost of the
Company's borrowings. The positive spread between the yield on the Company's
Mortgage Assets and the cost of borrowings will not necessarily be stable
regardless of the Company's business strategy to achieve such result over longer
periods of time. Accordingly, in periods of high interest rates, the net income
of the Company, and therefore the dividend yield on the Common Stock, may be
less attractive compared with alternative investments, which could negatively
impact the price of the Common Stock. If the anticipated or actual net yield on
the Company's Mortgage Assets declines or if prevailing market interest rates
rise, thereby decreasing the positive spread between the net yield on the
Mortgage Assets and the cost of the Company's borrowings, the market price of
the Common Stock may be adversely affected. The market price of the Company's
Common Stock may also be influenced by real or perceived future earnings
variability caused by changes in prepayment rates. In addition, if the market
price of other REIT stocks decline for any reason, or there is a broad-based
decline in real estate values or in the value of the Company's Mortgage Assets
and the market price of the Common Stock has been adversely affected due to any
of the foregoing reasons, the liquidity of the Common Stock may be negatively
impacted and investors who may desire or be required to sell shares of Common
Stock may experience losses.
ITEM 2. PROPERTIES
The Company's executive and administrative offices are located at 591 Redwood
Highway, Suite 3100, Mill Valley, California 94941, telephone (415) 389-7373.
Such offices are leased under a lease expiring on May 5, 2001.
ITEM 3. LEGAL PROCEEDINGS
At December 31, 1996, there were no pending legal proceedings to which the
Company was a party or of which any of its property was subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company's shareholders during the
fourth quarter of 1996.
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock is traded on the over-the counter market and is
quoted on the Nasdaq National Market under the symbol RWTI. The Company's Common
Stock was held by approximately 200 holders of record on March 17, 1997 and the
total number of beneficial shareholders holding stock through depository
companies was approximately 2,000. The high and low closing sales prices of
shares of the Common Stock as reported on the Nasdaq National Market composite
tape and the cash dividends declared for the periods indicated were as follows:
<TABLE>
<CAPTION>
STOCK PRICES
------------
HIGH LOW
---- ---
<S> <C> <C>
1995
Third Quarter (1) 22 16 7/8
Fourth Quarter 22 18
1996
First Quarter 21 3/4 18 3/4
Second Quarter 28 19 3/8
Third Quarter 32 1/4 23 1/4
Fourth Quarter 37 1/2 31 1/4
1997
As of March 17, 1997 56 3/4 36 1/2
</TABLE>
<TABLE>
<CAPTION>
CASH DIVIDENDS
----------------------------- AMOUNT
DATE DECLARED PAYABLE DATE PER SHARE
------------- ------------ ---------
<S> <C> <C> <C>
Common Stock 9/15/95 10/20/95 $0.20
12/13/95 1/19/96 $0.26
3/11/96 4/19/96 $0.46
6/14/96 7/18/96 $0.40
9/16/96 10/21/96 $0.40
12/16/96 1/21/97 $0.41
3/4/97 4/21/97 $0.60
</TABLE>
(1) THE COMPANY'S COMMON STOCK BEGAN TRADING ON AUGUST 4, 1995.
The Company intends to pay quarterly dividends. The Company intends to make
distributions to its stockholders of all or substantially all of its taxable
income each year (subject to certain adjustments) so as to qualify for the tax
benefits accorded to a REIT under the Code. All distributions will be made by
the Company at the discretion of the Board of Directors and will depend on the
taxable earnings of the Company, financial condition of the Company, maintenance
of REIT status and such other factors as the Board of Directors may deem
relevant from time to time. No dividends may be paid on the Common Stock unless
full cumulative dividends have been paid on the Preferred Stock. As of December
31, 1996, the full cumulative dividends have been paid on the Preferred Stock.
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<PAGE> 32
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data is for the years ended December 31, 1996
and December 31, 1995 and for the period from commencement of operations on
August 19, 1994 to December 31, 1994. It is qualified in its entirety by, and
should be read in conjunction with the more detailed information contained in
the Financial Statements and Notes thereto and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" included elsewhere in
this Form 10-K.
- - --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) PERIOD FROM
YEARS ENDED DECEMBER 31, AUGUST 19, 1994 TO
1996 1995 DECEMBER 31, 1994
----------- ----------- -----------------
<S> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Interest income $ 67,284 $ 15,726 $ 1,296
Interest expense 49,191 10,608 760
Interest rate agreement expense 1,158 339 8
Net interest income 16,935 4,779 528
Provision for credit losses 1,696 493 --
Net interest income after provision for credit losses 15,239 4,286 528
Operating expenses 2,554 1,131 146
Net income $ 12,685 $ 3,155 $ 382
Net income available to common stockholders $ 11,537 $ 3,155 $ 382
Net taxable income $ 15,168 $ 3,832 $ 353
Net taxable income available to common stockholders $ 14,020 $ 3,832 $ 353
Weighted average shares of common stock and
common stock equivalents 8,744,184 3,703,803 1,916,846
Primary earnings per share $ 1.32 $ 0.85 $ 0.20
Dividends declared per Class A preferred share -- $ 0.50 $ 0.25
Dividends declared per Class B preferred share $ 1.14 -- --
Dividends declared per common share $ 1.67 $ 0.46 --
BALANCE SHEET DATA:
Mortgage assets $ 2,153,428 $ 432,244 $ 117,477
Total assets $ 2,184,197 $ 441,557 $ 121,528
Borrowings $ 1,953,103 $ 370,316 $ 100,376
Total liabilities $ 1,973,192 $ 373,267 $ 101,248
Stockholders' equity $ 211,005 $ 68,290 $ 20,280
Number of Class A preferred shares outstanding -- -- 1,666,063
Number of Class B preferred shares outstanding 1,006,250 -- --
Number of common shares outstanding 10,996,572 5,517,299 208,332
OTHER DATA:
Average assets $ 995,467 $ 219,492 $ 57,862
Average borrowings $ 861,316 $ 174,926 $ 37,910
Average equity $ 127,020 $ 42,224 $ 19,584
Interest rate spread 1.11% 1.12% 0.79%
Net interest margin 1.70% 2.18% 2.53%
Operating expenses as a percent of net interest income 15.08% 23.66% 27.73%
Operating expenses as a percent of average assets 0.26% 0.52% 0.70%
Operating expenses as a percent of average equity 2.01% 2.68% 2.07%
Return on average assets 1.27% 1.44% 1.83%
Average assets/average equity 7.84x 5.20x 2.95x
Return on average equity 9.99% 7.47% 5.40%
Credit reserves $ 2,180 $ 490 --
Actual charge-offs $ 7 $ 4 --
</TABLE>
32
<PAGE> 33
Item 7. 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 26 of this Form 10-K.
OVERVIEW
Redwood Trust, Inc. is a mortgage finance company which acquires mortgages and
seeks to earn spread income while holding and managing the mortgages to
maturity. The Company uses both its equity and borrowed funds to acquire
mortgages. The Company's source of earnings is net interest income, or the
interest income earned on mortgages less interest expense paid on borrowed funds
and hedging costs. 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 has sought to structure its business to achieve operational
efficiencies and to minimize fixed costs. Instead of maintaining an in-house
mortgage origination staff, the Company acquires mortgage assets from mortgage
origination companies, savings and loans, banks and from the secondary mortgage
market. The Company out-sources mortgage servicing functions. Rather than build
a retail branch banking system to gather deposits (which would require the
Company to obtain a bank or savings and loan charter, pay taxes and be
regulated), the Company accesses borrowed funds in the capital markets. This
strategy enables the Company to keep its operating costs low. In the fourth
quarter of 1996, the Company's operating expenses to assets ratio was 0.21% and
its efficiency ratio (operating expenses to net interest income) was 13%.
As of December 31, 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 (24% of total mortgage
assets as of December 31, 1996), mortgage securities evidencing an interest in
pools of mortgage loans which have been fully insured against credit losses by
one of the government-sponsored mortgage entities such as GNMA, FHLMC and FNMA
(45% of total), 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 (30% of total), and mortgage
securities which are subordinated and have higher levels of credit risk such
that they have received a rating below BBB (1% of total). 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.
The Company seeks to acquire "A" quality single-family mortgage assets
consisting of "jumbo" mortgages which, in general, have loan balances greater
than $214,600. Because of their size, these jumbo loans are not eligible to be
33
<PAGE> 34
acquired or guaranteed by the government-sponsored mortgage entities. The
Company also acquires FNMA and FHLMC mortgage securities and smaller balance "A"
quality whole loans when such acquisitions are deemed attractive by management.
As of December 31, 1996, 44% of the whole mortgage loans owned by the Company
were secured by single-family residential properties located in California. In
addition, 70% of the properties underlying the mortgage pools in which the
Company owned an interest that was rated less than AA were located in
California. Management believes that the economy and the trend of residential
housing values in California were generally stable to improving in 1996.
The coupon rate the Company earns on its adjustable-rate mortgage assets (100%
of all mortgage assets as of December 31, 1996) 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 five months as of December 31,
1996. Borrowings have maturities ranging from one to twelve months; the average
term-to-next-adjustment for borrowings was approximately two months as of
December 31, 1996. The Company's interest rate agreement hedging program is
designed to reduce the impact of negative effects that could occur in a rising
interest rate environment as a result of mismatches between the adjustment dates
of the Company's assets and liabilities. Such mismatches averaged three months
at December 31, 1996. Changes in the coupon rates earned on the Company's
mortgages are limited by periodic and lifetime caps; the Company's hedging
program also seeks to mitigate the negative effects such mortgage 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.
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
additional growth in the future when management believes that growth is likely
to be additive to earnings per share potential.
RESULTS OF OPERATIONS: FOURTH QUARTER 1996 VS. FOURTH QUARTER 1995
TOTAL NET INCOME
Total net income, as calculated according to Generally Accepted Accounting
Principles ("GAAP"), to common and preferred shareholders increased by 270%,
from $1.3 million in the fourth quarter of 1995 to $4.8 million in the fourth
quarter of 1996. Total net income available to common shareholders after
preferred dividends increased by 212%, from $1.3 million in the fourth quarter
of 1995 to $4.1 million in the fourth quarter of 1996. Growth in interest income
revenue, net interest income, credit provision expenses, operating expenses and
net income has been driven primarily by asset growth over this period. From the
fourth quarter of 1995 to the fourth quarter of 1996, the daily average of total
assets during the period ("average assets") grew by 317% to $1.55 billion,
interest income revenue grew by 291% to $25.9 million, net interest income grew
by 196% to $6.0 million, credit provision expenses rose by 6% to $0.4 million
and operating expenses grew by 116% to $0.8 million. Average total equity grew
by 153% to $182.0 million.
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<PAGE> 35
Growth in revenues and net interest income have lagged average asset growth
somewhat as the Company has changed its asset mix towards lower credit risk
assets with narrower spreads and as the Company has utilized a higher percentage
of debt rather than equity to fund its mortgage assets. Credit provision
expenses have not increased pro rata with growth in average assets as the
Company has not added to its portfolio of securitized mortgages rated less than
AA since 1995. On average, the Company has moved towards an asset mix that,
through December 31, 1996, has required a lower average level of credit
provisions. Growth in operating expenses has lagged asset growth as the Company
has become more efficient in its operations.
The Company's primary income and expense categories are shown in Table 1.
<TABLE>
<CAPTION>
TABLE 1
NET INCOME
NET NET
REVENUES INTEREST INCOME INCOME
OR RATE NET CREDIT BEFORE AFTER
INTEREST INTEREST AGREEMENT INTEREST PROVISION OPERATING PREFERRED PREFERRED PREFERRED
INCOME EXPENSE EXPENSE INCOME EXPENSE EXPENSES DIVIDENDS DIVIDENDS DIVIDENDS
-------- -------- -------- ------- --------- -------- -------- -------- ----------
(dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 1,296 $ 760 $ 8 $ 528 $ 0 $ 146 $ 382 $ 0 $ 382
1995 15,726 10,608 339 4,779 493 1,131 3,155 0 3,155
1996 67,284 49,191 1,158 16,935 1,696 2,554 12,685 1,148 11,537
1995, Quarter 1 $ 2,170 $ 1,533 $ 16 $ 621 $ 19 $ 201 $ 401 $ 0 $ 401
1995, Quarter 2 2,960 2,190 82 688 40 198 450 0 450
1995, Quarter 3 3,986 2,432 112 1,442 84 364 994 0 994
1995, Quarter 4 6,610 4,453 129 2,028 350 368 1,310 0 1,310
1996, Quarter 1 9,131 6,202 151 2,778 331 493 1,954 0 1,954
1996, Quarter 2 12,901 9,075 255 3,571 477 594 2,500 0 2,500
1996, Quarter 3 19,371 14,447 350 4,574 516 671 3,387 388 2,999
1996, Quarter 4 25,881 19,467 402 6,012 372 796 4,844 760 4,084
</TABLE>
35
<PAGE> 36
SHARES OUTSTANDING
Table 2 below shows the number of common shares, preferred shares, and warrants
outstanding at the end of each reporting period. The table also shows the
average number of primary common shares (common shares outstanding as grossed up
based on a calculation of potential future dilution due to warrants and options)
used to calculate the Company's reported earnings per share.
<TABLE>
<CAPTION>
TABLE 2
NUMBER OF SHARES
COMMON PREFERRED AVERAGE
SHARES SHARES WARRANTS AVERAGE POTENTIAL AVERAGE COMMON
OUTSTANDING OUTSTANDING OUTSTANDING NUMBER OF DILUTION NUMBER OF AND
AT AT AT COMMON DUE TO PRIMARY PREFERRED
PERIOD PERIOD PERIOD SHARES WARRANTS COMMON SHARES
END END END OUTSTANDING AND OPTIONS SHARES OUTSTANDING
---------- ---------- ---------- ----------- ----------- -------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 1,874,395 0 1,666,063 1,676,080 240,766 1,916,846 1,676,080
1995 5,517,299 0 1,665,063 3,314,042 389,761 3,703,803 3,314,044
1996 10,996,572 1,006,250 412,894 7,950,175 794,009 8,744,184 8,332,330
1995, Quarter 1 1,874,395 0 1,666,063 1,874,395 240,766 2,115,161 1,874,395
1995, Quarter 2 1,874,395 0 1,666,063 1,874,395 188,699 2,063,094 1,874,395
1995, Quarter 3 5,516,313 0 1,666,063 3,944,129 239,009 4,183,138 3,944,129
1995, Quarter 4 5,517,299 0 1,665,063 5,516,310 563,197 6,079,507 5,516,310
1996, Quarter 1 5,521,376 0 1,665,063 5,521,376 608,211 6,129,587 5,521,376
1996, Quarter 2 8,520,116 0 1,563,957 7,813,974 786,258 8,600,232 7,813,974
1996, Quarter 3 9,069,653 1,006,250 1,076,431 8,732,326 783,848 9,516,174 9,246,389
1996, Quarter 4 10,996,572 1,006,250 412,894 9,705,138 747,334 10,452,472 10,711,388
</TABLE>
EARNINGS PER PRIMARY SHARE (EPS)
Reported earnings per primary common share (EPS) in the fourth quarter of 1996
were $0.39. This was an increase of 77% from the $0.22 earned in the fourth
quarter of 1995. As shown in Table 3, the two primary components of this
increase in EPS were a 47% increase in the return on equity earned by the
Company and a 20% increase in book value per share (the amount of equity per
share the Company has available with which to generate earnings).
36
<PAGE> 37
<TABLE>
<CAPTION>
TABLE 3
PRIMARY COMPONENTS OF EARNINGS PER SHARE
EARNINGS EARNINGS
RETURN PER ADJUSTMENT PER
AVERAGE ON AVERAGE FOR PRIMARY
COMMON AVERAGE COMMON POTENTIAL COMMON
EQUITY PER COMMON SHARE FUTURE SHARE
SHARE EQUITY OUTSTANDING DILUTION ("EPS")
--------- ------ ---------- -------- -------
<S> <C> <C> <C> <C> <C>
Fiscal 1994 $ 11.68 5.40% $ 0.23 $ 0.03 $ 0.20
1995 12.74 7.47% 0.95 0.10 0.85
1996 14.56 9.97% 1.45 0.13 1.32
1995, Quarter 1 $ 11.64 7.36% $ 0.21 $ 0.02 $ 0.19
1995, Quarter 2 12.04 7.97% 0.24 0.02 0.22
1995, Quarter 3 13.15 7.66% 0.25 0.01 0.24
1995, Quarter 4 13.05 7.28% 0.24 0.02 0.22
1996, Quarter 1 12.45 11.37% 0.35 0.03 0.32
1996, Quarter 2 14.42 8.88% 0.32 0.03 0.29
1996, Quarter 3 14.74 9.32% 0.34 0.02 0.32
1996, Quarter 4 15.69 10.73% 0.42 0.03 0.39
</TABLE>
Return on equity increased as a result of increasing operational and capital
efficiencies at the Company. As shown in Table 4, the return on total equity
(including common and preferred equity) earned by the Company rose from 7.28% in
the fourth quarter of 1995 to 10.65% in the fourth quarter of 1996. Net interest
income per dollar of equity increased from 11.27% to 13.22% as the Company
increased its capital utilization efficiency. Credit expenses as a percentage of
equity dropped from 1.95% to 0.82% as the Company shifted towards the
acquisition of lower credit risk assets. Operating expenses as a percentage of
equity dropped from 2.04% to 1.75% as the Company grew and became more
productive. See "Earning Asset Yield and Interest Rate Spread", "Net Interest
Income", "Credit Expenses" and "Operating Expenses" below.
<TABLE>
<CAPTION>
TABLE 4
PRIMARY COMPONENTS OF RETURN ON TOTAL EQUITY
NET
INTEREST RATIO OF
INCOME CREDIT OPERATING AVERAGE
RETURN ON PROVISIONS/ EXPENSE/ RETURN ON ASSETS
AVERAGE AVERAGE AVERAGE AVERAGE RETURN ON TO
TOTAL TOTAL TOTAL TOTAL AVERAGE TOTAL
EQUITY EQUITY EQUITY EQUITY ASSETS EQUITY
-------- --------- ------- ------- -------- ------
<S> <C> <C> <C> <C> <C> <C>
Fiscal 1994 7.47% 0.00% 2.07% 5.40% 1.83% 2.95x
1995 11.32% 1.17% 2.68% 7.47% 1.44% 5.20x
1996 13.34% 1.34% 2.01% 9.99% 1.27% 7.84x
1995, Quarter 1 11.39% 0.34% 3.69% 7.36% 1.28% 5.76x
1995, Quarter 2 12.20% 0.72% 3.51% 7.97% 1.10% 7.25x
1995, Quarter 3 11.12% 0.65% 2.81% 7.66% 1.86% 4.13x
1995, Quarter 4 11.27% 1.95% 2.04% 7.28% 1.41% 5.16x
1996, Quarter 1 16.16% 1.93% 2.86% 11.37% 1.54% 7.38x
1996, Quarter 2 12.68% 1.69% 2.11% 8.88% 1.30% 6.81x
1996, Quarter 3 12.71% 1.43% 1.87% 9.41% 1.18% 8.00x
1996, Quarter 4 13.22% 0.82% 1.75% 10.65% 1.25% 8.51x
</TABLE>
The Company's equity per share increased due to accretive stock offerings priced
at levels in excess of book value per share and, because the Company marks its
balance sheet assets to market value, due to increases in
37
<PAGE> 38
market values of the Company's mortgage portfolio. Book value per share growth
has been offset to some degree by the exercise of warrants and options, the
payment of dividends (which are based on taxable income) in excess of GAAP
income, declines in the market value of the Company's hedges and other factors.
As shown in Table 25, total equity per share increased by 42% from December 31,
1995 to December 31, 1996. Table 5 shows how each of the Company's stock
offerings increased the Company's total equity per share (and thus its earnings
per share potential).
<TABLE>
<CAPTION>
TABLE 5
ACCRETIVE STOCK OFFERINGS
% % %
INCREASE INCREASE INCREASE
IN IN IN
NUMBER PRICE PER NET NUMBER TOTAL EQUITY PER
SECURITY DATE OF SHARES SHARE PROCEEDS OF SHARES EQUITY SHARE
- - -------- ---- --------- ----- -------- --------- ------ -----
(dollars in thousands, except per share amounts)
<S> <C> <C> <C> <C> <C> <C> <C>
Common Stock - IPO 08/04/95 3,593,750 $ 15.50 $ 51,281 187% 228% 14%
Common Stock 04/19/96 2,875,000 20.25 54,730 52% 80% 18%
Class B Preferred 08/17/96 1,006,250 31.00 29,712 12% 24% 11%
Stock
Common Stock 11/19/96 1,250,000 31.75 39,171 12% 24% 10%
</TABLE>
TAXABLE INCOME
In order to determine its dividend levels, the Company must first determine its
pre-tax, or taxable, income as calculated according to IRS guidelines. As a
REIT, the Company deducts its dividend distributions from taxable income and is
required to pay Federal taxes on any remaining undistributed taxable income.
Since the Company intends to distribute 100% of its taxable income as dividends
(and as a REIT is required to distribute at least 95%), the Company is not
generally subject to Federal income tax. As a result of these REIT issues, the
Company's total dividends will reflect its taxable income rather than its total
net GAAP income.
Taxable income differs from GAAP because (i) taxable income credit expense
equals actual credit losses rather than credit provisions (actual credit losses
through December 31, 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 some
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.
Taxable income (before preferred dividends) in the fourth quarter of 1996 was
$5.4 million and was 12% higher than GAAP net income (before preferred
dividends) of $4.8 million during the same period. The table below presents the
major differences between GAAP and taxable income for the Company.
38
<PAGE> 39
<TABLE>
<CAPTION>
TABLE 6
TAXABLE INCOME
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>
Fiscal 1994 $ 382 $ 0 $ (28) $ 354 $ 354 4.99% 4.99%
1995 3,155 490 187 3,832 3,832 9.08% 9.08%
1996 12,685 1,689 794 15,168 14,020 12.11% 11.94%
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 1,083 1,083 8.35% 8.35%
1995, Quarter 4 1,310 347 156 1,813 1,813 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%
1996, Quarter 4 4,844 365 220 5,429 4,669 12.26% 11.93%
</TABLE>
DIVIDENDS
The Company declared a dividend of $0.41 per common share in the fourth quarter
of 1996 resulting in a total dividend distribution (including preferred
dividends) of $5.3 million, or 97% of taxable income earned during the quarter.
Through December 31, 1996, cumulative taxable income has exceeded cumulative
dividends paid or declared by $0.4 million; the Company intends to distribute
this excess taxable income as part of the Company's March 1997 dividend.
The fourth quarter common stock dividend of $0.41 per share represented a slight
increase over the $0.40 per common share declared in the third quarter of 1996
and an increase of 58% over the $0.26 declared for the fourth quarter of 1995.
Dividend per share growth from the third to the fourth quarter of 1996 did not
mirror the 28% increase in total taxable income after preferred dividend (from
$3.7 million to $4.7 million) due to a large increase in common shares eligible
to receive a dividend at year end stemming from the November common stock
offering of 1,250,000 shares and warrant exercises leading to the issuance of
597,202 shares of common stock in December.
The Company's 1,006,250 shares of Class B Preferred stock receive a quarterly
dividend of $0.755 per share or, if greater, the common stock dividend.
Preferred stock dividends were $0.386 per share in the third quarter of 1996
reflecting a partial quarter from the August 16th issuance date of the Preferred
through quarter end.
39
<PAGE> 40
<TABLE>
<CAPTION>
TABLE 7
DIVIDENDS
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>
Fiscal 1994 1,401,904 $ 0.25 $ 0.25 $ 350 0 $ 0.000 $ 0 $ 350
1995 3,510,933 1.09 0.96 3,370 0 0.000 0 3,370
1996 8,433,674 1.66 1.67 14,084 1,006,250 1.141 1,148 15,232
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 1,434 0 0.000 0 1,434
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
1996, Quarter 4 10,996,572 0.42 0.41 4,508 1,006,250 0.755 760 5,268
</TABLE>
EARNING ASSET YIELD AND INTEREST RATE SPREAD
The earning asset yield is the annualized interest income earned from the
Company's mortgage assets and cash balances (its earning assets) divided by the
total balance of these assets. As shown in Table 8, the fourth quarter of 1996
earning asset yield of 6.87% is a blend of the cash yield (5.31%) and the
mortgage yield (6.89%). The mortgage yield is a function of three factors which
are also shown in Table 8: coupon earned on the mortgages, the average cost
basis (adjusted purchase price) of the mortgages, and the income effect of the
amortization of premium and discount balances created when acquiring a mortgage
asset at a price other than par. The interest rate spread is the earning asset
yield less the Company's cost of funds and hedging. As shown in Table 8, the
Company's interest rate spread was 0.99%, equaling the earning asset yield of
6.87% less the cost of funds of 5.76% and the cost of hedging as a percent of
borrowed funds of 0.12%.
The cost of hedging represents the amortization of the purchase price of cap
agreements, net payments made on interest rate swaps, and other expenses related
to interest rate agreements. To date, the Company has not earned a significant
amount of hedge income from this hedging program; these interest rate agreements
are designed to protect the Company in the event of a large rapid increase in
interest rates and such an environment has not occurred in the life of the
Company. As shown in Table 8, the cost of hedging relative to the size of the
balance sheet has generally declined over time; this is a result of a low
volatility interest rate environment. Hedging costs could increase should the
environment change.
The yield on the Company's earning assets (mortgages plus cash) declined from
7.34% in the fourth quarter of 1995 to 6.87% in the fourth quarter of 1996, a
decline of 47 basis points. Over the same period, the Company's cost of funds
declined by 28 basis points from 6.04% to 5.76% and the Company's cost of
hedging declined by 6 basis points from 0.18% to 0.12%. As a result of these
changes, the spread the Company earned between the yield on its assets and its
cost of borrowed funds and hedging declined from 1.12% in the fourth quarter of
1995 to 0.99% in the fourth quarter of 1996.
The asset mix of the Company, and therefore the earning asset yield and the
spread the Company earned, changed from 1995 to 1996. During 1996, the Company
ceased the acquisition of higher-yielding, wider-spread, higher-credit-risk
assets such as mortgage securities rated below AA and focused on the acquisition
of lower-yielding, narrower-spread, lower-credit-risk assets such as
high-quality whole loans and mortgage securities
40
<PAGE> 41
rated AAA and AA. A competitive return on equity can be achieved by the Company
on these new higher-quality assets, despite a lower yield and a narrower
interest rate spread, as the Company makes a smaller internal capital allocation
to these assets and expenses a lower level of credit provisions.
Rapid asset growth has also led, on a temporary basis, to lower asset yields and
a narrower spread for the Company. Newly acquired adjustable-rate mortgages
typically have lower initial mortgage coupon rates than the Company earns on its
existing mortgage portfolio. Typically the coupon rates on newly acquired
mortgages are lower than average for six to twelve months. Thus the Company's
average spread has been narrower on a temporary basis during periods of rapid
balance sheet growth.
<TABLE>
<CAPTION>
TABLE 8
EARNING ASSET YIELD AND INTEREST RATE SPREAD
AVERAGE EFFECT OF
COUPON NET
RATE AVERAGE AVERAGE DISCOUNT/ NET EARNING INTEREST
DURING COST COUPON (PREMIUM) MORTGAGE CASH ASSET COST OF COST OF RATE
PERIOD BASIS YIELD AMORTIZATION YIELD YIELD YIELD FUNDS HEDGING SPREAD
------ ------ ------ ----------- ------- ----- ------ ------ ------- ------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 6.09% 100.0% 6.09% 0.53% 6.62% 4.73% 6.40% 5.55% 0.06% 0.79%
1995 7.16% 99.0% 7.23% 0.18% 7.41% 5.43% 7.37% 6.06% 0.19% 1.12%
1996 7.55% 100.7% 7.50% (0.52%) 6.98% 5.51% 6.95% 5.71% 0.13% 1.11%
1995, Quarter 1 6.32% 99.5% 6.35% 0.77% 7.12% 4.96% 7.09% 5.96% 0.06% 1.07%
1995, Quarter 2 6.82% 98.5% 6.92% 0.49% 7.42% 5.57% 7.40% 6.26% 0.23% 0.91%
1995, Quarter 3 7.29% 98.7% 7.39% 0.30% 7.68% 5.53% 7.64% 6.09% 0.28% 1.27%
1995, Quarter 4 7.59% 99.3% 7.64% (0.24%) 7.40% 5.48% 7.34% 6.04% 0.18% 1.12%
1996, Quarter 1 7.73% 98.9% 7.82% (0.37%) 7.45% 5.93% 7.40% 5.69% 0.14% 1.57%
1996, Quarter 2 7.47% 100.0% 7.48% (0.51%) 6.97% 5.61% 6.94% 5.57% 0.16% 1.21%
1996, Quarter 3 7.52% 101.0% 7.44% (0.49%) 6.95% 5.30% 6.92% 5.78% 0.14% 1.00%
1996, Quarter 4 7.58% 101.4% 7.48% (0.59%) 6.89% 5.31% 6.87% 5.76% 0.12% 0.99%
</TABLE>
In the fourth quarter of 1996, the Company's earning asset yield and spread were
diminished by 0.59% by the net effect of premium and discount amortization. In
the fourth quarter of 1995, this negative effect on yield and spread was only
0.24% (Table 8). The negative effect has increased even though mortgage
principal repayment rates have remained stable because the Company has acquired
more assets at prices above par. As shown in Table 9, the Company's discount
balance has grown from $10.9 million to $16.2 million over the last year while
its premium balance has grown from $8.3 million to $40.0 million. The net
premium/(discount) balance changed from negative $2.6 million to positive $20.7
million over that period. Premium pricing on asset acquisitions is a result of a
change in asset mix towards lower risk assets and is also reflective of
increasing prices for mortgage assets in general.
As shown in Table 9, the Company received mortgage principal repayments of $95
million in the fourth quarter of 1996 and $25 million in the fourth quarter of
1995; as a percentage of mortgage assets owned by the Company, the annualized
rate of mortgage principal repayment was 26% and 28% respectively. Over the last
five quarters, the rate of principal repayment for the Company's mortgage assets
has remained stable in the 26% to 29% range.
As shown in Table 9, the Company has amortized its discount balances into income
at an annualized rate of 5% to 8% over the last five quarters. This discount
amortization rate is substantially slower than the rate at which the principal
on the mortgages in the pools underlying the Company's discount mortgage assets
has repaid. The Company's discount balances are associated with mortgage assets
that have credit risk; discount balances act in effect as an additional form of
credit reserve for the Company. See "Credit Reserves" below.
41
<PAGE> 42
<TABLE>
<CAPTION>
TABLE 9
AMORTIZATION ON MORTGAGE ASSETS
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>
Fiscal 1994 $ 440 $ 101 63% $ 450 $ 19 12% $ 10 $ 82 $ 1,244 7%
1995 5,496 961 17% 3,426 605 18% (2,069) 356 38,824 18%
1996 16,596 910 5% 23,028 6,107 27% 6,432 (5,197) 258,425 27%
1995, Quarter 1 $ 1,440 $ 234 65% $ 785 $ 19 10% $ (655) $ 215 $ 2,673 9%
1995, Quarter 2 3,528 237 27% 1,175 3 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 1,707 25% 10,762 (1,436) 76,942 28%
1996, Quarter 4 16,236 217 5% 36,977 2,425 26% 20,741 (2,208) 95,610 26%
</TABLE>
The Company's earning asset yield and interest rate spread also declined during
1996 as prospective yields and spreads available from newly acquired mortgages
declined during the year. Mortgage prices rose more than would usually be
expected given changes in interest rates. Management believes mortgage prices
have risen due to strong demand from banks, savings and loans, and other
financial institutions (stemming from a continued state of over-capitalization),
an increase in the prices of financial assets in general, a decrease in interest
rate volatility, and other factors. The effect on the Company's earnings of this
increase in mortgage prices for new assets was offset to some degree by a
reduced cost of hedging.
At the same time that the Company's spread has narrowed for a variety of
reasons, some of which are temporary, the Company has significantly improved its
operating and capital efficiencies. These efficiencies have allowed the Company
to increase return on equity over this period despite lower yields and spreads.
NET INTEREST INCOME
Net interest income, or interest income revenues less the cost of funds and
hedging, increased from $2.0 million in the fourth quarter of 1995 to $6.0
million in the fourth quarter of 1996. This 300% increase in net interest income
was driven primarily by a 317% increase in average assets over the same period.
As shown in Table 10, the net interest margin (annualized net interest income
divided by average assets) declined from 2.18% to 1.56% over this period as the
Company funded an increasing percentage of its assets with debt rather than
equity. In the fourth quarter of 1995, the Company's average equity-to-assets
ratio (average equity divided by average assets) was 19.4%; in the fourth
quarter of 1996, the average equity-to-assets ratio was 11.8%. As a result of
this increase in assets relative to equity, the net interest income return on
average equity (net interest income divided by average equity) increased from
11.27% to 13.22%. It is this ratio, rather than net interest margin, which the
Company seeks to maximize with its balance sheet management program (while at
the same time seeking to manage risk).
The Company was able to increase its asset size relative to its equity base, and
thus increase net interest income as a percentage of equity, as it reduced its
average internal capital allocation due to reductions in credit and liquidity
risk on the balance sheet and as the Company more efficiently matched the timing
of inflows of capital and mortgage asset acquisitions so that it was less
under-leveraged on average compared to its target size (the Company's target
asset size and target equity-to-assets ratio are those levels that would be
reached if the Company grew to its maximum asset size as determined by the
Company's internal capital adequacy guidelines; see "Capital
Adequacy/Risk-Adjusted Capital Policy"). In the fourth quarter of 1995, the
actual average equity-to-assets ratio of 19.4% greatly exceeded the target
equity-to-asset ratio of 13.3%. The average balance sheet
42
<PAGE> 43
capacity utilization (or percent of capital employed, as shown in Table 10)
during that period was 69%; this measure is calculated by dividing the target
equity-to-asset ratio by the actual average equity-to-assets ratio. In the
fourth quarter of 1996, average balance sheet capacity utilization was 86%; the
average equity-to-assets ratio was 11.8% and the target equity to assets ratio
was 10.1%.
Another measure of balance sheet leverage is the ratio of spread-funded assets
to equity. This is the ratio of the amount of assets funded by debt at the
Company as divided by the Company's equity. It is similar to a debt-to-equity
ratio. As shown in Table 10, it increased from 4.1 times in the fourth quarter
of 1995 to 7.43 times in the fourth quarter of 1996. As a result, the percentage
of the Company's net interest income that was earned by assets funded with debt
(Table 10: % of net interest income from spread lending) increased to 56% in the
fourth quarter of 1996 while the portion of net interest income earned by assets
funded directly with equity (Table 10: % of net interest income from equity
investment) decreased to 44% of the total.
Management expects, based on market conditions as of December 31, 1996, that the
Company may seek to continue to reduce its balance sheet risks and, in a
corresponding manner, reduce its target equity-to-assets ratio. In addition, the
Company hopes to further improve its capital efficiency and balance sheet
capacity utilization by seeking to make further improvements in matching the
timing of inflows of capital with the acquisition of mortgage assets. If these
goals can be achieved, management believes that the net interest margin would
continue to decline but that net interest income as a percentage of equity might
increase.
Two other significant factors, discussed in "Earning Asset Yield and Interest
Rate Spread", contributed to changes in the net interest margin and net interest
income as a percentage of equity. The decline in the earning asset yield from
7.34% to 6.87% (as a result of declining interest rates and other factors)
reduced earnings on that portion of the balance sheet which was funded directly
with equity capital. The negative effect of this drop in earning asset yield on
return on equity was approximately 0.47%. In addition, the Company's interest
rate spread decreased, although this effect was overwhelmed by the positive
effect of the greater use of leverage which was made possible by the shift in
asset mix towards lower-risk, narrower spread mortgage assets. The net effect of
having a greater amount of spread funded assets but at narrower spreads can be
seen in Table 10 by looking at the spread lending contribution to return on
equity (interest rate spread times the ratio of spread-funded assets to equity).
The spread lending contribution to return on equity increased from 4.61% in the
fourth quarter of 1995 to 7.39% in the fourth quarter of 1996. The remainder of
the 13.22% net interest income return on equity not contributed by spread
lending was contributed by mortgage assets funded directly with equity.
<TABLE>
<CAPTION>
TABLE 10
NET INTEREST INCOME
AVERAGE RATIO SPREAD % OF % OF
NET EQUITY AVERAGE PERCENT OF LENDING NET NET
INTEREST TO TARGET OF SPREAD CONTRIBUTION INTEREST INTEREST
INCOME ASSETS EQUITY CAPITAL FUNDED TO INCOME INCOME
NET RETURN ON RATIO TO EMPLOYED INTEREST ASSETS RETURN FROM FROM
INTEREST AVERAGE DURING ASSETS DURING RATE TO ON EQUITY SPREAD
MARGIN EQUITY PERIOD RATIO PERIOD SPREAD EQUITY EQUITY INVESTMENT LENDING
------- ------- ------ ------ ------ ------ ------ ------- ---------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 2.53% 7.47% 33.8% 10.3% 30% 0.79% 1.94x 1.82% 75% 25%
1995 2.18% 11.32% 19.2% 13.1% 68% 1.12% 4.14x 4.57% 60% 40%
1996 1.70% 13.34% 12.8% 10.6% 83% 1.11% 6.78x 7.52% 44% 56%
1995, Quarter 1 1.98% 11.39% 17.4% 12.1% 70% 1.07% 4.72x 5.07% 55% 45%
1995, Quarter 2 1.69% 12.20% 13.8% 13.0% 94% 0.91% 6.20x 5.61% 54% 46%
1995, Quarter 3 2.69% 11.12% 24.2% 13.3% 55% 1.27% 3.08x 3.92% 65% 35%
1995, Quarter 4 2.18% 11.27% 19.4% 13.3% 69% 1.12% 4.10x 4.61% 59% 41%
1996, Quarter 1 2.19% 16.16% 13.6% 11.8% 87% 1.57% 6.34x 9.99% 38% 62%
1996, Quarter 2 1.86% 12.68% 14.7% 10.9% 74% 1.21% 5.78x 7.02% 45% 55%
1996, Quarter 3 1.59% 12.71% 12.5% 10.5% 84% 1.00% 6.94x 6.91% 46% 54%
1996, Quarter 4 1.56% 13.22% 11.8% 10.1% 86% 0.99% 7.43x 7.39% 44% 56%
</TABLE>
43
<PAGE> 44
Credit Losses and Provisions
Realized credit losses were $3,997 in the fourth quarter of 1995 and $6,520 in
the fourth quarter of 1996. The losses reduced taxable income and dividends by
the indicated amounts for those years, but did not impact reported GAAP net
income as they were previously provided for. As the Company's mortgage loan and
mortgage-backed securities portfolios become seasoned, the Company expects
actual realized credit losses to increase. Over time, the Company expects to
realize losses at a rate similar to its competitors (banks and thrifts) in the
high quality single-family mortgage lending business; this would imply an
increase in losses versus the Company's experience to date.
The Company reduced reported net income by $372,212 in the fourth quarter of
1996 to provide for possible future credit losses. The credit provision in the
fourth quarter of 1995 was $350,631. In each case the bulk of these provisions
related to potential future credit losses in the Company's portfolio of
securitized mortgages rated below BBB.
In general, the Company expects the level of its quarterly credit provision to
grow as the size of the balance sheet grows. Nevertheless, as a percentage of
total assets, credit provisions have been declining (see Table 11). This is
reflective of the Company's efforts over the last year to increase the average
credit quality of its assets by ceasing the acquisition of mortgage securities
rated below AA.
In the fourth quarter of 1996, the Company changed its policy regarding credit
provisions for whole loans. Formerly, the Company took a provision for "A"
quality whole loans at the time of acquisition equal to 0.30% of the principal
value of the mortgages. Such provisions were minor in the fourth quarter of 1995
as the volume of whole loan acquisitions in that quarter was small. In the
fourth quarter of 1996, the Company started taking whole loan credit provisions
on an on-going, rather than a one-time, basis in order to avoid large
unwarranted swings in reported income that could be caused by acquisitions of
bulk loan portfolios. Under the new policy, the Company will take on-going
credit provisions at an annual rate of 0.15% of the principal value of "A"
quality whole loans. Since most whole loan acquisitions in the fourth quarter of
1996 closed at the end of December, whole loan provisions were minor in that
quarter as well. The Company expects credit provisions to increase in 1997.
<TABLE>
<CAPTION>
Table 11
Credit Provisions and Actual Credit Losses
Annualized Annualized
Total Credit Credit
Total Actual Provisions Provisions
Credit Credit to Average to Average
Provisions Losses Assets Equity
---------- ------ ---------- ----------
(dollars in thousands)
<S> <C> <C> <C> <C>
Fiscal 1994 $ 0 $ 0 0.00% 0.00%
1995 493 4 0.22% 1.17%
1996 1,696 7 0.17% 1.34%
1995, Quarter 1 $ 19 $ 0 0.06% 0.34%
1995, Quarter 2 40 0 0.10% 0.72%
1995, Quarter 3 84 0 0.16% 0.65%
1995, Quarter 4 350 4 0.38% 1.95%
1996, Quarter 1 331 0 0.26% 1.93%
1996, Quarter 2 477 0 0.25% 1.69%
1996, Quarter 3 516 0 0.18% 1.43%
1996, Quarter 4 372 7 0.10% 0.82%
</TABLE>
Operating Expenses
The Company has been able to improve its operating efficiency over time. As
shown in Table 12, total operating expenses rose from $0.4 million in the fourth
quarter of 1995 to $0.8 million in the fourth quarter of 1996. As a
44
<PAGE> 45
percentage of assets, however, annualized operating expenses dropped from 0.40%
to 0.21% and as a percentage of equity annualized operating expenses dropped
from 2.04% to 1.75%. Thus the improvement in return on equity over this period
due to increasing operational efficiencies was 0.29%.
The Company expects operating expenses to rise in 1997 as the Company adds staff
and incurs other expenses. The Company generally expects its operating expense
ratios, however, to continue to improve.
<TABLE>
<CAPTION>
Table 12
Operating Expenses
Efficiency
Ratio
(Operating Average
Compensation Expense/ Operating Operating Assets per
and Other Total Net Expense/ Expense/ Ave. # of
Benefits Operating Operating Interest Average Average Employees
Expense Expense Expense Income) Assets Equity ($MM)
------- ------- ------- ------- ------ ------ -----
(dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 63 $ 83 $ 14 28% 0.70% 2.07% $ 12
1995 517 614 1,131 24% 0.52% 2.68% 39
1996 1,573 981 2,554 15% 0.26% 2.01% 109
1995, Quarter 1 $ 81 $120 $ 201 32% 0.64% 3.69% $ 25
1995, Quarter 2 81 117 198 29% 0.48% 3.51% 33
1995, Quarter 3 204 160 364 25% 0.68% 2.81% 39
1995, Quarter 4 151 217 368 18% 0.40% 2.04% 53
1996, Quarter 1 319 174 492 18% 0.39% 2.86% 69
1996, Quarter 2 384 210 594 17% 0.31% 2.11% 84
1996, Quarter 3 390 281 672 15% 0.23% 1.87% 115
1996, Quarter 4 480 316 796 13% 0.21% 1.75% 155
</TABLE>
Per Share Trends
As both the number of shares outstanding and the magnitude of the Company's
assets, equity base, revenues, and expenses have been increasing rapidly,
looking at several components of the Company's financial statements on a
per-share basis can be illustrative. In general, earnings per share growth will
be achieved when the Company can increase assets per share and/or equity per
share (and therefore revenue per share) while restraining the growth of
per-share expenses. Table 13 below shows the Company's assets, equity, and
income statement components on a per average share outstanding basis (including
both common and preferred shares). From the fourth quarter of 1995 to the fourth
quarter of 1996, the Company was able to increase its average assets per average
share by 114%, from $67 to $145. This increase was due to reduced
equity-to-assets ratio targets due to risk reductions in the balance sheet,
rising capital efficiencies resulting in greater balance sheet capacity
utilization, and increasing equity per share values. Revenues per share
increased by 102% and net interest income per share increased by 49% over the
one year period from fourth quarter 1995 to fourth quarter 1996. Because per
share costs of credit expenses and operating expenses remained stable or
declined, total net income per share (including preferred and common shares)
rose 88% from $0.24 to $0.45.
45
<PAGE> 46
<TABLE>
<CAPTION>
Table 13
Per Share Information
Average Average Net Interest Credit Operating
Assets Total Equity Revenues Income Provisions Expenses Net Income
per Average per Average per Average per Average per Average per Average per Average
Common and Common and Common and Common and Common and Common and Common and
Preferred Preferred Preferred Preferred Preferred Preferred Preferred
Share Share Share Share Share Share Share
---------- ---------- ---------- ----------- ---------- ----------- ----------
<S> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 34.52 $ 11.68 $ 0.77 $ 0.31 $ 0.00 $ 0.09 $ 0.22
1995 66.23 12.74 4.75 1.44 0.15 0.34 0.95
1996 119.47 15.24 8.08 2.03 0.20 0.31 1.52
1995, Quarter 1 $ 67.06 $ 11.64 $ 1.16 $ 0.33 $ 0.01 $ 0.11 $ 0.21
1995, Quarter 2 87.31 12.04 1.58 0.37 0.02 0.11 0.24
1995, Quarter 3 54.32 13.15 1.01 0.37 0.02 0.09 0.26
1995, Quarter 4 67.39 13.05 1.20 0.37 0.06 0.07 0.24
1996, Quarter 1 91.83 12.45 1.65 0.50 0.06 0.09 0.35
1996, Quarter 2 98.13 14.42 1.65 0.45 0.06 0.07 0.32
1996, Quarter 3 124.58 15.57 2.10 0.50 0.06 0.07 0.37
1996, Quarter 4 144.55 16.99 2.42 0.55 0.03 0.07 0.45
</TABLE>
Results of Operations: 1996 vs. 1995
For the full years of 1995 and 1996, total net income to common and preferred
shareholders increased by 302%, from $3.2 million to $12.7 million. Total net
income available to common shareholders after preferred dividends increased by
266%, from $3.2 million to $11.5 million. Growth in net interest income,
operating expenses, credit expenses and net income was driven primarily by
growth in average assets. From 1995 to 1996, average assets grew by 354%,
interest income revenue grew by 328%, net interest income grew by 254%, credit
provision expenses grew by 244%, and operating expenses grew by 126%. Average
total equity employed grew by 201%. See Table 1 and Table 15.
Reported earnings per primary common share ("EPS") in 1996 were $1.32. This was
an increase of 55% from the $0.85 earned in 1995. As shown in Table 3, the two
primary components of this increase were a 33% increase in return on average
common equity and a 14% increase in average common equity per common share.
As shown in Table 4, return on total equity rose from 7.47% in 1995 to 9.99% in
1996. Net interest income per dollar of equity rose from 11.32% in 1995 to
13.34% in 1996. Credit expenses increased from 1.17% of equity to 1.34% while
operating expenses dropped from 2.68% of equity to 2.01%. Total equity per share
rose as result of accretive stock offerings and other factors. See Table 5 and
Table 25.
Taxable income rose 296%, from $3.8 million in 1995 to $15.2 million in 1996.
Total dividends declared rose from $3.4 million to $15.2 million. Dividends
declared per common share rose 74%, from $0.96 to $1.67. See Tables 6 and 7.
From 1995 to 1996, the Company's average interest rate spread was stable, moving
from 1.12% in 1995 to 1.11% in 1996. The Company's average earning asset yield
dropped by 42 basis points from 7.37% to 6.95% but this drop was offset by a
cost of funds which was lower by 35 basis points and a cost of hedging which was
lower by 6 basis points. See Table 8.
The increase in net interest income as a percentage of equity from 11.32% to
13.34% was accomplished, despite a lower earning asset yield (which reduces
earnings on mortgages funded with equity) and a stable interest rate spread, as
the Company made greater use of leverage in 1996. The average equity-to-assets
ratio was 19.2% in 1995 and 12.8% in 1996, reflecting a decrease in the target
equity-to-assets ratio from 13.1% to 10.6% and an increase in balance sheet
capacity utilization from 68% to 83%. Primarily as a result of the increased use
of debt funding, the net interest margin declined from 2.18% in 1995 to 1.70% in
1996.
46
<PAGE> 47
Total realized credit losses were $3,997 in 1995 and $6,520 in 1996. Total
credit provisions were $0.5 million in 1995 (1.17% of equity and 0.22% of
assets) and $1.7 million in 1996 (1.34% of equity and 0.17% of assets),
reflecting a changing asset mix. See Table 11.
Operating expenses increased from $1.1 million in 1995 to $2.6 million in 1996.
Operating expense ratios improved as the efficiency ratio (operating expenses to
net interest income) dropped from 24% to 15%, operating expenses to assets
dropped from 0.52% to 0.26%, operating expenses to equity dropped from 2.68% to
2.01% and average assets per employee increased from $39 million to $109
million. See Table 12.
Results of Operations: 1995 vs. Fiscal year 1994
Fiscal year 1994 ("FY1994") represents the period from commencement of
operations on August 19, 1994 to December 31, 1994.
Total net income increased by 726%, from $0.4 million in FY1994 to $3.2 million
in 1995. Growth in net interest income, operating expenses, credit expenses and
net income was driven primarily by the increase in the length of the operating
periods and by growth in average assets. From FY1994 to 1995, average assets
grew by 279%, interest income revenue grew by 1,113%, net interest income grew
by 805%, credit provision expenses grew from zero to $0.5 million, and operating
expenses grew by 675%. Average total equity employed grew by 116%. See Table 1
and Table 15.
Reported earnings per primary common share in 1995 were $0.85. This was an
increase of 325% from the $0.20 earned in FY1994. A longer operating period
accounted for the bulk of this increase. As shown in Table 3, two other
components of this increase were a 38% increase in return on average common
equity and a 9% increase in average common equity per common share.
As shown in Table 4, return on total equity rose from 5.40% in FY1994 to 7.47%
in 1995. Net interest income per dollar of equity rose from 7.47% in FY1994 to
11.32% in 1995. There were no credit expenses in FY1994; credit expenses in 1995
were 1.17% of equity. Operating expenses increased from 2.07% of equity to 2.68%
as the Company increased salaries and added staff. Total equity per share rose
as a result of accretive stock offerings and other factors. See Table 5 and
Table 25.
Taxable income rose from $0.4 million in FY1994 to $3.8 million in 1995. Total
dividends declared rose from $0.4 million to $3.4 million. Dividends declared
per common share rose 284%, from $0.25 to $0.96. See Tables 6 and 7.
From FY1994 to 1995, the Company's average interest rate spread increased from
0.79% in FY1994 to 1.12% in 1995. The Company's average earning asset yield
increased 97 basis points from 6.40% to 7.37%. The Company's cost of funds
increased by 51 basis points from 5.55% to 6.06%. The cost of hedging increased
by 13 basis points from 0.06% to 0.19%. See Table 8.
The increase in net interest income as a percentage of equity from 7.47% to
11.32% was accomplished with a rising earning asset yield (which increases
earnings on mortgages funded with equity) and an increased interest rate spread.
In addition, the Company made greater use of leverage in 1995 as compared to
FY1994. The average equity-to-assets ratio was 33.8% in FY1994 and was 19.2%
times in 1995. Although the Company increased its target equity-to-assets ratio
as it increased levels of credit risk on its balance sheet, balance sheet
capacity utilization increased from 30% in FY1994 to 68% in 1995. See Table 10.
Total realized credit losses were $3,997 in 1995; there were no losses in
FY1994. The Company took no credit provisions in FY1994 due to the low-risk
nature of its mortgage assets at that time; total credit provisions were $0.5
million in 1995 (1.17% of equity and 0.22% of assets). See Table 11.
Operating expenses increased from $0.2 million in FY1994 to $1.1 million in 1995
as a result of a longer operating period. However, the efficiency ratio
(operating expenses to net interest income) dropped from 28%
47
<PAGE> 48
to 24%, operating expenses to assets dropped from 0.70% to 0.52% and average
assets per employee increased form $12 million to $39 million. Operating
expenses to equity increased from 2.07% to 2.68%. See Table 12.
Financial Condition
Summary
Management believes the Company is well capitalized for the level of risk
undertaken. The Company's assets are single-family mortgage assets. 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 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 well matched; all mortgages have
adjustable-rate coupons and are financed with equity and with 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 only takes credit risk on mortgages underwritten to "A"
quality standards. 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. 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.
End of Period Balance Sheet
The Company's assets consist primarily of earning assets (mortgage assets and
cash). As shown in the table below, the Company's assets increased by $1.74
billion or 395% during 1996.
<TABLE>
<CAPTION>
Table 14
End of Period Balance Sheet
Receivables
Interest and
Mortgage Rate Other Total Preferred Common Total
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 $ 872 $ 0 $ 20,280 $ 20,280
1995, Quarter 1 953 141,860 1,434 1,193 145,440 121,998 1,090 0 22,352 22,352
1995, Quarter 2 1,620 175,242 825 1,634 179,321 155,881 907 0 22,533 22,533
1995, Quarter 3 1,150 298,785 809 2,650 303,394 228,826 22,533 0 72,473 72,473
1995, Quarter 4 4,825 432,244 547 3,941 441,557 370,316 2,951 0 68,290 68,290
1996, Quarter 1 9,705 565,159 1,233 5,216 581,313 508,721 2,951 0 68,290 68,290
1996, Quarter 2 10,407 1,007,480 1,351 9,092 1,028,330 896,214 7,821 0 124,295 124,295
1996, Quarter 3 14,599 1,375,870 873 12,136 1,403,478 1,225,094 14,867 29,712 133,805 163,517
1996, Quarter 4 11,068 2,153,428 2,601 17,100 2,184,197 1,953,103 20,089 29,579 181,426 211,005
</TABLE>
Average Daily Balance Sheet
Table 15 presents the estimated average daily balances of the major components
of the Company's balance sheet.
48
<PAGE> 49
<TABLE>
<CAPTION>
Table 15
Average Daily Balance Sheet
Receivables
Interest and
Mortgage Rate Other Total Preferred Common Total
End of Period Cash Assets Agreements Assets Assets BorrowingsPayables Equity Equity Equity
- - ------------- ---- ------ ---------- ------ ------ ------------------ ------ ------ ------
(dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 6,627 $ 49,498 $ 790 $ 947 $ 57,862 $ 37,910 $ 368 $ 0 $ 19,584 $ 19,584
1995 4,272 209,120 993 5,107 219,49 174,926 2,342 0 42,224 42,224
1996 16,016 951,514 1,332 26,605 995,467 861,316 7,131 11,274 115,746 127,020
1995, Quarter 1 $ 1,217 $ 121,116 $1,399 $ 1,959 $ 125,691 $ 102,894 $ 977 $ 0 $ 21,820 $ 21,820
1995, Quarter 2 1,466 158,606 1,020 2,559 163,651 139,979 1,111 0 22,561 22,561
1995, Quarter 3 3,597 204,999 831 4,820 214,247 159,794 2,858 0 51,868 51,868
1995, Quarter 4 10,709 349,296 730 10,999 371,734 295,089 4,654 0 71,991 71,991
1996, Quarter 1 14,639 478,645 667 13,095 507,046 435,979 2,324 0 68,743 68,743
1996, Quarter 2 14,402 729,143 1,658 21,565 766,768 651,643 2,472 0 112,653 112,653
1996, Quarter 3 18,854 1,101,074 1,833 30,129 1,151,890 999,229 8,728 15,179 128,754 143,933
1996, Quarter 4 16,137 1,489,636 1,168 41,430 1,548,371 1,351,510 14,898 29,671 152,292 181,963
</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.
Lower-risk, lower-yield, narrower-spread, higher-priced assets may produce
higher returns on equity across a variety of scenarios for the Company than
riskier assets due to a lower capital allocation to the lower risk asset.
The Company acquired $876 million mortgage assets in the fourth quarter of 1996
and acquired a total of $2.0 billion mortgage assets in 1996. A majority of the
asset acquisitions in the fourth quarter did not close until late December, so
the income from these new assets will not have a significant effect on the
Company's income until the first quarter of 1997.
As shown in Table 16, an increasing percentage of the Company's acquisitions
have consisted of whole mortgage loans. The Company has also continued to
acquire adjustable-rate mortgage securities rated AAA and AA but has not
acquired mortgage securities rated below AA since 1995.
49
<PAGE> 50
<TABLE>
<CAPTION>
Table 16
Mortgage Asset Acquisitions
Average AAA A & Below
Asset Price "A" FHLMC &AA BBB BBB
Acquisitions as % of 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>
Fiscal 1994 $ 121,297 99.53% 5.87% 0.0% 64.8% 28.1% 4.3% 2.8%
1995 354,572 98.06% 7.25% 7.6% 53.7% 25.9% 5.7% 7.1%
1996 1,982,864 102.68% 7.60% 26.6% 45.3% 28.1% 0.0% 0.0%
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%
1996, Quarter 4 875,968 102.86% 7.81% 47.3% 17.5% 35.2% 0.0% 0.0%
</TABLE>
Summary of Mortgage Asset Characteristics
All the Company's mortgage assets acquired through December 31, 1996 were
single-family, adjustable-rate, first-lien mortgages or securitized interests in
pools of such loans. The average credit rating equivalent has been maintained at
AA+. As of December 31, 1996, 44% of the underlying properties of the whole
mortgage loans owned by the Company were located in California and approximately
70% of the properties underlying mortgage pools in which the Company owned a
securitized interest that was rated lower than AA were located in California
(based on the original composition of such pools). The Company carries its
mortgage assets on its balance sheet at the estimated bid-side market value of
these assets, which has approximated their historical amortized cost.
<TABLE>
<CAPTION>
Table 17
Mortgage Asset Summary
Estimated Securitized
Bid-Side Mortgages
Amortized Estimated Market Average Whole Rated
Mortgage Cost to Bid-Side Value to Credit Loans Below AA
Principal Amortized Principal Market Principal Rating Percent in Percent in
End of Period Value Cost Value Value Value Equiv. California California
- - ------------- ----- ---- ----- ----- ----- ------ ---------- ----------
(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+ n/a 71%
1995, Quarter 1 143,393 141,792 98.88% 141,860 98.93% AA+ n/a 72%
1995, Quarter 2 78,429 174,415 97.75% 175,242 98.21% AA+ n/a 72%
1995, Quarter 3 298,718 298,894 100.06% 298,785 100.02% AA+ n/a 70%
1995, Quarter 4 443,625 436,236 98.33% 432,244 97.43% AA+ 75% 70%
1996, Quarter 1 573,807 569,744 99.29% 565,159 98.49% AA+ 76% 70%
1996, Quarter 2 1,005,765 1,011,847 100.60% 1,007,480 100.17% AA+ 73% 70%
1996, Quarter 3 1,361,062 1,377,331 101.20% 1,375,870 101.09% AA+ 85% 70%
1996, Quarter 4 2,117,244 2,155,468 101.81% 2,153,427 101.71% AA+ 44% 70%
</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.
50
<PAGE> 51
<TABLE>
<CAPTION>
Table 18
Average Mortgage Asset Characteristics
Coupon Average
Interest Mortgage Rate vs. Number
Mortgage Rate Mortgage Fully- Fully- of Months
Coupon Index Net Indexed Indexed to Next Lifetime
End of Period Rate Level Margin Rate Rate Adjustment Cap
- - ------------- ---- ----- ------ ---- ---- ---------- ---
<S> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 6.00% 6.94% 2.25% 9.19% (3.19%) 3 11.48%
1995, Quarter 1 6.53% 6.47% 2.24% 8.71% (2.18%) 3 11.57%
1995, Quarter 2 6.94% 5.99% 2.21% 8.20% (1.26%) 3 11.54%
1995, Quarter 3 7.35% 5.86% 2.20% 8.06% (0.71%) 4 11.56%
1995, Quarter 4 7.50% 5.44% 2.08% 7.52% (0.02%) 3 11.54%
1996, Quarter 1 7.59% 5.47% 2.11% 7.58% 0.01% 3 11.53%
1996, Quarter 2 7.42% 5.72% 2.21% 7.93% (0.51%) 4 11.71%
1996, Quarter 3 7.55% 5.70% 2.21% 7.91% (0.36%) 4 11.69%
1996, Quarter 4 7.75% 5.58% 2.24% 7.82% (0.07%) 5 11.73%
</TABLE>
As shown in Table 19, over the course of 1996 the Company increased its
percentage of mortgage assets which had coupon rates adjusting as a function of
short-term U.S. Treasury interest rate indices. Such assets represented 58% of
all mortgage assets as of December 31, 1996. Since changes in the cost of the
Company's liabilities are generally correlated with changes in LIBOR rates, the
Company's spread income will be diminished should LIBOR rates rise relative to
U.S. Treasury rates. Management expects that this effect, should it occur, would
be offset to some degree by the interest rate agreements (caps, swaps, and basis
swaps) owned by the Company.
<TABLE>
<CAPTION>
Table 19
Mortgage Assets by Index
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
% of Total Mortgage Assets at Period End
----------------------------------------
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%
1996, Quarter 4 35.9% 1.4% 2.5% 56.1% 2.0% 2.1%
</TABLE>
The table below shows the balance of the Company's whole mortgage loans and the
Company's securitized mortgage assets segregated by credit rating equivalent.
Due to the "A" quality underwriting and documentation standards of the Company's
whole 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. As
a result, management believes that percentage of the Company's balance sheet
which had the equivalent of a AAA or AA rating was effectively 88% at December
31, 1995 and 95% at December 31, 1996.
51
<PAGE> 52
<TABLE>
<CAPTION>
Table 20
Mortgage Assets by Credit Rating Equivalent
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%
1996, Quarter 4 525,475 1,576,595 25,738 25,620 24.4% 73.2% 1.2% 1.2%
</TABLE>
Whole Mortgage Loans
The Company significantly increased the size of its whole mortgage loan
portfolio (mortgage loans which have not been securitized) in 1996. The table
below presents selected characteristics of the Company's whole mortgage loans.
52
<PAGE> 53
<TABLE>
<CAPTION>
Table 21
Whole Mortgage Loan Summary
At December 31, 1996 At December 31,1995
------------------- -------------------
(All ratios based on % of total loan portfolio balances (All dollars in thousands)
<S> <C> <C>
unless noted)
Face or Principal Value $ 515,033 $ 26,411
Carrying or Market Value 525,475 26,450
Adjustable-Rate 100% 100%
Single-Family 100% 100%
"A" Quality Underwriting 100% 100%
First Lien 100% 100%
Primary Residence 94% 100%
Property Located in Northern California 18% 30%
Property Located in Southern California 26% 44%
Top Ten States as of 12/31/96
California 43.5% 74.5%
Maryland 8.0% 1.6%
Virginia 4.3% 0.9%
Florida 4.2% 1.1%
Illinois 3.8% 0.0%
Massachusetts 3.4% 1.7%
New York 3.1% 0.0%
Connecticut 3.0% 1.3%
New Jersey 2.8% 1.2%
Texas 2.3% 3.9%
Number of Loans 2,172 109
Average Loan Size $ 237 $ 242
Loan Balance less than $214,600 23% 11%
Loan Balance greater than $500,000 8% 23%
Average Original Loan-to-Value Ratio (LTV) 77% 76%
Original LTV > 80% 25% 26%
% of Original LTV > 80% with Primary Mortgage Insurance 97% 100%
Effective Original LTV including Primary Mortgage 73% 72%
Insurance
1989 and Prior Years Origination 9% 0%
1990 Origination 4% 0%
1991 Origination 2% 0%
1992 Origination 4% 0%
1993 Origination 14% 0%
1994 Origination 52% 2%
1995 Origination 7% 98%
1996 Origination 8% 0%
Average Seasoning in Months 37 4
Non-Performing Assets (90+ days delinquent + f/c + REO) $ 1,249 $ 0
Number of Non-Performing Loans (NPAs) 7 0
Non-Performing Assets as % of Total Loan Balances 0.2% 0.0%
Real Estate Owned Assets (REO) $ 196 $ 0
Number of Real Estate Owned Assets 1 0
Real Estate Owned Assets as % of Total Loan Balances 0.04% 0.00%
</TABLE>
At December 31, 1996, the Company owned 2,172 whole mortgage loans with a total
principal balance of $515.0 million; at December 31, 1995 the Company owned 109
whole mortgage loans with a total principal balance of $26.4 million. All of
these whole loans were adjustable-rate, single-family loans underwritten to "A"
quality standards. At the end of 1996, the average whole loan size was $237,233.
California loans represent 44% of the total outstanding balance. Loans with
original loan-to-value ratios (LTV) in excess of 80% represent 25% of the total
outstanding balance; a substantial majority of these higher-LTV loans are
credit-enhanced with primary mortgage insurance serving to bring the effective
original LTV ratio on each of those loans to 75% or less. After giving effect to
this mortgage insurance, the average original LTV ratio of the Company's whole
loans was 73% at
53
<PAGE> 54
December 31, 1996. The ratio of the current loan balance to original home value
is lower than the original LTV ratios detailed here due to pay downs of mortgage
principal over time.
The Company defines non-performing assets ("NPAs") as whole loans which are
delinquent more than 90 days, in foreclosure or real estate owned (REO). As of
December 31, 1996, the Company's NPAs were $1.2 million, with six loans in
foreclosure and one real estate owned. At December 31, 1995 the Company had no
non-performing assets. Through December 31, 1996, the Company has experienced no
actual whole loan credit losses. Management expects actual credit losses to
occur in 1997 and eventually expects its whole loan credit losses to mirror the
experience of the "A" quality single-family residential mortgage market as a
whole. The Company is building a reserve for potential future credit losses; see
"Credit Reserves".
Securitized Mortgages Rated AAA to BBB
At December 31, 1996, 74% 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 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 investment-grade mortgage securities has credit-enhancement from a
third-party which provides the Company with full or 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. Through December 31, 1996, the Company has experienced no
actual credit losses from these mortgage assets.
Securitized Mortgages Rated Below BBB
In 1994 and 1995, the Company acquired a limited amount of securitized mortgage
assets with a credit rating equivalent of less than BBB. A substantial majority
of the mortgages in the pools underlying these securities were underwritten to
"A" quality standards. The Company may acquire additional such assets when
management believes that the cash flow and return on average equity over the
life of the asset, net of expected credit losses, will be attractive. 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. Such assets had an estimated bid-side
market value at December 31, 1996 of $25.6 million.
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. This would tend to increase the Company's earnings as
it amortizes these discount balances into income.
Approximately 98% of the Company's securitized assets with a credit rating
equivalent below BBB are credit-enhanced to some degree. These assets are
credit-enhanced 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 is likely to be significant as these
interests are subordinated to and provide credit-enhancement for other, more
senior, interests issued from the same mortgage pool. In effect, the Company is
providing a form of mortgage credit insurance to the senior interests in each of
these pools and therefore the Company would bear the credit risk of the entire
pool (which would be many times the size of the Company's interest) in the event
that the credit-enhancement junior to the Company's interest is exhausted. Total
potential credit losses to the Company are limited to the Company's cost basis
in these assets.
54
<PAGE> 55
In some of the mortgage pools underlying these securities, delinquencies
currently exceed management's original expectations. Delinquency levels in most
of these pools appeared to have stabilized during 1996.
Actual pool credit losses which have reduced the credit-enhancement protection
to the Company's below BBB-rated interests have occurred, but most of the
aggregate credit enhancement in these pools that existed at the time of
acquisition was still intact at December 31, 1996. The Company has experienced
no credit losses from these credit-enhanced assets in 1994, 1995, or 1996.
In 1995, the Company acquired two "first loss" assets. These are subordinated
interests with no credit-enhancement. At December 31, 1995, the estimated market
value of these assets approximated their historical amortized cost of $0.2
million; at December 31, 1996, the estimated market value was $0.3 million. All
credit losses in the related pools of mortgages will reduce the principal value
of these first loss assets and will be recognized as an actual credit loss by
the Company. As the Company's cost basis in its 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. The limit of the Company's potential credit losses on these assets is
equal to the amortized cost of $0.2 million. Total actual credit losses realized
by the Company on these first loss assets were $3,997 in 1995 and $6,520 in
1996.
Credit Reserves
The Company has been building a credit reserve for future potential credit
losses through taking quarterly credit provisions. These credit provisions
reduce reported GAAP earnings (but only future actual credit losses will reduce
taxable earnings and dividends). 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 whole loans and loans in the mortgage pools underlying
the Company's securitized mortgage assets which are seriously delinquent (90+
days delinquent, foreclosures and real estate owned). 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 (net of recoveries from any
individual loan private mortgage insurance), 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 the Company's whole loan and mortgage
securities portfolios at December 31, 1996 were to default and result in a loss.
For example, if 100% these seriously delinquent loans were to default and the
loss severity experienced was 25% of the loan balance, credit losses to the
Company would be $1,374,000 (63% of the current credit reserve). If such losses
happen, most of them would likely occur over the next twelve months (during
which time the Company will continue to take credit provisions and build its
reserve). The amount of actual credit losses that will be incurred from these
loans is unknown. This table below addresses the potential credit risk arising
from serious delinquencies as of December 31, 1996 only; it does not purport to
reflect potential losses that may occur over the life of these assets. In order
to complete the evaluation of the adequacy of its reserve levels, the Company
also considers additional credit losses that may arise from future
delinquencies. See also "Results of Operations, Credit Provisions".
55
<PAGE> 56
<TABLE>
<CAPTION>
Table 22
Potential Future Credit Losses Estimated Based on
Current 90+ Day Delinquencies Only
Cumulative Potential Potential Potential Potential Potential Potential
Estimated Future Future Future Future Future Future
Actual Losses Losses Losses Losses Losses Losses
Realized Assuming Assuming Assuming Assuming Assuming Assuming
Credit Loss Loss Loss Loss Loss Loss Loss
Loss Severity Severity Severity Severity Severity Severity Severity
End of Period Reserve Experience 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
1996, Quarter 4 2,180 26% 99 148 679 1,374 2,147 3,122
</TABLE>
The mortgage securities rated below BBB owned by the Company had a historical
amortized cost basis on the Company's books $15.2 million below the principal
value of such mortgage interests as of December 31, 1996. While this $15.2
million is not a credit reserve per se, the discount basis of these assets
should serve to offset a portion of any actual losses of principal due to credit
that may occur in these assets in the future. To the extent such losses are not
incurred, this $15.2 million discount will be amortized into the Company's
reported income over time as the mortgage principal of these assets pay down.
Due to their subordinated status, many of these below BBB-rated assets are not
currently receiving significant principal pay downs; unless impacted by poor
credit performance, the Company should start to receive a reasonable flow of
principal pay downs from these assets in three to ten years and thus may be able
to accelerate its amortization of its discount balances into income.
Interest Rate Agreements
The Company's interest rate agreements had a historical amortized cost basis of
$6.2 million at December 31, 1996 and $2.5 million at December 31, 1995. There
is a risk that the counter-parties to the interest rate agreements will not be
able to perform to the terms of these contracts. If this were to happen, the
Company's total accounting exposure would be limited to its historical amortized
cost basis in these assets, although the true economic opportunity cost to the
Company could be higher. Each of the twelve counter-parties to the Company's
interest rate agreements had a credit rating of at least "A" as of December 31,
1996. See "Note 3. Interest Rate Agreements" in the Notes to Financial
Statements for additional information.
Borrowings
At the end of 1996, the Company's debt consisted of collateralized borrowing
arrangements of various types (reverse repurchase agreements, notes payable,
revolving lines of credit). All such borrowings were short-term. During 1996,
the Company borrowed from fourteen different collateralized lenders. The
Company's ability to roll over such borrowings when they mature depends on the
market value, liquidity and credit quality of its assets, the soundness of the
Company's balance sheet as a whole, the state of the collateralized lending
market, and other factors. See "Note 5. Short-Term Borrowings" in the Notes to
Financial Statements for additional information. The Company has established
uncommitted borrowing facilities in this market in amounts in excess of its
current requirements.
On average, the Company believes that its average 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.
56
<PAGE> 57
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 a market level on a
monthly basis during the term of the borrowing, so the
term-to-next-rate-adjustment may be shorter than the term-to-maturity. At
December 31, 1996, the weighted average term-to-maturity was 98 days and the
weighted average term-to-next-rate-adjustment was 55 days; 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 adjusts the maturities and
other terms of its borrowings over time based on the interest rate
characteristics of its balance sheet, the degree to which interest rate risk has
been reduced through the use of interest rate agreements and other factors.
<TABLE>
<CAPTION>
Table 23
Borrowing Summary
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% 33,719 121,998 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% 282,442 228,826 38 days 31 days 5.95%
1995, Quarter 4 432,244 94.6% 409,014 370,316 74 days 26 days 6.01%
1996, Quarter 1 565,159 95.2% 537,874 508,721 48 days 19 days 5.62%
1996, Quarter 2 1,007,480 95.9% 965,795 896,214 72 days 72 days 5.70%
1996, Quarter 3 1,375,870 96.2% 1,324,220 1,225,094 102 days 71 days 5.78%
1996, Quarter 4 2,153,427 96.5% 2,077,098 1,953,103 98 days 55 days 5.83%
</TABLE>
Liquidity
A financial institution has ample liquidity when it is able, without seriously
disrupting its operations, 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 above in Table 23) less total borrowings and is based on the
market value of the Company's assets and market conditions in the collateralized
lending markets at period-end. Unused borrowing capacity will vary over time as
the market value of the Company's mortgage assets and market conditions
fluctuate and due to other factors. Potential immediate sources of liquidity
totaled $43 million at December 31, 1995 and $129 million at December 31, 1996.
The maintenance of liquidity is one of the goals of the Company's risk-adjusted
capital policy; under this policy, asset growth is limited in order to preserve
unused borrowing capacity for liquidity management purposes.
The Company's balance sheet generates liquidity on an on-going basis through
mortgage principal repayments and net earnings held prior to payment as
dividends. The Company's operations through December 31, 1996 have been cash
flow positive. 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 (although such sales could cause
realized losses). The table below shows the potential immediate sources of
liquidity available to the Company.
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<PAGE> 58
<TABLE>
<CAPTION>
Table 24
Sources of Liquidity
Potential
Immediate
Sources of
Liquidity Net
Estimated (Cash + Income Adjustments Net Cash
Unused Est. Unused Mortgage Before to Reconcile Provided
Cash Borrowing Borrowing Principal Preferred Net Income by Operating
Balance Capacity Capacity) Repayments Dividends to Net Cash Activities
------- --------- ---------- ---------- --------- ----------- -----------
(dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 1,027 $ 11,907 $ 12,934 $ 1,244 $ 382 $ 501 $ (119)
1995, Quarter 1 953 11,721 12,674 2,673 401 (191) 211
1995, Quarter 2 1,620 11,311 12,931 2,934 450 (870) (420)
1995, Quarter 3 1,150 53,616 54,766 8,319 994 (393) 601
1995, Quarter 4 4,825 38,698 43,523 24,898 1,310 (68) 1,242
1996, Quarter 1 9,705 29,153 38,858 32,814 1,954 127 2,081
1996, Quarter 2 10,407 69,581 79,988 53,058 2,500 320 2,820
1996, Quarter 3 14,599 99,126 113,725 76,942 3,387 5,553 8,940
1996, Quarter 4 11,068 123,995 135,063 95,610 4,844 1,790 6,634
</TABLE>
Stockholders' Equity
During 1996, the Company's equity base grew from $68 million to $211 million.
This growth was the result of the Company's April 1996 common stock offering
($55 million), the August 1996 preferred stock offering ($30 million), the
November 1996 common stock offering ($39 million), proceeds from the issuance of
common stock upon the exercise of warrants ($19 million), positive
mark-to-market adjustments on the Company's assets ($2 million), and common
stock sold pursuant to the Company's Dividend Reinvestment Plan ($1 million). A
downward adjustment to stockholders' equity of $3 million was made during 1996
because dividend distributions (which are based on taxable income, see "Results
of Operations - Taxable Income") have exceeded GAAP income.
Book value, or equity, per share (including common and preferred) increased by
42% from $12.38 to $17.58 during 1996. See Table 25.
For balance sheet purposes through December 31, 1996, the Company has valued 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 may fluctuate due to market conditions and other factors. The
difference between market value and historical amortized cost, or "Net
Unrealized Loss on Assets Available for Sale", was $2.7 million, or 0.2% 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.
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<PAGE> 59
<TABLE>
<CAPTION>
Table 25
Stockholders' Equity
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
1996, Quarter 4 139 (3,599) (3,460) (0.2%) 214,465 211,005 17.87 17.58
</TABLE>
Capital Adequacy/Risk-Adjusted Capital Policy
As a result of a change in asset mix towards assets with lower average levels of
credit, interest rate, and liquidity risk, the average amount of capital the
Company seeks to hold per dollar of asset on its balance sheet (its target
equity-to-assets ratio) decreased from 12.6% at December 31, 1995 to 10.0% at
December 31, 1996.
The target equity-to-assets ratio is determined through a Board-level process
determined by the Company's Risk-Adjusted Capital Policy. A target
equity-to-assets ratio is set for each of the Company's assets, based on the
Company's assessment of that asset's inherent credit risk, interest rate risk,
liquidity risk, ease of use as collateral for borrowings, and other
characteristics. The Company endeavors to hold enough capital for each asset to
act as a cushion to allow the Company to maintain operations under a wide
variety of adverse circumstances. 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%.
The formulas for determining the Company's per-asset capital requirements have
not changed significantly since the founding of the Company. Individual asset
capital allocations will vary over time as a function of the level of interest
rates compared to the periodic and life caps in the asset, trends in credit
quality, ease of use as collateral for borrowings, and other factors.
The Company's aggregate target equity-to-assets ratio is the sum of the capital
requirements for all of its individual assets divided by total assets. The
target equity-to-assets ratio for the Company as a whole will vary over time as
a result of the individual asset factors and as a function of its asset mix.
Due to market fluctuations and other factors, the Company may from time to time
have an actual equity-to-assets ratio that is lower than its target
equity-to-assets ratio. When this occurs, management will cease the acquisition
of new mortgage assets and will make plans to bring the Company's capital levels
back into compliance with its guidelines over time.
In certain limited circumstances and in limited amounts, the Company may, prior
to a planned equity offering, acquire or commit to acquire assets in excess of
the levels proscribed by its Risk-Adjusted Capital levels. For example, the
Company ended 1996 with assets of $68 million in excess of what could have been
supported by its capital base in the absence of this special provision. The
Company's capital ratios were brought back within its standard Risk-Adjusted
Capital guidelines through the Company's January 1997 secondary common stock
offering.
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<PAGE> 60
If the Company could continue to move towards a lower- risk balance sheet
(through acquiring higher-quality more-liquid mortgage assets, acquiring
mortgages with no periodic caps, replacing short-term debt with long-term debt,
or other such means), the Company would seek to lower its target
equity-to-assets ratio in what it believes to be an appropriate manner.
In general, the Company has been operating on average with significantly fewer
assets than would have been allowed under its Risk-Adjusted Capital system. The
average equity-to-assets ratio has exceeded the target equity-to-assets ratio;
the Company's balance sheet capacity has been under-utilized. Average balance
sheet capacity utilization was 68% in 1995, with an average equity-to-assets
ratio of 19.2% as compared to an average target equity-to-assets ratio of 13.1%.
Average balance sheet capacity utilization was 83% in 1996, with an average
balance sheet capacity utilization of 12.8% as compared to an average target
equity-to-assets ratio of 10.6%. The Company's rate of asset growth makes it
difficult for the Company to achieve optimum capital efficiency. The Company
generally raises equity capital before the acquisitions of related mortgage
assets settle on its balance sheet. The Company hopes to increase its capital
efficiency in the future through use of its equity shelf registration and
through committing to acquire some assets in advance of planned equity offerings
as described above.
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 Policy.
<TABLE>
<CAPTION>
Table 26
Excess Capital and Asset Growth Potential
Actual Potential Asset
End of Asset Growth
Target Period Size Potential
Equity Equity with with
to to Same Actual Same
Equity Assets Assets Excess Asset Asset Asset
End of Period Capital Ratio Ratio Capital Mix Size Mix
- - ------------- ------- ----- ----- ------- --- ---- ---
(dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C>
Fiscal 1994 $ 20,280 10.84% 16.69% $ 6,716 $ 187,048 $ 121,528 $ 65,520
1995, Quarter 1 22,352 12.41% 15.37% 3,970 180,173 145,440 34,733
1995, Quarter 2 22,533 12.95% 12.57% (1,069) 173,989 179,321 (5,332)
1995, Quarter 3 72,473 13.08% 23.89% 32,155 554,183 303,394 250,789
1995, Quarter 4 68,290 12.59% 15.47% 12,028 542,431 441,557 100,874
1996, Quarter 1 68,146 11.72% 11.72% 26 581,540 581,313 227
1996, Quarter 2 124,295 10.77% 12.09% 13,566 1,154,303 1,028,330 125,973
1996, Quarter 3 163,517 10.32% 11.65% 18,664 1,584,315 1,403,478 180,837
1996, Quarter 4 211,005 9.97% 9.66% (6,798) 2,116,028 2,184,197 (68,169)
</TABLE>
Class B Preferred Stock
In August 1996 the Company issued 1,006,250 shares of Class B Preferred Stock.
As of December 31, 1996, these shares traded on NASDAQ under the symbol RWTIP.
The liquidation preference of each share of Class B Preferred is $31.00.
Preferred holders receive a quarterly dividend equal to the greater of $0.755 or
the common stock dividend. Each share of Class B Preferred is convertible at any
time at the option of the holder thereof into one share of common stock (subject
to possible future adjustment in certain circumstances); the Company has the
right to force this conversion on or after October 1, 1999 providing that the
market price of the common stock for a period of time prior to such redemption
exceeds the conversion price (initially equal to the issue price of $31.00). The
Company also has the right to call the Preferred for $31.00 per share in cash
starting October 1, 1999. See "Note 7. Class B 9.74% Cumulative Convertible
Preferred Stock" in the Notes to Financial Statements for additional
information.
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<PAGE> 61
Warrants
At December 31, 1996, the Company had 412,894 warrants outstanding; at December
31, 1995 the Company had 1,665,063 warrants outstanding. In 1996, over 1.2
million warrants were exercised generating additional equity proceeds to the
Company of $18.8 million. As of December 31, 1996, the remaining warrants traded
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. See "Note 8. Stock Purchase Warrants" in the Notes to Financial
Statements for additional information. 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 $6.2 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 long-term pattern of net income which grows over time relative
to its competitors in the banking and savings and loan industries.
Changes in interest rates, mortgage principal repayment rates, and other factors
are likely, however, to cause short-term volatility in the Company's reported
EPS results; the Company generally does not seek to hedge away or otherwise
significantly reduce this potential short-term earnings volatility.
The Company has sought 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. Should the Company
acquire other types of mortgages (including fixed rate mortgages) in the future,
the Company anticipates it will seek to reduce interest rate risks through
funding with appropriately matched debt, through hedging, or other means. In
general, the Company does not seek to anticipate future changes in interest
rates. The Company seeks to prepare itself for a variety of possible future
interest rate environments.
A primary goal of the Company's asset/liability strategy is to preserve
liquidity by managing the net market value of the Company's balance sheet as
shown in the stockholders' equity account. Through December 31, 1996, all of the
Company's borrowings were secured by the market value of its mortgage assets. In
seeking to preserve liquidity and the Company's ability roll over short-term
borrowings, the Company allocates what it believes to be a sufficient amount of
capital to each mortgage asset and the Company has undertaken a hedging program
utilizing interest rate agreements. In the event of an increase in short-term
and/or long-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.
Management believes that the combined effect of the Company's equity allocations
and its hedging program are likely to preserve liquidity for the Company in most
interest rate environments. See "Asset/Liability Management and Effect of
Changes in Interest Rates -- Equity Duration" below. The market value of the
Company's mortgage assets can also fluctuate as a function of changes in supply
and demand, market volatility, and other factors which may be difficult or
impossible to hedge.
Changes in interest rates also may have an effect on the rate of mortgage
principal repayment; the Company has sought in the past to mitigate the economic
effect of changes in the mortgage principal repayment rate by balancing assets
purchased at a premium with assets purchased at a discount. Such balancing was
not possible in 1996, however, as virtually all mortgage assets which were
available for acquisition from the secondary mortgage market and which were
otherwise attractive to the Company were priced at a premium. As a result, the
Company has significantly increased its net unamortized premium balance relative
to the size of its balance sheet. Potential short-term earnings volatility with
respect to changes in mortgage principal repayment rates has increased as a
result. At December 31, 1996, the Company estimates that its quarterly EPS in
the short-term
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<PAGE> 62
would be decreased by approximately $0.01 for each one percentage point increase
in the Company's rate of mortgage principal repayment, all other factors being
equal; EPS would increase in a similar manner should principal repayment rates
slow.
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 December 31, 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 that most 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, given the balance sheet as of December 31, 1996, could be an
initial increase in earnings followed by decreased earnings after a lag period.
The Company's change in its mix of assets throughout 1996 increased the
Company's basis risk between LIBOR interest rates and U.S. Treasury bill
interest rates. The majority of the Company's assets at year-end had coupons
which changed as a function of U.S. Treasury bill rates while all the Company's
borrowings had a cost of funds which tends to change in conjunction with changes
in LIBOR rates. The Company believes its interest rate agreements mitigate to
some degree the extent to which a reduced spread for the Company would result
from LIBOR rates rising relative to U.S. Treasury interest rates. See "Note 3.
Interest Rate Agreements" in the Notes to Financial Statements for additional
information.
Should the Company continue its funding strategy in effect at December 31, 1996,
the Company's short-term earnings will also fluctuate to some extent with
changes in the relationship between six and twelve month interest rates (off of
which the coupons on Company's mortgage assets adjust) and one to six month
interest rates (on which the Company's cost of funds is based). All other
factors being equal, a flatter yield curve in the short end of the yield curve
(when six and twelve month rates are low relative to one to six month rates) may
have a negative effect on the Company's spread earnings.
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 were to achieve this goal, the Company's return on average equity,
earnings and dividends would, over longer periods of time, rise as short-term
interest rates rise, fall as short-term interest rates fall, and thus maintain a
constant or widening spread to the level of short-term interest rates over time.
Should long-term interest rates rise while short-term interest rates remain
stable, management expects, based on the Company's balance sheet as of December
31, 1996, that mortgage principal repayment rates may slow (thus benefiting
earnings) but the market value of the Company's assets, net of hedges, would
likely fall (thus potentially reducing the amount of assets the Company could
carry on its balance sheet). Other effects may occur in such a circumstance as
well.
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 five years 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
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<PAGE> 63
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 effects of "lookbacks" whereby
coupons on Company assets are set based on interest rates one to three months
prior, 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 three-month cumulative gap as a percentage of total assets was
negative 28% at December 31, 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 twelve-month
gap of positive 10% at December 31, 1996. This implies that the impact on net
interest income of increasing interest rates may be positive after several
quarters 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 basis,
what the actual impact of such interest rate changes on the Company's net income
would be, especially over shorter time periods.
The Company has a positive interest rate sensitivity gap for periods of one year
or longer 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).
<TABLE>
<CAPTION>
Table 27
Interest Rate Sensitivity Gap excluding Interest Rate Agreements
Cumulative Cumulative Cumulative Cumulative Cumulative Cumulative
3-Month 6-Month 9-Month One Year Three Year Five Year
Gap Gap Gap Gap Gap Gap
as a % of as a % of as a % of as a % of as a % of as a % of
Total Total Total Total Total Total
End of Period Assets Assets Assets Assets Assets Assets
- - ------------- ------ ------ ------ ------ ------ ------
<S> <C> <C> <C> <C> <C> <C>
Fiscal 1994 5% 15% 15% 15% 15% 15%
1995, Quarter 1 (27%) 14% 14% 14% 14% 14%
1995, Quarter 2 (33%) 11% 12% 12% 12% 12%
1995, Quarter 3 (19%) 18% 20% 23% 23% 23%
1995, Quarter 4 (26%) 9% 12% 15% 15% 15%
1996, Quarter 1 (34%) 4% 8% 11% 11% 11%
1996, Quarter 2 (3%) (2%) 5% 12% 12% 12%
1996, Quarter 3 (9%) (4%) 3% 12% 12% 12%
1996, Quarter 4 (28%) (12%) (1%) 10% 10% 10%
</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. These agreements also serve to remove some of the short-term risk
arising from
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<PAGE> 64
funding assets that have fixed coupon adjustments for six to twelve months with
liabilities that are fixed, on average as of December 31, 1996, for a three
month shorter period of time. In addition, the interest rate agreements are
designed to appreciate in market value in most circumstances in which short-term
and/or long-term interest rates rise sharply, thereby partially offsetting
likely concurrent declines in the market value of the Company's mortgage assets.
Interest Rate Futures and Options
The Company has used interest rate futures and may use 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; the Company uses them in a similar manner and for hedging purposes
only. The Company currently limits 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 limits its use of futures and listed options so that its profits from
such instruments will be limited to 5% or less of the Company's gross taxable
income on an annual basis. The Company had no positions in futures or options on
futures at December 31, 1995 or December 31, 1996.
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 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.
Seasonal Effects
There are three factors that management has identified which may have seasonal
effects on the Company's earnings. First, management believes that in many years
there may be more mortgage assets for sale by motivated sellers in the fourth
quarter of the year than at any other time. If this is true, in many years the
Company could grow at a faster rate in the fourth quarter than at other times of
the year. Secondly, mortgage principal repayment rates have a seasonal pattern
of slowing in the winter and accelerating in the summer. Since the Company's
premium amortization expenses are based on the Company's actual monthly
principal repayment experience, overall earnings may be higher, all other things
being equal, in the winter months. Finally, there is a mismatch in the day-count
method that is used each month to determine the Company's interest income from
mortgages and its interest expense from collateralized borrowings. As a result,
given the characteristics of the Company's balance sheet as of December 31, 1996
and assuming all other factors are equal, net interest income should tend to be
higher in quarters, such as the first and second quarters of the year, that have
fewer days.
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<PAGE> 65
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements of the Company and the related notes, together
with the Independent Auditors' Report thereon, are set forth on pages
F-3 through F-19 of this Form 10-K and incorporated herein by
reference.
Item 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 10 as to directors and executive
officers of the Company is incorporated herein by reference to the
definitive Proxy Statement to be filed pursuant to Regulation 14A under
the headings "Election of Directors" and "Management of the Company."
Item 11. EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated herein by reference
to the definitive Proxy Statement to be filed pursuant to Regulation
14A under the heading "Executive Compensation."
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 12 is incorporated herein by reference
to the definitive Proxy Statement to be filed pursuant to Regulation
14A under the heading "Security Ownership of Certain Beneficial Owners
and Management."
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
None.
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<PAGE> 66
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Documents filed as part of this report:
(1) Financial Statements
(2) Schedules to Financial Statements:
All financial statements schedules not included have been
omitted because they are either inapplicable or the
information required is provided in the Company's Financial
Statements and Notes thereto, included in Part II, Item 8, of
this Annual Report on Form 10-K.
(3) Exhibits:
<TABLE>
<CAPTION>
Exhibit
Number Exhibit
------- -------
<S> <C>
3.1 Articles of Amendment and Restatement of the Registrant (a)
3.2 Articles Supplementary of the Registrant (a)
3.3 Amended and Restated Bylaws of the Registrant (b)
3.3.1 Amended and Restated Bylaws, amended December 13, 1996 (g)
3.4 Articles Supplementary of the Registrant, dates August 14, 1995 (d)
3.4.1 Articles Supplementary of the Registrant relating to the Class B 9.74%
Cumulative Convertible Preferred Stock, filed August 9, 1996
(the "Preferred Stock") (f)
4.2 Specimen Common Stock Certificate (a)
4.3 Specimen Class B 9.74% Cumulative Convertible Preferred Stock
Certificate (f) 10.1 Purchase Terms Agreement, dated August 18, 1994,
between the Registrant and Montgomery Securities (a)
10.2 Registration Rights Agreement, dated August 19, 1994, between the Registrant and
Montgomery Securities (a)
10.3 Warrant Agreement, dated August 19, 1994, between the
Registrant and the Holders of the Warrants Acting
Through the Registrant as the Initial Warrant Agent (a)
10.4 Founders Rights Agreement, dated August 19, 1994, between the Registrant and the
original holders of Common Stock of the Registrant (a)
10.5 Form of Reverse Repurchase Agreement for use with Agency Certificates, Privately-
Issued Certificates and privately-issued CMOs (a)
10.5.1 Form of Reverse Repurchase Agreement for use with Whole Loan Mortgages (d)
10.6.1 Amended and Restated Loan and Security Agreement, dated as of May 26, 1995,
between the Registrant and Paine Webber Real Estate Securities, Inc. (d)
10.7 Pledge and Security Agreement, dated as of March 29, 1995, between the Registrant
and Greenwich Capital Financial Products, Inc. (a)
10.8 Forms of Interest Rate Cap Agreements (a)
10.9 Custody Agreement, dated August 22, 1994, between the Registrant and
Mellon Bank N.A. (b)
10.9.2 Clearance Agreement, dated December 1, 1996, between the Registrant and Bankers
Trust Company (d)
10.10 Employment Agreement, dated August 19, 1994, between the Registrant and
George E. Bull (a)
10.11 Employment Agreement, dated August 19, 1994, between the Registrant and
Douglas B. Hansen (a)
10.12 Employment Agreement, dated August 19, 1994, between the Registrant and
Frederick H. Borden (a)
10.13 Employment Agreement, dated August 19, 1994, between the Registrant and
Vickie L. Rath (a)
10.14 1994 Amended and Restated Executive and Non-Employee Director Stock
Option Plan (c)
</TABLE>
66
<PAGE> 67
<TABLE>
<S> <C>
10.14.1 1994 Amended and Restated Executive and Non-Employee Director Stock Option
Plan, amended March 6, 1996 (d)
10.14.2 Amended and Restated 1994 Executive and Non-Employee Director Stock Option
Plan, amended December 13, 1996 (h)
10.27 Administrative Services Agreement, dated August 19, 1994, between the
Registrant and GB Capital (a)
10.28 Form of Warrant Agent Agreement between the Registrant and Chemical
Mellon Shareholder Services, LLC, dated as of July 18, 1995 (a)
10.29 Form of Dividend Reinvestment Plan (b)
10.29.1 Form of Dividend Reinvestment and Stock Purchase Plan (g)
10.30 Office Building Lease (d)
10.30.1 Amendment to Office Building Lease
11.31 Statement re Computation of Per Share Earnings
23.1 Consent of Independent Accountants
27 Financial Data Schedule
</TABLE>
-----------------------------
(a) Incorporated by reference to the correspondingly numbered exhibit
to the Registration Statement on Form S-11 (33-92272) filed by
the Registrant with the Securities and Exchange Commission on
May 19, 1995.
(b) Incorporated by reference to the correspondingly numbered exhibit
to the Registration Statement on Form S-11 (33-97946) filed by the
Registrant with the Securities and Exchange Commission on
October 10, 1995.
(c) Incorporated by reference to the correspondingly numbered exhibit
to the Registration Statement on Form S-11 (33-94160) filed by the
Registrant with the Securities and Exchange Commission on June
30, 1995.
(d) Incorporated by reference to the correspondingly numbered exhibit
to the Registration Statement on Form S-11 (333-02962) filed by
the Registrant with the Securities and Exchange Commission on
March
26, 1996.
(e) Incorporated by reference to the Risk Factors section of the
Prospectus included in the Registration Statement on Form S-11
(333-02962) filed by the Registrant with the Securities and
Exchange Commission on March 26, 1996.
(f) 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.
(g) Incorporated by reference to the Registration Statement on Form
S-3 (333-18061) filed by the Registrant on January 2, 1997.
(h) Incorporated by reference to the correspondingly numbered exhibit
to Form 8-K (000-26436) filed by the Registrant with the
Securities and Exchange Commission on January 7, 1997.
(b) Reports on Form 8-K:
Form 8-K, filed January 7, 1997, related to the filing of the
Amended and Restated Bylaws of the Registrant, dated December
13, 1996, and the Amended and Restated 1994 Executive and
Non-Employee Director Stock Option Plan, dated December 13,
1996.
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<PAGE> 68
Glossary
As used in this document, the capitalized and other terms listed below have the
meanings indicated.
"Agency" means GNMA, FNMA or FHLMC.
"Agency Certificates" means GNMA ARM Certificates, FNMA ARM Certificates and
FHLMC ARM Certificates.
"Average Assets" means the daily average of total assets during the period.
"amortized cost" means, with respect to Mortgage Assets, the purchase price as
adjusted for subsequent amortization of discount or premium and for principal
repayments.
"ARM" means a Mortgage Loan or any mortgage loan underlying a Mortgage Security
that features adjustments of the underlying interest rate at predetermined times
based on an agreed margin to an established index. An ARM is usually subject to
periodic interest rate and/or payment caps and a lifetime interest rate cap.
"Asset Acquisition/Capital Allocation Policies" means the policies established
by the Board of Directors, including a majority of the Independent Directors,
establishing the guidelines for management in the type and quantity of Mortgage
Assets that may be purchased by the Company, which policies include, without
limitation, the asset acquisition policies, the credit risk management policies
and the capital and leverage policies.
"Board of Directors" means the Board of Directors of the Company.
"Capital Stock" means the Common Stock, Preferred Stock, and any additional
classes of capital stock authorized by the Board of Directors in the future.
"carrying value" means the value placed on an asset or liability for balance
sheet presentation purposes. With respect to Mortgage Assets and Interest Rate
Cap Agreements, the carrying value equals management's estimate of the bid-side
market value of the asset. Management generally bases its estimate on the lowest
of third-party bid-side indications of market value obtained on a regular basis
from firms making a market in or lending against such assets. With respect to
all other balance sheet items, carrying value equals amortized cost.
"CD Rate" means the weekly average of secondary market interest rates on
six-month negotiable certificates of deposit, as published by the Federal
Reserve Board in its Statistical Release H.15(519), Selected Interest Rates.
"CMOs" or "Collateral Mortgage Obligations" means adjustable- or fixed-rate debt
obligations (bonds) that are collateralized by Mortgage Loans or mortgage
certificates. CMOs are structured so that principal and interest payments
received on the collateral are sufficient to make principal and interest
payments on the bonds. Such bonds may be issued by United States government
sponsored entities or private issuers in one or more classes with fixed or
adjustable interest rates, maturities and degrees of subordination which are
characteristics designed for the investment objectives of different bond
purchasers.
"Code" means the Internal Revenue Code of 1986, as amended.
"Commercial CMOs" means CMOs collateralized by Commercial Mortgage Loans.
"Commercial Mortgage Assets" means Commercial Mortgage Loans and Commercial
Mortgage Securities.
"Commercial Mortgage Loans" means Mortgage Loans secured by commercial property.
"Commercial Mortgage Securities" means Mortgage Securities representing and
interest in, or secured by, Commercial Mortgage Loans.
68
<PAGE> 69
"Commercial Privately-Issued Certificates" means Pass-Through Certificates
representing an interest in Commercial Mortgage Loans.
"Commitments" means commitments issued by the Company which will obligate the
Company to purchase Mortgage Assets from the holders of the commitment for a
specified period of time, in a specified aggregate principal amount and at a
specified price.
"Commodity Exchange Act" means the Commodity Exchange Act, as amended (7 U.S.C.
** 1 et seq.)
"Common Stock" means the Company's shares of Common Stock, $0.01 par value per
share.
"Company" means Redwood Trust, Inc., a Maryland corporation.
"Compensation Committee" means the committee of the Board of Directors appointed
to review compensation issues and, among other things, administer the Stock
Option Plan.
"Conforming Mortgage Loan" means Single-Family Mortgage Loans that either comply
with requirements for inclusion in credit support programs sponsored by FHLMC or
FNMA or are FHA or VA Loans.
"coupon rate" means, with respect to Mortgage Assets, the annualized cash
interest income actually received from the asset, expressed as a percentage of
the face value of the asset.
"Dollar-Roll Agreement" means an agreement to sell a security for delivery on a
specified future date and a simultaneous agreement to repurchase the same or a
substantially similar security on a specified future date.
"DERs" means dividend equivalent rights under the Company's Stock Option Plan.
"DRP" means the dividend reinvestment plan adopted by the Company.
"11th District Cost of Funds Index" means the index made available monthly by
the Federal Home Loan Bank Board of the cost of funds of members of the Federal
Home Loan Bank 11th District.
"ERISA" means the Employee Retirement Income Security Act of 1974.
"ERISA Plan" means a pension, profit-sharing, retirement or other employee
benefit plan or account which is subject to ERISA.
"Excess Securities" means shares of Capital Stock or Warrants representing
ownership, directly or constructively, in excess of 9.8%, in number of shares or
value, of any class of shares of the outstanding Capital Stock (except as
otherwise waived by the Board of Directors).
"Exchange Act" means the Securities Exchange Act of 1934, as amended.
"Exercise Price" means the price payable to the Company to exercise a Warrant
($15.00) multiplied by the number of Warrants being exercised.
"face value" means, with respect to Mortgage Assets, the outstanding principal
balance of Mortgage Loans or Mortgage Securities comprising the Mortgage Assets.
In the absence of credit losses, the face value equals the sum of the principal
repayments that will be received by the Company over the life of the Mortgage
Asset.
"Federal Reserve Board" means the Board of Governors of the Federal Reserve
System.
"FHA" means the United States Federal Housing Administration.
69
<PAGE> 70
"FHA Loans" means Mortgage Loans insured by the FHA.
"FHLMC" means the Federal Home Loan Mortgage Corporation.
"FHLMC ARM Certificates" means adjustable-rate mortgage participation
certificates issued by FHLMC, either in certificate or book-entry form.
"FNMA" means the Federal National Mortgage Association.
"FNMA ARM Certificates" means adjustable-rate mortgage participation
certificates issued by FNMA, either in certificate or book-entry form.
"fully-indexed rate" means, with respect to ARMs, the rate that would be paid by
the borrower ("gross") or received by the Company as owner of the Mortgage Asset
("net") if the coupon rate on the ARM were able to adjust immediately to a
market rate without being subject to adjustment periods, periodic caps, or life
caps. It is equal to the current yield of the ARM index plus the gross or net
margin.
"GB Capital" means George E. Bull, III Capital Management, Inc.
"GNMA" means the Government National Mortgage Association.
"GNMA ARM Certificates" means fully modified pass-through adjustable-rate
mortgage-backed certificates guaranteed by GNMA and issued either in certificate
or book-entry form.
"gross margin" means, with respect to ARMs, the coupon rate to be paid by the
borrower. The term "gross" is used to differentiate payments made by the
borrower with the lower "net" payments actually received by the Company after
the acquisition of a Mortgage Asset. The difference between the gross margin and
the net margin reflects loan servicing fees and other pre-determined contractual
deductions. The fully-indexed gross coupon rate equals the current yield on the
ARM index (six month LIBOR, one year Treasury, etc.) plus the gross margin. The
actual coupon rate paid by the borrower may be lower than the fully-indexed
gross rate at the initiation of the loan if originated at a "teaser rate" or
during periods of rising interest rates due to the limitations of the ARM
adjustment schedule and the periodic and life caps. If so, the coupon rate paid
by the borrower would move towards the fully-indexed gross rate over time.
"haircut" means the over-collateralization amount required by a lender in
connection with a collateralized borrowing.
"HUD" means the Department of Housing and Urban Development.
"Independent Director" means a director of the Company who is not an officer or
employee of the Company and who is not affiliated with GB Capital.
"interest-only strip" or "IO" means a type of mortgage security which receives a
portion of the interest payments from an underlying pool of mortgage loans but
will receive little or no principal payments and hence will have little or no
face value. The market value and yield of an IO are unusually sensitive to the
prepayment rates experienced on and anticipated for the underlying pool of
mortgage loans. The market values and yields of IOs may increase as interest
rates increase and, in certain conditions, IOs may act in a counter-cyclical
manner as compared to other Mortgage Assets.
"interest rate adjustment indices" means, in the case of Mortgage Assets, any of
the objective indices based on the market interest rates of a specified debt
instrument (such as United States Treasury Bills in the case of the Treasury
Index and United States dollar deposits in London in the case of LIBOR) or based
on the average interest rate of a combination of debt instruments (such as the
11th District Cost of Funds Index), used as a reference base to reset the
interest rate for each adjustment period on the Mortgage Asset, and in the case
of borrowings, is used herein to mean the market interest rates of a specified
debt instrument (such as reverse
70
<PAGE> 71
repurchase agreements for Mortgage Securities) as well as any of the objective
indices described above that are used as a reference base to reset the interest
rate for each adjustment period under the related borrowing instrument.
"interest rate adjustment period" means, in the case of Mortgage Assets, the
period of time set forth in the debt instrument that determines when the
interest rate is adjusted and, with respect to borrowings, is used to mean the
term to maturity of a short-term, fixed-rate debt instrument (such as a 30-day
reverse repurchase agreement) as well as the period of time set forth in a
long-term, adjustable-rate debt instrument that determines when the interest
rate is adjusted.
"Investment Company Act" means the Investment Company Act of 1940, as amended.
"ISOs" means qualified incentive stock options granted under the Stock Option
Plan which meet the requirements of Section 422 of the Code.
"LIBOR" means London Inter-Bank Offered Rate as it may be defined, and for a
period of time specified, in a Mortgage Asset or borrowing of the Company.
"lifetime interest rate cap" or "life cap" means, with respect to adjustable
rate Mortgage Assets, in the case of a Mortgage Loan that is an ARM, the maximum
coupon rate that may accrue during any period over the term of such Mortgage
Loan as stated in the governing instruments evidencing such Mortgage Loan, and
in the case of a Mortgage Security evidencing ARMs, the maximum average coupon
rate that may accrue during any period over the term of such Mortgage security
as stated in the governing instruments thereof.
"liquidity capital cushion" is a term defined in the Company's Risk-Adjusted
Capital Policy. It represents a portion of the capital the Company is required
to maintain as part of this policy in order to continue to make asset
acquisitions. The liquidity capital cushion is that part of the required base
which is in excess of the Company's haircut requirements.
"Mezzanine Securities" means Mortgage Securities rated below the two highest
levels but no lower than a single "B" level under the S&P rating system (or
comparable level under other rating systems) and are supported by one or more
classes of Subordinated Securities which bear Realized Losses prior to the
classes of Mezzanine Securities.
"Mortgage Assets" means (i) Single-Family Mortgage Assets, (ii) Multifamily
Mortgage Assets, and (iii) Commercial Mortgage Assets.
"Mortgage Loans" means Single-Family Mortgage Loans, Multifamily Mortgage Loans
and Commercial Mortgage Loans.
"Mortgage Note" means a promissory note evidencing a Mortgage Loan.
"Mortgage Securities" means (i) Pass-Through Certificates and (iii) CMOs.
"Mortgaged Property" means a one- to four-unit residential property which may be
a detached home, townhouse, condominium or other dwelling unit, or multifamily
or commercial property, securing a Mortgage Note.
"Multifamily CMOs" means CMOs backed by Multifamily Mortgage Loans.
"Multifamily Mortgage Assets" means Multifamily Mortgage Loans and Multifamily
Mortgage Securities.
"Multifamily Mortgage Loans" means Mortgage Loans secured by multifamily (in
excess of four units) residential property.
71
<PAGE> 72
"Multifamily Mortgage Securities" means Mortgage Securities representing an
interest in, or secured by, Multifamily Mortgage Loans.
"Multifamily Privately-Issued Certificates" means Pass-through Certificates
evidencing ownership in a pool of Multifamily Mortgage Loans issued by private
institutions.
"Net Income" is the income of the Company as calculated using Generally Accepted
Accounting Principles (GAAP); Net Income may differ from taxable income.
"net margin" is part of the calculation of the coupon rate to be received by the
Company as owner of an ARM. The term "net" is used to differentiate payments
actually received by the Company from a Mortgage Asset from the higher "gross"
payment made by the borrower. The difference between the gross margin and the
net margin reflects loan servicing fees and other pre-determined contractual
deductions. The fully-indexed net rate equals the current yield on the ARM index
(six month LIBOR, one year Treasury, etc.) plus the net margin. The actual
coupon rate received by the Company may be lower than the fully-indexed net rate
at the initiation of the loan if originated at a "teaser rate" or during periods
of rising interest rates due to the limitations of the ARM adjustment schedule
and the periodic and life caps. If so, the coupon rate received by the Company
would move towards the fully-indexed net coupon rate over time.
"Nonconforming Mortgage Loans" means conventional Single-Family and Multifamily
Mortgage Loans that do not conform to one or more requirements of FHLMC or FNMA
for participation in one or more of such agencies' mortgage loss credit support
programs.
"NQSOs" means options to acquire Company Common Stock granted pursuant to the
Stock Option Plan which do not meet the requirements of section 422 of the Code.
"Ownership Limit" means 9.8% of the outstanding shares of Capital Stock, as may
be increased or reduced by the Board of Directors of the Company.
"Pass-Through Certificates" means securities (or interests therein) evidencing
undivided ownership interests in a pool of Mortgage Loans, the holders of which
receive a "pass-through" of the principal and interest paid in connection with
the underlying Mortgage Loans in accordance with the holders' respective,
undivided interests in the pool.
"periodic interest rate cap" or "periodic cap" means, with respect to ARMs, the
maximum change in the coupon rate permissible under the terms of the loan at
each coupon adjustment date. Periodic caps limit both the speed by which the
coupon rate can adjust upwards in a rising interest rate environment and the
speed by which the coupon rate can adjust downwards in a falling rate
environment.
"Preferred Stock" means the Class B 9.74% Cumulative Convertible Preferred
Stock.
"Privately-Issued Certificates" means privately-issued ARM Pass-Through
Certificates issued by the Company or an affiliate of the company or other third
party issuer.
"Qualified Hedges" means bona fide interest rate swap or cap agreements entered
into by the Company solely to hedge adjustable-rate indebtedness that the
Company incurred to acquire or carry Qualified REIT Real Estate Assets and any
futures and options, or other investments (other than Qualified REIT Real Estate
Assets) made by the Company to hedge its Mortgage Assets or borrowings that have
been determined by a favorable opinion of counsel to generate qualified income
for purposes of the 95% Gross Income Test applicable to REITs.
"Qualified REIT Real Estate Assets" means Pass-Through Certificates, Mortgage
Loans, Agency Certificates, and other assets of the type described in section
856(c) (6) (B) of the Code.
"Qualified REIT Subsidiary" means a corporation whose stock is entirely owned by
the REIT at all times during such corporation's existence.
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<PAGE> 73
"Qualifying Interests" means "mortgages and other liens on and interests in real
estate," as defined in Section 3(c) (5) (C) under the Investment Company Act.
"rating" means (i) the rating assigned to an asset by one or more of the four
nationally-recognized rating agencies as adjusted to the rating scale under the
S&P rating system, (ii) in the case of assets rated differently by such rating
agencies, the rating deemed by management to most appropriately reflect such
asset's credit quality or (iii) for unrated assets, the Company's deemed
comparable rating.
"Realized Losses" means losses incurred in respect of Mortgage Assets upon
foreclosure sales and other liquidations of underlying mortgaged priorities that
result in failure to recover all amounts due on the loans secured thereby.
"REIT" means Real Estate Investment Trust.
"REIT Provision of the Code" means Sections 856 through 860 of the Code.
"REMIC" means Real Estate Mortgage Investment Conduit.
"residuals" means the right to receive the remaining or residual cash flows from
a pool of Mortgage Loans or Mortgage Securities after distributing required
amounts to the holders of interests in or obligations backed by such loans or
securities and after payment of any required pool expenses.
"reverse repurchase agreement" means a borrowing device evidenced by an
agreement to sell securities or other assets to a third-party and a simultaneous
agreement to repurchase them at a specified future date and price, the price
difference constituting the interest on the borrowing.
"Risk-Adjusted Capital Policy" means the policy established by the Company which
limits management's ability to acquire additional assets during such times that
the actual capital base of the Company is less than a required amount defined in
the policy. The required amount is the sum of the haircuts required by the
Company's secured lenders (the required haircut) and the additional capital
levels called for under the policy which are determined with reference to the
various risks inherent in the Company's Mortgage Assets (the liquidity capital
cushion).
"RTC" means the Resolution Trust Corporation.
"Rule 144" means Rule 144 promulgated under the Securities Act.
"S&P" means Standard & Poor's Corporation.
"SEC" means the United States Securities and Exchange Commission.
"Securities" means the Preferred Stock, the Common Stock, the Warrants and the
Common Stock issuable pursuant to the exercise of Warrants.
"Securities Act" means the Securities Act of 1933, as amended.
"Senior Securities" means a class of Mortgage Security that has a priority right
to receive principal and/or interest from the underlying pool of Mortgage Loans.
"Senior-Subordinated Mortgage Securities" means a series of Pass-Through
Certificates of CMOs in which one or more classes have a priority right to
receive principal and/or interest payments from the underlying pool of Mortgage
Loans.
"Servicer" means a servicer or subservicer of the Mortgage Loans pursuant to a
servicing agreement with the Company.
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"Shelf Registration Statement" means the shelf registration statement filed
pursuant to the Registration Rights Agreement.
"Short-Term Investments" means the short-term bank certificates of deposit,
short-term United States treasury securities, short-term United States
government agency securities, commercial paper, repurchase agreements,
short-term CMOs, short-term asset-backed securities and other similar types of
short-term investment instruments, all of which will have maturities or average
lives of less than one year.
"Single-Family CMOs" means CMOs backed by Single-Family Mortgage Loans.
"Single-Family Mortgage Assets" means Single-Family Mortgage Loans and
Single-Family Mortgage Securities.
"Single-Family Mortgage Loans" means Mortgage Loans secured by single-family
(one- to four-units) residential property.
"Single-Family Mortgage Securities" means Mortgage Securities representing an
interest in, or secured by, Single-Family Mortgage Loans.
"Single-Family Privately-Issued Certificates" means Pass-Through Certificates
evidencing ownership in a pool of Single-Family Mortgage Loans issued by private
institutions.
"SMMEA" means the Secondary Mortgage Market Enhancement Act of 1984.
"Special Tax Counsel" means the law firm of Giancarlo & Gnazzo.
"Stock Option Plan" means the Amended and Restated 1994 Executive and
Non-employee Stock Option Plan adopted by the Company.
"Subordinated Securities" means a class of Mortgage Securities that is
subordinated to one or more other classes of Mortgage Securities, all of which
classes share the same collateral.
"Tax-Exempt Entity" means a qualified pension, profit-sharing or other employee
retirement benefit plan, Keogh plans, bank commingled trust funds for such
plans, individual retirement accounts and other similar entities intended to be
exempt from Federal income taxation.
"Treasury Department" means the United States Department of Treasury.
"Treasury Index" means the weekly average yield of U.S. Treasury securities,
adjusted to a constant maturity of one year, as published by the Board of
Governors of the Federal Reserve System.
"UBTI" means "unrelated business taxable income" as defined in Section 512 of
the Code.
"VA" means the United States Department of Veterans Affairs.
"VA Loans" means Mortgage Loans partially guaranteed by the VA under the
Servicemen's Readjustment Act of 1944, as amended.
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SIGNATURES
Pursuant to the requirements of Section 13 the Securities Act of 1934, the
Registrant has duly caused this amendment to its report on Form 10-K to be
signed on its behalf by the undersigned thereunto duly authorized.
REDWOOD TRUST, INC.
Dated: July 18, 1997 By: /s/ Vickie L. Rath
-------------------
Vickie L. Rath
Vice President, Treasurer and
Controller
(Principal Accounting Officer)
<PAGE> 76
REDWOOD TRUST, INC.
FINANCIAL STATEMENTS AND
INDEPENDENT AUDITORS' REPORT
FOR INCLUSION IN FORM 10-K
ANNUAL REPORT FILED WITH
SECURITIES AND EXCHANGE COMMISSION
DECEMBER 31, 1996
F-1
<PAGE> 77
REDWOOD TRUST, INC.
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
<S> <C>
Financial Statements: Page
Balance Sheets at December 31, 1996 and 1995...................................................... F-3
Statements of Operations for the years ended December 31, 1996 and
December 31, 1995 and for the period from August 19, 1994 to December 31, 1994.............. F-4
Statements of Stockholders' Equity for the years ended December 31, 1996 and
December 31, 1995 and for the period from August 19, 1994 to December 31, 1994.............. F-5
Statements of Cash Flows for the years ended December 31, 1996 and
December 31, 1995 and for the period from August 19, 1994 to December 31, 1994.............. F-6
Notes to Financial Statements..................................................................... F-7
Independent Auditors' Report............................................................................. F-19
Summary of Quarterly Results............................................................................. F-20
</TABLE>
F-2
<PAGE> 78
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
<TABLE>
<CAPTION>
REDWOOD TRUST, INC.
BALANCE SHEETS
(In thousands, except share data)
December 31,
1996 1995
----------- -----------
<S> <C> <C>
ASSETS
Mortgage assets
Mortgage securities $ 1,627,953 $ 405,794
Mortgage loans 525,475 26,450
----------- -----------
2,153,428 432,244
Cash and cash equivalents 11,068 4,825
Interest rate agreements 2,601 547
Accrued interest receivable 15,537 3,270
Other assets 1,563 671
----------- -----------
$ 2,184,197 $ 441,557
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Short-term borrowings $ 1,953,103 $ 370,316
Accrued interest payable 14,060 1,290
Accrued expenses and other liabilities 761 227
Dividends payable 5,268 1,434
----------- -----------
1,973,192 373,267
----------- -----------
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 shares authorized;
1,006,250 shares issued and
outstanding
($31,953 aggregate liquidation preference) 29,579 -
Common stock, par value $0.01 per share;
48,993,750 and 50,000,000 shares authorized;
10,996,572 and 5,517,299 shares issued and outstanding 110 55
Additional paid-in capital 187,507 73,895
Net unrealized loss on assets available for sale (3,460) (5,476)
Dividends in excess of net income (2,731) (184)
----------- -----------
211,005 68,290
----------- -----------
$ 2,184,197 $ 441,557
=========== ===========
</TABLE>
The accompanying notes are an integral part of these financial statements
<PAGE> 79
REDWOOD TRUST, INC.
STATEMENTS OF OPERATIONS
(In thousands, except share data)
<TABLE>
<CAPTION>
For the period
August 19, 1994
(date of
Years Ended commencement
December 31, of operations) to
1996 1995 December 31, 1994
---------- ---------- -----------------
<S> <C> <C> <C>
INTEREST INCOME
Mortgage assets $ 66,424 $ 15,494 $ 1,183
Cash and investments 860 232 113
---------- ---------- ----------
67,284 15,726 1,296
INTEREST EXPENSE 49,191 10,608 760
INTEREST RATE AGREEMENTS
Interest rate agreements expense 1,158 339 8
---------- ---------- ----------
NET INTEREST INCOME 16,935 4,779 528
Provision for credit losses 1,696 493 --
---------- ---------- ----------
Net interest income after provision for credit losses 15,239 4,286 528
Operating expenses 2,554 1,131 146
---------- ---------- ----------
NET INCOME 12,685 3,155 382
---------- ---------- ----------
Less cash dividends on Class B preferred stock 1,148 --
---------- ---------- ----------
NET INCOME AVAILABLE TO COMMON STOCKHOLDERS $ 11,537 $ 3,155 $ 382
========== ========== ==========
NET INCOME PER SHARE
Primary $ 1.32 $ 0.85 $ 0.20
Fully diluted $ 1.27 $ 0.83 $ 0.20
Weighted average shares of common stock and
common stock equivalents:
Primary 8,744,184 3,703,803 1,916,846
Fully diluted 9,084,769 3,780,882 1,916,846
Dividends declared per Class A preferred share $ -- $ 0.500 $ 0.250
Dividends declared per Class B preferred share $ 1.141 $ -- $ --
Dividends declared per common share $ 1.670 $ 0.460 $ --
</TABLE>
The accompanying notes are an integral part of these financial statements
F-4
<PAGE> 80
REDWOOD TRUST, INC.
STATEMENTS OF STOCKHOLDERS' EQUITY
For the Years ended December 31, 1996 and December 31, 1995 and the period from
August 19, 1994 (date of commencement of operations) to December 31, 1994 (In
thousands, except share data)
<TABLE>
<CAPTION>
Net
Unrealized
Preferred Stock Common Stock Loss
--------------------------------------------------------- Additional on Assets Dividends in
Class A Class B Paid-in Available Excess of
Shares Amount Shares Amount Shares Amount Capital for Sale Net Income Total
- - -----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Balance, August 19, 1994 -- -- -- -- 208,332 $ 2 $ 19 -- -- $ 21
- - -----------------------------------------------------------------------------------------------------------------------------------
Net income -- -- -- -- -- -- -- -- 382 382
Issuance of Class A
preferred stock 1,666,063 $ 22,785 -- -- -- -- -- -- -- 22,785
Dividends declared
Class A preferred -- -- -- -- -- -- -- -- (351) (351)
Fair value adjustment on
assets available for sale -- -- -- -- -- -- -- (2,557) -- (2,557)
- - -----------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1994 1,666,063 $ 22,785 -- -- 208,332 $ 2 $ 19 ($2,557) $ 31 $ 20,280
- - -----------------------------------------------------------------------------------------------------------------------------------
Net income -- -- -- -- -- -- -- -- 3,155 3,155
Additional Class A preferred
stock offering costs -- (8) -- -- -- -- -- -- -- (8)
Issuance of common stock (1,666,063) (22,777) -- -- 5,308,967 53 73,876 -- -- 51,152
Dividends declared
Class A preferred -- -- -- -- -- -- -- -- (833) (833)
Common -- -- -- -- -- -- -- -- (2,537) (2,537)
Fair value adjustment on
assets available for sale -- -- -- -- -- -- -- (2,919) -- (2,919)
- - -----------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1995 -- -- -- -- 5,517,299 $55 $ 73,895 ($5,476) ($ 184) $ 68,290
- - -----------------------------------------------------------------------------------------------------------------------------------
Net income -- -- -- -- -- -- -- -- 12,685 12,685
Issuance of Class B
preferred stock -- -- 1,006,250 29,579 -- -- -- -- -- 29,579
Issuance of common stock -- -- -- -- 5,479,273 55 113,612 -- -- 113,667
Dividends declared:
Class B Preferred -- -- -- -- -- -- -- -- (1,148) (1,148)
Common -- -- -- -- -- -- -- -- (14,084) (14,084)
Fair value adjustment on
assets available for sale -- -- -- -- -- -- -- 2,016 -- 2,016
- - -----------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1996 -- -- 1,006,250 $29,579 10,996,572 $110 $187,507 ($3,460) ($ 2,731) $ 211,005
- - -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
The accompanying notes are an integral part of these financial statements
F-5
<PAGE> 81
REDWOOD TRUST, INC.
STATEMENTS OF CASH FLOWS
(In thousands, except share data)
<TABLE>
<CAPTION>
For the period
August 19, 1994
(date of
Years Ended commencement
December 31, of operations) to
1996 1995 December 31, 1994
----------- --------- -----------------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 12,685 $ 3,155 $ 382
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Amortization of mortgage asset premium and discount, net 5,197 (356) (82)
Depreciation and amortization 96 64 13
Provision for credit losses on mortgage assets 1,696 493 --
Amortization of interest rate cap agreements 749 339 8
Increase in accrued interest receivable (12,267) (2,527) (743)
Increase in other assets (985) (346) (402)
Increase in accrued interest payable 12,770 614 676
Increase in accrued expenses and other 534 198 29
----------- --------- ---------
Net cash provided by (used in) operating activities 20,475 1,634 (119)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of mortgage assets (1,982,864) (354,572) (121,297)
Principal payments on mortgage assets 258,424 38,824 1,244
Purchases of interest rate cap agreements (4,427) (1,069) (1,799)
----------- --------- ---------
Net cash used in investing activities (1,728,867) (316,817) (121,852)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings from reverse repurchase agreements 1,582,787 269,940 100,376
Net proceeds from issuance of Class A preferred stock -- (8) 22,785
Net proceeds from issuance of Class B preferred stock 29,579 -- --
Net proceeds from issuance of common stock 113,667 51,152 --
Dividends paid (11,398) (2,103) (184)
----------- --------- ---------
Net cash provided by financing activities 1,714,635 318,981 122,977
Net increase in cash and cash equivalents 6,243 3,798 1,006
Cash and cash equivalents at beginning of period 4,825 1,027 21
----------- --------- ---------
Cash and cash equivalents at end of period $ 11,068 $ 4,825 $ 1,027
=========== ========= =========
Supplemental disclosure of cash flow information:
Cash paid for interest $ 36,831 $ 9,994 $ 84
=========== ========= =========
</TABLE>
The accompanying notes are an integral part of these financial statements
F-6
<PAGE> 82
REDWOOD TRUST, INC.
NOTES TO FINANCIAL STATEMENTS
December 31, 1996
NOTE 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Redwood Trust, Inc. ("Redwood Trust" or the "Company") was incorporated in
Maryland on April 11, 1994 and commenced operations on August 19, 1994. The
Company completed its initial public offering of 3,593,750 shares of Common
Stock on August 4, 1995 at a price of $15.50 per share. On April 19, 1996 the
Company completed its second public offering of 2,875,000 shares of Common Stock
at a price of $20.25 per share. 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 a price of $31.00 per share. On
November 19, 1996 the Company completed its third public offering of 1,250,000
shares of Common Stock at a price of $31.75 per share.
The Company's principal source of earnings is net interest income, or interest
income generated from its Mortgage Assets less the cost of borrowed funds and
hedging. 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.
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 which have been securitized by the Company following
acquisition, mortgage loans which have been securitized by others prior
to acquisition by the Company, interest only strips ("IO's") (all
together "Mortgage Securities") and mortgage loans.
Statement of Financial Accounting Standards No. 115, Accounting for
Certain Investments in Debt and Equity Securities ("SFAS 115"),
requires the Company to classify its Mortgage Securities as either
trading investments, available-for-sale investments or held-to-maturity
investments. Although the Company generally intends to hold most of its
Mortgage Securities until maturity, it may, from time to time, sell any
of its Mortgage Securities as part of its overall management of its
balance sheet. Accordingly, this flexibility requires the Company to
classify all of its Mortgage Securities 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 Securities 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 Security is adjusted.
Other-than-temporary unrealized losses are based on management's
assessment of various factors affecting the expected cash flow from the
Mortgage
F-7
<PAGE> 83
Securities, 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.
Mortgage loans are carried at their unpaid principal balance, net of
unamortized discount or premium.
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's 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 could be zero or negative. In the event
that the projected return on an investment in an IO 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 a specific portfolio of assets and
liabilities, with similar economic characteristics including a low life
strike, variable interest rate based on a market-sensitive index,
similar expected prepayment rate behavior and similar periodic caps,
exposing the Company to interest rate risk is identified. The hedge
instruments are chosen as the ones probable of substantially reducing
the interest rate risk being hedged, and a high degree of correlation
is maintained on an on-going basis. Currently, the Company invests in
"Interest Rate Agreements." Interest Rate 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, for example, a serious
deterioration of the ability of the counterparty to perform under the
terms of the Interest Rate Agreement.
F-8
<PAGE> 84
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
$257,493 at December 31, 1996 and $113,515 at December 31, 1995.
Depreciation expense and leasehold improvements amortization for the
years ended December 31, 1996 and December 31, 1995 and for the period
from August 19, 1994 to December 31, 1994 totaled $58,686, $30,255 and
$1,112, respectively. Accumulated depreciation and leasehold
improvement amortization totaled $90,053 at December 31, 1996 and
$31,367 at December 31, 1995.
Income Taxes
The Company has elected to be taxed as a Real Estate Investment Trust
("REIT") and intends to comply with the REIT provisions of the Internal
Revenue Code (the "Code") and the corresponding provisions of State
law. Accordingly, the Company will not be subject to Federal or state
income tax to the extent of its distributions to stockholders. In order
to maintain its status as a REIT, the Company is required, among other
requirements, to distribute at least 95% of its taxable income.
Earnings per Share
Earnings per share are based on the weighted average shares of common
stock outstanding plus common equivalent shares using the treasury
stock method. The treasury stock method calculation assumes all
dilutive common stock equivalents are exercised and the funds generated
by the exercise are used to buy back outstanding common stock at the
average market price during the reporting period, for primary earnings
per share, or at the end of period market price if higher, for fully
diluted earnings per share.
Credit Risk
The majority 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 December 31,
1996, the privately issued Mortgage Assets held by the Company had
rating equivalents ranging from AAA to unrated, with a weighted average
of AA+; the weighted average rating equivalent of all the Company's
Mortgage Assets was AA+. At December 31, 1995, the privately issued
Mortgage Assets held by the Company had rating equivalents ranging from
AAA to unrated, with a weighted average of A+; the weighted average
rating equivalent of all the Company's Mortgage Assets was AA+.
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 reserve is
increased by provisions charged to income from operations. When a loan
or portions of a loan are 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 year
ended December 31, 1996 the Company provided for $1,696,293 in credit
losses and incurred $6,456 in charge-offs, resulting in a
F-9
<PAGE> 85
reserve balance of $2,179,550 at December 31, 1996. During the year
ended December 31, 1995 the Company provided for $493,710 in credit
losses and incurred $3,997 in charge-offs, resulting in a reserve
balance of $489,713 at December 31, 1995. During the period from
August 19, 1994 to December 31, 1994, there were no provisions made
for credit losses and the Company incurred no charge-offs.
Reclassifications
Certain amounts for prior years have been reclassified to conform with
the 1996 presentation.
Recent Accounting Pronouncement
In June 1996 the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 125, "Accounting for Transfers
and Servicing of Financial Assets and Extinguishments of Liabilities"
("SFAS 125"). SFAS 125 provides accounting and reporting standards for
all types of securitization transactions involving the transfer of
financial assets including repurchase agreements and collateralized
borrowing arrangements. The Company will adopt this pronouncement
effective January 1, 1997. The adoption of SFAS 125 is not expected to
have a material impact on the Company's financial statements.
NOTE 2. MORTGAGE ASSETS
Mortgage Assets Excluding IO's
At December 31, 1996, Mortgage Assets, excluding IO's, consisted of the
following:
<TABLE>
<CAPTION>
FEDERAL
FEDERAL HOME NATIONAL
LOAN MORTGAGE MORTGAGE NON-AGENCY
CORPORATION ASSOCIATION MORTGAGE MORTGAGE
(IN THOUSANDS) SECURITIES SECURITIES SECURITIES LOANS TOTAL
------------ ----------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C>
Mortgage Assets, Gross $ 304,668 $ 635,268 $ 662,276 515,033 $ 2,117,245
Unamortized Discount 0 (234) (15,717) (142) (16,093)
Unamortized Premium 9,287 17,652 13,827 11,012 51,778
----------- ----------- ----------- ----------- -----------
Amortized Cost 313,955 652,686 660,386 525,903 2,152,930
Allowance for Credit Losses 0 0 (1,752) (428) (2,180)
Gross Unrealized Gains 1,091 2,082 2,746 0 5,919
Gross Unrealized Losses (185) (688) (4,477) 0 (5,350)
=========== =========== =========== =========== ===========
Carrying Value $ 314,861 $ 654,080 $ 656,903 525,475 $ 2,151,319
=========== =========== =========== =========== ===========
</TABLE>
F-10
<PAGE> 86
At December 31, 1995, Mortgage Assets, excluding IO's, consisted of the
following:
<TABLE>
<CAPTION>
FEDERAL HOME
LOAN MORTGAGE FEDERAL NON-AGENCY
CORPORATION NATIONAL MORTGAGE
ASSOCIATION MORTGAGE LOANS MORTGAGE
(IN THOUSANDS) SECURITIES SECURITIES SECURITIES LOANS TOTAL
--------- ---------- --------- --------- ---------
<S> <C> <C> <C> <C> <C>
Mortgage Assets, Gross $ 46,160 $ 190,061 $ 180,993 26,411 $ 443,625
Unamortized Discount 0 (313) (16,547) (172) (17,032)
Unamortized Premium 907 3,608 1,245 290 6,050
--------- --------- --------- --------- ---------
Amortized Cost 47,067 193,356 165,691 26,529 432,643
Allowance for Credit Losses 0 0 (411) (79) (490)
Gross Unrealized Gains 334 1,033 874 0 2,241
Gross Unrealized Losses (110) (458) (4,345) 0 (4,913)
========= ========= ========= ========= =========
Carrying Value $ 47,291 $ 193,931 $ 161,809 26,450 $ 429,481
========= ========= ========= ========= =========
</TABLE>
At December 31, 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
thirty years; the actual maturity is subject to change based on the prepayments
of the underlying mortgage loans.
At December 31, 1996, the average annualized effective yield was 7.10% based on
the amortized cost of the assets and 7.11% 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 or 2% every year) and lifetime caps. At December 31, 1996
and December 31, 1995 the weighted average lifetime cap was 11.73% and 11.54%,
respectively.
IO's
The amortized cost and fair value of the Company's IO's are summarized as
follows:
<TABLE>
<CAPTION>
(IN THOUSANDS) DECEMBER 31, 1996 DECEMBER 31, 1995
----------------- -----------------
<S> <C> <C>
Amortized Cost $2,539 $3,593
Gross Unrealized Gains 45 0
Gross Unrealized Losses (475) (830)
----------------------- ------ ------
Estimated Fair Value $2,109 $2,763
====== ======
</TABLE>
The average annualized effective yield at December 31, 1996 on the IO's was
11.24% based on the amortized cost of the assets and 13.53% based on the fair
value of the assets. The average annualized effective yield at December 31, 1995
on the IO's was 9.99% based on the amortized cost of the assets and 13.61% based
on the fair value of the assets.
F-11
<PAGE> 87
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) DECEMBER 31, 1996 DECEMBER 31, 1995
----------------- -----------------
<S> <C> <C>
Amortized Cost $6,200 $2,521
Gross Unrealized Gains 156 0
Gross Unrealized Losses (3,755) (1,974)
----------------------- ------- -------
Estimated Fair Value $2,601 $547
======= =======
</TABLE>
The sum of the notional amounts of all of the Company's Interest Rate Agreements
in effect was $1,128,000,000 at December 31, 1996 and $312,000,000 December 31,
1995, respectively.
Cap Agreements
The Company had fifty-seven outstanding Cap Agreements at December 31, 1996 and
twenty-three outstanding Cap Agreements at December 31, 1995. Potential future
earnings from each of these Cap Agreements are based on variations in the London
Inter-Bank Offered Rate ("LIBOR"). The sum of the notional amounts of the
Company's Cap Agreements in effect was $703,000,000 and $302,000,000 at December
31, 1996 and December 31, 1995, respectively. The weighted average cap strike
rate during the years ended December 31, 1996 and December 31, 1995 was 7.30%
and 7.71%, respectively. The weighted average cap strike rate during the period
from August 19, 1994 to December 31, 1994 was 7.50%. Under these Cap Agreements
the Company will receive cash payments should an agreed-upon reference rate,
either one-month or three-month LIBOR, increase above the strike rates of the
Cap Agreements.
Information on Cap Agreements outstanding at December 31, 1996 is summarized
below.
<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> <C>
1997 885,748 7.77% 5.50% 12.00% 1,287
1998 661,712 8.41% 5.95% 12.00% 1,281
1999 776,334 9.54% 6.94% 12.00% 1,418
2000 596,113 9.88% 7.50% 10.00% 1,094
2001 341,164 9.85% 7.50% 9.00% 663
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 $6,200
========
</TABLE>
Collar Agreement
At December 31, 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%
F-12
<PAGE> 88
Information on the Collar Agreement outstanding at December 31, 1996 is
summarized below.
<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>
January 1997 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 December 31, 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 $135,000,000 and $10,000,000 at December 31, 1996 and
December 31, 1995, respectively. Under these Swap Agreements, the Company
receives the 3 month LIBOR rate and pays the agreed upon fixed rate.
Information on Fixed Pay Rate Swaps outstanding at December 31, 1996 is
summarized 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>
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 December 31, 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 $110,000,000, with $90,000,000 maturing in August 1999 and
$20,000,000 maturing in September 1999.
Information on the Periodic Swap Agreements outstanding at December 31, 1996 is
summarized below.
<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>
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 December 31, 1996, the Company had entered into five LIBOR/Treasury bill
Basis Swap Agreements totaling $160 million in notional value. 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%. The maturities of these Basis Swap Agreements are as follows:
$30,000,000 in June 1998, $50,000,000 in December 1998, $30,000,000 in June 1999
F-13
<PAGE> 89
and $50,000,000 in December 1999. Information on Basis Swap Agreements
outstanding at December 31, 1996 is summarized below.
<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>
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.
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.
At December 31, 1996 the Company had $1,953,103,000 of Short-Term Borrowings
outstanding with a weighted average borrowing rate of 5.83% and a weighted
average maturity of 98 days. These borrowings were collateralized with
$2,050,813,000 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.
In September 1996, the Company entered into a $20,000,000, 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 December 31, 1996, borrowings under this facility totaled
$19,302,000 and were committed through January 15, 1997. These borrowings are
reflected in the $1,953,103,000 of Short-Term Borrowings outstanding at December
31, 1996.
At December 31, 1996 and December 31, 1995, the Short-Term Borrowings had the
following remaining maturities:
<TABLE>
<CAPTION>
(IN THOUSANDS) DECEMBER 31, 1996 DECEMBER 31, 1995
----------------- -----------------
<S> <C> <C>
Within 30 days $268,042 $75,808
30 to 90 days 667,567 175,921
Over 90 days 1,017,494 118,587
------------ ----------- - -------
Total Borrowings $1,953,103 $370,316
========== ========
</TABLE>
F-14
<PAGE> 90
For the years ended December 31, 1996 and December 31, 1995, the average balance
of Short-Term Borrowings was $861,316,000 and $174,926,000 with a weighted
average interest cost of 5.71% and 6.06%, respectively. For the period from
August 19, 1994 to December 31, 1994 the average balance of Short-Term
Borrowings was $37,910,000 with a weighted average interest cost of 5.50%. The
maximum balances outstanding during the years ended December 31, 1996 and
December 31, 1995 were $1,953,103,000 and $370,316,000, respectively. The
maximum balance outstanding during the period from August 19, 1994 to December
31, 1994 was $100,376,000.
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 December 31, 1996 and December 31, 1995.
FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments,
defines the fair value of a financial instrument as the amount at which the
instrument could be exchanged in a current transaction between willing parties,
other than in a forced liquidation sale.
<TABLE>
<CAPTION>
DECEMBER 31, 1996 DECEMBER 31, 1995
----------------- -----------------
CARRYING FAIR CARRYING FAIR
(IN THOUSANDS) AMOUNT VALUE AMOUNT VALUE
-------- ----- ------- -----
<S> <C> <C> <C> <C>
Assets
Mortgage Assets $2,151,319 $2,151,319 $ 429,481 $ 429,481
IO's 2,109 2,109 2,763 2,763
Interest Rate Agreements 2,601 2,601 547 547
</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,
short-term borrowings, accrued interest payable, accrued expenses and other
liabilities are reflected in the financial statements at their 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 9.74% CUMULATIVE CONVERTIBLE PREFERRED STOCK
On August 8, 1996, the Company issued 1,006,250 shares of Class B 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. After September 30, 1999,
the Company can either redeem or cause a conversion of the Class B Preferred
Stock. 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. The liquidation
preference entitles the holders of the Class B Preferred Stock to receive $31
per share plus any accrued dividends before any distribution is made on the
Common Stock.
F-15
<PAGE> 91
NOTE 8. STOCK PURCHASE WARRANTS
At December 31, 1996 and December 31, 1995 there were 412,894 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.
NOTE 9. STOCK OPTION PLAN
The Company has adopted a Stock Option Plan for executive officers, 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 stock dividend equivalent rights
("stock DERs") to such eligible recipients other than non-employee directors.
Non-employee directors are automatically provided annual grants of NQSOs with
stock 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 December 31, 1996 and
December 31, 1995, 1,138,743 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 December 31, 1996 and December 31, 1995, 299,633 and 168,333
ISOs had been granted, respectively. 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 stock DERs. For the years ended December 31, 1996 and December 31, 1995,
the stock DERs accrued on NQSOs resulted in non-cash charges to general and
administrative expenses of $328,374 and $54,513, respectively. Stock DERs
represent shares of stock which are issuable to holders of stock options when
the holders exercise the underlying stock options. The number of stock 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>
YEAR ENDED YEAR ENDED FISCAL YEAR ENDED
DECEMBER 31, 1996 DECEMBER 31, 1995 DECEMBER 31, 1994
----------------- ----------------- -----------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
----- -------- ------ -------- ------ --------
<S> <C> <C> <C> <C> <C> <C>
Outstanding options at beginning of period: 310,857 $ 9.48 188,333 $ 0.11 0 na
Options granted 141,300 36.01 166,972 17.55 188,333 $ 0.11
Options exercised (42,083) 0.11 (47,083) 0.11 0 na
Dividend equivalent rights earned 11,503 0.00 2,635 0.00 0 na
=========== =========== ===========
Outstanding options at end of period 421,577 19.05 310,857 9.48 188,333 0.11
=========== =========== ===========
Options exercisable at year-end 27,109 24.48 0 na 0 na
Weighted average fair value of options
granted during the year $2.34 $0.01 $0.01
</TABLE>
The table on the following page summarizes information about stock options
outstanding at December 31, 1996:
F-16
<PAGE> 92
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------------------------ ------------------------------------
NUMBER WEIGHTED-AVERAGE NUMBER
RANGE OF OUTSTANDING REMAINING WEIGHTED-AVERAGE EXERCISABLE WEIGHTED-AVERAGE
EXERCISE PRICES AT 12/31/96 CONTRACTUAL LIFE EXERCISE PRICE AT 12/31/96 EXERCISE PRICE
--------------- ----------- ---------------- ---------------- ----------- ------------------
<S> <C> <C> <C> <C> <C>
$0 to 1 113,305 7.8 years $0.10 5,659 $0.10
7 to 8 10,000 8.5 7.18 2,500 7.18
17 to 22 156,972 8.9 18.21 2,750 17.75
24 to 25 10,000 9.5 21.50 0 na
36 to 37 131,300 9.9 36.88 16,110 36.88
------- ------
$0 to 37 421,577 19.05 27,109 24.48
======= ======
</TABLE>
At December 31, 1996, the Company had one stock option plan, which is described
above. The Company applies APB Opinion 25 and related interpretations in
accounting for its Plan. Accordingly, no compensation cost has been recognized
for its Stock Option Plan. Had compensation cost for the Company's Stock Option
Plan been determined consistent with FASB Statement 123, the Company's net
income and earnings per share would have been reduced to the pro forma amounts
indicated below:
<TABLE>
<CAPTION>
YEAR ENDED YEAR ENDED
DECEMBER 31, 1996 DECEMBER 31, 1995
----------------- -----------------
<S> <C> <C> <C>
Net Income As reported $11,537 $3,155
(in thousands) Pro Forma $11,535 $3,155
Primary earnings As reported $1.32 $0.85
per share Pro Forma $1.32 $0.85
Fully diluted As reported $1.27 $0.83
earnings per share Pro Forma $1.27 $0.83
</TABLE>
The 1996 values are based on American valuation using the Black/Scholes option
pricing model as of December 13, 1996, the grant date, using the following
principal assumptions: expected stock price volatility 33%, risk free rate of
return 6.33%, post 1997 dividend growth of 10%, and a first exercise date of May
4, 1998. No adjustments have been made for forfeitures or non-transferability.
The actual value, if any, that the option recipient will realize from these
options will depend solely on the increase in the stock price over the option
price when the options are exercised.
NOTE 10. DIVIDENDS
The Company declared and paid the following dividends for the years ended
December 31, 1996 and December 31, 1995:
<TABLE>
<CAPTION>
DIVIDENDS PER SHARE
----------------------------------------------------
PREFERRED STOCK
DECLARATION RECORD PAYABLE TOTAL ---------------------------------- COMMON
DATE DATE DATE DIVIDENDS CLASS A CLASS B STOCK
---- ---- ---- --------- ------- ------- -----
<S> <C> <C> <C> <C> <C> <C>
12/16/96 12/31/96 1/21/97 $5,268,314 -- $0.755 $0.410
9/16/96 9/30/96 10/21/96 $4,016,274 -- $0.386 $0.400
6/14/96 6/28/96 7/18/96 $3,408,046 -- -- $0.400
3/11/96 3/29/96 4/19/96 $2,539,833 -- -- $0.460
12/13/95 12/29/95 1/19/96 $1,434,500 -- -- $0.260
9/15/95 9/29/95 10/20/95 $1,103,264 -- -- $0.200
6/19/95 6/30/95 7/21/95 $499,819 $0.300 -- --
3/17/95 3/31/95 4/21/95 $333,213 $0.200 -- --
</TABLE>
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 1996 which was paid in January 1997 is
F-17
<PAGE> 93
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 December 31, 1996 the Company had entered into a commitment to purchase
$5.1 million of Mortgage Assets for settlement in January 1997. At December 31,
1996 and December 31, 1995, the Company had no other outstanding commitments to
purchase or sell Mortgage Assets or to purchase, sell or terminate Interest Rate
Agreements. The Company also had no commitments to enter into additional reverse
repurchase agreements or other borrowings.
Rental expense for office properties under operating leases for the years ended
December 31, 1996 and December 31, 1995 was $107,889 and $64,082, respectively.
Rental expense for office properties under operating leases for the period from
August 19, 1994 to December 31, 1994 was $8,612.
Future minimum rental commitments as of December 31, 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 DECEMBER 31, 1996
DECEMBER 31, (IN THOUSANDS)
------------- -----------------------
<S> <C>
1997 121
1998 121
1999 121
2000 121
2001 40
---- ----
Total $524
====
</TABLE>
Because the lease is in the Company's name, the above amounts represent 100% of
the minimum future rental commitments. However, the Company shares certain
office expenses, such as lease payments and utilities, on a pro rata basis with
GB Capital. GB Capital is owned by certain officers of the Company. This
arrangement is covered by an Administrative Services and Facilities Sharing
Agreement. For the year ended December 31, 1996, the Company was bearing 95% of
the lease expenses and GB Capital was bearing 5%. For the year ended December
31, 1995 and for the period from August 19, 1994 to December 31, 1994, the
Company was bearing 70% of the lease expenses and GB Capital was bearing 30%.
F-18
<PAGE> 94
[COOPERS & LYBRAND L.L.P. LETTERHEAD]
REPORT OF INDEPENDENT ACCOUNTANTS
Board of Directors
Redwood Trust, Inc.
Mill Valley, California
We have audited the accompanying balance sheets of Redwood Trust, Inc. (the
Company) as of December 31, 1996 and 1995 and the related statements of
operations, stockholders' equity and cash flows for the years ended December 31,
1996 and 1995, and for the period from August 19, 1994 to December 31, 1994.
These financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements based
on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of the Company as of December 31,
1996 and 1995, and the results of its operations and its cash flows for the
years ended December 31, 1996 and 1995, and for the period from August 19, 1994
to December 31, 1994 in conformity with generally accepted accounting
principles.
San Francisco, California /s/ Coopers & Lybrand L.L.P.
February 21, 1997
F-19
<PAGE> 95
REDWOOD TRUST, INC.
SUMMARY OF QUARTERLY RESULTS
(unaudited)
(In thousands, except share data)
<TABLE>
<CAPTION>
First Second Third Fourth
Quarter Quarter Quarter Quarter
------- ------- ------- -------
Year ended December 31, 1996
- - ----------------------------
<S> <C> <C> <C> <C>
Operating results:
Interest income $ 9,131 $ 12,901 $19,371 $25,881
Interest expense 6,202 9,075 14,447 19,467
Interest rate agreement expense 151 255 350 402
Net interest income 2,778 3,571 4,574 6,012
Net income 1,954 2,500 3,387 4,844
Net income available to common stockholders 1,954 2,500 2,999 4,084
Net income per share 0.32 0.29 0.32 0.39
Dividends declared per common share 0.46 0.40 0.40 0.41
Dividends declared per Class A preferred share 0.00 0.00 0.00 0.00
Dividends declared per Class B preferred share 0.00 0.00 0.39 0.76
Year ended December 31, 1995
- - ----------------------------
Operating results:
Interest income $ 2,170 $ 2,961 $3,986 $6,610
Interest expense 1,533 2,191 2,432 4,452
Interest rate agreement expense 16 82 112 129
Net interest income 621 688 1,442 2,029
Net income 402 449 994 1,310
Net income per share 0.19 0.21 0.23 0.22
Dividends declared per common share 0.00 0.00 0.20 0.26
Dividends declared per Class A preferred share 0.20 0.30 0.00 0.00
Dividends declared per Class B preferred share 0.00 0.00 0.00 0.00
Year ended December 31, 1994
- - ----------------------------
Operating results:
Interest income (1) (1) $ 98 $ 1,198
Interest expense 10 750
Interest rate agreement expense 0 8
Net interest income 88 440
Net income 49 333
Net income per share 0.03 0.17
Dividends declared per common share 0.00 0.00
Dividends declared per Class A preferred share 0.00 0.25
Dividends declared per Class B preferred share 0.00 0.00
</TABLE>
(1) The Company commenced operations on August 19, 1994.
F-20
<PAGE> 96
REDWOOD TRUST, INC.
INDEX TO EXHIBIT
Sequentially
Exhibit Numbered
Number Page
----------------- ------------
10.30.1 Amendment to Office Building Lease 96
11.1 Computation of Earnings per Share 98
27 Financial Data Schedule 99
95
<PAGE> 1
EXHIBIT 10.30.1
THIRD AMENDMENT TO LEASE
This lease amendment, made and entered into as of the 5th day of February 1997,
by and between Shelterpoint Equities, Ltd., Lessor, and Redwood Trust, Inc. a
Maryland Corporation, Lessee.
RECITALS
WHEREAS Lessee is currently occupying space, commonly referred to as
Suite 3100, pursuant to that lease between Lessor and Lessee dated October 12,
1994 and modified February 21, 1995 and April 17, 1996, and
WHEREAS Lessor and Lessee desire to amend the lease to provide for the
addition of Suite 3180 in accordance with the terms and conditions hereinafter
set forth (the Third Amendment to Lease);
NOW THEREFORE, in consideration of the mutual covenants contained
herein, as well as other valuable consideration, it is hereby agreed as follows:
1. The effective date of this modification is April 1, 1997.
2. The rentable square footage shall be increased to approximately 6365
square feet and the common area maintenance percentage shall be increased to
7.53%. The additional footage is depicted as exhibit "A" attached. Useable
square footage is 5492.
3. Upon the effective date of this amendment, the minimum monthly rental
shall be increased to $11,673.97. Rent for Suite 3180 shall be prorated if the
space is not turned over to Lessee upon the effective date.
4. This amendment shall not effect the annual cost of living increase date
of December 9th of each year. All increased shall be governed by paragraph 6 (b)
of the lease.
5. Estimated monthly expenses for the combined footage shall be increased
to $4,264.55 and shall be administered in accordance with paragraph 6 (c) of the
lease. Expenses for Suite 3180 shall be prorated if the space is not turned over
to Lessee upon the effective date.
6. The security deposit shall be increased to $11,673.97 from $7,370.50.
The increase of $4,303.47 shall be paid upon the signing of this amendment.
7. The termination date of May 5, 2001 shall not be effected by this
amendment.
8. Lessee shall take space on an "as is" basis, however, Lessee shall be
permitted to improve the space in accordance with the plan as generally depicted
in Exhibit "B" attached. All improvements must be constructed with details and
materials which currently exist in Suite 3100, must comply with all applicable
building codes and ADA access requirements and must be completed by a licensed
building contractor. A $3,000.00 tenant improvement allowance will be paid by
Lessor to Lessee upon completion of their improvements as depicted in Exhibit
"B".
9. In the event, upon the termination of this lease, Lessee does not renew
the lease for an extended period of at least Four (4) years, Lessee shall pay to
Lessor the sum of Fifteen thousand ($15,000.00) which shall compensate Lessor
for the expense that may be required to reconfigure the space for a future
tenant. If the lease is renewed, the payment will not be required upon the
termination of the extended period.
96
<PAGE> 2
10. In the event Lessee does not renew and the space is re-leased to
another tenant, for a period of not less than 3 years and only paint and
carpeting are required, Lessor shall return the $15,000.00 to Lessee immediately
upon commencement of the new lease.
11. After March 1, 1998, Lessor shall notify Lessee of any space in the
complex, not subject to prior options or rights of refusal, which Lessor expects
have available for lease. Lessor shall provide Lessee with a summary of the
historic size, the current market rent and a floor plan if available. The space
shall be available to Lessee on an "as is" basis and the term shall be
co-terminous with the expiration of this lease. Lessee shall have 10 working
days from the date of notification to decide if Lessee will add the space to
this lease. This option shall not be available to Lessee during the last 6
months of this lease term.
12. All other terms and conditions, except as provided for in this
amendment or conditions which have been satisfied by prior agreements, shall
remain in full force and effect.
Lessor: Lessee:
/s/ Ray Hoffman /s/ Frederick H. Borden
- - ------------------------------ ---------------------------------------------
Shelterpoint Equities, Ltd. Redwood Trust, Inc., a Maryland Corporation
Date: February 11, 1997 Date: February 11, 1997
97
<PAGE> 1
EXHIBIT 11.1
REDWOOD TRUST, INC.
STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS
<TABLE>
<CAPTION>
For the period
August 19, 1994 (date
Twelve Months Twelve Months of commencement)
Ended Ended of operations) to
December 31, 1996 December 31, 1995 December 31, 1994
----------- ----------- -----------
<S> <C> <C> <C>
PRIMARY:
Average common shares outstanding ......................... 7,950,175 2,305,275 208,332
Average Class A preferred shares outstanding (A) ............. n/a 1,008,767 1,467,748
Net effect of dilutive stock options outstanding
during the period -- based on the treasury stock method .. 175,391 173,716 187,022
Net effect of dilutive stock warrants outstanding
during the period -- based on the treasury stock method .. 618,618 216,046 53,744
----------- ----------- -----------
Total .................................................. 8,744,184 3,703,803 1,916,846
=========== =========== ===========
Net Income ................................................... $11,537,318 $ 3,154,831 $ 381,804
=========== =========== ===========
Per Share Amount ............................................. $ 1.32 $ 0.85 $ 0.20
=========== =========== ===========
FULLY DILUTED:
Average common shares outstanding ............................ 7,950,175 2,305,275 208,332
Average Class A preferred shares outstanding (A) ............. n/a 1,008,767 1,467,748
Net effect of dilutive stock options outstanding
during the period -- based on the treasury stock method .. 209,427 170,144 187,022
Net effect of dilutive stock warrants outstanding
during the period -- based on the treasury stock method .. 858,279 296,696 53,744
Net effect of dilutive Class B preferred stock outstanding
during the period -- based on the treasury stock method .. 66,888 n/a n/a
----------- ----------- -----------
Total .................................................. 9,084,769 3,780,882 1,916,846
=========== =========== ===========
Net Income ................................................... $11,537,318 $ 3,154,831 $ 381,804
=========== =========== ===========
Per Share Amount ............................................. $ 1.27 $ 0.83 $ 0.20
=========== =========== ===========
</TABLE>
(A) Class A Preferred shares were considered common stock equivalents for all
periods outstanding as there was no stated yield and there was an automatic
conversion feature to convert the Class A preferred to common with no
additional proceeds to the company
98
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM DECEMBER 31,
1996 ANNUAL REPORT ON FORM 10-K AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO
SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<CURRENCY> U.S. DOLLARS
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> DEC-31-1996
<EXCHANGE-RATE> 1,000
<CASH> 11,068
<SECURITIES> 2,156,029
<RECEIVABLES> 15,537
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 2,184,197
<PP&E> 0
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0
29,579
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</TABLE>
