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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED: DECEMBER 31, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM _____________ TO ____________
COMMISSION FILE NUMBER: 1-13759
REDWOOD TRUST, INC.
(Exact name of Registrant as specified in its Charter)
MARYLAND 68-0329422
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
591 REDWOOD HIGHWAY, SUITE 3100
MILL VALLEY, CALIFORNIA 94941
(Address of principal executive offices) (Zip Code)
(415) 389-7373
(Registrant's telephone number, including area code)
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Securities registered pursuant to Section 12(b) of the Act: Name of Exchange on Which Registered:
CLASS B 9.74 % CUMULATIVE CONVERTIBLE PREFERRED STOCK, NEW YORK STOCK EXCHANGE
PAR VALUE $0.01 PER SHARE
(Title of Class)
COMMON STOCK, PAR VALUE $0.01 PER SHARE NEW YORK STOCK EXCHANGE
(Title of Class)
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Securities registered pursuant to Section 12(g) of the Act:
NONE
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 11, 1998 the aggregate market value of the voting stock held by
non-affiliates of the Registrant was $224,761,545.
The number of shares of the Registrant's Common Stock outstanding on March 11,
1998 was 14,070,557.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement issued in connection
with the 1998 Annual Meeting of Stockholders are incorporated by reference into
Part III.
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REDWOOD TRUST, INC.
1997 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................................................................. 32
Item 3. LEGAL PROCEEDINGS.......................................................... 32
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........................ 32
PART II
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY
AND RELATED STOCKHOLDER MATTERS............................................ 33
Item 6. SELECTED FINANCIAL DATA.................................................... 34
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS.............................. 35
Item 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................... 80
Item 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE..................................... 80
PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT......................... 80
Item 11. EXECUTIVE COMPENSATION..................................................... 80
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
OWNERS AND MANAGEMENT...................................................... 80
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS............................. 80
PART IV
Item 14. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENTS SCHEDULES AND
REPORTS ON FORM 8-K........................................................ 80
CONSOLIDATED 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 loans and securities (together "Mortgage
Assets") financed by the proceeds of equity offerings and by
borrowings. The Company produces net interest income on Mortgage Assets
qualifying as Qualified Real Estate Investment Trust ("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 and State 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"
commencing on page 20 of this Form 10-K. The principal executive
offices of the Company are located at 591 Redwood Highway, Suite 3100,
Mill Valley, California 94941, telephone (415) 389-7373. The address of
the Company's Web site is http://www.redwoodtrust.com. 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 27 of this Form 10-K.
Reference is made to the Glossary commencing on page 83 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 in the same direction, 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 or in
operating efficiencies. 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
have had adjustable interest rates based on changes in
short-term market interest rates;
- 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 credit 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;
- to attempt 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;
- to utilize interest rate caps, swaps, futures and similar
instruments to mitigate the risk of the cost of its liabilities
increasing relative to the earnings on Mortgage Assets;
- to seek to minimize prepayment risk by structuring a diversified
portfolio with a variety of prepayment characteristics, through
hedging, 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 and other forms of long-term
financing;
- to add staff to seek to increase the Company's ability to source
Mortgage Assets in a value-added manner;
- to broaden the scope of its mortgage acquisitions over time to
include hybrid ARM and fixed rate single-family mortgages,
multifamily mortgages and commercial mortgages when management
deems such purchases to be in the best interests of
shareholders;
- to strive to become more cost-efficient and capital-efficient
over time; and
- to pursue other opportunities in mortgage finance when
management deems such activities to be in the best interest of
shareholders.
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,
government-sponsored entities ("GSE's"), 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
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lower its effective borrowing costs over time through direct funding
with collateralized lenders rather than using Wall Street
intermediaries or by 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 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, 1997
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. Through the end of 1997, all Mortgage Assets acquired by the
Company bore adjustable interest rates. Hybrid ARMS, with an initial
period to the first rate adjustment greater than one year, made up 1.6%
of Mortgage Assets. Fixed-rate Mortgage Assets may be acquired in the
future, when they satisfy the Company's Asset Acquisition/Capital
Allocation and asset/liability management 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 or better
under Standard and Poor's Corporation ("S&P") rating system and at the
comparable level under other rating systems.
The Company has not acquired residuals, interest-only strips,
principal-only strips, inverse floaters, companion bonds, first loss
Subordinated Bonds rated below BBB or mortgage securities rated below
B, except on a limited basis. The Company expects that the Company's
focus will continue to be on the acquisition of Mortgage Loans and
Mortgage Securities of a pass-thru nature rather than on the
acquisition of these types of assets. The Company may seek to acquire
additional mortgage securities rated below AA, including securities
rated below B. The Company may create a variety of different types of
assets, including the types mentioned in this paragraph, through the
normal process of securitization of the Company's own Mortgage Assets.
The Company does not plan to create taxable mortgage pools or acquire
or retain any Real Estate Mortgage Investment Conduit ("REMIC")
residual interest that may give rise to the distribution to
shareholders of "excess inclusion" income as defined under Section 860E
of the Code. See "Certain Federal Income Tax Considerations - Taxation
of Tax-Exempt Entities."
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 (e.g.,
caps, swaps and futures) 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
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index. 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 - 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 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
Securities is management's estimate of the bid side of the market value
for such assets. "Carrying value" for Mortgage Loans is amortized cost
net of any specific credit reserves on such Mortgage Loans. Management
usually bases its estimates on the lowest of third-party bid-side
indications of market value for Mortgage Securities obtained from firms
making a market in or lending against Mortgage Securities. 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 Security
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 Securities (net of any specific credit reserves on such
Mortgage Securities), 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." To determine the fair market value of the
Company's Mortgage Loans as reported in "Note 9: Fair Value of
Financial Instruments", management uses the same process as described
above for Mortgage Securities.
All of the Mortgage Loans underlying the Company's Mortgage Assets at
December 31, 1997 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 Non-conforming Mortgage Loans. Conventional
Conforming Mortgage Loans will comply with the requirements for
inclusion in a loan guarantee program sponsored by either the Federal
Home Loan Mortgage Corporation ("FHLMC") or the Federal National
Mortgage Association ("FNMA"). The Company also may acquire United
States Federal Housing Administration ("FHA") Loans or United States
Department of Veteran Affairs ("VA") Loans, which qualify for inclusion
in a pool of Mortgage Loans guaranteed by GNMA. As of January 1, 1998,
the maximum principal balance allowed on Conforming Mortgage Loans
ranges from $227,150 ($340,725 for Mortgage Loans secured by Mortgaged
Properties located in either Alaska or Hawaii) for one-unit to $436,600
($654,900 for Mortgage Loans secured by mortgaged properties located in
either Alaska or Hawaii) for four-unit residential loans.
Non-conforming 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 Non-conforming
Mortgage Loans it purchases will be non-conforming 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 Non-conforming Mortgage Loans are expected to meet the
requirements for sale to national private mortgage conduit programs in
the secondary mortgage market.
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The Company currently expects that substantial amount of the
Single-Family Mortgage Loans acquired by it will be adjustable-rate
mortgages ("ARMs"). The interest rate on an ARM is typically tied to an
index (such as the London Interbank Offered Rate ("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. Some ARMs have relatively long first periods
during which the mortgage coupon rate is fixed, after which the
mortgage coupon will change in an adjustable fashion ("Hybrid ARMS").
Initial fixed periods for Hybrid ARMS typically range from three to ten
years. The Company expects it will also acquire hybrid and fixed-rate
Single-Family Mortgage Loans.
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 analyses.
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 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 and
Multi-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.,. non-governmental) credit enhancements.
Such credit enhancements provide an extra layer of loss coverage in the
event that losses are incurred upon foreclosure sales or other
liquidations of underlying mortgaged properties in amounts that exceed
the holder's equity interest in the property and result in Realized
Losses. Forms of credit enhancements include, but are not limited to,
limited issuer guarantees, reserve funds, private mortgage guaranty
pool insurance, over-collateralization and subordination.
Subordination is a form of credit enhancement frequently used and
involves the issuance of multiple classes of Senior-Subordinated
Mortgage Securities. Such classes are structured into a hierarchy of
levels for purposes of allocating Realized Losses and also for defining
priority of rights to payment of principal and interest. Typically, one
or more classes of Senior Securities are created which are rated in one
of the two highest rating levels by one or more nationally recognized
rating agencies and which are supported by one or more classes of
Mezzanine Securities and Subordinated Securities that bear Realized
Losses prior to the classes of Senior Securities. Mezzanine Securities
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
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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. The Government National Mortgage Association
("GNMA") is a wholly-owned corporate instrumentality of the United
States within the Department of Housing and Urban Development ("HUD").
Section 306(g) of Title III of the National Housing Act of 1934, as
amended (the "Housing Act"), authorizes GNMA to guarantee the timely
payment of the principal 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, GSE 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 residential 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 ("COFI"), 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
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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, GSE 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 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 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 COFI, 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 Collateralized Mortgage Obligations
("CMOs"). The Company may, from time to time, invest in adjustable- or
fixed-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
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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 CMOs
some of which, such as Planned Amortization Class CMOs ("PAC Bonds"),
provide protection against prepayment uncertainty. Parallel pay CMOs
are structured to provide payments of principal on certain payment
dates to more than one class. These simultaneous payments are taken
into account in calculating the stated maturity date or final
distribution date of each class which, as with other CMO structures,
must be retired by its stated maturity date or final distribution date
but may be retired earlier. PAC Bonds generally require payment of a
specified amount of principal on each payment date so long as
prepayment speeds on the underlying collateral fall within a specified
range. PAC Bonds are always parallel pay CMOs with the required
principal payment on such securities having the highest priority after
interest has been paid to all classes.
Other types of CMO issues include Targeted Amortization Class CMOs
("TAC Bonds"), which are similar to PAC Bonds. While PAC Bonds maintain
their amortization schedule within a specified range of prepayment
speeds, TAC Bonds are generally targeted to a narrow range of
prepayment speeds or a specified pricing speed. TAC Bonds can provide
protection against prepayment uncertainty since cash flows generated
from higher prepayments of the underlying mortgage-related assets are
applied to the various other pass-through tranches so as to allow the
TAC Bonds to maintain their amortization schedule.
CMOs may be subject to certain rights of issuers thereof to redeem such
CMOs prior to their stated maturity dates, which may have the effect of
diminishing the Company's anticipated return on its investment.
Privately-Issued Single-Family and Multifamily CMOs are supported by
private credit enhancements similar to those used for Privately-Issued
Certificates and are often issued as Senior-Subordinated Mortgage
Securities. The Company will only acquire CMOs that constitute
beneficial ownership in grantor trusts holding Mortgage Loans, or
regular interests in REMICs, or that otherwise constitute Qualified
REIT Real Estate Assets (provided that the Company has obtained a
favorable opinion of counsel or a ruling from the Internal Revenue
Service ("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
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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 non-recourse 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.
The Company may buy or originate Commercial 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., non-
governmental) credit enhancements ("Commercial Privately-Issued
Certificates") or as CMOs ("Commercial CMOs"). Commercial Mortgage
Securities may pay adjustable rates of interest. Because of the great
diversity in characteristics of the Commercial Mortgage Loans that
secure or underlie Commercial Mortgage Securities, however, such
securities will also have diverse characteristics. Although many
Commercial Mortgage Securities are backed by large pools of Commercial
Mortgage Loans with relatively small individual principal balances,
Commercial Mortgage Securities may be backed by Commercial Mortgage
Loans collateralized by only a few commercial properties or a single
commercial property. Because the risk involved in single commercial
property financings is highly concentrated, single-property Commercial
Mortgage Securities to date have tended to be limited to extremely
desirable commercial properties with excellent values and/or lease
agreements with extremely creditworthy and reliable tenants, such as
major corporations.
Commercial Mortgage Securities generally are structured with some form
of private credit enhancement to protect against potential Realized
Losses on the underlying Mortgage Assets. As with Single-Family
Mortgage Securities, such credit enhancements provide an extra layer of
loss coverage in cases where the equityholder's equity interest in the
underlying mortgaged property has been completely extinguished. Because
of the particular risks that accompany Commercial Mortgage Securities,
the required amount and corresponding cost of such credit support may
be significant. Credit supports used in the Commercial Mortgage
Securities market have included, but have not been limited to, limited
issuer guarantees, reserve funds, Subordinated Securities (which bear
the risks of default before more senior classes of securities of the
same issuer), cross-collateralization, over-collateralization,
cross-default provisions, subordination and letters of credit. The
Company expects that multiple-class structures, featuring
Senior-Subordinated Mortgage Securities, will continue to be the most
common form of credit enhancement used in the Commercial Mortgage
Securities markets. In addition to credit support, Commercial Mortgage
Securities may be structured with liquidity protections intended to
provide assurance of timely payment of principal and interest. Such
protections may include surety bonds, letters of credit and payment
advance agreements. The process used to rate Commercial Mortgage
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. Non-
governmental entities that have issued or sponsored Commercial Mortgage
Securities include owners of commercial properties, originators of and
investors in Commercial 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
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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.
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 has focused primarily on the acquisition of floating-rate,
adjustable-rate and, beginning in 1997, hybrid ARM assets, but intends
to acquire fixed-rate assets in the future. The Company generally
intends to acquire fixed-rate loans when such loans can meet its return
and other standards when funded on a long-term basis, financed with
equity only, or funded on a short-term basis with a comprehensive
hedging program. Generally it is anticipated that any such long-term
financing or comprehensive hedging program will serve to reduce the
risk that could arise from the funding of term fixed-rate assets with
variable-rate debt.
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 may seek to acquire other mortgage finance businesses when
management deems such activities to be in the best interest of the
Company's shareholders.
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. 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, to effect a change in
strategy, 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's current policy is to
seek to distribute 100% of its taxable income as dividends over time.
The Company may also make distributions constituting returns of capital
should the return expectations of the stockholders 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. Management monitors the overall portfolio risk
and determines appropriate levels of provision for credit loss and
provides such information to the Board of Directors.
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 mortgages and the nature and level of credit
enhancements supporting such securities. Most of the Mortgage
Securities acquired by the Company have some degree of protection from
normal credit losses. At December 31, 1997 and December 31, 1996, 29%
and 45%, respectively, of the Company's Mortgage Assets were Mortgage
Securities covered by credit protection in the form of a 100% guarantee
from a GSE ("Agency Certificates").
An additional 25% and 31% of the Company's Mortgage Assets at December
31, 1997 and December 31, 1996, respectively, were Privately-Issued
Certificates and represented interests in pools of residential mortgage
loans with partial credit enhancement; of these amounts, 99% and 96%
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, some Mortgage
Securities 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. The Company has
undertaken an independent underwriting review of a sample of the loans
underlying the
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Privately-Issued Certificates that are rated below BBB which represent
1% and 4% of the Company's Privately-Issued Certificates as of December
31, 1997 and 1996, respectively.
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 generally 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 generally
underwrite all Multifamily and Commercial Mortgage Loans that the
Company acquires. 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 GSE 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 and/or cause
adverse tax consequences for the Company. 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 funded short-term
less the book value of total collateralized short-term borrowings plus
the actual investment on a historical amortized cost basis in
subsidiary trusts ("mortgage equity interests") wherein Mortgage Assets
are funded with non-recourse, long-term debt less the book value of any
parent-level debt associated with these mortgage equity interests, less
any unsecured debt.
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 had 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 with respect
to short-term funded assets is the current aggregate over-
collateralization amount or "haircut" that lenders require the Company
to hold as capital. The haircut for each such Mortgage Asset is
determined by the lender based on the risk characteristics and
liquidity of that asset. Haircut levels on individual borrowings range
from 2% for Agency Certificates and Mortgage Loans to 25% for certain
Privately-Issued Certificates, and currently average 3% to 5% for the
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Company as a whole. Should the market value of the pledged assets
decline, the Company will be required to deliver additional collateral
to the lenders in order to maintain a constant over-collateralization
level on its short-term borrowings.
The second component of the Company's capital requirement with respect
to short-term funded assets 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 short-term lenders for additional collateral
should the market value of the Company's short-term funded 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 short-term funded Mortgage Assets.
Liquidity capital cushions are assigned to each short-term funded
Mortgage Asset based on management's assessment of that Mortgage
Asset's market price volatility, credit risk, liquidity and
attractiveness for use as collateral by short-term 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
short-term funded 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 3% to 15% of
the sum of the market value of the Company's short-term funded Mortgage
Assets and the book value of its long-term funded 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
short-term funded Mortgage Assets changes, as liquidity capital
cushions set by the Board of Directors are adjusted over time, and as
the balance of funding between short-term and long-term changes. As of
December 31, 1997, the aggregate Risk-Adjusted Capital Requirement was
7.51% of total assets. The Company's actual capital base was 9.73% of
total assets at December 31, 1997, thus the Company was not utilizing,
at that time, all of the leverage potential available to the Company
under its Risk- Adjusted Capital policies.
Over 50% of the Company's borrowings were short-term at December 31,
1997. The Company's short-term borrowings have consisted of
collateralized borrowing arrangements of various types (reverse
repurchase agreements, notes payable, and revolving lines of credit).
As of December 31, 1997, the Company had no outstanding notes payable
or revolving lines of credit. The Company's long-term borrowings at
December 31, 1997 consisted of non-recourse, floating-rate with life
caps, collateralized mortgage bonds. 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, the issuance of
long-term collateralized debt or similar instruments in the form of
collateralized mortgage bonds, collateralized bond obligations, REMICs,
FASITs, or other forms, and the issuance of secured and unsecured debt
securities such as commercial paper, medium-term notes and senior or
subordinated notes.
At December 31, 1997, the Company had not entered into commitment
agreements under which the lender would be required to enter into new
reverse repurchase agreements during a specified period of time, nor
did the Company 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 short-term collateralized borrowings
only with financial institutions meeting credit standards approved by
the Company's Board of Directors, including
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approval by a majority of Independent Directors, and monitors the
financial condition of such institutions on a regular basis.
A reverse repurchase agreement, although structured as a sale and
repurchase obligation, acts as a financing 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
To the extent consistent with its election to qualify as a REIT, the
Company follows an interest rate risk management program intended to
protect principally against the effects of substantial increases in
interest rates. 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 frequency of its
adjustable-rate Mortgage Assets and related borrowings. The Company's
interest rate risk management program encompasses a number of
procedures. 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, hybrid and fixed-rate Mortgage Assets purchased by the
Company. 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 and by modifying the effective
characteristics of borrowing through the use of interest rate
agreements. Through use of these procedures, the Company intends to
minimize differences between interest rate adjustment periods of
Mortgage Assets and related borrowings that may occur.
The Company purchases and sells, from time to time, interest rate caps,
interest rate floors, interest rate swaps, interest rate futures,
options on interest rate futures 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. The Company also may use such
instruments to modify the characteristics of any fixed-rate loan
issuance or to hedge the anticipated issuance of future liabilities or
the market value of certain assets. 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
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need to maintain the Company's status as a REIT. See "Certain Federal
Income Tax Considerations - General - Gross Income Tests." This
determination may result in management electing to have the Company
bear a level of interest rate risk that could otherwise be hedged when
management believes, based on all relevant facts, that bearing such
risk is prudent in light of competing tax and market risks. 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 programs 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 and floor agreement is a legal contract between
the Company and a third party firm (the "counter-party"). When the
Company purchases a cap or floor contract, 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 reference rate
(typically one- or three-month LIBOR) rise above (cap agreements) or
fall below (floor agreements) the "strike" rate specified in the
contract. Each contract has a "notional face" amount. Should the
reference rate rise above the contractual strike rate in a cap, the
Company will earn cap income. Should the reference rate fall below the
contractual strike rate in a floor, the Company will earn floor income.
Payments on an annualized basis will equal the contractual notional
face amount times the difference between actual reference rates and the
contracted strike rate. When the Company sells a cap or floor
agreement, the Company receives a premium payment but may be liable for
future payments based on movements in the reference rate.
Interest rate swaps are agreements in which a series of interest rate
flows are exchanged over a prescribed period. The notional amount on
which the interest payments are based is not exchanged. Most of the
Company's swaps involve the exchange of either fixed interest payments
for floating interest payments or the exchange of one floating interest
payment for another floating interest payment based on a different
index. Most of the interest rate swaps require that the Company provide
collateral in the form of Mortgage Assets to the counterparty.
Interest Rate Futures ("Futures") are contracts for the delivery of
securities or cash in which the seller agrees to deliver on a specified
future date, a specified instrument (or the cash equivalent), at a
specified price or yield. Under these agreements, if the Company has
sold (bought) the futures, the Company will generally receive
additional cash flows if interest rates rise (fall). Conversely, the
Company will generally pay additional cash flows if interest rates fall
(rise).
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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.
At December 31, 1997, 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
assuming stable interest rates. Looking at these two factors only (and
thus ignoring periodic and life caps and other risks such as basis risk
and prepayment risk), 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, 1997 had coupon rates
that adjust to market levels at least every twelve months, with a
weighted average term to reset of approximately four months. The
majority of the Company's borrowings at December 31, 1997 will either
mature or adjust to a market interest rate level within six months of
such date. The short-term borrowings had a weighted average term to
rate reset of 31 days at December 31, 1997. 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 and/or Treasury 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, basis and prepayment risks, no strategy can
completely insulate the Company from the effect of interest rate
changes, prepayment risks, mortgage credit losses, defaults by
counterparties, or liquidity risk. 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 over the
long-term.
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, when possible, balancing Mortgage Assets purchased at
a premium with Mortgage Assets purchased at a discount when such types
of assets are available in the marketplace. In certain operating
environments, including most of 1997, however, it has not been possible
for the Company to acquire assets with a zero net balance of discount
and premium. In such circumstances, the risk of earnings variability
resulting from changes in prepayment rates rises. In addition, the
Company may purchase interest-only strips, principal-only strips and/or
other financial assets such as floors, calls, swaptions and futures, as
a hedge against
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prepayment risks. The Company may also seek to create and sell
interest-only and principal-only strips from existing assets to help
manage prepayment risk. Prepayment risk is monitored by management and
the Board of Directors through periodic review of the impact of a
variety of prepayment scenarios on the Company's revenues, net
earnings, dividends, cash flow and net balance sheet market value.
The Company owns a variety of non-agency Mortgage Securities which are
structured so that for several years they receive either less than or
more than a pro rata share of principal repayments experienced in the
underlying mortgage pool as a whole. In such Mortgage Securities, one
or more classes of Senior Securities are ordinarily entitled to receive
all principal prepayments on the underlying pool of loans until such
Senior Securities have been paid down to a specified amount determined
by formula. To illustrate, 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 1997, the Company received $973.1 million in principal payments
on its Mortgage Assets. One commonly used measure of the average annual
rate of prepayment of mortgage principal is the conditional prepayment
rate ("CPR"). The CPR for the Company's Mortgage Assets was 25% for
1997. In addition to prepayments, the Company also receives scheduled
mortgage principal payments (payments representing the normal principal
amortization of a 30-year mortgage loan). Thus, the total amount of
repayments of mortgage principal received each month exceeds the level
of prepayments. The annualized rate of principal repayment (total
principal received as a percent of average face value of Mortgage
Assets) the Company experienced was 34%. The amortized cost of the
Company's Mortgage Assets at December 31, 1997 was equal to 102.20% of
the face value of the assets; the net premium was 2.20%. The smaller
the level of net discount or premium, the less risk there is that
fluctuations in prepayment rates will affect earnings. The Company may
use interest rate agreements and other means to seek to mitigate the
risk that premium amortization expenses may rise as mortgage
prepayments increase in falling interest rate environments.
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 or holding in their portfolio. 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 most of the Mortgage Loans it acquires by
securitizing the loans into Mortgage Securities or pledging the loans
to secure the issuance of long-term debt in the manner which will best
meet its own needs.
In addition to creating Mortgage Securities and issuing long-term debt
with 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 Mortgage Securities improve in credit quality through
seasoning, as values rise on the underlying properties or when the
credit quality of junior classes of Mortgage Securities improve 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. In December 1997, the Company
completed its first re-securitization.
The Company may conduct its securitization activities through one or
more taxable or REIT-qualifying subsidiaries formed for such purpose.
In 1997, the Company formed Sequoia Mortgage Funding Corporation
("Sequoia"), a REIT-qualifying subsidiary, to carry out
securitizations. During 1997, Sequoia completed three
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securitizations. The Company issued $1.3 billion of non-recourse debt,
which appears on the balance sheet, and $0.05 billion of securities
through a re-REMIC as a result of these securitizations.
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 Internal Revenue
Code of 1986, as amended (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 failed to qualify as a
REIT in any particular year, it would be subject to Federal income tax
as a regular, domestic corporation, and its stockholders would be
subject to tax in the same manner as stockholders of such corporation.
In this event, the Company could be subject to potentially substantial
income tax liability in respect of each taxable year that it fails to
qualify as a REIT, and the amount of earnings and cash available for
distribution to its stockholders could be significantly reduced or
eliminated.
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 by the Company each
taxable year. The Company must solicit information from certain of its
shareholders to verify ownership levels and its Articles of
Incorporation provide restrictions regarding the transfer of the
Company's shares in order to aid in meeting the stock ownership
requirements. If the Company were to fail either of the stock ownership
tests, it would generally be disqualified from REIT status, unless, in
the case of the "five or fewer" requirement, the recently enacted "good
faith" exemption is available.
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
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(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, and
(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 non-qualifying 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,
options, futures and forward contracts 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) for four years prior to 1998, less than 30% of the
Company's gross income must have been 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").
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" below 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.
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QUALIFIED REIT SUBSIDIARIES
The Company currently holds some of its assets through Sequoia Mortgage
Funding Corporation, a wholly-owned subsidiary, which it believes is a
"Qualified REIT Subsidiary". As such its assets, liabilities and income
are generally treated as assets, liabilities and income of the Company
for purposes of each of the above REIT qualification tests.
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.
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 uses 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.
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The Company recently formed, but is not yet operating, a taxable REIT
subsidiary. There is currently proposed legislation in Congress
(described below) which could, if passed, restrict or eliminate the
Company's ability to use such taxable subsidiary.
TAXATION OF STOCKHOLDERS
COMMON STOCK
Distributions (including constructive distributions) made to holders of
Common Stock other than tax-exempt entities (and not designated as
capital gain dividends) 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 mid-term if
the stock was held for more than twelve months and long-term if the
stock was held for more than eighteen months. 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.
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.
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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. However, if the Company were to
hold residual interests in a REMIC, or if a pool of its assets were to
be treated as a "taxable mortgage pool," a portion of the dividends
paid to a tax-exempt stockholder may be subject to tax as unrelated
business taxable income ("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.
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
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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-United States 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 United States Federal income tax from
gains recognized upon disposition of its shares.
INFORMATION REPORTING AND BACKUP WITHHOLDING
The Company will report to its U.S. shareholders and the Internal
Revenue Service the amount of distributions paid during each calendar
year, and the amount of tax withheld, if any. Under the backup
withholding rules, a shareholder may be subject to backup withholding
at the rate of 31% with respect to distributions paid unless such
holder (a) is a corporation or comes within certain other exempt
categories and, when required, demonstrates that fact; or (b) provides
a taxpayer identification number, certifies as to no loss of exemption
from backup withholding, and otherwise complies with applicable
requirements of the backup withholding rules. A shareholders that does
not provide the Company with its correct taxpayer identification number
may also be subject to penalties imposed by the Internal Revenue
Service. Any amount paid as backup withholding will be creditable
against the shareholder's income tax liability. In addition, the
Company may be required to withhold a portion of dividends and capital
gain distributions to any shareholders who do not certify under
penalties of perjury their non-foreign status to the Company.
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PROPOSED TAX LEGISLATION
The President's 1999 Budget Plan (released on February 2, 1998)
includes certain tax proposals applicable to REITs that may be relevant
to the Company. In particular, one proposal would prohibit a REIT from
owning more than 10% of the voting power or value of the stock of any
corporation other than a "Qualified REIT Subsidiary". (The current 10%
ownership limit described previously relates only to voting power.)
This proposal is intended to limit the ability of REITs to form taxable
subsidiaries to undertake activities that would otherwise give rise to
non-qualifying income or assets if earned or held by a REIT directly.
It is proposed to be effective with respect to stock acquired on or
after the date of "first committee action" (by the House Ways & Means
Committee or the Senate Finance Committee) and any grandfathering with
respect to stock acquired prior to the date of "first committee action"
would be terminated if the applicable corporation engages in a new
trade or business or acquires substantial new assets after such date.
To date no such committee action has occurred .
Another proposal would generally expand the "five or fewer" stock
ownership test to also limit entities from owning or controlling 50%
of a REITs stock.
It is unclear whether these or any of the President's other tax
proposals will be enacted, and if so, in what form. It is therefore
unclear whether (i) the Company will in fact be able to utilize its
recently formed taxable subsidiary to achieve its intended benefits or
(ii) will otherwise be adversely effected by the President's tax
proposals.
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, GSEs,
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 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. 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.
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EMPLOYEES
As of March 11, 1998, the Company had nineteen employees.
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, the supply of and
demand for such Mortgage Assets and conditions in debt markets. 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 or, in the case of certain forms
of long-term debt, face 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 3% 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 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, rating agency and
bond insurer requirements for long-term financing 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. At December 31, 1997, the Company relied
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on short-term borrowings to fund over 50% of its Mortgage Assets that
have adjustable-rate coupons and long-term maturities. The Company may,
in the future, utilize short-term borrowings to fund hybrid and
fixed-rate Mortgage Assets. 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 the event the Company is not able to renew or replace
maturing borrowings, the Company could be required to sell Mortgage
Assets under adverse market conditions and could incur losses as a
result. In addition, in such event, the Company may be required to
terminate Interest Rate 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
which are short-term funded 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 short-term funded
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 short-term borrowing obligations of the Company from 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 on the Company's short-term debt (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 or
hybrid Mortgage Assets pursuant to its Asset Acquisition/Capital
Allocation Policies, such fixed-rate Mortgage Assets, if funded with
short-term debt, may be more susceptible to margin calls as increases
in interest rates tend to more negatively affect the market value of
fixed-rate or hybrid 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
short-term or long-term 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 some
of the Company's Mortgage Assets in the future will continue to bear,
adjustable interest or pass-through rates based on short-term interest
rates, and substantially all of the Company's borrowings connected with
adjustable-rate assets will bear interest at short-term rates. Such
borrowings, if short-term, will typically have maturities or resets 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
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Company which will be utilized to fund the Mortgage Assets and, to the
extent such costs rise more rapidly than the yields on such Mortgage
Assets, 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 some circumstances, however, the yield on the Company's
Mortgage Assets may fall faster than the Company's cost of funds, thus
decreasing net interest income. In the longer-term, lower short-term
interest rates are expected to be more likely to lead to lower net
income and higher short-term interest rates are expected to be more
likely to lead to higher 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,
borrowings or net interest income.
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 adjustable-rate, fixed-rate and hybrid Mortgage Loans and Mortgage
Securities backed by adjustable-rate, fixed-rate and hybrid Mortgage
Loans usually can be expected to increase when mortgage interest rates
fall below the then-current interest rates on such assets and decrease
when mortgage interest rates exceed the then-current interest rates on
the assets, 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, general
economic conditions and other factors. 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,
balancing Mortgage Assets purchased at a premium with Mortgage Assets
purchased at a discount and prepayment hedging. In certain operating
environments, however, it may not be possible for the Company to
acquire assets with a zero net balance of discount and premium. The
Company may choose not to hedge prepayment risk, and any such hedges
may not be effective. In such circumstances, the risk of earning
variability resulting from changes in prepayment rates may rise. In
addition, the Company has purchased interest-only strips and may in the
future purchase interest-only and principal-only strips to a limited
extent. No strategy can completely insulate the Company from prepayment
risks arising from the effects of interest rate changes while
simultaneously meeting returns acceptable to shareholders.
Changes in anticipated prepayment rates of Mortgage Assets could affect
the Company in several adverse ways. The faster than anticipated
prepayment of any adjustable-, hybrid- or fixed-rate Mortgage Asset
with a premium balance that is owned 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, increased prepayments may
disadvantage the Company in environments where the Company can only
acquire assets with lower returns than its existing assets. 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 Mortgage Loans)
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
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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/or when 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.
The Company purchases and sells from time to time interest rate caps,
interest rate swaps, interest rate futures 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 to modify the characteristics of any
fixed-rate loan issuance or to hedge the anticipated issuance of future
liabilities or the market value of certain assets. In this way, the
Company intends generally to hedge as much of the interest rate risk
and prepayment 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 purposes 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 floors or
enters into other contractual interest rate agreements, 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 an on-going basis, no
assurance can be given that the Company can avoid such third party
risks.
RISK OF LOSS ON SINGLE-FAMILY MORTGAGE ASSETS
At December 31, 1997, 54% of the Mortgage Assets owned by the Company
were Mortgage Securities. The Company bears the risk of loss on any
Mortgage Securities it purchases in the secondary mortgage market or
otherwise. However, 99% of Mortgage Securities at December 31, 1997,
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 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
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Loans may also cease to be eligible collateral for short-term
borrowings and, to the extent not funded with long-term, non-recourse
debt, would have to be financed by the Company out of other funds or
funded with equity until ultimately liquidated, resulting in increased
financing costs, 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.
The Company is building a credit reserve for potential 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 Generally Accepted Accounting Principles ("GAAP").
Moreover, for tax purposes, credit losses are not covered by the GAAP
credit provisions; rather, credit losses reduce the Company's taxable
income in the period in which they are realized and hence would 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 may 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. If the anticipated or actual net yield on the
Company's Mortgage Assets declines or if prevailing short-term 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.
RECENT PROPOSED TAX LEGISLATION
The President's recently released 1999 Budget Plan includes certain
proposed legislative changes which, if enacted, could adversely affect
the Company and its ability to engage in certain activities. Under the
President's proposals, among other things, a REIT would be prohibited
from owning more than 10 percent of the stock of a corporation (other
than a "Qualified REIT Subsidiary") measured either by vote or by
value, rather than more than 10 percent of the voting stock of such a
corporation as under current law. If this proposal is adopted, the
Company will be unable to establish taxable subsidiaries through which
to engage in non-qualifying activities, such as the holding of property
primarily for sale in the ordinary course of business or certain
hedging activities. It is impossible to predict at this time whether
one or more of the President's proposals, or other proposals
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<PAGE> 32
which would similarly affect the Company, will ultimately be adopted.
See "Certain Federal Income Tax Considerations - Proposed Tax
Legislation".
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, 1997, 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 1997.
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
As of January 28, 1998, the Company's Common Stock is listed and traded
on the New York Stock Exchange under the symbol RWT. Prior to that
date, the Company's Common Stock was traded on the over-the-counter
market and was quoted on the Nasdaq National Market under the symbol
RWTI. The Company's Common Stock was held by approximately 400 holders
of record on March 11, 1998 and the total number of beneficial
shareholders holding stock through depository companies was
approximately 4,000. The high and low closing sales prices of shares of
the Common Stock as reported on the New York Stock Exchange or the
Nasdaq National Market composite tape and the cash dividends declared
on the Common Stock for the periods indicated below were as follows:
<TABLE>
<CAPTION>
Stock Prices Dividends
High Low Declared
------------------------------------
<S> <C> <C> <C>
Year Ended
December 31, 1998
-----------------
First Quarter (through
March 11, 1998) $22 1/2 $18 5/8 N/A
Year Ended
December 31, 1997
-----------------
First Quarter $56 3/4 $36 1/2 $0.60
Second Quarter $57 1/8 $39 1/4 $0.60
Third Quarter $50 $27 7/8 $0.60
Fourth Quarter $31 3/4 $19 9/16 $0.35
Year Ended
December 31, 1996
-----------------
First Quarter $21 3/4 $18 3/4 $0.46
Second Quarter $28 $19 3/8 $0.40
Third Quarter $32 1/4 $23 1/4 $0.40
Fourth Quarter $37 1/2 $31 1/4 $0.41
</TABLE>
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, 1997, the full cumulative dividends have been paid on the
Preferred Stock.
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<PAGE> 34
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data is for the years ended December 31, 1997,
1996 and 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
Consolidated 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>
- ------------------------------------------------------------------------------------------------------------------------------
(IN THOUSANDS, EXCEPT PER SHARE DATA) PERIOD FROM
YEARS ENDED DECEMBER 31, AUGUST 19, 1994 TO
1997 1996 1995 DECEMBER 31, 1994
------------------------------------------------------------------------
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Interest income $ 198,604 $ 67,284 $ 15,726 $ 1,296
Interest expense 160,277 49,191 10,608 760
Interest rate agreement expense 3,741 1,158 339 8
Net interest income 34,586 16,935 4,779 528
Net income 27,561 12,685 3,155 382
Net income available to common stockholders $ 24,746 $ 11,537 $ 3,155 $ 382
Net taxable income $ 29,964 $ 15,168 $ 3,832 $ 354
Net taxable income available to common
stockholders $ 27,149 $ 14,020 $ 3,832 $ 354
Weighted average shares of common stock and
common stock equivalents - "diluted" 13,680,410 8,744,184 3,703,803 1,916,846
Diluted earnings per share $ 1.81 $ 1.32 $ 0.85 $ 0.20
Dividends declared per Class A preferred
share N/A N/A $ 0.500 $ 0.250
Dividends declared per Class B preferred
share $ 3.020 $ 1.141 N/A N/A
Dividends declared per common share $ 2.150 $ 1.670 $ 0.460 N/A
BALANCE SHEET DATA:
Mortgage assets $ 3,366,622 $ 2,153,428 $ 432,244 $ 117,477
Total assets $ 3,444,197 $ 2,184,197 $ 441,557 $ 121,528
Short-term debt $ 1,914,525 $ 1,953,103 $ 370,316 $ 100,376
Long-term debt $ 1,172,801 -- -- --
Total liabilities $ 3,109,660 $ 1,973,192 $ 373,267 $ 101,248
Total stockholders' equity $ 334,537 $ 211,005 $ 68,290 $ 20,280
Number of Class A preferred shares
outstanding -- -- -- 1,666,063
Number of Class B preferred shares
outstanding 909,518 1,006,250 -- --
Number of common shares outstanding 14,284,657 10,996,572 5,517,299 208,332
OTHER DATA:
Average assets (amortized cost) $ 3,036,725 $ 999,762 $ 220,616 $ 58,414
Average borrowings $ 2,709,208 $ 861,316 $ 174,926 $ 37,910
Average equity $ 307,029 $ 131,315 $ 43,349 $ 20,137
Interest rate spread 0.68% 1.09% 1.11% 0.72%
Net interest margin 1.14% 1.69% 2.17% 2.50%
Operating expenses as a percent of net
interest income 13.47% 15.08% 23.66% 27.73%
Operating expenses as a percent of average
assets 0.15% 0.26% 0.51% 0.69%
Operating expenses as a percent of average
equity 1.52% 1.94% 2.61% 2.01%
Return on average assets 0.91% 1.27% 1.43% 1.81%
Average assets/average equity 9.89x 7.61x 5.09x 2.93x
Return on average equity 8.98% 9.66% 7.28% 5.25%
Credit reserves $ 4,931 $ 2,180 $ 490 --
Actual credit losses $ 179 $ 7 $ 4 --
</TABLE>
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<PAGE> 35
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the
Consolidated 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 27 of this Form 10-K.
OVERVIEW
Redwood Trust, Inc. is a financial institution specializing in the
single-family residential mortgage spread lending business. The Company
earns net income to the extent that the interest income it earns from
its mortgage loans and securities exceeds the cost of borrowed funds,
hedging, credit loss expenses and operating expenses.
The Company seeks to earn net interest income from first-lien
single-family residential mortgage loans and securities underwritten to
"A" or "prime" quality standards. The Company believes its primary
competitors in the "A" quality mortgage spread lending business are
banks, savings and loans, insurance companies, the two
government-sponsored mortgage entities ("GSEs": Fannie Mae and Freddie
Mac) and other mortgage Real Estate Investment Trusts ("REITs").
The Company has chosen to pursue a wholesale strategy (such as is
employed by the GSEs) rather than a retail strategy (such as is
employed by most banks and savings and loans). Like the GSEs, the
Company does not originate loans directly but rather acquires loans
from mortgage origination companies and from the secondary mortgage
market. Like the GSEs, the Company out-sources the servicing of its
mortgage loans and sources its borrowings on a wholesale basis in the
capital markets rather than seeking retail deposits through a branch
banking system. The Company believes that its wholesale strategy allows
the Company to operate in a highly efficient manner while remaining
focused on its core spread lending business.
Over the past year, the Company has moved a long way towards
transforming itself from a spread lending company managing mortgage
securities funded with short-term debt to a spread lending company
managing high-quality single-family mortgage loans funded with
long-term debt. The impact of this transition on the Company's results
is discussed below.
The Company has elected to be considered a REIT with respect to Federal
and state income taxes. This election generally allows the Company to
avoid paying corporate income tax so long as it distributes at least
95% of its taxable income as dividends and meets the other REIT
requirements.
RESULTS OF OPERATIONS
Mortgage Asset Acquisitions, Principal Repayments and Net Asset Growth
In the fourth quarter of 1997, the Company acquired $342 million in
mortgage assets, including $275 million in mortgage loans and $67
million in mortgage securities. The Company received mortgage principal
repayments of $347 million and sold mortgage securities for $46 million
during this period. The net decline in total assets was $81 million, or
2%, in the fourth quarter of 1997.
In 1997, the Company acquired $1.3 billion in mortgage loans and $1.0
billion in mortgage securities. The Company received mortgage principal
repayments of $973 million and sold mortgage securities for $88
million. Total assets grew by $1.3 billion, or 58%, to $3.4 billion.
35
<PAGE> 36
In 1996, the Company acquired $0.5 billion in mortgage loans and $1.5
billion in mortgage securities. The Company received mortgage principal
repayments of $258 million. Total assets grew by $1.7 billion, or 395%,
to $2.2 billion.
Through December 31, 1997, all mortgage loans acquired have been
high-quality, adjustable-rate, first-lien mortgages on single-family
residential properties. All mortgage securities acquired have
represented securitized interests in pools of adjustable rate,
single-family mortgage loans.
One commonly used measure of the average annual rate of prepayment of
mortgage principal is the conditional prepayment rate ("CPR"). The CPR
for the Company's mortgage loans and the mortgages contained in the
pools underlying its mortgage securities increased from 19% in 1995 to
25% in both 1996 and 1997. The CPR rate of the Company's mortgage asset
portfolio in the fourth quarter of 1997 was 27%. The CPR rate of the
Company's mortgage asset portfolio has ranged between 23% and 29% since
the fourth quarter of 1995.
In addition to prepayments, the Company also receives scheduled
mortgage principal payments (payments representing the normal principal
amortization of a 30-year mortgage loan). Some mortgage securities
owned by the Company are subject to call provisions and some receive
accelerated payments, i.e., a greater than pro-rata share of principal
repayments generated by the underlying mortgage pool. Thus the total
amount of repayment of mortgage principal received each month exceeds
the level of prepayments. The average annualized rate of mortgage
principal repayment from all of these sources as a percent of the
average principal balance of mortgage assets increased from 18% in 1995
to 27% in 1996 to 34% in 1997. Principal repayments from all sources
accelerated to 43% in the fourth quarter of 1997. The annualized rate
of mortgage principal repayment of the Company's mortgage assets has
ranged between 26% and 32% from the fourth quarter of 1995 through the
third quarter of 1997.
Creation of Mortgage Equity Interests, Issuance of Long-Term Debt,
REMICs
Over the past year, the Company has concentrated on reducing liquidity
risk and other risks on its balance sheet by replacing short-term debt
with long-term debt. It has done this through the creation of "mortgage
equity interests." The Company defines a mortgage equity interest as
the ownership of the equity portion of a mortgage spread lending
"subsidiary trust" wherein the assets of the trust are funded with
long-term debt or similar instruments, the debt and other liabilities
of the trust are non-recourse to the Company, and liquidity risk is
essentially eliminated. Mortgage equity interests can be created
through transactions structured as collateralized mortgage bonds,
collateralized bond obligations, REMICs, FASITs and other means.
Through its special-purpose finance subsidiary, Sequoia Mortgage
Funding Corporation ("Sequoia"), the Company issued $1.3 billion of
non-recourse, floating-rate, long-term debt in 1997 in the form of
collateralized mortgage bonds. The Company used the proceeds to reduce
short-term debt. All of the long-term debt is rated AAA, amortizes at
approximately the same rate as the collateral and has a 10% lifetime
interest rate cap. On a consolidated basis, long-term debt at year end
was $1.2 billion and represented 38% of total debt. At year end, the
investment in the mortgage equity interests created through the Sequoia
program totaled $49 million. Liquidity and market value fluctuation
risk for that portion of the Company's equity base has been
substantially eliminated. Recognizing this risk reduction, the Company
requires significantly lowered Risk-Adjusted Capital guideline amounts
for Sequoia assets as opposed to assets held in the Redwood Trust
parent corporation funded with short-term debt. As a result, the
Company's overall weighted average Risk-Adjusted Capital guideline
equity-to-assets ratio declined from 9.97% at the end of 1996 to 7.51%
at the end of 1997.
In 1994 and 1995, the Company acquired a $55 million portfolio of
mortgage equity interests which had been created by others in the form
of subordinated tranches of REMIC transactions. The Company was able to
effectively re-finance this portfolio of mortgage equity interests in
December 1997 through a non-recourse re-REMIC transaction with an
insurance company as the counter-party. Through this transaction, the
Company was able to reduce its net equity capital investment in this
portfolio from $20 million to $9 million. This transaction
significantly reduced the Company's credit risk and liquidity risk from
this portfolio, while at the same time enhanced the Company's return on
equity from these assets and freed up a substantial portion of the
Company's original capital investment in this portfolio for
reallocation to fund future growth opportunities.
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<PAGE> 37
Although this re-REMIC transaction is most easily understood as a
financing, it qualified as a sale for accounting purposes. As a result,
the company recognized a gain on sale from the re-REMIC of $0.54
million for GAAP income and $0.35 million for taxable income and the
net amount of $46.4 million of assets in the REMIC which were
refinanced through the issuance of re-REMIC securities do not appear on
the Company's consolidated balance sheet.
Mortgage equity interests created and retained by the Company through
the re-REMIC and Sequoia transactions totaled $58 million at year end.
The Company generally intends to fund ownership of mortgage equity
interests with equity capital rather than through the use of debt. Over
17% of the Company's equity base was allocated to mortgage equity
interests at year end 1997. The Company intends to seek to increase
this allocation over time through the creation of additional mortgage
equity interests and through the acquisition of mortgage equity
interests created by others.
Interest Income
From the third quarter of 1997 to the fourth quarter of 1997, interest
income declined by 5%. This decrease was the result of lower coupon
rates and higher prepayments. In the fourth quarter of 1997, average
earning assets of $3.30 billion generated interest income of $54.0
million. In the third quarter of 1997, average earning assets of $3.33
billion generated interest income of $56.5 million.
In the fourth quarter of 1997, the Company's earning asset yield
(interest income annualized and divided by the average daily amortized
cost of earning assets) of 6.54% was below the yield of 6.80% achieved
in the third quarter of 1997. The average mortgage coupon rate
(mortgage interest payments annualized and divided by the average daily
principal value of mortgages) fell from 7.77% to 7.70%. The coupon
yield on the Company's average amortized cost of 102.2% for the
Company's mortgages also fell 0.07%, from 7.60% to 7.53%. Net mortgage
premium and discount amortization expenses increased from $6.9 million
to $8.2 million from the third to the fourth quarter of 1997. These
expenses reduced the yield on earning assets by 0.98% in the fourth
quarter of 1997 and 0.79% in the third quarter of 1997. This 0.19%
reduction in yield due to prepayments and the 0.07% drop in coupon
rates resulted in the yield on earning assets falling by 0.26% in the
fourth quarter of 1997 from the previous quarter.
From 1996 to 1997, interest income increased by 195%. From 1995 to
1996, interest income increased by 328%. These increases were driven
primarily by a 203% increase in average earning assets (mortgage assets
plus cash) from 1996 to 1997 and a 355% increase in average earning
assets from 1995 to 1996. In 1997, the Company's average earning assets
of $2.95 billion generated interest income of $198.6 million. In 1996,
average earning assets of $0.97 billion generated interest income of
$67.3 million. In 1995, average earning assets of $0.21 billion
generated interest income of $15.7 million.
In 1997, the Company's earning asset yield was 6.74%. The average
mortgage coupon rate was 7.72%. Since the Company's average amortized
cost was 102.1% of mortgage principal value during the year, the coupon
yield on amortized cost for the Company's mortgages was 7.56%. Net
mortgage premium amortization expenses of $23.4 million reduced the
coupon yield by 0.81% for a net mortgage yield of 6.75%. The yield
earned on the Company's cash balances during the year was 5.53%; the
blended earning asset yield was 6.74%.
The Company's earning asset yield was 6.93% in 1996. The average
mortgage coupon rate was 7.55%. Since the Company's average amortized
cost for mortgage assets was 100.7% of mortgage principal value during
the year, the coupon yield on amortized cost for the Company's
mortgages was 7.50%. Net mortgage premium amortization expenses of $5.2
million reduced the coupon yield by 0.55% for a net mortgage yield of
6.95%. The yield earned on the Company's cash balances during the
quarter was 5.51%, bringing the overall 1996 blended earning asset
yield to 6.93%.
The Company's earning asset yield was 7.36% in 1995. The average
mortgage coupon rate was 7.16%. Since the Company's average amortized
cost for mortgage assets was 99.0% of mortgage principal value during
the year, the coupon yield on amortized cost for the Company's
mortgages was 7.23%. Net mortgage discount amortization income of $0.36
million increased the coupon yield by 0.17% for a net mortgage yield of
7.40%. The yield
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<PAGE> 38
earned on the Company's cash balances during the quarter was 5.43%,
bringing the overall 1995 blended earning asset yield to 7.36%.
The 6.74% earning asset yield for 1997 was lower than the 6.93% for
1996. The actual coupon yield on the mortgage assets was slightly
higher in 1997 than in 1996 (7.56% versus 7.50%). The Company's average
amortized cost for mortgage assets, however, was higher in 1997 than in
1996 (102.1% versus 100.7%) as was the total mortgage principal
repayment rate (34% versus 27%). The reduction in mortgage yield due to
net premium amortization expense increased from 0.55% in 1996 to 0.81%
in 1997.
The 6.93% earning asset yield for 1996 was lower than the 7.36% for
1995. The actual coupon yield on the mortgage assets was higher in 1996
than in 1995 (7.50% versus 7.23%). The Company's average amortized cost
for mortgage assets, however, was higher in 1996 than in 1995 (100.7%
versus 99.0%) as was the total mortgage principal repayment rate (27%
versus 18%). The negative impact to mortgage yield due to net premium
amortization expense was 0.55% in the 1996, whereas net discount
amortization income contributed 0.17% to mortgage yield in 1995.
During 1996 and 1997, the Company generally acquired mortgage assets
with lower risk characteristics than those assets previously acquired.
As a result, average credit quality improved, with the percentage of
the balance sheet consisting of subordinated mortgage securities rated
below AA falling from 12.4% at the end of 1995 to 2.5% at the end of
1996 to 0.3% at the end of 1997. This change in asset mix was one of
the factors allowing significant decreases in the equity-to-assets
capital adequacy guideline as determined by the Company's Risk-Adjusted
Capital Policy.
The lower risk assets acquired by the Company generally had higher
acquisition prices reflecting their lower risk. As a result, the
Company earned a lower yield on these mortgages. This is part of the
Company's current strategy of seeking to earn higher returns on equity
over time by utilizing lower-risk, reduced spread assets in conjunction
with greater leverage. To some degree, the slight decrease in the
earning asset yield in 1997 also reflects the high pricing levels
(relative to the risk) for mortgages that have prevailed in the
mortgage market for several quarters.
Interest Expense
From the third quarter of 1997 to the fourth quarter of 1997, interest
expense increased by 1%. Total average borrowings remained relatively
stable. In the third quarter of 1997, average borrowings were $3.05
million of which 12% were long-term borrowings. In the fourth quarter
of 1997, average borrowings were $3.06 million of which 20% were
long-term borrowings. This increase in higher cost long-term
borrowings, combined with a slight increase in short-term interest
rates, resulted in an increase in the Company's cost of funds from
6.02% to 6.09% from the third to the fourth quarter of 1997.
From 1996 to 1997, interest expense increased by 226%. This increase
was driven primarily by a 215% increase in average borrowings from 1996
to 1997. Average borrowings were $0.86 billion in 1996 and $2.71
billion in 1997. Borrowings increased at a slightly faster rate during
1997 than did earning assets (215% versus 203%) as the Company utilized
a greater percentage of debt rather than equity to fund its growing
mortgage operations. The average equity-to-assets ratio for the Company
was 10.1% in 1997 as compared to 13.1% in 1996.
An additional factor driving the increase in interest expense from 1996
to 1997 was a 0.21% increase in the Company's cost of funds from 5.71%
in 1996 to 5.92% in 1997. This increase reflects higher levels of
short-term interest rates; the average daily one month LIBOR rate was
0.19% higher in 1997 than in 1996. The increase in cost of funds also
reflects the issuance of long-term debt during the third and fourth
quarters of 1997 and a change in the mix of assets towards mortgage
loans rather than mortgage securities.
From 1995 to 1996, interest expense increased by 364%. This increase
was driven primarily by a 392% increase in average borrowings from 1995
to 1996. Average borrowings were $0.17 billion in 1995. Borrowings
increased at a faster rate during 1996 than did earning assets (392%
versus 355%) as the Company utilized a greater percentage of debt
rather than equity to fund its growing mortgage operations. The average
equity-to-assets ratio for the Company was 13.1% in 1996 as compared to
19.6% in 1995. The Company's cost of funds
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<PAGE> 39
decreased by 0.35% from 6.06% in 1995 to 5.71% in 1996. The decrease in
cost of funds primarily reflects the decrease in short-term interest
rates during this period; the average daily one month LIBOR rate was
0.52% lower in 1996 than in 1995. The Company's cost of funds did not
fall by the full 0.52% decline in short-term rates due to a change in
the mix of assets towards mortgage loans rather than mortgage
securities and because the average term-to-next-rate-adjustment of the
Company's liabilities exceeded one month so the cost of funds did not
drop as quickly as the one month LIBOR rate did.
Interest Rate Agreements Expense
Interest rate agreements are a form of interest rate insurance, or
hedging, which the Company utilizes to reduce the effects that large
changes in interest rates could have on its balance sheet and earnings.
The Company seeks to hedge, in part, the market value and earnings
risks arising from the life caps, periodic caps and the fixed coupon
period to the next adjustment date for its adjustable-rate mortgage
assets. The Company also, in part, may hedge the market value of
acquired mortgage loans prior to securitization into a mortgage equity
interest, hedge the anticipated issuances of liabilities, hedge premium
amortization risk that may arise from falling interest rates, and hedge
the risk arising from any hybrid or fixed rate mortgages which are
funded short-term or on a non-matched basis. The Company may use
interest rate agreements for other hedging purposes as well.
Interest rate agreements expense increased from $1.03 million in the
third quarter of 1997 to $1.27 million in the fourth quarter of 1997.
This net expense increased as a percent of average assets from 0.12% to
0.15%, and as a percent of average borrowings from 0.14% to 0.17%. This
increase was due to an increase in the number of interest rate
agreements which were effective during the fourth quarter.
From 1996 to 1997, net interest rate agreement expense grew by 222%,
from $1.16 million to $3.74 million. The net interest rate agreement
expenses grew during this period as total assets and borrowings grew.
In 1996, interest rate agreement expenses represented 0.12% of average
assets and 0.13% of average borrowings. In 1997, net interest rate
agreement expense represented 0.12% of average assets and 0.14% of
average borrowings.
From 1995 to 1996, net interest rate agreement expense grew by 241%,
from $0.34 million to $1.16 million. Net interest rate agreement
expenses grew during this period as total assets and borrowings grew.
In 1995, net interest rate agreement expenses represented 0.15% of
average assets and 0.19% of average borrowings.
Net Interest Income
Net interest income is interest income less interest expense and net
interest rate agreement expenses. Net interest income decreased from
$9.6 million in the third quarter of 1997 to $6.2 million in the fourth
quarter of 1997. The Company's interest rate spread narrowed due to a
decline in the yield on earning assets and an increase in the cost of
funds during these periods as discussed above.
Net interest income increased from $16.9 million in 1996 to $34.6
million in 1997, an increase of 104%. This increase was driven by
balance sheet growth. Growth in net interest income was less than the
growth in average equity of 133%. Net interest income as a percentage
of average equity decreased from 12.90% to 11.26%.
Net interest income grew more slowly than the growth in net average
equity primarily due to a narrowing in the spread between the Company's
yield on earning assets and the cost of its borrowed funds and net
hedging expenses (its interest rate spread). The Company's interest
rate spread was 1.09% in 1996 as compared to 0.68% in 1997. As
discussed above, the Company's yield on earning assets fell by 0.19%
from 1996 to 1997 while the cost of funds rose by 0.21% and the cost of
hedging rose by 0.01%. The Company has generally been seeking to
maintain or improve its return on equity by offsetting the narrower
spread it earns from lower risk assets through the greater use of
leverage. Because the Company was not able to employ all of its
capital, particularly in the second half of 1997, this strategy was not
yet fully effective.
Net interest income increased from $4.8 million in 1995 to $16.9
million in 1996, an increase of 254%. This increase was driven by the
growth in average total equity of 203%. Net interest income as a
percentage of average equity increased from 11.03% to 12.90%.
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Net interest income grew faster in 1996 than the growth in net average
equity, despite a narrowing in the Company's interest rate spread. The
Company's interest rate spread was 1.11% in 1995 as compared to 1.09%
in 1996. The Company's yield on earning assets fell by 0.43% from 1995
to 1996 while the cost of funds declined by 0.35% and the cost of
hedging fell by 0.06%. Net interest income grew faster than the
Company's average total equity due to the Company's increased use of
leverage during the period. The Company's average equity-to-assets
ratio decreased from 19.6% in 1995 to 13.1% in 1996.
Please see "Interest Income" and "Interest Expense" above for a
discussion of the factors that resulted in a trend towards a more
narrow interest rate spread over time.
Credit Provision Expense and Actual Credit Losses
The Company establishes credit provisions in order build a reserve for
potential future credit losses. Total credit provisions decreased from
$0.94 million in the third quarter of 1997 to $0.52 million in the
fourth quarter of 1997. This decrease was primarily the result of the
re-REMIC transaction discussed above which allowed the Company to stop
building up its credit reserves on its mortgage securities portfolio.
Total credit provisions of $2.93 million in 1997 equaled 0.10% of
average assets and 0.95% of average equity in 1997. Total credit
provisions of $1.70 million in 1996 equaled 0.17% of average total
assets and 1.29% of average equity. Total credit provisions of $0.49
million in 1995 equaled 0.22% of average total assets and 1.14% of
average equity.
The Company takes credit provisions for risk of credit loss from its
portfolio of below-BBB rated subordinated mortgage securities as a
function of projections of potential future losses. The Company reviews
its loss projections based on trends in serious delinquencies and loan
loss severities (actual losses realized as a percent of defaulted loan
balances) in the underlying mortgage pools. Credit provisions for these
assets were $0.43 million in 1997, $1.35 million in 1996 and $0.41
million in 1995. As a result of the re-REMIC transaction discussed
above, the Company was able to significantly reduce its basis, and thus
its credit risk, on this portfolio. This decline in credit risk
resulted in a decline in the amount of credit provision required on
these assets in 1997 as compared to 1996.
The Company takes credit provisions for its mortgage loan portfolio to
provide for expected credit losses over the life of the portfolio. The
Company took mortgage loan provisions of $2.50 million in 1997, $0.35
million in 1996 and $0.08 million in 1995. The Company's current policy
is to set aside annual credit provisions for mortgage loans on an
on-going basis equaling 0.10% to 0.20% of its mortgage loan portfolio.
Though 1997, the annual provisions taken were greater than 0.20% of the
loan portfolio as the Company sought to establish a higher base level
of credit reserves. The increase in mortgage loans provisions from 1995
to 1996 was the result of average mortgage loans increasing from $0.01
billion in 1995 to $0.08 billion 1996. The increase in mortgage loans
provisions from 1996 to 1997 was a result of average mortgage loans
increasing from $0.08 billion in 1996 to $0.96 billion in 1997.
The Company realized actual credit losses of $179,000 in 1997, $7,000
in 1996 and $3,000 in 1995. Total cumulative actual credit losses from
the inception of the Company through December 31, 1997 have been
$189,000.
Credit provisions reduce net income and earnings per share but only
actual credit losses are deducted when calculating taxable income.
Dividends from a REIT are based on taxable income, so future dividends
levels will be influenced by the rate of actual realized credit loss
rather than the rate of credit provisioning. Thus, the Company's
current credit reserve will not serve to insulate the Company's
dividends from the effects of future actual realized credit losses.
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Gain or Loss on Sale Transactions
The Company sold $88.0 million of mortgage securities in 1997. The gain
on the sale of $42 million of mortgage securities sold in the third
quarter was $0.17 million. In conjunction with the sale of these
mortgage securities, the Company wrote down related interest rate
agreements in the amount of $0.15 million, thereby reducing the net
gain to $0.02 million. The net gain from this sale, combined with the
$0.54 million gain in the fourth quarter of 1997 from the sale of $46
million of mortgage securities through the re-REMIC transaction
discussed above, resulted in total 1997 gains on sales transactions of
$0.56 million. These gains increased diluted earnings per share by
$0.03 in 1997. There were no gains or losses on sales in 1995 or 1996.
Operating Expenses
Total operating expenses decreased from $1.15 million in the third
quarter of 1997 to $1.13 million in fourth quarter of 1997. Operating
expenses as a percentage of average assets remained at 0.13%, operating
expenses as a percentage of average equity improved slightly from 1.33%
to 1.29%, the efficiency ratio (operating expenses as a percentage of
net interest income) worsened from 11.93% to 18.25% (due to a decrease
in net interest income), and average assets per employee decreased
slightly from $244 million to $242 million.
From 1996 to 1997, total operating expenses increased by 82%, from
$2.55 million to $4.66 million. From 1995 to 1996, total operating
expenses increased by 126%, from $1.13 million to $2.55 million.
Compensation and other operating expenses increased as the scope of
Company's operations expanded. The Company had 7 employees at the end
of 1995, 10 employees at the end of 1996 and 15 employees at the end of
1997. In addition, a portion of the stock options granted to
management, employees, and directors have dividend equivalent rights
("DERs") attached; the DER expense increased as the dividend per common
share rose and the number of outstanding stock options with DERs
attached increased. DER expense decreased from the third to the fourth
quarter of 1997 as the dividend declined.
Operating expense ratios have improved as the Company realized
economies of scale through growth. From 1996 to 1997, operating
expenses as a percentage of assets improved from 0.26% to 0.15%,
operating expenses as a percentage of average equity improved from
1.94% to 1.52%, the efficiency ratio improved from 15.08% to 13.47%,
and average assets per employee increased from $109 million to $242
million. From 1995 to 1996, operating expenses as a percentage of
assets improved from 0.51% to 0.26%, operating expenses as a percentage
of average equity improved from 2.61% to 1.94%, the efficiency ratio
improved from 23.66% to 15.08%, and average assets per employee
improved from $39 million to $109 million.
The Company has adopted a Stock Option Plan for executive officers,
employees and non-employee directors. At December 31, 1997 there were
840,644 stock options outstanding, 591,729 of which had current pay
DERs attached and 206,832 of which had stock DERs attached. A portion
of these DERs are subject to minimum dividend and/or vesting
requirements. Holders of DERs are generally eligible to receive all
types of distributions made to common shareholders, including any
non-cash or return of capital distributions. To the extent options have
been granted with current pay DERs attached, GAAP and taxable income
will recognize the expense as cash payments accrue to the holders of
the underlying option. To the extent options have been granted with
stock DERs, there will be a non-cash charge to operating expenses for
GAAP for the value of the DERs which accrue. There is no expense
recognized for taxable income for stock DERs until the underlying
option is exercised. In addition, for taxable income purposes only,
when non-qualified stock options ("NQSO") are exercised, the Company
will recognize an expense equal to the difference between the fair
market value of the stock and the exercise price paid. Although this is
a non-operating, non-cash expense, such expenses arising from the
future exercise of options will the lower the Company's taxable income,
and thus its dividend, in the quarters when NQSOs are exercised. For
additional detail, see "Note 10. Stockholders Equity - Stock Option
Plan" in the Notes to Consolidated Financial Statements.
Net Income Before Preferred Dividends
From the third quarter of 1997 to the fourth quarter of 1997, total net
income available to common and preferred shareholders decreased by 33%,
from $7.55 million to $5.08 million. Return on average assets dropped
from
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0.88% to 0.59% due to the interest spread narrowing and the decreased
level of utilization of capital. The return on total average equity
(common plus preferred) decreased from 8.60% to 5.43%. The return on
total average equity in the first half of 1997 was 11.43%.
Total net income available to common and preferred shareholders
increased from $12.69 million in 1996 to $27.56 million in 1997, an
increase of 117%. Return on average assets dropped from 1.27% to 0.91%
while return on total average equity (common plus preferred) decreased
from 9.66% to 8.98%. As discussed above, the positive effect of strong
asset growth, increased use of leverage and improved operational
efficiencies partially offset the negative effects of interest spread
narrowing.
Total net income available to common and preferred shareholders
increased from $3.16 million in 1995 to $12.69 million in 1996, an
increase of 302%. Return on assets dropped from 1.43% to 1.27% due
interest spread narrowing. Due to increased use of debt funding and
improved operating efficiencies, however, the return on total average
equity (common plus preferred) increased from 7.28% to 9.66%.
Preferred Dividends
The Company's Class B 9.74% Cumulative Convertible Preferred Stock
("preferred stock") was issued in the third quarter of 1996. Total 1997
preferred dividends were $2.82 million; total 1996 preferred dividends
were $1.15 million. The preferred dividend was greater in 1997 than in
1996 as preferred stock was outstanding 365 days in 1997 as compared to
138 days in 1996. The quarterly preferred dividend equals the greater
of the common stock dividend or $0.755 per share. Each share of
preferred stock is convertible at the option of the holder at any time
into one share of common stock. There were 1,006,250 preferred shares
outstanding at December 31, 1996 as compared to 909,518 shares
outstanding at December 31, 1997. In 1997, preferred shareholders
converted 96,732 shares into common stock. After September 1999, the
Company has the right to force the conversion of each share of
preferred stock into one share of common stock, providing the price of
the common stock exceeds $31.00, or to redeem the preferred stock at
$31.00 per share.
Net Income Available to Common Shareholders
From the third quarter of 1997 to the fourth quarter of 1997, net
income available to common shareholders decreased by 36%, from $6.86
million to $4.40 million. Over the same period, average common equity
increased by 1%, from $319.0 million to $323.6 million. Return on
average common equity decreased from 8.73% to 5.80%.
From 1996 to 1997, net income available to common shareholders
increased by 114%, from $11.5 million to $24.7 million. Over the same
period, average common equity increased by 132%, from 120.0 million to
$279.1 million. Return on average common equity decreased from 9.61% to
8.87%.
From 1995 to 1996, net income available to common shareholders
increased by 266%, from $3.16 million to $11.5 million. Over the same
period, average common equity increased by 177%, from $43.3 million to
$120.0 million. Return on average common equity increased from 7.28% to
9.61%.
Diluted Earnings Per Share
From the third quarter of 1997 to the fourth quarter of 1997, diluted
earnings per share fell by 36%, from $0.47 to $0.30. The average number
of diluted common shares outstanding decreased by 1% and net income
available to common shareholders decreased by 36%. This decrease in
diluted earnings per share was the result of a 37% decrease in return
on equity while average book value per common share increased 1%.
From 1996 to 1997, diluted earnings per share rose by 37%, from $1.32
to $1.81. The average number of diluted common shares outstanding
increased by 56% and net income available to common shareholders
increased by 114% during the same period. The primary factor driving
the increase in diluted earnings per share was a 39% increase in
average book value (equity) per common share from 1996 to 1997. Book
value per share increased as the Company issued new common stock at
prices in excess of book value.
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From 1995 to 1996, diluted earnings per share rose by 55%, from $0.85
to $1.32. The average number of diluted common shares outstanding
increased by 136% and net income available to common shareholders
increased by 266%. This increase in diluted earnings per share was made
possible by a 32% increase in return on common equity and a 15%
increase in average book value (equity) per common share.
Taxable Income after Preferred Dividend
As a REIT, the Company is required to distribute as dividends over time
at least 95% of its taxable income. Taxable income can vary from GAAP
income due to a variety of reasons, such as differences in credit
expenses (actual credit losses are deducted from taxable income rather
than credit provisions), premium and discount amortization, accounting
for stock options as well as other differences.
From the third quarter of 1997 to the fourth quarter of 1997, taxable
income after preferred dividends fell 34%, from $7.46 million to $4.90
million. The taxable return on average common equity dropped from 9.36%
to 6.06% during this period.
Taxable income after preferred dividend in 1997 of $27.15 million was
greater than 1997 GAAP income available to common shareholders of
$24.75 million due to differences in credit expenses of $2.75 million,
premium and discount amortization differences of negative $0.18
million, gain on sale differences of negative $0.19 million and
operating expense differences of $0.02 million.
Taxable income after preferred dividend in 1996 of $14.02 million was
greater than 1996 GAAP income available to common shareholders of
$11.54 million due to differences in credit expenses of $1.69 million,
premium and discount amortization differences of $0.45 million and
operating expense differences of $0.34 million.
Taxable income before preferred dividend in 1995 of $3.83 million was
greater than 1995 GAAP income of $3.16 million due to differences in
credit expenses of $0.49 million, premium and discount amortization
differences of $0.17 million and operating expense differences of $0.28
million.
On a taxable income basis, return on average common equity was 9.73%
for 1997 as compared to 11.68% for 1996 and 8.84% for 1995. Taxable
return on average common equity was generally influenced by the same
factors that reduced GAAP return on average common equity.
Common Share Dividends
In accordance with REIT rules, over time the Company's dividends will
reflect the Company's level of taxable income earned. Dividends per
common share have exceeded GAAP earnings per common share primarily
because taxable income has exceeded GAAP income in each year. Effective
with the fourth quarter 1997 dividend, the Company's policy is to
declare a common dividend each quarter equal to that quarter's taxable
income per common share entitled to a dividend. In order to assist the
Company with this goal, starting in 1998, the first three quarter
dividends will be declared after taxable income has been determined for
the quarter. The dividend declaration for the first, second and third
quarter dividends is expected occur in the fourth week of April, July
and October, respectively. The record and payable dates will be
announced at the time the dividend is declared. In order to comply with
REIT dividend distribution rules, the Company's fourth quarter dividend
will be declared in December based on estimated fourth quarter taxable
income. The Company's common dividend is expected to vary from quarter
to quarter, both due to fluctuations in the Company's operating results
and due to changes in other operating and non-operating items that
impact taxable income.
In the fourth quarter of 1997, the Company declared common dividends of
$0.35 per share, a decrease from the dividends declared in the third
quarter of 1997 of $0.60 per share. Total common dividends declared
were $8.75 million in the third quarter of 1997 and $5.00 million in
the fourth quarter of 1997.
The Company declared common dividends of $2.15 per share in 1997,
resulting in a distribution of $28.84 million. Including preferred
dividends, the Company distributed $31.65 million, or 105.6% of the
taxable income earned in
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1997. Through December 31, 1997, the Company had cumulatively declared
dividends equaling 102.6% of cumulative taxable income earned through
that date. At December 31, 1997, cumulative dividends declared in
excess of cumulative taxable income were $1.29 million.
The Company declared common dividends of $1.67 per share in 1996,
resulting in the distribution of $14.08 million. Including preferred
dividends, the Company distributed $15.23 million, or 100.4% of the
taxable income earned in 1996.
In 1995, the Company declared common dividends of $0.96 per share,
resulting in the distribution of $3.37 million. The Company had no
preferred shares outstanding. The Company distributed 88.0% of the
taxable income earned in 1995.
FINANCIAL CONDITION
Mortgage Loans
From December 31, 1996 to December 31, 1997, the Company's mortgage
loan portfolio grew in size by 195% and increased as a percentage of
the Company's mortgage assets from 24.5% to 46.1%. Over this period,
the percentage of the Company's mortgage loan properties located in
California dropped, the average seasoning declined, the average loan
size increased and the effective average loan-to-value ratio decreased.
The percentage of the loan portfolio in non-performing status increased
slightly from 0.24% to 0.25% during this period.
At December 31, 1997, the Company owned 5,041 adjustable-rate,
first-lien mortgage loans on single-family residential properties with
a principal value of $1.52 billion and an amortized cost of $1.55
billion. The Company estimates that the bid-side market value of the
Company's mortgage loan portfolio at December 31, 1997 was
approximately $1.55 billion. Hybrid loans, with first adjustment
periods longer than one year, were 3.6% of mortgage loans.
As verified by its re-underwriting process, the Company believes that
all mortgage loans owned as of December 31, 1997 were generally
originated to "A" quality, or "Prime" quality, underwriting standards.
The average loan size was $301,000. Loans with current balances less
than $214,600 (the 1997 Fannie Mae/Freddie Mac limit for most loans)
made up 18% of the dollar balance of the Company's mortgage loan
portfolio, while loans with current balances in excess of $500,000 made
up 37%. Loans on owner-occupied houses made up 89% of the loan
portfolio; second homes represented 8% and investment properties 3%. As
of December 31, 1997, the average seasoning of the loan portfolio was
18 months.
At December 31, 1997, 38% of loans had original loan-to-value ratios
("OLTV") in excess of 80%. Of these, 95% had either primary mortgage
insurance ("PMI") or additional collateral in the form of pledged
accounts. The average original LTV for the Company's loan portfolio was
78% as of December 31, 1997; after giving effect to PMI and additional
collateral, the average effective LTV was 66%.
At December 31, 1997, 29% of the mortgage loans owned by the Company
were on properties located in California (11% in Northern California
and 18% in Southern California). Loans in Florida were 9%, loans in New
York were 7% and loans in Georgia were 5% of the total. All other
states were less than 5%.
At December 31, 1997, 17 mortgage loans were non-performing assets
("NPAs"), as they were over 90 days delinquent, in bankruptcy, in
foreclosure, or had become Real Estate Owned ("REO"). The loan balance
of these NPAs totaled $3.90 million, or 0.25% of the mortgage loan
portfolio and 0.11% of total assets. Included in this NPA balance was
REO of $0.71 million resulting from the default of 4 loans.
If all of the NPAs as of December 31, 1997 were to default rather than
cure, and the loss severity experienced on these loans was 10%, 20%,
30%, or 40%, the Company estimates its realized credit losses from
these assets would be $396,000, $793,000, $1,189,000 or $1,586,000,
respectively. The mortgage loan credit reserve as of December 31, 1997
was $2.85 million. Cumulatively through December 31, 1997, the Company
has achieved resolution or liquidation on six defaulted mortgage loans:
the average loss severity on those loans was 7%. The
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analysis in this paragraph reviews the risk of loss from NPAs as of
December 31, 1997 only; it does not purport to analyze or measure
credit losses from additional NPAs that may arise after December 31,
1997.
At December 31, 1996, the Company owned 2,172 adjustable-rate,
first-lien mortgage loans on single-family residential properties with
a principal value of $0.52 billion and an amortized cost of $0.53
billion. The Company estimates that the bid-side market value of these
mortgage loans at December 31, 1996 was approximately $0.53 billion.
None of these mortgage loans were hybrid loans with first adjustment
periods longer than one year.
The average loan size at December 31, 1996 was $237,000. Loans with
current balances less than $207,000 (the 1996 FNMA/FHLMC limit for most
loans) made up 23% of the Company's mortgage loan portfolio, while
loans with current balances in excess of $500,000 made up 8%. Loans on
owner-occupied houses made up 94% of the loan portfolio; second homes
represented 4% and investment properties 2%. As of December 31, 1996,
the average seasoning of the loan portfolio was 37 months.
At December 31, 1996, 25% of the loans had a loan-to-value ratio (LTV)
at origination in excess of 80%. Of these, 97% of these loans had
primary mortgage insurance (PMI). The average original LTV for the
Company's mortgage loan portfolio was 77% as of December 31, 1996;
after giving effect to PMI, the average effective original LTV was 73%.
At December 31, 1996, 44% of the mortgage loans owned by the Company
were on properties located in California (18% in Northern California
and 26% in Southern California). Loans in Maryland were 8% of the
total. All other states were less than 5%.
At December 31, 1996, 7 loans were non-performing assets. The loan
balance of these NPAs totaled $1.25 million, or 0.24% of the mortgage
loan portfolio and 0.06% of total assets. Included in this total was
one REO of $0.2 million.
If all the NPAs as of December 31, 1996 were to default rather than
cure, and the loss severity experienced on these loans was 10%, 20%,
30%, or 40%, the Company estimated its realized credit losses from
these assets would have been $127,000, $253,000, $380,000 or $506,000,
respectively. The mortgage loan credit reserve as of December 31, 1996
was $428,000.
Mortgage Securities
From December 31, 1996 to December 31, 1997, the Company's portfolio of
mortgage securities increased by 12%. Mortgage securities declined as a
percentage of total mortgage assets from 75.5% to 53.9%. All of the
Company's mortgage securities represent interests in pools of
adjustable rate, first lien mortgages on single-family residential
properties. None of the loans underlying these mortgage securities were
hybrid loans with first adjustment periods longer than one year.
At December 31, 1997, the principal value of the Company's mortgage
securities was $1.78 billion and the amortized cost was $1.82 billion.
The Company estimates that the bid-side market value of the Company's
mortgage securities portfolio at December 31, 1997 was approximately
$1.81 billion.
At December 31, 1997, 99.5% of the Company's mortgage securities had a
credit rating equivalent of AAA or AA. The remaining 0.5% represent the
retained mortgage equity interests in the re-REMIC discussed above.
Securities guaranteed by Fannie Mae or Freddie Mac made up 54.3% of the
mortgage securities portfolio. Non-agency mortgage securities
structured with large amounts of subordination or other forms of
third-party credit enhancement and rated AAA or AA made up 45.2% of the
mortgage securities portfolio. Based on information available as of
December 31, 1997, the Company had no reason to suspect that it would
be likely to incur credit losses in the foreseeable future from its
mortgage securities rated AAA or AA.
The Company has taken and expects to continue to take credit losses on
the mortgage equity interests in the re-REMIC. Although the loans in
the mortgage pools underlying these securities were, for the most part,
originated to "A" quality standards, these interests are subordinated
to other securities issued from the same pools and
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therefore are subject to leveraged credit risk with respect to the
underlying mortgages. At December 31, 1997, the re-REMIC mortgage
equity interests had a principal value of $21.0 million, an amortized
cost before credit reserve of $9.1 million and an estimated market
value of $9.3 million. If all the underlying loans were to default, the
maximum loss the Company could incur would be $9.1 million and the
maximum impact to reported earnings, after taking into account the
credit reserve of $2.1 million, would be $7.0 million.
The Company estimates that if all the loans underlying mortgage equity
interests in the re-REMIC which were over 90 days delinquent, in
foreclosure, in bankruptcy, or REO as of December 31, 1997 were to
default and have a loss severity of 10%, 20%, 30%, or 40%, realized
credit losses for the Company would be $0.39 million, $0.89 million,
$1.16 million or $1.83 million, respectively. The Company's credit
reserve for these assets at December 31, 1997 was $2.1 million.
Cumulatively, from the acquisition dates of mortgage securities rated
below investment grade through December 31, 1997, 254 defaulted
mortgage loans in the underlying pools had been liquidated and the
average loss severity on these loans was 21%. The analysis in this
paragraph reviews the risk of loss from seriously delinquent loans
underlying the Company's mortgage securities as of December 31, 1997
only; it does not purport to analyze or measure credit losses from
additional serious delinquencies that may arise after December 31,
1997.
At December 31, 1996, the principal value of the Company's mortgage
securities was $1.60 billion and the amortized cost was $1.63 billion.
The Company estimates that the bid-side market value of the Company's
mortgage securities portfolio at December 31, 1996 was approximately
$1.63 billion.
At December 31, 1996, 96.6% of the Company's mortgage securities had a
credit rating equivalent of AAA or AA, 1.6% had a credit rating
equivalent of A or BBB and 1.8% had a credit rating equivalent less
than BBB. Securities guaranteed by Fannie Mae or Freddie Mac made up
59.4% of total mortgage securities. Other AAA and AA securities made up
37.2% of the mortgage securities portfolio.
At December 31, 1996, below-BBB rated securities had a principal value
of $40.8 million, an amortized cost before credit reserve of $28.9
million and a market value of $25.6 million. The Company's credit
reserve for these assets at December 31, 1996 was $1.75 million. The
Company estimates that if all the loans in the underlying mortgage
pools which were over 90 days delinquent, in foreclosure, in
bankruptcy, or REO as of December 31, 1996 were to default and have a
loss severity of 10%, 20%, 30%, or 40%, realized credit losses for the
Company would be $0.06 million, $0.61 million, $2.04 million, or $3.65
million, respectively.
Total Mortgage Asset Portfolio Characteristics
At December 31, 1997, the average credit rating equivalent of all of
the Company's mortgage assets (loans plus securities) was AA+, with
mortgage loans (the bulk of the value which would be rated AAA if
securitized and rated) representing 46.1% of the total mortgage asset
portfolio and AAA and AA mortgage securities representing 53.6%.
At December 31, 1997, all mortgage assets consisted of adjustable-rate
mortgages. Hybrid mortgages, with first adjustment periods longer than
one year, made up 1.6% of mortgage assets. The average coupon rate
accruing on mortgage assets was 7.71%. The average level of the
short-term interest rate indices which determine coupon adjustments was
5.68%. Since the average net margin was 2.06%, the highest potential
average mortgage coupon rate (the fully-indexed rate) at that time was
7.74%. The actual coupon rate was lower than the fully-indexed rate by
0.03%.
At December 31, 1997, 34.9% of the Company's mortgage assets had coupon
rate adjustments every six months based on the six-month LIBOR or CD
index and 20.1% had monthly adjustments based on the one-month LIBOR
index. Mortgage assets with annual coupon adjustments based on the six-
month or one-year U.S. Treasury index were 41.9% of the portfolio.
Hybrid mortgages, that will have annual coupon adjustments based on the
one-year Treasury index after the initial fixed period, represented
1.6%. Mortgage assets with other indices made up 1.5% of the total. At
December 31, 1997, the average term-to-next-coupon-adjustment for all
mortgage assets was 4 months. For most mortgage assets, coupon rate
adjustments are based on the index level 30 to 75 days prior to the
start of a new coupon accrual period.
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Potential coupon rate changes can be limited by periodic and life caps.
At December 31, 1997, all of the Company's assets had a life cap and
the average mortgage asset life time maximum cap rate was 12.08%. At
December 31, 1997, periodic caps limited coupon changes to 2% annually
for 67.2% of mortgage assets and there were no periodic caps on 32.8%
of mortgage assets.
At December 31, 1996, the average mortgage asset credit rating
equivalent was AA+, with mortgage loans representing 24.5% of the total
mortgage asset portfolio, AAA and AA mortgage securities representing
73.0%, A and BBB rated mortgage securities representing 1.2% and
below-BBB rated mortgage securities representing 1.3%.
At December 31, 1996, all mortgage assets consisted of adjustable-rate
mortgages. The average coupon rate accruing on these assets was 7.75%.
The average level of the short-term interest rate indices which
determine coupon adjustments was 5.58%. Since the average net margin
was 2.24%, the highest potential average mortgage coupon rate (the
fully-indexed rate) at that time was 7.82%. The actual coupon rate was
lower than the fully-indexed rate by 0.07%.
At December 31, 1996, 38.7% of the Company's mortgage assets had coupon
rate adjustments every six months based on the six month LIBOR or CD
index and 1.4% had monthly adjustments based on the one month LIBOR
index. Six month or one year U.S. Treasury index mortgage assets made
up 57.7% of the total. Mortgage assets with other indices made up 2.2%
of the total. At December 31, 1996, the average term-to-next-coupon-
adjustment for all mortgage assets was 5 months.
At December 31, 1996, the Company's average mortgage asset life time
maximum cap rate was 11.73%. At December 31, 1996, periodic caps
limited coupon changes to 2% annually for 95.5% of the mortgage assets
and there were no periodic caps on 4.5% of the mortgage assets.
Allocation of Equity to Mortgage Assets
The Company assigns a capital requirement to each mortgage asset
through its Risk-Adjusted Capital Policy process. Allocations are based
on the perceived risk characteristics of each asset and its associated
borrowings and hedges. At December 31, 1997, 51.7% of the Company's
$335 million of capital was allocated to AAA and AA-rated mortgage
securities funded short-term, 17.4% was allocated to mortgage equity
interests (the equity portion of the two Sequoia Trusts and the
re-REMIC) and 8.2% was allocated to mortgage loans which will most
likely be used to create mortgage equity interests in the future but
which were funded short-term at that time. The remainder of the
Company's equity capital -- 22.7% of the total -- was not being
utilized.
At December 31, 1996, 71.5% of the Company's $211 million of capital
was allocated to AAA and AA-rated mortgage securities funded
short-term, 8.9% was allocated to short-funded securities rated less
than AA, and 22.8% was allocated to short-funded mortgage loans. The
total capital allocated at that time equaled 103.2% of the Company's
actual capital base, as the Company at year end 1996 had acquired
additional assets in excess of its normal balance sheet capacity
pursuant to its expanded capital guidelines which are in effect in
certain circumstances prior to a planned equity offering.
Interest Rate Agreements
At December 31, 1997, the Company owned $5.3 billion notional face of
interest rate agreements, principally caps and swaps. These interest
rate agreements had various start dates, maturity dates, and interest
rate protection features; See "Note 6. Interest Rate Agreements" and
"Note 9. Fair Value of Financial Instruments" in the Notes to
Consolidated Financial Statements for additional detail.
These agreements are designed to reduce the Company's interest rate and
market value fluctuation risk. They had a historical amortized cost
basis of $10.78 million and an estimated bid-side market value of $1.52
million as of December 31, 1997. Market values were lower than
amortized cost due to a drop in interest rate volatility assumptions in
the marketplace for interest rate agreements, a drop in interest rates,
the effect of taking bid-ask
47
<PAGE> 48
spread mark-downs on new agreements and due to the mis-matched timing
of GAAP amortization methods for premiums paid for interest rate caps
and the rate of actual economic decay in their market values. Interest
rate agreements hedging mortgage loans are carried on the balance sheet
at historical amortized cost, as a result changes in market values of
these interest rate agreements are not shown in the valuation account.
Market value fluctuations for interest rate agreements hedging mortgage
securities are reflected in the Company's interest rate agreement
market valuation account.
At December 31, 1996, the Company owned $2.6 billion notional face of
interest rate agreements with a historical amortized cost basis of $6.2
million and an estimated bid-side market value of $2.6 million.
There is a risk that the counter-parties to the Company's 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 credit loss
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. Through December 31, 1997, each of the
counter-parties to the Company's interest rate agreements had a credit
rating of at least "A".
Borrowings, Cash Balances and Liquidity
At December 31, 1997, the Company's borrowings consisted of $1.9
billion short-term collateralized borrowing arrangements such as
reverse repurchase agreements, notes payable, and revolving lines of
credit ("short-term debt"), and $1.2 billion non-recourse, floating
rate, amortizing long-term debt ("long-term debt"). The long-term debt
was issued in the second half of 1997 in the form of collateralized
mortgage bonds through the Company's Sequoia program. The funds raised
in the long-term debt offerings were used to reduce short-term debt.
Long-term debt at year end represented 38% of total debt.
At December 31, 1997, the Company's short-term debt totaled $1.9
billion with a weighted average debt rate of 6.00% as compared to $2.0
billion with a weighted average debt rate of 5.83% at December 31,
1996. Long-term debt totaled $1.2 billion at December 31, 1997 with a
weighted average all-in-cost of 6.38%. The Company had no long-term
debt at December 31, 1996.
As the Company reduces risks on its balance sheet, it is able to use a
greater amount of leverage under its Risk-Adjusted Capital Policy.
However, the Company's debt-to-equity ratio declined from 9.11x at
December 31, 1996 to 8.96x at December 31, 1997 because the Company was
not taking advantage of its increased ability to leverage its balance
sheet. See "Stockholders' Equity, Capital Efficiency and Capital
Adequacy." The average debt-to-equity ratio increased from 6.56x during
1996 to 8.82x during 1997.
At December 31, 1997, $1.2 billion of the mortgage assets served as
collateral for the Company's long term debt. The remaining mortgage
assets, which had a market value of $2.2 billion, were available to
collateralize the Company's short-term debt. The Company estimates it
had additional borrowing capacity in excess of its current requirements
of $183 million at year end. In addition, the Company had $25 million
of unrestricted cash. The monthly principal and interest payments
received on the mortgages which serve as collateral to the long-term
debt are held in trust until the bond payment date and are included in
the Company's cash balances as "restricted cash."
At December 31, 1996, the Company had borrowings equaling 90.7% of the
$2.15 billion market value of its mortgage assets available to
collateralize such borrowings. The Company estimates it had additional
borrowing capacity at that time of $124 million, as well as $11 million
of unrestricted cash.
The Company's liquidity status, borrowing capacity, and ability to roll
over its short-term debt as it matures depend on the market value,
liquidity and credit quality of its assets, the soundness and
capitalization of the Company's balance sheet, the state of the
collateralized lending market and other factors. If the Company's
liquidity or borrowing capacity were to become seriously diminished,
the Company would most likely seek to sell its mortgage assets (the
sale of which, in such circumstances, might be difficult and most
likely would be at a loss). In order to avoid such an occurrence, the
Company seeks to maintain what it believes to be a prudent level of
capital, i.e., the Company restricts its asset growth according to its
Risk-Adjusted Capital Policy and thereby seeks to maintain adequate
unused borrowing capacity.
48
<PAGE> 49
At December 31, 1997 and December 31, 1996, the average
term-to-maturity of the Company's short-term debt was 64 days and 98
days and the average term-to-next-rate-adjustment was 31 days and 52
days, respectively; the term-to-next-rate-adjustment was shorter than
the term-to-maturity as some of the Company's debt had a cost of funds
that adjusted to market levels on a monthly or daily basis during the
term of the debt. In general, the cost of short-term borrowings has
been able to reset more quickly to interest rate conditions than coupon
rates on the Company's mortgages could adjust to those same changes.
Through its hedging program, the Company seeks to mitigate the
short-term impact that a large increase in interest rates could have on
its cost of funds and spread earnings
At December 31, 1997, the stated maturity on the Company's long-term
debt ranged from 26 to 32 years. The expected life of the debt was
three to six years, as the debt generally pays down as the underlying
mortgages pay down. The debt is callable by the Company before its
stated maturity date. The interest rate on the long-term debt resets
monthly. At December 31, 1997, 14% of the long-term debt had an
interest rate tied to the daily average Fed Funds rate, 50% had an
interest rate tied to a moving average of the one-year Treasury rate
and 36% had an interest rate tied to one-month LIBOR. The debt is AAA
rated, adjustable-rate, amortizes at approximately the same rate as the
collateral and has a lifetime interest rate cap of 10%.
Stockholders' Equity, Capital Efficiency and Capital Adequacy
From December 31, 1996 to December 31, 1997, the Company's equity
(exclusive of the market valuation account) grew from $214.5 million to
$344.6 million. This equity growth was the result of the Company
issuing $157.3 million in common stock through stock offerings, the
exercise of warrants and from stock issuance pursuant to the Company's
Dividend Reinvestment and Stock Purchase Plan. Equity was reduced in
the second half of 1997 by $23.1 million through the Company's Stock
Repurchase Program. Dividends, which are based on taxable income,
exceeded GAAP earnings by $4.1 million in 1997, reducing stockholders'
equity.
Book value, or equity, per common share (excluding the market valuation
account) increased by 32% from $16.81 on December 31, 1996 to $22.25 on
December 31, 1997. The primary driver of this book value growth was
accretive stock offerings at prices in excess of book value.
For balance sheet purposes, the Company carries its mortgage securities
and associated interest rate agreements at their estimated bid-side
market value (historical amortized cost less market valuation account).
The total market valuation account for the Company was a negative $3.5
million on December 31, 1996 and negative $10.1 million on December 31,
1997. As a result of this accounting treatment, the Company's reported
equity base and book value per share fluctuates due to market
conditions and other factors. Mortgage loans, associated interest rate
agreements and all other assets and liabilities were carried on the
Company's balance sheet at December 31, 1997 at amortized cost.
The Company estimated that the bid-side market value (or realizable
value) of all its assets less the cost of paying off all of its
obligations was approximately $211.2 million at December 31, 1996 and
$334.9 million at December 31, 1997. The net total "mark-to-market"
value for the Company's assets and liabilities was $3.3 million lower
than amortized cost at December 31, 1996 and $9.7 million lower than
amortized cost at December 31, 1997. Between December 31, 1996 and
December 31, 1997, the liquidation value of the Company's mortgage
assets increased while the liquidation value of its interest rate
agreements dropped. The Company expects that the net total
"mark-to-market" value of the Company may fluctuate significantly over
time.
Through its Risk-Adjusted Capital Policy, the Company assigns a
guideline capital adequacy amount (expressed in the form of a guideline
equity-to-assets ratio) to each of its mortgage assets. For short-term
funded assets, this ratio will fluctuate over time, based on changes in
that asset's credit quality, liquidity characteristics, potential for
market value fluctuation, interest rate risk, prepayment risk, and the
over-collateralization requirements for that asset set by the
Company's collateralized short-term lenders. Capital requirements for
mortgage equity interests generally equal the Company's net investment.
The sum of the capital adequacy amounts for all of the Company's
mortgage assets is the Company's aggregate guideline capital adequacy
amount.
49
<PAGE> 50
Since management believes that the bulk of the capital currently
necessary to manage the Company prudently is needed due to the
liquidity and market value fluctuation risks that arise from the
utilization of short-term debt, the guideline capital amount has
declined as the Company has eliminated some of these risks through the
creation of mortgage equity interests.
The Company does not expect that its actual capital levels will always,
exceed the guideline amount. The Company measures all of its mortgage
assets funded with short-term debt at estimated market value for the
purpose of making Risk-Adjusted Capital calculations. If interest rates
were to rise in a significant manner, the Company's capital guideline
amount would rise (as the potential interest rate risk of its mortgages
would increase, at least on a temporary basis, due to periodic and life
caps) while its actual capital levels as determined for the Risk-
Adjusted Capital Policy would likely fall as the market values of its
mortgages, net of mark-to-market gains on hedges, fell (market value
declines may be temporary as well, as future coupon adjustments may
help to restore some of the lost market value). In this circumstance,
or any other circumstance in which the Company's actual capital levels
fell below the Company's capital adequacy guideline amount, the Company
would cease the acquisition of new mortgage assets until capital
balance was restored. In defined circumstances prior to a planned
equity offering, management is authorized by the Board of Directors to
acquire mortgage assets in a limited amount beyond the usual
constraints of the Company's Risk-Adjusted Capital Policy.
As expressed as an equity-to-assets ratio, the Company's average
Risk-Adjusted Capital Policy guideline capital amount declined from
10.9% of assets in 1996 to 9.1% in 1997. The average guideline capital
amount was 8.1% in the fourth quarter of 1997. Since 1995, the Company
has adjusted its asset and funding mix in a manner that it believes
presents the Company with lower levels of anticipated risk. The capital
guideline has continued to drop as a result of this adjustment.
The actual average equity-to-asset ratio for the Company declined from
13.1% in 1996 to 10.1% in 1997. The actual average equity-to-asset
ratio was 10.2% in the fourth quarter of 1997. Since actual
equity-to-asset ratios have been higher in all these periods than the
capital guideline ratios, the Company could have owned more mortgage
assets during those periods and still met its capital guidelines.
Balance sheet capacity utilization (the percentage of the Company's
capital employed in the mortgage spread lending business as opposed to
being un-utilized) is a key measure of capital efficiency for the
Company. Even though average balance sheet capacity utilization
increased from 83% in 1996 to 90% in 1997, it has been declining
throughout 1997 due to the decline in capital requirements. It was 79%
in the fourth quarter of 1997.
From June 12, 1997 through the common stock equity offering of July 25,
1997, the Company was at its approximate maximum asset size as
determined by its Risk-Adjusted Capital Policy. Accordingly, the
Company ceased making firm commitments to new asset acquisitions during
that period. Approximately $29.4 million of the proceeds from the July
offering was necessary to bring the Company into compliance with its
normal capital guidelines. As a result of this constraint on
acquisitions during the early part of the quarter, the level of total
asset acquisitions for the third quarter of 1997 may have been less
than otherwise would have been the case.
Beginning in September 1997, strong demand for mortgage assets in an
environment of reduced supply led to increasing prices for mortgage
loans and mortgage securities. These rising prices together with the
potential for increased mortgage prepayment rates led the Company to
reduce the rate at which it sought to acquire new mortgage assets.
Although this decision resulted in the Company's balance sheet having
excess capital in the latter part of 1997, management believed that
long-term shareholder value would be maximized by refraining from
committing significant capital to the new mortgage acquisitions until
mortgage prices adjusted downwards. Although mortgage prices did fall
somewhat in the fourth quarter of 1997, as of year end 1997 the Company
had still not resumed its prior rate of growth. Mortgage prices
continued to fall in the first quarter of 1998. In order to utilize
excess capital and increase long-term shareholder value, a common stock
repurchase program was announced in September. The Company repurchased
a total of 840,000 shares for $23.1 million as of December 31, 1997.
The Company continued to repurchase stock in the first quarter of 1998.
50
<PAGE> 51
Risk Management
The Company seeks to manage the potential credit, interest rate,
liquidity and other risks inherent in all financial institutions in a
prudent manner designed to insure the longevity of the Company while,
at the same time, seeking to provide an opportunity for shareholders to
realize attractive total rates of return through long-term stock
ownership in the Company. While the Company does not seek to avoid
risk, it does seek, to the best of its ability, to assume risks that
can be quantified from historical experience, to actively manage such
risk, to earn sufficient compensation to justify the taking of such
risks and to maintain capital levels consistent with the risks it does
undertake.
The Company seeks to limit credit risk by maintaining what it believes
to be high quality mortgage loan underwriting standards. The Company is
a nationwide "A" (or "prime") quality lending company: it acquires and
owns first mortgages on single-family residential properties which have
been underwritten to the highest levels of underwriting standards
generally in use for these types of loans. Credit losses from such
mortgages tend to be cyclical. Historically, however, the magnitude of
credit loss incurred from high quality single-family mortgages during
historical credit cycles has been contained relative to credit losses
arising from other forms of commercial, consumer and residential
mortgage lending.
The Company seeks to manage liquidity risk and short-term borrowing
roll-over risk (which could be caused by market value fluctuations of
assets pledged as collateral for short-term borrowings or by changes in
lending markets) through: (1) maintaining what it believes to be a high
quality and liquid portfolio of mortgage assets, (2) maintaining a
hedging program utilizing interest rate agreements designed to
partially mitigate net changes in the market values of its assets, (3)
maintaining what it believes to be a prudent level of capitalization
(and therefore a prudent level of unused borrowing capacity), and (4)
replacing a portion of its short-term borrowings with long-term
borrowings. Liquidity risks and short-term borrowing roll-over risks
cannot be completely eliminated unless the Company can replace all of
its short-term borrowings with long-term borrowings. At December 31,
1997, the Company remained exposed to such risk, particularly in
general market environments of rapidly rising interest rates, market
dislocation or illiquidity.
The Company seeks to manage some of its interest rate risk through
matching the interest rate characteristics of its mortgages and its
borrowings to the degree that management believes is likely to be in
the best interests of the shareholders in the long-term.
The Company does not seek to be perfectly matched or to entirely
eliminate interest rate risk. Through December 31, 1997, the Company
has paired adjustable-rate mortgages with variable-rate liabilities.
The Company has generally maintained borrowings which adjust to market
conditions several months faster than its assets. This short-term
mis-match was lower on the Company's balance sheet at the end of 1997
than in prior periods. For larger interest rate increases, the
potential short-term negative earnings impact resulting from this
short-term mis-match should be partially mitigated by the Company's
interest rate agreements. In addition, since the Company's
adjustable-rate earning assets have exceeded its liabilities through
December 31, 1997, the longer term impact of an increase in short-term
interest rates may be positive after a lag period (once the coupon rate
on the assets has fully adjusted to the rate increase). Conversely,
while the short-term earnings effect of a decline in short-term
interest rates may be positive, the longer-run effect after a lag
period may be a decline in earnings relative to what they otherwise
would have been after the coupon rates on the assets have adjusted
downwards.
Through December 31, 1997, the Company generally has assumed some other
types of asset/liability mis-matches as well, including some yield
curve flattening risk (the risk of six and twelve month interest rates
falling relative to one and three month interest rates) and some "TED"
spread risk (the risk of U.S. Treasury rates falling relative to LIBOR
rates, as the percentage of the Company's assets which adjust off of
Treasury rates exceeds the percent of the Company's liabilities which
adjust off of Treasury rates). Certain other types of interest rate
risks remain partially unhedged as well. Management believes that the
assumption of these risks, to the extent undertaken by the Company, is
more likely than not to result in higher earnings for the Company in
the long-term but also, from time to time, may cause earnings
volatility and opportunity cost from foregone growth potential.
Management believes that retained interest rate risks (to the extent
they are separate from liquidity and market value fluctuation risk) are
51
<PAGE> 52
unlikely to cause a safety and soundness issue for the Company except
in relatively extreme and unexpected scenarios.
If the rate of mortgage principal repayment of the Company's mortgage
assets is faster than expected, the rate at which the Company amortizes
its net premium balances as an expense will increase and earnings will
be reduced relative to what they would have been otherwise. Changes in
principal repayment rates may be a source of earnings volatility for
the Company. In addition, faster principal repayments may reduce the
Company's net asset growth rate; net asset growth is generally an
important component of future earnings growth. Prospects for the
Company may also be reduced by higher than expected mortgage principal
repayments if the potential return characteristics of assets then
available for acquisition are less attractive than those of the
existing assets held in portfolio. Prepayment rates for adjustable-rate
mortgages increased during the third and fourth quarters of 1997 and
such prepayment rates may further increase in the first half of 1998.
Slowing rates of mortgage principal repayment could exacerbate certain
liquidity, market value fluctuation, and interest rate risks in a
rising interest rate environment.
While adjustable-rate mortgage principal repayment rates are not highly
predictable, management believes the strongest influencing factor in
the past has been the absolute level of longer-term interest rates. As
longer-term rates drop, adjustable-rate mortgage principal repayments
have tended to increase, particularly if longer-term rates drop
relative to shorter-term interest rates. In addition, management
believes adjustable-rate mortgage principal repayments have been
increasing on a secular trend basis due to structural and behavioral
changes in the mortgage origination market. Through December 31, 1997,
the Company has not sought to hedge mortgage principal repayment risk
but rather has sought to analyze, based on individual mortgage
characteristics, the propensity of each acquired mortgage or mortgage
pool to experience accelerated principal repayment rates and to adjust
its acquisition price bid accordingly based on the level of perceived
downside (and upside) earnings risk. The Company has been able to
effectively reduce the prepayment risk on some of its assets though the
issuance of long-term debt with certain characteristics.
The pricing of mortgage assets relative to the underlying risk in the
assets, and relative to levels at which the Company can issue long-term
debt, has a large effect on the Company's net asset growth and equity
utilization, and therefore on the Company's earnings growth. Higher
mortgage prices on an absolute basis or on a relative basis as compared
to debt markets will slow growth. The Company cannot hedge earnings
volatility that may arise from this source.
Virtually all of the Company's assets and liabilities are financial in
nature. As a result, interest rates, changes in 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 Principles and the Company's dividends are generally
determined based on 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.
52
<PAGE> 53
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 1
<TABLE>
<CAPTION>
INCOME STATEMENT FOR THREE MONTHS ENDING
--------------------------------------------------------
(ALL DOLLARS IN THOUSANDS) DEC. 31, SEP. 30, JUN. 30, MAR. 31,
1997 1997 1997 1997
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Mortgage Loans:
Coupon Income $ 24,911 $ 21,432 $ 14,474 $ 10,784
Amortization of Discount Balances 0 1 8 11
Amortization of Premium Balances (2,088) (1,803) (1,462) (940)
-------- -------- -------- --------
Interest Income: Mortgage Loans 22,823 19,630 13,020 9,855
Mortgage Securities:
Coupon Income 36,595 41,124 39,879 31,440
Amortization of Discount Balances 258 375 409 261
Amortization of Premium Balances (6,091) (5,085) (4,065) (3,150)
-------- -------- -------- --------
Interest Income: Mortgage Securities 30,762 36,414 36,223 28,551
Total Interest Income From Mortgage Assets 53,585 56,044 49,243 38,406
Interest Income: Cash Balances 399 499 266 162
-------- -------- -------- --------
Total Interest Income 53,984 56,543 49,509 38,568
Interest Expense on Short-Term Debt (31,964) (40,318) (38,958) (28,900)
Interest Expense on Long-Term Debt (14,567) (5,570) 0 0
-------- -------- -------- --------
Total Interest Expense (46,531) (45,888) (38,958) (28,900)
Interest Rate Agreement Expense (1,281) (1,064) (912) (602)
Interest Rate Agreement Income 12 26 73 7
-------- -------- -------- --------
Net Interest Rate Agreement Expense (1,269) (1,038) (839) (595)
Net Interest Income 6,184 9,617 9,712 9,073
Provision for Potential Credit Losses
Mortgage Loans (1,516) (473) (299) (215)
Mortgage Securities 1,000 (470) (477) (480)
-------- -------- -------- --------
Total Credit Provision (516) (943) (776) (695)
Gain (Loss) on Sale Transactions 543 20 0 0
Operating Expenses
Compensation and Benefits Expense (422) (441) (516) (529)
Dividend Equivalent Rights Expense (145) (361) (358) (203)
Other Operating Expenses (561) (346) (341) (435)
-------- -------- -------- --------
Total Operating Expenses (1,128) (1,148) (1,215) (1,167)
Other Income (Expenses) 0 0 0 0
Corporate Income Tax Expense 0 0 0 0
-------- -------- -------- --------
Net Income Before Preferred Dividends $ 5,083 $ 7,546 $ 7,721 $ 7,211
Preferred Dividends (686) (687) (687) (755)
-------- -------- -------- --------
Net Income to Common Shareholders $ 4,397 $ 6,859 $ 7,034 $ 6,456
======== ======== ======== ========
Calculation of Taxable REIT Income
GAAP Net Income Before Preferred Dividends $ 5,083 $ 7,546 $ 7,721 $ 7,211
Mortgage Amortization Differences 105 (95) (103) (87)
Credit Provisions less Actual Losses 475 875 747 653
Gain (Loss) on Sale Differences (190) 0 0 0
Operating Expense Differences 113 (175) (50) 135
-------- -------- -------- --------
Taxable Income Before Preferred Dividend $ 5,586 $ 8,151 $ 8,315 $ 7,912
======== ======== ======== ========
</TABLE>
53
<PAGE> 54
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 1 (CONTINUED)
<TABLE>
<CAPTION>
INCOME STATEMENT FOR THREE MONTHS ENDING
--------------------------------------------------------
(ALL DOLLARS IN THOUSANDS) DEC. 31, SEP. 30, JUN. 30, MAR. 31,
1996 1996 1996 1996
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Mortgage Loans:
Coupon Income $ 2,582 $ 1,656 $ 749 $ 479
Amortization of Discount Balances 11 7 11 2
Amortization of Premium Balances (189) (62) (43) (19)
Interest Income: Mortgage Loans 2,404 1,601 717 462
Mortgage Securities:
Coupon Income 25,292 18,901 12,973 8,965
Amortization of Discount Balances 206 264 234 175
Amortization of Premium Balances (2,236) (1,645) (1,225) (688)
-------- -------- -------- --------
Interest Income: Mortgage Securities 23,262 17,520 11,982 8,452
Total Interest Income From Mortgage Assets 25,666 19,121 12,699 8,914
Interest Income: Cash Balances 215 250 202 217
-------- -------- -------- --------
Total Interest Income 25,881 19,371 12,901 9,131
Interest Expense on Short-Term Debt (19,467) (14,447) (9,075) (6,202)
Interest Expense on Long-Term Debt 0 0 0 0
-------- -------- -------- --------
Total Interest Expense (19,467) (14,447) (9,075) (6,202)
Interest Rate Agreement Expense (403) (350) (255) (151)
Interest Rate Agreement Income 1 0 0 0
-------- -------- -------- --------
Net Interest Rate Agreement Expense (402) (350) (255) (151)
Net Interest Income 6,012 4,574 3,571 2,778
Provision for Potential Credit Losses
Mortgage Loans (35) (178) (140) 5
Mortgage Securities (337) (338) (337) (336)
-------- -------- -------- --------
Total Credit Provision (372) (516) (477) (331)
Gain (Loss) on Sale Transactions 0 0 0 0
Operating Expenses
Compensation and Benefits Expense (343) (309) (305) (234)
Dividend Equivalent Rights Expense (137) (81) (79) (85)
Other Operating Expenses (316) (281) (210) (174)
-------- -------- -------- --------
Total Operating Expenses (796) (671) (594) (493)
Other Income (Expenses) 0 0 0 0
Corporate Income Tax Expense 0 0 0 0
-------- -------- -------- --------
Net Income Before Preferred Dividends $ 4,844 $ 3,387 $ 2,500 $ 1,954
Preferred Dividends (760) (388) -- --
-------- -------- -------- --------
Net Income to Common Shareholders $ 4,084 $ 2,999 $ 2,500 $ 1,954
======== ======== ======== ========
Calculation of Taxable REIT Income
GAAP Net Income Before Preferred Dividends $ 4,844 $ 3,387 $ 2,500 $ 1,954
Mortgage Amortization Differences 131 61 82 175
Credit Provisions less Actual Losses 365 516 477 331
Gain (Loss) on Sale Differences 0 0 0 0
Operating Expense Differences 89 84 83 89
-------- -------- -------- --------
Taxable Income Before Preferred Dividend $ 5,429 $ 4,048 $ 3,142 $ 2,549
======== ======== ======== ========
</TABLE>
54
<PAGE> 55
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 1 (CONTINUED)
<TABLE>
<CAPTION>
INCOME STATEMENT FOR YEAR ENDING
------------------------------------------------------------
(ALL DOLLARS IN THOUSANDS) DEC. 31, DEC. 31, DEC. 31, DEC. 31,
1997 1996 1995 1994
--------- --------- --------- ---------
<S> <C> <C> <C> <C>
Mortgage Loans:
Coupon Income $ 71,601 $ 5,466 $ 379 $ 0
Amortization of Discount Balances 20 31 4 0
Amortization of Premium Balances (6,293) (313) (4) 0
Interest Income: Mortgage Loans 65,328 5,184 379 0
Mortgage Securities:
Coupon Income 149,038 66,131 14,759 1,102
Amortization of Discount Balances 1,303 879 915 101
Amortization of Premium Balances (18,391) (5,794) (559) (19)
--------- --------- --------- ---------
Interest Income: Mortgage Securities 131,949 61,216 15,115 1,184
Total Interest Income From Mortgage Assets 197,277 66,400 15,494 1,184
Interest Income: Cash Balances 1,326 884 232 112
--------- --------- --------- ---------
Total Interest Income 198,604 67,284 15,726 1,296
Interest Expense on Short-Term Debt (140,140) (49,191) (10,608) (760)
Interest Expense on Long-Term Debt (20,137) 0 0 0
--------- --------- --------- ---------
Total Interest Expense (160,277) (49,191) (10,608) (760)
Interest Rate Agreement Expense (3,859) (1,159) (339) (8)
Interest Rate Agreement Income 118 1 0 0
--------- --------- --------- ---------
Net Interest Rate Agreement Expense (3,741) (1,158) (339) (8)
Net Interest Income 34,586 16,935 4,779 528
Provision for Potential Credit Losses
Mortgage Loans (2,503) (348) (79) 0
Mortgage Securities (427) (1,348) (414) 0
--------- --------- --------- ---------
Total Credit Provision (2,930) (1,696) (493) 0
Gain (Loss) on Sale Transactions 563 0 0 0
Operating Expenses
Compensation and Benefits Expense (1,819) (1,191) (463) (63)
Dividend Equivalent Rights Expense (1,067) (382) (54) --
Other Operating Expenses (1,772) (981) (614) (83)
--------- --------- --------- ---------
Total Operating Expenses (4,658) (2,554) (1,131) (146)
Other Income (Expenses) 0 0 0 0
Corporate Income Tax Expense 0 0 0 0
--------- --------- --------- ---------
Net Income Before Preferred Dividends $ 27,561 $ 12,685 $ 3,155 $ 382
Preferred Dividends (2,815) (1,148) -- --
--------- --------- --------- ---------
Net Income to Common Shareholders $ 24,746 $ 11,537 $ 3,155 $ 382
--------- --------- --------- ---------
Calculation of Taxable REIT Income
GAAP Net Income Before Preferred Dividends $ 27,561 $ 12,685 $ 3,155 $ 382
Mortgage Amortization Differences (180) 449 175 (28)
Credit Provisions less Actual Losses 2,750 1,689 490 0
Gain (Loss) on Sale Differences (190) 0 (0) 0
Operating Expense Differences 23 345 12 0
--------- --------- --------- ---------
Taxable Income Before Preferred Dividend $ 29,964 $ 15,168 $ 3,832 $ 354
--------- --------- --------- ---------
</TABLE>
55
<PAGE> 56
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 2
<TABLE>
<CAPTION>
AT
--------------------------------------------------------------------
BALANCE SHEETS DEC. 31, SEP. 30, JUN. 30, MAR. 31,
(ALL DOLLARS IN THOUSANDS) 1997 1997 1997 1997
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Cash and Cash Equivalents $ 49,549 $ 57,696 $ 29,425 $ 12,985
Mortgage Loans:
Principal Value 1,519,124 1,348,619 1,111,029 716,009
Unamortized Premium 34,844 30,852 25,442 15,951
Unamortized Discount 0 0 (123) (131)
Real Estate Owned 713 220 346 128
Reserve For Credit Losses (2,855) (1,363) (929) (630)
Market Valuation Account 0 0 0 (1,291)
----------- ----------- ----------- -----------
Total Mortgage Loans 1,551,826 1,378,328 1,135,765 730,035
Mortgage Securities:
Principal Value 1,779,375 2,010,374 2,179,186 1,839,720
Unamortized Premium 51,329 56,082 62,219 49,156
Unamortized Discount (12,442) (14,387) (14,968) (15,510)
Reserve For Credit Losses (2,076) (3,093) (2,651) (2,203)
Market Valuation Account (1,390) 10,619 3,603 3,516
----------- ----------- ----------- -----------
Total Mortgage Securities 1,814,796 2,059,595 2,227,389 1,874,679
Total Mortgage Assets 3,366,622 3,437,923 3,363,154 2,604,714
Interest Rate Agreements 10,781 11,708 12,233 7,879
Market Valuation Account (8,681) (8,782) (7,366) (2,106)
----------- ----------- ----------- -----------
Total Interest Rate Agreements 2,100 2,926 4,867 5,773
Accrued Interest Receivable 23,119 23,859 24,065 17,722
Fixed Assets, Leasehold, Org. Costs 539 358 257 259
Prepaid Expenses and Other Receivables 2,268 2,490 2,738 1,611
----------- ----------- ----------- -----------
Other Assets 25,926 26,707 27,060 19,592
Total Assets $ 3,444,197 $ 3,525,252 $ 3,424,506 $ 2,643,064
=========== =========== =========== ===========
Short-Term Borrowings $ 1,914,525 $ 2,639,773 $ 3,102,784 $ 2,373,279
Long-Term Borrowings 1,172,801 497,367 0 0
Accrued Interest Payable 14,476 20,216 18,153 14,962
Accrued Expenses and Other Payables 2,172 2,129 1,743 1,262
Dividends Payable 5,686 9,433 8,638 7,899
----------- ----------- ----------- -----------
Total Liabilities $ 3,109,660 $ 3,168,918 $ 3,131,318 $ 2,397,402
Preferred Stock $ 26,736 $ 26,733 $ 26,733 $ 29,383
Common Stock 143 146 133 119
Additional Paid-in Capital 324,555 333,841 274,420 219,461
Net Market Valuation Account (10,071) 1,837 (3,762) 118
Retained Earnings after Dividends (6,826) (6,223) (4,336) (3,419)
----------- ----------- ----------- -----------
Total Stockholders' Equity 334,537 356,334 293,188 245,662
Total Liabilities plus Stockholders' Equity $ 3,444,197 $ 3,525,252 $ 3,424,506 $ 2,643,064
=========== =========== =========== ===========
</TABLE>
56
<PAGE> 57
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 2 (CONTINUED)
<TABLE>
<CAPTION>
AT
--------------------------------------------------------------------
BALANCE SHEETS DEC. 31, SEP. 30, JUN. 30, MAR. 31,
(ALL DOLLARS IN THOUSANDS) 1996 1996 1996 1996
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Cash and Cash Equivalents $ 11,068 $ 14,599 $ 10,407 $ 9,705
Mortgage Loans:
Principal Value 514,837 126,426 69,154 24,831
Unamortized Premium 12,389 1,535 686 191
Unamortized Discount (142) (153) (160) (171)
Real Estate Owned 196 0 0 0
Reserve For Credit Losses (428) (393) (214) (74)
Market Valuation Account (1,377) 279 200 84
----------- ----------- ----------- -----------
Total Mortgage Loans 525,475 127,694 69,666 24,861
Mortgage Securities:
Principal Value 1,602,212 1,234,636 936,611 548,976
Unamortized Premium 41,928 31,072 22,004 12,599
Unamortized Discount (15,951) (16,185) (16,448) (16,683)
Reserve For Credit Losses (1,752) (1,421) (1,084) (747)
Market Valuation Account 1,516 74 (3,269) (3,847)
----------- ----------- ----------- -----------
Total Mortgage Securities 1,627,953 1,248,176 937,814 540,298
Total Mortgage Assets 2,153,428 1,375,870 1,007,480 565,159
Interest Rate Agreements 6,200 3,286 2,835 2,534
Market Valuation Account (3,599) (2,413) (1,484) (1,301)
----------- ----------- ----------- -----------
Total Interest Rate Agreements 2,601 873 1,351 1,233
Accrued Interest Receivable 14,134 10,781 7,292 4,496
Fixed Assets, Leasehold, Org. Costs 257 265 233 198
Prepaid Expenses and Other Receivables 2,709 1,090 1,567 522
----------- ----------- ----------- -----------
Other Assets 17,100 12,136 9,092 5,216
Total Assets $ 2,184,197 $ 1,403,478 $ 1,028,330 $ 581,313
=========== =========== =========== ===========
Short-Term Borrowings $ 1,953,103 $ 1,225,094 $ 896,214 $ 508,721
Long-Term Borrowings 0 0 0 0
Accrued Interest Payable 14,060 10,379 4,052 1,616
Accrued Expenses and Other Payables 761 472 361 290
Dividends Payable 5,268 4,016 3,408 2,540
----------- ----------- ----------- -----------
Total Liabilities $ 1,973,192 $ 1,239,961 $ 904,035 $ 513,167
Preferred Stock $ 29,579 $ 29,712 $ 0 $ 0
Common Stock 110 91 85 55
Additional Paid-in Capital 187,507 138,081 130,441 73,926
Net Market Valuation Account (3,460) (2,060) (4,553) (5,065)
Retained Earnings after Dividends (2,731) (2,307) (1,678) (770)
----------- ----------- ----------- -----------
Total Stockholders' Equity 211,005 163,517 124,295 68,146
Total Liabilities plus Stockholders' Equity $ 2,184,197 $ 1,403,478 $ 1,028,330 $ 581,313
=========== =========== =========== ===========
</TABLE>
57
<PAGE> 58
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 2 (CONTINUED)
<TABLE>
<CAPTION>
AT
--------------------------------------------------------------------
BALANCE SHEETS DEC. 31, DEC. 31, DEC. 31, DEC. 31,
(ALL DOLLARS IN THOUSANDS) 1997 1996 1995 1994
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Cash and Cash Equivalents $ 49,549 $ 11,068 $ 4,825 $ 1,027
Mortgage Loans:
Principal Value 1,519,124 514,837 26,411 0
Unamortized Premium 34,844 12,389 210 0
Unamortized Discount 0 (142) (172) 0
Real Estate Owned 713 196 0 0
Reserve For Credit Losses (2,855) (428) (79) 0
Market Valuation Account 0 (1,377) 80 0
----------- ----------- ----------- -----------
Total Mortgage Loans 1,551,826 525,475 26,450 0
Mortgage Securities:
Principal Value 1,779,375 1,602,212 417,214 120,627
Unamortized Premium 51,329 41,928 9,433 828
Unamortized Discount (12,442) (15,951) (16,860) (1,320)
Reserve For Credit Losses (2,076) (1,752) (411) 0
Market Valuation Account (1,390) 1,516 (3,582) (2,658)
----------- ----------- ----------- -----------
Total Mortgage Securities 1,814,796 1,627,953 405,794 117,477
Total Mortgage Assets 3,366,622 2,153,428 432,244 117,477
Interest Rate Agreements 10,781 6,200 2,521 1,791
Market Valuation Account (8,681) (3,599) (1,974) 101
----------- ----------- ----------- -----------
Total Interest Rate Agreements 2,100 2,601 547 1,892
Accrued Interest Receivable 23,119 14,134 3,270 743
Fixed Assets, Leasehold, Org. Costs 539 257 206 201
Prepaid Expenses and Other Receivables 2,268 2,709 465 188
----------- ----------- ----------- -----------
Other Assets 25,926 17,100 3,941 1,132
Total Assets $ 3,444,197 $ 2,184,197 $ 441,557 $ 121,529
=========== =========== =========== ===========
Short-Term Borrowings $ 1,914,525 $ 1,953,103 $ 370,316 $ 100,376
Long-Term Borrowings 1,172,801 0 0 0
Accrued Interest Payable 14,476 14,060 1,290 676
Accrued Expenses and Other Payables 2,172 761 227 29
Dividends Payable 5,686 5,268 1,434 167
----------- ----------- ----------- -----------
Total Liabilities $ 3,109,660 $ 1,973,192 $ 373,267 $ 101,248
Preferred Stock $ 26,736 $ 29,579 $ 0 $ 22,785
Common Stock 143 110 55 2
Additional Paid-in Capital 324,555 187,507 73,895 19
Net Market Valuation Account (10,071) (3,460) (5,476) (2,557)
Retained Earnings after Dividends (6,826) (2,731) (184) 31
----------- ----------- ----------- -----------
Total Stockholders' Equity 334,537 211,005 68,290 20,280
Total Liabilities plus Stockholders' Equity $ 3,444,197 $ 2,184,197 $ 441,557 $ 121,528
=========== =========== =========== ===========
</TABLE>
58
<PAGE> 59
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 3
<TABLE>
<CAPTION>
AT OR
MORTGAGE ASSET CHARACTERISTICS FOR THREE MONTHS ENDING
-------------------------------------------------------------
(ALL DOLLARS IN THOUSANDS) DEC. 31, SEP. 30, JUN. 30, MAR. 31,
1997 1997 1997 1997
------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
Average Characteristics of Loans and Securities (Mortgage Assets)
at End of Period
Single-Family Properties 100% 100% 100% 100%
Adjustable Rate 100% 100% 100% 100%
First Lien 100% 100% 100% 100%
Average Credit Rating Equivalent AA+ AA+ AA+ AA+
Amortized Cost as % of Principal Value 102.23% 102.16% 102.21% 101.94%
Coupon Rate 7.71% 7.75% 7.73% 7.70%
Months to Next Coupon Adjustment 4 4 5 5
Level of Index 5.68% 5.65% 5.77% 5.98%
Net Margin 2.06% 2.11% 2.15% 2.21%
Fully Indexed Coupon Rate 7.74% 7.76% 7.92% 8.19%
Coupon Versus Fully-Indexed Rate -0.03% -0.01% -0.19% -0.49%
Net Life Cap 12.08% 12.03% 12.01% 11.91%
Percentage of Mortgage Assets by Credit Type, by Amortized Cost
Mortgage Loans 46.1% 40.2% 33.8% 28.1%
Mortgage Securities: AAA/AA 53.6% 58.2% 64.5% 69.8%
Mortgage Securities: A/BBB 0.0% 0.7% 0.8% 1.0%
Mortgage Securities: Below BBB 0.3% 0.9% 0.9% 1.1%
----------- ---------- ---------- ----------
Total Mortgage Assets (%) 100.0% 100.0% 100.0% 100.0%
Total Mortgage Assets (Amortized Cost) $ 3,372,943 $3,431,760 $3,363,131 $2,605,323
Percentage of Mortgage Assets by Index, Adjustment Frequency,
and Annualized Periodic Cap, By Principal Value
1 Month LIBOR, adjusts monthly, no periodic cap 20.1% 12.4% 8.9% 2.6%
6 Month LIBOR, adjusts every 6 months, 2% periodic cap 22.5% 26.2% 27.5% 32.4%
6 Month LIBOR, adjusts every 6 months, no periodic cap 11.2% 11.4% 7.4% 1.9%
6 Month CD, adjusts every 6 months, 2% periodic cap 1.2% 1.3% 1.5% 1.9%
6 Month Treasury, adjusts every 6 months, 2% periodic cap 0.6% 0.6% 0.6% 0.8%
6 Month Treasury, adjusts every 6 months, no periodic cap 0.5% 0.5% 0.5% 0.7%
3/1 Hybrid: 12 Month Treasury with 3 year initial coupon 1.6% 1.7% 1.8% 2.4%
12 Month Treasury, adjusts annually, 2% periodic cap 40.7% 44.5% 50.3% 55.4%
12 Month Treasury, adjusts annually, no periodic cap 0.1% 0.1% 0.1% 0.1%
Other 1.5% 1.3% 1.4% 1.8%
----------- ---------- ---------- ----------
Total Mortgage Assets (%) 100.0% 100.0% 100.0% 100.0%
Total Mortgage Assets (Principal Value) $ 3,299,212 $3,359,213 $3,290,562 $ 2,555,857
Net Mortgage Asset Growth
Mortgage Acquisitions $ 342,283 $ 369,463 $ 962,890 $ 627,075
Mortgage Principal Repayments (347,427) (252,398) (199,945) (173,362)
Amortization (7,921) (6,512) (5,109) (3,818)
Credit Losses (40) (68) (28) (41)
Sales (45,712) (41,856) 0 0
----------- ---------- ---------- ----------
Change in Mortgage Assets (Amortized Cost) (58,817) 68,629 757,808 449,854
</TABLE>
59
<PAGE> 60
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 3 (CONTINUED)
<TABLE>
<CAPTION>
AT OR
MORTGAGE ASSET CHARACTERISTICS FOR THREE MONTHS ENDING
-----------------------------------------------------------------
(ALL DOLLARS IN THOUSANDS) DEC. 31, SEP. 30, JUN. 30, MAR. 31,
1996 1996 1996 1996
<S> <C> <C> <C> <C>
Average Characteristics of Loans and Securities (Mortgage Assets)
at End of Period
Single-Family Properties 100% 100% 100% 100%
Adjustable Rate 100% 100% 100% 100%
First Lien 100% 100% 100% 100%
Average Credit Rating Equivalent AA+ AA+ AA+ AA+
Amortized Cost as % of Principal Value 101.81% 101.20% 100.60% 99.29%
Coupon Rate 7.75% 7.55% 7.42% 7.59%
Months to Next Coupon Adjustment 5 4 4 3
Level of Index 5.58% 5.70% 5.72% 5.47%
Net Margin 2.24% 2.21% 2.21% 2.11%
Fully Indexed Coupon Rate 7.82% 7.91% 7.93% 7.58%
Coupon Versus Fully-Indexed Rate -0.07% -0.36% -0.51% 0.01%
Net Life Cap 11.73% 11.69% 11.71% 11.53%
Percentage of Mortgage Assets by Credit Type, by Amortized Cost
Mortgage Loans 24.5% 9.3% 6.9% 4.4%
Mortgage Securities: AAA/AA 73.0% 86.8% 87.7% 86.1%
Mortgage Securities: A/BBB 1.2% 1.8% 2.5% 4.6%
Mortgage Securities: Below BBB 1.3% 2.1% 2.9% 4.9%
---------- ---------- ---------- --------
Total Mortgage Assets (%) 100.0% 100.0% 100.0% 100.0%
Total Mortgage Assets (Amortized Cost) $2,155,469 $1,377,331 $1,011,847 $569,743
Percentage of Mortgage Assets by Index, Adjustment Frequency,
and Annualized Periodic Cap, By Principal Value
1 Month LIBOR, adjusts monthly, no periodic cap 1.4% 2.3% 3.3% 6.6%
6 Month LIBOR, adjusts every 6 months, 2% periodic cap 36.2% 45.9% 54.4% 63.2%
6 Month LIBOR, adjusts every 6 months, no periodic cap 0.0% 0.0% 0.0% 0.0%
6 Month CD, adjusts every 6 months, 2% periodic cap 2.5% 2.4% 3.3% 8.7%
6 Month Treasury, adjusts every 6 months, 2% periodic cap 1.1% 1.7% 2.4% 0.0%
6 Month Treasury, adjusts every 6 months, no periodic cap 0.9% 1.3% 1.9% 3.6%
3/1 Hybrid: 12 Month Treasury with 3 year initial coupon 0.0% 0.0% 0.0% 0.0%
12 Month Treasury, adjusts annually, 2% periodic cap 55.7% 45.0% 32.8% 14.6%
12 Month Treasury, adjusts annually, no periodic cap 0.0% 0.0% 0.0% 0.0%
Other 2.2% 1.4% 1.9% 3.3%
---------- ---------- ---------- --------
Total Mortgage Assets (%) 100.0% 100.0% 100.0% 100.0%
Total Mortgage Assets (Principal Value) $2,117,244 $1,361,062 $1,005,764 $573,807
Net Mortgage Asset Growth
Mortgage Acquisitions $875,968 $443,860 $496,184 $166,852
Mortgage Principal Repayments (95,610) (76,942) (53,058) (32,814)
Amortization (2,213) (1,434) (1,022) (531)
Credit Losses (7) 0 0 0
Sales 0 0 0 0
---------- ---------- ---------- --------
Change in Mortgage Assets (Amortized Cost) 778,138 365,484 442,104 133,507
</TABLE>
60
<PAGE> 61
SUPPLEMENTAL HISTORICAL INFORMATION
<TABLE>
<CAPTION>
TABLE 3 (CONTINUED) AT OR
MORTGAGE ASSET CHARACTERISTICS FOR YEAR ENDING
----------------------------------------------------------
(ALL DOLLARS IN THOUSANDS) DEC. 31, DEC. 31, DEC. 31, DEC. 31,
1997 1996 1995 1994
<S> <C> <C> <C> <C>
Average Characteristics of Loans and Securities (Mortgage Assets)
at End of Period
Single-Family Properties 100% 100% 100% 100%
Adjustable Rate 100% 100% 100% 100%
First Lien 100% 100% 100% 100%
Average Credit Rating Equivalent AA+ AA+ AA+ AA+
Amortized Cost as % of Principal Value 102.23% 101.81% 98.33% 99.59%
Coupon Rate 7.71% 7.75% 7.50% 6.00%
Months to Next Coupon Adjustment 4 5 3 3
Level of Index 5.68% 5.58% 5.44% 6.94%
Net Margin 2.06% 2.24% 2.08% 2.25%
Fully Indexed Coupon Rate 7.74% 7.82% 7.52% 9.19%
Coupon Versus Fully-Indexed Rate -0.03% -0.07% -0.02% -3.19%
Net Life Cap 12.08% 11.73% 11.54% 11.48%
Percentage of Mortgage Assets by Credit Type, by Amortized Cost
Mortgage Loans 46.1% 24.5% 6.1% 0.0%
Mortgage Securities: AAA/AA 53.6% 73.0% 81.5% 92.9%
Mortgage Securities: A/BBB 0.0% 1.2% 5.8% 4.3%
Mortgage Securities: Below BBB 0.3% 1.3% 6.6% 2.8%
---------- ---------- -------- --------
Total Mortgage Assets (%) 100.0% 100.0% 100.0% 100.0%
Total Mortgage Assets (Amortized Cost) $3,372,943 $2,155,469 $436,236 $120,135
Percentage of Mortgage Assets by Index, Adjustment
Frequency, and Annualized
Periodic Cap, By Principal Value
1 Month LIBOR, adjusts monthly, no periodic cap 20.1% 1.4% 7.6% 3.9%
6 Month LIBOR, adjusts every 6 months, 2% periodic cap 22.5% 36.2% 60.3% 78.3%
6 Month LIBOR, adjusts every 6 months, no periodic cap 11.2% 0.0% 0.0% 0.0%
6 Month CD, adjusts every 6 months, 2% periodic cap 1.2% 2.5% 12.2% 17.8%
6 Month Treasury, adjusts every 6 months, 2% periodic cap 0.6% 1.1% 0.0% 0.0%
6 Month Treasury, adjusts every 6 months, no periodic cap 0.5% 0.9% 4.9% 0.0%
3/1 Hybrid: 12 Month Treasury with 3 year initial coupon 1.6% 0.0% 0.0% 0.0%
12 Month Treasury, adjusts annually, 2% periodic cap 40.7% 55.7% 12.3% 0.0%
12 Month Treasury, adjusts annually, no periodic cap 0.1% 0.0% 0.0% 0.0%
Other 1.5% 2.2% 2.7% 0.0%
---------- ---------- -------- --------
Total Mortgage Assets (%) 100.0% 100.0% 100.0% 100.0%
Total Mortgage Assets (Principal Value) $3,299,212 $2,117,244 $443,625 $120,627
Net Mortgage Asset Growth
Mortgage Acquisitions $2,301,711 $1,982,864 $354,572 $121,297
Mortgage Principal Repayments (973,132) (258,424) (38,824) (1,244)
Amortization (23,361) (5,200) 357 82
Credit Losses (179) (7) (4) (0)
Sales (87,565) 0 0 0
---------- ---------- -------- --------
Change in Mortgage Assets (Amortized Cost) 1,217,474 1,719,233 316,101 120,135
</TABLE>
61
<PAGE> 62
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 4
<TABLE>
<CAPTION>
AT
------------------------------------------------
MORTGAGE LOAN SUMMARY DEC. 31, SEP. 30, JUN. 30, MAR. 31,
(ALL DOLLARS IN THOUSANDS) 1997 1997 1997 1997
--------- --------- --------- -------
<S> <C> <C> <C> <C>
Number of Loans 5,041 4,651 3,983 2,795
Principal Value $1,519,837 $1,348,839 $1,111,376 $ 716,137
Amortized Cost 1,554,681 1,379,691 1,136,694 731,957
Reported Value (Net of Credit Reserve) 1,551,826 1,378,328 1,135,765 730,035
Estimated Bid-Side Market Value 1,552,586 1,379,166 1,136,004 729,561
Adjustable-Rate 100% 100% 100% 100%
Single-Family 100% 100% 100% 100%
"A" Quality Underwriting 100% 100% 100% 100%
First Lien 100% 100% 100% 100%
Primary Residence (Owner-Occupied) 89% 91% 92% 94%
Second Home 8% 7% 6% 4%
Investor Property 3% 2% 2% 2%
Average Loan Size $ 301 $ 290 $ 279 $ 256
Loan Balance (Less than) Conventional Loan Balance Limit ($214,600 in 1997) 18% 19% 20% 20%
Loan Balance (Greater than) $500,000 37% 33% 27% 14%
Original Loan-To-Value Ratio (LTV) 78% 77% 78% 74%
Original LTV (Greater than) 80% 38% 35% 33% 24%
% of Original LTV (Greater than) 80% with Primary Mortgage 95% 96% 94% 94%
Insurance or Pledged Account Collateral
Effective Average Original LTV Including Primary 66% 66% 69% 68%
Mortgage Insurance or Pledged Account Collateral
1990 and Prior Years' Origination 4% 4% 6% 9%
1991 Origination * * 1% 1%
1992 1% 1% 2% 3%
1993 4% 4% 6% 9%
1994 13% 17% 23% 41%
1995 1% 2% 2% 4%
1996 11% 14% 18% 30%
1997 66% 58% 42% 2%
Average Seasoning in Months 18 19 22 33
Northern California 11% 13% 13% 17%
Southern California 18% 19% 21% 24%
Florida 9% 9% 8% 5%
New York 7% 6% 5% 4%
Georgia 5% 4% 3% 2%
New Jersey 4% 4% 4% 3%
Connecticut 4% 4% 4% 3%
Texas 4% 4% 4% 3%
Colorado 4% 3% 3% 2%
Maryland 3% 3% 4% 6%
Illinois 3% 3% 3% 4%
Arizona 2% 3% 3% 1%
Other States 26% 25% 25% 26%
</TABLE>
*: less than 0.5%
62
<PAGE> 63
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 4 (CONTINUED)
<TABLE>
<CAPTION>
AT
-----------------------------------------
MORTGAGE LOAN SUMMARY DEC. 31, SEP. 30, JUN. 30, MAR. 31,
(ALL DOLLARS IN THOUSANDS) 1996 1996 1996 1996
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Number of Loans 2,172 478 257 101
Principal Value $515,033 $126,426 $ 69,154 $ 24,831
Amortized Cost 527,280 127,808 69,680 24,851
Reported Value (Net of Credit Reserve) 525,475 127,694 69,666 24,861
Estimated Bid-Side Market Value 525,475 127,694 69,666 24,861
Adjustable-Rate 100% 100% 100% 100%
Single-Family 100% 100% 100% 100%
"A" Quality Underwriting 100% 100% 100% 100%
First Lien 100% 100% 100% 100%
Primary Residence (Owner-Occupied) 94% 99% 99% 100%
Second Home 4% 1% 1% 0%
Investor Property 2% 0% 0% 0%
Average Loan Size $ 237 $ 264 $ 269 $ 246
Loan Balance [Less Than] Conventional Loan Balance Limit ($214,600 in 1997) 22% 15% 13% 27%
Loan Balance [Greater Than] $500,000 8% 12% 13% 25%
Original Loan-To-Value Ratio (LTV) 77% 78% 76% 77%
Original LTV [Greater Than] 80% 25% 32% 23% 27%
% of Original LTV [Greater Than] 80% with Primary Mortgage 97% 100% 100% 100%
Insurance or Pledged Account Collateral
Effective Average Original LTV Including Primary 73% 73% 73% 73%
Mortgage Insurance or Pledged Account Collateral
1990 and Prior Years' Origination 13% 0% 0% 0%
1991 Origination 2% 0% 0% 0%
1992 4% 0% 0% 0%
1993 14% 7% 1% 0%
1994 52% 43% 2% 2%
1995 7% 32% 63% 98%
1996 8% 18% 34% 0%
1997 0% 0% 0% 0%
Average Seasoning in Months 37 9 4 7
Northern California 18% 34% 30% 30%
Southern California 26% 51% 43% 46%
Florida 4% * 1% 1%
New York 3% * * 0%
Georgia 2% * 1% 1%
New Jersey 3% * * 1%
Connecticut 3% 1% 1% 1%
Texas 2% 1% 1% 4%
Colorado 1% 2% 3% 3%
Maryland 8% * 1% 2%
Illinois 4% * 1% 0%
Arizona 2% 0% 0% 0%
Other States 24% 11% 18% 11%
</TABLE>
*: less than 0.5%
63
<PAGE> 64
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 4 (CONTINUED)
AT
<TABLE>
<CAPTION>
MORTGAGE LOAN SUMMARY DEC. 31, DEC. 31, DEC. 31, DEC. 31,
(ALL DOLLARS IN THOUSANDS) 1997 1996 1995 1994
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Number of Loans 5,041 2,172 109 0
Principal Value $1,519,837 $ 515,033 $ 26,411 $ 0
Amortized Cost 1,554,681 527,280 26,449 0
Reported Value (Net of Credit Reserve) 1,551,826 525,475 26,450 0
Estimated Bid-Side Market Value 1,552,586 525,475 26,450 0
Adjustable-Rate 100% 100% 100% n/a
Single-Family 100% 100% 100% n/a
"A" Quality Underwriting 100% 100% 100% n/a
First Lien 100% 100% 100% n/a
Primary Residence (Owner-Occupied) 89% 94% 100% n/a
Second Home 8% 4% 0% n/a
Investor Property 3% 2% 0% n/a
Average Loan Size $ 301 $ 237 $ 242 n/a
Loan Balance Less than Conventional Loan Balance Limit ($214,600 in 1997) 18% 23% 11% n/a
Loan Balance Greater Than $500,000 37% 8% 13% n/a
Original Loan-To-Value Ratio (LTV) 78% 77% 76% n/a
Original LTV Greater than 80% 38% 25% 26% n/a
% of Original LTV Greater than 80% with Primary Mortgage 95% 97% 100% n/a
Insurance or Pledged Account Collateral
Effective Average Original LTV Including Primary 66% 73% 72% n/a
Mortgage Insurance or Pledged Account Collateral
1990 and Prior Years' Origination 4% 13% 0% n/a
1991 Origination * 2% 0% n/a
1992 1% 4% 0% n/a
1993 4% 14% 0% n/a
1994 13% 52% 2% n/a
1995 1% 7% 98% n/a
1996 11% 8% 0% n/a
1997 66% 0% 0% n/a
Average Seasoning in Months 18 37 4 n/a
Northern California 11% 18% 30% n/a
Southern California 18% 26% 44% n/a
Florida 9% 4% 1% n/a
New York 7% 3% 0% n/a
Georgia 5% 2% 1% n/a
New Jersey 4% 3% 1% n/a
Connecticut 4% 3% 1% n/a
Texas 4% 2% 4% n/a
Colorado 4% 1% 3% n/a
Maryland 3% 8% 2% n/a
Illinois 3% 4% 0% n/a
Arizona 2% 2% 2% n/a
Other States 26% 24% 11% n/a
</TABLE>
*: less than 0.5%
64
<PAGE> 65
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 5
<TABLE>
<CAPTION>
EARNING ASSET YIELD, INTEREST RATE SPREAD FOR THREE MONTHS ENDING
-------------------------------------
AND INTEREST RATE MARGIN DEC. 31, SEP. 30, JUN. 30, MAR. 31,
1997 1997 1997 1997
------ ------ ------ ------
<S> <C> <C> <C> <C>
Mortgage Coupon Rate (All Mortgage Assets) 7.70 7.77 7.74 7.70%
Amortized Cost as % of Principal Value 102.20 102.22 102.15 101.84%
Coupon Yield on Amortized Cost 7.53 7.60 7.57 7.56%
Effect of Premium/Discount Amortization -0.98% -0.79% -0.71% -0.68%
Mortgage Yield 6.55 6.81 6.86 6.88%
Cash Yield 5.59 5.60 5.52 5.33%
------ ------ ------ ------
Earning Asset Yield (Mortgages plus Cash) 6.54 6.80 6.86 6.87%
Cost of Funds of Short-Term Borrowings 5.96 5.98 5.86 5.62%
Cost of Funds of Long-Term Borrowings 6.40 6.28 n/a n/a
------ ------ ------ ------
Total Cost of Funds 6.09 6.02 5.86 5.62%
Cost of Hedging (as % of Borrowings) 0.17 0.14 0.13 0.12%
Interest Rate Spread 0.28 0.64 0.87 1.13%
Net Interest Margin (Net Interest Income/Assets) 0.72 1.12 1.31 1.57%
Net Interest Income/Average Equity 7.06 11.13 13.25 15.30%
SELECTED OPERATING RATIOS AND RETURN ON EQUITY
Credit Provisions as a % of Assets 0.06 0.11 0.10 0.12%
Credit Provisions as a % of Equity 0.59 1.09 1.06 1.17%
Operating Expenses to Average Assets 0.13 0.13 0.16 0.20%
Operating Expenses to Average Equity 1.29 1.33 1.66 1.97%
Efficiency Ratio (Op. Exp./Net Int. Income) 18.25 11.93 12.51 12.86%
Average Assets Per Employee ($MM) $ 242 $ 244 $ 257 $ 221
GAAP Return on Total Equity 5.80 8.73 10.53 12.16%
GAAP Return on Common Equity 5.43 8.60 10.65 12.44%
Taxable Income Return on Total Equity 6.38 9.43 11.34 13.34%
Taxable Income Return on Common Equity 6.06 9.36 11.55 13.79%
GAAP Return on Average Assets 0.59 0.88 1.04 1.25%
PRINCIPAL PAYDOWN AND PREPAYMENT RATES
Average Annual Conditional Prepayment Rate (CPR) of Underlying
Mortgages in Mortgage Securities and Mortgage Loan Pools 27% 24% 23% 24%
Annualized Principal Payment as % of Average Principal Balance of
Mortgage Securities and Mortgage Loans 43% 31% 28% 32%
Average Annual Conditional Prepayment Rate (CPR) of Underlying
Mortgages in Mortgage Loan Pools 24% 23% 28% 24%
Annualized Principal Payment as % of Average Principal Balance of
Mortgage Loans 29% 29% 35% 32%
Average Annual Conditional Prepayment Rate (CPR) of Underlying
Mortgages in Mortgage Securities Pools 30% 25% 22% 23%
Annualized Principal Payment as % of Average Principal Balance of
Mortgage Securities 53% 33% 26% 31%
</TABLE>
65
<PAGE> 66
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 5 (CONTINUED)
<TABLE>
<CAPTION>
EARNING ASSET YIELD, INTEREST RATE SPREAD FOR THREE MONTHS ENDING
-----------------------------------
AND INTEREST RATE MARGIN DEC. 31, SEP. 30, JUN. 30, MAR. 31,
1996 1996 1996 1996
------ ------ ----- -----
<S> <C> <C> <C> <C>
Mortgage Coupon Rate (All Mortgage Assets) 7.58% 7.52% 7.47% 7.73%
Amortized Cost as % of Principal Value 101.41% 100.98% 99.95% 98.85%
Coupon Yield on Amortized Cost 7.48% 7.44% 7.48% 7.82%
Effect of Premium/Discount Amortization -0.59% -0.52% -0.56% -0.44%
Mortgage Yield 6.89% 6.92% 6.92% 7.38%
Cash Yield 5.31% 5.30% 5.61% 5.93%
------ ------ ----- -----
Earning Asset Yield (Mortgages plus Cash) 6.87% 6.90% 6.90% 7.34%
Cost of Funds of Short-Term Borrowings 5.76% 5.78% 5.57% 5.69%
Cost of Funds of Long-Term Borrowings n/a n/a n/a n/a
------ ------ ----- -----
Total Cost of Funds 5.76% 5.78% 5.57% 5.69%
Cost of Hedging (as % of Borrowings) 0.12% 0.14% 0.16% 0.14%
Interest Rate Spread 0.99% 0.98% 1.17% 1.51%
Net Interest Margin (Net Interest Income/Assets) 1.55% 1.58% 1.85% 2.17%
Net Interest Income/Average Equity 13.01% 12.40% 12.14% 14.92%
SELECTED OPERATING RATIOS AND RETURN ON EQUITY
Credit Provisions as a % of Assets 0.10% 0.18% 0.25% 0.26%
Credit Provisions as a % of Equity 0.81% 1.40% 1.62% 1.78%
Operating Expenses to Average Assets 0.21% 0.23% 0.31% 0.38%
Operating Expenses to Average Equity 1.72% 1.82% 2.02% 2.64%
Efficiency Ratio (Op. Exp./Net Int. Income) 13.23% 14.69% 16.63% 17.71%
Average Assets Per Employee ($MM) $ 155 $ 115 $ 84 $ 70
GAAP Return on Total Equity 10.48% 9.18% 8.50% 10.50%
GAAP Return on Common Equity 10.53% 9.06% 8.50% 10.50%
Taxable Income Return on Total Equity 11.75% 10.97% 10.69% 13.69%
Taxable Income Return on Common Equity 12.03% 11.06% 10.69% 13.69%
GAAP Return on Average Assets 1.25% 1.17% 1.30% 1.52%
PRINCIPAL PAYDOWN AND PREPAYMENT RATES
Average Annual Conditional Prepayment Rate (CPR) of Underlying
Mortgages in Mortgage Securities and Mortgage Loan Pools 23% 24% 29% 26%
Annualized Principal Payment as % of Average Principal Balance of
Mortgage Securities and Mortgage Loans 26% 28% 29% 27%
Average Annual Conditional Prepayment Rate (CPR) of Underlying
Mortgages in Mortgage Loan Pools 32% 19% 28% 19%
Annualized Principal Payment as % of Average Principal Balance of
Mortgage Loans 42% 25% 37% 25%
Average Annual Conditional Prepayment Rate (CPR) of Underlying
Mortgages in Mortgage Securities Pools 22% 24% 29% 26%
Annualized Principal Payment as % of Average Principal Balance of
Mortgage Securities 24% 28% 28% 27%
</TABLE>
66
<PAGE> 67
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 5 (CONTINUED)
<TABLE>
<CAPTION>
EARNING ASSET YIELD, INTEREST RATE SPREAD FOR YEAR ENDING
------------------------------------
AND INTEREST RATE MARGIN DEC. 31, DEC. 31, DEC. 31, DEC. 31,
1997 1996 1995 1994
------ ------ ----- ------
<S> <C> <C> <C> <C>
Mortgage Coupon Rate (All Mortgage Assets) 7.72% 7.55% 7.16% 6.09%
Amortized Cost as % of Principal Value 102.13% 100.68% 99.02% 100.02%
Coupon Yield on Amortized Cost 7.56% 7.50% 7.23% 6.09%
Effect of Premium/Discount Amortization -0.81% -0.55% 0.17% 0.45%
Mortgage Yield 6.75% 6.95% 7.40% 6.54%
Cash Yield 5.53% 5.51% 5.43% 4.73%
------ ------ ----- ------
Earning Asset Yield (Mortgages plus Cash) 6.74% 6.93% 7.36% 6.33%
Cost of Funds of Short-Term Borrowings 5.86% 5.71% 6.06% 5.55%
Cost of Funds of Long-Term Borrowings 6.31% n/a n/a n/a
------ ------ ----- ------
Total Cost of Funds 5.92% 5.71% 6.06% 5.55%
Cost of Hedging (as % of Borrowings) 0.14% 0.13% 0.19% 0.06%
Interest Rate Spread 0.68% 1.09% 1.11% 0.72%
Net Interest Margin (Net Interest Income/Assets) 1.14% 1.69% 2.17% 2.50%
Net Interest Income/Average Equity 11.27% 12.90% 11.03% 7.27%
SELECTED OPERATING RATIOS AND RETURN ON EQUITY
Credit Provisions as a % of Assets 0.10% 0.17% 0.22% 0.00%
Credit Provisions as a % of Equity 0.95% 1.29% 1.14% 0.00%
Operating Expenses to Average Assets 0.15% 0.26% 0.51% 0.69%
Operating Expenses to Average Equity 1.52% 1.94% 2.61% 2.01%
Efficiency Ratio (Op. Exp./Net Int. Income) 13.47% 15.08% 23.66% 27.73%
Average Assets Per Employee ($MM) $ 242 $ 109 $ 39 $ 12
GAAP Return on Total Equity 8.98% 9.66% 7.28% 5.25%
GAAP Return on Common Equity 8.87% 9.61% 7.28% 5.25%
Taxable Income Return on Total Equity 9.76% 11.55% 8.84% 4.86%
Taxable Income Return on Common Equity 9.73% 11.68% 8.84% 4.86%
GAAP Return on Average Assets 0.91% 1.27% 1.43% 1.81%
PRINCIPAL PAYDOWN AND PREPAYMENT RATES
Average Annual Conditional Prepayment Rate (CPR) of Underlying
Mortgages in Mortgage Securities and Mortgage Loan Pools 25% 25% 19% 9%
Annualized Principal Payment as % of Average Principal Balance of
Mortgage Securities and Mortgage Loans 34% 27% 18% 7%
Average Annual Conditional Prepayment Rate (CPR) of Underlying
Mortgages in Mortgage Loan Pools 24% 26% 5% n/a
Annualized Principal Payment as % of Average Principal Balance of
Mortgage Loans 31% 35% 6% n/a
Average Annual Conditional Prepayment Rate (CPR) of Underlying
Mortgages in Mortgage Securities Pools 25% 24% 19% 9%
Annualized Principal Payment as % of Average Principal Balance of
Mortgage Securities 36% 27% 19% 2%
</TABLE>
67
<PAGE> 68
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 6
<TABLE>
<CAPTION>
AT OR
AVERAGE DAILY BALANCE SHEET FOR THREE MONTHS ENDING
--------------------------------------------------------
(ALL DOLLARS IN THOUSANDS) DEC. 31, SEP. 30, JUN. 30, MAR. 31,
1997 1997 1997 1997
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Cash $ 28,592 $ 35,647 $ 19,307 $ 12,147
Mortgage Loans 1,360,029 1,155,099 758,445 574,781
Mortgage Securities 1,914,118 2,136,442 2,111,832 1,658,629
Credit Reserve (4,679) (3,873) (3,083) (2,394)
Market Valuation Adjustment, Mortgage Assets $ 5,937 $ 6,072 $ 1,913 $ 1,022
Interest Rate Agreements 11,207 11,943 11,185 6,899
Market Valuation Adjustment, Interest Rate Agreements (8,792) (8,640) (4,576) (4,004)
Other Assets 117,643 85,689 75,928 58,856
----------- ----------- ----------- -----------
Total Assets 3,424,055 3,418,379 2,970,951 2,305,936
----------- ----------- ----------- -----------
Short-Term Borrowings 1,233,924 2,695,438 2,659,914 2,056,051
Long-Term Borrowings 910,870 355,028 0 0
Other Liabilities 20,912 24,714 20,530 15,691
----------- ----------- ----------- -----------
Total Liabilities 2,165,706 3,075,181 2,680,444 2,071,742
----------- ----------- ----------- -----------
Preferred Stock 26,733 26,733 28,946 29,545
Common Stock 328,384 321,492 265,561 208,426
Market Valuation Adjustment $ (2,855) $ (2,568) $ (2,663) $ (2,982)
Retained Earnings, after Dividend (4,783) (2,458) (1,337) (795)
----------- ----------- ----------- -----------
Stockholders' Equity 347,479 343,199 290,507 234,194
----------- ----------- ----------- -----------
Amortized Cost of Total Assets 3,426,910 3,420,947 2,973,614 2,308,918
Equity, before Market Valuation Adjustments 350,334 345,767 293,170 237,176
BORROWING COMPOSITIONS (AT END OF PERIOD)
Short-Term Borrowings: 1 to 6 Month LIBOR, no caps 62.0% 84.1% 100.0% 100.0%
Long-Term Borrowings: 1 Month LIBOR, 10% cap 13.8% 9.9% 0.0% 0.0%
Long-Term Borrowings: Federal Funds, 10% cap 5.3% 6.0% 0.0% 0.0%
Long-Term Borrowings: 1 Year Treasury, 10% cap 18.9% 0.0% 0.0% 0.0%
----------- ----------- ----------- -----------
Total Borrowings % 100.0% 100.0% 100.0% 100.0%
Total Borrowings $ $ 3,087,326 $ 3,137,140 $ 3,102,784 $ 2,373,279
LIQUIDITY (AT END OF PERIOD)
Unrestricted Cash $ 24,893 $ 28,758 $ 29,425 $ 12,985
Estimated Borrowing Capacity 182,713 206,442 160,338 140,561
----------- ----------- ----------- -----------
Total Liquidity $ 207,606 $ 235,200 $ 189,763 $ 153,546
Total Liquidity as Percent of Short-Term Borrowings 11% 9% 6% 6%
NET PREMIUM AS % OF EQUITY AND ASSETS (AT END OF PERIOD)
Unamortized Premium of Mortgage Assets $ 86,173 $ 86,934 $ 87,661 $ 65,107
Unamortized Discount of Mortgage Assets (12,442) (14,387) (15,091) (15,641)
Unamortized Premium of Long-Term Debt (5,795) 0 0 0
----------- ----------- ----------- -----------
Net Premium $ 67,937 $ 72,548 $ 72,569 $ 49,466
Net Premium as Percent of Equity (before Market Value Adjustments) 19.7% 20.5% 24.4% 20.1%
Net Premium as Percent of Assets (Amortized Cost) 2.0% 2.1% 2.1% 1.9%
</TABLE>
68
<PAGE> 69
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 6 (CONTINUED)
<TABLE>
<CAPTION>
AT OR
AVERAGE DAILY BALANCE SHEET FOR THREE MONTHS ENDING
--------------------------------------------------------
(ALL DOLLARS IN THOUSANDS) DEC. 31, SEP. 30, JUN. 30, MAR. 31,
1996 1996 1996 1996
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Cash $ 16,137 $ 18,854 $ 14,402 $ 14,639
Mortgage Loans 143,368 93,991 45,313 25,279
Mortgage Securities 1,347,617 1,010,853 688,697 457,841
Credit Reserve (1,952) (1,491) (1,002) (594)
Market Valuation Adjustment, Mortgage Assets $ 603 $ (2,279) $ (3,865) $ (3,880)
Interest Rate Agreements 4,681 3,185 2,737 2,503
Market Valuation Adjustment, Interest Rate Agreements (3,513) (1,352) (1,080) (1,836)
Other Assets 41,430 30,129 21,566 13,094
----------- ----------- ----------- -----------
Total Assets 1,548,371 1,151,890 766,768 507,046
----------- ----------- ----------- -----------
Short-Term Borrowings 1,351,510 999,229 651,643 435,979
Long-Term Borrowings 0 0 0 0
Other Liabilities 14,898 8,728 2,472 2,324
----------- ----------- ----------- -----------
Total Liabilities 1,366,408 1,007,957 654,115 438,303
----------- ----------- ----------- -----------
Preferred Stock 29,671 15,179 0 0
Common Stock 156,594 132,924 117,695 73,998
Market Valuation Adjustment $ (2,910) $ (3,631) $ (4,945) $ (5,716)
Retained Earnings, after Dividend (1,392) (539) (97) 461
----------- ----------- ----------- -----------
Stockholders' Equity 181,963 143,933 112,653 68,743
----------- ----------- ----------- -----------
Amortized Cost of Total Assets 1,551,281 1,155,521 771,713 512,762
Equity, before Market Valuation Adjustments 184,873 147,564 117,598 74,459
BORROWING COMPOSITIONS (AT END OF PERIOD)
Short-Term Borrowings: 1 to 6 Month LIBOR, no caps 100.0% 100.0% 100.0% 100.0%
Long-Term Borrowings: 1 Month LIBOR, 10% cap 0.0% 0.0% 0.0% 0.0%
Long-Term Borrowings: Federal Funds, 10% cap 0.0% 0.0% 0.0% 0.0%
Long-Term Borrowings: 1 Year Treasury, 10% cap 0.0% 0.0% 0.0% 0.0%
----------- ----------- ----------- -----------
Total Borrowings % 100.0% 100.0% 100.0% 100.0%
Total Borrowings $ $ 1,953,103 $ 1,225,094 $ 896,214 $ 508,721
LIQUIDITY (AT END OF PERIOD)
Unrestricted Cash $ 11,068 $ 14,599 $ 10,407 $ 9,705
Estimated Borrowing Capacity 123,995 99,126 69,581 29,153
----------- ----------- ----------- -----------
Total Liquidity $ 135,063 $ 113,725 $ 79,988 $ 38,858
Total Liquidity as Percent of Short-Term Borrowings 7% 9% 9% 8%
NET PREMIUM AS % OF EQUITY AND ASSETS (AT END OF PERIOD)
Unamortized Premium of Mortgage Assets $ 54,318 $ 32,607 $ 22,690 $ 12,790
Unamortized Discount of Mortgage Assets (16,093) (16,338) (16,608) (16,854)
Unamortized Premium of Long-Term Debt 0 0 0 0
----------- ----------- ----------- -----------
Net Premium $ 38,225 $ 16,270 $ 6,082 $ (4,064)
Net Premium as Percent of Equity (before Market Value Adjustments) 17.8% 9.8% 4.7% -5.6%
Net Premium as Percent of Assets (Amortized Cost) 1.7% 1.2% 0.6% -0.7%
</TABLE>
69
<PAGE> 70
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 6 (CONTINUED)
<TABLE>
<CAPTION>
AT OR
AVERAGE DAILY BALANCE SHEET FOR YEAR ENDING
--------------------------------------------------------
(ALL DOLLARS IN THOUSANDS) DEC. 31, DEC. 31, DEC. 31, DEC. 31,
1997 1996 1995 1994
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Cash $ 24,001 $ 16,016 $ 4,272 $ 6,627
Mortgage Loans 964,768 77,215 5,006 0
Mortgage Securities 1,956,452 877,907 204,284 50,080
Credit Reserve (3,514) (1,262) (92) 0
Market Valuation Adjustment, Mortgage Assets $ (1,134) $ (2,347) $ (78) $ (583)
Interest Rate Agreements 10,325 3,280 2,039 759
Market Valuation Adjustment, Interest Rate Agreements (2,482) (1,948) (1,046) 31
Other Assets 84,693 26,606 5,107 948
----------- ----------- ----------- -----------
Total Assets 3,033,108 995,467 219,492 57,862
----------- ----------- ----------- -----------
Short-Term Borrowings 2,390,132 861,316 174,926 37,910
Long-Term Borrowings 319,076 0 0 0
Other Liabilities 20,488 7,131 2,342 367
----------- ----------- ----------- -----------
Total Liabilities 2,729,696 868,447 177,268 38,277
----------- ----------- ----------- -----------
Preferred Stock 27,978 11,274 0 0
Common Stock 281,405 120,436 43,390 20,941
Market Valuation Adjustment $ (3,617) $ (4,295) $ (1,124) $ (552)
Retained Earnings, after Dividend (2,354) (395) (42) (804)
----------- ----------- ----------- -----------
Stockholders' Equity 303,412 127,020 42,224 19,585
----------- ----------- ----------- -----------
Amortized Cost of Total Assets 3,036,725 999,762 220,616 58,414
Equity, before Market Valuation Adjustments 307,029 131,315 43,349 20,137
BORROWING COMPOSITIONS (AT END OF PERIOD)
Short-Term Borrowings: 1 to 6 Month LIBOR, no caps 62.0% 100.0% 100.0% 100.0%
Long-Term Borrowings: 1 Month LIBOR, 10% cap 13.8% 0.0% 0.0% 0.0%
Long-Term Borrowings: Federal Funds, 10% cap 5.3% 0.0% 0.0% 0.0%
Long-Term Borrowings: 1 Year Treasury, 10% cap 18.9% 0.0% 0.0% 0.0%
----------- ----------- ----------- -----------
Total Borrowings % 100.0% 100.0% 100.0% 100.0%
Total Borrowings $ $ 3,087,326 $ 1,953,103 $ 370,316 $ 100,376
LIQUIDITY (AT END OF PERIOD)
Unrestricted Cash $ 24,893 $ 11,068 $ 4,825 $ 1,027
Estimated Borrowing Capacity 182,713 123,995 38,698 11,907
----------- ----------- ----------- -----------
Total Liquidity $ 207,606 $ 135,063 $ 43,523 $ 12,934
Total Liquidity as Percent of Short-Term Borrowings 11% 7% 12% 13%
NET PREMIUM AS % OF EQUITY AND ASSETS (AT END OF PERIOD)
Unamortized Premium of Mortgage Assets $ 86,173 $ 54,318 $ 9,644 $ 827
Unamortized Discount of Mortgage Assets (12,442) (16,093) (17,032) (1,320)
Unamortized Premium of Long-Term Debt (5,795) 0 0 0
----------- ----------- ----------- -----------
Net Premium $ 67,937 $ 38,225 $ (7,389) $ (493)
Net Premium as Percent of Equity (before Market Value Adjustments) 19.7% 17.8% -10.0% -2.2%
Net Premium as Percent of Assets (Amortized Cost) 2.0% 1.7% -1.7% -0.4%
</TABLE>
70
<PAGE> 71
SUPPLEMENTAL HISTORICAL INFORMATION
<TABLE>
<CAPTION>
TABLE 7 AT OR
ESTIMATED PERIOD-END BID-SIDE MARKET VALUE / FOR THREE MONTHS ENDING
------------------------------------------------------
REALIZABLE VALUE DEC. 31, SEP. 30, JUN. 30, MAR. 31,
(ALL DOLLARS IN THOUSANDS) 1997 1997 1997 1997
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Cash $ 49,549 $ 57,696 $ 29,425 $ 12,985
Mortgage Loans 1,552,586 1,379,166 1,136,004 729,561
Mortgage Securities 1,814,796 2,059,595 2,227,389 1,874,679
Interest Rate Agreements 1,522 2,169 4,206 5,773
Other Assets 25,156 26,048 25,857 19,291
Short-Term Borrowings 1,914,525 2,639,773 3,102,784 2,373,279
Long-Term Borrowings 1,172,938 497,465 0 0
Other Liabilities 21,201 30,628 27,515 23,411
----------- ----------- ----------- -----------
"Mark-To-Market" of Total Equity 334,945 356,808 292,582 245,598
Liquidation Cost of Preferred Equity 28,195 28,195 28,195 30,989
----------- ----------- ----------- -----------
"Mark-To-Market" of Common Equity $ 306,750 $ 328,613 $ 264,387 $ 214,610
"Mark-To-Market" of Common Equity Per Common Share Outstanding $ 21.47 $ 22.54 $ 19.95 $ 18.03
Reported Common Equity Per Common Share Outstanding $ 21.55 $ 22.61 $ 20.11 $ 18.17
Historical Cost of Common Equity Per Common Share Outstanding $ 22.25 $ 22.49 $ 20.39 $ 18.16
AVERAGE BALANCE SHEET UTILIZATION DURING PERIOD
VERSUS RISK-ADJUSTED CAPITAL GUIDELINES
Actual Average Equity/Assets 10.2% 10.1% 9.9% 10.3%
Average Risk-Adjusted Capital Guideline 8.1% 9.0% 9.5% 10.1%
Balance Sheet Capacity Utilization 79% 89% 96% 98%
Excess Capital and Asset Growth Potential At Period End
Ending Actual Equity/Assets 9.71% 10.12% 8.55% 9.28%
Ending Risk-Adjusted Capital Guideline 7.51% 8.59% 9.41% 10.09%
Excess Capital $ 76,189 $ 54,038 $ (29,417) $ (21,029)
Estimated Asset Growth Potential (Same Asset Mix and Funding) $ 1,013,956 $ 629,081 $ (312,637) $ (208,706)
Estimated Asset Growth Potential Assuming All Assets (existing
and future) Use Long-Term Funding $ 4,748,787 $ 5,373,637 $ 4,005,833 $ 3,589,525
INVESTMENT OF RISK-ADJUSTED CAPITAL
Assets with Short-Term Funding
Agencies 24.1% 26.2% 36.0% 37.1%
Mortgage Securities Rated "AAA" or "AA" 27.6% 27.0% 36.6% 37.2%
Mortgage Securities Rated "A" or below 0.0% 6.0% 6.4% 7.6%
Whole Loans 8.2% 18.3% 31.1% 26.7%
----------- ----------- ----------- -----------
Total Assets with Short-Term Funding 59.9% 77.5% 110.1% 108.6%
Assets with Long-Term, Non-Recourse Funding
Mortgage Securities Rated "A" or below 2.7% 0.0% 0.0% 0.0%
Whole Loans 14.7% 7.4% 0.0% 0.0%
----------- ----------- ----------- -----------
Total Assets with Long-Term, Non-Recourse Funding 17.4% 7.4% 0.0% 0.0%
Excess Capital 22.7% 15.1% -10.1% -8.6%
----------- ----------- ----------- -----------
Total Market-Value of Capital % 100.0% 100.0% 100.0% 100.0%
Total Market-Value of Capital $ $ 334,945 $ 356,808 $ 292,582 $ 245,598
</TABLE>
71
<PAGE> 72
SUPPLEMENTAL HISTORICAL INFORMATION
<TABLE>
<CAPTION>
TABLE 7 (CONTINUED) AT OR
ESTIMATED PERIOD-END BID-SIDE MARKET VALUE/ FOR THREE MONTHS ENDING
--------------------------------------------------------
REALIZABLE VALUE DEC. 31, SEP. 30, JUN. 30, MAR. 31,
(ALL DOLLARS IN THOUSANDS) 1996 1996 1996 1996
----------- ----------- ----------- -------------
<S> <C> <C> <C> <C>
Cash $ 11,068 $ 14,599 $ 10,407 $ 9,705
Mortgage Loans 525,475 127,694 69,666 24,861
Mortgage Securities 1,627,953 1,248,176 937,814 540,298
Interest Rate Agreements 2,601 873 1,351 1,233
Other Assets 16,778 11,766 8,864 4,987
Short-Term Borrowings 1,953,103 1,225,094 896,214 508,721
Long-Term Borrowings 0 0 0 0
Other Liabilities 19,531 14,457 7,522 4,240
----------- ----------- ----------- -------------
"Mark-To-Market" of Total Equity 211,241 163,557 124,366 68,123
Liquidation Cost of Preferred Equity 31,194 31,194 0 0
----------- ----------- ----------- -------------
"Mark-To-Market" of Common Equity $ 180,047 $ 132,363 $ 124,366 $ 68,123
"Mark-To-Market" of Common Equity Per Common Share Outstanding $ 16.37 $ 14.59 $ 14.60 $ 12.34
Reported Common Equity Per Common Share Outstanding $ 16.50 $ 14.75 $ 14.59 $ 12.34
Historical Cost of Common Equity Per Common Share Outstanding $ 16.81 $ 14.98 $ 15.12 $ 13.26
AVERAGE BALANCE SHEET UTILIZATION DURING PERIOD VERSUS
RISK-ADJUSTED CAPITAL GUIDELINES
Actual Average Equity/Assets 11.9% 12.8% 15.2% 14.5%
Average Risk-Adjusted Capital Guideline 10.2% 10.7% 11.4% 12.8%
Balance Sheet Capacity Utilization 86% 84% 75% 88%
Excess Capital and Asset Growth Potential At Period End
Ending Actual Equity/Assets 9.66% 11.65 12.09 11.72%
Ending Risk-Adjusted Capital Guideline 9.97% 10.32 10.77 11.72%
Excess Capital $ (6,798) $ 18,664 $ 13,566 $ 26
Estimated Asset Growth Potential (Same Asset Mix and Funding) $ (68,169) $ 180,836 $ 125,972 $ 227
Estimated Asset Growth Potential Assuming All Assets (existing
and future) Use Long-Term Funding $ 3,181,906 $ 2,767,399 $ 2,155,950 $ 1,192,215
INVESTMENT OF RISK-ADJUSTED CAPITAL
Assets with Short-Term Funding
Agencies 39.1% 48.0% 44.9% 36.0%
Mortgage Securities Rated "AAA" or "AA" 32.4% 22.2% 24.4% 33.6%
Mortgage Securities Rated "A" or below 8.9% 11.4% 14.8% 27.1%
Whole Loans 22.8% 7.0% 5.0% 3.3%
----------- ----------- ----------- -------------
Total Assets with Short-Term Funding 103.2% 88.6% 89.1% 100.0%
Assets with Long-Term, Non-Recourse Funding
Mortgage Securities Rated "A" or below 0.0% 0.0% 0.0% 0.0%
Whole Loans 0.0% 0.0% 0.0% 0.0%
----------- ----------- ----------- -------------
Total Assets with Long-Term, Non-Recourse Funding 0.0% 0.0% 0.0% 0.0%
Excess Capital -3.2% 11.4% 10.9% 0.0%
----------- ----------- ----------- -------------
Total Market-Value of Capital % 100.0% 100.0% 100.0% 100.0%
Total Market-Value of Capital $ $ 211,241 $ 163,557 $ 124,366 $ 68,123
</TABLE>
72
<PAGE> 73
SUPPLEMENTAL HISTORICAL INFORMATION
<TABLE>
<CAPTION>
TABLE 7 (CONTINUED) AT OR
ESTIMATED PERIOD-END BID-SIDE MARKET VALUE/ FOR YEAR ENDING
------------------------------------------------------
REALIZABLE VALUE DEC. 31, DEC. 31, DEC. 31, DEC. 31,
(ALL DOLLARS IN THOUSANDS) 1997 1996 1995 1994
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Cash $ 49,549 $ 11,068 $ 4,825 $ 1,027
Mortgage Loans 1,552,586 525,475 26,450 0
Mortgage Securities 1,814,796 1,627,953 405,794 117,477
Interest Rate Agreements 1,522 2,601 547 1,892
Other Assets 25,156 16,778 3,671 888
Short-Term Borrowings 1,914,525 1,953,103 370,316 100,376
Long-Term Borrowings 1,172,938 0 0 0
Other Liabilities 21,201 19,531 2,829 872
----------- ----------- ----------- ------------
"Mark-To-Market" of Total Equity 334,945 211,241 68,142 20,036
Liquidation Cost of Preferred Equity 28,195 31,194 0 0
----------- ----------- ----------- ------------
"Mark-To-Market" of Common Equity $ 306,750 $ 180,047 $ 68,142 $ 20,036
"Mark-To-Market" of Common Equity Per Common Share Outstanding $ 21.47 $ 16.37 $ 12.35 $ 10.69
Reported Common Equity Per Common Share Outstanding $ 21.55 $ 16.50 $ 12.38 $ 10.82
Historical Cost of Common Equity Per Common Share Outstanding $ 22.25 $ 16.81 $ 13.37 $ 12.18
AVERAGE BALANCE SHEET UTILIZATION DURING PERIOD VERSUS
RISK-ADJUSTED CAPITAL GUIDELINES
Actual Average Equity/Assets 10.1% 13.1% 19.6% 34.5%
Average Risk-Adjusted Capital Guideline 9.1% 10.9% 13.4% 10.6%
Balance Sheet Capacity Utilization 90% 83% 68% 31%
Excess Capital and Asset Growth Potential At Period End
Ending Actual Equity/Assets 9.71% 9.66% 15.47% 16.69%
Ending Risk-Adjusted Capital Guideline 7.51% 9.97% 12.59 10.84%
Excess Capital $ 76,189 $ (6,798) $ 12,028 $ 6,716
Estimated Asset Growth Potential (Same Asset Mix and Funding) $ 1,013,956 $ (68,169) $ 100,874 $ 65,519
Estimated Asset Growth Potential Assuming All Assets (existing
and future) Use Long-Term Funding $ 4,748,787 $ 3,181,906 $ 1,325,602 $ 392,001
INVESTMENT OF RISK-ADJUSTED CAPITAL
Assets with Short-Term Funding
Agencies 24.1% 39.1% 29.3% 33.0%
Mortgage Securities Rated "AAA" or "AA" 27.6% 32.4% 22.7% 18.8%
Mortgage Securities Rated "A" or below 0.0% 8.9% 26.8% 14.7%
Whole Loans 8.2% 22.8% 3.5% 0.0%
----------- ----------- ----------- ------------
Total Assets with Short-Term Funding 59.9% 103.2% 82.3% 66.5%
Assets with Long-Term, Non-Recourse Funding
Mortgage Securities Rated "A" or below 2.7% 0.0% 0.0% 0.0%
Whole Loans 14.7% 0.0% 0.0% 0.0%
----------- ----------- ----------- ------------
Total Assets with Long-Term, Non-Recourse Funding 17.4% 0.0% 0.0% 0.0%
Excess Capital 22.7% -3.2% 17.7% 33.5%
----------- ----------- ----------- ------------
Total Market-Value of Capital % 100.0% 100.0% 100.0% 100.0%
Total Market-Value of Capital $ $ 334,945 $ 211,241 $ 68,142 $ 20,036
</TABLE>
73
<PAGE> 74
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 8
<TABLE>
<CAPTION>
AT OR
CREDIT PROVISIONS AND CREDIT RESERVES FOR THREE MONTHS ENDING
--------------------------------------
(ALL DOLLARS IN THOUSANDS) DEC. 31, SEP. 30, JUN. 30, MAR. 31,
1997 1997 1997 1997
------- ------- ------- -------
<S> <C> <C> <C> <C>
MORTGAGE LOANS
Credit Provision During Period $ 1,516 $ 473 $ 299 $ 215
Actual Losses During Period 23 40 0 13
Cumulative Actual Losses 76 53 13 13
Mortgage Loan Credit Reserve at End of Period 2,855 1,363 929 630
Annualized Mortgage Loan Credit Provision as % of Average
Amortized Cost of Mortgage Loans 0.45% 0.16% 0.16% 0.15%
Mortgage Loan Credit Reserve as % of Amortized Cost
of Mortgage Loans at Period End 0.18% 0.10% 0.08% 0.09%
Non-Performing Assets: 90+ Days Delinquent, Foreclosures,
Bankruptcies, and REO
Number of Loans 17 13 12 6
Non-Performing Assets Loan Balance $ 3,903 $ 2,792 $ 2,366 $ 1,220
Non-Performing Assets as % of Amortized Cost of Mortgage Loans 0.25% 0.20% 0.21% 0.17%
Non-Performing Assets as % of Amortized Cost of Total Assets 0.11% 0.08% 0.07% 0.05%
Mortgage Loan Credit Reserve as % of Non-Performing Assets 73% 49% 39% 52%
Credit Experience of Mortgage Loans
Liquidated Defaulted Loans (Cumulative) 6 4 1 1
Average Loss Severity Experience (Cumulative) 7% 6% 7% 7%
Scenario Analysis of Potential Credit Losses Over Next 12 Months If All Current
(But No Future) Non-Performing Mortgage Loans Default:
At 10% Loss Severity $ 396 $ 283 $ 241 $ 124
At 20% Loss Severity 793 567 481 248
At 30% Loss Severity 1,189 850 722 372
At 40% Loss Severity 1,586 1,133 962 496
Mortgage Loan Credit Reserve at End of Period $ 2,855 $ 1,363 $ 929 $ 630
MORTGAGE SECURITIES
Credit Provision During Period $(1,000) $ 470 $ 477 $ 480
Actual Losses During Period 17 28 29 29
Cumulative Actual Losses 113 97 69 40
Mortgage Securities Credit Reserve at End of Period 2,076 3,093 2,651 2,203
Annualized Mortgage Securities Credit Provision as % of Average
Amortized Cost of Mortgage Securities Rated (Less than) BBB -20.9% 6.4% 6.6% 6.6%
Mortgage Securities Credit Reserve as % of Amortized Cost of
Mortgage Securities Rated (Less than) BBB at End of Period 22.8% 10.6% 9.1% 7.6%
Amortized Cost of Mortgage Securities Rated (Less than) BBB at End of Period $ 9,109 $29,189 $29,113 $28,955
Credit Experience of Loans in Pools Underlying Mortgage Securities Rated
(Less than) BBB (Since Acquisition)
Resolved Defaulted Loans (Cumulative) 254 182 137 90
Average Loss Severity Experience (Cumulative) 21% 23% 24% 25%
Scenario Analysis of Potential Credit Losses Over Next 12 Months
If All Current (But No Future) Seriously Delinquent Loans in Mortgage
Pools Underlying Less than BBB Rated Securities Default:
At 10% Loss Severity $ 389 $ 724 $ 109 $ 80
At 20% Loss Severity 894 2,286 1,488 792
At 30% Loss Severity 1,163 3,789 3,702 2,845
At 40% Loss Severity 1,825 6,437 6,410 5,103
Mortgage Securities Credit Reserve at End of Period $ 2,076 $ 3,093 $ 2,651 $ 2,203
</TABLE>
74
<PAGE> 75
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 8 (CONTINUED)
<TABLE>
<CAPTION>
AT OR
CREDIT PROVISIONS AND CREDIT RESERVES FOR THREE MONTHS ENDING
------------------------------------------
(ALL DOLLARS IN THOUSANDS) DEC. 31, SEP. 30, JUN. 30, MAR. 31,
1996 1996 1996 1996
-------- -------- -------- --------
<S> <C> <C> <C> <C>
MORTGAGE LOANS
Credit Provision During Period $ 35 $ 178 $ 140 $ (5)
Actual Losses During Period 0 0 0 0
Cumulative Actual Losses 0 0 0 0
Mortgage Loan Credit Reserve at End of Period 428 393 214 74
Annualized Mortgage Loan Credit Provision as % of Average
Amortized Cost of Mortgage Loans 0.10% 0.76% 1.23% -0.08%
Mortgage Loan Credit Reserve as % of Amortized Cost
of Mortgage Loans a Period End 0.08% 0.31% 0.31% 0.30%
Non-Performing Assets: 90+ Days Delinquent, Foreclosures, Bankruptcies, and REO
Number of Loans 7 3 2 1
Non-Performing Assets Loan Balance $ 1,249 $ 404 $ 279 $ 190
Non-Performing Assets as % of Amortized Cost of Mortgage Loans 0.24% 0.32% 0.40% 0.77%
Non-Performing Assets as % of Amortized Cost of Total Assets 0.06% 0.03% 0.03% 0.03%
Mortgage Loan Credit Reserve as % of Non-Performing Assets 34% 97% 77% 39%
Credit Experience of Mortgage Loans
Liquidated Defaulted Loans (Cumulative) 0 0 0 0
Average Loss Severity Experience (Cumulative) 0% 0% 0% 0%
Scenario Analysis of Potential Credit Losses Over Next 12 Months If All Current
(But No Future) Non-Performing Mortgage Loans Default:
At 10% Loss Severity $ 127 $ 41 $ 28 $ 19
At 20% Loss Severity 253 82 56 39
At 30% Loss Severity 380 123 85 58
At 40% Loss Severity 506 164 113 77
Mortgage Loan Credit Reserve at End of Period $ 428 $ 393 $ 214 $ 74
MORTGAGE SECURITIES
Credit Provision During Period $ 337 $ 338 $ 337 $ 336
Actual Losses During Period 7 -- -- --
Cumulative Actual Losses 11 4 4 4
Mortgage Securities Credit Reserve at End of Period 1,752 1,421 1,084 747
Annualized Mortgage Securities Credit Provision as % of Average
Amortized Cost of Mortgage Securities Rated (Less than) BBB 4.7% 4.7% 4.7% 4.7%
Mortgage Securities Credit Reserve as % of Amortized Cost of
Mortgage Securities Rated (Less than) BBB at End of Period 6.1% 4.9% 3.8% 2.7%
Amortized Cost of Mortgage Securities Rated (Less than) BBB at End of Period $ 28,935 $ 28,906 $ 28,858 $ 28,051
Credit Experience of Loans in Pools Underlying Mortgage Securities Rated
(Less than) BBB (Since Acquisition)
Resolved Defaulted Loans (Cumulative) 59 28 15 4
Average Loss Severity Experience (Cumulative) 27% 22% 16% 10%
Scenario Analysis of Potential Credit Losses Over Next 12 Months If All Current
(But No Future) Seriously Delinquent Loans in Mortgage Pools Underlying
(Less than) BBB Rated Securities Default:
At 10% Loss Severity $ 63 $ 61 $ 40 $ 20
At 20% Loss Severity 608 123 91 39
At 30% Loss Severity 2,040 1,131 1,364 597
At 40% Loss Severity 3,647 3,041 3,148 2,162
Mortgage Securities Credit Reserve at End of Period $ 1,752 $ 1,421 $ 1,084 $ 747
</TABLE>
75
<PAGE> 76
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 8 (CONTINUED)
<TABLE>
<CAPTION>
AT OR
CREDIT PROVISIONS AND CREDIT RESERVES FOR YEAR ENDING
-------------------------------------
(ALL DOLLARS IN THOUSANDS) DEC. 31, DEC. 31, DEC. 31, DEC. 31,
1997 1996 1995 1994
------- ------- ------- -------
<S> <C> <C> <C> <C>
MORTGAGE LOANS
Credit Provision During Period $ 2,503 $ 349 $ 79 $ 0
Actual Losses During Period 76 0 0 0
Cumulative Actual Losses 76 0 0 0
Mortgage Loan Credit Reserve at End of Period 2,855 428 79 0
Annualized Mortgage Loan Credit Provision as % of Average
Amortized Cost of Mortgage Loans 0.26% 0.45% 1.58% n/a
Mortgage Loan Credit Reserve as % of Amortized Cost
of Mortgage Loans a Period End 0.18% 0.08% 0.30% n/a
Non-Performing Assets: 90+ Days Delinquent, Foreclosures, Bankruptcies, and REO
Number of Loans 17 7 0 0
Non-Performing Assets Loan Balance $ 3,903 $ 1,249 $ 0 $ 0
Non-Performing Assets as % of Amortized Cost of Mortgage Loans 0.25% 0.24% 0.00% 0.00%
Non-Performing Assets as % of Amortized Cost of Total Assets 0.11% 0.06% 0.00% 0.00%
Mortgage Loan Credit Reserve as % of Non-Performing Assets 73% 34% n/a n/a
Credit Experience of Mortgage Loans
Liquidated Defaulted Loans (Cumulative) 6 0 0 0
Average Loss Severity Experience (Cumulative) 7% 0% 0% 0%
Scenario Analysis of Potential Credit Losses Over Next 12 Months If All Current
(But No Future) Non-Performing Mortgage Loans Default:
At 10% Loss Severity $ 396 $ 127 $ 0 $ 0
At 20% Loss Severity 793 253 0 0
At 30% Loss Severity 1,189 380 0 0
At 40% Loss Severity 1,586 506 0 0
Mortgage Loan Credit Reserve at End of Period $ 2,855 $ 428 $ 79 $ 0
MORTGAGE SECURITIES
Credit Provision During Period $ 427 $ 1,348 $ 414 $ 0
Actual Losses During Period 104 7 4 --
Cumulative Actual Losses 113 11 4 --
Mortgage Securities Credit Reserve at End of Period 2,076 1,752 411 0
Annualized Mortgage Securities Credit Provision as % of Average
Amortized Cost of Mortgage Securities Rated Less than BBB 1.7% 4.7% 2.9% 0.0%
Mortgage Securities Credit Reserve as % of Amortized Cost of
Mortgage Securities Rated Less than BBB at End of Period 22.8% 6.1% 1.4% 0.0%
Amortized Cost of Mortgage Securities Rated Less than BBB at End of Period $ 9,109 $28,935 $28,869 $ 3,376
Credit Experience of Loans in Pools Underlying Mortgage Securities Rated
Less than BBB (Since Acquisition)
Resolved Defaulted Loans (Cumulative) 254 59 2 0
Average Loss Severity Experience (Cumulative) 21% 27% 9% 0%
Scenario Analysis of Potential Credit Losses Over Next 12 Months If All Current
(But No Future) Seriously Delinquent Loans in Mortgage Pools
Underlying Less than BBB Rated Securities Default:
At 10% Loss Severity $ 389 $ 63 $ 15 $ 0
At 20% Loss Severity 894 608 29 0
At 30% Loss Severity 1,163 2,040 103 0
At 40% Loss Severity 1,825 3,647 768 0
Mortgage Securities Credit Reserve at End of Period $ 2,076 $ 1,752 $ 411 $ 0
</TABLE>
76
<PAGE> 77
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 9
<TABLE>
<CAPTION>
AT OR
SHARES OUTSTANDING AND PER SHARE DATA FOR THREE MONTHS ENDING
----------------------------------------------------
(ALL DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) DEC. 31, SEP. 30, JUN. 30, MAR. 31,
1997 1997 1997 1997
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Shares Outstanding and Receiving Dividends at Period End
Common (RWT) 14,284,657 14,576,477 13,251,847 11,905,957
Class A Preferred (converted 9/95) 0 0 0 0
Class B Preferred (RTW-PB) 909,518 909,518 909,518 999,638
---------- ---------- ---------- ----------
Total 15,194,175 15,485,995 14,161,365 12,905,595
Common Dividend Declared $ 0.350 $ 0.600 $ 0.600 $ 0.600
Class A Preferred Dividend Declared n/a n/a n/a n/a
Class B Preferred Dividend Declared $ 0.755 $ 0.755 $ 0.755 $ 0.755
Common Dividend Total $ 5,000 $ 8,746 $ 7,951 $ 7,144
Class A Preferred Dividend Total 0 0 0 0
Class B Preferred Dividends Total 686 687 687 755
---------- ---------- ---------- ----------
Total Dividend $ 5,686 $ 9,433 $ 8,638 $ 7,899
Taxable Income Earned $ 5,586 $ 8,150 $ 8,315 $ 7,912
Dividend Pay-Out Ratio for Period 101.8% 115.7% 103.9% 99.8%
Cumulative Dividend Pay-Out Ratio 102.6% 102.7% 99.7% 98.5%
Warrants Outstanding at Period End (expired 12/31/97) 0 149,466 236,297 272,304
Average Shares Outstanding During Period
Common 14,375,992 14,316,678 12,997,566 11,605,171
Class A Preferred 0 0 0 0
Class B Preferred 909,518 909,518 990,725 1,005,515
---------- ---------- ---------- ----------
Total 15,285,510 15,226,196 13,988,291 12,610,686
Calculation of "Diluted" Common Shares
Average Number of Common Shares Outstanding 14,375,992 14,316,678 12,997,566 11,605,171
Potential Dilution Due to Warrants 57,139 130,489 182,137 258,422
Potential Dilution Due to Options 99,383 177,434 291,227 253,274
---------- ---------- ---------- ----------
Total Average "Diluted" Common Shares 14,532,514 14,624,601 13,470,930 12,116,867
Net Income to Common Shareholders $ 4,397 $ 6,859 $ 7,034 $ 6,456
Total Average "Diluted" Common Shares 14,532,514 14,624,601 13,470,930 12,116,867
---------- ---------- ---------- ----------
Earnings Per Share ("Diluted") $ 0.30 $ 0.47 $ 0.52 $ 0.53
Average Number of Common Shares Outstanding ("Basic") 14,375,992 14,316,678 12,997,566 11,605,171
Earnings Per Share ("Basic") $ 0.31 $ 0.48 $ 0.54 $ 0.56
Per Share Ratios (Average Common and Preferred
Shares Outstanding)
Average Total Assets $ 224.19 $ 224.68 $ 212.58 $ 183.09
Average Total Equity $ 22.92 $ 22.71 $ 20.96 $ 18.81
Net Interest Income $ 0.40 $ 0.63 $ 0.70 $ 0.72
Credit Expenses $ 0.03 $ 0.06 $ 0.06 $ 0.06
Operating Expenses $ 0.07 $ 0.07 $ 0.09 $ 0.09
Gain/(Loss) on Sale $ 0.03 $ 0.00 $ 0.00 $ 0.00
Net Income $ 0.33 $ 0.50 $ 0.55 $ 0.57
</TABLE>
77
<PAGE> 78
SUPPLEMENTAL HISTORICAL INFORMATION
TABLE 9 (CONTINUED)
<TABLE>
<CAPTION>
AT OR
SHARES OUTSTANDING AND PER SHARE DATA FOR THREE MONTHS ENDING
----------- ----------- ----------- -----------
(ALL DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) DEC. 31, SEP. 30, JUN. 30, MAR. 31,
1996 1996 1996 1996
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Shares Outstanding and Receiving Dividends at Period End
Common (RWT) 10,996,572 9,069,653 8,520,116 5,521,376
Class A Preferred (converted 9/95) 0 0 0 0
Class B Preferred (RTW-PB) 1,006,250 1,006,250 0 0
----------- ----------- ----------- -----------
Total 12,002,822 10,075,903 8,520,116 5,521,376
Common Dividend Declared $ 0.410 $ 0.400 $ 0.400 $ 0.460
Class A Preferred Dividend Declared n/a n/a n/a n/a
Class B Preferred Dividend Declared $ 0.755 $ 0.386 n/a n/a
Common Dividend Total $ 4,508 $ 3,628 $ 3,408 $ 2,540
Class A Preferred Dividend Total 0 0 0 0
Class B Preferred Dividend Total 760 388 0 0
----------- ----------- ----------- -----------
Total Dividend $ 5,268 $ 4,016 $ 3,408 $ 2,540
Taxable Income Earned $ 5,429 $ 4,048 $ 3,142 $ 2,549
Dividend Pay-Out Ratio for Period 97.0% 99.2% 108.5% 99.7%
Cumulative Dividend Pay-Out Ratio 97.9% 98.3% 97.9% 93.0%
Warrants Outstanding at Period End (expired 12/31/97) 412,894 1,076,431 1,563,957 1,665,063
Average Shares Outstanding During Period
Common 9,705,138 8,732,326 7,813,974 5,521,376
Class A Preferred 0 0 0 0
Class B Preferred 1,006,250 514,063 0 0
----------- ----------- ----------- -----------
Total 10,711,388 9,246,389 7,813,974 5,521,376
Calculation of "Diluted" Common Shares
Average Number of Common Shares Outstanding 9,705,138 8,732,326 7,813,974 5,521,376
Potential Dilution Due to Warrants 570,415 621,455 603,426 443,984
Potential Dilution Due to Options 176,919 162,393 182,832 164,227
----------- ----------- ----------- -----------
Total Average "Diluted" Common Shares 10,452,472 9,516,174 8,600,232 6,129,587
Net Income to Common Shareholders $ 4,084 $ 2,999 $ 2,500 $ 1,954
Total Average "Diluted" Common Shares 10,452,472 9,516,174 8,600,232 6,129,587
----------- ----------- ----------- -----------
Earnings Per Share ("Diluted") $ 0.39 $ 0.32 $ 0.29 $ 0.32
Average Number of Common Shares Outstanding ("Basic") 9,705,138 8,732,326 7,813,974 5,521,376
Earnings Per Share ("Basic") $ 0.42 $ 0.34 $ 0.32 $ 0.35
Per Share Ratios (Average Common and Preferred Shares Outstanding)
Average Total Assets $ 144.83 $ 124.97 $ 98.76 $ 92.87
Average Total Equity $ 17.26 $ 15.96 $ 15.05 $ 13.49
Net Interest Income $ 0.55 $ 0.50 $ 0.45 $ 0.50
Credit Expenses $ 0.03 $ 0.06 $ 0.06 $ 0.06
Operating Expenses $ 0.07 $ 0.07 $ 0.07 $ 0.09
Gain/(Loss) on Sale $ 0.00 $ 0.00 $ 0.00 $ 0.00
Net Income $ 0.45 $ 0.37 $ 0.32 $ 0.35
</TABLE>
78
<PAGE> 79
SUPPLEMENTAL HISTORICAL INFORMATION
<TABLE>
<CAPTION>
TABLE 9 (CONTINUED) AT OR
SHARES OUTSTANDING AND PER SHARE DATA FOR YEAR ENDING
----------------------------------------------------
(ALL DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) DEC. 31, DEC. 31, DEC. 31, DEC. 31,
1997 1996 1995 1994
----------- ----------- ---------- ---------
<S> <C> <C> <C> <C>
Shares Outstanding and Receiving Dividends at Period End
Common (RWT) 14,284,657 10,996,572 5,517,299 208,332
Class A Preferred (converted 9/95) 0 0 0 1,666,063
Class B Preferred (RTW-PB) 909,518 1,006,250 0 0
----------- ----------- ----------- -----------
Total 15,194,175 12,002,822 5,517,299 1,874,395
Common Dividend Declared $ 2.150 $ 1.670 $ 0.460 n/a
Class A Preferred Dividend Declared n/a n/a $ 0.500 $ 0.250
Class B Preferred Dividends Declared $ 3.020 $ 1.141 n/a n/a
Common Dividend Total $ 28,840 $ 14,084 $ 2,537 $ 0
Class A Preferred Dividend Total 0 0 833 350
Class B Preferred Dividends Total 2,815 1,148 0 0
----------- ----------- ----------- -----------
Total Dividend $ 31,655 $ 15,232 $ 3,370 $ 350
Taxable Income Earned $ 29,963 $ 15,168 $ 3,832 $ 353
Dividend Pay-Out Ratio for Period 105.6% 100.4% 88.0% 99.2%
Cumulative Dividend Pay-Out Ratio 102.6% 97.9% 88.9% 99.2%
Warrants Outstanding at Period End (expired 12/31/97) 0 412,894 1,665,063 1,666,063
Average Shares Outstanding During Period
Common 13,334,163 7,950,175 2,487,857 208,332
Class A Preferred -- -- 826,185 1,467,748
Class B Preferred 953,435 382,155 -- --
----------- ----------- ----------- -----------
Total 14,287,598 8,332,330 3,314,042 1,676,080
Calculation of "Diluted" Common Shares
Average Number of Common Shares Outstanding 13,334,163 7,950,175 3,314,042 1,676,080
Potential Dilution Due to Warrants 191,513 618,618 221,112 240,766
Potential Dilution Due to Options 154,734 175,391 168,649 0
----------- ----------- ----------- -----------
Total Average "Diluted" Common Shares 13,680,410 8,744,184 3,703,803 1,916,846
Net Income to Common Shareholders $ 24,746 $ 11,537 $ 3,155 $ 382
Total Average "Diluted" Common Shares 13,680,410 8,744,184 3,703,803 1,916,846
----------- ----------- ----------- -----------
Earnings Per Share ("Diluted") $ 1.81 $ 1.32 $ 0.85 $ 0.20
Average Number of Common Shares Outstanding ("Basic") 13,334,163 7,950,175 3,314,042 1,676,080
Earnings Per Share ("Basic") $ 1.86 $ 1.45 $ 0.95 $ 0.23
Per Share Ratios (Average Common and Preferred Shares Outstanding)
Average Total Assets $ 212.54 $ 119.99 $ 66.57 $ 34.85
Average Total Equity $ 21.49 $ 15.76 $ 13.08 $ 12.01
Net Interest Income $ 2.42 $ 2.03 $ 1.44 $ 0.32
Credit Expenses $ 0.21 $ 0.20 $ 0.15 $ 0.00
Operating Expenses $ 0.32 $ 0.31 $ 0.34 $ 0.09
Gain/(Loss) on Sale $ 0.04 $ 0.00 $ 0.00 $ 0.00
Net Income $ 1.93 $ 1.52 $ 0.95 $ 0.23
</TABLE>
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ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Consolidated Financial Statements of the Company and the related
Notes, together with the Independent Auditors' Report thereon, are set
forth on pages F-1 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.
ITEM 14. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENTS SCHEDULES AND REPORTS ON
FORM 8-K
(a) Documents filed as part of this report:
(1) Consolidated Financial Statements
(2) Schedules to Consolidated Financial Statements:
All Consolidated Financial Statements schedules not included
have been omitted because they are either inapplicable or the
information required is provided in the Company's Consolidated
Financial Statements and Notes thereto, included in Part II,
Item 8, of this Annual Report on Form 10-K.
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<PAGE> 81
(3) Exhibits:
Exhibit
Number Exhibit
<TABLE>
<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, dated 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)
4.4 Indenture dated as of June 1, 1997 between Sequoia Mortgage
Trust 1 (a wholly-owned, consolidated subsidiary of the
Registrant) and First Union National Bank, as Trustee (i)
4.4.1 Indenture dated as of October 1, 1997 between Sequoia
Mortgage Trust 2 (a wholly-owned, consolidated subsidiary of
the Registrant) and Norwest Bank Minnesota, N.A., as Trustee
(j)
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)
10.4 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 Mortgage
Loans (d)
10.6.1 Amended and Restated Loan and Security Agreement, dated May
26, 1995, between the Registrant and Paine Webber Real
Estate Securities, Inc. (d)
10.7 Pledge and Security Agreement, dated 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)
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)
</TABLE>
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<PAGE> 82
<TABLE>
<S> <C>
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
11.1 Statement re: Computation of Per Share Earnings
21 List of Subsidiaries
23 Consent of 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 with the Securities and Exchange
Commission on July 18, 1996.
(g) Incorporated by reference to the Registration Statement on
Form S-3 (333-18061) filed by the Registrant with the
Securities and Exchange Commission 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.
(i) Incorporated by reference to the Form 8-K filed by Sequoia
Mortgage Funding Corporation with the Securities and Exchange
Commission on August 12, 1997.
(j) Incorporated by reference to the Form 8-K filed by Sequoia
Mortgage Funding Corporation with the Securities and Exchange
Commission on November 18, 1997.
(b) Reports on Form 8-K:
None.
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<PAGE> 83
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" or "Agency ARM Certificates" means GNMA, FNMA and FHLMC
Certificates.
"amortized cost" means, with respect to Mortgage Assets, the purchase price as
adjusted for subsequent amortization of discount or premium and for principal
repayments.
"ARM" means a Mortgage Loan or any Mortgage Loan underlying a Mortgage Security
that features adjustments of the underlying interest rate at predetermined
times based on an agreed margin to an established index. An ARM is usually
subject to periodic interest rate and/or payment caps and a lifetime interest
rate cap.
"Asset Acquisition/Capital Allocation Policies" means the policies established
by the Board of Directors, including a majority of the Independent Directors,
establishing the guidelines for management in the type and quantity of Mortgage
Assets that may be purchased by the Company, which policies include, without
limitation, the asset acquisition policies, the credit risk management policies
and the capital and leverage policies.
"Board of Directors" means the Board of Directors of the Company.
"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 Securities and Interest
Rate Agreements, the carrying value equals management's estimate of the
bid-side market value of the asset. With respect to Mortgage Loans and
associated Interest Rate Agreements, the carrying value equals the Company's
amortized cost net of any specific credit reserves established for such assets.
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.
"CMOs" or "Collateralized Mortgage Obligations" means adjustable- or
fixed-rate debt obligations (bonds) that are collateralized by Mortgage Loans
or mortgage certificates. CMOs are structured so that principal and interest
payments received on the collateral are sufficient to make principal and
interest payments on the bonds. Such bonds may be issued by United States
government-sponsored entities or private issuers in one or more classes with
fixed or adjustable interest rates, maturities and degrees of subordination
which are characteristics designed for the investment objectives of different
bond purchasers.
"Code" means the Internal Revenue Code of 1986, as amended.
"Commercial CMOs" means CMOs collateralized by Commercial Mortgage Loans.
"Commercial Mortgage Assets" means Commercial Mortgage Loans and Commercial
Mortgage Securities.
"Commercial Mortgage Loans" means Mortgage Loans secured by commercial
property.
"Commercial Mortgage Securities" means Mortgage Securities representing an
interest in, or secured by, Commercial Mortgage Loans.
"Commercial Privately-Issued Certificates" means Pass-Through Certificates
representing an interest in Commercial Mortgage Loans.
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<PAGE> 84
"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. 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.
"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 and Stock Purchase Plan adopted by the
Company.
"11th District Cost of Funds Index" or "COFI" means the index made available
monthly by the Federal Home Loan Bank Board of San Francisco of the cost of
funds of members of the Federal Home Loan Bank's 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.
"Exchange Act" means the Securities Exchange Act of 1934, as amended.
"Exercise Price" means the price payable to the Company to exercise an
outstanding Warrant or Stock Option.
"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.
"FASB" means the Financial Accounting Standards Board.
"Federal Reserve Board" means the Board of Governors of the Federal Reserve
System.
"FHA" means the United States Federal Housing Administration.
"FHA Loans" means Mortgage Loans insured by the FHA.
"FHLMC" means the Federal Home Loan Mortgage Corporation.
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<PAGE> 85
"FHLMC Certificates" means mortgage participation certificates issued by FHLMC,
either in certificate or book-entry form.
"FNMA" means the Federal National Mortgage Association.
"FNMA Certificates" means 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.
"GNMA" means the Government National Mortgage Association.
"GNMA Certificates" means fully modified pass-through mortgage-backed
certificates guaranteed by GNMA and issued either in certificate or book- entry
form.
"gross margin" means, with respect to ARMs, the amount to be added to the
underlying index to determine 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.
"haircut" means the over-collateralization amount required by a lender in
connection with certain collateralized borrowings.
"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.
"interest-only strip" or "IO" means a type of mortgage security which receives
a portion of the interest payments from an underlying pool of mortgage loans
but will receive little or no principal payments and hence will have little or
no face value. The market value and yield of an IO are unusually sensitive to
the prepayment rates experienced on and anticipated for the underlying pool of
mortgage loans. The market values and yields of IOs may increase as interest
rates increase and, in certain conditions, IOs may act in a counter-cyclical
manner as compared to other Mortgage Assets.
"interest rate adjustment indices" means, in the case of Mortgage Assets, any
of the objective indices based on the market interest rates of a specified debt
instrument (such as United States Treasury Bills in the case of the Treasury
Index and United States dollar deposits in London in the case of LIBOR) or
based on the average interest rate of a combination of debt instruments (such
as the 11th District Cost of Funds Index), used as a reference base to reset
the interest rate for each adjustment period on the Mortgage Asset, and in the
case of borrowings, is used herein to mean the market interest rates of a
specified debt instrument (such as reverse repurchase agreements for Mortgage
Securities) as well as any of the objective indices described above that are
used as a reference base to reset the interest rate for each adjustment period
under the related borrowing instrument.
"interest rate adjustment period" means, in the case of Mortgage Assets, the
period of time set forth in the debt instrument that determines when the
interest rate is adjusted and, with respect to borrowings, is used to mean the
term to reset or 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.
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<PAGE> 86
"Interest Rate Agreements" means interest rate options, interest rate swaps,
interest rate futures and options on interest rate futures.
"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 an adjustable-rate Mortgage Loan, 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 an adjustable-rate Mortgage Security, 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. With respect
to certain long-term borrowings, the maximum coupon rate that may accrue during
any period over the term of such borrowing.
"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 Equity Interest" means the ownership of the equity portion of a
mortgage spread lending subsidiary trust wherein the assets of the trust are
funded with long-term debt, the debt and other liabilities of the trust are
non-recourse to the Company, and liquidity risk is essentially eliminated.
"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) property.
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<PAGE> 87
"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.
"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 specific pool structure.
"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 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, cap, floor or other
interest rate agreements entered into by the Company solely to hedge
adjustable-rate indebtedness that the Company incurred to acquire or carry
Qualified REIT Real Estate Assets and any futures and options, or other
investments (other than Qualified REIT Real Estate Assets) made by the Company
to hedge its Mortgage Assets or borrowings that have been determined by a
favorable opinion of counsel to generate qualified income for purposes of the
95% Gross Income Test applicable to REITs.
"Qualified REIT Real Estate Assets" means Pass-Through Certificates, Mortgage
Loans, Agency Certificates, and other assets of the type described in section
856(c) (6) (B) of the Code.
"Qualified REIT Subsidiary" means a corporation whose stock is entirely owned
by the REIT at all times during such corporation's existence.
"Qualifying Interests" means "mortgages and other liens on and interests in
real estate," as defined in Section 3(c) (5) (C) under the Investment Company
Act.
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"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).
"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.
"Sequoia" means the special-purpose finance subsidiary of Redwood Trust, Inc.
"Servicer" means a servicer or subservicer of the Mortgage Loans pursuant to a
servicing agreement with the Company or other third-parties.
"SFAS" means Statement of Financial Accounting Standards issued by the FASB.
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"Short-Term Debt" means reverse repurchase agreements, notes payable,
revolving lines of credit and/or any other collateralized short-term
borrowings.
"Short-Term Investments" means the short-term bank certificates of deposit,
short-term United States treasury securities, short-term United States
government agency securities, commercial paper, repurchase agreements,
short-term CMOs, short-term asset-backed securities and other similar types of
short-term investment instruments, all of which will have maturities or average
lives of less than one year.
"Single-Family CMOs" means CMOs backed by Single-Family Mortgage Loans.
"Single-Family Mortgage Assets" means Single-Family Mortgage Loans and
Single-Family Mortgage Securities.
"Single-Family Mortgage Loans" means Mortgage Loans secured by single-family
(one- to four-units) residential property.
"Single-Family Mortgage Securities" means Mortgage Securities representing an
interest in, or secured by, Single-Family Mortgage Loans.
"Single-Family Privately-Issued Certificates" means Pass-Through Certificates
evidencing ownership in a pool of Single-Family Mortgage Loans issued by
private institutions.
"SMMEA" means the Secondary Mortgage Market Enhancement Act of 1984.
"Special Tax Counsel" means the law firm of Giancarlo & Gnazzo, a Professional
Corporation.
"Stock Option Plan" means the Amended and Restated 1994 Executive and
Non-employee Stock Option Plan adopted by the Company.
"Subordinated 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 United States 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 or 15(d) the Securities Exchange Act
of 1934, the Registrant has duly caused this report to be signed on its behalf
by the undersigned thereunto duly authorized.
REDWOOD TRUST, INC.
Dated: March 11, 1998 By: /s/ George E. Bull
------------------------------------
George E. Bull
Chairman and Chief Executive Officer
Pursuant to the requirements the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
Signature Title Date
<S> <C> <C>
/s/ George E. Bull George E. Bull March 11, 1998
- ------------------------------------ Chairman of the Board and
Chief Executive Officer
(Principal Executive Officer)
/s/ Douglas B. Hansen Douglas B. Hansen March 11, 1998
- ------------------------------------ Director, President and
Chief Financial Officer
(Principal Financial Officer)
/s/ Frederick H. Borden Frederick H. Borden March 11, 1998
- ------------------------------------ Vice Chairman of the Board and
Secretary
/s/ Vickie L. Rath Vickie L. Rath March 11, 1998
- ------------------------------------ Vice President, Treasurer and
Controller
(Principal Accounting Officer)
/s/ Dan A. Emmett Dan A. Emmett March 11, 1998
- ------------------------------------ Director
/s/ Thomas F. Farb Thomas F. Farb March 11, 1998
- ------------------------------------ Director
/s/ Nello Gonfiantini Nello Gonfiantini March 11, 1998
- ------------------------------------ Director
/s/ Charles J. Toeniskoetter Charles J. Toeniskoetter March 11, 1998
- ------------------------------------ Director
</TABLE>
90
<PAGE> 91
REDWOOD TRUST, INC.
CONSOLIDATED FINANCIAL STATEMENTS AND
INDEPENDENT AUDITORS' REPORT
FOR INCLUSION IN FORM 10-K
ANNUAL REPORT FILED WITH
SECURITIES AND EXCHANGE COMMISSION
DECEMBER 31, 1997
F-1
<PAGE> 92
REDWOOD TRUST, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
Consolidated Financial Statements: Page
<S> <C>
Consolidated Balance Sheets at December 31, 1997 and 1996...................... F-3
Consolidated Statements of Operations for the years ended
December 31, 1997, 1996 and 1995.......................................... F-4
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1997, 1996 and 1995.......................................... F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 1997, 1996 and 1995.......................................... F-6
Notes to Consolidated Financial Statements..................................... F-7
Independent Auditors' Report...................................................... F-19
Summary of Quarterly Results...................................................... F-20
</TABLE>
F-2
<PAGE> 93
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
<TABLE>
<CAPTION>
December 31, 1997 December 31, 1996
----------------- -----------------
<S> <C> <C>
ASSETS
Mortgage assets:
Mortgage securities, net $ 1,814,796 $ 1,627,953
Mortgage loans, net 1,551,826 525,475
----------- -----------
3,366,622 2,153,428
Cash and cash equivalents:
Unrestricted 24,892 11,068
Restricted 24,657 --
----------- -----------
49,549 11,068
Accrued interest receivable 23,119 14,134
Interest rate agreements 2,100 2,601
Other assets 2,807 2,966
----------- -----------
$ 3,444,197 $ 2,184,197
----------- -----------
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Short-term debt $ 1,914,525 $ 1,953,103
Long-term debt, net 1,172,801 --
Accrued interest payable 14,476 14,060
Accrued expenses and other liabilities 2,172 761
Dividends payable 5,686 5,268
----------- -----------
3,109,660 1,973,192
----------- -----------
Commitments and contingencies (See Note 11)
STOCKHOLDERS' EQUITY
Preferred stock, par value $0.01 per share; Class B 9.74% Cumulative
Convertible 909,518 and 1,006,250 shares authorized, issued and
outstanding
($28,882 aggregate liquidation preference) 26,736 29,579
Common stock, par value $0.01 per share;
49,090,482 and 48,993,750 shares authorized;
14,284,657 and 10,996,572 issued and outstanding 143 110
Additional paid-in capital 324,555 187,507
Net unrealized loss on assets available-for-sale (10,071) (3,460)
Dividends in excess of net income (6,826) (2,731)
----------- -----------
334,537 211,005
----------- -----------
$ 3,444,197 $ 2,184,197
=========== ===========
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-3
<PAGE> 94
REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share data)
<TABLE>
<CAPTION>
Years Ended December 31,
1997 1996 1995
------------ ------------ ------------
<S> <C> <C> <C>
INTEREST INCOME
Mortgage assets $ 197,278 $ 66,424 $ 15,494
Cash and investments 1,326 860 232
------------ ------------ ------------
198,604 67,284 15,726
INTEREST EXPENSE
Short-term debt 140,140 49,191 10,608
Long-term debt 20,137 -- --
------------ ------------ ------------
160,277 49,191 10,608
Net interest rate agreements expense 3,741 1,158 339
------------ ------------ ------------
NET INTEREST INCOME 34,586 16,935 4,779
Provision for credit losses 2,930 1,696 493
Net (gain)/loss on sale transactions (563) -- --
Operating expenses 4,658 2,554 1,131
------------ ------------ ------------
NET INCOME 27,561 12,685 3,155
------------ ------------ ------------
Less cash dividends on Class B preferred stock 2,815 1,148 --
------------ ------------ ------------
NET INCOME AVAILABLE TO COMMON STOCKHOLDERS $ 24,746 $ 11,537 $ 3,155
============ ============ ============
NET INCOME PER SHARE
Basic $ 1.86 $ 1.45 $ 0.95
Diluted $ 1.81 $ 1.32 $ 0.85
Weighted average shares of common stock and
common stock equivalents:
Basic 13,334,163 7,950,175 3,314,042
Diluted 13,680,410 8,744,184 3,703,803
Dividends declared per Class A preferred share $ -- $ -- $ 0.500
Dividends declared per Class B preferred share $ 3.020 $ 1.141 $ --
Dividends declared per common share $ 2.150 $ 1.670 $ 0.460
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-4
<PAGE> 95
REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY For the years ended December
31,
1997, 1996 and 1995 (In thousands, except share data)
Net
<TABLE>
<CAPTION>
Preferred stock Common stock
-------------------------------------------------------------------------------
Class A Class B AdditionaL
------------------------------------------------------------------------------- paid-in
Shares Amount Shares Amount Shares Amount capital
- -------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance, December 31, 1994 1,666,063 $ 22,785 -- -- 208,332 $ 2 $ 19
- -------------------------------------------------------------------------------------------------------------------------------
Net income -- -- -- -- -- -- --
Conversion of preferred stock (1,666,063) (22,785) -- -- 1,667,134 17 22,768
Issuance of common stock -- -- -- -- 3,641,833 36 51,108
Dividends declared:
Class A preferred -- -- -- -- -- -- --
Common -- -- -- -- -- -- --
Net unrealized loss on
assets available-for-sale -- -- -- -- -- -- --
- -------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1995 -- -- -- -- 5,517,299 55 73,895
- -------------------------------------------------------------------------------------------------------------------------------
Net income -- -- -- -- -- -- --
Issuance of Class B
preferred stock -- -- 1,006,250 29,579 -- -- --
Issuance of common stock -- -- -- -- 5,479,273 55 113,612
Dividends declared:
Class B preferred -- -- -- -- -- -- --
Common -- -- -- -- -- -- --
Net unrealized gain on
assets available-for-sale -- -- -- -- -- -- --
- -------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1996 -- -- 1,006,250 29,579 10,996,572 110 187,507
- -------------------------------------------------------------------------------------------------------------------------------
Net income -- -- -- -- -- -- --
Conversion of preferred stock -- -- (96,732) (2,843) 96,732 1 2,842
Issuance of common stock -- -- -- -- 4,031,353 41 157,321
Repurchase of common stock -- -- -- -- (840,000) (9) (23,115)
Dividends declared:
Class B preferred -- -- -- -- -- -- --
Common -- -- -- -- -- -- --
Net unrealized loss on
assets available-for-sale -- -- -- -- -- -- --
- -------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1997 -- -- 909,518 $ 26,736 14,284,657 $ 143 $ 324,555
===============================================================================================================================
<CAPTION>
Net
unrealized
gain (loss)
on assets Dividends in
available- excess of
for-sale net income Total
- ----------------------------------------------------------------------
<C> <C> <C>
Balance, December 31, 1994 $ (2,557) $ 31 $ 20,280
- ----------------------------------------------------------------------
Net income -- 3,155 3,155
Conversion of preferred stock -- -- --
Issuance of common stock -- -- 51,144
Dividends declared:
Class A preferred -- (833) (833)
Common -- (2,537) (2,537)
Net unrealized loss on
assets available-for-sale (2,919) -- (2,919)
- ----------------------------------------------------------------------
Balance, December 31, 1995 (5,476) (184) 68,290
- ----------------------------------------------------------------------
Net income -- 12,685 12,685
Issuance of Class B
preferred stock -- -- 29,579
Issuance of common stock -- -- 113,667
Dividends declared:
Class B preferred -- (1,148) (1,148)
Common -- (14,084) (14,084)
Net unrealized gain on
assets available-for-sale 2,016 -- 2,016
- ----------------------------------------------------------------------
Balance, December 31, 1996 (3,460) (2,731) 211,005
- ----------------------------------------------------------------------
Net income -- 27,561 27,561
Conversion of preferred stock -- -- --
Issuance of common stock -- -- 157,362
Repurchase of common stock -- -- (23,124)
Dividends declared:
Class B preferred -- (2,815) (2,815)
Common -- (28,841) (28,841)
Net unrealized loss on
assets available-for-sale (6,611) -- (6,611)
- ----------------------------------------------------------------------
Balance, December 31, 1997 $ (10,071) $ (6,826) $ 334,537
======================================================================
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-5
<PAGE> 96
REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
<TABLE>
<CAPTION>
Years Ended
December 31,
1997 1996 1995
----------- ----------- -----------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 27,561 $ 12,685 $ 3,155
Adjustments to reconcile net income to net cash
provided by operating activities:
Amortization of mortgage asset premium and discount, net 23,361 5,197 (356)
Amortization of deferred bond issuance costs 533 -- --
Amortization of long-term debt premium (131) -- --
Depreciation and amortization 148 96 64
Provision for credit losses on mortgage assets 2,930 1,696 493
Amortization of interest rate agreements 3,155 749 339
Net (gain)/loss on sale transactions (563) -- --
Increase in accrued interest receivable (8,985) (12,267) (2,527)
(Increase) decrease in other assets 11 (985) (346)
Increase in accrued interest payable 416 12,770 614
Increase in accrued expenses and other 1,411 534 198
----------- ----------- -----------
Net cash provided by operating activities 49,847 20,475 1,634
CASH FLOWS FROM INVESTING ACTIVITIES:
Net increase in restricted cash (24,657) -- --
Purchases of mortgage securities (978,979) (1,455,267) (327,816)
Purchases of mortgage loans (1,322,732) (527,597) (26,756)
Proceeds from sales of mortgage securities 88,284 -- --
Principal payments on mortgage securities 684,150 231,942 38,517
Principal payments on mortgage loans 288,982 26,482 307
Purchases of interest rate agreements (7,892) (4,427) (1,069)
----------- ----------- -----------
Net cash used in investing activities (1,272,844) (1,728,867) (316,817)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from (repayments on) short-term borrowings (38,578) 1,582,787 269,940
Proceeds from long-term borrowings 1,285,197 -- --
Repayments on long-term borrowings (112,798) -- --
Net proceeds from issuance of Class B preferred stock -- 29,579 --
Net proceeds from issuance of common stock 157,362 113,667 51,144
Repurchases of common stock (23,124) -- --
Dividends paid (31,238) (11,398) (2,103)
----------- ----------- -----------
Net cash provided by financing activities 1,236,821 1,714,635 318,981
Net increase in cash and cash equivalents 13,824 6,243 3,798
Cash and cash equivalents at beginning of period 11,068 4,825 1,027
----------- ----------- -----------
Cash and cash equivalents at end of period $ 24,892 $ 11,068 $ 4,825
=========== =========== ===========
Supplemental disclosure of cash flow information:
Cash paid for interest expense $ 160,690 $ 36,831 $ 9,994
=========== =========== ===========
Non-cash transactions:
Conversion of preferred stock $ 2,843 $ -- $ 22,785
=========== =========== ===========
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-6
<PAGE> 97
REDWOOD TRUST, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1997
NOTE 1. THE COMPANY
Redwood Trust, Inc. ("Redwood Trust") was incorporated in Maryland on April 11,
1994 and commenced operations on August 19, 1994. During 1997, Redwood Trust
formed Sequoia Mortgage Funding Corporation ("Sequoia"), a special-purpose
finance subsidiary. Redwood Trust and Sequoia (collectively, the "Company")
acquire and manage real estate mortgage assets ("Mortgage Assets") which may be
acquired as whole loans ("Mortgage Loans") or as mortgage securities
representing interests in or obligations backed by pools of mortgage loans
("Mortgage Securities"). The Company currently acquires Mortgage Assets that
are secured by single-family real estate properties throughout the United
States. The Company utilizes both debt and equity to finance its acquisitions.
The Company may also use other securitization techniques to enhance the value
and liquidity of the Company's Mortgage Assets.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of Redwood Trust and
Sequoia. All inter-company balances and transactions have been eliminated.
Substantially all of the assets of Sequoia are pledged or subordinated to
support long-term debt in the form of collateralized mortgage bonds ("Long-Term
Debt") and are not available for the satisfaction of general claims of the
Company. The Company's exposure to loss on the assets pledged as collateral is
limited to its net investment, as the Long-Term Debt is non-recourse to the
Company.
Certain amounts for prior years have been reclassified to conform with the 1997
presentation.
INCOME TAXES
The Company has elected to be taxed as a Real Estate Investment Trust ("REIT")
under the Internal Revenue Code (the "Code") and the corresponding provisions
of State law. In order to qualify as a REIT, the Company must annually
distribute at least 95% of its taxable income to shareholders and meet certain
other requirements. If these requirements are met, the Company generally will
not be subject to Federal or state income taxation at the corporate level with
respect to the taxable income it distributes to its shareholders. Because the
Company believes it meets the REIT requirements and also intends to distribute
all of its taxable income, no provision has been made for income taxes in the
accompanying consolidated financial statements, as the Company believes it has
met the prescribed distribution requirements.
MORTGAGE ASSETS
The Company's Mortgage Assets consist of Mortgage Securities and Mortgage
Loans. 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.
Mortgage Securities
Statement of Financial Accounting Standards ("SFAS") No. 115, Accounting for
Certain Investments in Debt and Equity Securities, 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
F-7
<PAGE> 98
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, to maintain flexibility, the Company currently classifies
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
carrying value 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 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
Mortgage Loans are carried at their unpaid principal balance, net of
unamortized discount or premium and specific credit reserves established for
such assets.
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.
DEFERRED BOND ISSUANCE COSTS
Costs incurred in connection with the issuance of Long-Term Debt in the form of
collateralized mortgage bonds are deferred and amortized over the estimated
lives of the Long-Term Debt using the interest method adjusted for the effects
of prepayments. Deferred bond issuance costs are included in the carrying
value of the Long-Term Debt.
INTEREST RATE AGREEMENTS
The Company utilizes various types of Interest Rate Agreements to hedge the
interest rate and liquidity risks inherent in its investment and financing
strategies.
SFAS No. 119, Disclosure about Derivative Financial Instruments, requires the
Company to provide certain disclosures concerning its derivative instruments
according to a set of prescribed guidelines. The nature of the Company's
investment and financing strategies exposes the Company to interest rate risk.
As part of its asset/liability management activities, the Company uses interest
rate options, interest rate swaps and interest rate futures (collectively
"Interest Rate Agreements") to hedge exposures or modify the interest rate
characteristics of related balance sheet items. Currently, the Company enters
into all Interest Rate Agreements as hedges. Under the Company's hedging
policy, a specific portfolio of assets and liabilities with similar economic
characteristics such as a low life strike, variable interest rate based on a
market- sensitive index, similar expected prepayment rate behavior and similar
periodic caps, 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. These hedge
instruments are intended to reduce the interest rate risk being hedged by
providing income to offset potential reduced net interest income under certain
interest rate scenarios. The Company periodically evaluates the effectiveness
of these hedges under various interest rate scenarios.
Interest Rate Agreements that are hedging available-for-sale Mortgage
Securities are carried at fair value with unrealized gains and losses reported
as a separate component of equity, consistent with the reporting of unrealized
gains and losses on the related securities. Similarly, Interest Rate
Agreements that are used to hedge Mortgage Loans, short-term debt or long-term
debt are carried at amortized cost.
F-8
<PAGE> 99
Net premiums on interest rate option agreements are amortized as a component of
net interest income over the effective period of the interest rate option using
the effective interest method. The income and/or expense related to interest
rate option and swap agreements is recognized on an accrual basis. Realized
gains and losses from the settlement or early termination of Interest Rate
Agreements are deferred and amortized into net interest income over the
remaining term of the original Interest Rate Agreement, or, if shorter, over
the remaining term of the associated hedged asset or liability, as adjusted for
estimated future principal repayments. In the event that a hedged asset or
liability is sold or extinguished, any related hedging gains or losses would be
recognized as an adjustment to the gain or loss on the disposition of the
related asset or liability.
Unrealized losses on Interest Rate Agreements that are considered
other-than-temporary are recognized in income and the carrying value 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.
DEBT
Short-term and long-term debt are carried at their unpaid principal balances,
net of any unamortized discount or premium and any unamortized deferred bond
issuance costs. Any discount or premium is recognized as an adjustment to
interest expense using the effective interest method based on the maturity
schedule of the related borrowings.
NET INCOME PER SHARE
Net income per share for the years ended December 31, 1997, 1996 and 1995 is
shown in accordance with SFAS No. 128, Earnings Per Share, which was effective
for fiscal years ended after December 15, 1997 and requires restatement of
prior period earnings per share ("EPS"). Basic net income per share is
computed by dividing net income available to common stockholders by the
weighted average number of common shares outstanding during the period.
Diluted net income per share is computed by dividing the diluted net income
available to common stockholders by the weighted average number of common
shares and common equivalent shares outstanding during the period. The common
equivalent shares are calculated using the treasury stock method which assumes
that 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.
The following tables provide reconciliations of the numerators and denominators
of the basic and diluted net income per share computations for the years ended
December 31, 1997, 1996 and 1995.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, 1997
INCOME SHARES PER-SHARE
(IN THOUSANDS, EXCEPT SHARE DATA) (NUMERATOR) (DENOMINATOR) AMOUNT
-------------------------------------------------
<S> <C> <C> <C>
Net Income $ 27,561
Cash dividends on Class B preferred stock (2,815)
-------------------------------------------------
Basic EPS - Income available to common stockholders 24,746 13,334,163 $ 1.86
-------------------------------------------------
Effect of dilutive securities -
Stock options 191,513
Stock warrants (a) 154,734
-------------------------------------------------
Diluted EPS - Income available to common stockholders $ 24,746 13,680,410 $ 1.81
-------------------------------------------------
</TABLE>
F-9
<PAGE> 100
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, 1996
INCOME SHARES PER-SHARE
(IN THOUSANDS, EXCEPT SHARE DATA) (NUMERATOR) (DENOMINATOR) AMOUNT
-----------------------------------------------
<S> <C> <C> <C>
Net Income $ 12,685
Cash dividends on Class B preferred stock (1,148)
-----------------------------------------------
Basic EPS - Income available to common stockholders 11,537 7,950,175 $ 1.45
-----------------------------------------------
Effect of dilutive securities -
Stock options 175,391
Stock warrants (a) 618,618
-----------------------------------------------
Diluted EPS - Income available to common stockholders $ 11,537 8,744,184 $ 1.32
===============================================
</TABLE>
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, 1995
INCOME SHARES PER-SHARE
(IN THOUSANDS, EXCEPT SHARE DATA) (NUMERATOR) (DENOMINATOR) AMOUNT
----------------------------------------------
<S> <C> <C> <C>
Net Income $ 3,155
Cash dividends on Class B preferred stock 0
----------------------------------------------
Basic EPS - Income available to common stockholders 3,155 3,314,042 $ 0.95
Effect of dilutive securities - ----------------------------------------------
Stock options 173,716
Stock warrants (a) 216,045
Diluted EPS - Income available to common stockholders $ 3,155 3,703,803 $ 0.85
----------------------------------------------
</TABLE>
(a) The Stock warrants expired on December 31, 1997.
USE OF ESTIMATES
The preparation of financial statements in conformity with Generally Accepted
Accounting Principles requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenue and expenses during the reported period.
Actual results could differ from those estimates. The primary estimates
inherent in the accompanying consolidated financial statements are discussed
below.
Fair Value. The Company uses estimates in establishing fair value for its
investments available-for-sale. 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. Estimates of
fair value for all remaining investments available-for-sale are based primarily
on management's judgment. 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. The fair value of all on- and off- balance sheet
financial instruments is presented in Notes 3, 6 and 9.
Allowance for Credit Losses. An allowance for credit losses is maintained at a
level deemed appropriate by management to provide for known, future 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 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
F-10
<PAGE> 101
the allowance. The Company's actual credit losses may differ from those
estimates used to establish the allowance.
RECENT ACCOUNTING PRONOUNCEMENTS
On June 30, 1997, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 130, Reporting Comprehensive Income. This statement requires companies to
classify items of other comprehensive income by their nature in a financial
statement and display the accumulated balance of other comprehensive income
separately from retained earnings and additional paid-in capital in the equity
section of a statement of financial position, and is effective for financial
statements issued for fiscal years beginning after December 15, 1997. The
impact to the Company of adopting SFAS No. 130 is not expected to be
significant.
NOTE 3. MORTGAGE ASSETS
At December 31, 1997, Mortgage Assets consisted of the following:
<TABLE>
<CAPTION>
MORTGAGE SECURITIES MORTGAGE
----------------------------
(IN THOUSANDS) AGENCY NON-AGENCY LOANS TOTAL
--------------------------------------------------------------
<S> <C> <C> <C> <C>
Mortgage Assets, Gross $ 953,937 $ 825,438 $ 1,519,837 $ 3,299,212
Unamortized Discount (174) (12,268) 0 (12,442)
Unamortized Premium 32,722 18,606 34,844 86,172
--------------------------------------------------------------
Amortized Cost 986,485 831,776 1,554,681 3,372,942
Allowance for Credit Losses 0 (2,076) (2,855) (4,931)
Gross Unrealized Gains 2,598 3,984 0 6,582
Gross Unrealized Losses (4,286) (3,685) 0 (7,971)
--------------------------------------------------------------
Carrying Value $ 984,797 $ 829,999 $ 1,551,826 $ 3,366,622
==============================================================
</TABLE>
At December 31, 1996, Mortgage Assets consisted of the following:
<TABLE>
<CAPTION>
MORTGAGE SECURITIES MORTGAGE
----------------------------
(IN THOUSANDS) AGENCY NON-AGENCY LOANS TOTAL
--------------------------------------------------------------
<S> <C> <C> <C> <C>
Mortgage Assets, Gross $ 939,936 $ 662,276 $ 515,033 $ 2,117,245
Unamortized Discount (234) (15,717) (142) (16,093)
Unamortized Premium 26,939 16,366 11,012 54,317
--------------------------------------------------------------
Amortized Cost 966,641 662,925 525,903 2,155,469
Allowance for Credit Losses 0 (1,752) (428) (2,180)
Gross Unrealized Gains 3,173 2,791 0 5,964
Gross Unrealized Losses (873) (4,952) 0 (5,825)
--------------------------------------------------------------
Carrying Value $ 968,941 $ 659,012 $ 525,475 $ 2,153,428
==============================================================
</TABLE>
At December 31, 1997 and 1996, all investments in Mortgage Assets consisted of
interests in adjustable-rate mortgages on residential properties. Agency
Mortgage Securities ("Agency Securities") represent securitized interests in
pools of adjustable-rate mortgages from the Federal Home Loan Mortgage
Corporation and the Federal National Mortgage Association. The Agency
Securities are guaranteed as to principal and interest by these United States
government-sponsored entities. The original maturity of the majority of the
Mortgage Assets
F-11
<PAGE> 102
is thirty years; the actual maturity is subject to change based on the
prepayments of the underlying mortgage loans.
At December 31, 1997 and 1996, the average annualized effective yield on the
Mortgage Assets was 6.86% and 7.11%, respectively, based on the amortized cost
of the assets. The coupons on most of the adjustable-rate mortgage securities
and loans owned by the Company 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, 1997 and 1996, the weighted average
lifetime cap was 12.06% and 11.73%, respectively.
During the second half of 1997, the Company sold Mortgage Securities with a
face value of approximately $87.0 million. Proceeds and realized gains and
losses on the sales of Mortgage Securities for the year ended December 31, 1997
are presented below. No such sales occurred for the years ended December 31,
1996 or 1995.
<TABLE>
<CAPTION>
(IN THOUSANDS) 1997
--------
<S> <C>
Proceeds from sales of available-for-sale $ 88,284
securities
Available-for-sale securities gains $ 746
Available-for-sale securities losses (28)
Write-down on related interest rate agreements (155)
--------
Net gain on sales of available-for-sale securities $ 563
========
</TABLE>
NOTE 4. ALLOWANCE FOR CREDIT LOSSES
The following table summarizes the activity in the Allowance for Credit Losses
for the years ended December 31:
<TABLE>
<CAPTION>
(IN THOUSANDS) 1997 1996 1995
---------------------------------
<S> <C> <C> <C>
Balance at January 1 $ 2,180 $ 490 $ 0
Provision for credit losses 2,930 1,696 493
Charge-offs (179) (6) (3)
---------------------------------
Balance at December 31 $ 4,931 $ 2,180 $ 490
=================================
</TABLE>
The Allowance for Credit Losses is classified on the Consolidated Balance
Sheets as a component of Mortgage Assets.
NOTE 5. COLLATERAL FOR LONG-TERM DEBT
The Company has pledged collateral in order to secure the Long-Term Debt issued
in the form of collateralized mortgage bonds ("Bond Collateral"). This Bond
Collateral consists primarily of adjustable-rate, conventional, 30-year
mortgage loans secured by first liens on one- to four-family residential
properties. All Bond Collateral is pledged to secure repayment of the related
Long-Term Debt obligation. All principal and interest (less servicing and
related fees) on the Bond Collateral is remitted to a trustee and is available
for payment on the Long-Term Debt obligation. The Company's exposure to loss
on the Bond Collateral is limited to its net investment, as the Long-Term Debt
is non-recourse to the Company. The Company may also be exposed to losses from
prepayments of the underlying loans to the extent of unamortized net premium on
the loans or deferred bond issuance costs related to the issuance of the
Long-Term Debt.
F-12
<PAGE> 103
The components of the Bond Collateral at December 31, 1997 are summarized as
follows:
<TABLE>
<CAPTION>
(IN THOUSANDS) 1997
----------
<S> <C>
Mortgage loans $1,191,487
Restricted cash and cash equivalents 24,657
Accrued interest receivable 7,401
----------
$1,223,545
==========
</TABLE>
For presentation purposes, the various components of the Bond Collateral
summarized above are reflected in their corresponding line items on the
Consolidated Balance Sheets.
NOTE 6. INTEREST RATE AGREEMENTS
The amortized cost and carrying value of the Company's Interest Rate Agreements
at December 31, 1997 and 1996 are summarized as follows:
<TABLE>
<CAPTION>
(IN THOUSANDS) 1997 1996
-------- --------
<S> <C> <C>
Amortized Cost $ 10,781 $ 6,200
Gross Unrealized Gains 650 156
Gross Unrealized Losses (9,331) (3,755)
-------- --------
Carrying Value $ 2,100 $ 2,601
======== ========
</TABLE>
The following table summarizes the aggregate notional amounts of all of the
Company's Interest Rate Agreements as well as the credit exposure related to
these instruments at December 31, 1997 and 1996.
<TABLE>
<CAPTION>
NOTIONAL AMOUNTS CREDIT EXPOSURE (A)
-------------------------------------------------------
(IN THOUSANDS) 1997 1996 1997 1996
-------------------------------------------------------
<S> <C> <C> <C> <C>
Interest Rate Options $4,862,200 $2,231,200 $ 0 $ 0
Interest Rate Swaps 473,000 405,000 12,392 2,727
Interest Rate Futures 58,000 0 46 0
-------------------------------------------------------
Total Interest Rate Agreements $5,393,200 $2,636,200 $ 12,438 $ 2,727
=======================================================
</TABLE>
(a) Reflects the fair market value of all cash and collateral of the Company
held by counterparties.
Interest Rate Options, which include caps, floors and collars (collectively,
"Options"), are agreements which transfer, modify or reduce interest rate risk
in exchange for the payment of a premium when the contract is initiated.
Interest rate cap agreements provide cash flows to the Company to the extent
that a specific interest rate index exceeds a fixed rate. Conversely, interest
rate floor agreements produce cash flows to the Company to the extent that the
referenced interest rate index falls below the agreed upon fixed rate.
Interest rate collar agreements consist of the purchase of a cap agreement
subsidized by the sale of a floor agreement, thus incorporating both of the
above mentioned types of cash flows. The Company's credit risk on the Options
is limited to the amortized cost of the Options agreements.
Interest Rate Swaps ("Swaps") are agreements in which a series of interest rate
flows are exchanged over a prescribed period. The notional amount on which the
interest payments are based is not exchanged. Most of the Company's Swaps
involve the exchange of either fixed interest payments for floating interest
payments or the exchange of one floating interest payment for another floating
interest payment based on a different index. Most of the Swaps require that the
Company provide collateral in the form of Mortgage Assets to the counterparty.
Should the counterparty fail to return the collateral, the Company would be at
risk for the fair market value of that asset.
F-13
<PAGE> 104
Interest Rate Futures ("Futures") are contracts for the delivery of securities
or cash in which the seller agrees to deliver on a specified future date, a
specified instrument (or the cash equivalent), at a specified price or yield.
Under these agreements, if the Company has sold (bought) the futures, the
Company will generally receive additional cash flows if interest rates rise
(fall). Conversely, the Company will generally pay additional cash flows if
interest rates fall (rise).
In general, the Company has incurred credit risk to the extent that the
counterparties to the Interest Rate Agreements do not perform their obligations
under the Interest Rate Agreements. If one of the counterparties does not
perform, the Company would not receive the cash to which it would otherwise be
entitled under the Interest Rate Agreement. In order to mitigate this risk,
the Company has only entered into Interest Rate Agreements with counterparties
rated A or better or that are transacted on a national exchange. Furthermore,
the Company has entered into Interest Rate Agreements with several different
counterparties in order to reduce the risk of credit exposure to any one
counterparty.
NOTE 7. SHORT-TERM DEBT
The Company has entered into reverse repurchase agreements and other forms of
collateralized short-term borrowings (collectively, "Short-Term Debt") to
finance acquisitions of a portion of its Mortgage Assets. This Short-Term Debt
is collateralized by a portion of the Company's Mortgage Assets.
At December 31, 1997, the Company had $1.9 billion of Short-Term Debt
outstanding with a weighted average borrowing rate of 6.00% and a weighted
average remaining maturity of 64 days. This debt was collateralized with $2.0
billion of Mortgage Assets. At December 31, 1996, the Company had $2.0 billion
of Short-Term Debt outstanding with a weighted average borrowing rate of 5.83%
and a weighted average remaining maturity of 98 days. This debt was
collateralized with $2.1 billion of Mortgage Assets.
At December 31, 1997 and 1996, the Short-Term Debt had the following remaining
maturities:
<TABLE>
<CAPTION>
(IN THOUSANDS) 1997 1996
---------- ----------
<S> <C> <C>
Within 30 days $ 823,545 $ 268,042
30 to 90 days 533,543 667,567
Over 90 days 557,437 1,017,494
---------- ----------
Total Short-Term Debt $1,914,525 $1,953,103
========== ==========
</TABLE>
For the years ended December 31, 1997, 1996 and 1995, the average balance of
Short-Term Debt was $2.4 billion, $0.9 billion and $0.2 billion with a weighted
average interest cost of 5.86%, 5.71% and 6.06%, respectively. The maximum
balance outstanding during the years ended December 31, 1997, 1996 and 1995 was
$3.1 billion, $2.0 billion and $0.4 billion, respectively.
NOTE 8. LONG-TERM DEBT
During the third and fourth quarters of 1997, the Company issued $1.28 billion
of Long-Term Debt in the form of collateralized mortgage bonds. The Long-Term
Debt was issued by two business trusts established by the Company's
wholly-owned subsidiary, Sequoia Mortgage Funding Corporation ("Sequoia").
Each series of Long-Term Debt consists of two classes of bonds at variable
rates of interest. Payments received on the Bond Collateral are used to make
payments on the Long-Term Debt. The obligations under the Long-Term Debt are
payable solely from the Bond Collateral and are otherwise non-recourse to the
Company. The maturity of each class is directly affected by the rate of
principal prepayments on the related Bond Collateral. The Long-Term Debt is
also subject to redemptions according to the specific terms of the individual
indentures as defined in the corresponding prospectus. As a result, the actual
maturity of any class of this series of Long-Term Debt is likely to occur
earlier than its stated maturity.
F-14
<PAGE> 105
The components of the Long-Term Debt along with selected other information are
summarized below:
<TABLE>
<CAPTION>
(IN THOUSANDS) DECEMBER 31, 1997
-----------------
<S> <C>
Long-Term Debt $ 1,170,709
Unamortized premium on Long-Term Debt 5,795
Deferred bond issuance costs (3,703)
-----------
Total Long-Term Debt $ 1,172,801
===========
Range of coupons on bonds 6.0583% to 6.5033%
Stated maturities 2024 - 2029
</TABLE>
For the year ended December 31, 1997, the average effective interest cost for
Long-Term Debt, as adjusted for the amortization of bond premium, deferred bond
issuance costs and other related expenses, was 6.31%. Interest paid on
Long-Term Debt for the year ended December 31, 1997 totaled $16.7 million.
NOTE 9. 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, 1997 and 1996. SFAS 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>
(IN THOUSANDS) 1997 1996
------------------------- -------------------------
CARRYING CARRYING
AMOUNT FAIR VALUE AMOUNT FAIR VALUE
------------------------- -------------------------
<S> <C> <C> <C> <C>
Assets
Mortgage Assets $3,366,622 $3,367,381 $2,153,428 $2,153,428
Interest Rate Agreements $ 2,100 $ 1,522 $ 2,601 $ 2,601
Liabilities
Long-Term Debt $1,172,801 $1,172,938 0 0
</TABLE>
The carrying amounts of all other balance sheet accounts as reflected in the
financial statements approximate fair value because of the short- term nature
of these accounts.
NOTE 10. STOCKHOLDER'S EQUITY
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.
As of December 31, 1997, 96,732 shares of the Class B Preferred Stock have been
converted into 96,732 shares of the Company's Common Stock. At December 31,
1997 and 1996, there were 909,518 and 1,006,250 shares of the Class B Preferred
Stock outstanding, respectively.
F-15
<PAGE> 106
STOCK OPTION PLAN
The Company has adopted a Stock Option Plan for executive officers, employees
and non-employee directors (the "Plan"). The Plan authorizes the Board of
Directors (or a committee appointed by the Board of Directors) to grant
"incentive stock options" as defined under Section 422 of the Code ("ISOs"),
options not so qualified ("NQSOs"), deferred stock, restricted stock,
performance shares, stock appreciation rights and limited stock appreciation
rights ("Awards") and dividend equivalent rights ("DERs") to such eligible
recipients other than non-employee directors. Non-employee directors are
automatically provided annual grants of NQSOs with DERs pursuant to a formula
under the Plan.
The number of shares of Common Stock available under the 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, 1997 and 1996,
1,158,404 and 1,138,737 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, 1997 and 1996, 354,265 and 299,633 ISOs had been granted,
respectively. The exercise price for ISOs granted under the 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 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 Plan permits certain stock options granted under the plan to
accrue stock DERs. For the years ended December 31, 1997, 1996 and 1995, the
stock DERs accrued on NQSOs that had a stock DER feature resulted in charges to
operating expenses of $437,393, $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.
A summary of the status of the Company's Plan as of December 31 and changes
during the years ending on those dates is presented below.
<TABLE>
<CAPTION>
1997 1996 1995
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
(IN THOUSANDS, EXCEPT SHARE DATA) SHARES PRICE SHARES PRICE SHARES PRICE
- ------- --------- ------- --------- ------- ---------
<S> <C> <C> <C> <C> <C> <C>
Outstanding options at January 1 421,583 $ 19.05 310,857 $ 9.48 188,333 $ 0.11
Options granted 460,328 37.08 141,300 36.01 166,972 17.55
Options exercised (54,485) 0.89 (42,083) 0.11 (47,083) 0.11
Dividend equivalent rights earned 13,218 0.00 11,509 0.00 2,635 0.00
------- ------- -------
Outstanding options at December 31 840,644 29.79 421,583 19.05 310,857 9.48
======= ======= =======
Options exercisable at year-end 81,774 22.10 27,109 24.48 0 na
Weighted average fair value of options
granted during the year $ 3.17 $ 2.34 $ 0.01
</TABLE>
F-16
<PAGE> 107
The following table summarizes information about stock options outstanding at
December 31, 1997.
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
-------------------------------------------------- ---------------------------------
NUMBER WEIGHTED-AVERAGE NUMBER
RANGE OF OUTSTANDING REMAINING WEIGHTED-AVERAGE EXERCISABLE WEIGHTED-AVERAGE
EXERCISE PRICES AT 12/31/97 CONTRACTUAL LIFE EXERCISE PRICE AT 12/31/97 EXERCISE PRICE
- ----------------------------------------------------------------------- ---------------------------------
<S> <C> <C> <C> <C> <C>
$0 to 8 83,294 7.2 $ 0.71 11,552 $ 1.58
17 to 19 155,972 7.9 18.19 41,493 18.15
20 to 30 98,976 9.8 23.62 1,750 23.74
36 to 38 381,300 9.0 37.45 26,979 36.88
45 to 53 121,102 9.5 45.68 0 0.00
------- -------
$0 to 53 840,644 8.8 29.79 81,774 22.10
</TABLE>
At December 31, 1997, the Company had one Stock Option Plan, which is described
above. The Company applies Accounting Principles Board ("APB") Opinion 25 and
related interpretations in accounting for this plan. Accordingly, no
compensation cost has been recognized for its Plan. Had compensation cost for
the Company's Plan been determined consistent with SFAS No. 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 DECEMBER 31,
1997 1996 1995
------------- ------------- ------------
<S> <C> <C> <C> <C>
Net Income As reported $ 24,746 $ 11,537 $ 3,155
(IN THOUSANDS) Pro Forma $ 24,504 $ 11,535 $ 3,155
Basic earnings As reported $ 1.86 $ 1.45 $ 0.95
per share Pro Forma $ 1.84 $ 1.45 $ 0.95
Diluted As reported $ 1.81 $ 1.32 $ 0.85
earnings per share Pro Forma $ 1.79 $ 1.32 $ 0.85
</TABLE>
For purposes of determining values for use in the above table, the 1997 values
are based on American valuation using the Black/Scholes option pricing model as
of the various grant dates, using the following principal assumptions:
expected stock price volatility 33%, risk free rates of return based on the 5
year treasury rate at the date of grant and a post-option dividend growth rate
of 10%. 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.
STOCK PURCHASE WARRANTS
For the years ended December 31, 1997 and 1996, 412,484 and 1,252,169 Warrants
were exercised, respectively. Each Warrant entitled the holder to purchase
1.000667 shares of the Company's Common Stock at an exercise price of $15.00
per share. The Warrants expired on December 31, 1997.
STOCK REPURCHASES
In 1997, the Company's Board of Directors approved the repurchase of up to
1,455,000 shares of the Company's Common Stock. Pursuant to this repurchase
program, the Company repurchased 840,000 shares of its Common Stock for $23.1
million during 1997. The repurchased shares have been returned to the
Company's authorized but unissued shares of Common Stock.
F-17
<PAGE> 108
DIVIDENDS
The Company declared and paid the following dividends for the years ended
December 31, 1997 and 1996:
<TABLE>
<CAPTION>
TOTAL DIVIDENDS PER SHARE
DECLARATION RECORD PAYABLE DIVIDENDS CLASS B COMMON
DATE DATE DATE (IN THOUSANDS) PREFERRED STOCK STOCK
---- ---- ---- -------------- --------------- -----
<S> <C> <C> <C> <C> <C>
12/12/97 12/31/97 1/21/98 $5,686 $0.755 $0.350
9/8/97 9/30/97 10/21/97 $9,433 $0.755 $0.600
6/12/97 6/30/97 7/21/97 $8,638 $0.755 $0.600
3/5/97 3/31/97 4/21/97 $7,899 $0.755 $0.600
12/16/96 12/31/96 1/21/97 $5,268 $0.755 $0.410
9/16/96 9/30/96 10/21/96 $4,016 $0.386 $0.400
6/14/96 6/28/96 7/18/96 $3,408 -- $0.400
3/11/96 3/29/96 4/19/96 $2,540 -- $0.460
</TABLE>
Under the Internal Revenue Code of 1986, a dividend declared by a REIT in
October, November or December of a calendar year and payable to shareholders of
record as of a specified date in such month, will be deemed to have been paid
by the Company and received by the shareholders on the last day of that
calendar year, provided the dividend is actually paid before February 1st of
the following calendar year. Therefore, the dividend declared in December 1997
which was paid in January 1998 is considered taxable income to shareholders in
the year declared. The Company's dividends are not eligible for the dividends
received deduction for corporations.
NOTE 11. COMMITMENTS AND CONTINGENCIES
At December 31, 1997, the Company had entered into a commitment to purchase
$7.3 million of Mortgage Assets for settlement in January 1998.
At December 31, 1997, the Company is obligated under non-cancelable operating
leases with expiration dates through 2001. The future minimum lease payments
under these non-cancelable leases are as follows: 1998 through 2000 - $197,304;
2001 - $65,768.
NOTE 12. SUBSEQUENT EVENTS
During January and February, 1998, pursuant to its stock repurchase program
(see Note 10), the Company repurchased 214,100 shares of the Company's Common
Stock for $4.2 million.
F-18
<PAGE> 109
[COOPERS & LYBRAND LETTERHEAD]
REPORT OF INDEPENDENT ACCOUNTANTS
Board of Directors
Redwood Trust, Inc.
Mill Valley, California
We have audited the accompanying consolidated balance sheets of Redwood Trust,
Inc. and Subsidiary (the Company) as of December 31, 1997 and 1996 and the
related consolidated statements of operations, stockholders' equity and cash
flows for each of the three years in the period ended December 31, 1997. 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 consolidated financial position of the Company as of
December 31, 1997 and 1996, and the consolidated results of its operations and
its cash flows for each of the three years in the period ended December 31,
1997, in conformity with generally accepted accounting principles.
/s/ COOPERS & LYBRAND L.L.P.
San Francisco, California
February 25, 1998
F-19
<PAGE> 110
REDWOOD TRUST, INC.
SUMMARY OF QUARTERLY RESULTS
(unaudited)
(In thousands, except share data)
<TABLE>
<CAPTION>
Fourth Third Second First
Quarter Quarter Quarter Quarter
------- ------- ------- -------
<S> <C> <C> <C> <C>
Year ended December 31, 1997
Operating results:
Interest income $53,984 $56,543 $49,509 $38,568
Interest expense 46,531 45,888 38,958 28,900
Interest rate agreement expense 1,269 1,038 839 595
Net interest income 6,184 9,617 9,712 9,073
Net income 5,083 7,546 7,721 7,211
Net income available to common stockholders 4,397 6,859 7,034 6,456
Net income per share - diluted 0.30 0.47 0.52 0.53
Dividends declared per common share 0.350 0.600 0.600 0.600
Dividends declared per Class B preferred share 0.755 0.755 0.755 0.755
Year ended December 31, 1996
Operating results:
Interest income $25,881 $19,371 $12,901 $ 9,131
Interest expense 19,467 14,447 9,075 6,202
Interest rate agreement expense 402 350 255 151
Net interest income 6,012 4,574 3,571 2,778
Net income 4,844 3,387 2,500 1,954
Net income available to common stockholders 4,084 2,999 2,500 1,954
Net income per share - diluted 0.39 0.32 0.29 0.32
Dividends declared per common share 0.410 0.400 0.400 0.460
Dividends declared per Class B preferred share 0.755 0.386 0.000 0.000
</TABLE>
F-20
<PAGE> 111
REDWOOD TRUST, INC.
INDEX TO EXHIBIT
<TABLE>
<CAPTION>
Sequentially
Exhibit Numbered
Number Page
- -------------- --------------
<S> <C> <C>
11.1 Computation of Earnings per Share 112
21 List of Subsidiaries 113
23 Consent of Accountants 114
27 Financial Data Schedule 115
</TABLE>
111
<PAGE> 1
EXHIBIT 11.1
REDWOOD TRUST, INC.
STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS
<TABLE>
<CAPTION>
Twelve Months Twelve Months Twelve Months
Ended Ended Ended
December 31, 1997 December 31, 1996 December 31, 1995
----------------- ----------------- -----------------
<S> <C> <C> <C>
Basic:
Average common shares outstanding ......................... 13,334,163 7,950,175 3,314,042
----------- ----------- -----------
Total ............................................... 13,334,163 7,950,175 3,314,042
=========== =========== ===========
Net Income ................................................ $24,746,164 $11,537,318 $ 3,154,831
=========== =========== ===========
Per Share Amount .......................................... $ 1.86 $ 1.45 $ 0.95
=========== =========== ===========
Diluted:
Average common shares outstanding ......................... 13,334,163 7,950,175 3,314,042
Net effect of dilutive stock options outstanding
during the period -- based on the treasury stock method 191,513 175,391 173,716
Net effect of dilutive stock warrants outstanding
during the period -- based on the treasury stock method 154,734 618,618 216,046
----------- ----------- -----------
Total ............................................... 13,680,410 8,744,184 3,703,804
=========== =========== ===========
Net Income ................................................ $24,746,164 $11,537,318 $ 3,154,831
=========== =========== ===========
Per Share Amount .......................................... $ 1.81 $ 1.32 $ 0.85
=========== =========== ===========
</TABLE>
112
<PAGE> 1
EXHIBIT 21
LIST OF SUBSIDIARIES
OF
REDWOOD TRUST, INC.
Sequoia Mortgage Funding Corporation
Sequoia Mortgage Trust 1
Sequoia Mortgage Trust 2
113
<PAGE> 1
EXHIBIT 23
[COOPERS & LYBRAND LETTERHEAD]
CONSENT OF INDEPENDENT ACCOUNTANTS
We consent to the incorporation by reference in the registration
statements on Form S-3 (Nos. 33-97398, 333-25643 and 333-18061)
and on form S-8/S-3 (No. 333-20253) of our report dated February
25, 1998, on our audits of the consolidated financial statements
of Redwood Trust, Inc. and Subsidiary as of December 31, 1997
and 1996, and for the years ended December 31, 1997, 1996 and
1995, which report is included in this Annual Report on Form
10-K. We also consent to the reference to our firm under the
caption "Experts."
/s/ COOPERS & LYBRAND L.L.P.
San Francisco, California
March 12, 1998
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM DECEMBER 31,
1997 ANNUAL REPORT ON FORM 10-K AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO
SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
<CASH> 49,549
<SECURITIES> 3,368,722
<RECEIVABLES> 23,119
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 3,444,197
<PP&E> 0
<DEPRECIATION> 0
<TOTAL-ASSETS> 3,444,197
<CURRENT-LIABILITIES> 1,936,859
<BONDS> 1,172,801
0
26,736
<COMMON> 324,698
<OTHER-SE> (16,897)
<TOTAL-LIABILITY-AND-EQUITY> 3,444,197
<SALES> 0
<TOTAL-REVENUES> 198,604
<CGS> 0
<TOTAL-COSTS> 0
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</TABLE>
