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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-K
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1996
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission file number 1-9819
RESOURCE MORTGAGE CAPITAL, INC.
(Exact name of registrant as specified in its charter)
Virginia 52-1549373
(State or other jurisdiction of incorporation) (I.R.S. Employer I.D. No.)
or organization)
10900 Nuckols Road, Third Floor, Glen Allen, Virginia 23060
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (804) 217-5800
Securities registered pursuant to Section 12(b) of the Act: Title of
each class Name of each exchange on which registered Common Stock, $.01 par
value New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: Title
of each class Name of each exchange on which registered Series A 9.75%
Cumulative Convertible Nasdaq National Market Preferred Stock, $.01 par value
Series B 9.55% Cumulative Convertible Nasdaq National Market Preferred Stock,
$.01 par value Series C 9.73% Cumulative Convertible Nasdaq National Market
Preferred Stock, $.01 par value
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 XX 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. |X|
As of February 28, 1997, the aggregate market value of the voting stock held by
non-affiliates of the registrant was approximately $606,673,975 (20,055,338
shares at a closing price on The New York Stock Exchange of $30.25). Common
stock outstanding as of February 28, 1997 was 20,890,742 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Definitive Proxy Statement to be filed pursuant to Regulation
14A within 120 days from December 31, 1996, are incorporated by reference into
Part III.
RESOURCE MORTGAGE CAPITAL, INC.
1996 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PAGE
PART I
Item 1. BUSINESS................................................ 3
Item 2. PROPERTIES.............................................. 15
Item 3. LEGAL PROCEEDINGS....................................... 15
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS..... 15
PART II
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY
AND RELATED STOCKHOLDER MATTERS......................... 16
Item 6. SELECTED FINANCIAL DATA................................. 17
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS........... 18
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA............. 38
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE.................. 38
PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT...... 38
Item 11. EXECUTIVE COMPENSATION.................................. 38
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
OWNERS AND MANAGEMENT................................... 38
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.......... 38
PART IV
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
AND REPORTS ON FORM 8-K................................. 38
Item 1. BUSINESS
General
Resource Mortgage Capital, Inc. (the "Company") is a mortgage and consumer
finance company which uses its production operations to create investments for
its portfolio. Currently, the Company's primary production operations include
the origination of mortgage loans secured by multi-family properties and the
origination of loans secured by manufactured homes. The Company intends to
expand its production sources in the future to include other financial products,
such as commercial real estate loans. The Company will generally securitize the
loans funded as collateral for collateralized bonds, limiting its credit risk
and providing long-term financing for its portfolio. The majority of the
Company's current investment portfolio is comprised of loans or securities (ARM
loans or ARM securities) that have coupon rates which adjust over time (subject
to certain limitations) in conjunction with changes in short-term interest
rates. The Company has elected to be treated as a real estate investment trust
(REIT) for federal income tax purposes and, as such, must distribute
substantially all of its taxable income to shareholders and will generally not
be subject to federal income tax.
The Company's principal sources of earnings are net interest income on its
investment portfolio. The Company's investment portfolio consists principally of
collateral for collateralized bonds, ARM securities and loans held for
securitization. The Company funds its portfolio investments with both borrowings
and cash raised from the issuance of equity. For the portion of the
portfolio investments funded with borrowings, the Company generates net interest
income to the extent that there is a positive spread between the yield on the
earning assets and the cost of borrowed funds. For that portion of the balance
sheet that is funded with equity, net interest income is primarily a
function of the yield generated from the interest-earning asset. The cost of the
Company's borrowings may be increased or decreased by interest rate swap, cap,
or floor agreements.
Business Focus and Strategy
The Company strives to create a diversified portfolio of investments that
in the aggregate generates stable income for the Company in a variety of
interest rate environments and preserves the capital base of the Company. The
Company seeks to generate growth in earnings and dividends per share in a
variety of ways, including (i) developing production capabilities to originate
and acquire financial assets in order to create attractively priced investments
for its portfolio, as well as controlling the underwriting and servicing of such
financial assets; (ii) adding investments to its portfolio when opportunities in
the market are favorable and (iii) increasing the efficiency with which the
Company utilizes its equity capital over time. To increase potential returns to
shareholders, the Company also employs leverage through the use of secured
borrowings (such as collateralized bonds) and repurchase agreements to fund a
portion of its portfolio investments. As mentioned previously, the Company's
current production operations are comprised primarily of multi-family and
manufactured housing lending. The Company's strategy is to expand these
production sources as well as to diversify into other financial products such as
commercial real estate loans. The Company also intends to selectively purchase
single-family loans in bulk with the intent to securitize such loans as
collateral for collateralized bonds. By pursuing these strategies, the Company
believes it can create investments for its portfolio at a lower effective cost
than if investments of comparable risk profiles were purchased in the market,
although there can be no assurance that the Company will be successful in
accomplishing this strategy.
The Company expects to fund the majority of the future growth in its
investment portfolio by the issuance of collateralized bonds, which are debt
securities collateralized by a pool of mortgage and/or manufactured housing
loans. The loans which collateralize the collateralized bonds are treated as
assets of the Company and the collateralized bonds are treated as liabilities of
the Company. The Company generates net interest income to the extent that there
is a positive spread between the yield on the loans which collateralize the
collateralized bonds and the cost of the collateralized bond financing. The net
interest spread will be directly impacted by the level of prepayments and credit
losses on the underlying loans. The collateralized bond structure utilized by
the Company generally limits its credit risk to the overcollateralization
portion in each securitization, represented primarily by its net investment in
the securitization (collateral for collateralized bonds less the collateralized
bonds) and which amounts to between 2% and 5% of the initial loan pool. In
addition, the collateralized bonds are non-recourse to the Company, although the
Company may invest in a portion of the collateralized bonds issued. The Company
may issue collateralized bonds from time to time based on its current portfolio
management strategy, loan funding volume, market conditions and other factors.
The Company's collateralized bond securitization strategy differs from the
more common pass-through securitization structure used by other companies and
also used primarily by the Company prior to 1995. As mentioned above,
collateralized bond securitizations are recorded as financing transactions and,
as such, there is no gain on sale recognition at securitization. Rather, income
from these securities is recognized over their lives as net interest margin,
which is generally not taxable to the Company as a REIT. Conversely, prior to
1995, income was primarily recognized as gain on sale of mortgage loans and was
generated primarily by a taxable affiliated entity and, as such, was fully
taxable. The Company believes that recognizing income over time as a result of
utilizing the Company's current collateralized bond securitization strategy will
reduce the earnings volatility that could have been experienced by utilizing
former securitization strategies.
Production Operations
The Company's current production operations consist primarily of the
origination and purchase of loans, and the securitization of such loans. The
production operations enable the Company to enhance its return on shareholders'
equity (ROE) by earning a favorable net interest spread while loans are being
accumulated for securitization and creating investments for its portfolio at a
lower cost than if such investments were purchased from third parties. The
creation of investments involves the issuance of collateralized bonds or
pass-through securities collateralized by the loans generated from the Company's
production activities and the retention of one or more classes of the
collateralized bonds or securities relating to such issuance. The issuance of
collateralized bonds and pass-through securities generally limits the Company's
credit and interest rate risk in contrast to retaining loans in its investment
portfolio in whole-loan form.
Until May 1996, the Company's production operations were comprised mainly of
its single-family mortgage operations that concentrated on the "non-conforming"
segment of the residential loan market. The Company funded its single-family
loans directly through mortgage brokers (wholesale) and purchased loans through
a network of mortgage companies (correspondents). The single-family loans which
were originated or purchased by the Company were secured by properties that were
geographically-diversified throughout the United States. The Company built this
single-family production operation from a start-up in 1988, funding $18.2
billion in principal amount of loans since inception. Loans originated through
the Company's former single-family mortgage operations constitute the majority
of loans underlying the securities that comprise the Company's current
investment portfolio.
On May 13, 1996, the Company sold its single-family mortgage operations to
Dominion Mortgage Services, Inc. (Dominion), a wholly-owned subsidiary of
Dominion Resources, Inc. (NYSE:D), for $68 million. Included in the sale of the
single-family mortgage operations were the Company's single-family
correspondent, wholesale and servicing operations. The sale resulted in a gain
of $17.3 million, which was net of a provision of $31.0 million for possible
losses on single-family loans where the Company has retained a portion of the
credit risk and where prior to the sale the Company had serviced such
single-family loans. The terms of the sale included an initial cash payment
of $20.5 million, with the remainder of the purchase price to be paid evenly
over the next five years pursuant to a note agreement. As a result of the sale,
the Company is precluded from originating certain types of single-family
mortgage loans through either correspondents or a wholesale network for a period
of five years from the date of the sale. The Company may acquire single-family
mortgage loans through bulk purchases of $25 million or more.
Since the sale, the Company's primary production operations have been focused
on multi-family lending and manufactured housing lending. The Company is
currently broadening its multi-family lending capabilities to include other
types of commercial real estate loans and to expand its manufactured housing
lending to include inventory financing to manufactured housing dealers. The
Company may also purchase single-family loans on a "bulk" basis from time to
time and may originate such loans on a retail basis.
The Company believes that it has been successful in operating its production
activities. Since its initial public offering in February 1988, the Company's
average total ROE has been 17%. The Company estimates that its ROE has averaged
4% higher than it would have otherwise been as a result of its production
operations. For purposes of the above percentages, ROE was calculated on a
weighted average basis prior to unrealized gains or losses on available-for-sale
mortgage securities. The single-family operations have contributed $62 million
to the Company's net earnings since 1988, including the $17.3 million of net
gain recorded in May 1996, and have produced a positive mark-to-market on
related single-family investments of $65.2 million as of December 31, 1996.
While there can be no assurances in this regard, the Company believes that
its future production activities will continue to have a favorable impact on its
ROE and to create investments for its portfolio at a lower all-in cost than if
investments with comparable risk profiles were purchased from third parties.
Multi-family Lending Operations
The Company currently originates multi-family mortgage loans which are
secured by apartment properties that have qualified for low-income housing tax
credits (LIHTCs) under Section 42 of the Internal Revenue Code. Since 1992, the
Company has funded approximately $355 million of multi-family mortgage loans
through a brokerage arrangement with Multi-Family Capital Markets (MCM), a
Richmond, Virginia-based company which the Company acquired in August 1996 for
$4 million. The Company believes the acquisition of MCM will complement the
Company's current strategy of expanding its multi-family lending activities and
will improve its competitive position in the marketplace for such loans. The
Company plans to broaden its income property lending beyond LIHTC apartment
properties during 1997. Such properties may include apartment properties that
have not received LIHTCs, assisted living and retirement housing, limited and
full service hotels, urban or suburban office buildings, retail shopping strips
and centers, light industrial buildings and manufactured housing parks. The
Company contemplates that it would service and securitize such loans
in its multi-family production.
As of December 31, 1996, the Company had $208.2 million in principal balance
of multi-family loans held for securitization. Such loans had an average
principal balance of $3.6 million, and ranged in size from $0.6 million to $11.0
million. The Company has commitments to fund loans through 1998 of approximately
$522 million as of December 31, 1996. As of such date, the Company had 17
employees directly involved in its multi-family lending operations.
Current federal law provides that each state receive an annual allocation of
LIHTCs. Each state then allocates portions of its LIHTC allocation to various
developers for the purpose of constructing or rehabilitating low-income housing
apartment properties. Based upon current allocation amounts, approximately
110,000 apartment units nationwide are constructed or rehabilitated annually.
For property owners to be eligible for, and remain in compliance with the LIHTC
regulations, owners must "set aside" at least 20% of the units for rental to
families with income of 50% or less of the median income for the locality as
determined by the Department of Housing and Urban Development (HUD), or at least
40% of the units to families with income of 60% or less of the HUD median
income. Most owners elect the "40-60 set-aside" and designate 100% of the units
in the project as LIHTC units. Additionally, rents cannot exceed 30% of the
annual HUD median income adjusted for the unit's designated "family size."
Generally, the LIHTCs are sold by the developers to investors prior to
construction in order to provide additional equity for the project. The sale of
the LIHTCs typically provides funds equal to approximately 50% of the
construction costs of the project. The multi-family loans made by the Company
normally fund the difference between the project cost (including a fee to the
developer) and the funds generated from the sale of the LIHTCs. In addition to
providing substantial equity for the apartment project, the Company believes the
LIHTCs provide a strong on-going incentive to the owner of the property to
maintain the property and meet its debt service obligations, since the owner,
upon foreclosure, would lose any LIHTCs not already taken and may be subject to
recapture of a portion of the LIHTCs already taken.
With the acquisition of MCM, the multi-family mortgage loans originated by
the Company are now sourced through the Company's direct relationships with
developers and syndicators. There are no correspondent or broker relationships.
Once a sufficient volume of multi-family loans are accumulated, the Company
plans to securitize such loans through the issuance of collateralized bonds. The
Company anticipates that the issuance of the collateralized bonds will limit the
Company's future credit and interest rate risk on such multi-family loans. The
Company presently intends to accumulate approximately $250 million of
multi-family loans for a collateralized bond series to be issued during the
first half of 1997. The Company has previously issued one series of
collateralized bonds backed by multi-family loans. See "Loan Securitization
Strategy."
Underwriting. The Company underwrites all multi-family loans it originates.
Among other criteria, the Company underwrites each multi-family loan to a
minimum debt service coverage ratio of 1.15 times the property's net operating
income, with a maximum loan to value of 80% of appraised value. The Company
believes that such criteria are consistent with general underwriting standards
for LIHTC multi-family properties. The Company's underwriting criteria are
designed to assess the particular property's current and future capacity to make
all debt service payments on a current basis and to ensure that adequate
collateral value exists to support the loan. Each multi-family loan funded by
the Company is approved by an internal loan committee, with a majority of its
members not directly related to the lending function.
Because the Company funds the loans at fixed-interest rates and also commits
to funding future loans at fixed-interest rates, the Company is exposed to
interest rate risk to the extent that interest rates increase in the future. The
Company strives to mitigate such risk by the use of futures contracts and
forward contracts of US treasury securities with duration characteristics
similar to the multi-family loans and commitments.
Manufactured Housing Lending Operations
The Company began to build the infrastructure of its manufactured housing
lending operations during the fourth quarter of 1995 and commenced funding loans
on manufactured homes during the second quarter of 1996. The Company believes
that manufactured housing is a growing market with strong customer demand. The
Company entered this business primarily to diversify its existing product line
and to increase its overall production. Manufactured housing lending complements
the Company's residential lending and securitization expertise.
A manufactured home is distinguished from a traditional single-family home in
that the housing unit is constructed in a plant, transported to the site and
secured to a foundation, whereas a single-family home is built on the site.
Loans on manufactured homes may take the form of a consumer installment loan
(i.e., a personal property loan) when the borrower rents or owns the lot
underlying the manufactured home or a traditional mortgage loan when the
borrower owns the lot. To date, the Company has only originated consumer
installment loans on manufactured homes, but plans to originate mortgage loans
in the future. The Company offers both fixed and adjustable rate loans with
terms ranging from 7 to 30 years. As of December 31, 1996, the Company had $41
million in principal balance of manufactured housing loans in inventory and had
commitments outstanding of approximately $15 million. The average funded amount
per loan is approximately $37,000. As of December 31, 1996, the Company had 60
employees directly involved in its manufactured housing lending operations.
The rising cost of site built single-family housing in the United States has
shifted consumer demand toward manufactured housing as an affordable alternative
to traditional single-family homes. According to the December 1996 Manufacturing
Report by the Manufactured Housing Institute, manufactured home sales,
approximately 52% of which were multi-section homes, represented an estimated
24% of all new housing units produced in the United States in 1996. This
represented a 7% increase in all new housing units produced in the United States
since 1991. During 1996, approximately 363,000 manufactured homes were shipped
to retailers (i.e., dealers) which then sell the homes to consumers, with the
majority of such sales being financed as personal property loans using an
installment sales contract. As the manufactured home is generally transported on
public roads, each home is usually titled with the respective state department
of motor vehicles.
The Company's manufactured housing lending business is operated out of the
Company's main office in Glen Allen, Virginia (the "home" office) and is
supported currently with regional offices in North Carolina, Georgia, Texas and
Michigan. The Company is planning to establish a fifth regional office on the
West Coast during the second quarter of 1997. Each regional office supports
three to four district sales managers who establish and maintain relationships
with manufactured housing dealers. By using the home/regional/district office
structure, the Company has created a decentralized customer service and loan
origination organization with centralized controls and support functions. The
Company believes that this approach also provides the Company with a greater
ability to maintain customer service, to respond to market conditions, to enter
and exit local markets and to test new products.
The Company's current sources of originations are its dealer network and
direct marketing to consumers. In the future, the Company plans to expand its
sources of origination to nearly all sources for manufactured housing loans by
establishing relationships with park owners, developers of manufactured housing
communities, manufacturers of manufactured homes, brokers and correspondents.
The Company currently advertises in trade publications to reach dealers and
solicits loans through direct mail and telemarketing.
The Company's dealer qualification criteria includes minimum equity
requirements, minimum years of experience for principal officers, acceptable
historical financial performance and various business references. The dealer
application package is submitted by the dealer to the regional office manager
for review and approval. As of December 31, 1996, the Company had 480 approved
dealers with 752 sales locations. The Company plans to continue to expand its
dealer network.
Inventory Financing. The Company will offer inventory financing, or "lines of
credit," to retail dealers for the purpose of purchasing manufactured housing
inventory to display and sell to customers beginning in 1997. Under such
arrangements, the Company will lend against the dealer's line of credit when an
invoice representing the purchase of a manufactured home by a dealer is
presented to the Company by the manufacturer of the manufactured home. Prior to
approval of the line of credit for the dealer, the Company will perform a
financial review of the manufacturer as well as the dealer. The Company will
perform monthly inspections of the dealer's inventory financed by the Company
and annual reviews of both the dealer and the manufacturer. Entrance into this
area of financing is consistent with the Company's strategy to be a
"full-service" provider to the manufactured housing industry.
Underwriting. The Company underwrites 100% of the manufactured housing
loans it originates. The loans are underwritten at the regional offices based on
guidelines established by the Company. Home office approvals are required when
loan amounts exceed specified lines of credit authority. Turnaround for
approvals are within four to twenty-four hours with fundings usually within
twenty-four to forty eight hours of receipt of complete documentation.
Because of the decentralization of the Company's manufactured housing
business, in addition to the Company's underwriting process and dealer approval
program, the Company also plans to perform regional and district office reviews
on a frequent basis to ensure that required procedures are being followed. These
reviews will include the collections area, the remarketing of foreclosed or
repossessed homes, underwriting, dealer performance and quality control. The
periodic regional quality control reviews are performed to ensure that the
underwriting guidelines are consistently applied. The Company also performs
customer audits both before and after funding of the loan.
Manufactured housing loans are primarily fixed-interest rate with some
adjustable-rate and step-rate loans. To reduce interest rate risk associated
with fixed-rate products, the Company will mitigate such risks through the use
of forward sales, futures and/or swaps until the pool of loans is securitized.
As of December 31, 1996, 95.3% of the loans were fixed-rate.
The Company perfects its security interest on the loans that are in the
form of installment sales contracts by filing title with the department of
motor vehicles or UCC financing statements with the respective state. Such
loans are eligible REIT assets.
Single-family Lending
Pursuant to the terms of the sale of the Company's single-family operations
to Dominion during the second quarter of 1996, the Company is precluded from
originating or purchasing certain types of single-family loans through a
wholesale or correspondent network through April, 2001. However, the Company may
purchase any type of single-family loans on a "bulk" basis, i.e., in blocks of
$25 million or more, and may originate loans on a retail basis. The Company
intends to purchase single-family loans in bulk to the extent that the Company
can generate a favorable return on investment upon securitization. Due to the
sale of its single-family operations, the Company does not currently have the
internal capability to directly underwrite or service single-family mortgage
loans. In the future, the Company may re-establish an internal underwriting and
servicing capability for single-family mortgage loans, similar to that which
existed prior to the sale of its single-family operations. In the interim, the
Company plans to occasionally bulk purchase "A" quality loans and the Company
may utilize independent contractors to assist in the underwriting and servicing
of such loans.
Loan Servicing
During 1996, the Company established the capability to service both
multi-family and manufactured housing loans funded through its production
operations. The purpose of servicing the loans funded through the production
operations is to better manage the Company's credit exposure while the loans are
held for securitization, as well as the exposure which is usually generated when
the Company retains a portion of the credit risk on a pool of the mortgage loans
after securitization. The multi-family servicing function includes collection
and remittance of principal and interest payments, administration of tax and
insurance accounts, management of the replacement reserve funds, collection of
certain insurance claims and, if the loan defaults, the resolution of such
defaulted loan through either a modification or the foreclosure and sale of the
property.
The manufactured housing servicing function was also established in 1996 and is
operated in Fort Worth, Texas. As the servicer of such manufactured housing
loans, the Company is responsible for the collection of monthly payments, and if
the loan defaults, the resolution of such defaulted loan through either a
modification or the repossession and sale of the related property. Minimizing
the time between the date the loan goes in default and the time that the
manufactured home is repossessed and sold is critical to mitigating losses on
these loans.
Loan Securitization Strategy
When a sufficient volume of loans is accumulated, the Company will generally
securitize the loans through the issuance of collateralized bonds. The Company
believes that securitization is an efficient and cost effective way for the
Company to (i) reduce capital otherwise required to own the loans in whole loan
form; (ii) limit the Company's exposure to credit risk on the loans; (iii) lower
the overall cost of financing the loans and (iv) depending on the securitization
structure, limit the Company's exposure to interest rate and/or valuation risk.
As a result of the reduction in the availability of mortgage pool insurance, and
the Company's desire to both reduce its recourse borrowings as a percentage of
its overall borrowings, as well as, the variability of its earnings, the Company
has utilized the collateralized bond structure for securitizing substantially
all of its loan production since the beginning of 1995. Prior to 1995, the
Company issued pass-through securities, in a senior-subordinated structure or
with pool insurance.
The securities are structured by the Company so that a substantial portion of
the securities are rated in one of the two highest rating categories (i.e., AA
or AAA) by at least one of the nationally recognized rating agencies. Credit
enhancement for these securities may take the form of over-collateralization,
subordination, reserve funds, mortgage pool insurance, bond insurance,
third-party limited guaranties or any combination of the foregoing. The Company
strives to use the most cost effective security structure and form of credit
enhancement available at the time of securitization. Securities issued by the
Company are not generally guaranteed by a federal agency. Each series of
securities is expected to be fully payable from the collateral pledged to secure
the series. Regardless of the form of credit enhancement, the Company may retain
a limited portion of credit risk related to the loans after securitization. See
"Credit Exposures" in Item 7. "Management's Discussion and Analysis of Financial
Condition and Results of Operations".
Master Servicing
The Company performs the function of master servicer for certain of the
securities it has issued, including all of the securities it issued since 1995.
The master servicer's function typically includes monitoring and reconciling the
loan payments remitted by the servicers of the loans, determining the payments
due on the securities and determining that the funds are correctly sent to a
trustee or investors for each series of securities. Master servicing
responsibilities also include monitoring the servicers' compliance with its
servicing guidelines. As master servicer, the Company is paid a monthly fee
based on the outstanding principal balance of each such loan master serviced or
serviced by the Company as of the last day of each month. The Company has been
master servicing mortgage loans since November 1993.
Investment Portfolio
Strategy
The core of the Company's earnings are derived from its investment portfolio.
The Company's strategy for its investment portfolio is to create a diversified
portfolio of high quality assets that in the aggregate generates stable income
for the Company in a variety of interest rate and prepayment environments and
preserves the capital base of the Company. In many instances, the Company's
investment strategy involves not only the creation of the asset, but structuring
the related borrowing through the securitization process to create a stable
yield profile.
At December 31, 1996, the Company's investments included the following amounts
at their carrying basis:
% of
(amounts in thousands) Balance Total
---------- ----------
Investments:
Portfolio assets:
Collateral for collateralized bonds $2,702,294 68 %
Mortgage securities:
Adjustable-rate mortgage securities 758,946 19
Fixed-rate mortgage 32,535 1
Other mortgage securities 100,556 3
Other portfolio assets 96,236 2
---------- -----------
3,690,567 93
Loans held for securitization 265,537 7
----------- --------
Total investments $ 3,956,104 100 %
========== =========
The Company continuously monitors the aggregate projected net yield of its
investment portfolio under various interest rate and prepayment environments.
While certain investments may perform poorly in an increasing interest rate
environment, certain investments may perform well, and others may not be
impacted at all. Generally, the Company adds investments to its portfolio which
are designed to increase the diversification and reduce the variability of the
yield produced by the portfolio in different interest rate environments. The
Company may add new types of investments to its portfolio in the future.
Approximately $3.2 billion of the Company's portfolio assets as of December
31, 1996 are comprised of loans or securities that have coupon rates which
adjust over time (subject to certain periodic and lifetime limitations) in
conjunction with changes in short-term interest rates. Generally, during a
period of rising interest rates, the Company's net interest spread earned on its
investment portfolio will decrease. The decrease of the net interest spread
results from (i) the lag in resets of the ARM loans underlying the ARM
securities and collateral for collateralized bonds relative to the rate resets
on the associated borrowings and (ii) rate resets on the ARM loans which are
generally limited to 1% every six months, while the associated borrowings have
no such limitation. As interest rates stabilize and the ARM loans reset, the net
interest margin may be restored to its former level as the yields on the ARM
loans adjust to market conditions. Conversely, net interest margin may increase
following a fall in short-term interest rates. This increase may be temporary as
the yields on the ARM loans adjust to the new market conditions after a lag
period. In each case, however, the Company expects that the increase or decrease
in the net interest spread due to changes in the short-term interest rates to be
temporary. The net interest spread may also be increased or decreased by the
cost or proceeds of interest rate swap, cap or floor agreements.
Because of the 1% periodic cap nature of the ARM loans underlying the ARM
securities, these securities may decline in market value in a rising interest
rate environment. In a rapidly increasing rate environment, as was experienced
in 1994, a decline in value may be significant enough to impact the amount of
funds available under repurchase agreements to borrow against these securities.
In order to maintain liquidity, the Company may be required to sell certain
securities. To mitigate this potential liquidity risk, the Company strives to
maintain excess liquidity to cover any additional margin required in a rapidly
increasing interest rate environment, defined as a 3% increase in short-term
interest rates over a twelve-month time period. The Company has also entered
into an interest rate swap transaction aggregating $1.02 billion notional
amount, which is designed to protect the Company's cash flow and earnings on the
ARM securities and certain collateral on collateralized bonds in a rapidly
rising interest rate environment. Under the terms of this interest rate swap
agreement, the Company receives payment if one-month LIBOR increases by 1% or
more in any six-month period. Finally, the Company has purchased $1.5 billion
notional of interest rate cap agreements to reduce the risk of the lifetime
interest rate limitation on the ARM securities and on certain collateralized
bonds owned by the Company. Liquidity risk also exists with all other
investments pledged as collateral for repurchase agreements, but to a lesser
extent.
The remaining portion of the Company's portfolio assets as of December 31,
1996, approximately $0.5 billion, are comprised of loans or securities that have
coupon rates that are either fixed or do not reset within the next 15 months.
The Company has limited its interest rate risk on such investments through (i)
the issuance of fixed-rate collateralized bonds and notes payable, (ii) interest
rate swap agreements (Company receives floating, pays fixed) and (iii) equity,
which in the aggregate totals approximately $0.8 billion as of the same date.
Overall, the Company's interest rate risk is primarily related to the rate of
change in short term interest rates, not the level of short term interest rates.
Investment in collateralized bonds. Collateral for collateralized bonds
represents the single largest investment in the Company's portfolio. Interest
margin on the net investment in collateralized bonds (defined as the principal
balance of collateral for collateralized bonds less the principal balance of the
collateralized bonds outstanding) is derived primarily from the difference
between (i) the cash flow generated from the mortgage collateral pledged to
secure the collateralized bonds and (ii) the amounts required for payment on the
collateralized bonds and related insurance and administrative expenses.
Collateralized bonds are generally non-recourse to the Company. The Company's
yield on its net investment in collateralized bonds is affected primarily by
changes in interest rates and prepayment rates and, to a lesser extent, credit
losses on the underlying loans. The Company may retain for its investment
portfolio certain classes of the collateralized bonds issued and pledge such
classes as collateral for repurchase agreements.
ARM securities. Another segment of the Company's portfolio is the
investments in ARM securities. The interest rates on the majority of the
Company's ARM securities reset every six months and the rates are subject to
both periodic and lifetime limitations. Generally, the repurchase agreements,
which finance a portion of the ARM securities, have a fixed rate of interest
over a term that ranges from 30 to 90 days and, therefore, are not subject to
repricing limitations. As a result, the net interest margin on the ARM
securities could decline if the spread between the yield on the ARM security
versus the interest rate on the repurchase agreement was to be reduced. The
Company may increase its return on equity by pledging the ARM securities as
collateral for repurchase agreements.
Fixed-rate mortgage securities. Fixed-rate mortgage securities consist of
securities that have a fixed-rate of interest for specified periods of time.
Certain fixed-rate mortgage securities have a fixed interest rate for the first
3, 5 or 7 years and an interest rate that adjusts at six- or twelve-month
intervals thereafter, subject to periodic and lifetime interest rate caps. The
Company's yields on these securities are primarily affected by changes in
prepayment rates. Such yields will decline with an increase in prepayment rates
and will increase with a decrease in prepayment rates. The Company generally
borrows against its fixed-rate mortgage securities through the use of repurchase
agreements.
Other mortgage securities. Other mortgage securities consist primarily of
interest-only securities (I/Os), principal-only securities (P/Os) and residual
interests which were either purchased or were created through the Company's
production operations. An I/O is a class of a collateralized bond or a mortgage
pass-through security that pays to the holder substantially all interest. A P/O
is a class of a collateralized bond or a mortgage pass-through security that
pays to the holder substantially all principal. Residual interests represent the
excess cash flows on a pool of mortgage collateral after payment of principal,
interest and expenses of the related mortgage-backed security or repurchase
arrangement. Residual interests may have little or no principal amount and may
not receive scheduled interest payments. Included in the residual interests at
December 31, 1996 was $53.5 million of equity ownership in residual trusts which
own collateral financed with repurchase agreements. The collateral consists
primarily of agency ARM securities. The Company's borrowings against its other
mortgage securities is limited by certain loan covenants to 3% of shareholders'
equity. The yields on these securities are affected primarily by changes in
prepayment rates and by changes in short-term interest rates.
Other portfolio assets. Other portfolio assets consists of an installment
note from Dominion received as part of the consideration for the sale of the
single-family mortgage operations, single-family homes leased to home builders
and other financing lease receivables. The installment note received totaled
$47.5 million in the aggregate and bears interest at a rate of 6.5%, which is
paid quarterly. The principal balance of the note is being paid in five equal
installments of $9.5 million which began January 2, 1997. The single-family
homes leased to builders at December 31, 1996 totaled $33.3 million. The leases
average twelve to eighteen months with the Company selling the home at the end
of the lease. The lease rates are typically based on one-month LIBOR plus a
spread.
Loans held for securitization. Loans held for securitization consist
primarily of loans originated or purchased through the Company's production
operations that have not been securitized. During the accumulation period, the
Company is exposed to risks of interest rate fluctuations and may enter into
hedging transactions to reduce the change in value of such loans caused by
changes in interest rates. The Company is also at risk for credit losses on
these loans during accumulation. This risk is managed through the application of
loan underwriting and risk management standards and procedures and the
establishment of reserves.
Hedging and other portfolio transactions. As part of its asset/liability
management process, the Company enters into interest rate agreements such as
interest rate caps and swaps and financial futures contracts ("hedges"). These
agreements are used to reduce interest rate risk which arises from the lifetime
interest rate caps on the ARM securities, the mismatched repricing of portfolio
investments versus borrowed funds and assets repricing on indices such as the
prime rate which are different than the related borrowing indices. The
agreements are designed to protect the portfolio's cash flow and to stabilize
the portfolio's yield profile in a variety of interest rate environments.
Risks
The Company is exposed to three types of risks inherent in its investment
portfolio. These risks include credit risk (inherent in the security structure),
prepayment/interest rate risk (inherent in the underlying loan) and margin call
risk (inherent in the security if it is used as collateral for borrowings). For
a discussion of credit risk, see "Credit Exposure" in "Management's Discussion
and Analysis of Financial Condition and Results of Operations". For
prepayment/interest rate risk and margin call risk, the Company has developed
analytical tools and risk management strategies to monitor and address these
risks, including (i) weekly mark-to-market of a representative basket of
securities within the portfolio, (ii) monthly analysis using advanced
option-adjusted spread (OAS) methodology to calculate the expected change in the
market value of various representative securities within the portfolio under
various extreme scenarios and (iii) monthly static cash flow and yield
projections under 49 different scenarios. Such tools allow the Company to
continually monitor and evaluate its exposure to these risks and to manage the
risk profile of the investment portfolio in response to changes in the risk
profile. While the Company may use such tools, there can be no assurance the
Company will accomplish the goal of adequately managing the risk profile
of the investment portfolio.
The Company also views its hedging activities as a tool to manage these
identified risks. For the risks associated with the periodic and lifetime
interest rate caps on the ARM securities and certain collateral for
collateralized bonds, the Company uses interest rate cap and interest rate swap
agreements. The purpose of these transactions is to protect the Company in the
event that interest rates increase to levels higher on the index than the
periodic and/or lifetime caps on the underlying ARM loans will allow the ARM
loans to reset. The caps effectively lift the lifetime cap on a portion of the
ARM securities and certain collateral for collateralized bonds in the Company's
portfolio while the various interest rate swap agreements limit the Company's
exposure to changes in the financing rates on a portion of these securities.
Eurodollar financial futures and options contracts may be utilized to hedge
the risks associated with financing a portion of the investment portfolio with
variable-rate repurchase agreements. These instruments synthetically lengthen
the duration of the repurchase agreement financing, typically from one month to
three and six months. The Company will receive additional cash flow if the
related Eurodollar index increases above the contracted rates. If, however, the
Eurodollar index decreases below contracted rates, the Company will pay
additional cash flow. As of December 31, 1996, the Company had lengthened the
duration of $1.0 billion of its repurchase agreements and certain collateralized
bonds to three months.
As the Company uses reverse repurchase agreements to finance a portion of
its ARM investment portfolio, the Company is exposed to liquidity risk in the
form of margin calls if the market value of the securities pledged as collateral
for the repurchase agreements decline. The Company has established equity
requirements for each type of investment to take into account the price
volatility and liquidity of each such investment. The Company models and plans
for the margin call risk related to its repurchase borrowings through the use of
its OAS model to calculate the projected change in market value of its
investments that are pledged as collateral for repurchase borrowings under
various adverse scenarios. The Company generally maintains enough immediate or
available liquidity to meet margin call requirements if short-term interest
rates increased by up to 300 basis points over a one-year period. As of December
31, 1996, the Company had total repurchase agreements outstanding of $756.4
million, secured by ARM securities, fixed-rate mortgage securities and other
mortgage securities at their market values of $757.4 million, $28.5 million and
$20.1million, respectively. The Company also has liquidity risk inherent to its
investment in certain residual trusts. These trusts are subject to margin calls
and the Company, at its option, can provide additional equity to the trust to
meet the margin call. Should the Company not provide the additional equity, the
assets of the trust could be sold to meet the trusts' obligations, resulting in
a potential loss to the Company.
During 1996, the Company structured all of its ARM loan securitizations as
collateralized bonds, with the financing, in effect, incorporated into the bond
structure. This structure eliminates the need for repurchase agreements,
consequently eliminating the margin call risk and to a lesser degree the
interest rate risk. During 1996, the Company issued approximately $2.04 billion
in collateralized bonds, primarily collateralized by ARM loans. The Company
plans to continue to use collateralized bonds as its primary securitization
vehicle.
Federal Income Tax Considerations
General
The Company and its qualified REIT subsidiaries (collectively Resource REIT)
believes it has complied and, intends to comply in the future, with the
requirements for qualification as a REIT under the Internal Revenue Code (the
Code). To the extent that Resource REIT qualifies as a REIT for federal income
tax purposes, it generally will not be subject to federal income tax on the
amount of its income or gain that is distributed to shareholders. However,
various subsidiaries of the Company, which conduct the production operations and
are included in the Company's consolidated financial statements prepared in
accordance with generally accepted accounting principles ("GAAP"), are not
qualified REIT subsidiaries. Consequently, all of the nonqualified REIT
subsidiaries' taxable income is subject to federal and state income taxes.
The REIT rules generally require that a REIT invest primarily in real
estate-related assets, its activities be passive rather than active and it
distribute annually to its shareholders substantially all of its taxable income.
The Company could be subject to a number of taxes if it failed to satisfy those
rules or if it acquired certain types of income-producing real property through
foreclosure. Although no complete assurances can be given, Resource REIT does
not expect that it will be subject to material amounts of such taxes.
Resource REIT's failure to satisfy certain Code requirements could cause the
Company to lose its status as a REIT. If Resource REIT failed to qualify as a
REIT for any taxable year, it would be subject to federal income tax (including
any applicable minimum tax) at regular corporate rates and would not receive
deductions for dividends paid to shareholders. As a result, the amount of
after-tax earnings available for distribution to shareholders would decrease
substantially. While the Board of Directors intends to cause Resource REIT to
operate in a manner that will enable it to qualify as a REIT in future taxable
years, there can be no certainty that such intention will be realized.
Qualification of the Company as a REIT
Qualification as a REIT requires that Resource REIT satisfy a variety of
tests relating to its income, assets, distributions and ownership. The
significant tests are summarized below.
Sources of Income
To qualify as a REIT in any taxable year, Resource REIT must satisfy three
distinct tests with respect to the sources of its income: the "75% income test,"
the "95% income test" and the "30% income test." The 75% income test requires
that Resource REIT derive at least 75% of its gross income (excluding gross
income from prohibited transactions) from certain real estate-related sources.
In order to satisfy the 95% income test, at least an additional 20% of
Resource REIT's gross income for the taxable year must consist either of income
that qualifies under the 75% income test or certain other types of passive
income.
The 30% income test, unlike the other income tests, prescribes a ceiling for
certain types of income. A REIT may not derive more than 30% of its gross income
from the sale or other disposition of (i) stock or securities held for less than
one year, (ii) dealer property that is not foreclosure property or (iii) certain
real estate property held for less than four years.
If Resource REIT fails to meet either the 75% income test or the 95% income
test, or both, in a taxable year, it might nonetheless continue to qualify as a
REIT, if its failure was due to reasonable cause and not willful neglect and the
nature and amounts of its items of gross income were properly disclosed to the
Internal Revenue Service. However, in such a case Resource REIT would be
required to pay a tax equal to 100% of any excess non-qualifying income. No
analogous relief is available to REITs that fail to satisfy the 30% income test.
Nature and Diversification of Assets
At the end of each calendar quarter, three asset tests must be met by
Resource REIT. Under the "75% asset test," at least 75% of the value of Resource
REIT's total assets must represent cash or cash items (including receivables),
government securities or real estate assets. Under the "10% asset test",
Resource REIT may not own more than 10% of the outstanding voting securities of
any single non-governmental issuer, if such securities do not qualify under the
75% asset test. Under the "5% asset test," ownership of any stocks or securities
that do not qualify under the 75% asset test must be limited, in respect of any
single non-governmental issuer, to an amount not greater than 5% of the value of
the total assets of Resource REIT.
If Resource REIT inadvertently fails to satisfy one or more of the asset
tests at the end of a calendar quarter, such failure would not cause it to lose
its REIT status, provided that (i) it satisfied all of the asset tests at the
close of a preceding calendar quarter and (ii) the discrepancy between the
values of Resource REIT's assets and the standards imposed by the asset tests
either did not exist immediately after the acquisition of any particular asset
or was not wholly or partially caused by such an acquisition. If the condition
described in clause (ii) of the preceding sentence was not satisfied, Resource
REIT still could avoid disqualification by eliminating any discrepancy within 30
days after the close of the calendar quarter in which it arose.
Distributions
With respect to each taxable year, in order to maintain its REIT status,
Resource REIT generally must distribute to its shareholders an amount at least
equal to 95% of the sum of its "REIT taxable income" (determined without regard
to the deduction for dividends paid and by excluding any net capital gain) and
any after-tax net income from certain types of foreclosure property minus any
"excess noncash income." The Code provides that distributions relating to a
particular year may be made early in the following year, in certain
circumstances. The Company will balance the benefit to the shareholders of
making these distributions and maintaining REIT status against their impact on
the liquidity of the Company. In an unlikely situation, it may benefit the
shareholders if the Company retained cash to preserve liquidity and thereby lose
REIT status.
For federal income tax purposes, Resource REIT is required to recognize
income on an accrual basis and to make distributions to its shareholders when
income is recognized. Accordingly, it is possible that income could be
recognized and distributions required to be made in advance of the actual
receipt of such funds by Resource REIT. The nature of Resource REIT's
investments is such that it expects to have sufficient cash to meet any federal
income tax distribution requirements.
Taxation of Distributions by the Company
Assuming that Resource REIT maintains its status as a REIT, any distributions
that are properly designated as "capital gain dividends" will generally be taxed
to shareholders as long-term capital gains, regardless of how long a shareholder
has owned his shares. Any other distributions out of Resource REIT's current or
accumulated earnings and profits will be dividends taxable as ordinary income.
Shareholders will not be entitled to dividends-received deductions with respect
to any dividends paid by Resource REIT. Distributions in excess of Resource
REIT's current or accumulated earnings and profits will be treated as tax-free
returns of capital, to the extent of the shareholder's basis in his shares and,
as gain from the disposition of shares, to the extent they exceed such basis.
Shareholders may not include on their own tax returns any of Resource REIT
ordinary or capital losses. Distributions to shareholders attributable to
"excess inclusion income" of Resource REIT will be characterized as excess
inclusion income in the hands of the shareholders. Excess inclusion income can
arise from Resource REIT's holdings of residual interests in real estate
mortgage investment conduits and in certain other types of mortgage-backed
security structures created after 1991. Excess inclusion income constitutes
unrelated business taxable income ("UBTI") for tax-exempt entities (including
employee benefit plans and individual retirement accounts) and it may not be
offset by current deductions or net operating loss carryovers. In the unlikely
event that the Company's excess inclusion income is greater than its taxable
income, the Company's distribution would be based on the Company's excess
inclusion income. In 1996 the Company's excess inclusion income was
approximately 7.9% of its taxable income. Although Resource REIT itself would be
subject to a tax on any excess inclusion income that would be allocable to a
"disqualified organization" holding its shares, Resource REIT's by-laws provide
that disqualified organizations are ineligible to hold Resource REIT's shares.
Dividends paid by Resource REIT to organizations that generally are exempt
from federal income tax under Section 501(a) of the Code should not be taxable
to them as UBTI except to the extent that (i) purchase of shares of Resource
REIT was financed by "acquisition indebtedness" or (ii) such dividends
constitute excess inclusion income.
Taxable Income
Resource REIT uses the calendar year for both tax and financial reporting
purposes. However, there may be differences between taxable income and income
computed in accordance with GAAP. These differences primarily arise from timing
differences in the recognition of revenue and expense for tax and GAAP purposes.
Additionally, Resource REIT's taxable income does not include the taxable income
of its taxable affiliate, although the affiliate is included in the Company's
GAAP consolidated financial statements. For the year ended December 31, 1996,
Resource REIT's estimated taxable income available to common shareholders was
approximately $51.4 million.
A portion of the dividends paid during 1996 was allocated to satisfy 1995
distribution requirements and a portion of the dividends paid in 1997 will be
allocated to satisfy 1996 distribution requirements. Approximately 94.4% of
dividends paid during 1996 represented ordinary income for federal tax purposes.
Regulation
As an approved mortgage and consumer loan originator, the Company is subject
to various federal and state regulations. A violation of such regulations may
result in the Company losing its ability to originate mortgage and consumer
loans in the respective jurisdiction.
The rules and regulations applicable to the production operations, among
other things, prohibit discrimination and establish underwriting guidelines that
include provisions for inspections and appraisals, require credit reports on
prospective borrowers and fix maximum loan amounts. Certain of the Company's
funding activities are subject to, among other laws, the Equal Credit
Opportunity Act, Federal Truth-in-Lending Act and the Real Estate Settlement
Procedures Act and the regulations promulgated thereunder that prohibit
discrimination and require the disclosure of certain basic information to
mortgagors concerning credit terms and settlement costs.
Additionally, there are various state and local laws and regulations
affecting the production operations. The production operations will be licensed
in those states requiring such a license. Production operations may also be
subject to applicable state usury statutes. The Company believes that it is in
present material compliance with all material rules and regulations to which it
is subject.
Competition
The Company competes with a number of institutions with greater financial
resources in originating and purchasing loans through their production
operations. In addition, in purchasing portfolio investments and in issuing
securities, the Company competes with investment banking firms, savings and loan
associations, banks, mortgage bankers, insurance companies and other lenders,
GNMA, FHLMC and FNMA and other entities purchasing mortgage assets, many of
which have greater financial resources than the Company. Additionally,
securities issued relative to its production operations will face competition
from other investment opportunities available to prospective purchasers.
Employees
As of December 31, 1996, the Company had 116 employees.
Item 2. PROPERTIES
The Company's executive and administrative offices and operations offices are
both located in Glen Allen, Virginia, on properties leased by the Company. The
address is 10900 Nuckols Road, Glen Allen, Virginia 23060.
Item 3. LEGAL PROCEEDINGS
There were no material pending legal proceedings, outside the normal course of
business, to which the Company was a party or of which any of its property was
subject at December 31, 1996.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company's stockholders during the
fourth quarter of 1996.
PART II
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company's common stock is traded on the New York Stock Exchange under the
trading symbol RMR. The Company's common stock was held by approximately 4,197
holders of record as of February 28, 1997. During the last two years, the high
and low closing stock prices and cash dividends declared on common stock were as
follows:
Cash Dividends
High Low Declared
----- ---- ---------
1996
First quarter $ 22 $18 3/4 $ 0.510
Second quarter 25 1/8 19 1/2 0.550
Third quarter 25 1/2 21 1/4 0.585
Fourth quarter 29 5/8 23 7/8 0.620
1995
First quarter $ 17 3/4 $ 10 3/8 $0.360
Second quarter 20 3/4 15 0.400
Third quarter 21 1/2 16 5/8 0.440
Fourth quarter 21 5/8 18 5/8 0.480
Item 6. SELECTED FINANCIAL DATA
(amounts in thousands except share data)
Years ended December 31, 1996 1995 1994 1993 1992
- ----------------------------------------------------------------------------------------------------------------------
Net interest margin $ 74,907 $ 42,419 $ 44,364 $ 40,627 $ 23,357
Gain on sale of single-family mortgage operations 17,285 - - - -
Net gain on sale of assets 503 9,651 27,723 27,977 28,941
Other income 1,116 2,963 1,454 734 426
General and administrative expenses 20,763 18,123 21,284 15,211 14,555
--------------- -------------- --------------- --------------- ---------------
Net income $ 73,048 $ 36,910 $ 52,257 $ 54,127 $ 38,169
=============== ============== =============== =============== ===============
Total revenue $ 330,971 $ 266,496 $ 256,483 $ 200,967 $ 179,455
=============== ============== =============== =============== ===============
Total expenses $ 257,923 $ 146,840 $ 141,286 $229,586 $ 204,226
=============== ============== =============== =============== ===============
Net income per common share
Primary $ 3.08 $ 1.70 $ 2.64 $ 3.12 $ 2.73
Fully-diluted (1) 2.96 - - - -
Dividends declared per share:
Common $ 2.265 $ 1.68 $ 2.76 $ 3.06 $ 2.60
Series A Preferred 2.375 1.17 - - -
Series B Preferred 2.375
0.42 - - -
Series C Preferred 0.600 -
- - -
Return on average common shareholders' equity (2) 21.6% 12.5% 19.2% 25.8% 27.7%
Principal balance of loans funded $ 1,475,461 $ 916,386 $ 2,861,443 $ 4,093,714 $5,334,174
As of December 31, 1996 1995 1994 1993 1992
- --------------------------------------------------------------------------------------------------------------------------
Portfolio assets: (3)
Collateral for Collateralized bonds $ 2,702,294 $1,028,935 $ 441,222 $ 434,698 571,567
Mortgage securities 892,037 2,149,416 2,579,759 2,300,949 1,401,578
Other 96,236 27,585 16,859 - -
Loans held for securitization 265,537 220,048 501,272 777,769 123,627
Total assets 3,987,457 3,490,038 3,600,596 3,726,762 2,239,656
Collateralized bonds (4) 2,519,708 949,139 424,800 561,441 432,677
Repurchase agreements 756,448 1,983,358 2,804,946 2,754,166 1,315,334
Total liabilities 3,483,840 3,135,215 3,403,125 3,473,730 2,062,219
Shareholders' equity (2) 439,215 359,582 270,149 177,437 253,032
Number of common shares outstanding 20,653,593 20,198,654 20,078,013 19,331,932 16,507,100
Book value per common share (2) $ 14.52 $ 13.50 $ 13.45 $ 13.09 $ 10.75
Number of employees 116 199 180 150 80
- ------------------------------------------------------------------------------------------------------------------------------
(1) Fully-diluted net income per common share is not presented for 1995 as the Company's cumulative
convertible preferred stock and Stock Appreciation Rights (SARs) outstanding are anti-dilutive.
Prior to 1995, no preferred stock was outstanding, and all SARs outstanding were anti-dilutive.
(2) Excludes unrealized gain/loss on investments available-for-sale.
(3) Collateral for collateralized bonds and mortgage securities are shown at fair value as of December 31, 1996, 1995 and
1994 and at amortized cost as of December 31, 1993 and prior.
(4) Substantially all of this debt is non-recourse to the Company.
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Resource Mortgage Capital, Inc. (the Company) is a mortgage and consumer finance
company which uses its production operations to create investments for its
portfolio. Currently, the Company's primary loan production operations include
the origination of mortgage loans secured by multi-family properties and the
origination of loans secured by manufactured homes. The Company will securitize
loans funded principally as collateral for collateralized bonds, limiting its
credit risk and providing long-term financing for those loans securitized. The
Company may also use other securitization vehicles for its loan production, such
as pass-through securities. The Company intends to expand its production sources
in the future to include other financial products, such as commercial real
estate loans. The majority of the Company's current investment portfolio is
comprised of loans or securities ("ARM loans" or "ARM securities") that have
coupon rates which adjust over time (subject to certain limitations) in
conjunction with changes in short-term interest rates. The Company has elected
to be treated as a real estate investment trust (REIT) for federal income tax
purposes and, as such, must distribute substantially all of its taxable income
to shareholders and will generally not be subject to federal income tax.
On May 13, 1996, the Company completed the sale of its single-family mortgage
operations to Dominion Mortgage Services, Inc. (Dominion), a wholly-owned
subsidiary of Dominion Resources, Inc., for $68 million. Included in the
single-family mortgage operations were the Company's single-family
correspondent, wholesale and servicing operations. The sale resulted in a net
gain of $17.3 million. Such amount included a provision of $31.0 million for
possible losses on single-family loans where the Company has retained a portion
of the credit risk and where, prior to the sale, the Company had serviced such
single-family loans.
The Company's principle source of earnings is net interest income on its
investment portfolio. The Company's investment portfolio consists principally of
collateral for collateralized bonds, ARM securities and loans held for
securitization. The Company funds its portfolio investments with both borrowings
and cash raised from the issuance of equity capital. For the portion of
portfolio investments funded with borrowings, the Company generates net interest
income to the extent that there is a positive spread between the yield on the
earning assets and the cost of borrowed funds. For that portion of the balance
sheet that is funded with equity capital, net interest income is primarily a
function of the yield generated from the interest-earning asset. The cost of the
Company's borrowings may be increased or decreased by interest rate swap, cap or
floor agreements.
Approximately $3.2 billion of the Company's investment portfolio as of December
31, 1996, is comprised of ARM loans or ARM securities. Generally, during a
period of rising interest rates, the Company's net interest spread earned on its
investment portfolio will decrease. The decrease of the net interest spread
results from (i) the lag in resets of the ARM loans underlying the ARM
securities and collateral for collateralized bonds relative to the rate resets
on the associated borrowings and (ii) rate resets on the ARM loans which are
generally limited to 1% every six months, while the associated borrowings have
no such limitation. As interest rates stabilize and the ARM loans reset, the net
interest margin may be restored to its former level as the yields on the ARM
loans adjust to market conditions. Conversely, net interest margin may increase
following a fall in short-term interest rates. However, this increase may be
temporary as the yields on the ARM loans adjust to the new market conditions
after a lag period. In each case, however, the Company expects that the increase
or decrease in the net interest spread due to changes in the short-term interest
rates is temporary. The net interest spread may also be increased or decreased
by the cost or proceeds of interest rate swap, cap or floor agreements.
The Company strives to create a diversified portfolio of investments that, in
the aggregate, generates stable income for the Company in a variety of interest
rate environments and preserves the capital base of the Company. The Company
seeks to generate growth in earnings and dividends per share in a variety of
ways, including (i) adding investments to its portfolio when opportunities in
the market are favorable; (ii) developing production capabilities to originate
and acquire financial assets in order to create attractively priced investments
for its portfolio, as well as control the underwriting and servicing of such
financial assets and (iii) increasing the efficiency with which the Company
utilizes its equity capital over time. To increase potential returns to
shareholders, the Company also employs leverage through the use of secured
borrowings and repurchase agreements to fund a portion of its portfolio
investments. Currently, the Company's production operations are comprised of
multi-family and manufactured housing lending. The Company's strategy is to
expand these existing production sources as well as to diversify into other
financial products such as commercial real estate loans. The Company also
intends to selectively purchase single-family loans in bulk with the intent to
securitize such loans as collateral for collateralized bonds. By pursuing these
strategies, the Company believes it can create investments for the portfolio at
a lower effective cost than if investments of comparable risk profiles were
purchased in the market, although there can be no assurance that the Company
will be successful in accomplishing this strategy.
In order to grow its equity base, the Company may issue additional shares of
preferred or common stock. Management strives to issue such additional shares
when it believes existing shareholders are likely to benefit from such offerings
through higher earnings and dividends per share than as compared to the level of
earnings and dividends the Company would likely generate without such offerings.
On August 30, 1996, the Company acquired Multi-Family Capital Markets, Inc.
(MCM), which specializes in the sourcing, underwriting and closing of
multi-family loans secured by first liens on apartment properties that have
qualified for low income housing tax credits. The Company acquired all of the
outstanding stock and assets of MCM for $4.0 million. The Company believes this
acquisition will complement its current strategy of expanding its multi-family
lending business and will improve its competitive position in the marketplace
for such loans.
RESULTS OF OPERATIONS
- ---------------------------------------------------------------------------
For the Year Ended December 31,
----------------------------------------
(amounts in thousands except per 1996 1995 1994
share information)
- ---------------------------------------------------------------------------
Net interest margin $ 74,907 $ 42,419 $ 44,364
Gain on sale of single-family 17,285 - -
mortgage operations
Gain on sale of assets, net 503 9,651 27,723
General and administrative expenses 20,763 18,123 21,284
Net income 73,048 36,910 52,257
Primary net income per common share 3.08 1.70 2.64
Fully-diluted net income per 2.96 - (1) - (1)
common share
Principal balance of loans
funded through production operations 744,001 893,953 2,861,443
Dividends declared per share:
Common $ 2.27 $ 1.68 $ 2.76
Series A Preferred 2.38 1.17 -
Series B Preferred 2.38 0.42 -
Series C Preferred 0.60 - -
- -----------------------------------------------------------------------------
(1) Fully-diluted net income per common share is not presented in 1995 as the
Company's cumulative convertible preferred stock and Stock Appreciation Rights
(SARs) outstanding are anti-dilutive. In 1994, no preferred stock was
outstanding, and all SARs outstanding were anti-dilutive.
1996 Compared to 1995. The increase in the Company's net income and net income
per common share during 1996 as compared to 1995 is primarily the result of the
increase in net interest margin and the gain on the sale of the single-family
operations. This increase was offset partially by a decline in the gain on sale
of assets and an increase in general and administrative expenses.
Net interest margin for 1996 increased to $74.9 million, or 76.6%, over net
interest margin of $42.4 million for 1995. This increase was a result of an
overall increase in the net interest spread on all interest-earning assets which
increased to 1.58% for 1996 versus 1.06% for 1995, as well as the increased
contribution from the net investment in collateralized bonds. The increase in
the net interest spread is attributable to the ARM securities being
fully-indexed during 1996, and the more favorable interest rate environment on
both collateralized bonds and borrowings related to the ARM securities. During
1995, as a result of rising short-term rates during both 1994 and early 1995,
the Company's ARM securities were generally not fully-indexed throughout the
year.
The sale of the Company's single-family mortgage operations in 1996 generated a
net gain of $17.3 million. Previously, the single-family mortgage operations had
contributed to the Company's earnings through the securitization and sale of
loans funded through its production activities, recorded as gain on sale of
assets. In 1995, the Company recorded a net gain on sale of assets related to
the securitization and sale of loans amounting to $4.7 million. No gain on
securitization or sale of loans was recorded in 1996. Net gain on sale of assets
during 1996 resulted primarily from the sale of certain portfolio assets
totaling approximately $2.0 million, offset partially by the write-down of
certain assets for permanent impairment of $1.5 million. In 1995, the Company
sold portfolio assets for a net gain of $3.8 million and recorded no
write-downs. The Company also sold previously purchased mortgage servicing
rights in 1995 for a gain of $1.2 million.
General and administrative expenses increased $2.6 million, or 14.6%, to $20.8
million in 1996, as the Company continued building its infrastructure for its
manufactured housing operations. General and administrative expenses also
increased from 1995 as a result of the Company's continued expansion of its
wholesale origination capabilities for its single-family mortgage operations
prior to their sale. The Company continues to expand its manufactured housing
operations, and in August 1996, acquired MCM to expand its multi-family and
commercial real estate lending businesses. Currently the Company retains the
servicing for all loans funded through its production operations. The growth of
the production operations should continue to cause general and administrative
expenses to increase in 1997.
1995 Compared to 1994. The decrease in the Company's earnings during 1995 as
compared to 1994 is primarily the result of the decrease in net gain on sale of
assets and the decrease in net interest margin. These decreases were partially
offset by a decrease in general and administrative expenses.
Net gain on sale of assets decreased $18.0 million, or 65.2%, to $9.7 million in
1995 from $27.7 million in 1994. This decrease resulted from the combined effect
of (i) the Company's change in securitization strategy in 1995 to the issuance
of collateralized bonds which are accounted for as financing transactions,
versus the use of pass-through mortgage security structures in 1994, which are
accounted for as sales, (ii) the lower mortgage loan funding levels by the
Company as a result of a decrease in overall industry-wide mortgage loan
originations, resulting from a higher level of price competition for mortgage
loans and (iii) the flatter yield curve, which had an adverse impact on the
Company's production of ARM loans.
Net interest margin decreased $2.0 million, or 4.4%, to $42.4 million in 1995
from $44.4 million for 1994. This decrease resulted primarily from the change in
the net interest spread on the interest-earning assets, which declined from
1.12% in 1994 to 1.06% in 1995. The decline in net interest spread was
attributable to a temporary reduction in the net interest spread in ARM
securities. This temporary reduction resulted from the interest rate on
borrowings increasing at a faster rate than the ARM securities which
collateralize these borrowings. In December 1995, the net interest spread had
increased to 1.18% as a result of the upward resets on the ARM securities and
the more favorable short-term interest rate environment. Net interest margin
also declined as a result of the increase in the provision for credit losses,
which was $2.9 million and $2.1 million in 1995 and 1994, respectively.
General and administrative expenses decreased 14.9%, to $18.1 million for 1995
from $21.3 million for 1994. This decline resulted primarily from the Company's
effort to reduce costs in line with the reduced level of mortgage loan
originations.
The following table summarizes the average balances of the Company's
interest-earning assets and their average effective yields, along with the
Company's average interest-bearing liabilities and the related average effective
interest rates, for each of the periods presented.
Average Balances and Effective Interest Rates
- --------------------------------------------------------------------------------------------------------------------------
Year Ended December 31,
------------------------------------------------------------------------------
(amounts in thousands) 1996 1995 1994
------------------------ ------------------------- -------------------------
Average Effective Average Effective Average Effective
Balance Rate Balance Rate Balance Rate
-------------- --------- ------------- ---------- -------------- ----------
Interest-earning assets: (1)
Collateral for collateralized bonds(2)(3) $ 1,832,141 8.11 % $ 711,316 8.58 % $ 375,147 8.99
Adjustable-rate mortgage securities 1,741,169 6.76 2,137,170 6.81 2,310,047 5.39
Fixed-rate mortgage securities 38,025 10.75 94,102 7.87 205,305 7.31
Other mortgage securities 53,194 14.00 56,644 15.61 72,934 19.76
Other portfolio assets 57,114 8.23 25,403 10.38 8,093 9.45
Loans held for securitization 354,216 8.31 331,995 8.54 602,517 6.45
----------- ----- ------------- ------- -------------- --------
Total interest-earning assets $ 4,075,859 7.66 % $ 3,356,630 7.56 % $ 3,574,043 6.36 %
============== ====== ============= ======= ============== ========
Interest-bearing liabilities:
Collateralized bonds (3) $ 1,742,054 6.50 % $ 679,551 7.21 % $ 380,099 8.28 %
Repurchase agreements:
Adjustable-rate mortgage 1,651,507 5.55 1,986,872 6.20 2,179,775 4.67
securities
Fixed-rate mortgage securities 31,156 5.67 78,486 5.54 192,738 5.23
Other mortgage securities 8,967 5.66 6,392 6.32 6,722 5.00
Loans held for securitization 164,664 6.22 184,910 7.34 6,805 5.98
Notes payable:
Other portfolio assets 1,241 10.42 11,329 8.78 422,979 5.25
Loans held for securitization 65,065 5.13 89,776 6.76 62,078 8.27
Commercial paper - - - - 55,353 3.59
=========== ===== =========== ======= =========== =====
Total interest-bearing liabilities $ 3,664,654 6.08 % $3,037,316 6.50 % $3,306,549 5.24%
============== ====== =========== ======= ============ =======
Net interest spread on all investments(3) 1.58 % 1.06 % 1.12 %
====== ======= ========
Net yield on average interest-earning assets 2.19 % 1.68 % 1.51 %
====== ======= ========
(1) Average balances exclude adjustments made in accordance with Statement of Financial Accounting
Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities", to record available
for sale securities at fair value.
(2) Average balances exclude funds held by trustees of $2,839, $3,815, and $8,855 for the years ended
December 31, 1996, 1995 and 1994, respectively.
(3) Effective rates are calculated excluding non-interest related collateralized bond expenses and provision
for credit losses.
1996 compared to 1995. The increase in net interest spread for 1996 relative to
1995 is primarily the result of the increase in the spread on ARM securities and
an increase in the average balance and spread on the net investment in
collateralized bonds, which for 1996, constituted the largest portion of the
Company's investment portfolio on a weighted average basis. The net interest
spread benefited as a result of the declining short-term interest rate
environment during the first part of 1996, which had the impact of reducing the
Company's borrowing costs faster than it reduced the yields on the Company's
interest-earning assets. The Company's overall weighted average borrowing costs
decreased to 6.08% for 1996 from 6.50% for 1995. The overall yield on
interest-earning assets increased to 7.66% from 7.56% as the Company's portfolio
became more heavily weighted in collateral for collateralized bonds which have
higher effective rates than ARM securities. Collateral for collateralized bonds
increased to an average $1.8 billion for the year ended December 31, 1996, or
158%, from an average $711.3 million for the year ended December 31, 1995. The
net interest spread on the net investment in collateralized bonds increased 24
basis points, from 1.37% for 1995, to 1.61% for 1996. The net interest spread on
ARM securities increased 60 basis points, from 0.61% for 1995 to 1.21% for 1996.
As rates stabilized in the latter half of 1996, the ARM securities and ARM loans
reset downward, causing the net interest spread on these assets to narrow in the
third and fourth quarters of 1996.
1995 compared to 1994. The net interest margin on the Company's investment
portfolio decreased slightly to $42.4 million for 1995 from $44.4 million for
1994. The decrease in net interest margin on the Company's investment portfolio
is generally attributable to a decrease in the spread on such investments during
1995, which was partially offset by a net increase in capital invested by the
Company in the portfolio. The spread on the Company's investment portfolio
decreased from 1.12% for 1994 to 1.06% for 1995. Specifically, the spread on the
Company's ARM securities decreased from 0.72% for 1994 to 0.61% for 1995,
principally as a result of increased repurchase agreement borrowing costs. This
decline was offset by the increase in the spread on the net investment in
collateralized bonds, which increased to 1.37% in 1995 from 0.71% in 1994. The
increase in the net interest spread for the net investment in collateralized
bonds resulted principally from lower financing costs in 1995. The average
balance of collateral for collateralized bonds increased to $711.3 million for
1995 from $375.1 million for 1994, consistent with the Company's current
securitization strategy, while the average balance for ARM securities declined
from $2.3 billion in 1994 to $2.1 billion in 1995.
The following tables summarize the amount of change in interest income and
interest expense due to changes in interest rates versus changes in volume:
1996 to 1995 1995 to 1994
------------------------------------- -------------------------------------
(amounts in thousands) Rate Volume Total Rate Volume Total
----------- ------------ ----------- ------------ ----------- ------------
Collateral for collateralized bonds $ (3,102) $ 90,770 $ 87,668 $ (1,469) $ 28,757 $ 27,288
Adjustable-rate mortgage securities (1,143) (26,782) (27,925) 29,423 (8,349) 21,074
Fixed-rate mortgage securities 5,293 (8,608) (3,315) 1,254 (8,850) (7,596)
Other mortgage securities (878) (518) (1,396) (2,702) (2,871) (5,573)
Other portfolio assets (411) 2,474 2,063 82 1,790 1,872
Loans held for securitization (723) 1,813 1,090 27,404 (37,893) (10,489)
------------ ----------- ------------------------ ------------ ------------
Total interest income (964) 59,149 58,185 53,992 (27,416 ) 26,576
------------ ----------- ------------------------ ------------ ------------
Collateralized bonds (4,314) 68,547 64,233 (3,433) 20,959 17,526
Repurchase agreements:
Adjustable-rate mortgage securities (11,449) (18,501) (29,950) 29,315 (7,913) 21,402
Fixed-rate mortgage securities 102 (2,657) (2,555) 642 (6,375) (5,733)
Other mortgage securities (39) 151 112 84 (16) 68
Loans held for securitization (1,851) (1,319) (3,170) 20,844 (29,484) (8,640)
Notes payable:
Other portfolio assets 222 (1,086) (864) 243 345 588
Loans held for securitization (1,246) (1,426) (2,672) (648 ) 1,580 932
Commercial paper - - - - (1,986) (1,986)
Total interest expense (18,575) 43,709 25,134 47,047 (22,890) 24,157
------------ ----------- ------------------------ ------------ ------------
Net interest income $ 17,611 $ 15,440 $ 33,051 $ 6,945 $ (4,526) $ 2,419
============ =========== ======================== ============ ============
Note: The change in interest income and interest expense due to changes in both volume and rate, which cannot
be segregated, has been allocated proportionately to the change due to volume and the change due to rate. This
table excludes other interest expense and provision for credit losses.
PORTFOLIO RESULTS
The Company's investment strategy is to create a diversified portfolio of
securities that, in the aggregate, generates stable income in a variety of
interest rate and prepayment rate environments and preserves the capital base of
the Company. The Company has pursued its strategy of concentrating on its
production activities to create investments with attractive yields. In many
instances, the Company's investment strategy has involved not only the creation
or acquisition of the asset, but also the related long-term, non-recourse
borrowings such as through the issuance of collateralized bonds.
Interest Income and Interest-Earning Assets
The Company's average interest-earning assets grew to $4.1 billion during the
year ended December 31, 1996, an increase of 21% from $3.4 billion of average
interest-earning assets during the year ended December 31, 1995. Average
interest-earning assets at December 31, 1995, decreased slightly from $3.6
billion during the year ended December 31, 1994 as a result of the sale of $0.6
billion of securities during 1995. Total interest income rose 23%, from $253.9
million during the year ended December 31, 1995, to $312.1 million during the
same period of 1996. Total interest income had also risen $26.6 during 1995 from
$227.3 million during the year ended December 31, 1994. Overall, the yield on
average interest-earning assets rose to 7.66% for the year ended December 31,
1996, from 7.56% and 6.36% for the years ended December 31, 1995 and 1994,
respectively. This increase resulted from the ARM securities resetting upwards
to become fully-indexed and the investment in higher yielding collateral for
collateralized bonds continuing to grow. As indicated in the table below, the
average yields were 2.07%, 1.46% and 1.28% higher than the average daily
six-month LIBOR interest rate during 1996, 1995 and 1994, respectively. The
majority of the ARM loans underlying the Company's ARM securities and collateral
for collateralized bonds are indexed to and reset based upon the level of the
London InterBank Offered Rate (LIBOR) for six-month deposits (six-month LIBOR).
Earning Asset Yield
($ in millions)
- -------------- --------------- -- ------------- --- -------------- ---- ------------------ ---------------
Average Asset Yield
Interest-Earning Interest Average Daily Average versus Six
Assets Income Asset Yield Six Month Month LIBOR
- -------------- --------------- -- ------------- --- -------------- ---- ------------------ ---------------
1994 $ 3,574.0 $ 227.3 6.36% 5.08% 1.28%
1995 3,356.6 253.9 7.56% 6.10% 1.46%
1996 4,075.9 312.1 7.66% 5.59% 2.07%
- -------------- -- ------------ --- ------------ --- -------------- ---- ------------------ ---------------
The net yield on average interest-earning assets increased to 2.19% for the year
ended December 31, 1996, compared to 1.68% and 1.51% for the year ended December
31, 1995 and 1994, respectively. This increase is principally due to the
increase in the spread earned on the interest-earning assets, despite an
increase in average interest-earning assets to $4.1 billion for the year ended
December 31, 1996, from $3.4 billion in 1995. Average interest-earning assets
may continue to increase as the Company retains loans funded through its
production operations as collateral for collateralized bonds. Net yield on
average interest-earning assets may decrease as a result. Net yield as a
percentage of net average assets (defined as interest-earning assets less
non-recourse collateralized bonds issued), was 3.16% for the year ended December
31, 1996, versus 1.81% and 1.51% for the same periods in 1995 and 1994,
respectively. Net yield as a percentage of net average assets is expected to
increase due to the continued use of non-recourse collateralized bonds. The net
yield percentages presented below exclude non-interest related expenses such as
provision for credit losses and interest on senior notes payable. For the years
ended December 31, 1996, 1995 and 1994, if these expenses were included, the net
yield on average interest-earning assets would be 1.84%, 1.26% and 1.24%,
respectively and the net yield on net average assets would be 2.65%, 1.36% and
1.24%, respectively.
Net Yield on Average Interest-Earning Assets
($ in millions)
- ----------------- ----------------- --- ---------------- -- --------------- -- ----------------
Net Yield on
Average Average Net Yield on
Interest-Earning Interest-Earning Net Average Net Average
Assets Assets Assets (1) Assets
- ----------------- ----------------- --- ---------------- -- --------------- -- ----------------
1994 $ 3,574.0 1.51% $ 3,574.0 1.51%
1995 3,356.6 1.68% 3,110.2 1.81%
1996 4,075.9 2.19% 2,825.0 3.16%
- ----------------- -- -------------- --- ---------------- -- --------------- -- ----------------
(1) Average interest-earning assets less non-recourse collateralized bonds.
The average asset yield is reduced for the amortization of premiums, net of
discounts on the Company's investment portfolio. By creating its investments
through its production operations, the Company believes that premium amounts are
less than if the investments were acquired in the market. As indicated in the
table below, premiums on the Company's ARM securities, fixed-rate securities and
collateral for collateralized bonds at December 31, 1996 were $54.1 million, or
approximately 1.60% of the aggregate investment portfolio balance. The mortgage
principal repayment rate for the Company (indicated in the table below as "CPR
Annualized Rate") was 24% for the year ended December 31, 1996. The Company
expects that the long-term prepayment speeds will range between 18% and 24%. CPR
stands for "constant prepayment rate" and is a measure of the annual prepayment
rate on a pool of loans.
Premium Basis and Amortization
($ in millions)
- --------------------------------------------------------------------------------
Amortization
Ending Expense
CPR Investment as a % of
Net Amortization Annualized Principal Average
Premium Expense Rate Balance Assets
- --------------------------------------------------------------------------------
1994 $ 37.2 $ 5.6 (1) $ 2,975.0 0.16%
1995 46.6 7.9 (1) 3,048.9 0.24%
1996 54.1 13.8 24% 3,379.0 0.34%
- --------------------------------------------------------------------------------
(1) CPR rates were not available for those periods.
Interest Expense and Cost of Funds
The Company's largest expense is the interest cost on borrowed funds. Funds to
finance the investment portfolio are borrowed primarily in the form of
collateralized bonds or repurchase agreements, both of which are primarily
indexed to LIBOR, principally one-month LIBOR. For the year ended December 31,
1996, interest expense increased to $222.7 million from $197.5 million for the
year ended 1995, while the average cost of funds decreased to 6.08% for 1996
compared to 6.50% for 1995. The Company's cost of funds rose in conjunction with
the increase in the one-month LIBOR rate through the second quarter of 1995 and
then began to decline correspondingly with the decline in interest rates since
that time. The cost of funds for the year ended December 31, 1995, compared to
1994, increased as a result of the low interest rates during the first half of
1994 compared to the rapidly rising interest rates during the first half of
1995.
The Company may use interest rate swaps, caps and financial futures to manage
its interest rate risk. The net costs during the related period of these
instruments are included in the cost of funds table below.
Cost of Funds
($ in millions)
- -------------------------------------------------------------------------
Cost of
GAAP Funds
Average Interest Cost Average versus
Borrowed Expense of One-month One-month
Funds (a) Funds LIBOR LIBOR
- -------------------------------------------------------------------------
1994 $3,306.5 $173.4 5.24% 4.47% 0.77%
1995 3,037.3 197.5 6.50% 5.97% 0.53%
1996 3,664.7 222.7 6.08% 5.45% 0.63%
- -------------------------------------------------------------------------
(a) Excludes non-interest-related expenses and interest on non-portfolio
related notes payable.
Interest Rate Agreements
As part of its asset/liability management process, the Company enters into
interest rate agreements, such as interest rate caps and swaps, and financial
futures contracts ("hedges"). These agreements are used to reduce interest rate
risk which arise from the lifetime yield caps on the ARM securities, the
mismatched repricing of portfolio investments versus borrowed funds and assets
repricing on indices such as the prime rate which are different than the related
borrowing indices, primarily one-month LIBOR. The agreements are designed to
protect the portfolio's cash flow and to provide income and capital appreciation
to the Company in the event that short-term interest rates rise quickly.
The following table includes all interest rate agreements in effect at December
31, 1996, 1995 and 1994 for asset/liability management of the investment
portfolio. This table excludes all hedge agreements in effect for the Company's
production operations. Generally, interest rate swaps and caps are used to
manage the interest rate risk associated with assets that have periodic and
annual reset limitations financed with borrowings that have no such limitations.
Financial futures contracts and options on futures are used to effectively
lengthen the terms of repurchase agreement financing, generally from one month
to three and six months. There were no financial futures contracts and options
on futures outstanding at December 31, 1996. The average notional amount of
futures and options on futures outstanding during 1996 were $738 million and
$533 million, respectively. Amounts presented are aggregate notional amounts. To
the extent any of these agreements are terminated, gains and losses are
generally amortized over the remaining period of the original agreement.
Instruments Used for Interest Rate Risk Management Purposes(1)
($ in millions)
- --------------------------------------------------------------------
Notional Interest Interest Financial Options on
Amounts Rate Caps Rate Swaps Futures Futures
- --------------------------------------------------------------------
1994 $ 1,475 $ - $ - $ -
1995 1,575 1,227 1,000 2,130
1996 1,499 1,453 - -
- --------------------------------------------------------------------
(1) Excludes all hedge agreements in effect for the Company's production
operations.
Net Interest Rate Agreement Expense
The net interest rate agreement expense, or hedging expense, equals the
expenses, net of any benefits received, from these agreements. For the year
ended December 31, 1996, net hedging expense amounted to $6.62 million versus
$3.70 million and $0.40 million for the years ended December 31, 1995 and 1994,
respectively. Such amounts exclude the hedging costs and benefits associated
with the Company's production activities as these amounts are deferred as
additional premium or discount on the loan funded and amortized over the life of
the loan as an adjustment to its yield. The increase in net interest rate
agreement expense for 1996 compared to 1995 is primarily the result of the
addition of an interest rate swap agreements to reduce the Company's exposure to
basis risk for certain collateral for collateralized bonds and to cap the
borrowing costs during any six-month period for a portion of the short-term
borrowings. The increase in the net interest rate agreement expense for 1995
compared to 1994 is due primarily to the addition of an interest rate swap
agreement entered into to reduce the interest rate risk on fixed-rate loans in
the collateral for collateralized bonds.
Net Interest Rate Agreement Expense
($ in millions)
- --------------------------------------------------------------------
Net Expense Net Expense as
Net Interest as Percentage Percentage of
Rate of Average Average
Agreement Assets Borrowings
Expense (annualized) (annualized)
- --------------------------------------------------------------------
1994 $ 0.40 0.011% 0.012%
1995 3.70 0.110% 0.122%
1996 6.62 0.162% 0.181%
- --------------------------------------------------------------------
Fair value
The fair value of the available-for-sale portion of the Company's investment
portfolio as of December 31, 1996, as measured by the net unrealized gain on
investments available-for-sale, was $64.4 million above its amortized cost
basis, which represents a $69.2 million improvement from December 31, 1995. At
December 31, 1995, the fair value Company's investment portfolio was below its
amortized cost basis by $4.8 million. This increase in the portfolio's value is
primarily attributable to the increase in the value of the collateral for
collateralized bonds relative to the collateralized bonds issued during the last
twelve months, as well as an increase in value of the Company's ARM securities
due principally to the ARM securities being fully-indexed. The portfolio also
benefited from the stabilization of interest rates and the reduction in
amortized cost basis of its investments through additional provision for losses.
At December 31, 1994, the fair value of the Company's available-for-sale
investments was $72.7 million below its amortized cost basis, reflecting
market-place volatility due to the rapid increase in short-term interest rates
at the time.
Credit Exposures
The Company has historically securitized its loan production in pass-through or
collateralized bonds securitization structures. With either structure, the
Company may use overcollateralization, subordination, reserve funds, bond
insurance, mortgage pool insurance or any combination of the foregoing for
credit enhancement. Regardless of the form of credit enhancement, the Company
may retain a limited portion of the direct credit risk after securitization.
This risk can include risk of loss related to hazards not covered under standard
hazard insurance policies and credit risks on loans not covered by standard
borrower mortgage insurance, or pool insurance.
Beginning in 1994, the Company issued pass-through securities which used
subordination structures as their form of credit enhancement. The credit risk of
subordinated pass-through securities is concentrated in the subordinated classes
(which may themselves partially be credit enhanced with reserve funds or pool
insurance) of the securities, thus allowing the senior classes of the securities
to receive the higher credit rating. To the extent credit losses are greater
than expected (or exceed the protection provided by any reserve funds or pool
insurance), the holders of the subordinated securities will experience a lower
yield (which may be negative) than expected on their investments. At December
31, 1996, the Company retained $19.4 million in aggregate principal amount of
subordinated securities, which are carried at a value of $2.1 million,
reflecting such potential credit loss exposure.
With collateralized bond structures, the Company also retains credit risk
relative to the amount of overcollateralization required in conjunction with the
bond insurance. Losses are generally first applied to the overcollateralization
amount, with any losses in excess of that amount borne by the bond insurer or
the holders of the various classes of the collateralized bonds. The Company only
incurs credit losses to the extent that losses are incurred in the repossession,
foreclosure and sale of the underlying collateral. Such losses generally equal
the excess of the principal amount outstanding plus servicer advances, less any
proceeds from mortgage or hazard insurance, over the liquidation value of the
collateral. To compensate the Company for retaining this loss exposure, the
Company generally receives an excess yield on the collateralized loans relative
to the yield on the collateralized bonds. At December 31, 1996, the Company
retained $88.0 million in aggregate principal amount of overcollateralization
and had reserves, or otherwise had provided covera