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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
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For the quarter ended June 30, 2003 Commission file number 1-10360
CRIIMI MAE INC.
(Exact name of registrant as specified in its charter)
Maryland 52-1622022
(State or other jurisdiction of (I.R.S. Employer
Incorporation or organization) Identification No.)
11200 Rockville Pike
Rockville, Maryland 20852
(301) 816-2300
(Address, including zip code, and telephone number,
including area code, of registrant's principal executive offices)
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Securities Registered Pursuant to Section 12(b) of the Act:
Name of each exchange on
Title of each class which registered
- ------------------- ------------------------------
Common Stock New York Stock Exchange, Inc.
Series B Cumulative Convertible New York Stock Exchange, Inc.
Preferred Stock
Series F Redeemable Cumulative Dividend New York Stock Exchange, Inc.
Preferred Stock
Series G Redeemable Cumulative Dividend New York Stock Exchange, Inc.
Preferred Stock
Securities Registered Pursuant to Section 12(g) of the Act:
None
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Sections 12, 13 or 15 (d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes [X] No[ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [X] No [ ]
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
Class Outstanding as of August 12, 2003
----- ---------------------------------
Common Stock, $0.01 par value 15,204,985
2
CRIIMI MAE INC.
Quarterly Report on Form 10-Q
Page
PART I. Financial Information
Item 1. Financial Statements
Consolidated Balance Sheets as of June 30, 2003
(unaudited) and December 31, 2002............................. 3
Consolidated Statements of Income for the three months and six
months ended June 30, 2003 and 2002 (unaudited)............... 4
Consolidated Statements of Changes in Shareholders' Equity
for the six months ended June 30, 2003 (unaudited)............ 5
Consolidated Statements of Cash Flows for the six
months ended June 30, 2003 and 2002 (unaudited)............... 6
Notes to Consolidated Financial Statements (unaudited)......... 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations........................... 39
Item 3. Quantitative and Qualitative Disclosures about Market Risk..... 66
Item 4. Controls and Procedures........................................ 68
PART II. Other Information
Item 4. Submission of Matters to a Vote of Security Holders ........... 69
Item 6. Exhibits and Reports on Form 8-K............................... 69
Signature ............................................................... 71
3
PART I
ITEM 1. FINANCIAL STATEMENTS
CRIIMI MAE INC.
CONSOLIDATED BALANCE SHEETS
June 30, December 31,
2003 2002
---------------------- ----------------------
(Unaudited)
Assets:
Mortgage assets:
Subordinated CMBS pledged to secure recourse debt, at fair value $ 533,553,192 $ 535,507,892
CMBS pledged to secure Securitized Mortgage
Obligation - CMBS, at fair value 339,661,921 326,472,580
Other MBS, at fair value 2,510,958 5,247,771
Insured mortgage securities, at fair value 221,185,172 275,340,234
Equity investments 5,101,234 6,247,868
Other assets 27,886,513 24,987,348
Receivables 14,881,924 16,293,489
Servicing other assets 8,342,242 13,775,138
Servicing cash and cash equivalents 3,728,241 12,582,053
Other cash and cash equivalents 8,912,224 16,669,295
Restricted cash and cash equivalents - 7,961,575
------------------- - -------------------
Total assets $ 1,165,763,621 $ 1,241,085,243
=================== ===================
Liabilities:
Bear Stearns variable rate secured debt $ 298,750,000 $ -
BREF senior subordinated secured note 31,266,667 -
Securitized mortgage obligations:
Collateralized bond obligations-CMBS 287,092,325 285,844,933
Collateralized mortgage obligations-
insured mortgage securities 204,312,861 252,980,104
Mortgage payable 7,273,309 7,214,189
Payables and accrued expenses 10,363,786 26,675,724
Servicing liabilities 877,202 756,865
Exit variable-rate secured borrowing - 214,672,536
Series A senior secured notes - 92,788,479
Series B senior secured notes - 68,491,323
------------------- -------------------
Total liabilities 839,936,150 949,424,153
------------------- -------------------
Shareholders' equity:
Preferred stock, $0.01 par; 75,000,000 shares
authorized; 3,424,992 shares issued and outstanding 34,250 34,250
Common stock, $0.01 par; 300,000,000 shares
authorized; 15,201,685 and 13,945,068 shares
issued and outstanding, respectively 152,017 139,451
Accumulated other comprehensive income 121,445,455 102,122,057
Deferred compensation - (19,521)
Warrants outstanding 2,564,729 -
Additional paid-in capital 630,762,116 619,197,711
Accumulated deficit (429,131,096) (429,812,858)
------------------- -------------------
Total shareholders' equity 325,827,471 291,661,090
------------------- -------------------
Total liabilities and shareholders' equity $ 1,165,763,621 $ 1,241,085,243
=================== ===================
The accompanying notes are an integral part of these consolidated
financial statements.
4
CRIIMI MAE INC.
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
For the three For the six
months ended June 30, months ended June 30,
2003 2002 2003 2002
--------------- -------------- --------------- --------------
Interest income:
CMBS $ 22,113,768 $ 25,600,119 $ 44,185,745 $ 51,136,504
Insured mortgage securities 4,275,108 6,143,229 8,927,001 12,638,723
--------------- -------------- --------------- --------------
Total interest income 26,388,876 31,743,348 53,112,746 63,775,227
--------------- -------------- --------------- --------------
Interest and related expenses:
Bear Stearns variable rate secured debt 3,669,301 - 6,496,936 -
BREF senior subordinated secured note 1,207,790 - 2,258,889 -
Exit variable-rate secured borrowing - 3,825,304 859,106 7,696,951
Series A senior secured notes - 2,928,412 2,130,722 5,892,821
Series B senior secured notes - 3,444,073 2,697,006 6,809,205
Fixed-rate collateralized bond obligations-CMBS 6,202,624 6,573,995 12,743,002 12,939,900
Fixed-rate collateralized mortgage obligations
- insured securities 4,115,623 6,160,178 9,675,763 12,654,718
Other interest expense 234,954 253,400 471,377 497,982
--------------- -------------- --------------- --------------
Total interest expense 15,430,292 23,185,362 37,332,801 46,491,577
--------------- -------------- --------------- --------------
Net interest margin 10,958,584 8,557,986 15,779,945 17,283,650
--------------- -------------- --------------- --------------
General and administrative expenses (2,859,711) (2,679,860) (5,808,353) (5,882,474)
Depreciation and amortization (145,534) (368,564) (318,824) (608,540)
Servicing revenue 2,765,026 2,494,037 4,889,587 5,257,573
Servicing general and administrative expenses (2,093,154) (2,134,890) (4,324,125) (4,625,984)
Servicing amortization, depreciation, and impairment expenses (554,490) (402,931) (887,752) (910,810)
Servicing restructuring expenses (144,371) (141,240) (144,371) (141,240)
Servicing gain on sale of servicing rights - 4,817,598 - 4,817,598
Income tax benefit (expense) 13,854 (975,220) 186,230 (908,776)
Equity in (losses) earnings from investments (6,933) 118,438 121,335 232,742
Other income, net 352,483 585,528 695,659 1,430,431
Net gains (losses) on mortgage security dispositions 38,290 (146,473) 226,500 (256,292)
Impairment on CMBS (8,947,878) (5,151,091) (8,947,878) (5,151,091)
Hedging expense (274,166) (306,569) (626,488) (396,327)
BREF maintenance fee (424,356) - (795,667) -
Recapitalization expenses (531,863) (244,444) (3,148,841) (244,444)
Gain on extinguishment of debt - - 7,337,424 -
--------------- -------------- --------------- --------------
(12,812,803) (4,535,681) (11,545,564) (7,387,634)
--------------- -------------- --------------- --------------
Net (loss) income before cumulative effect of change
in accounting principle (1,854,219) 4,022,305 4,234,381 9,896,016
Cumulative effect of adoption of SFAS 142 - - - (9,766,502)
--------------- -------------- --------------- --------------
Net (loss) income before dividends paid or accrued
on preferred shares (1,854,219) 4,022,305 4,234,381 129,514
Dividends paid or accrued on preferred shares (1,726,560) (1,726,560) (3,552,619) (4,661,750)
--------------- -------------- --------------- --------------
Net (loss) income to common shareholders $ (3,580,779) $ 2,295,745 $ 681,762 $ (4,532,236)
=============== ============== =============== ==============
Net (loss) income to common shareholders per common share:
Basic - before cumulative effect of change
in accounting principle $ (0.24) $ 0.16 $ 0.05 $ 0.39
=============== ============== =============== ==============
Basic - after cumulative effect of change
in accounting principle $ (0.24) $ 0.16 $ 0.05 $ (0.34)
=============== ============== =============== ==============
Diluted - before cumulative effect of change
in accounting principle $ (0.24) $ 0.16 $ 0.04 $ 0.38
=============== ============== =============== ==============
Diluted - after cumulative effect of change
in accounting principle $ (0.24) $ 0.16 $ 0.04 $ (0.34)
=============== ============== =============== ==============
Shares used in computing basic income (loss) per share 15,176,070 13,915,490 15,068,051 13,487,773
=============== ============== =============== ==============
The accompanying notes are an integral part of these consolidated
financial statements.
5
CRIIMI MAE INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
For the six months ended June 30, 2003
(Unaudited)
Preferred Common Accumulated
Stock Stock Additional Other Total
Par Par Paid-in Accumulated Comprehensive Warrants Deferred Shareholders'
Value Value Capital Deficit Income Outstanding Compensation Equity
-------- ----- ---------- ------------ ------------- ----------- -------- -------------
Balance at December 31, 2002 $ 34,250 $ 139,451 $ 619,197,711 $(429,812,858) $102,122,057 $ - $ (19,521) $291,661,090
Net income before dividends paid or
accrued on preferred shares - - - 4,234,381 - - - 4,234,381
Adjustment to unrealized gains and
losses on mortgage assets - - - - 18,764,241 - - 18,764,241
Adjustment to unrealized losses
on derivative financial instruments - - - - 559,157 - - 559,157
Dividends paid on preferred shares - - - (3,552,619) - - - (3,552,619)
Common stock issued - 12,566 13,581,534 - - - - 13,594,100
Amortization of deferred compensation - - - - - - 19,521 19,521
Accelerated vesting of stock options - - 547,600 - - - - 547,600
Warrants issued - - (2,564,729) - - 2,564,729 - -
-------- --------- ------------- -------------- ------------- ---------- ------ ------------
Balance at June 30, 2003 $ 34,250 $ 152,017 $ 630,762,116 $(429,131,096) $121,445,455 $2,564,729 $ - $325,827,471
======== ========= ============= ============== ============ ========== ====== =============
The accompanying notes are an integral part of these consolidated
financial statements.
6
CRIIMI MAE INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
For the six months ended June 30,
2003 2002
------------------ -----------------
Cash flows from operating activities:
Net income before dividends paid or accrued on preferred shares $ 4,234,381 $ 129,514
Adjustments to reconcile net income before dividends paid or accrued on
preferred shares to net cash provided by operating activities:
Gain on extinguishment of debt (non-cash portion) (7,787,370) -
Amortization of discount and deferred financing costs on debt 4,003,449 3,075,631
Discount amortization on mortgage assets, net (5,549,199) (5,677,819)
Accrual of extension fees related to Exit Debt 336,921 2,137,877
Depreciation and other amortization 318,824 608,540
Net (gains) losses on mortgage security dispositions (226,500) 256,292
Equity in earnings from investments (121,335) (232,742)
Servicing amortization, depreciation and impairment 887,752 910,810
Hedging expense 626,488 396,327
Recapitalization expenses (non-cash portion) 1,079,463 -
Amortization of deferred compensation 19,521 76,690
Impairment on CMBS 8,947,878 5,151,091
Gain on sale of servicing rights - 4,817,598
Cumulative effect of adoption of SFAS 142 - 9,766,502
Changes in assets and liabilities:
Decrease in restricted cash and cash equivalents 7,961,575 30,186,877
Decrease (increase) in receivables and other assets 2,409,711 (6,975,698)
Decrease in payables and accrued expenses (3,010,059) (4,366,333)
Decrease (increase) in servicing other assets 1,240,256 (6,715,966)
Increase (decrease) in servicing liabilities 120,337 (2,610,804)
Sales of other MBS, net 2,774,560 873,048
------------------ -----------------
Net cash provided by operating activities 18,266,653 31,807,435
------------------ -----------------
Cash flows from investing activities:
Proceeds from mortgage security prepayments and dispositions 54,146,348 37,115,941
Distributions received from AIM Limited Partnerships 1,229,885 1,464,075
Receipt of principal payments from insured mortgage securities 1,622,803 1,980,474
Cash received in excess of income recognized on subordinated CMBS 3,022,847 1,857,293
Proceeds from sale of servicing rights by CMSLP - 8,230,561
Purchases of investment-grade CMBS by CMSLP - (9,905,520)
Sales of investment-grade CMBS by CMSLP 3,316,508 -
------------------ -----------------
Net cash provided by investing activities 63,338,391 40,742,824
------------------ -----------------
Cash flows from financing activities:
Principal payments on securitized mortgage debt obligations (49,876,799) (32,907,210)
Principal payments on recourse debt (377,202,338) (18,900,334)
Principal payments on secured borrowings and other debt obligations (53,944) (50,161)
Proceeds from issuance of debt 330,000,000 -
Payment of debt issuance costs (5,944,647) -
Payment of dividends on preferred shares (8,732,299) -
Proceeds from the issuance of common stock, net 13,594,100 24,049
Redemption of Series E Preferred Stock, including accrued dividends - (18,733,912)
------------------ -----------------
Net cash used in financing activities (98,215,927) (70,567,568)
------------------ -----------------
Net (decrease) increase in other cash and cash equivalents (16,610,883) 1,982,691
Cash and cash equivalents, beginning of period (1) 29,251,348 17,298,873
------------------ -----------------
Cash and cash equivalents, end of period (1) $ 12,640,465 $ 19,281,564
================== =================
(1) Comprised of Servicing cash and cash equivalents and Other cash and
cash equivalents.
The accompanying notes are an integral part of these consolidated
financial statements.
7
CRIIMI MAE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
1. ORGANIZATION
General
CRIIMI MAE Inc. (together with its consolidated subsidiaries, unless the
context otherwise indicates, We or CRIIMI MAE) is a commercial mortgage company
structured as a self-administered real estate investment trust (or REIT). We
currently own, and manage, primarily through our servicing subsidiary, CRIIMI
MAE Services Limited Partnership (CMSLP or CRIIMI MAE Services), a significant
portfolio of commercial mortgage-related assets. We have focused primarily on
non-investment grade (rated below BBB- or unrated) commercial mortgage-backed
securities (subordinated CMBS). As the holder of the most subordinate tranches,
we are exposed to a higher risk of losses, but we also have the potential for
enhanced returns.
Our core holdings are subordinated CMBS ultimately backed by pools of
commercial mortgage loans on hotel, multifamily, retail and other commercial
real estate. We also own directly and indirectly government-insured mortgage
backed securities and a limited number of other assets. We also are a trader in
CMBS, residential mortgage-backed securities, agency debt securities and other
fixed income securities.
January 2003 Recapitalization
On January 23, 2003, we completed a recapitalization of the secured debt
incurred upon our emergence from Chapter 11 in April 2001 (the Exit Debt). This
recapitalization was funded with approximately $344 million in proceeds from
debt and equity financings and a portion of our available cash and liquid
assets. The recapitalization included:
o BREF Equity and Secured Debt. - We issued approximately $14 million in
common equity and $30 million in secured subordinated debt to Brascan
Real Estate Finance Fund I L.P., a private asset management fund
established by Brascan Corporation and a New York-based management
team. We refer to the secured subordinated debt as the BREF Debt and
Brascan Real Estate Finance Fund I L.P. as BREF Fund.
o Bear Stearns Secured Financing. - We received $300 million in secured
financing in the form of a repurchase transaction from a unit of Bear,
Stearns & Co., Inc. We refer to the secured financing as the Bear
Stearns Debt and the unit of Bear Stearns and Co., Inc. as Bear
Stearns.
o New Leadership. - Additions to management, including Barry S. Blattman
as Chairman of the Board, Chief Executive Officer and President.
Mr. Blattman has more than 15 years of experience in commercial real
estate finance, which included overseeing the real estate debt group at
Merrill Lynch from 1996 to 2001. Mr. Blattman is also the managing
member of Brascan Real Estate Financial Partners LLC, which owns 100%
of the general partner of BREF Fund. In addition on August 13, 2003,
our Board of Directors appointed Mark R. Jarrell, a Director, as
President and Chief Operating Officer effective September 15, 2003 as
discussed in Note 14. Mr. Blattman will continue as our Chairman of
the Board and Chief Executive Officer.
See Notes 6 and 11 for a further discussion of these debt and equity
financings.
Other
We were incorporated in Delaware in 1989 under the name CRI Insured
Mortgage Association, Inc. In July 1993, we changed our name to CRIIMI MAE Inc.
and reincorporated in Maryland. In June 1995, certain mortgage businesses
affiliated with C.R.I., Inc. (CRI) were merged into CRIIMI MAE Inc. (the
Merger). We are not a government sponsored entity or in any way affiliated with
the United States government or any United States government agency.
8
REIT Status/Net Operating Loss for Tax Purposes
REIT Status. We have elected to qualify as a REIT for tax purposes under
sections 856-860 of the Internal Revenue Code. We are required to meet income,
asset, ownership and distribution tests to maintain our REIT status. Although
there can be no assurance, we believe that we have satisfied the REIT
requirements for all years through, and including 2002. There can also be no
assurance that we will maintain our REIT status for 2003 or subsequent years. If
we fail to maintain our REIT status for any taxable year, we will be taxed as a
regular domestic corporation subject to federal and state income tax in the year
of disqualification and for at least the four subsequent years. Depending on the
amount of any such federal and state income tax, we may have insufficient funds
to pay any such tax and also may be unable to comply with some or all of our
obligations, including the Bear Stearns and BREF Debt.
We and two of our subsidiaries incorporated in 2001 jointly elected to
treat such two subsidiaries as taxable REIT subsidiaries (TRS) effective January
1, 2001. The TRSs allow us to earn non-qualifying REIT income while maintaining
our REIT status. These two subsidiaries hold all of the partnership interests of
CMSLP.
Net Operating Loss for Tax Purposes/Trader Election. For tax purposes we
have elected to be classified as a trader in securities. We trade in both short
and longer duration fixed income securities, including CMBS, residential
mortgage-backed securities and agency debt securities (such securities traded
and all other securities of the type described constituting the "Trading Assets"
to the extent owned by us or any qualified REIT subsidiary, meaning generally
any wholly owned subsidiary that is not a taxable REIT subsidiary). Such Trading
Assets are classified as Other MBS on our balance sheet.
As a result of our election in 2000 to be taxed as a trader, we recognized
a mark-to-market tax loss on our Trading Assets on January 1, 2000 of
approximately $478 million (the January 2000 Loss). Such loss is being
recognized evenly for tax purposes over four years beginning with the year 2000
and ending in 2003. We expect such loss to be ordinary, which allows us to
offset our ordinary income.
We generated a net operating loss (or NOL) for tax purposes of
approximately $83.6 million during the year ended December 31, 2002. As such,
our taxable income was reduced to zero and, accordingly, our REIT distribution
requirement was eliminated for 2002. As of December 31, 2002, our accumulated
and unused net operating loss (or NOL) was $223.8 million. Any accumulated and
unused net operating losses, subject to certain limitations, generally may be
carried forward for up to 20 years to offset taxable income until fully
utilized. Accumulated and unused net operating losses cannot be carried back
because we are a REIT.
There can be no assurance that our position with respect to our election as
a trader in securities will not be challenged by the Internal Revenue Service
(or IRS) and, if challenged, will be defended successfully by us. As such, there
is a risk that the January 2000 Loss will be limited or disallowed, resulting in
higher tax basis income and a corresponding increase in REIT distribution
requirements. It is possible that the amount of any under-distribution for a
taxable year could be corrected with a "deficiency dividend" as defined in
Section 860 of the Internal Revenue Code, however, interest may also be due to
the IRS on the amount of this under-distribution.
If we are required to make taxable income distributions to our shareholders
to satisfy required REIT distributions, all or a substantial portion of these
distributions, if any, may be in the form of non-cash dividends. There can be no
assurance that such non-cash dividends would satisfy the REIT distribution
requirements and, as such, we could lose our REIT status or may not be able to
satisfy some or all of our obligations, including the Bear Stearns and BREF
Debt.
Our future use of NOLs for tax purposes could be substantially limited in
the event of an "ownership change" as defined under Section 382 of the Internal
Revenue Code. As a result of these limitations imposed by Section 382 of the
Internal Revenue Code, in the event of an ownership change, our ability to use
our NOL carryforwards in future years may be limited and, to the extent the NOL
carryforwards cannot be fully utilized under these limitations within the
carryforward periods, the NOL carryforwards would expire unutilized.
Accordingly, after any ownership change, our ability to use our NOLs to reduce
or offset taxable income would be substantially limited or not available under
Section 382. In general, a company reaches the "ownership change" threshold if
the
9
"5% shareholders" increase their aggregate ownership interest in the
company over a three-year testing period by more than 50 percentage points. The
ownership interest is measured in terms of total market value of the company's
capital stock. If an "ownership change" occurs under Section 382 of the Internal
Revenue Code, our prospective use of our accumulated and unused NOL and the
remaining January 2000 Loss of a combined total amount of approximately $328.1
million as of June 30, 2003 will be limited.
We do not believe BREF Fund's investment in our common stock and warrant to
purchase common stock has created an "ownership change" under Section 382. In
addition, we are not aware of any other acquisition of shares of our capital
stock that has created an "ownership change" under Section 382. We have adopted
a shareholder rights plan and amended our charter to minimize the chance of an
ownership change within the meaning of Section 382 of the Internal Revenue Code;
however there can be no assurance that an ownership change will not occur.
Investment Company Act
Under the Investment Company Act of 1940, as amended, an investment company
is required to register with the Securities and Exchange Commission (SEC) and is
subject to extensive restrictive and potentially adverse regulation relating to,
among other things, operating methods, management, capital structure, dividends
and transactions with affiliates. However, as described below, companies
primarily engaged in the business of acquiring mortgages and other liens on and
interests in real estate (Qualifying Interests) are excluded from the
requirements of the Investment Company Act.
To qualify for the Investment Company Act exclusion, we, among other
things, must maintain at least 55% of our assets in Qualifying Interests (the
55% Requirement) and are also required to maintain an additional 25% in
Qualifying Interests or other real estate-related assets (Other Real Estate
Interests and such requirement, the 25% Requirement). According to current SEC
staff interpretations, we believe that all of our government-insured mortgage
securities constitute Other Real Estate Interests and that substantially all of
our government insured mortgage securities constitute Qualifying Interests. In
accordance with current SEC staff interpretations, we believe that all of our
subordinated CMBS constitute Other Real Estate Interests and that certain of our
subordinated CMBS also constitute Qualifying Interests. On certain of our
subordinated CMBS, we, along with other rights, have the unilateral right to
direct foreclosure with respect to the underlying mortgage loans. Based on such
rights and our economic interest in the underlying mortgage loans, we believe
that the related subordinated CMBS constitute Qualifying Interests. As of June
30, 2003, we believe that we were in compliance with both the 55% Requirement
and the 25% Requirement.
If the SEC or its staff were to take a different position with respect to
whether such subordinated CMBS constitute Qualifying Interests, we could, among
other things, be required either (i) to change the manner in which we conduct
our operations to avoid being required to register as an investment company or
(ii) to register as an investment company, either of which could have a material
adverse effect on us. If we were required to change the manner in which we
conduct our business, we would likely have to dispose of a significant portion
of our subordinated CMBS or acquire significant additional assets that are
Qualifying Interests. Alternatively, if we were required to register as an
investment company, we expect that our operating expenses would significantly
increase and that we would have to significantly reduce our indebtedness, which
could also require us to sell a significant portion of our assets. No assurances
can be given that any such dispositions or acquisitions of assets, or
deleveraging, could be accomplished on favorable terms, or at all. There are
restrictions under certain of the operative documents evidencing the Bear
Stearns and BREF Debt, which could limit possible actions we may take in
response to any need to modify our business plan in order to register as an
investment company or avoid the need to register. Certain dispositions or
acquisitions of assets could require approval or consent of certain holders of
this Debt. Any such results could have a material adverse effect on us.
Further, if we were deemed an unregistered investment company, we could be
subject to monetary penalties and injunctive relief. We would be unable to
enforce contracts with third parties and third parties could seek to obtain
rescission of transactions undertaken during the period we were deemed an
unregistered investment company, unless the court found that under the
circumstances, enforcement (or denial of rescission) would produce a more
equitable result than nonenforcement (or grant of rescission) and would not be
inconsistent with the Investment Company Act.
10
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
Our consolidated financial statements are prepared on the accrual basis of
accounting in accordance with accounting principles generally accepted in the
United States (or GAAP). The preparation of financial statements in conformity
with GAAP requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
In our opinion, the accompanying unaudited consolidated financial
statements contain all adjustments (consisting of only normal recurring
adjustments and consolidating adjustments) necessary to present fairly the
consolidated balance sheets as of June 30, 2003 and December 31, 2002 (audited),
the consolidated results of operations for the three and six months ended June
30, 2003 and 2002, and the consolidated cash flows for the six months ended June
30, 2003 and 2002. The accompanying consolidated financial statements include
the financial results of CRIIMI MAE and all of our majority-owned and controlled
subsidiaries. All significant intercompany accounts and transactions have been
eliminated in consolidation.
These consolidated financial statements have been prepared pursuant to the
rules and regulations of the SEC. Certain information and note disclosures
normally included in annual financial statements prepared in accordance with
GAAP have been condensed or omitted. While management believes that the
disclosures presented are adequate to make the information not misleading, these
consolidated financial statements should be read in conjunction with the
consolidated financial statements and the notes included in our Annual Report on
Form 10-K for the year ended December 31, 2002.
Reclassifications
Certain 2002 amounts have been reclassified to conform to the 2003
presentation.
Income Recognition and Carrying Basis
Subordinated CMBS and Other Mortgage-Backed Securities
We recognize income on our subordinated CMBS in accordance with Emerging
Issues Task Force (EITF) Issue No. 99-20, "Recognition of Interest Income and
Impairment on Purchased and Retained Beneficial Interests in Securitized
Financial Assets". Under EITF 99-20, we calculate a revised yield based on the
current amortized cost of the investment and the revised future cash flows when
there has been a change in estimated future cash flows from the cash flows
previously projected (due to credit losses and/or prepayment speeds). This
revised yield is applied prospectively to recognize interest income. We classify
our subordinated CMBS as "available for sale" and carry them at fair market
value and temporary changes in fair value are recorded as a component of
shareholders' equity.
Interest income on other mortgage-backed securities (or Other MBS) consists
of amortization of the discount or premium on primarily investment-grade
securities, plus the stated investment interest payments received or accrued on
Other MBS. The difference between the cost and the unpaid principal balance at
the time of purchase is carried as a discount or premium and amortized over the
remaining contractual life of the investment using the effective interest
method. The effective interest method provides a constant yield of income over
the term of the investment. Our Other MBS are classified as "available for
sale." As a result, we carry these securities at fair value and changes in fair
value are recorded as a component of shareholders' equity. Upon the sale of such
securities, any gain or loss is recognized in the income statement.
11
Insured Mortgage Securities
Our consolidated investment in insured mortgage securities consists of
participation certificates generally evidencing a 100% undivided beneficial
interest in government-insured multifamily mortgages issued or sold pursuant to
programs of the Federal Housing Administration, or FHA, and mortgage-backed
securities guaranteed by the Government National Mortgage Association, or GNMA.
Payment of principal and interest on FHA-insured certificates is insured by the
U.S. Department of Housing and Urban Development, or HUD, pursuant to Title 2 of
the National Housing Act. Payment of principal and interest on GNMA
mortgage-backed securities is guaranteed by GNMA pursuant to Title 3 of the
National Housing Act. Our insured mortgage securities are classified as
"available for sale." As a result, we carry our insured mortgage securities at
fair value and changes in fair value are recorded as a component of
shareholders' equity.
Insured mortgage securities income consists of amortization of the discount
or premium plus the stated mortgage interest payments received or accrued. The
difference between the cost and the unpaid principal balance at the time of
purchase is carried as a discount or premium and amortized over the remaining
contractual life of the mortgage using the effective interest method. The
effective interest method provides a constant yield of income over the term of
the mortgage security.
Impairment
Subordinated CMBS
We assess each subordinated CMBS for other than temporary impairment when
the fair market value of the asset declines below amortized cost and when one of
the following conditions also exists: (1) our revised projected cash flows
related to the subordinated CMBS and the subordinated CMBS's current cost basis
result in a decrease in the yield compared to what was previously used to
recognize income, or (2) fair value has been below amortized cost for a
significant period of time and we conclude that we no longer have the ability or
intent to hold the security for the period that fair value is expected to be
below amortized cost through the period of time we expect the value to recover
to amortized cost. This decrease in yield would be primarily a result of the
credit quality of the security declining and a determination that the current
estimate of expected future credit losses exceeds credit losses as originally
projected or that expected credit losses will occur sooner than originally
projected. The amount of impairment loss is measured by comparing the fair
value, based on available market information and management's estimates, of the
subordinated CMBS to its current amortized cost basis; the difference is
recognized as a loss in the income statement. We assess current economic events
and conditions that impact the value of our subordinated CMBS and the underlying
real estate in making judgments as to whether or not other than temporary
impairment has occurred. During the three and six months ended June 30, 2003, we
recognized impairment charges of $8.9 million on our subordinated CMBS. During
the three and six months ended June 30, 2002, we recognized approximately $5.2
million of impairment charges on our subordinated CMBS. See Note 4 for further
discussion of the impairment charges.
Insured Mortgage Securities
We assess each insured mortgage security for other than temporary
impairment when the fair market value of the asset declines below amortized cost
for a significant period of time and we conclude that we no longer have the
ability to hold the security through the market downturn. The amount of
impairment loss is measured by comparing the fair value of an insured mortgage
security to its current amortized cost basis, with the difference recognized as
a loss in the income statement. We did not recognize any impairment on our
insured mortgage securities during the three and six months ended June 30, 2003
and 2002.
Equity Investments
We recognize impairment on our investments accounted for under the equity
method if a decline in the market value of the investment below its carrying
basis is judged to be "other than temporary". During the six months ended June
30, 2003, American Insured Mortgage Investors, American Insured Mortgage
Investors - Series 85, L.P., American Insured Mortgage Investors L.P. - Series
86 and American Insured Mortgage Investors L.P. -
12
Series 88 (collectively referred to as the AIM Limited Partnerships for
which we serve through a subsidiary as the general partner, own a partnership
interest from 2.9% to 4.9% in each of the partnerships, and own a 20% interest
in the advisor to each partnership) experienced a significant amount of
prepayments of their insured mortgages. These prepayments reduced cash flows on
our 20% investment in the advisor to the AIM Limited Partnerships. As a result,
in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets," and
SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets,"
the advisor to the AIM Limited Partnerships evaluated its investment in the
advisory contracts for impairment. The estimated future undiscounted cash flows
from this investment were projected to be less than the book value of the
investment as of June 30, 2003. As a result, the advisor believed that its
investment in the advisory contracts was impaired at June 30, 2003. The advisor
estimated the fair value of its investment using a discounted cash flow
methodology. The advisor wrote down the value of its investment in the advisory
contracts to the AIM Limited Partnerships and recorded an impairment charge. We
recorded our portion of the impairment charge, totaling approximately $109,000,
during the three and six months ended June 30, 2003. This impairment charge is
included in Equity in (losses) earnings from investments in our Consolidated
Statement of Income. This investment is included in our Portfolio Investment
segment. We did not recognize any impairment charges on our equity investments
during the three and six months ended June 30, 2002.
As a result of the significant prepayments experienced by the AIM Limited
Partnerships, CMSLP's cash flows from its subadvisory contracts with the AIM
Limited Partnerships have been reduced. As a result, in accordance with SFAS No.
142 and SFAS No. 144, we evaluated CMSLP's investment in the subadvisory
contracts for impairment. Our estimated future undiscounted cash flows from this
investment were projected to be less than the book value on the investment at
June 30, 2003. As a result, we believed that CMSLP's investment in the
subadvisory contracts was impaired at June 30, 2003. We estimated the fair value
of the investment using a discounted cash flow methodology. We wrote down the
value of CMSLP's investment in the subadvisory contracts with the AIM Limited
Partnerships and recorded an impairment charge of approximately $198,000 during
the three and six months ended June 30, 2003, which is included in Servicing
amortization, depreciation and impairment expenses in our Consolidated Statement
of Income.
Consolidated Statements of Cash Flows
The following is the supplemental cash flow information:
Three months ended June 30, Six months ended June 30,
2003 2002 2003 2002
------------ ------------ ------------ --------------
Cash paid for interest $13,639,643 $20,420,677 $34,822,386 $37,155,371
Non-cash investing and financing activities:
Restricted stock issued -- -- -- 129,675
Preferred stock dividends paid in shares of
common stock -- 3,444,792 -- 3,444,792
Comprehensive Income
The following table presents comprehensive income for the three and six
months ended June 30, 2003 and 2002:
Three months ended June 30, Six months ended June 30,
2003 2002 2003 2002
------------- ----------------- -------------- ---------------
Net (loss) income before dividends
paid or accrued on preferred shares $ (1,854,219) $ 4,022,305 $ 4,234,381 $ 129,514
Adjustment to unrealized
gains/losses on mortgage assets 15,737,268 35,548,935 18,764,241 36,668,028
Adjustment to unrealized losses on
derivative financial instruments 211,071 (812,055) 559,157 (741,474)
------------- -------------- ------------- --------------
Comprehensive income $ 14,094,120 $ 38,759,185 $23,557,779 $ 36,056,068
============= ============== ============= ==============
13
The following table summarizes our accumulated other comprehensive income:
June 30, December 31,
2003 2002
--------------- --------------
Unrealized gains on mortgage assets $ 121,874,063 $ 103,109,822
Unrealized losses on derivative
financial instruments (428,608) (987,765)
--------------- --------------
Accumulated other comprehensive income $ 121,445,455 $ 102,122,057
=============== ==============
Stock-Based Compensation
We account for our stock-based compensation arrangements in accordance with
the intrinsic value method as defined by Accounting Principles Board Opinion
(APB) No. 25, "Accounting for Stock Issued to Employees". SFAS No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure", which was
effective January 1, 2003 for us, requires certain disclosures related to our
stock-based compensation arrangements. The following table presents the effect
on net income and earnings per share if we had applied the fair value
recognition provisions of SFAS No. 123, "Accounting for Stock-Based
Compensation", to our stock-based compensation (in thousands, except per share
amounts):
Three months ended June 30, Six months ended June 30,
2003 2002 2003 2002
---------- ----------- -------------- --------------
Net income (loss) to common shareholders (1) $ (3,581) $ 2,296 $ 682 $ (4,532)
Less: Stock-based compensation expense
determined under the fair value based
method for all awards (182) (560) (414) (704)
---------- ----------- --------------- -------------
Pro forma net income (loss) to common
shareholders $(3,763) $ 1,736 $ 268 $ (5,236)
========== =========== =============== =============
Earnings per share:
Basic - as reported $ (0.24) $ 0.16 $ 0.05 $ (0.34)
========== =========== =============== =============
Basic - pro forma $ (0.25) $ 0.12 $ 0.02 $ (0.39)
========== =========== =============== =============
Diluted - as reported $ (0.24) $ 0.16 $ 0.04 $ (0.34)
========== =========== =============== =============
Diluted - pro forma $ (0.25) $ 0.12 $ 0.02 $ (0.39)
========== =========== =============== =============
(1) Includes approximately $3 and $17 of stock-based compensation expense
during the three months ended June 30, 2003 and 2002, respectively, and
approximately $567 and $77 during the six months ended June 30, 2003 and 2002,
respectively.
Recent Accounting Pronouncements
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities," which replaces Emerging Issues
Task Force Issue No. 94-3, "Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity (including Certain
Costs Incurred in a Restructuring)." The new standard requires companies to
recognize costs associated with exit or disposal activities when they are
incurred rather than at the date of a commitment to an exit or disposal plan.
The statement is to be applied prospectively to exit or disposal activities
initiated after December 31, 2002. See Notes 9 and 10 for a discussion of the
effect of this new pronouncement on our financial statements.
In January 2003, the FASB issued FASB Interpretation (or FIN) No. 46,
"Consolidation of Variable Interest Entities", an interpretation of Accounting
Research Bulletin No. 51, "Consolidated Financial Statements." FIN No. 46
explains how to identify variable interest entities and how an enterprise
assesses its interests in a variable interest entity to decide whether to
consolidate that entity. This Interpretation requires existing unconsolidated
variable interest entities to be consolidated by their primary beneficiaries if
the entities do not effectively disperse risks among parties involved. FIN No.
46 is effective immediately for variable interest entities created after January
31, 2003, and to variable interest entities in which an enterprise obtains an
interest after that date. The Interpretation applies in the first fiscal year or
interim period beginning after June 15, 2003, to variable interest entities in
which an enterprise holds a variable interest that it acquired before February
1, 2003. We do not expect the adoption of FIN No. 46 to have a material effect
on our financial position or results of operations.
As the result of recent guidance from the SEC, 2002 earnings per share
recomputations will be reduced to reflect amounts of initial preferred stock
offering costs related to preferred stock redeemed in 2002 beginning in our
third quarter 2003 consolidated financial statements.
14
3. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following estimated fair values of our consolidated financial
instruments are presented in accordance with GAAP, which define fair value as
the amount at which a financial instrument could be exchanged in a current
transaction between willing parties, in other than a forced sale or liquidation.
These values do not represent our liquidation value or the value of the
securities under a portfolio liquidation.
As of June 30, 2003 As of December 31, 2002
(in thousands) Amortized Cost Fair Value Amortized Cost Fair Value
- -------------- -------------- ---------- -------------- ----------
ASSETS:
Subordinated CMBS pledged to secure
recourse debt (1) $ 465,542 $ 533,553 $ 473,571 $ 535,508
CMBS pledged to secure Securitized Mortgage
Obligation - CMBS (1) 288,677 339,662 287,040 326,473
Other MBS (1) 2,534 2,511 5,308 5,248
Insured mortgage securities (1) 218,412 221,185 273,655 275,340
Interest rate protection agreements (1) 366 -- 992 4
Servicing other assets See footnote (2) See footnote (2) See footnote (2) See footnote (2)
Servicing cash and cash equivalents 3,728 3,728 12,582 12,582
Other cash and cash equivalents 8,912 8,912 16,669 16,669
Restricted cash and cash equivalents -- -- 7,962 7,962
LIABILITIES:
BREF senior subordinated secured note 31,267 35,087 -- --
Bear Stearns variable rate secured debt 298,750 298,750 -- --
Exit variable-rate secured borrowing -- -- 214,673 214,673
Series A senior secured notes -- -- 92,788 92,788 (3)
Series B senior secured notes -- -- 68,491 68,491 (3)
Securitized mortgage obligations:
Collateralized bond obligations-CMBS 287,092 339,662 285,845 326,473
Collateralized mortgage obligations-insured
mortgage securities 204,313 213,318 252,980 266,367
Mortgage payable 7,273 7,446 7,214 7,341
Interest rate swap (1) -- 63 -- --
(1) Recorded at fair value in the accompanying Consolidated Balance Sheet.
(2) CMSLP owned subordinated CMBS and interest-only strips with an aggregate
amortized cost basis of approximately $1.7 million and $1.9 million and a
fair value of approximately $1.8 million and $2.1 million as of June 30,
2003 and December 31, 2002, respectively. Additionally, CMSLP owned
investment-grade CMBS with an aggregate cost basis and fair value of
approximately $3.3 million as of December 31, 2002. The investment-grade
CMBS were sold in January 2003 in connection with the company's
recapitalization.
(3) Since these notes were redeemed in January 2003 at face value, we disclosed
the face value as the fair value as of December 31, 2002.
The following methods and assumptions were used to estimate the fair value
of each class of financial instruments:
CMBS
Our determination of fair values for our CMBS portfolio is a subjective
process. The process begins with the compilation and evaluation of pricing
information (such as nominal spreads to U.S. Treasury securities or nominal
yields) that, in our view, is commensurate with the market's perception of value
and risk of comparable assets. We use a variety of sources to compile such
pricing information including: (i) recent offerings and/or secondary trades of
comparable CMBS (i.e., securities comparable to our CMBS or to the CMBS (or
collateral) underlying our CMBS issued in connection with CRIIMI MAE Trust I
Series 1996-C1 (or CBO-1) and CRIIMI MAE Commercial Mortgage Trust Series
1998-C1 (or CBO-2)), (ii) communications with dealers and active CMBS investors
regarding the pricing and valuation of comparable securities, (iii)
institutionally available research reports, (iv) analyses prepared by the
nationally recognized rating organizations responsible for the initial rating
assessment and on-going surveillance of such CMBS, and (v) other qualitative and
quantitative factors that may impact the value of the CMBS such as the market's
perception of the issuers of the CMBS and the credit fundamentals of the
15
commercial properties securing each pool of underlying commercial mortgage
loans. We make further fair value adjustments to such pricing information based
on our specific knowledge of our CMBS and the impact of relevant events, which
is then used to determine the fair value of our CMBS using a discounted cash
flow approach. Expected future gross cash flows are discounted at market yields
for our rated CMBS, depending on the rating, and at a fixed discount rate for
our unrated/issuer's equity. Furthermore, the fair value for those CMBS
incurring principal losses and interest shortfalls (i.e., B- and CCC rated
bonds, and our unrated/issuer's equity) based on our overall expected loss
estimate are valued at a loss adjusted yield to maturity that, in our view, is
commensurate with the market's perception of value and risk of comparable
securities, using the same discounted cash flow approach. Such anticipated
principal losses and interest shortfalls, as well as potential recoveries of
such shortfalls, have been taken into consideration in the calculation of fair
values and yields to maturity used to recognize interest income as of June 30,
2003. We have disclosed the range of discount rates by rating category used in
determining the fair values as of June 30, 2003 in Note 4.
The liquidity of the subordinated CMBS market has historically been
limited. Additionally, during adverse market conditions, the liquidity of such
market has been severely limited. For this reason, among others, management's
estimate of the value of our subordinated CMBS could vary significantly from the
value that could be realized in a current transaction between a willing buyer
and a willing seller in other than a forced sale or liquidation.
Other MBS
The fair value of the Other MBS is an estimate based on the indicative
market price from publicly available pricing services, as well as management
estimates. We normally apply a slight discount to such prices as we believe it
better reflects fair value between willing buyers and sellers due to the
relatively smaller sizes of this component of the trading securities.
Insured Mortgage Securities
We calculated the estimated fair value of the insured mortgage securities
portfolio as of June 30, 2003 and December 31, 2002, using a discounted cash
flow methodology. The cash flows were discounted using a discount rate and other
assumptions that, in our view, was commensurate with the market's perception of
risk and value. We used a variety of sources to determine the discount rate
including (i) institutionally available research reports and (ii) communications
with dealers and active insured mortgage security investors regarding the
valuation of comparable securities.
Servicing, Restricted and Other Cash and Cash Equivalents
The carrying amount approximates fair value because of the short maturity
of these instruments.
Obligations Under Financing Facilities
The fair values of the securitized mortgage obligations as of June 30, 2003
and December 31, 2002 were calculated using a discounted cash flow methodology
similar to that discussed for CMBS above. The carrying amount of the Bear
Stearns Debt (and at December 31, 2002, the Exit Variable-Rate Secured
Borrowing) approximates fair value because the current rate on the debt resets
monthly based on market rates. The fair value of the BREF Debt was estimated by
applying a discount rate to the debt's future cash flows. The discount rate was
determined by considering the BREF Debt's relative position in our capital
structure in relation to our other capital. The fair value of the mortgage
payable is estimated based on current market interest rates of commercial
mortgage debt. As of December 31, 2002, the fair values of the Series A and
Series B Senior Secured Notes are the same as the face values since the notes
were redeemed in January 2003.
Derivative Financial Instruments
The fair values of our interest rate swaps and interest rate caps are the
estimated amounts that we would realize to terminate the agreements as of June
30, 2003 and December 31, 2002, taking into account current interest rates and
the current creditworthiness of the counterparties. The amounts were determined
based on quotes received from the counterparties to the agreements.
16
4. CMBS
As of June 30, 2003, we owned, in accordance with GAAP, CMBS with an
aggregate face amount of approximately $1.5 billion rated from A+ to CCC and
unrated. Such CMBS had an aggregate fair value of approximately $873 million
(representing approximately 75% of our total consolidated assets) and an
aggregate amortized cost of approximately $754 million. Such CMBS represent
investments in securities issued in connection with CBO-1, CBO-2 and Nomura
Asset Securities Corporation Series 1998-D6 (or Nomura). The following is a
summary of the ratings of our CMBS as of June 30, 2003 (in millions):
Rating (1) Fair Value % of CMBS
---------- ---------- ---------
A+, BBB+ or BBB (2) $ 339.6 39%
BB+, BB or BB- $ 346.1 40%
B+, B, B- or CCC $ 168.8 19%
Unrated $ 18.7 2%
(1) Ratings are provided by Standard & Poor's.
(2) Represents investment grade securities that we reflect as assets on our
balance sheet as a result of CBO-2. As indicated in footnote 4 to the table
below, GAAP requires both these assets (reflected as "CMBS pledged to Secure
Securitized Mortgage Obligation-CMBS") and their related liabilities (reflected
as "Collateralized bond obligations - CMBS") to be reflected on our balance
sheet. All cash flows related to the investment grade CMBS are used to service
the corresponding debt. As a result, we currently receive no cash flows from the
investment grade CMBS.
As of June 30, 2003, the weighted average interest rate and the loss
adjusted weighted average life (based on face amount) of the investment grade
securities was 7.0% and 8.3 years, respectively. The weighted average interest
rate and the loss adjusted weighted average life (based on face amount) of the
BB+ through unrated CMBS securities, sometimes referred to as the retained
portfolio, were 4.6% and 10.8 years, respectively. The aggregate investment by
the rating of the CMBS is as follows:
Discount Rate
or Range of
Weighted Loss Discount Rates
Face Amount Average Adjusted Fair Value Used to Amortized Cost Amortized Cost
as of Pay Weighted as of Calculate Fair as of 6/30/03 as of 12/31/02
Security Rating 6/30/03 (in Rate as of Average 6/30/03 (in Value as of (in millions) (in millions)
millions) 6/30/03 Life (1) millions) 6/30/03 (9) (5) (6)
- ------------------------------------------------------------------------------------------------------------------------------
Investment Grade Portfolio
- --------------------------
A+ (4) $ 62.6 7.0% 3 years $ 66.8 4.1% $ 59.8 $ 59.4
BBB+ (4) 150.6 7.0% 9 years 158.0 6.2% 132.9 132.3
BBB (4) 115.2 7.0% 10 years 114.8 7.1% 95.9 95.3
Retained Portfolio
- ------------------
BB+ 319.0 7.0% 12 years 265.6 9.5%-9.9% 225.1 223.0
BB 70.9 7.0% 14 years 54.9 10.5% 47.2 46.8
BB- 35.5 7.0% 14 years 25.6 11.4% 21.0 20.8
B+ 88.6 7.0% 14 years 50.6 14.7% 46.5 46.0
B 177.2 6.9% 17 years 94.9 15.2%-15.5% 85.9 85.1
B- (2) 118.3 0.8% 24 years 22.1 (9) 21.7 28.1
CCC (2) 70.9 0.0% 2 years 1.2 (9) 1.2 3.8
Unrated/Issuer's
Equity (2) (3) 309.4 1.7% 1 year 18.7 (9) 17.0 20.0
--------- -------- ---------- --------
Total (8) $ $ 1,518.2 5.1% 10 years $ 873.2 (8) $ 754.2 (7) $ 760.6
========== ======== ========== ========
17
(1) The loss adjusted weighted average life represents the weighted average
expected life of the CMBS based on our current estimate of future losses.
As of June 30, 2003, the fair values of the B-, CCC and the
unrated/issuer's equity in Nomura, CBO-1, and CBO-2 were derived primarily
from interest cash flow anticipated to be received since our current loss
expectation assumes that the full principal amount of these securities
will not be recovered. See also "Advance Limitations, Appraisal Reductions
and Losses on CMBS" below.
(2) The CBO-1, CBO-2 and Nomura CMBS experience interest shortfalls when the
weighted average net coupon rate on the underlying CMBS is less than the
weighted average stated coupon payments on our subordinated CMBS. Such
interest shortfalls will continue to accumulate until they (i) are repaid
through either excess interest and/or recoveries on the underlying CMBS or
a recharacterization of principal cash flows, or (ii) are realized as a
loss of principal on the subordinated CMBS. Such anticipated losses,
including shortfalls, have been taken into consideration in the
calculations of fair market values and yields to maturity used to
recognize interest income as of June 30, 2003.
(3) The unrated subordinated CMBS from CBO-2 currently does not have a stated
coupon rate since this security is only entitled to the residual cash flow
payments, if any, remaining after paying the securities with a higher
payment priority. As a result, effective coupon rates on these securities
are highly sensitive to the effective coupon rates and monthly cash flow
payments received from the underlying CMBS that represent the collateral
for CBO-2.
(4) In connection with CBO-2, $62.6 million (originally A rated, currently A+
rated) and $60.0 million (originally BBB rated, currently BBB+ rated) face
amount of investment grade CMBS were sold with call options and $345
million (originally A rated, currently A+ rated) face amount were sold
without call options. Also in connection with CBO-2, in May 1998, we
initially retained $90.6 million (originally BBB rated, currently BBB+
rated) and $115.2 million (originally BBB- rated, currently BBB rated)
face amount of CMBS, both with call options, with the intention to sell
these CMBS at a later date. Such sale occurred March 5, 1999. Since we
retained call options on certain sold CMBS (currently rated A+, BBB+ and
BBB bonds), we did not surrender control of these CMBS pursuant to the
requirements of SFAS No. 125, and thus these CMBS are accounted for as a
financing and not a sale. Since the transaction is recorded as a partial
financing and a partial sale, we have retained these CMBS with call
options, from which we currently receive no cash flows, and reflected them
in our CMBS on the balance sheet.
(5) Amortized cost reflects approximately $8.9 million of impairment charges
related to the unrated/issuer's equity bonds, the CCC bond and the B- bond
in CBO-2, which were recognized during the three months ended June 30,
2003. These impairment charges are in addition to the cumulative
impairment charges of approximately $248.4 million that were recognized
through December 31, 2002. The impairment charges are discussed later in
this Note 4.
(6) Amortized cost reflects approximately $248.4 million of cumulative
impairment charges related to certain CMBS (all bonds except those rated
A+ and BBB+), which were recognized through December 31, 2002.
(7) See Notes 1 and 8 to Notes to Consolidated Financial Statements for
information regarding the subordinated CMBS for tax purposes.
(8) As of June 30, 2003, the aggregate fair values of the CBO-1, CBO-2 and
Nomura bonds were approximately $19.1 million, $848.7 million and
$5.4 million, respectively.
(9) As a result of the estimated loss of principal on these CMBS, we have used
a significantly higher discount rate to determine a reasonable fair value
of these CMBS. The weighted average loss adjusted yield-to-maturity of the
B-, CCC and unrated/issuer's equity is 15.3%, 15.0% and 21.8%,
respectively.
Mortgage Loan Pool
Through CMSLP, our servicing subsidiary, we perform servicing functions on
commercial mortgage loans totaling $16.5 billion and $17.4 billion as of June
30, 2003 and December 31, 2002, respectively. The mortgage loans underlying our
subordinated CMBS portfolio are secured by properties of the types and in the
geographic locations identified below:
06/30/03 12/31/02 Geographic 06/30/03 12/31/02
Property Type Percentage(i) Percentage(i) Location(ii) Percentage(i) Percentage(i)
- ------------- ------------- ------------- ----------- ------------- -------------
Retail........ 31% 31% California........ 16% 17%
Multifamily... 27% 28% Texas............. 12% 12%
Hotel......... 16% 15% Florida........... 8% 8%
Office........ 14% 13% Pennsylvania...... 6% 5%
Other (iv).... 12% 13% Georgia........... 4% 4%
---- --------- Other(iii)........ 54% 54%
Total..... 100% . 100% ---- -----------
==== ========= Total......... 100% 100%
==== ===========
18
(i) Based on a percentage of the total unpaid principal balance of the
underlying loans.
(ii) No significant concentration by region.
(iii) No other individual state makes up more than 5% of the total.
(iv) Our ownership interest in one of the 20 CMBS transactions underlying
CBO-2 includes subordinated CMBS in which our exposure to losses
arising from certain healthcare and senior housing mortgage loans is
limited by other subordinated CMBS (referred to herein as the
Subordinated Healthcare/Senior-Housing CMBS). These other CMBS are not
owned by us and are subordinate to our CMBS in this transaction. As a
result, our investment in such underlying CMBS will only be affected
if interest shortfalls and/or realized losses on such healthcare and
senior housing mortgage loans are in excess of the Subordinated
Healthcare/Senior-Housing CMBS. We currently estimate that the
interest shortfalls and/or realized losses on such healthcare and
senior housing mortgage loans will exceed the Subordinated
Healthcare/Senior Housing CMBS.
Specially Serviced Mortgage Loans
CMSLP performs special servicing on the loans underlying our subordinated
CMBS portfolio. A special servicer typically provides asset management and
resolution services with respect to nonperforming or underperforming loans
within a pool of mortgage loans. When serving as special servicer of a mortgage
loan pool, CMSLP has the authority, subject to certain restrictions in the
applicable CMBS pooling and servicing documents, to deal directly with any
borrower that fails to perform under certain terms of its mortgage loan,
including the failure to make payments, and to manage any loan workouts and
foreclosures. As special servicer, CMSLP earns fee income on services provided
in connection with any loan servicing function transferred to it from the master
servicer. We believe that because we own the first loss unrated or lowest rated
bond of virtually all of the CMBS transactions related to our subordinated CMBS,
CMSLP has an incentive to efficiently and effectively resolve any loan workouts.
As of June 30, 2003 and December 31, 2002, specially serviced mortgage loans
included in the commercial mortgage loans described above were as follows:
06/30/03 12/31/02
--------- --------
Specially serviced loans due to monetary default (a) $ 908.8 million $736.1 million
Specially serviced loans due to covenant default/other 260.0 million 74.7 million
---------------- --------------
Total specially serviced loans (b) $1,168.8 million $810.8 million
================ ==============
Percentage of total mortgage loans (b) 7.1% 4.7%
================ ===============
(a) Includes $134.7 million and $130.5 million, respectively, of real estate
owned by the underlying securitization trusts. See also the table below
regarding property type concentrations for further information on real
estate owned by underlying trusts.
(b) As of July 31, 2003, total specially serviced loans were approximately $1.1
billion, or 6.8% of the total mortgage loans. See discussion below for
additional information regarding specially serviced loans.
The specially serviced mortgage loans as of June 30, 2003 were secured by
properties of the types and located in the states identified below:
Property Type $ (in millions) Percentage Geographic Location $ (in millions) Percentage
- ------------- --------------- ---------- ------------------- --------------- ----------
Hotel......... $ 715.4 (1) 61% Florida.............. $ 169.9 14%
Retail........ 240.5 (2) 21% Texas................ 122.8 10%
Healthcare.... 93.6 8% California........... 103.2 9%
Office........ 52.1 4% Oregon............... 91.4 8%
Multifamily... 38.2 3% Georgia ............. 55.6 5%
Industrial.... 19.5 2% Other................ 625.9 54%
Other......... 9.5 1% ---------- ---------
-------- ----- Total................ $1,168.8 100%
Total..... $1,168.8 100% ========== =========
======== =====
(1) Approximately $87.4 million of these loans in special servicing are
real estate owned by the underlying securitization trusts.
(2) Approximately $32.6 million of these loans in special servicing are
real estate owned by the underlying securitization trusts.
19
As reflected above, as of June 30, 2003, approximately $715.4 million, or
61%, of the specially serviced mortgage loans were secured by mortgages on hotel
properties. The hotel properties that secure the mortgage loans underlying our
CMBS are geographically diverse, with a mix of hotel property types and
franchise affiliations. The following table summarizes the hotel mortgage loans
underlying our CMBS as of June 30, 2003:
Total Outstanding Percentage of Amount in
Principal Balance Total Hotel Loans Special Servicing
----------------- ----------------- -----------------
Full service hotels (1) $ 1.4 billion 54% $ 237.3 million
Limited service hotels (2) 1.2 billion 46% 478.1 million
-------------- ---- ---------------
Totals $ 2.6 billion 100% $ 715.4 million
============== ==== ===============
(1) Full service hotels are generally mid-price, upscale or luxury hotels
with restaurant and lounge facilities and other amenities.
(2) Limited service hotels are generally hotels with room-only operations
or hotels that offer a bedroom and bathroom, but limited other
amenities, and are often in the budget or economy group.
Of the $715.4 million of hotel loans in special servicing as of June 30,
2003, approximately $488.8 million, or 68%, relate to eight borrowing
relationships more fully described as follows:
o Twenty-seven loans with scheduled principal balances as of June 30,
2003 totaling approximately $136.2 million spread across three CMBS
transactions secured by hotel properties in the western and Pacific
northwestern states. As of June 30, 2003, our total exposure,
including advances, on these loans was approximately $167.9 million.
The borrower filed for bankruptcy protection in February 2002. The
borrower indicated that the properties had experienced reduced
operating performance due to new competition, the economic recession,
and reduced travel resulting from the September 11, 2001 terrorist
attacks. We entered into a consensual settlement agreement dated
February 25, 2003 pursuant to which the loan terms were amended and
modified, which was subsequently approved and confirmed by the
bankruptcy court on March 28, 2003. The borrower continues to make
payments under the modified terms, and, during the three months ended
June 30, 2003, the borrower sold one of the properties that secured
these loans. In addition, the borrower has remitted approximately
$1.5 million in funds from debtor-in-possession accounts, which is
expected to be applied to arrearages. The parties are currently
proceeding toward closing a comprehensive loan modification that is
expected to return the loans to performing status in the near future.
o One loan with a scheduled principal balance as of June 30, 2003
totaling approximately $128.4 million, secured by 93 limited service
hotels located in 29 states. As of June 30, 2003, our total exposure,
including advances, on this loan was approximately $128.4 million.
The loan was transferred to special servicing in January 2003. The loan
is current for payments, but was transferred to special servicing due
to the unauthorized leasing of some of the collateral properties by the
borrower, and unapproved franchise changes by the borrower, among other
reasons. We entered into a Confidentiality and Pre-Negotiation
Agreement in an attempt to reach a consensual resolution of this
matter, but, subsequent to June 30, 2003, the borrower filed for
bankruptcy.
o One loan with a scheduled principal balance as of June 30, 2003
totaling approximately $80.7 million secured by 13 extended stay hotels
located throughout the U.S. This loan was transferred to special
servicing in January 2003 due to the borrower's request for forbearance
and the resulting possibility of an imminent payment default. In its
request, the borrower cited continuing reduced operating performance at
its hotel properties, which it did not expect to improve in the
foreseeable future. Subsequent to June 30, 2003, this loan was sold to
a third party.
o Five loans with scheduled principal balances as of June 30, 2003
totaling approximately $45.3 million secured by hotel properties in
Florida and Texas. As of June 30, 2003, our total exposure, including
advances, on these loans was approximately $49.5 million. The loans are
past due for the July 2002 and all subsequent payments. We have reached
a preliminary agreement with the borrower on a consensual modification
of the loan terms, and are working toward a formal modification
agreement that is expected to return the loans to performing status in
the first quarter of 2004.
20
o Eight real estate owned properties with scheduled principal balances as
of June 30, 2003 totaling approximately $26.1 million secured by hotel
properties. As of June 30, 2003, our total exposure, including
advances, on these loans was approximately $31.9 million. The loans
were transferred into special servicing in December 2001 due to the
bankruptcy filing of each special purpose borrowing entity and their
parent company. As part of a consensual plan, eight properties were
foreclosed and became real estate owned by underlying securitization
trusts. Subsequent to June 30, 2003, two of these properties with an
aggregate unpaid balance of $5.9 million were sold.
o One loan with a scheduled principal balance as of June 30, 2003
totaling approximately $27.7 million, secured by 9 limited service
hotels located in 8 states. As of June 30, 2003 the loan was current.
The loan is currently in special servicing due to an unauthorized
transfer of the properties to an entity which assumed the controlling
interest in the borrowing entity. Subsequent to the transfer, the new
controlling party in interest has requested payment relief citing
reduced operating performance at the properties.
o One loan with a scheduled principal balance as of June 30, 2003 of
approximately $25.6 million, secured by a full service hotel in Boston,
Massachusetts. As of June 30, 2003, our total exposure, including
advances, on this loan was approximately $27.0 million. This loan was
transferred into special servicing in March 2003. The borrower has
stated an inability to make payments, and has requested a loan
restructuring due to reduced operating performance at the property.
o Nine loans with scheduled principal balances as of June 30, 2003
totaling approximately $18.8 million secured by limited service hotels
in midwestern states. As of June 30, 2003, our total exposure,
including advances, on these loans was approximately $23.6 million. The
loans are past due for the April 2002 and all subsequent payments. The
borrower cites reduced occupancy related to the downturn in travel as
the cause for a drop in operating performance at the properties. We
were attempting to negotiate a workout with the borrower when the
borrower filed for bankruptcy protection in February 2003. A cash
collateral order has been entered into and we are working with the
borrower towards a consensual emergence plan.
For each of the borrowing relationships described in the paragraphs above,
we believe that we have made an appropriate estimate of losses that we may incur
in the future, which are used in determining our CMBS yields and fair values.
There can be no assurance that any of the loans described above will return to
performing status. Circumstances which could prevent them from returning to
performing status include, but are not limited to, a continuing or more
pronounced downturn in the economy or in the real estate market, a change in
local market conditions, a drop in performance of the property, an increase in
interest rates, and terrorist attacks. There can be no assurance that the losses
incurred in the future will not exceed our current estimates (see discussion
below regarding the increase in loss estimates).
The following table provides a summary of the change in the balance of
specially serviced loans from December 31, 2002 to March 31, 2003 and from April
1, 2003 to June 30, 2003 (in millions):
April - June Jan. - March
2003 2003
------------- -------------
Specially Serviced Loans, beginning of period $1,154.0 $ 810.8
Transfers in due to monetary default 166.3 239.7
Transfers in due to covenant default and other 7.4 158.6
Transfers out of special servicing (153.2) (48.5)
Loan amortization (1) (5.7) (6.6)
----------- ---------
Specially Serviced Loans, end of period $1,168.8 $1,154.0
=========== =========
(1) Represents the reduction of the scheduled principal balances due to
borrower payments or, in the case of loans in monetary default,
advances made by master servicers.
21
Advance Limitations, Appraisal Reductions and Losses on CMBS
We experience shortfalls in expected cash flow on our CMBS prior to the
recognition of a realized loss primarily due to servicing advance limitations
resulting from appraisal reductions. An appraisal reduction event generally
results in reduced master servicer principal and interest advances based on the
amount by which the sum of the unpaid principal balance of the loan, accumulated
principal and interest advances and other expenses exceeds 90% (in most cases)
of the newly appraised value of the property underlying the mortgage loan. As
the holder of the lowest rated and first loss bonds, our bonds are the first to
experience interest shortfalls as a result of the reduced advancing requirement.
In general, the master servicer can advance up to a maximum of the difference
between 90% of the property's appraised value and the sum of accumulated
principal and interest advances and expenses. As an example, assuming a weighted
average coupon of 6% on a first loss subordinated CMBS, a $1 million appraisal
reduction would reduce our net cash flows by $60,000 on an annual basis. The
ultimate disposition or work-out of the mortgage loan may result in a higher or
lower realized loss on our subordinated CMBS than the calculated appraisal
reduction amount. Appraisal reductions for the CMBS transactions in which we
retain an ownership interest as reported by the underlying trustees or as
calculated by CMSLP* were as follows (in thousands):
CBO-1 CBO-2 Nomura Total
----- ----- ------- -----
Year 2000 $ 1,872 $ 18,871 $ -- $ 20,743
Year 2001 15,599 31,962 874 48,435
Year 2002 9,088 48,953 13,530 71,571
January 1, 2003 through June 30, 2003 9,169 46,969 4,328 60,466
------- -------- ------- ---------
Cumulative Appraisal Reductions through June 30, 2003 $35,728 $146,755 $18,732 $ 201,215
======= ======== ======= =========
* Not all underlying CMBS transactions require the calculation of an
appraisal reduction; however, when CMSLP obtains a third-party appraisal, it
calculates one.
As previously discussed, certain securities from the CBO-1, CBO-2 and
Nomura transactions are expected to experience principal write-downs over their
expected lives. The following tables summarize the actual realized losses on our
CMBS through June 30, 2003 (including realized mortgage loan losses expected to
pass through to our CMBS during the next month) and the expected future losses
through the life of the CMBS (in thousands):
CBO-1 CBO-2 Nomura Total
----- ----- ------- -----
Year 1999 actual realized losses $ 738 $ -- $ -- $ 738
Year 2000 actual realized losses 3,201 1,087 -- 4,288
Year 2001 actual realized losses 545 8,397 238 9,180
Year 2002 actual realized losses 11,554 25,113 563 37,230
Actual realized losses, January 1 through June 30, 2003 2,006 16,229 662 18,897
-------- -------- ------- ----------
Cumulative actual realized losses through June 30, 2003 $ 18,044 $ 50,826 $ 1,463 $ 70,333
======== ======== ======= ==========
Cumulative expected realized loss estimates (including
cumulative actual realized losses) through the year 2003 $ 31,014 $123,247 $ 8,566 $ 162,827
Expected loss estimates for the year 2004 54,441 122,314 14,921 191,676
Expected loss estimates for the year 2005 17,355 71,376 8,484 97,215
Expected loss estimates for the years 2006-2008 8,548 43,765 8,173 60,486
Expected loss estimates for the years 2009-2011 6,492 18,463 3,955 28,910
Expected loss estimates for the remaining life of CMBS 3,938 12,292 1,790 18,020
-------- -------- ------- ---------
Cumulative expected loss estimates (including cumulative
actual realized losses) through life of CMBS $121,788 $391,457 $45,889 $ 559,134
======== ======== ======= =========
As of June 30, 2003, we revised our overall expected loss estimate related
to our subordinated CMBS from $503 million to $559 million, with such total
losses occurring or expected to occur through the life of the subordinated CMBS
portfolio. These revisions to the overall expected loss estimate were primarily
the result of increased projected losses due to lower than anticipated
appraisals and lower internal estimates of values on real estate owned by
underlying trusts and properties underlying certain defaulted mortgage loans,
which, when combined with the updated loss severity experience and changes in
the timing of resolution and disposition of the specially serviced assets, has
resulted in higher projected loss severities on loans and real estate owned by
underlying trusts currently or anticipated to be in special servicing. The
primary reasons for lower appraisals and lower estimates of value resulting in
higher projected loss severities on mortgage loans and real estate owned by the
22
underlying securitization trusts include the poor performance of certain
properties and related markets and failed workout negotiations due, in large
part, to the continued softness in the economy, the continued downturn in travel
and, in some cases, over-supply of hotel properties, and a shift in retail
activity in some markets, including the closing of stores by certain national
and regional retailers. There can be no assurance that our revised overall
expected loss estimate of $559 million will not be exceeded as a result of
additional or existing adverse events or circumstances. Such events or
circumstances include, but are not limited to, the receipt of new or updated
appraisals at lower than anticipated amounts, legal proceedings (including
bankruptcy filings) involving borrowers, a continued weak economy or recession,
continued hostilities in the Middle East or elsewhere, terrorism, unexpected
delays in the disposition or other resolution of specially serviced mortgage
loans, additional defaults, or an unforeseen reduction in expected recoveries,
any of which could result in additional future credit losses and/or further
impairment to our subordinated CMBS, the effect of which could be materially
adverse to us.
We have also determined that there has been an adverse change in expected
future cash flows for the unrated/issuer's equity bonds, the CCC bond and the B-
bond in CBO-2 as of June 30, 2003 due to the factors mentioned in the preceding
paragraph. As a result, we believe these bonds have been impaired under EITF
99-20 and SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," as of June 30, 2003. As the fair values of these impaired bonds
aggregated approximately $8.9 million below the amortized cost basis as of June
30, 2003, we recorded other than temporary impairment charges through the income
statement of that same amount during the three months ended June 30, 2003.
Yield to Maturity
The following table summarizes yield-to-maturity information relating to
our CMBS on an aggregate pool basis:
Current
Anticipated Anticipated Anticipated
Yield-to- Yield-to- Yield-to-
Maturity Maturity Maturity
Pool as of 1/1/02 (1) as of 1/1/03 (1) as of 7/1/03 (1)
---- ----------------- ----------------- -----------------
CBO-2 CMBS 12.1% (2) 11.6% (2) 11.5% (2)
CBO-1 CMBS 14.3% (2) 11.6% (2) 21.6% (2)
Nomura CMBS 28.7% (2) 8.0% (2) 16.9% (2)
------ ------ ------
Weighted Average (3) 12.4% (2) 11.6% (2) 11.7% (2)
(1) Represents the anticipated weighted average yield over the expected average
life of the CMBS as of January 1, 2002, January 1, 2003 and July 1, 2003
based on our estimate of the timing and amount of future credit losses and
other significant items that are anticipated to affect future cash flows.
(2) As previously discussed, as of December 31, 2001, June 30, 2002, September
30, 2002, December 31, 2002 and June 30, 2003, we revised our overall
expected loss estimate related to our subordinated CMBS from $307 million
to $335 million, $351 million, $448 million, $503 million and $559 million,
respectively, which resulted in impairment recognition to certain
subordinated CMBS. As a result of recognizing impairment, we revised the
anticipated yields as of January 1, 2002, July 1, 2002, October 1, 2002,
January 1, 2003 and July 1, 2003, which were or are, in the case of revised
anticipated yields as of July 1, 2003, used to recognize interest income
beginning on each of those dates. These anticipated revised yields took
into account the lower cost basis due to the impairment recognized on the
subordinated CMBS as of dates the losses were revised, and contemplated
larger than previously anticipated losses.
(3) GAAP requires that the income on CMBS be recorded based on the effective
interest method using the anticipated yield over the expected life of these
mortgage assets. This method can result in accounting income recognition
which is greater than or less than cash received. During the six months
ended June 30, 2003, we recognized approximately $5.6 million of discount
amortization, partially offset by approximately $3.0 million of cash
received in excess of income recognized on subordinated CMBS due to the
effective interest method. During the six months ended June 30, 2002, we
recognized approximately $5.7 million of discount amortization, partially
offset by approximately $1.9 million of cash received in excess of income
recognized on subordinated CMBS due to the effective interest method.
Determining Fair Value of CMBS
We use a discounted cash flow methodology for determining the fair value of
our subordinated CMBS. See Note 3 for a discussion of our fair value
methodology.
23
Key Assumptions in Determining Fair Value
The gross mortgage loan cash flows from each commercial mortgage loan pool
and their corresponding distribution on the CMBS may be affected by numerous
assumptions and variables including:
(i) changes in the timing and/or amount of credit losses on the commercial
mortgage loans (credit risk), which are a function of:
o the percentage of mortgage loans that experience a default either
during the mortgage term or at maturity (referred to in the industry as
a default percentage);
o the recovery period represented by the time that elapses between the
default of a commercial mortgage loan and the subsequent foreclosure
and liquidation of the corresponding real estate (a period of time
referred to in the industry as a lag); and,
o the percentage of mortgage loan principal lost as a result of the
deficiency in the liquidation proceeds resulting from the foreclosure
and sale of the commercial real estate (referred to in the industry as
a loss severity);
(ii) the discount rate used to derive fair value, which is comprised of the
following:
o a benchmark risk-free rate, calculated by using the current,
"on-the-run" U.S. Treasury curve and interpolating a comparable
risk-free rate based on the weighted-average life of each CMBS; plus,
o a credit risk premium; plus,
o a liquidity premium;
(iii) delays and changes in monthly cash flow distributions relating to
mortgage loan defaults and/or extensions in the loan's term
to maturity (see Extension Risk below); and
(iv) the receipt of mortgage payments earlier than projected (prepayment).
Sensitivities of Key Assumptions
Since we use a discounted cash flow methodology to derive the fair value of
our CMBS, changes in the timing and/or the amount of cash flows received from
the underlying commercial mortgage loans, and their allocation to the CMBS, will
directly impact the value of such securities. Accordingly, delays in the receipt
of cash flows and/or decreases in future cash flows resulting from higher than
anticipated credit losses will result in an overall decrease in the fair value
of our CMBS. Furthermore, any increase/(decrease) in the required rate of return
for CMBS will result in a corresponding (decrease)/increase in the value of such
securities. We have included the following narrative and numerical disclosures
to demonstrate the sensitivity of such changes to the fair value of our CMBS.
Key Assumptions Resulting in an Adverse Impact to Fair Value
Factors which could adversely affect the valuation of our CMBS include: (i)
the receipt of future cash flows less than anticipated due to higher credit
losses (i.e., higher credit losses resulting from a larger percentage of loan
defaults, and/or losses occurring sooner than projected, and/or longer periods
of recovery between the date of default and liquidation, and/or higher loss of
principal, see "Sensitivity of Fair Value to Changes in Credit Losses" below),
(ii) an increase in the required rate of return (see "Sensitivity of Fair Value
to Changes in the Discount Rate" below) for CMBS, and/or (iii) the receipt of
cash flows later than anticipated (see "Sensitivity of Fair Value to Extension
Risk" below).
Sensitivity of Fair Value to Changes in Credit Losses
For purposes of this disclosure, we used a market convention for simulating
the impact of increased credit losses on CMBS. Generally, the industry uses a
combination of an assumed percentage of loan defaults (referred to in the
industry as a Constant Default Rate or "CDR"), a lag period and an assumed loss
severity. For purposes of this disclosure, we assumed the following loss
scenarios, each of which was assumed to begin immediately following June 30,
2003: (i) 3.0% per annum of the commercial mortgage loans were assumed to
default and 30% of the then outstanding principal amount of the defaulted
commercial mortgage loans
24
were assumed to be lost (referred to in the industry as a 3.0% CDR and 30%
loss severity, and referred to herein as the "3%/30% CDR Loss Scenario"), and
(ii) 3.0% per annum of each commercial mortgage was assumed to default and 40%
of the then outstanding principal amount of each commercial mortgage loan was
assumed to be lost (referred to in the industry as a 3.0% CDR and 40% loss
severity, and referred to herein as the "3%/40% CDR Loss Scenario"). The
reduction in amount of cash flows resulting from the 3%/30% CDR Loss Scenario
and the 3%/40% CDR Loss Scenario would result in a corresponding decline in the
fair value of our aggregate CMBS by approximately $49.4 million (or 5.7%) and
$248.5 million (or 28.5%), respectively. The reduction in amount of cash flows
resulting from the 3%/30% CDR Loss Scenario and the 3%/40% CDR Loss Scenario
would result in a corresponding decline in the fair value of our subordinated
CMBS (BB+ through unrated/issuer's equity) by approximately $49.4 million (or
9.3%) and $248.5 million (or 46.6%), respectively.
The aggregate amount of credit losses assumed under the 3%/30% CDR Loss
Scenario and the 3%/40% CDR Loss Scenario totaled approximately $727 million and
$970 million, respectively. These amounts are in comparison to the aggregate
amount of anticipated credit losses expected by us as of June 30, 2003 of
approximately $559 million used to calculate GAAP income yields. It should be
noted that the amount and timing of the anticipated credit losses assumed by us
related to the GAAP income yields are not directly comparable to those assumed
under the 3%/30% CDR Loss Scenario and the 3%/40% CDR Loss Scenario.
Sensitivity of Fair Value to Changes in the Discount Rate
The required rate of return used to determine the fair value of our CMBS is
comprised of many variables, such as a risk-free rate, a liquidity premium and a
credit risk premium. These variables are combined to determine a total rate
that, when used to discount the CMBS's assumed stream of future cash flows,
results in a net present value of such cash flows. The determination of such
rate is dependent on many quantitative and qualitative factors, such as, but not
limited to, the market's perception of the issuers and the credit fundamentals
of the commercial real estate underlying each pool of commercial mortgage loans.
For purposes of this disclosure, we assumed that the discount rate used to
determine the fair value of our CMBS increased by 100 basis points and 200 basis
points. The increase in the discount rate by 100 and 200 basis points,
respectively, would result in a corresponding decline in the value of our
aggregate CMBS by approximately $50.8 million (or 5.8%) and $97.4 million (or
11.2%), respectively, and our subordinated CMBS by approximately $32.5 million
(or 6.1%) and $62.1 million (or 11.6%), respectively.
The sensitivities above are hypothetical and should be used with caution.
As the figures indicate, changes in fair value based on variations in
assumptions generally cannot be extrapolated because the relationship of the
change in assumption to the change in fair value may not be linear. Also, the
effect of a variation in a particular assumption on the fair value of the
retained interest is calculated without changing any other assumption; in
reality, changes in one factor may result in changes in another (for example,
increases in market interest rates may result in lower prepayments and increased
credit losses), which might magnify or counteract the sensitivities.
Sensitivity of Fair Value to Extension Risk
For purposes of this disclosure, we assumed that the maturity date of each
commercial mortgage loan underlyin