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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
(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, 1999
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM __________ TO ___________
COMMISSION FILE NUMBER: 1-13447
ANNALY MORTGAGE MANAGEMENT, INC.
(Exact Name of Registrant as Specified in its Governing Instruments)
MARYLAND 22-3479661
(State or other jurisdiction of (I.R.S. Employer
incorporation of organization) Identification Number)
12 East 41st Street, Suite 700
New York, New York 10017
(Address of Principal Executive Offices)
(212) 696-0100
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Name of Each Exchange
Title of Each Class on Which Registered
- ------------------- -------------------
Common Stock, par value $.01 per share New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
None.
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days:
Yes __X__ No _____
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.
At March 22, 2000 the aggregate market value of the voting stock held by
non-affiliates of the Registrant was $114,944,217
The number of shares of the Registrant's Common Stock outstanding on March 22,
2000 was 13,743,363
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the Registrant's definitive Proxy Statement dated March 31, 2000,
issued in connection with the 2000 Annual Meeting of Stockholders of the
Registrant to be held on May 15, 2001 are incorporated by reference into Part
III.
ANNALY MORTGAGE MANAGEMENT, INC.
================================================================================
1999 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PART I
PAGE
----
ITEM 1. BUSINESS 1
ITEM 2. PROPERTIES 29
ITEM 3. LEGAL PROCEEDINGS 29
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 29
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY
AND RELATED SHAREHOLDER MATTERS 30
ITEM 6. SELECTED FINANCIAL DATA 31
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS 32
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 44
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 46
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE 46
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT 46
ITEM 11. EXECUTIVE COMPENSATION 46
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT 46
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 46
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND
REPORTS ON FORM 8-K 46
FINANCIAL STATEMENTS F-1
SIGNATURES 48
EXHIBIT INDEX 49
PART I
ITEM 1. BUSINESS
THE COMPANY
Background
Annaly Mortgage Management, Inc owns and manages a portfolio of
mortgage-backed securities, including mortgage pass-through certificates,
collateralized mortgage obligations (or CMOs) and other securities representing
interests in or obligations backed by pools of mortgage loans. Our principal
business objective is to generate net income for distribution to our
stockholders from the spread between the interest income on our mortgage-backed
securities and the costs of borrowing to finance our acquisition of
mortgage-backed securities. We have elected to be taxed as a real estate
investment trust (or REIT) under the Internal Revenue Code. Therefore,
substantially all of our assets consist of qualified REIT real estate assets (of
the type described in Section 856(c)(6)(B) of the Internal Revenue Code). We
commenced operations on February 18, 1997. We are self-advised and self-managed.
We have financed our purchases of mortgage-backed securities with the net
proceeds of equity offerings and borrowings under repurchase agreements whose
interest rates adjust based on changes in short-term market interest rates.
Assets
Under our capital investment policy, at least 75% of our total assets must
be comprised of high-quality mortgage-backed securities and short-term
investments. High quality securities means securities (1) that are rated within
one of the two highest rating categories by at least one of the nationally
recognized rating agencies, (2) that are unrated but are guaranteed by the
United States government or an agency of the United States government, or (3)
that are unrated but we determine them to be of comparable quality to rated high
quality mortgage-backed securities.
The remainder of our assets, comprising not more than 25% of our total
assets, may consist of other qualified REIT real estate assets which are unrated
or rated less than high quality but which are at least "investment grade" (rated
"BBB" or better by Standard & Poor's Corporation (S&P) or the equivalent by
another nationally recognized rating agency) or, if not rated, we determine them
to be of comparable credit quality to an investment which is rated "BBB" or
better.
We may acquire mortgage-backed securities backed by single-family
residential mortgage loans as well as securities backed by loans on
multi-family, commercial or other real estate-related properties. To date, all
of the mortgage-backed securities that we have acquired have been backed by
single-family residential mortgage loans.
To date, all of the securities that we have acquired have been agency
mortgage-backed securities which, although not rated, carry an implied "AAA"
rating. Agency mortgage-backed securities are mortgage-backed securities for
which a government agency or federally chartered corporation, such as the
Federal Home Loan Mortgage Corporation (or FHLMC), the Federal National Mortgage
Association (or FNMA) or the Government National Mortgage Association (or GNMA),
guarantees payments of principal or interest on the securities. Agency
mortgage-backed securities consist of agency pass-through certificates and CMOs
issued or guaranteed by an agency. Pass-through certificates provide for a
pass-through of the monthly interest and principal payments made by the
borrowers on the underlying mortgage loans. CMOs divide a pool of mortgage loans
into multiple tranches with different principal and interest payment
characteristics.
At December 31, 1999, approximately 31% of our mortgage-backed securities
were adjustable-rate pass-though certificates, approximately 34% of our
mortgage-backed securities were fixed-rate pass-through certificates or CMOs,
and approximately 35% of our mortgage-backed securities were CMO floaters. Our
adjustable-rate pass-through certificates are backed by adjustable-rate mortgage
loans and have coupon rates which adjust over time, subject to interest rate
caps and lag periods, in conjunction with changes in short-term interest rates.
CMO floaters are tranches of CMOs mortgage-backed securities where the interest
rate adjusts in conjunction with changes in short-term interest rates. CMO
floaters may be backed by fixed-rate mortgage loans or, less often, by
adjustable-rate mortgage loans. In this Form 10-K, except where the context
indicates otherwise, we use the term "adjustable-rate securities" or
"adjustable-rate mortgage-backed securities" to refer to adjustable-rate
pass-through certificates and CMO floaters. At December 31, 1999, the weighted
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average yield on our portfolio of earning assets was 6.77%, and the weighted
average term to next rate adjustment was 11 months.
We intend to continue to invest in adjustable-rate pass-through
certificates, fixed-rate mortgage-backed securities and CMO floaters. Although
we have not done so to date, we may also invest on a limited basis in mortgage
derivative securities representing the right to receive interest only or a
disproportionately large amount of interest. We have not and will not invest in
real estate mortgage investment conduit (or REMIC) residuals, other CMO
residuals or any mortgage-backed securities, such as inverse floaters, which
have imbedded leverage as part of their structural characteristics.
Borrowings
We attempt to structure our borrowings to have interest rate adjustment
indices and interest rate adjustment periods that, on an aggregate basis,
correspond generally to the interest rate adjustment indices and periods of our
adjustable-rate mortgage-backed securities. However, periodic rate adjustments
on our borrowings are generally more frequent than rate adjustments on our
mortgage-backed securities. At December 31, 1999, the weighted average cost of
funds for all of our borrowings was 5.26%, the weighted average original term to
next rate adjustment of these borrowings was 72 days, and the weighted average
term to next rate adjustment of these borrowings was 20 days.
We generally expect to maintain a ratio of debt-to-equity of between 8:1
and 12:1, although the ratio may vary from time to time depending upon market
conditions and other factors that our management deems relevant. For purposes of
calculating this ratio, our equity is equal to the value of our investment
portfolio on a mark-to-market basis, less the book value of our obligations
under repurchase agreements and other collateralized borrowings. At December 31,
1999, our ratio of debt-to-equity was 12.9:1.
Hedging
To the extent consistent with our election to qualify as a REIT, we may
enter into hedging transactions to attempt to protect our mortgage-backed
securities and related borrowings against the effects of major interest rate
changes. This hedging would be used to mitigate declines in the market value of
our mortgage-backed securities during periods of increasing or decreasing
interest rates and to limit or cap the rates on our borrowings. These
transactions would be entered into solely for the purpose of hedging interest
rate or prepayment risk and not for speculative purposes. To date, we have not
entered into any hedging transactions.
Compliance With REIT and Investment Company Requirements
We constantly monitor our mortgage-backed securities and the income from these
securities and, to the extent we enter into hedging transactions in the future,
will monitor income from our hedging transactions as well, so as to ensure at
all times that we maintain our qualification as a REIT and our exempt status
under the Investment Company Act.
Management
Our executive officers are:
o Michael A.J. Farrell, Chairman of the Board and Chief Executive
Officer
o Timothy J. Guba, President and Chief Operating Officer
o Wellington J. St. Claire, Vice Chairman of the Board and Chief
Investment Officer
o Kathryn F. Fagan, Chief Financial Officer and Treasurer
Messrs. Farrell and Guba and Ms. St. Claire have an average of 17 years
experience in the investment banking and investment management industries where,
in various capacities, they have each managed portfolios of mortgage-backed
securities, arranged collateralized borrowings and utilized hedging techniques
to mitigate interest rate and other risk within fixed-income portfolios. Ms.
Fagan is a certified public accountant and, prior to becoming our Chief
Financial Officer and Treasurer, served as Chief Financial Officer and
Controller of a publicly owned savings and loan
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association. Since 1994, Messrs. Farrell and Guba and Ms. St. Claire have
managed Fixed Income Discount Advisory Company (or FIDAC), a registered
investment advisor which, at December 31, 1999, managed, assisted in managing or
supervised approximately $1.4 billion in gross assets for a wide array of
clients, of which, at that date, approximately $450 million was managed on a
discretionary basis.
Management's duties on behalf of FIDAC's clients may create conflicts of
interest if members of management are presented with corporate opportunities
that may benefit both us and clients for which FIDAC acts as investment advisor.
In the event that an investment opportunity arises, the investment will be
allocated to another entity or us by determining the entity or account for which
the investment is most suitable. In making this determination, our management
will consider the investment strategy and guidelines of each entity or account
with respect to acquisition of assets, leverage, liquidity and other factors
which management determines appropriate.
Distributions
To maintain our qualification as a REIT, we must distribute substantially
all of our taxable income to our stockholders for each year. We have done this
in the past and intend to continue to do so in the future. We also have declared
and paid regular quarterly dividends in the past and intend to do so in the
future. We have adopted a dividend reinvestment plan to enable holders of common
stock to reinvest dividends automatically in additional shares of common stock.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain statements contained herein are not, and certain statements
contained in our future filings with the Securities and Exchange Commission (the
"SEC" or the "Commission"), in our press releases or in our other public or
shareholder communications may not be, based on historical facts and are
"Forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. Forward-looking statements which are based on
various assumptions, (some of which are beyond our control) may be identified by
reference to a future period or periods, or by the use of forward-looking
terminology, such as "may," "will," "believe," "expect," "anticipate,"
"continue," or similar terms or variations on those terms, or the negative of
those terms. Actual results could differ materially from those set forth in
forward-looking statements due to a variety of factors, including, but not
limited to, changes in interest rates, changes in yield curve, changes in
prepayment rates, the availability of mortgage-backed securities for purchase,
the availability of financing and, if available, the terms of any financing. For
a discussion of the risks and uncertainties which could cause actual results to
differ from those contained in the forward-looking statements, see "Risk
Factors." We do not undertake, and specifically disclaim any obligation, to
publicly release the result of any revisions which may be made to any
forward-looking statements to reflect the occurrence of anticipated or
unanticipated events or circumstances after the date of such statements.
3
BUSINESS STRATEGY
General
Our principal business objective is to generate income for distribution to
our stockholders, primarily from the net cash flows on our mortgage-backed
securities. Our net cash flows result primarily from the difference between the
interest income on our mortgage-backed security investments and our borrowing
costs on our mortgage-backed securities. To achieve our business objective and
generate dividend yields, our strategy is:
o to purchase mortgage-backed securities, the majority of which we
expect to have adjustable interest rates based on changes in
short-term market interest rates;
o to acquire mortgage-backed securities that we believe:
- we have the necessary expertise to evaluate and manage;
- we can readily finance;
- are consistent with our balance sheet guidelines and risk
management objectives; and
- provide attractive investment returns in a range of scenarios;
o to finance purchases of mortgage-backed securities with the proceeds
of equity offerings and, to the extent permitted by our capital
investment policy, to utilize leverage to increase potential returns
to stockholders through borrowings (primarily under repurchase
agreements);
o to attempt to structure our borrowings to have interest rate
adjustment indices and interest rate adjustment periods that, on an
aggregate basis, generally correspond to the interest rate adjustment
indices and interest rate adjustment periods of our adjustable-rate
mortgage-backed securities;
o to seek to minimize prepayment risk by structuring a diversified
portfolio with a variety of prepayment characteristics and through
other means; and
o to issue new equity or debt and increase the size of our balance sheet
when opportunities in the market for mortgage-backed securities are
likely to allow growth in earnings per share.
We believe we are able to obtain cost efficiencies through our
facilities-sharing arrangement with FIDAC and by virtue of our management's
experience in managing portfolios of mortgage-backed securities and arranging
collateralized borrowings. We will strive to become even more cost-efficient
over time by:
o seeking to raise additional capital from time to time in order to
increase our ability to invest in mortgage-backed securities;
o striving to lower our effective borrowing costs over time by seeking
direct funding with collateralized lenders, rather than using
financial intermediaries, and investigating the possibility of using
commercial paper and medium term note programs;
o improving the efficiency of our balance sheet structure by
investigating the issuance of uncollateralized subordinated debt,
preferred stock and other forms of capital; and
o utilizing information technology to the fullest extent possible in our
business, including to improve our ability to monitor the performance
of our mortgage-backed securities and to lower our operating costs.
4
Mortgage-Backed Securities
General
To date, all of the mortgage-backed securities that we have acquired have
been agency mortgage-backed securities which, although not rated, carry an
implied "AAA" rating. Agency mortgage-backed securities are mortgage-backed
securities where a government agency or federally chartered corporation, such as
FHLMC, FNMA or GNMA, guarantees payments of principal or interest on the
securities. Agency mortgage-backed securities consist of agency pass-through
certificates and CMOs issued or guaranteed by an agency.
Even though we have only acquired securities with an implied "AAA" rating
so far, under our capital investment policy we have the ability to acquire
securities of lower quality. Under our policy, at least 75% of our total assets
must be high quality mortgage-backed securities and short-term investments. High
quality securities means securities (1) that are rated within one of the two
highest rating categories by at least one of the nationally recognized rating
agencies, (2) that are unrated but are guaranteed by the United States
government or an agency of the United States government, or (3) that are unrated
or whose ratings have not been updated but that our management determines are of
comparable quality to rated high quality mortgage-backed securities.
Under our capital investment policy, the remainder of our assets,
comprising not more than 25% of total assets, may consist of mortgage-backed
securities and other qualified REIT real estate assets which are unrated or
rated less than high quality, but which are at least "investment grade" (rated
"BBB" or better by S&P or the equivalent by another nationally recognized rating
organization) or, if not rated, we determine them to be of comparable credit
quality to an investment which is rated "BBB" or better. We intend to structure
our portfolio to maintain a minimum weighted average rating (including our
deemed comparable ratings for unrated mortgage-backed securities) of our
mortgage-backed securities of at least single "A" under the S&P rating system
and at the comparable level under the other rating systems.
Our allocation of investments among the permitted investment types may vary
from time-to-time based on the evaluation by our Board of Directors of economic
and market trends and our perception of the relative values available from these
types of investments, except that in no event will our investments that are not
high quality exceed 25% of our total assets.
We acquire only those mortgage-backed securities that we believe we have
the necessary expertise to evaluate and manage, that are consistent with our
balance sheet guidelines and risk management objectives and that we believe we
can readily finance. Since we generally hold the mortgage-backed securities we
acquire until maturity, we generally do not seek to acquire assets whose
investment returns are attractive in only a limited range of scenarios. We
believe that future interest rates and mortgage prepayment rates are very
difficult to predict. Therefore, we seek to acquire mortgage-backed securities
which we believe will provide acceptable returns over a broad range of interest
rate and prepayment scenarios.
Our mortgage-backed securities consist of pass-through certificates and
collateralized mortgage obligations (or CMOs) issued or guaranteed by FHLMC,
FNMA or GNMA. We have not and will not invest in REMIC residuals, other CMO
residuals or mortgage-backed securities, such as inverse floaters, which have
imbedded leverage as part of their structural characteristics.
Description of Mortgage-Backed Securities
The mortgage-backed securities that we acquire provide funds for mortgage
loans made primarily to residential homeowners. Our securities generally
represent interests in pools of mortgage loans made by savings and loan
institutions, mortgage bankers, commercial banks and other mortgage lenders.
These pools of mortgage loans are assembled for sale to investors (like us) by
various government, government-related and private organizations.
Mortgage-backed securities differ from other forms of traditional debt
securities, which normally provide for periodic payments of interest in fixed
amounts with principal payments at maturity or on specified call dates. Instead,
mortgage-backed securities provide for a monthly payment, which consists of both
interest and principal. In effect, these payments are a "pass-through" of the
monthly interest and principal payments made by the individual borrower on the
mortgage loans, net of any fees paid to the issuer or guarantor of the
securities. Additional payments result from prepayments of principal upon the
sale, refinancing or foreclosure of the underlying residential property, net of
fees or costs which may be incurred. Some mortgage-backed securities, such as
securities issued by GNMA, are described as
5
"modified pass-through." These securities entitle the holder to receive all
interest and principal payments owed on the mortgage pool, net of certain fees,
regardless of whether or not the mortgagors actually make mortgage payments when
due.
The investment characteristics of pass-through mortgage-backed securities
differ from those of traditional fixed-income securities. The major differences
include the payment of interest and principal on the mortgage-backed securities
on a more frequent schedule, as described above, and the possibility that
principal may be prepaid at any time due to prepayments on the underlying
mortgage loans or other assets. These differences can result in significantly
greater price and yield volatility than is the case with traditional
fixed-income securities.
The occurrence of mortgage prepayments is affected by various factors
including the level of interest rates, general economic conditions, the age of
the mortgage loan, the location of the property and other social and demographic
conditions. Generally prepayments on mortgage-backed securities increase during
periods of falling mortgage interest rates and decrease during periods of rising
mortgage interest rates. We may reinvest prepayments at higher or lower interest
rates than the original investment, thus affecting the yield of our investments.
To the extent mortgage-backed securities are purchased at a premium, faster
than expected prepayments would result in a faster than expected amortization of
the premium paid. Conversely, if these securities were purchased at a discount,
faster than expected prepayments would accelerate our recognition of income.
CMOs may allow for shifting of prepayment risk from slower-paying tranches
to faster-paying tranches. This is in contrast to mortgage pass-through
certificates where all investors share equally in all payments, including all
prepayments, on the underlying mortgages.
FHLMC Certificates
FHLMC is a privately-owned government-sponsored enterprise created pursuant
to an Act of Congress on July 24, 1970. The principal activity of FHLMC
currently consists of the purchase of mortgage loans or participation interests
in these loans and the resale of the loans and participations in the form of
guaranteed mortgage-backed securities. FHLMC guarantees to each holder of FHLMC
certificates the timely payment of interest at the applicable pass-through rate
and ultimate collection of all principal on the holder's pro rata share of the
unpaid principal balance of the related mortgage loans, but does not guarantee
the timely payment of scheduled principal of the underlying mortgage loans. The
obligations of FHLMC under our guarantees are solely those of FHLMC and are not
backed by the full faith and credit of the United States. If FHLMC were unable
to satisfy these obligations, distributions to holders of FHLMC certificates
would consist solely of payments and other recoveries on the underlying Mortgage
Loans and, accordingly, monthly distributions to holders of FHLMC certificates
would be affected by delinquent payments and defaults on such Mortgage Loans.
FHLMC certificates may be backed by pools of single-family mortgage loans
or multi-family mortgage loans. These underlying mortgage loans may have
original terms to maturity of up to 40 years. FHLMC certificates may be issued
under cash programs (composed of mortgage loans purchased from a number of
sellers) or guarantor programs (composed of mortgage loans purchased from one
seller in exchange for participation certificates representing interests in the
mortgage loans purchased).
FHLMC certificates may pay interest at a fixed rate or an adjustable rate.
The interest rate paid on adjustable-rate FHLMC certificates (or FHLMC ARMs)
adjusts periodically within 60 days prior to the month in which the interest
rates on the underlying mortgage loans adjust. The interest rates paid on
certificates issued under FHLMC's standard ARM programs adjust in relation to
the Treasury index. Other specified indices used in FHLMC ARM programs include
the 11th District Cost of Funds Index published by the Federal Home Loan Bank of
San Francisco, LIBOR and other indices. Interest rates paid on fully-indexed
FHLMC ARM certificates equal the applicable index rate plus a specified number
of basis points. The majority of series of FHLMC ARM certificates issued to date
have evidenced pools of mortgage loans with monthly, semi-annual or annual
interest adjustments. Adjustments in the interest rates paid are generally
limited to an annual increase or decrease of either 100 or 200 basis points and
to a lifetime cap of 500 or 600 basis points over the initial interest rate.
Certain FHLMC programs include mortgage loans which allow the borrower to
convert the adjustable mortgage interest rate to a fixed rate. Adjustable-rate
mortgages which are converted into fixed-rate mortgage loans are repurchased by
FHLMC or by the seller of the loan to FHLMC at the unpaid principal balance of
the loan plus accrued interest to the due date of the last adjustable rate
interest payment.
6
FNMA Certificates
FNMA is a privately-owned, federally-chartered corporation organized and
existing under the Federal National Mortgage Association Charter Act. FNMA
provides funds to the mortgage market primarily by purchasing home mortgage
loans from local lenders, thereby replenishing their funds for additional
lending. FNMA guarantees to the registered holder of a FNMA certificate that it
will distribute amounts representing scheduled principal and interest on the
mortgage loans in the pool underlying the FNMA certificate, whether or not
received, and the full principal amount of any such mortgage loan foreclosed or
otherwise finally liquidated, whether or not the principal amount is actually
received. The obligations of FNMA under its guarantees are solely those of FNMA
and are not backed by the full faith and credit of the United States. If FNMA
were unable to satisfy its obligations, distributions to holders of FNMA
certificates would consist solely of payments and other recoveries on the
underlying mortgage loans and, accordingly, monthly distributions to holders of
FNMA certificates would be affected by delinquent payments and defaults on these
mortgage loans.
FNMA certificates may be backed by pools of single-family or multi-family
mortgage loans. The original terms to maturities of the mortgage loans generally
do not exceed 40 years. FNMA certificates may pay interest at a fixed rate or an
adjustable rate. Each series of FNMA ARM certificates bears an initial interest
rate and margin tied to an index based on all loans in the related pool, less a
fixed percentage representing servicing compensation and FNMA's guarantee fee.
The specified index used in different series has included the Treasury Index,
the 11th District Cost of Funds Index published by the Federal Home Loan Bank of
San Francisco, LIBOR and other indices. Interest rates paid on fully-indexed
FNMA ARM certificates equal the applicable index rate plus a specified number of
basis points. The majority of series of FNMA ARM certificates issued to date
have evidenced pools of mortgage loans with monthly, semi-annual or annual
interest rate adjustments. Adjustments in the interest rates paid are generally
limited to an annual increase or decrease of either 100 or 200 basis points and
to a lifetime cap of 500 or 600 basis points over the initial interest rate.
Certain FNMA programs include mortgage loans which allow the borrower to convert
the adjustable mortgage interest rate of the ARM to a fixed rate.
Adjustable-rate mortgages which are converted into fixed-rate mortgage loans are
repurchased by FNMA or by the seller of the loans to FNMA at the unpaid
principal of the loan plus accrued interest to the due date of the last
adjustable rate interest payment. Adjustments to the interest rates on FNMA ARM
certificates are typically subject to lifetime caps and periodic rate or payment
caps.
GNMA Certificates
GNMA is a wholly owned corporate instrumentality of the United States
within the Department of Housing and Urban Development (or HUD). The National
Housing Act of 1934 authorizes GNMA to guarantee the timely payment of the
principal of and interest on certificates which represent an interest in a pool
of mortgages insured by the Federal Housing Administration (or FHA) or partially
guaranteed by the Department of Veterans Affairs and other loans eligible for
inclusion in mortgage pools underlying GNMA certificates. Section 306(g) of the
Housing Act provides that the full faith and credit of the United States is
pledged to the payment of all amounts which may be required to be paid under any
guaranty by GNMA.
At present, most GNMA certificates are backed by single-family mortgage
loans. The interest rate paid on GNMA certificates may be a fixed rate or an
adjustable rate. The interest rate on GNMA certificates issued under GNMA's
standard ARM program adjusts annually in relation to the Treasury index.
Adjustments in the interest rate are generally limited to an annual increase or
decrease of 100 basis points and to a lifetime cap of 500 basis points over the
initial coupon rate.
Single-Family and Multi-Family Privately-Issued Certificates
Single-family and multi-family privately-issued certificates are
pass-through certificates that are not issued by one of the agencies and that
are backed by a pool of conventional single-family or multi-family mortgage
loans. These certificates are issued by originators of, investors in, and other
owners of mortgage loans, including savings and loan associations, savings
banks, commercial banks, mortgage banks, investment banks and special purpose
"conduit" subsidiaries of these institutions.
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While agency pass-through certificates are backed by the express obligation
or guarantee of one of the agencies, as described above, privately-issued
certificates are generally covered by one or more forms of private (i.e.,
non-governmental) credit enhancements. These credit enhancements provide an
extra layer of loss coverage in the event that losses are incurred upon
foreclosure sales or other liquidations of underlying mortgaged properties in
amounts that exceed the equity holder's equity interest in the property. Forms
of credit enhancements include limited issuer guarantees, reserve funds, private
mortgage guaranty pool insurance, over-collateralization and subordination.
Subordination is a form of credit enhancement frequently used and involves
the issuance of classes of senior and subordinated mortgage-backed securities.
These classes are structured into a hierarchy to allocate losses on the
underlying mortgage loans and also for defining priority of rights to payment of
principal and interest. Typically, one or more classes of senior securities are
created which are rated in one of the two highest rating levels by one or more
nationally recognized rating agencies and which are supported by one or more
classes of mezzanine securities and subordinated securities that bear losses on
the underlying loans prior to the classes of senior securities. Mezzanine
securities, as used in this prospectus, refers to classes that are rated below
the two highest levels but no lower than a single "B" level under the S&P rating
system (or comparable level under other rating systems) and are supported by one
or more classes of subordinated securities which bear realized losses prior to
the classes of mezzanine securities. Subordinated securities, as used in this
prospectus, refers to any class that bears the "first loss" from losses from
underlying mortgage loans or that is rated below a single "B" level (or, if
unrated, we deem it to be below that level). In some cases, only classes of
senior securities and subordinated securities are issued. By adjusting the
priority of interest and principal payments on each class of a given series of
senior-subordinated mortgage-backed securities, issuers are able to create
classes of mortgage-backed securities with varying degrees of credit exposure,
prepayment exposure and potential total return, tailored to meet the needs of
sophisticated institutional investors.
Collateralized Mortgage Obligations and Multi-Class Pass-Through Securities
We may also invest in collateralized mortgage obligations (or CMOs) and
multi-class pass-through securities. CMOs are debt obligations issued by special
purpose entities that are secured by mortgage-backed certificates, including, in
many cases, certificates issued by government and government-related guarantors,
including, GNMA, FNMA and FHLMC, together with certain funds and other
collateral. Multi-class pass-through securities are equity interests in a trust
composed of mortgage loans or other mortgage-backed securities. Payments of
principal and interest on underlying collateral provide the funds to pay debt
service on the CMO or make scheduled distributions on the multi-class
pass-through securities. CMOs and multi-class pass-through securities may be
issued by agencies or instrumentalities of the U.S. Government or by private
organizations. The discussion of CMOs in the following paragraphs is similarly
applicable to multi-class pass-through securities.
In a CMO, a series of bonds or certificates is issued in multiple classes.
Each class of CMOs, often referred to as a "tranche," is issued at a specific
coupon rate (which, as discussed below, may be an adjustable rate subject to a
cap) and has a stated maturity or final distribution date. Principal prepayments
on collateral underlying a CMO may cause it to be retired substantially earlier
than the stated maturity or final distribution date. Interest is paid or accrues
on all classes of a CMO on a monthly, quarterly or semi-annual basis. The
principal and interest on underlying mortgages may be allocated among the
several classes of a series of a CMO in many ways. In a common structure,
payments of principal, including any principal prepayments, on the underlying
mortgages are applied to the classes of the series of a CMO in the order of
their respective stated maturities or final distribution dates, so that no
payment of principal will be made on any class of a CMO until all other classes
having an earlier stated maturity or final distribution date have been paid in
full.
Other types of CMO issues include classes such as parallel pay CMOs, some
of which, such as planned amortization class CMOs (or PAC bonds), provide
protection against prepayment uncertainty. Parallel pay CMOs are structured to
provide payments of principal on certain payment dates to more than one class.
These simultaneous payments are taken into account in calculating the stated
maturity date or final distribution date of each class which, as with other CMO
structures, must be retired by its stated maturity date or final distribution
date but may be retired earlier. PAC bonds generally require payment of a
specified amount of principal on each payment date so long as prepayment speeds
on the underlying collateral fall within a specified range. PAC bonds are always
parallel pay CMOs with the required principal payment on the securities having
the highest priority after interest has been paid to all classes.
8
Other types of CMO issues include targeted amortization class CMOs (or TAC
bonds), which are similar to PAC bonds. While PAC bonds maintain their
amortization schedule within a specified range of prepayment speeds, TAC bonds
are generally targeted to a narrow range of prepayment speeds or a specified
prepayment speed. TAC bonds can provide protection against prepayment
uncertainty since cash flows generated from higher prepayments of the underlying
mortgage-related assets are applied to the various other pass-through tranches
so as to allow the TAC bonds to maintain their amortization schedule.
A CMO may be subject to the issuer's right to redeem the CMO prior to its
stated maturity date, which may have the effect of diminishing the anticipated
return on our investment. Privately-issued CMOs are supported by private credit
enhancements similar to those used for privately-issued certificates and are
often issued as senior-subordinated mortgage-backed securities. We will only
acquire CMOs or multi-class pass-through certificates that constitute debt
obligations or beneficial ownership in grantor trusts holding mortgage loans, or
regular interests in REMICs, or that otherwise constitute qualified REIT real
estate assets under the Internal Revenue Code (provided that we have obtained a
favorable opinion of our tax advisor or a ruling from the IRS to that effect).
Adjustable-Rate Mortgage Pass-Through Certificates and Floating Rate
Mortgage-Backed Securities (or "Floaters")
Most of the mortgage pass-through certificates we acquire are
adjustable-rate mortgage pass-through certificates. This means that their
interest rates may vary over time based upon changes in an objective index, such
as:
o LIBOR or the London Interbank Offered Rate. The interest rate that
banks in London offer for deposits in London of U.S. dollars.
o Treasury Index. A monthly or weekly average yield of benchmark U.S.
Treasury securities, as published by the Federal Reserve Board.
o CD Rate. The weekly average of secondary market interest rates on
six-month negotiable certificates of deposit, as published by the
Federal Reserve Board.
These indices generally reflect short-term interest rates. The underlying
mortgages for adjustable-rate mortgage pass-through certificates are
adjustable-rate mortgage loans (or ARMs).
We also acquire "floating rate CMOs" or "floaters." One or more tranches of
a CMO may have coupon rates that reset periodically at a specified increment
over an index such as LIBOR. These adjustable-rate tranches are sometime known
as "floating-rate CMOs" or "floaters" and may be backed by fixed or
adjustable-rate mortgages. To date, fixed-rate mortgages have been more commonly
utilized for this purpose.
Adjustable-rate mortgage pass-through certificates and floating-rate CMOs
are typically issued with lifetime caps on the coupon rate. These caps, similar
to the caps on ARMs, represent a ceiling beyond which the coupon rate on an
adjustable-rate mortgage pass-through certificate or a floating-rate CMO may not
increase regardless of increases in the interest rate index on which the
adjustable-rate mortgage pass-through certificate or floating-rate CMO is based.
There are two main categories of indices for adjustable-rate mortgage
pass-through certificates and floaters: (1) those based on U.S. Treasury
securities, and (2) those derived from calculated measures such as a cost of
funds index or a moving average of mortgage rates. Commonly utilized indices
include the one-year Treasury note rate, the three-month Treasury bill rate, the
six-month Treasury bill rate, rates on long-term Treasury securities, the 11th
District Federal Home Loan Bank Costs of Funds Index, the National Median Cost
of Funds Index, one-month or three-month LIBOR, the prime rate of a specific
bank, or commercial paper rates. Some indices, such as the one-year Treasury
rate, closely mirror changes in market interest rate levels. Others, such as the
11th District Home Loan Bank Cost of Funds Index, tend to lag changes in market
interest rate levels. We seek to diversify our investments in adjustable-rate
mortgage pass-through certificates and floaters among a variety of indices and
reset periods so that we are not at any one time unduly exposed to the risk of
interest rate fluctuations. In selecting adjustable-rate mortgage pass-through
certificates and floaters for investment, we will also consider the liquidity of
the market for the different mortgage-backed securities.
We believe that adjustable-rate mortgage pass-through certificates and
floaters are particularly well-suited to our investment objective of high
current income, consistent with modest volatility of net asset value, because
the value of adjustable-rate mortgage pass-through certificates and floaters
generally remains relatively stable as compared to
9
traditional fixed-rate debt securities paying comparable rates of interest.
While the value of adjustable-rate mortgage pass-through certificates and
floaters, like other debt securities, generally varies inversely with changes in
market interest rates (increasing in value during periods of declining interest
rates and decreasing in value during periods of increasing interest rates), the
value of adjustable-rate mortgage pass-through certificates and floaters should
generally be more resistant to price swings than other debt securities because
the interest rates on these securities move with market interest rates.
Accordingly, as interest rates change, the value of our shares should be
more stable than that of funds which invest primarily in securities backed by
fixed-rate mortgages or in other non-mortgage-backed debt securities, which do
not provide for adjustment in the interest rates in response to changes in
interest rates.
Adjustable-rate mortgage pass-through certificates and floaters typically
have caps, which limit the maximum amount by which the interest rate may be
increased or decreased at periodic intervals or over the life of the floater. To
the extent that interest rates rise faster than the allowable caps on the
adjustable-rate mortgage pass-through certificates and floaters, these
securities will behave more like fixed-rate securities. Consequently, interest
rate increases in excess of caps can be expected to cause these securities to
behave more like traditional debt securities than adjustable-rate securities
and, accordingly, to decline in value to a greater extent than would be the case
in the absence of these caps.
Adjustable-rate mortgage pass-through certificates and floaters, like other
mortgage-backed securities, differ from conventional bonds in that principal is
to be paid back over the life of the security rather than at maturity. As a
result, we receive monthly scheduled payments of principal and interest on these
securities and may receive unscheduled principal payments representing
prepayments on the underlying mortgages. When we reinvest the payments and any
unscheduled prepayments we receive, we may receive a rate of interest on the
reinvestment which is lower than the rate on the existing security. For this
reason, adjustable-rate mortgage pass-through certificates and floaters are less
effective than longer-term debt securities as a means of "locking in"
longer-term interest rates. Accordingly, adjustable-rate mortgage pass-through
certificates and floaters, while generally having less risk of price decline
during periods of rapidly rising rates than fixed-rate mortgage-backed
securities of comparable maturities, have less potential for capital
appreciation than fixed-rate securities during periods of declining interest
rates.
As in the case of fixed-rate mortgage-backed securities, to the extent
these securities are purchased at a premium, faster than expected prepayments
would result in a faster than expected amortization of the premium paid.
Conversely, if these securities were purchased at a discount, faster than
expected prepayments would accelerate our recognition of income.
As in the case of fixed-rate CMOs, floating-rate CMOs may allow for
shifting of prepayment risk from slower-paying tranches to faster-paying
tranches. This is in contrast to mortgage pass-through certificates where all
investors share equally in all payments, including all prepayments, on the
underlying mortgages.
Other Floating Rate Instruments
We may also invest in structured floating-rate notes issued or guaranteed
by government agencies, such as FNMA and FHLMC. These instruments are typically
structured to reflect an interest rate arbitrage (i.e., the difference between
the agency's cost of funds and the income stream from specified assets of the
agency) and their reset formulas may provide more attractive returns than other
floating rate instruments. The indices used to determine resets are the same as
those described above.
Mortgage Loans
We may from time to time invest a small percentage of our assets directly
in single-family, multi-family or commercial mortgage loans. We expect that the
majority of these mortgage loans would be ARMs. The interest rate on an ARM is
typically tied to an index (such as LIBOR or the interest rate on Treasury
bills), and is adjustable periodically at specified intervals. These mortgage
loans are typically subject to lifetime interest rate caps and periodic interest
rate or payment caps. The acquisition of mortgage loans generally involves
credit risk. We may obtain credit enhancement to mitigate this risk; however,
there can be no assurances that we will able to obtain credit enhancement or
that credit enhancement would mitigate the credit risk of the underlying
mortgage loans.
Capital Investment Policy
10
Asset Acquisitions
Our capital investment policy provides that at least 75% of our total
assets will be comprised of high quality mortgage-backed securities and
short-term investments. The remainder of our assets (comprising not more than
25% of total assets), may consist of mortgage-backed securities and other
qualified REIT real estate assets which are unrated or rated less than high
quality but which are at least "investment grade" (rated "BBB" or better) or, if
not rated, are determined by us to be of comparable credit quality to an
investment which is rated "BBB" or better.
Our capital investment policy requires that we structure our portfolio to
maintain a minimum weighted average rating (including our deemed comparable
ratings for unrated mortgage-backed securities) of our mortgage-backed
securities of at least single "A" under the S&P rating system and at the
comparable level under the other rating systems. To date, all of the
mortgage-backed securities we have acquired have been pass-through certificates
or CMOs issued or guaranteed by FHLMC, FNMA or GNMA which, although not rated,
have an implied "AAA" rating.
We intend to acquire only those mortgage-backed securities which we believe
we have the necessary expertise to evaluate and manage, which we can readily
finance and which are consistent with our balance sheet guidelines and risk
management objectives. Since we expect to hold our mortgage-backed securities
until maturity, we generally do not seek to acquire assets whose investment
returns are only attractive in a limited range of scenarios. We believe that
future interest rates and mortgage prepayment rates are very difficult to
predict and, as a result, we seek to acquire mortgage-backed securities which we
believe provide acceptable returns over a broad range of interest rate and
prepayment scenarios.
Among the asset choices available to us, our policy is to acquire those
mortgage-backed securities which we believe generate the highest returns on
capital invested, after considering,
o the amount and nature of anticipated cash flows from the asset,
o our ability to pledge the asset to secure collateralized borrowings,
o The increase in our capital requirement determined by our capital
investment policy resulting from the purchase and financing of the
asset, and
o the costs of financing, hedging, managing and reserving for the asset.
Prior to acquisition, we assess potential returns on capital employed over the
life of the asset and in a variety of interest rate, yield spread, financing
cost, credit loss and prepayment scenarios.
We also give consideration to balance sheet management and risk
diversification issues. We deem a specific asset which we are evaluating for
potential acquisition as more or less valuable to the extent it serves to
increase or decrease certain interest rate or prepayment risks which may exist
in the balance sheet, to diversify or concentrate credit risk, and to meet the
cash flow and liquidity objectives our management may establish for our balance
sheet from time to time. Accordingly, an important part of the asset evaluation
process is a simulation, using our risk management model, of the addition of a
potential asset and our associated borrowings and hedges to the balance sheet
and an assessment of the impact this potential asset acquisition would have on
the risks in and returns generated by our balance sheet as a whole over a
variety of scenarios.
We focus primarily on the acquisition of adjustable-rate mortgage-backed
securities, including floaters. We have, however, purchased a significant amount
of fixed-rate mortgage-backed securities and may continue to do so in the future
if, in our view, the potential returns on capital invested, after hedging and
all other costs, would exceed the returns available from other assets or if the
purchase of these assets would serve to reduce or diversify the risks of our
balance sheet.
Although we have not yet done so, we may purchase the stock of mortgage
REITs or similar companies when we believe that these purchases would yield
attractive returns on capital employed. When the stock market valuations of
these companies are low in relation to the market value of their assets, these
stock purchases can be a way for us to acquire an interest in a pool of
mortgage-backed securities at an attractive price. We do not, however, presently
intend to invest in the securities of other issuers for the purpose of
exercising control or to underwrite securities of other issuers.
11
We may acquire newly-issued mortgage-backed securities, and also will seek
to expand our capital base in order to further increase our ability to acquire
new assets, when the potential returns from new investments appears attractive
relative to the return expectations of stockholders. We may in the future
acquire mortgage-backed securities by offering our debt or equity securities in
exchange for the mortgage-backed securities.
We generally intend to hold mortgage-backed securities for extended
periods. In addition, the REIT provisions of the Internal Revenue Code limit in
certain respects our ability to sell mortgage-backed securities. We may decide
to sell assets from time to time, however, for a number of reasons including to
dispose of an asset as to which credit risk concerns have arisen, to reduce
interest rate risk, to substitute one type of mortgage-backed security for
another, to improve yield or to maintain compliance with the 55% requirement
under the Investment Company Act, and generally to re-structure the balance
sheet when we deem advisable. Our Board of Directors has not adopted any policy
that would restrict management's authority to determine the timing of sales or
the selection of mortgage-backed securities to be sold.
We do not invest in principal-only interests in mortgage-backed securities,
residual interests, accrual bonds, inverse-floaters, two-tiered index bonds,
cash flow bonds, mortgage-backed securities with imbedded leverage or
mortgage-backed securities that would be deemed unacceptable for collateralized
borrowings, excluding shares in mortgage REITs.
As a requirement for maintaining REIT status, we will distribute to
stockholders aggregate dividends equaling at least 95% of our taxable income
(excluding capital gains) for the taxable year ending December 31, 2000, and at
least 90% of our taxable income (excluding capital gains) for subsequent taxable
years. We will make additional distributions of capital when the return
expectations of the stockholders appear to exceed returns potentially available
to us through making new investments in mortgage-backed securities. Subject to
the limitations of applicable securities and state corporation laws, we can
distribute capital by making purchases of our own capital stock or through
paying down or repurchasing any outstanding uncollateralized debt obligations.
Our asset acquisition strategy may change over time as market conditions
change and as we evolve.
Credit Risk Management
We have not taken on credit risk to date, but may do so in the future. In
that event, we will review credit risk and other risk of loss associated with
each investment and determine the appropriate allocation of capital to apply to
the investment under our capital investment policy. Our Board of Directors will
monitor the overall portfolio risk and determine appropriate levels of provision
for loss.
Capital and Leverage
We expect generally to maintain a debt-to-equity ration of between 8:1 and
12:1, although the ratio may vary from time to time depending upon market
conditions and other factors our management deems relevant, including the
composition of our balance sheet, haircut levels required by lenders, the market
value of our mortgage-backed securities in our portfolio and "excess capital
cushion" percentages (as described below) set by our board of directors from
time to time. For purposes of calculating this ratio, our equity (or capital
base) is equal to the value of our investment portfolio on a mark-to-market
basis less the book value of our obligations under repurchase agreements and
other collateralized borrowings. At December 31, 1999, our ratio of
debt-to-equity was 12.9:1.
Our goal is to strike a balance between the under-utilization of leverage,
which reduces potential returns to stockholders, and the over-utilization of
leverage, which could reduce our ability to meet our obligations during adverse
market conditions. Our capital investment policy limits our ability to acquire
additional assets during times when our debt-to-equity ratio exceeds 12:1. Our
capital base represents the approximate liquidation value of our investments and
approximates the market value of assets that we can pledge or sell to meet
over-collateralization requirements for our borrowings. The unpledged portion of
our capital base is available for us to pledge or sell as necessary to maintain
over-collateralization levels for our borrowings.
We are prohibited from acquiring additional assets during periods when our
capital base is less than the minimum amount required under our capital
investment policy, except as may be necessary to maintain REIT status or our
exemption from the Investment Company Act. In addition, when our capital base
falls below our risk-managed capital requirement, our management is required to
submit to our board a plan for bringing our capital base into
12
compliance with our capital investment policy guidelines. We anticipate that in
most circumstances we can achieve this goal without overt management action
through the natural process of mortgage principal repayments. We anticipate that
our capital base is likely to exceed our risk-managed capital requirement during
periods following new equity offerings and during periods of falling interest
rates and that our capital base could fall below the risk-managed capital
requirement during periods of rising interest rates.
The first component of our capital requirements is the current aggregate
over-collateralization amount or "haircut" the lenders require us to hold as
capital. The haircut for each mortgage-backed security is determined by our
lenders based on the risk characteristics and liquidity of the asset. Haircut
levels on individual borrowings generally range from 3% for certain FHLMC, FNMA
or GNMA mortgage-backed securities to 20% for certain privately-issued
mortgage-backed securities. At December 31, 1999, the weighted average haircut
level on our securities was 3.4%. Should the market value of our pledged assets
decline, we will be required to deliver additional collateral to our lenders to
maintain a constant over-collateralization level on our borrowings.
The second component of our capital requirement is the "excess capital
cushion." This is an amount of capital in excess of the haircuts required by our
lenders. We maintain the excess capital cushion to meet the demands of our
lenders for additional collateral should the market value of our mortgage-backed
securities decline. The aggregate excess capital cushion equals the sum of
liquidity cushion amounts assigned under our capital investment policy to each
of our mortgage-backed securities. We assign excess capital cushions to each
mortgage-backed security based on our assessment of the mortgage-backed
security's market price volatility, credit risk, liquidity and attractiveness
for use as collateral by lenders. The process of assigning excess capital
cushions relies on our management's ability to identify and weigh the relative
importance of these and other factors. In assigning excess capital cushions, we
also give consideration to hedges associated with the mortgage-backed security
and any effect such hedges may have on reducing net market price volatility,
concentration or diversification of credit and other risks in the balance sheet
as a whole and the net cash flows that we can expect from the interaction of the
various components of our balance sheet.
Our Board reviews on a periodic basis various analyses prepared by our
management of the risks inherent in our balance sheet, including an analysis of
the effects of various scenarios on our net cash flow, earnings, dividends,
liquidity and net market value. Should our Board determine that the minimum
required capital base set by our capital investment policy is either too low or
too high, our Board may raise or lower the capital requirement accordingly.
Our capital investment policy stipulates that at least 25% of the capital
base maintained to satisfy the excess capital cushion must be invested in
AAA-rated adjustable-rate mortgage-backed securities or assets with similar or
better liquidity characteristics.
A substantial portion of our borrowings are short-term or variable-rate
borrowings. Our borrowings are implemented primarily through repurchase
agreements, but in the future may also be obtained through loan agreements,
lines of credit, dollar-roll agreements (an agreement to sell a security for
delivery on a specified future date and a simultaneous agreement to repurchase
the same or a substantially similar security on a specified future date) and
other credit facilities with institutional lenders and issuance of debt
securities such as commercial paper, medium-term notes, CMOs and senior or
subordinated notes. We enter into financing transactions only with institutions
that we believe are sound credit risks and follow other internal policies
designed to limit our credit and other exposure to financing institutions.
We expect to continue to use repurchase agreements as our principal
financing device to leverage our mortgage-backed securities portfolio. We
anticipate that, upon repayment of each borrowing under a repurchase agreement,
we will use the collateral immediately for borrowing under a new repurchase
agreement. At present, we have entered into uncommitted facilities with 23
lenders for borrowings in the form of repurchase agreements. We have not at the
present time entered into any commitment agreements under which the lender would
be required to enter into new repurchase agreements during a specified period of
time, nor do we presently plan to have liquidity facilities with commercial
banks. We may, however, enter into such commitment agreements in the future. We
enter into repurchase agreements primarily with national broker-dealers,
commercial banks and other lenders which typically offer this type of financing.
We enter into collateralized borrowings only with financial institutions meeting
credit standards approved by our Board, and we monitor the financial condition
of these institutions on a regular basis.
A repurchase agreement, although structured as a sale and repurchase
obligation, acts as a financing under which we effectively pledge our
mortgage-backed securities as collateral to secure a short-term loan. Generally,
the other party to the agreement makes the loan in an amount equal to a
percentage of the market value of the pledged collateral. At the
13
maturity of the repurchase agreement, we are required to repay the loan and
correspondingly receive back our collateral. While used as collateral, the
mortgage-backed securities continue to pay principal and interest which are for
our benefit. In the event of our insolvency or bankruptcy, certain repurchase
agreements may qualify for special treatment under the Bankruptcy Code, the
effect of which, among other things, would be to allow the creditor under the
agreement to avoid the automatic stay provisions of the Bankruptcy Code and to
foreclose on the collateral agreement without delay. In the event of the
insolvency or bankruptcy of a lender during the term of a repurchase agreement,
the lender may be permitted, under applicable insolvency laws, to repudiate the
contract, and our claim against the lender for damages may be treated simply as
an unsecured creditor. In addition, if the lender is a broker or dealer subject
to the Securities Investor Protection Act of 1970, or an insured depository
institution subject to the Federal Deposit Insurance Act, our ability to
exercise our rights to recover our securities under a repurchase agreement or to
be compensated for any damages resulting from the lender's insolvency may be
further limited by those statutes. These claims would be subject to significant
delay and, if and when received, may be substantially less than the damages we
actually incur.
Substantially all of our borrowing agreements require us to deposit
additional collateral in the event the market value of existing collateral
declines, which may require us to sell assets to reduce our borrowings. We have
designed our liquidity management policy to maintain a cushion of equity
sufficient to provide required liquidity to respond to the effects under our
borrowing arrangements of interest rate movements and changes in market value of
our mortgage-backed securities, as described above. However, a major disruption
of the repurchase or other market relied that we rely on for short-term
borrowings would have a material adverse effect on us unless we were able to
arrange alternative sources of financing on comparable terms.
Our articles of incorporation and bylaws do not limit our ability to incur
borrowings, whether secured or unsecured.
Interest Rate Risk Management
To the extent consistent with our election to qualify as a REIT, we follow
an interest rate risk management program intended to protect our portfolio of
mortgage-backed securities and related debt against the effects of major
interest rate changes. Specifically, our interest rate risk management program
is formulated with the intent to offset the potential adverse effects resulting
from rate adjustment limitations on our mortgage-backed securities and the
differences between interest rate adjustment indices and interest rate
adjustment periods of our adjustable-rate mortgage-backed securities and related
borrowings.
Our interest rate risk management program encompasses a number of
procedures, including the following:
o we attempt to structure our borrowings to have interest rate
adjustment indices and interest rate adjustment periods that, on an
aggregate basis, generally correspond to the interest rate adjustment
indices and interest rate adjustment periods of our adjustable-rate
mortgage-backed securities; and
o we attempt to structure our borrowing agreements relating to
adjustable-rate mortgage-backed securities to have a range of
different maturities and interest rate adjustment periods (although
substantially all will be less than one year).
We adjust the average maturity adjustment periods of our borrowings on an
ongoing basis by changing the mix of maturities and interest rate adjustment
periods as borrowings come due and are renewed. Through use of these procedures,
we attempt to minimize the differences between the interest rate adjustment
periods of our mortgage-backed securities and related borrowings that may occur.
Although we have not done so to date, we may purchase from time to time
interest rate caps, interest rate swaps, interest rate collars, caps or floors,
"interest only" mortgage-backed securities and similar instruments to attempt to
mitigate the risk of the cost of our variable rate liabilities increasing at a
faster rate than the earnings on our assets during a period of rising interest
rates or to mitigate prepayment risk. We may hedge as much of the interest rate
risk as our management determines is in our best interests, given the cost of
the hedging transactions and the need to maintain our status as a REIT. This
determination may result in our electing to bear a level of interest rate or
prepayment risk that could otherwise be hedged when management believes, based
on all relevant facts, that bearing the risk is advisable.
We seek to build a balance sheet and undertake an interest rate risk
management program which is likely to generate positive earnings and maintain an
equity liquidation value sufficient to maintain operations given a variety of
14
potentially adverse circumstances. Accordingly, our hedging program addresses
both income preservation, as discussed above, and capital preservation concerns.
For capital preservation, we monitor our "duration." This is the expected
percentage change in market value of our assets that would be caused by a 1%
change in short and long-term interest rates. To monitor duration and the
related risks of fluctuations in the liquidation value of our equity, we model
the impact of various economic scenarios on the market value of our
mortgage-backed securities and liabilities. At December 31, 1999, we estimate
that the duration of our assets was 2%. We believe that our interest rate risk
management program will allow us to maintain operations throughout a wide
variety of potentially adverse circumstances. Nevertheless, in order to further
preserve our capital base (and lower our duration) during periods when we
believe a trend of rapidly rising interest rates has been established, we may
decide to enter into or increase hedging activities or to sell assets. Each of
these actions may lower our earnings and dividends in the short term to further
our objective of maintaining attractive levels of earnings and dividends over
the long term.
We may elect to conduct a portion of our hedging operations through one or
more subsidiary corporations which would not be a qualified REIT subsidiary and
would be subject to Federal and state income taxes. To comply with the asset
tests applicable to us as a REIT, the value of the securities of the any taxable
subsidiary we hold must be limited to less than 5% of the value of our total
assets as of the end of each calendar quarter and we may not own more than 10%
of the voting securities of the taxable subsidiary. A taxable subsidiary would
not elect REIT status and would distribute any net profit after taxes to us and
its other stockholders. Any dividend income we receive from the taxable
subsidiary (combined with all other income generated from our assets, other than
qualified REIT real estate assets) must not exceed 25% of our gross income.
We believe that we have developed a cost-effective asset/liability
management program to provide a level of protection against interest rate and
prepayment risks. However, no strategy can completely insulate us from interest
rate changes and prepayment risks. Further, as noted above, the Federal income
tax requirements that we must satisfy to qualify as a REIT limit our ability to
hedge our interest rate and prepayment risks. We monitor carefully, and may have
to limit, our asset/liability management program to assure that we do not
realize excessive hedging income, or hold hedging assets having excess value in
relation to total assets, which would result in our disqualification as a REIT
or, in the case of excess hedging income, the payment of a penalty tax for
failure to satisfy certain REIT income tests under the Internal Revenue Code,
provided the failure was for reasonable cause. In addition, asset/liability
management involves transaction costs which increase dramatically as the period
covered by the hedging protection increases. Therefore, we may be unable to
hedge effectively our interest rate and prepayment risks.
Prepayment Risk Management
We seek to minimize the effects of faster or slower than anticipated
prepayment rates through structuring a diversified portfolio with a variety of
prepayment characteristics, investing in mortgage-backed securities with
prepayment prohibitions and penalties, investing in certain mortgage-backed
security structures which have prepayment protections, and balancing assets
purchased at a premium with assets purchased at a discount. We monitor
prepayment risk through periodic review of the impact of a variety of prepayment
scenarios on our revenues, net earnings, dividends, cash flow and net balance
sheet market value.
Future Revisions in Policies and Strategies
Our Board of Directors has established the investment policies and
operating policies and strategies set forth in this prospectus supplement. The
Board has the power to modify or waive these policies and strategies without the
consent of the stockholders to the extent that the Board determines that the
modification or waiver is in the best interests of our stockholders. Among other
factors, developments in the market which affect our policies and strategies or
which change our assessment of the market may cause our Board to revise our
policies and strategies.
Potential Acquisitions, Strategic Alliances and Other Investments
From time to time we have had discussions with other parties regarding
possible transactions including acquisitions of other businesses or assets,
investments in other entities, joint venture arrangements, or strategic
alliances, including a strategic alliance with Liberty Capital, a privately-held
financial services company headquartered in Ohio. To date, none of these
discussions have gone beyond the preliminary stage. We have also considered from
time to time entering into related businesses.
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During 1998, we made an initial investment of $49,980 in Annaly
International Mortgage Management, Inc. Annaly International explores business
opportunities overseas, including the origination of mortgages. Annaly
International has not commenced operations beyond this exploratory stage. We now
own 24.99% of the equity of Annaly International in the form of non-voting
securities. The remaining equity of Annaly International is owned by FIDAC 1
Partners. FIDAC 1 Partners is owned by Michael A.J. Farrell, our Chairman and
Chief Executive Officer, Timothy J. Guba, our President and Chief Operating
Officer, Wellington J. St. Claire, our Vice Chairman and Chief Investment
Officer, Kathryn F. Fagan, our Chief Operating Officer, and other persons.
Annaly International made investments of $39,967 in Annaly.com, Inc.
Annaly.com explores opportunities to acquire or originate mortgages in the
United States. Annaly.com has established a website at http://www.annaly.com but
has not commenced the acquisition or origination of mortgages. Annaly
International owns 51% of the equity of Annaly.com. The remaining equity of
Annaly.com is owned by FIDAC. Mr. Farrell is the sole shareholder of FIDAC.
Prior to making our investment in Annaly International we consulted with
our tax advisors to ensure that the investment would not cause us to fail to
satisfy the asset and source of income tests applicable to us as a REIT. Prior
to making any additional equity investment in Annaly International or any other
equity investment, we will similarly consult with our tax advisors.
We may, from time to time, continue to explore possible acquisitions,
investments, joint venture arrangements and strategic alliances, as well as the
further development of the business of Annaly International or Annaly.com.
Dividend Reinvestment and Share Purchase Plan
We have adopted a dividend reinvestment and share purchase plan. Under the
dividend reinvestment feature of the plan, existing shareholders can reinvest
their dividends in additional shares of our common stock. Under the share
purchase feature of the plan, new and existing shareholders can purchase shares
of our common stock. We have filed and the SEC has declared effective a Form S-3
registration statement registering 2,000,000 shares that may be issued under the
plan.
Legal Proceedings
There are no material pending legal proceedings to which we are a party or
to which any of our property is subject.
FEDERAL INCOME TAX CONSIDERATIONS
The following discusses the material United States federal income tax
considerations that relate to our treatment as a REIT and that apply to an
investment in our stock. No assurance can be given that the conclusions set out
below would be sustained by a court if challenged by the IRS. This summary deals
only with stock that you hold as a capital asset, which generally means property
that is held for investment. It does not address tax considerations applicable
to you if you are a person subject to special tax rules, such as:
o a dealer or trader in securities;
o a financial institution;
o an insurance company;
o a stockholder that holds our stock as a hedge, part of a straddle,
conversion transaction or other arrangement involving more than one
position;
o a stockholder whose functional currency is not the United States
dollar; or
o a tax-exempt or foreign taxpayer, except to the extent discussed
below.
The discussion below is based upon the provisions of the United States
Internal Revenue Code of 1986 and regulations, rulings and judicial decisions
interpreting the Internal Revenue Code as of the date of this prospectus; any of
16
these authorities may be repealed, revoked or modified, perhaps with retroactive
effect, so as to result in federal income tax consequences different from those
discussed below.
The discussion set out below is intended only as a summary of the material
United States federal income tax consequences of our treatment as a REIT and of
an investment in our stock. We urge you to consult your own tax advisor as to
the tax consequences of an investment in our stock, including the application to
your particular situation of the tax considerations discussed below, as well as
the application of state, local or foreign tax laws. The statements of United
States tax law set out below are based on the laws in force and their
interpretation as of the date of this prospectus, and are subject to any changes
occurring after that date.
General
We have elected to become subject to tax as a REIT for federal income tax
purposes effective for our taxable year ending December 31, 1997. We plan to
continue to meet the requirements for taxation as a REIT. There can be no
assurance, however, that we will qualify as a REIT in any particular taxable
year, given the highly complex nature of the rules governing REITs, the ongoing
importance of factual determinations and the possibility of future changes in
our circumstances. If we were not to qualify as a REIT in any particular year,
we would be subject to federal income tax as a regular domestic corporation, and
you would be subject to tax in the same manner as a stockholder of a regular
domestic corporation. In this event, we could be subject to a potentially
substantial income tax liability in respect of each taxable year that we fail to
qualify as a REIT, and the amount of earnings and cash available for
distribution to you and other stockholders could be significantly reduced or
eliminated. See "Failure to Qualify" below.
REIT Qualification Requirements
The following is a brief summary of the material technical requirements
that we must meet on an ongoing basis in order to qualify, and remain qualified,
as a REIT under the Internal Revenue Code.
Stock Ownership Tests
We must meet the following stock ownership tests:
(1) our capital stock must be transferable;
(2) our capital stock must be held by at least 100 persons during at least
335 days of a taxable year of 12 months (or during a proportionate
part of a taxable year of less than 12 months); and
(2) no more than 50% of the value of our capital stock may be owned,
directly or indirectly, by five or fewer individuals at any time
during the last half of the taxable year. In applying this test, the
Internal Revenue Code treats some entities as individuals.
Tax-exempt entities, other than private foundations and certain
unemployment compensation trusts, are generally not treated as individuals for
these purposes. The requirements of items (2) and (3) above do not apply to the
first taxable year for which we made an election to be taxed as a REIT. However,
these stock ownership requirements must be satisfied in each subsequent taxable
year. Our articles of incorporation provide restrictions regarding the transfer
of our shares in order to aid us in meeting the stock ownership requirements. In
addition, we are required under Treasury Department regulations to demand annual
written statements from the record holders of designated percentages of our
capital stock disclosing actual and constructive stock ownership and to maintain
permanent records showing the information we have received as to the actual and
constructive stock ownership and a list of those persons failing or refusing to
comply with our demand.
Asset Tests
We generally must meet the following asset tests at the close of each
quarter of each taxable year:
(a) at least 75% of the value of our total assets must consist of
Qualified REIT Real Estate Assets, government securities, cash and
cash items; and
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(b) the value of securities that we hold (other than government
securities) may not exceed 25% of the value of our total assets, and
in addition, we generally may not hold securities of any one issuer
(other than a taxable REIT subsidiary) that constitute
(1) 5% or more of the value of our total assets,
(2) 10% of the outstanding voting securities of the issuer or
(3) 10% of the total value of the securities of the issuer.
A Qualified REIT Real Estate Assets means pass-through certificates,
mortgage loans and other assets of the type described in Section 856(c)(5)(B) of
the Internal Revenue Code.
Gross Income Tests
We generally must meet the following gross income tests for each taxable
year:
(a) at least 75% of our gross income must be derived from the real estate
sources specified in the Internal Revenue Code, including interest
income and gain from the disposition of Qualified REIT Real Estate
Assets or "qualified temporary investment income, which is income
derived from new capital within one year of its receipt; and
(b) at least 95% of our gross income for each taxable year must be derived
from sources of income qualifying for the 75% gross income test
described in (a), dividends, interest, and gains from the sale of
stock or other financial instruments (including interest rate swap and
cap agreements, options, futures contracts, forward rate agreements or
similar financial instruments entered into to hedge variable rate debt
incurred to acquire Qualified REIT Real Estate Assets) not held for
sale in the ordinary course of business.
Distribution Requirement
We generally must distribute to our stockholders at least 95% of our REIT
taxable income before deductions of dividends paid and excluding net capital
gain for the taxable year ending December 31,2000; for subsequent taxable years,
this requirement is 90% of REIT taxable income before deductions of dividends
paid and excluding net capital gain. However, we may elect to retain, rather
than distribute, our net long-term capital gains and pay the tax on these gains,
while our stockholders include their proportionate share of the undistributed
long-term capital gains in income and receive a credit for their share of the
tax that we pay.
Failure to Qualify
If we fail to qualify for taxation as a REIT in any taxable year and relief
provisions do not apply, we will be subject to tax, including any applicable
alternative minimum tax, on our taxable income at regular corporate rates.
Distributions to stockholders in any year in which we fail to qualify as a REIT
will not be deductible by us, nor will we be required to make distributions.
Unless entitled to relief under specific statutory provisions, we also will be
disqualified from taxation as a REIT for four taxable years following the year
during which qualification was lost. It is not possible to state whether in all
circumstances we would be entitled to such statutory relief.
Recent Developments
The Taxpayer Relief Extension Act of 1999 introduced changes that affect
our ability to qualify as a REIT. The Act added a restriction that a REIT may
not own 10% or more of the total value of the securities (except certain debt
instruments) of any issuer in addition to the existing limitation that a REIT
may not own 10% or more of the voting securities of any issuer (see "REIT
Qualification Requirements- -Asset Tests"). The Act did provide a transition
rule under which securities that a REIT held on July 12, 1999 will not be
subject to this new limitation, assuming that the issuer of the securities does
not engage in a substantially new line of business or acquire a substantial
asset. This transition rule should exempt our ownership of 24.99% of the equity
of Annaly International Mortgage Management, Inc., as operated on July 12, 1999,
from the new restriction.
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In addition, the Act provided that a REIT may own up to 100% of the stock
of "taxable REIT subsidiaries" so long as no more than 20% of a REIT's assets
are represented by securities of taxable REIT subsidiaries. To qualify as a
taxable REIT subsidiary, the subsidiary must join with its parent REIT in making
an election. Although not subject to the 10% vote or value test, a taxable REIT
subsidiary is otherwise subject to the REIT asset tests. Before we form any
taxable REIT subsidiary, we will consult with our tax advisor to determine
whether the formation and contemplation method of operation of the taxable REIT
subsidiary would case us to fail to satisfy these REIT asset tests or any other
REIT requirements.
Finally, the Act reduced the annual distribution requirement of a REIT from
the prior 95% of REIT taxable income to 90%. This reduced distribution
requirement applies to taxable years beginning after December 31, 2000 (see
"REIT Qualification Requirements- -Distribution Requirement").
Taxation of Annaly Mortgage Management
In any year in which we qualify as a REIT, we generally will not be subject
to federal income tax on that portion of our REIT taxable income or capital gain
that we distribute to our stockholders. We will, however, be subject to federal
income tax at normal corporate income tax rates upon any undistributed taxable
income or capital gain.
Notwithstanding our qualification as a REIT, we may also be subject to tax
in the following other circumstances:
o If we fail to satisfy either the 75% or the 95% gross income test, but
nonetheless maintain our qualification as a REIT because we meet other
requirements, we generally would be subject to a 100% tax on the
greater of the amount by which we fail either the 75% or the 95% gross
income test multiplied by a fraction intended to reflect our
profitability.
o We will also be subject to a tax of 100% on net income derived from
any "prohibited transaction" which is, in general, a sale or other
disposition of property held primarily for sale to customers in the
ordinary course of business.
o If we have (1) net income from the sale or other disposition of
foreclosure property that is held primarily for sale to customers in
the ordinary course of business or (2) other non-qualifying income
from foreclosure property, it will be subject to federal income tax at
the highest corporate income tax rate.
o If we fail to distribute during each calendar year at least the sum of
(1) 85% of our REIT ordinary income for such year, (2) 95% of our REIT
capital gain net income for such year and (3) any undistributed amount
of ordinary and capital gain net income from the preceding taxable
years, we would be subject to a 4% federal excise tax on the excess of
the required distribution over the amounts actually distributed during
the taxable year.
o If we acquire any asset from a C corporation in a transaction in which
the basis of the asset is determined by reference to the basis of the
asset in the hands of a C corporation and we recognize gain upon a
disposition of such asset occurring within 10 years of its
acquisition, then we would be subject to tax to the extent of any
built-in gain at the highest regular corporate rate.
o We also may be subject to the corporate alternative minimum tax, as
well as other taxes in situations not presently contemplated.
If we fail to qualify as a REIT in any taxable year and the relief
provisions provided in the Internal Revenue Code do not apply, we would be
subject to federal income tax, including any applicable alternative minimum tax,
on our taxable income in that taxable year and all subsequent taxable years at
the regular corporate income tax rates. We would not be allowed to deduct
distributions to shareholders in these years, nor would we be required to make
them under the Internal Revenue Code. Further, unless entitled to the relief
provisions of the Internal Revenue Code, we also would be disqualified from
re-electing REIT status for the four taxable years following the year during
which we became disqualified.
We intend to monitor on an ongoing basis our compliance with the REIT
requirements described above. In order to maintain our REIT status, we will be
required to limit the types of assets that we might otherwise acquire, or hold
19
some assets at times when we might otherwise have determined that the sale or
other disposition of these assets would have been more prudent.
Taxation of Stockholders
Unless you are a tax-exempt entity, distributions that we make to you,
including constructive distributions, generally will be subject to tax as
ordinary income to the extent of our current and accumulated earnings and
profits as determined for federal income tax purposes. If the amount we
distribute to you exceeds your allocable share of current and accumulated
earnings and profits, the excess will be treated as a return of capital to the
extent of your adjusted basis in your stock, which will reduce your basis in
your stock but will not be subject to tax. If the amount we distribute to you
also exceeds your adjusted basis, this excess amount will be treated as a gain
from the sale or exchange of a capital asset. Distributions you receive, whether
characterized as ordinary income or as capital gain, are not eligible for the
corporate dividends received deduction.
Distributions that we designate as capital gain dividends generally will be
subject to tax as long-term capital gain to you, to the extent that the
distributions to you and the other shareholders do not exceed our actual net
capital gain for the taxable year. In the event that we realize a loss for the
taxable year, you will not be permitted to deduct any share of that loss.
Further, if we, or a portion of our assets, were to be treated as a taxable
mortgage pool, any excess inclusion income that is allocated to you could not be
offset by any net operating loss that you may have. Future Treasury Department
regulations may require that you take into account, for purposes of computing
your individual alternative minimum tax liability, some of our tax preference
items.
Dividends that we declare during the last quarter of the calendar year and
actually pay to you during January of the following taxable year generally are
treated as if we had paid, and you had received, them on December 31 of the
calendar year and not on the date actually paid and received. In addition, we
may elect to treat other dividends distributed after the close of the taxable
year as having been paid during the taxable year, so long as they meet the
requirements described in the Internal Revenue Code, but you will be treated as
having received these dividends in the taxable year in which their distribution
is actually made.
If you sell or otherwise dispose of our stock, you will generally recognize
a capital gain or loss in an amount equal to the difference between the amount
realized and your adjusted basis in the stock, which gain or loss will be
long-term if you have held the stock for more than one year. Any loss that you
recognize on the sale or exchange of our stock that you have held for six months
or less generally will be treated as a long-term capital loss to the extent,
with respect to the stock, of (1) any long-term capital gain dividends that you
receive and (2) any long-term capital gain that we retain and the tax on which
you receive a credit.
If we do not qualify as a REIT in any year, distributions that we make to
you would be taxable in the same manner discussed above, except that:
o we would not be allowed to designate any distributions as capital gain
dividends;
o distributions would be eligible for the corporate dividends received
deduction;
o the excess inclusion income rules would not apply to you; and
o you would not receive any share of our tax preference items.
In this event, however, we could be subject to potentially substantial
federal income tax liability, and the amount of earnings and cash available for
distribution to you and other stockholders could be significantly reduced or
eliminated.
Information Reporting and Backup Withholding
We will report to our domestic stockholders and to the IRS the amount of
distributions that we pay, and the amount of tax that we withhold on these
distributions for each calendar year. Under the backup withholding rules, you
may be subject to backup withholding tax at a rate of 31% with respect to
distributions paid unless you:
o are a corporation or otherwise within an exempt category and
demonstrate this fact when required; or
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o provide a taxpayer identification number, certify as to no loss of
exemption from backup withholding tax and otherwise comply with
applicable requirements of the backup withholding tax rules.
If you do not provide us with your correct taxpayer identification number,
then you may also be subject to penalties imposed by the IRS.
Backup withholding tax is not an additional tax. Any amounts withheld under
the backup withholding tax rules will be refunded or credited against your
United States federal income tax liability, provided that you furnish the
required information to the IRS.
Taxation of Tax-Exempt Entities
The discussion under this heading only applies to you if you are a
tax-exempt entity.
Subject to the discussion below regarding a pension-held REIT,
distributions received from us or gain realized on the sale of our stock will
not be taxable as unrelated business taxable income (UBTI), provided that:
o you have not incurred indebtedness to purchase or hold our stock;
o you do not otherwise use our shares in an unrelated trade or business;
and
o we, consistent with our present intent, do not hold a residual
interest in a REMIC that gives rise to excess inclusion income as
defined under section 860E of the Internal Revenue Code.
If we were to be treated as a taxable mortgage pool, however, a substantial
portion of the dividends you receive may be subject to tax as UBTI.
In addition, a substantial portion of the dividends you receive may
constitute UBTI if we are treated as a pension-held REIT and you are a qualified
pension trust that holds more than 10% by value of our interests at any time
during a taxable year. For these purposes, a qualified pension trust is any
pension or other retirement trust that qualifies under section 401(a) of the
Internal Revenue Code. We would be treated as a pension-held REIT if (1) we
would not have qualified as a REIT but for the provisions of the Internal
Revenue Code which look through qualified pension trust stockholders to the
qualified pension trusts beneficiaries in determining stock ownership of a REIT
and (2) at least one qualified pension trust holds more than 25% of our stock by
value or one or more qualified pension trusts (each owning more than 10% of our
stock by value) hold in the aggregate more than 50% of our stock by value.
Assuming compliance with the ownership limit provisions set forth in our
articles of incorporation, it is unlikely that pension plans will accumulate
sufficient stock to cause us to be treated as a pension-held REIT.
If you are exempt from federal income taxation under sections 501(c)(7),
(c)(9), (c)(17), and (c)(20) of the Internal Revenue Code, then distributions
you receive may also constitute UBTI; we urge you to consult your tax advisor
concerning the applicable set aside and reserve requirements.
United States Federal Income Tax Considerations Applicable to Foreign Holders
The discussion under this heading applies to you only if you are not a U.S.
person. A U.S. person is a person who is:
o a citizen or resident of the United States;
o a corporation, partnership, or other entity created or organized in
the United States or under the laws of the United States or of any
political subdivision thereof;
o an estate whose income is includible in gross income for United States
Federal income tax purposes regardless of its source; or
o a trust, if (1) a court within the United States is able to exercise
primary supervision over the administration of the trust and one or
more U.S. persons have authority to control all substantial
21
decisions of the trust, or (2) the trust was in existence on August
26, 1996 and has made an election to be treated as a U.S. person;
This discussion is only a brief summary of the United States federal tax
consequences that apply to you, which are highly complex, and does not consider
any specific facts or circumstances that may apply to you and your particular
situation. We urge you to consult your tax advisor regarding the United States
federal tax consequences of acquiring, holding and disposing of our stock, as
well as any tax consequences that may arise under the laws of any foreign,
state, local or other taxing jurisdiction.
Distributions
Except for distributions attributable to gain from the dispositions of real
property interests or designated as capital gains dividends, distributions you
receive from us generally will be subject, to the extent of our earnings and
profits, to withholding of United States federal income tax at the rate of 30%,
unless reduced or eliminated by an applicable tax treaty or unless the
distributions are treated as effectively connected with a United States trade or
business. If you wish to claim the benefits of an applicable tax treaty, you may
need to satisfy certification and other requirements, some of which will change
on January 1, 2001.
Distributions you receive that are in excess of our earnings and profits
will be treated as a tax-free return of capital to the extent of your adjusted
basis in your stock. If the amount of the distribution also exceeds your
adjusted basis, this excess amount will be treated as gain from the sale or
exchange of our stock as described below. If we cannot determine at the time we
make a distribution whether the distribution will exceed our earnings and
profits, the distribution will be subject to withholding at the same rate as
dividends. These withheld amounts, however, will be refundable or creditable
against your United States federal tax liability if it is subsequently
determined that the distribution was, in fact, in excess of our earnings and
profits. If you receive a dividend that is treated as being effectively
connected with your conduct of a trade or business within the United States, the
dividend will be subject to the United States federal income tax on net income
that applies to United States persons generally and may be subject to the branch
profits tax if you are a corporation.
Distributions that we make to you and designate as capital gains dividends,
other than those attributable to the disposition of a United States real
property interest, generally will not be subject to United States federal income
taxation, unless:
o your investment in our stock is effectively connected with your
conduct of a trade or business within the United States; or
o you are a nonresident alien individual who is present in the United
States for 183 days or more in the taxable year and other requirements
are met.
Distributions that are attributable to your disposition of United States
real property interests are subject to income and withholding taxes pursuant to
the Foreign Investment in Real Property Act of 1980 (FIRPTA), and may also be
subject to branch profits tax if you are a corporation that is not entitled to
treaty relief or exemption. However, because we do not expect to hold assets
that would be treated as United States real property interests as defined by
FIRPTA, the FIRPTA provisions should not apply to your investment in our stock.
Gain on Disposition
You generally will not be subject to United States federal income tax on
gain recognized on a sale or other disposition of our stock unless:
o the gain is effectively connected with your conduct of a trade or
business within the United States;
o you are a nonresident alien individual who holds our stock as a
capital asset and is present in the United States for 183 or more days
in the taxable year and other requirements are met; or
o you are subject to tax under the FIRPTA rules discussed below.
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Gain that is effectively connected with your conduct of a trade or business
within the United States will be subject to the United States federal income tax
on net income that applies to United States persons generally and may be subject
to the branch profits tax if you are a corporation. However, these
effectively-connected gains will not be subject to withholding. We urge you to
consult applicable treaties, which may provide for different rules.
Under FIRPTA, you may be subject to tax on gain recognized from your sale
or other disposition of our stock if we were to both (1) hold United States real
property interests and (2) fail to qualify as a domestically-controlled REIT. A
REIT qualifies as domestically-controlled as long as less than 50% in value of
its shares of beneficial interest are held by foreign persons at all times
during the shorter of (1) the previous five years and (2) the period in which
the REIT is in existence. As mentioned above, we do not expect to hold any
United States real property interests. Furthermore, we will likely qualify as a
domestically-controlled REIT, although no assurances can be provided because our
shares are publicly-traded.
State and Local Taxes
We and our stockholders may be subject to state or local taxation in
various jurisdictions, including those in which we or they transact business or
reside. The state and local tax treatment that applies to us and our
stockholders may not conform to the federal income tax consequences discussed
above. Consequently, we urge you to consult your own tax advisor regarding the
effect of state and local tax laws.
COMPETITION
We believe that our principal competition in the business of acquiring and
holding mortgage-backed securities are financial institutions such as banks,
savings and loans, life insurance companies, institutional investors such as
mutual funds and pension funds, and certain other mortgage REITs. The existence
of these competitive entities, as well as the possibility of additional entities
forming in the future, may increase the competition for the acquisition of
mortgage-backed securities resulting in higher prices and lower yields on
assets.
RISK FACTORS
An investment in our stock involves a number of risks. Before making an
investment decision, you should carefully consider all of the risks described in
this prospectus. If any of the risks discussed in this prospectus actually
occur, our business, financial condition and results of operations could be
materially adversely affected. If this were to occur, the trading price of our
common stock could decline significantly and you may lose all or part of your
investment.
If the interest payments on our borrowings increase relative to the
interest we earn on our mortgage-backed securities, it may adversely affect
our profitability
We earn money based upon the difference between the interest payments we
earn on our mortgage-backed security investments and the interest payments we
must make on our borrowings. If the interest payments on our borrowings increase
relative to the interest we earn on our mortgage-backed securities, our
profitability may be adversely affected.
The interest payments on our borrowings may increase relative to the
interest we earn on our mortgage-backed securities for various reasons discussed
in this section.
Differences in timing of interest rate adjustments on our mortgage-backed
securities and our borrowings may adversely affect our profitability
We rely primarily on short-term borrowings to acquire mortgage-backed
securities with long-term maturities. Accordingly, if short-term interest
rates increase, this may adversely affect our profitability.
Most of the mortgage-backed securities we acquire are adjustable-rate
securities. This means that their interest rates may vary over time based
upon changes in an objective index, such as:
o LIBOR or the London Interbank Offered Rate. The interest rate that
banks in London offer for deposits in London of U.S. dollars.
23
o Treasury Index. A monthly or weekly average yield of benchmark U.S.
Treasury securities, as published by the Federal Reserve Board.
o CD Rate. The weekly average of secondary market interest rates on
six-month negotiable certificates of deposit, as published by the
Federal Reserve Board.
These indices generally reflect short-term interest rates. On December
31, 1999, approximately 67% of our mortgage-backed securities were
adjustable-rate securities.
The interest rates on our borrowings similarly vary with changes in an
objective index. However, the interest rates on our borrowings generally
adjust more frequently than the interest rates on our mortgage-backed
securities. For example, on December 31, 1999, our adjustable-rate
securities had a weighted average term to next rate adjustment of 11
months, while our borrowings had a weighted average term to next rate
adjustment of 20 days. Accordingly, in a period of rising interest rates,
we could experience a decrease in net income or a net loss because the
interest rates on our borrowings adjust faster than the interest rates on
our mortgage-backed securities.
Interest rate caps on our mortgage-backed securities may adversely affect
our profitability
Our adjustable-rate securities are typically subject to periodic and
lifetime interest rate caps which limit the amount an interest rate can
increase during any given period. Our borrowings are not subject to similar
restrictions. Accordingly, in a period of rapidly increasing interest
rates, we could experience a decrease in net income or a net loss because
the interest rates on our borrowings could increase without limitation
while the interest rates on our adjustable-rate mortgage-backed securities
would be limited by caps.
Because we acquire fixed rate securities, an increase in interest rates may
adversely affect our profitability
While the majority of our investments consist of adjustable-rate
securities, we also invest in fixed-rate mortgage-backed securities. In a
period of rising interest rates, our interest payments would increase while
the interest we earn on our fixed rate securities would not change. This
would adversely affect our profitability. On December 31, 1999,
approximately 34% of our mortgage-backed securities were fixed rate
securities.
An increase in prepayment rates may adversely affect our profitability
The mortgage-backed securities we acquire are backed by pools of mortgage
loans. We receive payments, generally, from the payments that are made on these
underlying mortgage loans. When borrowers prepay their mortgage loans at faster
rates than expected, this results in faster prepayments than expected on the
mortgage-backed securities using the effective yield method. These faster than
expected prepayments may adversely affect our profitability.
We often purchase mortgage-backed securities that have a higher interest
rate than the market interest rate at the time. In exchange for this higher
interest rate, we must pay a premium over market value to acquire the security.
In accordance with accounting rules, we amortize this premium over the term of
the mortgage-backed security using the effective yield method. If the
mortgage-backed security is prepaid in whole or in part prior to its expected
maturity date, however, we must expense the premium that is being prepaid at the
time of the prepayment. This adversely affects our profitability. On December
31, 1999, approximately 83% of the mortgage-backed securities we owned had been
acquired at a premium.
Prepayment rates generally increase when interest rates fall and decrease
when interest rates rise, but changes in prepayment rates are difficult to
predict. Prepayment rates also may be affected by conditions in the housing and
financial markets, general economic conditions and the relative interest rates
on fixed-rate and adjustable-rate mortgage loans.
We may seek to reduce prepayment risk by acquiring mortgage-backed
securities at a discount. If a discounted security is prepaid in whole or in
part prior to its expected maturity date, we will earn income on the amount of
the discount that is being prepaid. This will improve our profitability if there
are faster than expected prepayments. On December 31, 1999, approximately 17% of
the mortgage-backed securities we owned had been acquired at a discount.
We can also acquire mortgage-backed securities that are less affected by
prepayments. For example, we can acquire collateralized mortgage obligations or
CMO's, a type of mortgage-backed security. CMO's divide a pool of mortgage loans
into multiple tranches that allow for shifting of prepayment risks from
slower-paying tranches to faster-paying
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tranches. This is in contrast to pass-through or pay-through mortgage-backed
securities, where all investors share equally in all payments, including all
prepayments. As discussed below, the Investment Company Act imposes restrictions
on our purchase of CMO's. On December 31, 1999, approximately 35% of our
mortgage-backed securities were CMO's and approximately 65% of our
mortgage-backed securities were pass-through or pay-through securities.
While we seek to minimize prepayment risk to the extent practical, in
selecting investments we must balance prepayment risk against other risks and
the potential returns of each investment. No strategy can completely insulate us
from prepayment risk.
An increase in interest rates may adversely affect our book value
Increases in interest rates may negatively affect the market value of our
mortgage-backed securities. Our fixed-rate securities, generally, are more
negatively affected by these increases. In accordance with accounting rules, we
reduce our book value by the amount of any decrease in the market value of our
mortgage-backed securities. During the year 1999, rising interest rates
contributed to a decline in our book value from $9.95 per share at the beginning
of the year to $7.60 per share at the end of the year.
Our strategy involves significant leverage
We seek to maintain a ratio of debt-to-equity of between 8:1 and 12:1,
although our ratio may be above or below this amount. We incur this leverage by
borrowing against a substantial portion of the market value of our
mortgage-backed securities. By incurring this leverage, we can enhance our
returns. However, this leverage, which is fundamental to our investment
strategy, also creates significant risks.
Our leverage may cause substantial losses
Because of our significant leverage, we may incur substantial losses
if our borrowing costs increase. Our borrowing costs may increase for any
of the following reasons:
o Short-term interest rates increase
o The market value of our mortgage-backed securities decreases
o Interest rate volatility increases
o The availability of financing in the market decreases
Our leverage may cause margin calls and defaults and force us to sell
assets under adverse market conditions
Because of our leverage, a decline in the value of our mortgage-backed
securities may result in our lenders initiating margin calls. A margin call
means that the lender requires us to pledge additional collateral to
re-establish the ratio of the value of the collateral to the amount of the
borrowing. Our fixed-rate mortgage-backed securities generally are more
susceptible to margin calls as increases in interest rates tend to more
negatively affect the market value of fixed-rate securities.
If we are unable to satisfy margin calls, our lenders may foreclose on
our collateral. This could force us to sell our mortgage-backed securities
under adverse market conditions. Additionally, in the event of our
bankruptcy, our borrowings, which are generally made under repurchase
agreements, may qualify for special treatment under the Bankruptcy Code.
This special treatment would allow the lenders under these agreements to
avoid the automatic stay provisions of the Bankruptcy Code and to liquidate
the collateral under these agreements without delay.
Liquidation of collateral may jeopardize our REIT status
To continue to qualify as a REIT, we must comply with requirements
regarding our assets and our sources of income. If we are compelled to
liquidate our mortgage-backed securities,