Back to GetFilings.com
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, 2001
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 Charter)
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) (Zip Code)
(212) 696-0100
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange 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 25, 2002 the aggregate market value of the voting stock held by
non-affiliates of the Registrant was $1,393,968,716
The number of shares of the Registrant's Common Stock outstanding on March 25,
2002 was 82,870,659
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the Registrant's definitive Proxy Statement issued in connection
with the 2002 Annual Meeting of Stockholders of the Registrant to be held on May
17, 2002 are incorporated by reference into Part III.
ANNALY MORTGAGE MANAGEMENT, INC.
- --------------------------------------------------------------------------------
2001 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PART I
PAGE
ITEM 1. BUSINESS 1
ITEM 2. PROPERTIES 26
ITEM 3. LEGAL PROCEEDINGS 26
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 26
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY
AND RELATED STOCKHOLDER MATTERS 27
ITEM 6. SELECTED FINANCIAL DATA 29
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS 31
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 47
FINANCIAL STATEMENTS F-1
SIGNATURES 61
EXHIBIT INDEX 62
PART I
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain statements contained in this annual report, 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.
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)(5)(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 that (1) are rated within
one of the two highest rating categories by at least one of the nationally
recognized rating agencies, (2) are unrated but are guaranteed by the United
States government or an agency of the United States government, or (3) 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, 2001, approximately 60% of our mortgage-backed securities
were adjustable-rate pass-though certificates, approximately 22% of our
mortgage-backed securities were fixed-rate pass-through certificates or CMOs,
and approximately 18% 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
1
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. Our fixed-rate pass-through certificates are backed
by fixed-rate mortgage rates which do not adjust over time. 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, 2001, the weighted average yield on our portfolio of
earning assets was 4.41%, and the weighted average term to next rate adjustment
on adjustable rate securities was 24 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, 2001, the weighted average cost of
funds for all of our borrowings was 2.18%, the weighted average original term to
maturity was 119 days, and the weighted average term to next rate adjustment of
these borrowings was 85 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,
2001, our ratio of debt-to-equity was 9.5:1.
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, Chief Executive, Officer
and President;
o Wellington J. St. Claire, Vice Chairman of the Board and Chief
Investment Officer;
o Kathryn F. Fagan, Chief Financial Officer and Treasurer; and
2
o Jennifer A. Stephens, Secretary and Investment Officer.
Mr. Farrell and Ms. St. Claire have an average of 21 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. Mr. Farrell was
appointed our President effective as of January 1, 2002. 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 association. Ms. Stephens has worked for us since
December 1996. Since 1994, Mr. Farrell and Ms. St. Claire have managed Fixed
Income Discount Advisory Company (or FIDAC), a registered investment advisor
which, at December 31, 2001, managed, assisted in managing or supervised
approximately $3 billion in gross assets for a wide array of clients, all of
which, assets on that date were managed on a discretionary basis. Mr. Farrell is
the sole stockholder of FIDAC.
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.
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
5
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 "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 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.
Various factors affect the rate at which mortgage prepayments occur,
including changes in 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 a yield that is higher
or lower than the yield on the prepaid investment, thus affecting the weighted
average 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 mortgage 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 its gurantees 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, defaults and deliquencies on the underlying mortgage
loans would adversely affect monthly distributions to holders of FHLMC
certificates.
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 acquired from one
seller in exchange for 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
6
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.
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, defaults and delinquencies on the
underlying mortgage loans would adversely affect monthly distributions to
holders of FNMA certificates.
FNMA certificates may be backed by pools of single-family or multi-family
mortgage loans. The original term to maturity of any such mortgage loan
generally does 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.
7
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.
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 Form 10-K, 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
Form 10-K, 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 loans or 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.
8
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.
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 diminish 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
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.
9
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 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 accelerate our amortization of the premium. 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.
10
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
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 consideration of the following:
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.
11
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.
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 our
desire 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 90% of our taxable income
(excluding capital gains) for each taxable year. 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.
12
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 ratio 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, 2001, our ratio of
debt-to-equity was 9.5:1.
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 of directors a plan for bringing our capital base into
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, 2001, the weighted average haircut
level on our securities was 3.5%. 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.
13
Our board of directors 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 of directors
determine that the minimum required capital base set by our capital investment
policy is either too low or too high, our board of directors 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 22
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 of directors, 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 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.
14
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, interest rate
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
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, 2001, we estimate
that the duration of our assets was 1.2%. 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. We could, however, elect to
treat a subsidiary as a "taxable REIT subsidiary," in which case we could own
100% of the voting stock of such subsidiary, provided that the value of the
stock that we own in all such taxable REIT subsidiaries does not exceed 20% of
the value of our total assets at the close of any calendar quarter. A taxable
subsidiary would not elect REIT status
15
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 Form 10-K. The board of
directors has the power to modify or waive these policies and strategies without
the consent of the stockholders to the extent that the board of directors
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 of directors 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. To date, none of these discussions have gone beyond the preliminary
stage. We have also considered from time to time entering into related
businesses, although to date we have not done entered into such businesses.
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 33% of the equity of Annaly International in the form of non-voting
securities. The remaining equity of Annaly International is owned by FIDAC,
Michael A.J. Farrell, our Chairman, Chief Executive Officer, and President,
Wellington J. St. Claire, our Vice Chairman, Chief Investment Officer, Kathryn
F. Fagan, our Chief Financial Officer and Treasurer, Jennifer A. Stephens, our
Secretary and Investment Officer and other persons. Mr. Farrell is the sole
shareholder of FIDAC.
During 1998, Annaly International made an initial investment of $20,400 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 I Partners, whose partners
include FIDAC and our executive officers.
16
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.
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 Form 10-K. If any of the risks discussed in this Form 10-K 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 spread between the interest payments we earn
on our mortgage-backed securities 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 adjustable-rate mortgage-backed securities for various
reasons discussed in this section.
o 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, an increase in short-term
interest rates may adversely affect our profitability.
17
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.
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,
2001, approximately 78% of our mortgage-backed securities were adjustable-rate
securities.
The interest rates on our borrowings similarly vary with changes in an
objective index. Nevertheless, the interest rates on our borrowings generally
adjust more frequently than the interest rates on our adjustable-rate
mortgage-backed securities. For example, on December 31, 2001, our
adjustable-rate securities had a weighted average term to next rate adjustment
of 24 months, while our borrowings had a weighted average term to next rate
adjustment of 85 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
adjustable-rate mortgage-backed securities.
o Interest rate caps on our mortgage-backed securities may adversely affect
our profitability
Our adjustable-rate mortgage-backed securities are typically subject to
periodic and lifetime interest rate caps. Periodic interest rate caps limit the
amount an interest rate can increase during any given period. Lifetime interest
rate caps limit the amount an interest rate can increase through maturity of a
mortgage-backed security. 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.
o 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
mortgage-backed securities, we also invest in fixed-rate mortgage-backed
securities. In a period of rising interest rates, our interest payments could
increase while the interest we earn on our fixed rate mortgage-backed securities
would not change. This would adversely affect our profitability. On December 31,
2001, approximately 22% 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 rates
that are faster than expected, this results in prepayments that are faster than
expected on the mortgage-backed securities. 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 the 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 was prepaid at the time
of the prepayment. This
18
adversely affects our profitability. On December 31, 2001, approximately 95% of
the mortgage-backed securities we owned were 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 equal to the
amount of the remaining discount. This will improve our profitability if the
discounted securities are prepaid faster than expected
We can also acquire mortgage-backed securities that are less affected by
prepayments. For example, we can acquire collateralized mortgage obligations or
CMOs, a type of mortgage-backed security. CMOs divide a pool of mortgage loans
into multiple tranches that allow for shifting of prepayment risks from
slower-paying tranches to faster-paying 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 of 1940 (or the Investment Company Act) imposes
restrictions on our purchase of CMOs. On December 31, 2001, approximately 18% of
our mortgage-backed securities were CMOs and approximately 72% 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.
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 at times 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. Nevertheless, this leverage, which is fundamental to our investment
strategy, also creates significant risks.
o 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; or
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
19
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.
o 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, we may be unable to comply with these
requirements, ultimately jeopardizing our status as a REIT.
o We may exceed our target leverage ratios
We seek to maintain a ratio of debt-to-equity of between 8:1 and 12:1.
However, we are not required to stay within this leverage ratio. If we exceed
this ratio, the adverse impact on our financial condition and results of
operations from the types of risks described in this section would likely be
more severe.
o We may not be able to achieve our optimal leverage
We use leverage as a strategy to increase the return to our investors.
However, we may not be able to achieve our desired leverage for any of the
following reasons:
o we determine that the leverage would expose us to excessive risk;
o our lenders do not make funding available to us at acceptable rates;
or
o our lenders require that we provide additional collateral to cover our
borrowings
o We may incur increased borrowing costs which would adversely affect our
profitability
Currently, all of our borrowings are collateralized borrowings in the form
of repurchase agreements. If the interest rates on these repurchase agreements
increase, it would adversely affect our profitability.
Our borrowing costs under repurchase agreements generally correspond to
short-term interest rates such as LIBOR or a short-term Treasury index, plus or
minus a margin. The margins on these borrowings over or under short-term
interest rates may vary depending upon:
o the movement of interest rates;
o the availability of financing in the market; or
o the value and liquidity of our mortgage-backed securities,
If we are unable to renew our borrowings at favorable rates, our profitability
may be adversely affected
Since we rely primarily on short-term borrowings, our ability to achieve
our investment objectives depends not only on our ability to borrow money in
sufficient amounts and on favorable terms, but also on our ability to renew or
20
replace on a continuous basis our maturing short-term borrowings. If we are not
able to renew or replace maturing borrowings, we would have to sell our assets
under possibly adverse market conditions.
We have not used derivatives to mitigate our interest rate and prepayment risks
Our policies permit us to enter into interest rate swaps, caps and floors
and other derivative transactions to help us mitigate our interest rate and
prepayment risks described above. However, we have determined in the past that
the cost of these transactions outweighs the benefits. In addition, we will not
enter into derivative transactions if we believe they will jeopardize our status
as a REIT. If we decide to enter into derivative transactions in the future,
these transactions may mitigate our interest rate and prepayment risks but
cannot insulate us from these risks.
Our investment strategy may involve credit risk
We may incur losses if there are payment defaults under our mortgage-backed
securities.
To date, all of our mortgage-backed securities have been agency
certificates which, although not rated, carry an implied "AAA" rating. Agency
certificates are mortgage-backed securities where Freddie Mac, Fannie Mae or
Ginnie Mae guarantees payments of principal or interest on the certificates.
Even though we have only acquired "AAA" securities so far, pursuant to our
capital investment policy we have the ability to acquire securities of lower
credit quality. Under our policy:
o 75% of our investments must have a "AA" or higher rating by Standard &
Poor's Corporation (or S&P), or an equivalent rating by a similar
nationally recognized rating organization, or our management must
determine that the investments are of comparable credit quality to
investments with these ratings;
o the remaining 25% of our investments must have a "BBB" or higher
rating by S&P, or an equivalent rating by a similar nationally
recognized rating organization, or our management must determine that
the investments are of comparable credit quality to investments with
these ratings. Securities with ratings of "BBB" or higher are commonly
referred to as "investment grade" securities; and
o we seek to have a minimum weighted average rating for our portfolio of
at least "A" by S&P.
If we acquire mortgage-backed securities of lower credit quality, we may
incur losses if there are defaults under those mortgage-backed securities or if
the rating agencies downgrade the credit quality of those mortgage-backed
securities.
We have not established a minimum dividend payment level
We intend to pay quarterly dividends and to make distributions to our
stockholders in amounts such that all or substantially all of our taxable income
in each year (subject to certain adjustments) is distributed. This will enable
us to qualify for the tax benefits accorded to a REIT under the Code. We have
not established a minimum dividend payment level and our ability to pay
dividends may be adversely affected for the reasons described in this section.
All distributions will be made at the discretion of our board of directors and
will depend on our earnings, our financial condition, maintenance of our REIT
status and such other factors as our board of directors may deem relevant from
time to time.
Because of competition, we may not be able to acquire mortgage-backed securities
at favorable yields
Our net income depends, in large part, on our ability to acquire
mortgage-backed securities at favorable spreads over our borrowing costs. In
acquiring mortgage-backed securities, we compete with other REITs, investment
banking firms, savings and loan associations, banks, insurance companies, mutual
funds, other lenders and other entities that purchase mortgage-backed
securities, many of which have greater financial resources than us. As a result,
in the future, we may not be able to acquire sufficient mortgage-backed
securities at favorable spreads over our borrowing costs.
21
We are dependent on our key personnel
We are dependent on the efforts of our key officers and employees,
including Michael A. J. Farrell, Chairman of the board of directors, Chief
Executive Officer, and President, Wellington J. St. Claire, Vice Chairman and
Chief Investment Officer, Kathryn F. Fagan, Chief Financial Officer and
Treasurer, and Jennifer A Stephens, Secretary and Investment Officer. The loss
of any of their services could have an adverse effect on our operations.
Although we have employment agreements with each of them, we cannot assure you
they will remain employed with us.
Some of our officers and employees have potential conflicts of interest
Some of our officers and employees have potential conflicts of interest
with us. The material potential conflicts are as follows:
o Our officers and employees manage assets for other clients
Mr. Farrell, Ms. St. Claire and other officers and employees are actively
involved in managing mortgage-backed securities and other fixed income assets
for institutional clients through Fixed Income Discount Advisory Company. FIDAC
is a registered investment adviser which on December 31, 2001 managed, assisted
in managing or supervised approximately $3 billion in gross assets on a
discretionary basis for a wide array of clients. FIDAC has advised us that
effective April 30, 2002, it will no longer manage the assets of FBR Asset
Investment Corporation. The U.S. Dollar Floating Rate Fund is a fund managed by
FIDAC. Mr. Farrell is a Director of the Floating Rate Fund. These officers will
continue to perform services for FIDAC, the institutional clients and the
Floating Rate Fund. Mr. Farrell is also the sole shareholder of FIDAC.
These responsibilities may create conflicts of interest for these officers
and employees if they are presented with corporate opportunities that may
benefit us and the institutional clients and the Floating Rate Fund. Our
officers allocate investments among Annaly Mortgage Management, Inc. (or
Annaly), the institutional clients and the Floating Rate Fund by determining the
entity or account for which the investment is most suitable. In making this
determination, our officers consider the investment strategy and guidelines of
each entity or account with respect to acquisition of assets, leverage,
liquidity, and other factors that our officers determine appropriate.
o Some of our directors and officers have ownership interests in our
affiliates that create potential conflicts of interest
Mr. Farrell, our Chairman, Chief Executive Officer and President, and our
other directors and officers, have direct and indirect ownership interests in
our affiliates that create potential conflicts of interest.
During 1998, we made an initial investment of $49,980 in Annaly
International Mortgage Management, Inc. (or Annaly International). Annaly
International explores business opportunities overseas, including the
origination of mortgages. Annaly International has not commenced operations
beyond this exploratory stage. We own 33% of the equity of Annaly International
in the form of non-voting securities. The remaining equity of Annaly
International is owned by FIDAC, Michael A.J. Farrell, Wellington J. St. Claire,
our Vice Chairman and Chief Investment Officer, Kathryn F. Fagan, our Chief
Financial Officer and Treasurer.
During 1998, Annaly International made an initial investment of $20,400 in
Annaly.com, Inc. (or Annaly.Com) Annaly.com explores opportunities to acquire or
originate mortgages in the United States. Annaly.com has established a Web site
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.
Our management allocates rent and other office expenses between our
affiliate and us. These allocations may create conflicts of interest. Our
management currently allocates rent and other expenses 90% to Annaly and 10% to
FIDAC. Our audit committee must approve any change in these allocation
percentages. In addition, we may enter
22
into agreements, such as technology sharing or research agreements, with our
affiliates in the future. These agreements would present potential conflicts of
interest. Our management will obtain prior approval of our audit committee prior
to entering into any agreements with our affiliates.
We and our shareholders are subject to certain tax risks
o Our failure to qualify as a REIT would have adverse tax consequences
We believe that since 1997 we have qualified for taxation as a REIT for
federal income tax purposes. We plan to continue to meet the requirements for
taxation as a REIT. Many of these requirements, however, are highly technical
and complex. The determination that we are a REIT requires an analysis of
various factual matters and circumstances that may not be totally within our
control. For example, to qualify as a REIT, at least 75% of our gross income
must come from real estate sources and 95% of our gross income must come from
real estate sources and certain other sources that are itemized in the REIT tax
laws. We are also required to distribute to stockholders at least 90% (95% with
respect to taxable years beginning before January 1, 2001) of our REIT taxable
income (excluding capital gains). Even a technical or inadvertent mistake could
jeopardize our REIT status. Furthermore, Congress and the Internal Revenue
Service (or IRS) might make changes to the tax laws and regulations, and the
courts might issue new rulings that make it more difficult or impossible for us
to remain qualified as a REIT.
If we fail to qualify as a REIT, we would be subject to federal income tax
at regular corporate rates. Also, unless the IRS granted us relief under certain
statutory provisions, we would remain disqualified as a REIT for four years
following the year we first fail to qualify. If we fail to qualify as a REIT, we
would have to pay significant income taxes and would therefore have less money
available for investments or for distributions to our stockholders. This would
likely have a significant adverse effect on the value of our securities. In
addition, the tax law would no longer require us to make distributions to our
stockholders.
o We have certain distribution requirements
As a REIT, we must distribute 90% (95% with respect to taxable years
beginning before January 1, 2001) of our annual taxable income. The required
distribution limits the amount we have available for other business purposes,
including amounts to fund our growth. Also, it is possible that because of the
differences between the time we actually receive revenue or pay expenses and the
period we report those items for distribution purposes, we may have to borrow
funds on a short-term basis to meet the 90% distribution requirement.
o We are also subject to other tax liabilities
Even if we qualify as a REIT, we may be subject to certain federal, state
and local taxes on our income and property. Any of these taxes would reduce our
operating cash flow.
Loss of Investment Company Act exemption would adversely affect us
We intend to conduct our business so as not to become regulated as an
investment company under the Investment Company Act of 1940 (or the Investment
Company Act). If we fail to qualify for this exemption, our ability to use
leverage would be substantially reduced and we would be unable to conduct our
business as described in this Form 10-K.
The Investment Company Act exempts entities that are primarily engaged in
the business of purchasing or otherwise acquiring mortgages and other liens on
and interests in real estate. Under the current interpretation of the SEC staff,
in order to qualify for this exemption, we must maintain at least 55% of our
assets directly in these qualifying real estate interests. Mortgage-backed
securities that do not represent all of the certificates issued with respect to
an underlying pool of mortgages may be treated as securities separate from the
underlying mortgage loans and, thus, may not qualify for purposes of the 55%
requirement. Our ownership of these mortgage-backed securities, therefore, is
limited by the provisions of the Investment Company Act. In addition, in meeting
the 55% requirement under the Investment Company Act, we treat as qualifying
interests mortgage-backed securities issued with respect to
23
an underlying pool as to which we hold all issued certificates. If the SEC or
its staff adopts a contrary interpretation, we could be required to sell a
substantial amount of our mortgage-backed securities, under potentially adverse
market conditions. Further, in order to insure that we at all times qualify for
the exemption from the Investment Company Act, we may be precluded from
acquiring mortgage-backed securities whose yield is somewhat higher than the
yield on mortgage-backed securities that could be purchased in a manner
consistent with the exemption. The net effect of these factors may be to lower
our net income.
Issuances of large amounts of our stock could cause our price to decline
As of March 25, 2002, 82,870,659 shares of our common stock were
outstanding. We may issue additional shares of common stock or shares of
preferred stock that are convertible into common stock. If we issue a
significant number of shares of common stock or convertible preferred stock in a
short period of time, there could be a dilution of the existing common stock and
a decrease in the market price of the common stock.
We may change our policies without stockholder approval
Our board of directors and management determine all of our policies,
including our investment, financing and distribution policies. Although they
have no current plans to do so, they may amend or revise these policies at any
time without a vote of our stockholders. Policy changes could adversely affect
our financial condition, results of operations, the market price of our common
stock or our ability to pay dividends or distributions.
Maryland Business Combination Act
The Maryland General Corporation Law establishes special requirements for
"business combinations" between a Maryland corporation and "interested
stockholders" unless exemptions are applicable. An interested stockholder is any
person who beneficially owns 10% or more of the voting power of our
then-outstanding voting stock. Among other things, the law prohibits for a
period of five years a merger and other similar transactions between us and an
interested stockholder unless the board of directors approved the transaction
prior to the party becoming an interested stockholder. The five-year period runs
from the most recent date on which the interested stockholder became an
interested stockholder. The law also requires a super majority stockholder vote
for such transactions after the end of the five-year period. This means that the
transaction must be approved by at least:
o 80% of the votes entitled to be cast by holders of outstanding voting
shares; and
o two-thirds of the votes entitled to be cast by holders of outstanding
voting shares other than shares held by the interested stockholder or
an affiliate of the interested stockholder with whom the business
combination is to be effected.
As permitted by the Maryland General Corporation Law, we have elected not
to be governed by the Maryland business combination statute. We made this
election by opting out of this statute in our articles of incorporation. If,
however, we amend our articles of incorporation to opt back in to the statute,
the business combination statute could have the effect of discouraging offers to
acquire us and of increasing the difficulty of consummating any such offers,
even if our acquisition would be in our stockholders' best interests.
Maryland Control Share Acquisition Act
Maryland law provides that "control shares" of a Maryland corporation
acquired in a "control share acquisition" have no voting rights except to the
extent approved by a vote of the stockholders. Two-thirds of the shares eligible
to vote must vote in favor of granting the "control shares" voting rights.
"Control shares" are shares of stock that, taken together with all other shares
of stock the acquirer previously acquired, would entitle the acquirer to
exercise voting power in electing directors within one of the following ranges
of voting power:
o One-tenth or more but less than one third of all voting power;
24
o One-third or more but less than a majority of all voting power; or
o A majority or more of all voting power.
Control shares do not include shares of stock the acquiring person is
entitled to vote as a result of having previously obtained stockholder approval.
A "control share acquisition" means the acquisition of control shares, subject
to certain exceptions.
If a person who has made (or proposes to make) a control share acquisition
satisfies certain conditions (including agreeing to pay expenses), he may compel
our board of directors to call a special meeting of stockholders to consider the
voting rights of the shares. If such a person makes no request for a meeting, we
have the option to present the question at any stockholders' meeting.
If voting rights are not approved at a meeting of stockholders then,
subject to certain conditions and limitations, we may redeem any or all of the
control shares (except those for which voting rights have previously been
approved) for fair value. We will determine the fair value of the shares,
without regard to voting rights, as of the date of either:
o the last control share acquisition; or
o the meeting where stockholders considered and did not approve voting
rights of the control shares.
If voting rights for control shares are approved at a stockholders' meeting
and the acquirer becomes entitled to vote a majority of the shares of stock
entitled to vote, all other stockholders may obtain rights as objecting
stockholders and, thereunder, exercise appraisal rights. This means that you
would be able to force us to redeem your stock for fair value. Under Maryland
law, the fair value may not be less than the highest price per share paid in the
control share acquisition. Furthermore, certain limitations otherwise applicable
to the exercise of dissenters' rights would not apply in the context of a
control share acquisition. The control share acquisition statute would not apply
to shares acquired in a merger, consolidation or share exchange if we were a
party to the transaction. The control share acquisition statute could have the
effect of discouraging offers to acquire us and of increasing the difficulty of
consummating any such offers, even if our acquisition would be in our
stockholders' best interests.
25
ITEM 2. PROPERTIES
Our executive and administrative office is located at 12 East 41st Street,
Suite 700, New York, New York 10017, telephone 212-696-0100. This office is
leased under a noncancelable lease expiring December 2007.
ITEM 3. LEGAL PROCEEDINGS
At December 31, 2001, there were no pending legal proceedings to which we
were a party, or to which any of our property was subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
We did not submit any matters to a vote of our stockholders during the
fourth quarter of 2001.
26
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock began trading publicly on October 8, 1997 and is traded on
the New York Stock Exchange under the trading symbol "NLY". As of March 25,
2002, we had 82,870,659 shares of common stock issued and outstanding which were
held by 30,650 holders of record.
The following table sets forth, for the periods indicated, the high, low,
and closing sales prices per share of common stock as reported on the New York
Stock Exchange composite tape and the cash dividends declared per share of our
common stock.
Stock Prices
High Low Close
First Quarter ended March 31, 2001 $11.50 $ 8.75 $11.26
Second Quarter ended June 30, 2001 $13.76 $10.50 $13.71
Third Quarter ended September 30, 2001 $14.93 $12.70 $14.45
Fourth Quarter ended December 31, 2001 $17.01 $13.20 $16.00
High Low Close
First Quarter ended March 31, 2000 $ 9.25 $ 7.19 $ 8.88
Second Quarter ended June 30, 2000 $ 9.38 $ 8.19 $ 8.88
Third Quarter ended September 30, 2000 $ 9.50 $ 8.06 $ 9.13
Fourth Quarter ended December 31, 2000 $ 9.50 $ 7.88 $ 9.06
High Low Close
First Quarter ended March 31, 1999 $10.25 $ 7.94 $10.25
Second Quarter ended June 30, 1999 $11.38 $ 9.31 $11.25
Third Quarter ended September 30, 1999 $11.50 $ 9.19 $ 9.31
Fourth Quarter ended December 31, 1999 $ 9.44 $ 8.06 $ 8.75
Cash Dividends
Declared Per Share
First Quarter ended March 31, 2001 $0.30
Second Quarter ended June 30, 2001 $0.40
Third Quarter ended September 30, 2001 $0.45
Fourth Quarter ended December 31, 2001 $0.60
First Quarter ended March 31, 2000 $0.35
Second Quarter ended June 30, 2000 $0.30
Third Quarter ended September 30, 2000 $0.25
Fourth Quarter ended December 31, 2000 $0.25
First Quarter ended March 31, 1999 $0.33
Second Quarter ended June 30, 1999 $0.35
Third Quarter ended September 30, 1999 $0.35
Fourth Quarter ended December 31, 1999 $0.35
27
We intend to pay quarterly dividends and to distribute to our stockholders
that all or substantially all of our taxable income in each year (subject to
certain adjustments). This will enable us to qualify for the tax benefits
accorded to a REIT under the Code. We have not established a minimum dividend
payment level and our ability to pay dividends may be adversely affected for the
reasons described under the caption "Risk Factors." All distributions will be
made at the discretion of our board of directors and will depend on our
earnings, our financial condition , maintenance of our REIT status and such
other factors as our board of directors may deem relevant from time to time.
28
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data are derived from our audited
financial statements for the years ended December 31, 2001, 2000, 1999 and 1998,
and the period ended December 31, 1997. The selected financial data should be
read in conjunction with the more detailed information contained in the
Financial Statements and Notes thereto and "Management's Discussion and Analysis
of Financial Condition and Results of Operations" included elsewhere in this
Form 10-K.
SELECTED FINANCIAL DATA
(dollars in thousands, except for per share data)
February 18,
1997
(commencement
For the Year For the Year For the Year For the Year of operations)
Ended Ended Ended Ended through
December 31, December 31, December 31, December 31, December 31,
2001 2000 1999 1998 1997 (1)
---------------- ------------ ------------ ------------ --------------
Statement of Operations Data:
Days in period 365 366 365 365 317
Interest income $ 263,058 $ 109,750 $ 89,812 $ 89,986 $ 24,713
Interest expense 168,055 92,902 69,846 75,735 19,677
-----------------------------------------------------------------------
Net interest income $ 95,003 $ 16,848 $ 19,966 $ 14,251 $ 5,036
Gain on sale of mortgage-backed securities 4,586 2,025 454 3,344 735
General and administrative expenses
(G&A expense) 7,311 2,286 2,281 2,106 852
-----------------------------------------------------------------------
Net income $ 92,278 $ 16,587 $ 18,139 $ 15,489 $ 4,919
=======================================================================
Basic net income per average share $2.23 $1.18 $1.41 $1.22 $0.83
Diluted net income per average share $2.21 $1.15 $1.35 $1.19 $0.80
Dividends declared per share $1.75 $1.15 $1.38 $1.21 $0.79
December 31 December 31, December 31, December 31, December 31,
Balance Sheet Data: 2001 2000 1999 1998