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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934 [FEE REQUIRED]
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1999
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
FOR THE TRANSITION PERIOD FROM __________ TO ___________
COMMISSION FILE NUMBER: 1-13563
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LASER MORTGAGE MANAGEMENT, INC.
(EXACT NAME OF THE REGISTRANT AS SPECIFIED IN ITS CHARTER)
MARYLAND 22-3535916
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
C\O MARINER MORTGAGE MANAGEMENT, LLC
65 EAST 55TH STREET, NEW YORK, 10022
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (212) 758-2024
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
NAME OF EACH EXCHANGE
TITLE OF EACH CLASS: ON WHICH REGISTERED:
COMMON STOCK, $.001 PAR VALUE 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 THE 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 24, 2000, THE AGGREGATE MARKET VALUE OF THE VOTING STOCK HELD
BY NON-AFFILIATES OF THE REGISTRANT WAS APPROXIMATELY $55,052,371, BASED UPON
THE CLOSING SALE PRICE OF THE COMMON STOCK ON THE NEW YORK STOCK EXCHANGE ON
THAT DATE. AT MARCH 24, 2000, THE REGISTRANT HAD OUTSTANDING 14,839,583 SHARES
OF COMMON STOCK.
DOCUMENTS INCORPORATED BY REFERENCE
PORTIONS OF THE REGISTRANT'S DEFINITIVE PROXY STATEMENT ISSUED IN CONNECTION
WITH THE 2000 ANNUAL MEETING OF STOCKHOLDERS ARE INCORPORATED BY REFERENCE INTO
PART III HEREOF.
LASER MORTGAGE MANAGEMENT, INC.
TABLE OF CONTENTS
PART I
Item 1. Business......................................................3
Item 2. Properties...................................................18
Item 3. Legal Proceedings............................................18
Item 4. Submission of Matters to a Vote of Security Holders..........18
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters..........................................19
Item 6. Selected Financial Data......................................20
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations..........................21
Item 7A. Quantitative and Qualitative Disclosures About Market Risk...34
Item 8. Financial Statements and Supplementary Data..................35
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.....................................35
PART III
Item 10. Directors and Executive Officers of the Registrant...........35
Item 11. Executive Compensation.......................................35
Item 12. Security Ownership of Certain Beneficial Owners
and Management...............................................36
Item 13. Certain Relationships and Related Transactions...............36
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports
on Form 8-K..................................................36
Financial Statements...................................................F-1
PART I
ITEM 1. BUSINESS.
REFERENCE IS MADE TO THE GLOSSARY COMMENCING ON PAGE 37 OF THIS REPORT
FOR DEFINITIONS OF TERMS USED IN THE FOLLOWING DESCRIPTION OF THE COMPANY'S
BUSINESS AND ELSEWHERE IN THIS REPORT.
GENERAL
LASER Mortgage Management, Inc. (the "Company"), a Maryland
corporation, is a specialty finance company, organized in September 1997, that
invests primarily in mortgage-backed securities and mortgage loans. The
mortgage-backed securities include mortgage pass-through certificates,
collateralized mortgage obligations, other securities representing interests in,
or obligations backed by, pools of mortgage loans and mortgage derivative
securities (collectively, the "Mortgage Securities"). The mortgage loans are
secured by first or second liens on single-family residential, multi-family
residential, commercial or other real property (the "Mortgage Loans" and,
together with the Mortgage Securities, the "Mortgage Assets"). See
"--Description of Assets."
Mariner Mortgage Management, LLC ("Mariner"), an affiliate of Mariner
Investment Group, Inc., manages the Company's day-to-day operations.
The Company has elected to be taxed and intends to continue to qualify
as a real estate investment trust (a "REIT") under the Internal Revenue Code of
1986, as amended (the "Code"), commencing with its short taxable year ended
December 31, 1997, and such election has not been revoked. The Company has
qualified as a REIT for the taxable years since its inception, and generally
will not be subject to federal income tax provided that it distributes its
income to its stockholders and maintains its qualification as a REIT. See
"--Federal Income Tax Considerations."
The Company has been delevering its portfolio by selling certain
securities and repaying borrowings in an attempt to reduce the portfolio's
susceptibility to basis and interest rate risk and to create additional
liquidity. As of December 31, 1999, based upon "available-for-sale" accounting
treatment, the Company's net asset value per share was $4.91 per share. During
the year ended December 31, 1999, the Company reduced its portfolio by
approximately $721 million at a loss of approximately $(19.8) million.
RECENT DEVELOPMENTS
On November 15, 1999, the Company announced that its Board of
Directors authorized management to conduct a competitive sale of its less liquid
portfolio assets as part of its ongoing program to reduce the volatility of the
Company's assets. As of February 29, 2000, the Company has approximately $11
million (based on December 31, 1999 estimated fair value) of these assets
remaining to be sold.
INVESTMENT STRATEGY
The Company was organized to create and manage an investment
portfolio, principally of Mortgage Assets, that, in combination with financing
and hedging activities, would generate income for distribution to its
stockholders while preserving the Company's capital base. The Company maintained
a portfolio at its peak of approximately $3.8 billion of Mortgage Assets in June
1998. Since June 1998, the Company has been delevering its portfolio of Mortgage
Assets.
The Company is authorized to acquire the following types of
investments: (1) fixed and adjustable rate mortgage pass-through certificates
("Pass-Through Certificates"), which are securities collateralized by pools of
Mortgage Loans issued and sold to investors by private, non-governmental issuers
("Privately-Issued Certificates") or by various U.S. government agencies or
instrumentalities, such as the Federal Home Loan Mortgage Corporation ("FHLMC"),
the Federal National Mortgage Association ("FNMA") and the Government National
Mortgage Association ("GNMA") (collectively, "Agency Certificates"); (2)
collateralized mortgage obligations, including regular interests in REMICs
("CMOs"), which are fixed and adjustable rate debt obligations collateralized by
Mortgage Loans or Pass-Through Certificates; (3) Mortgage Loans; (4) mortgage
derivative securities ("Mortgage Derivatives"), including interest-only
securities ("IOs") which receive only certain interest payments from a pool of
Mortgage Securities or Mortgage Loans; (5) subordinate interests ("Subordinate
Interests"), which are classes of Mortgage Securities junior to other classes of
Mortgage Securities in the right to receive payments from the underlying
Mortgage Loans; and (6) other fixed-income securities in an amount not to exceed
5% of total assets. Consistent with the Company's policy of maintaining its
status as a REIT for federal income tax purposes, substantially all of the
Company's assets consist of assets of the type described in Section 856(c)(5)(b)
of the Code ("Qualified Real Estate Assets"). See "--Description of Assets" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Financial Condition--Investments."
The Company is required to invest at least 70% of its total assets
(the "70% Asset Group") in (i) securities which are rated within one of the two
highest ratings categories by one of the Rating Agencies but not guaranteed by
the U.S. government or an agency or instrumentality thereof, such as FHLMC and
FNMA Certificates, (ii) securities which are unrated but are guaranteed by the
U.S. government or an agency or instrumentality thereof or (iii) Mortgage Loans
to borrowers who would otherwise meet FHLMC, FNMA or GNMA guidelines, except
with respect to the size of the loans. At December 31, 1999, 84% of the
Company's total assets were in the 70% Asset Group.
The remainder of the Company's assets, not to exceed 30% of its total
assets (the "30% Asset Group"), may consist of Mortgage Loans (other than those
included in the 70% Asset Group), retained Subordinate Interests and
fixed-income securities (other than those included in the 70% Asset Group) that
are primarily Qualified Real Estate Assets but also include non-investment grade
high yield corporate debt. To attempt to minimize the potentially higher level
of credit and liquidity risk of these securities, the Company has attempted to
limit its investments in, and diversify its portfolio of, securities in the 30%
Asset Group. At December 31, 1999, 16% of the Company's total assets were in the
30% Asset Group.
References to ratings of Mortgage Assets apply only at the time a
transaction is entered into by the Company. Any subsequent change in a rating
assigned to a Mortgage Asset or change in the percentage of Company assets
invested in certain Mortgage Assets or other instruments resulting from market
fluctuations or other changes in the Company's total assets will not require the
Company to dispose of an investment. If different Rating Agencies assign
different ratings to the same Mortgage Assets, the Company will determine which
rating it believes most accurately reflects the Mortgage Asset's quality and
risk at that time taking into account numerous factors, including the price of
the security, available public information regarding the issuer and liquidity
concerns. A rating is not a recommendation to buy, sell or hold a security,
inasmuch as such rating does not comment as to the market price of the security
or the suitability of the security for a particular investor. There is no
assurance that a rating will continue for any given period of time or that a
rating will not be lowered or withdrawn entirely by a Rating Agency if, in its
judgment, circumstances so warrant.
As a requirement for maintaining REIT status, the Company intends to
distribute to stockholders aggregate distributions equaling at least 95% (90%
after 2000) of its Taxable Income. See "--Federal Income Tax Considerations." As
described above, the Company anticipates making additional distributions of
capital to stockholders from time to time. Subject to the limitations of
applicable state securities and corporation laws, the Company may distribute
capital by making purchases of its own capital stock or making distributions in
excess of earnings.
OPERATING POLICIES AND STRATEGIES
The Company adopted compliance guidelines, including restrictions on
acquiring, holding and selling assets, to ensure that the Company continues to
qualify as a REIT. Before acquiring any asset, the Company determines whether
such asset would constitute a Qualified Real Estate Asset. Substantially all of
the assets that the Company intends to acquire are expected to be Qualified Real
Estate Assets. The Company regularly monitors purchases of Mortgage Assets and
the income generated from such assets, including income from its hedging
activities, in an effort to ensure that at all times the Company maintains its
qualification as a REIT and its exemption under the Investment Company Act of
1940, as amended (the "Investment Company Act"). Mariner, in conjunction with a
nationally recognized independent public accounting firm, has developed internal
accounting and testing procedures for the Company and monitors and conducts
quarterly compliance reviews to determine compliance with the REIT Provisions of
the Code.
CAPITAL AND LEVERAGE POLICIES
The Company's operations were leveraged approximately 1.6 to 1 as of
December 31, 1999. The Company has been delevering its portfolio since June
1998, thereby increasing its equity-to-assets ratio. At December 31, 1999, the
Company's equity-to-assets ratio was 61.7%, and ranged from a high of 61.7% to a
low of 14.6% during 1999. Initially, the Company financed its acquisition of
Mortgage Assets through proceeds of its initial public offering in December 1997
and several concurrent private placements, and subsequently financed any
acquisitions primarily by borrowing against or "leveraging" its existing
portfolio and using the proceeds to acquire additional Mortgage Assets. The
Company's target for its equity-to-assets ratio depends on market conditions and
other relevant factors.
The equity-to-assets ratio is total stockholders' equity as a
percentage of total assets. The Company's total stockholders' equity, for
purposes of this calculation, equals the Company's stockholders' equity
determined in accordance with GAAP. For purposes of calculating the
equity-to-assets ratio, the Company's total assets include the value of the
Company's investment portfolio on a marked-to-market-basis. For purchased
Mortgage Assets, the Company obtains market quotes for its Mortgage Assets from
independent broker-dealers that make markets in securities similar to those in
the Company's portfolio. The Board of Directors has discretion to deviate from
or change the Company's indebtedness policy at any time. However, the Company
endeavors to maintain an adequate capital base to protect against interest rate
environments in which the Company's financing and hedging costs might exceed
interest income from its Mortgage Assets. These conditions could occur, for
example, when, due to interest rate fluctuations, interest income on the
Company's Mortgage Assets (which occur during periods, such as the first three
quarters of 1998, of rapidly rising interest rates or during periods when the
Mortgage Loans in the portfolio are prepaying rapidly) lags behind interest rate
increases in the Company's variable rate borrowings.
SHORT-TERM BORROWING
Mortgage Assets, other than securitized Mortgage Loans, are financed
primarily at short-term borrowing rates through reverse repurchase agreements.
Reverse repurchase agreements are sales of pledged securities to a lender at
discounted prices in return for an agreement by the lender to resell the same or
substantially similar securities to the borrower on some future date at an
agreed price.
Reverse repurchase agreements are structured as sale and repurchase
obligations that allow a borrower to pledge purchased Mortgage Assets as
collateral securing short-term loans to finance the purchase of such Mortgage
Assets. Typically, the lender in a reverse repurchase arrangement makes a loan
in an amount equal to a percentage of the market value of the pledged
collateral. At maturity, the borrower is required to repay the loan and the
pledged collateral is released. Pledged Mortgage Assets continue to pay
principal and interest to the borrower.
Reverse repurchase agreements are expected to continue to be the
principal means of leveraging the Company's Mortgage Assets. The Company enters
into reverse repurchase agreements with financially sound institutions,
including broker-dealers, commercial banks and other lenders.
Reverse repurchase agreements also require the Company to deposit
additional collateral (a "margin call") or reduce its borrowings thereunder, if
the market value of the pledged collateral declines. This may require the
Company to sell Mortgage Assets to provide such additional collateral or to
reduce the amount borrowed. If these sales were made at prices lower than the
carrying value of the Mortgage Assets, the Company would experience losses.
Principally during the third quarter of 1998, the Company was subject to
numerous margin calls under its collateralized borrowings and was forced to sell
Mortgage Assets to reduce the amount borrowed which resulted in losses to the
Company. In 1998, the Company realized a loss of $(52.4) million, or $(2.62) per
weighted average share, on sales of Mortgage Securities and terminations of
interest rate swaps as the Company raised cash to meet increased margin
requirements.
During the years ended December 31, 1999 and 1998, the Company met
every margin call initiated by its lenders despite the devaluation of the
Company's portfolio, which substantially reduced the Company's liquidity. As of
December 31, 1999 and 1998, the Company's cash and cash equivalents balance was
$16.0 million and $30.4 million, respectively. The Company believes that it has
sufficient assets to meet margin calls.
INTEREST RATE RISK MANAGEMENT STRATEGY AND HEDGING ACTIVITIES
The Company expects to follow an interest rate risk management
strategy designed to protect against the adverse effects of major interest rate
changes. The Company may enter into hedging transactions which include interest
rate swaps, interest rate collars, caps, floors and options. These instruments
are used to hedge as much of the interest rate risk of the Company as the
Company determines is in the best interest of the stockholders, given the cost
of such hedges and the need to maintain the Company's status as a REIT.
Hedging instruments often are not traded on regulated exchanges,
guaranteed by an exchange or its clearing house, or regulated by any U.S. or
foreign governmental authorities. Consequently, there are no requirements with
respect to recordkeeping, financial responsibility or segregation of customer
funds and positions. The business failure of a counterparty with which the
Company has entered into a hedging transaction will most likely result in a
default. The default of a counterparty with which the Company has entered into a
hedging transaction may result in the loss of unrealized profits and force the
Company to cover its resale commitments, if any, at the then current market
price. Although generally the Company seeks to reserve for itself the right to
terminate its hedging positions, it may not always be possible to dispose of or
close out a hedging position without the consent of the counterparty, and the
Company may not be able to enter into an offsetting contract in order to cover
its risk. There can be no assurance that a liquid secondary market will exist
for hedging instruments purchased or sold, and the Company may be required to
maintain a position until exercise or expiration, which could result in losses.
The Company did not enter into any interest rate swaps during the year
ended December 31, 1999, after having used them extensively in 1997 and 1998.
In December 1997, the Company entered into interest rate swaps with an
aggregate notional amount of $1,035 million. The Company used these interest
rate swaps to hedge its available-for-sale portfolio of fixed-rate Agency
Certificates. The primary objective of this hedging strategy was to change the
interest rate characteristics of these securities from fixed to variable rates,
to better correspond to the maturity and repricing characteristics of the
short-term repurchase agreements used by the Company to fund these investments.
This primary objective was the basis for the Company's hedge accounting
treatment. The Company continually monitored the swaps to ensure that they were
effective at changing the interest rate characteristics of the securities. A
secondary objective was to offset fluctuations in the fair value of the
securities caused by fluctuations in market interest rates.
In September 1998, the Company experienced margin calls and believed
it prudent to increase its liquidity and, therefore, liquidated a large portion
of its Agency Certificates. In conjunction with the liquidation of these
securities positions, the Company also discontinued hedge accounting for the
related swaps with an aggregate notional amount of $485 million. The Company
recognized the unrealized loss on these swaps as an element of the overall loss
on the liquidation of the securities of $(26.0) million. In October 1998, the
Company liquidated Agency Certificates in response to continued margin calls and
the need for liquidity. The overall October 1998 loss on the liquidation of
Agency Certificates, including losses recognized upon suspension of hedge
accounting for the remaining swap with a notional amount of $550 million,
totaled $(35.0) million. On the day of each suspension of hedge accounting, the
affected swaps were closed out without additional gain or loss.
The valuations and other information used by the Company to monitor
the effectiveness of its interest rate swap hedging strategy were obtained
through multiple independent dealer quotes. This same information was used to
record the investments and swaps in the Company's financial statements and to
determine the Company's net asset value. The Company has never purchased or
written options to enter into swaps.
Hedging activity involves transaction costs, and such costs can
increase significantly as the period covered by such activity increases.
Therefore, the Company may be prevented from effectively hedging all of its
interest rate risk. Certain losses incurred in connection with hedging
activities may be capital losses that would not be deductible to offset ordinary
REIT income. In such a situation, the Company would have incurred an economic
loss of capital that would not be deductible to offset the ordinary income from
which dividends must be paid.
In particular, when the Company earns income under such instruments,
it will seek advice from Special Tax Counsel as to whether such income
constitutes qualifying income for purposes of the 95% Gross Income Test and as
to the proper characterization of such arrangements for purposes of the REIT
Asset Tests. The "95% Gross Income Test" means the requirement for each taxable
year that at least 95% of the Company's gross income for each taxable year must
be derived from certain specified real estate sources including interest income
and gain from the disposition of Qualified Real Estate Assets or "qualified
temporary investment income" (i.e., income derived from "new capital" within one
year of the receipt of such capital), dividends, interest and gains from the
sale of stock or other securities (including certain interest rate swap or cap
agreements, options, forward rate agreements and similar financial instruments
entered into to reduce the interest rate risk with respect to debt incurred to
acquire Qualified Real Estate Assets) not held for sale in the ordinary course
of business. See "--Federal Income Tax Considerations--Requirements for
Qualification--Gross Income Tests." This determination may result in the Company
electing to bear a level of interest rate risk that could otherwise be hedged
when it believes, based on all relevant facts, that bearing such risk is
advisable to maintain its status as a REIT.
DESCRIPTION OF ASSETS
The Company is permitted to acquire the following types of investments
subject to the operating restrictions described in "--Operating Policies and
Strategies."
PASS-THROUGH CERTIFICATES
The Company's investments in Mortgage Securities are concentrated in
Pass-Through Certificates. The Pass-Through Certificates the Company acquires
consist primarily of fixed and adjustable rate Agency Certificates and
Privately-Issued Certificates and represent interests in Mortgage Loans
primarily secured by liens on single-family residential, multi-family
residential and commercial real properties, but also may be secured by liens on
other types of real property. As of December 31, 1999, 64% of the Company's
portfolio consisted of Pass-Through Certificates.
FHLMC CERTIFICATES. FHLMC is a privately-owned, government-sponsored
enterprise created pursuant to an act of Congress. FHLMC purchases conventional
conforming Mortgage Loans or participation interests therein and resells the
loans and participations so purchased 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 guarantees are solely those of FHLMC and are not backed by the full
faith and credit of the U.S. government. If FHLMC were unable to satisfy such
obligations, distributions to holders of FHLMC Certificates would consist solely
of payments and other recoveries on the underlying Mortgage Loans and,
accordingly, monthly distributions to holders of FHLMC Certificates would be
affected by delinquent payments and defaults on such Mortgage Loans.
FHLMC Certificates may be backed by pools of Mortgage Loans secured by
single-family or multi-family residential properties. Such underlying Mortgage
Loans may have original terms to maturity of up to 40 years. FHLMC Certificates
may pay interest at a fixed or adjustable rate. The interest rate paid on FHLMC
adjustable rate mortgage ("ARM") certificates adjusts periodically within 60
days prior to the month in which the interest rates on the underlying Mortgage
Loans adjust. The interest rates paid on FHLMC ARM Certificates issued under
FHLMC's standard ARM programs adjust in relation to the Treasury Index. Other
specified indices used in FHLMC ARM programs include the 11th District Cost of
Funds Index published by the Federal Home Loan Bank of San Francisco (the "11th
District Index") and LIBOR. Interest rates paid on fully-indexed FHLMC ARM
Certificates equal the applicable index rate plus a specified number of basis
points ranging typically from 125 to 250 basis points.
FNMA CERTIFICATES. FNMA is a privately-owned, federally chartered
corporation that provides funds to the mortgage market primarily by purchasing
Mortgage Loans (with respect to residential properties) from local lenders,
thereby replenishing their funds for additional lending. FNMA guarantees to each
registered holder of a FNMA Certificate that it will distribute amounts
representing scheduled principal and interest at the rate provided by the FNMA
Certificate on the Mortgage Loans in the pool underlying the FNMA Certificate
whether or not received, and the full principal amount of any such 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 U.S.
government. If FNMA were unable to satisfy such obligations, distributions to
holders of FNMA Certificates would consist solely of payments and other
recoveries on the underlying Mortgage Loans and, accordingly, monthly
distributions to holders of FNMA Certificates would be affected by delinquent
payments and defaults on such Mortgage Loans.
FNMA Certificates may be backed by pools of Mortgage Loans secured by
single-family or multi-family residential properties. The original terms to
maturities of the Mortgage Loans generally do not exceed 40 years. FNMA
Certificates may pay interest at a fixed rate or adjustable rate. Each series of
FNMA ARM Certificates bears an initial interest rate and margin tied to an index
based on all loans in the related pool, less a fixed percentage representing
servicing compensation and FNMA's guarantee fee. The specified index used in
each such series has included the Treasury Index, the 11th District Index and
LIBOR. Interest rates paid on fully-indexed FNMA ARM Certificates equal the
applicable index rate plus a specified number of basis points ranging typically
from 125 to 250 basis points.
GNMA CERTIFICATES. GNMA is a wholly-owned corporate instrumentality of
the United States within the Department of Housing and Urban Development
("HUD"). GNMA guarantees the timely payment of the principal of and interest on
certificates which represent an interest in a pool of mortgages insured by the
United States Federal Housing Authority (the "FHA") and other loans eligible for
inclusion in mortgage pools underlying GNMA certificates. GNMA certificates are
general obligations of the U.S. government.
GNMA certificates may pay a fixed or adjustable coupon rate. At
present, most GNMA certificates issued under GNMA's standard ARM program adjust
annually in relation to the Treasury Index. Interest rates paid on GNMA ARM
Certificates typically equal the index rate plus 150 basis points. Adjustments
in the interest rate are generally limited to an annual increase or decrease of
100 basis points and to a lifetime cap of 500 basis points over the initial
coupon rate.
PRIVATELY-ISSUED CERTIFICATES. Privately-Issued Certificates are
structured similarly to Agency Certificates and are issued by originators of,
and investors in, Mortgage Loans, including savings and loan associations,
savings banks, commercial banks, mortgage banks, investment banks and special
purpose subsidiaries of such institutions. Privately-Issued Certificates are
usually backed by a pool of fixed or adjustable rate Mortgage Loans and are
generally structured with one or more types of credit enhancement, including
mortgage pool insurance or subordination. However, Privately-Issued Certificates
are typically not guaranteed by an entity having the credit status of FHLMC,
FNMA or GNMA.
SUBORDINATE INTERESTS
The Company is permitted to acquire Subordinate Interests in pools of
Mortgage Loans securitized by others. The credit quality of Mortgage Loans and
Mortgage Securities collateralized by underlying Mortgage Loans depends on a
number of factors, including their loan-to-value ratio, their terms and the
geographic diversification of the properties securing the Mortgage Loans and, in
the case of multi-family and commercial properties, the creditworthiness of
tenants. As of December 31, 1999, 19% of the Company's portfolio consisted of
Subordinate Interests.
In a securitization, payments of principal of and interest on the
underlying Mortgage Loans may be allocated among several classes of Mortgage
Securities issued in the securitization in many ways, and the credit quality of
a particular class of Mortgage Securities depends primarily on its payment
priority. In a typical securitization, the Subordinate Interests absorb losses
from defaults or foreclosures on the Mortgage Loan collateral before such losses
are allocated to more senior classes, providing credit protection to more senior
classes. As a result, Subordinate Interests carry significant credit risks.
Subordinate Interests in a typical securitization are subject to a substantially
greater risk of non-payment than more senior classes. Accordingly, Subordinate
Interests are assigned lower credit ratings, or no rating at all. Neither the
Subordinate Interests nor the underlying mortgages are guaranteed by agencies,
or instrumentalities of the U.S. government.
As a result of the typical "senior-subordinated" securitization
structure, Subordinate Interests are extremely sensitive to losses on the
underlying Mortgage Loans. For example, if the Company owns a $10 million
Subordinate Interest in an issuance of Mortgage Securities consisting of $100
million of Mortgage Loan collateral, a 7% loss on the underlying Mortgage Loans
will result in a 70% loss on the Subordinate Interest. Accordingly, the holder
of the Subordinate Interest is particularly interested in minimizing the loss
frequency (the percentage of the Mortgage Loan balance that defaults over the
life of the Mortgage Loan collateral) and the loss severity (the amount of loss
on a defaulted Mortgage Loan, I.E., the principal amount of the Mortgage Loan
unrecovered after applying any recovery to the expenses of foreclosure and
accrued interest) on the underlying Mortgage Loans. The loss frequency on a pool
of Mortgage Loans will depend upon a number of factors, most of which will be
beyond the control of the Company or the applicable Master Servicer.
Many of the Subordinate Interests acquired by the Company will not
have been registered under the Securities Act, but instead, will have initially
been sold in private placements. Such unregistered Subordinate Interests will be
subject to certain restrictions on resale and, accordingly, will have more
limited marketability and illiquidity than registered Securities. Although there
are some exceptions, most issuers of multi-class Mortgage Securities elect to be
treated, for federal income tax purposes, as REMICs. Although the Company sought
to purchase Subordinate Interests at a price designed to return the Company's
investment and generate a profit thereon, there can be no assurance that such
goal will be met or that the Company's investment in a Subordinate Interest will
be returned in full or at all.
MORTGAGE DERIVATIVES
The Company is permitted to invest in Mortgage Derivatives, including
IOs, Inverse IOs, Sub IOs and floating rate derivatives. Mortgage Derivatives
provide for the holder to receive interest only, principal only, or interest and
principal in amounts that are disproportionate to those payable on the
underlying Mortgage Loans. Payments on Mortgage Derivatives are highly sensitive
to the rate of prepayments on the underlying Mortgage Loans. If the actual
prepayment rate on such Mortgage Loans is more rapid than anticipated, the rates
of return on Mortgage Derivatives representing the right to receive interest
only or a disproportionately large amount of interest, I.E., IOs, would be
likely to decline. Conversely, the rates of return on Mortgage Derivatives
representing the right to receive principal only or a disproportionate amount of
principal, I.E., POs, would be likely to increase in the event of rapid
prepayments. As of December 31, 1999, 8% of the Company's portfolio consisted of
Mortgage Derivatives, all of which were IOs.
Some IOs in which the Company is permitted to invest, such as Inverse
IOs, bear interest at a floating rate that varies inversely with (and often at a
multiple of) changes in a specific index. The yield to maturity of an Inverse IO
is extremely sensitive to changes in the related index. The Company also is
permitted to invest in inverse floating rate Mortgage Derivatives which are
similar in structure and risk to Inverse IOs, except inverse floating rate
Mortgage Derivatives are generally issued with a greater stated principal amount
than Inverse IOs.
Other IOs in which the Company is permitted to invest, such as Sub
IOs, have the characteristics of a Subordinate Interest. A Sub IO is not
entitled to any payments of principal; moreover, interest on a Sub IO often is
withheld in a reserve fund or spread account to fund required payments of
principal and interest to more senior tranches of Mortgage Securities. Once the
balance in the spread account reaches a certain level, excess funds are paid to
the holders of the Sub IO. These Sub IOs provide credit support to the senior
classes and thus bear substantial credit risks. In addition, because a Sub IO
receives only interest payments, its yield is extremely sensitive to the rate of
prepayments (including prepayments as a result of defaults) on the underlying
Mortgage Loans.
IOs can be an effective hedging device because they generally increase
in value as fixed rate Mortgage Securities decrease in value. The Company also
is permitted to invest in other types of derivatives currently available in the
market and other Mortgage Derivatives that may be developed in the future. The
Company does not intend to purchase REMIC residuals or other CMO residuals.
CMOS
The Company is permitted to invest in CMOs, including adjustable rate
and fixed rate CMOs issued by private issuers or FHLMC, FNMA or GNMA. CMOs are a
series of bonds or certificates ordinarily issued in multiple classes, each of
which consists of several classes with different maturities and often complex
priorities of payment, secured by a single pool of Mortgage Loans, Pass-Through
Certificates, other CMOs or other Mortgage Assets. Principal prepayments on
collateral underlying a CMO may cause it to be retired substantially earlier
than the stated maturities or final distribution dates. Interest is paid or
accrues on all interest bearing classes of a CMO on a monthly, quarterly or
semi-annual basis. The principal and interest on underlying Mortgages Loans may
be allocated among the several classes of a series of a CMO in many ways,
including pursuant to complex internally leveraged formulas that make the CMO
class especially sensitive to interest rate or prepayment risk. As of December
31, 1999, the Company did not own any CMOs.
CMOs may be subject to certain rights of issuers thereof to redeem
such CMOs prior to their stated maturity dates, which may have the effect of
diminishing the Company's anticipated return on its investment. Privately-issued
single-family, multi-family and commercial CMOs are supported by private credit
enhancements similar to those used for Privately-Issued Certificates and are
often issued as senior-subordinated Mortgage Securities. The Company intends to
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 Real Estate
Assets (provided that the Company has obtained a favorable opinion of the
Company's Special Tax Counsel or a ruling from the Service to that effect).
MORTGAGE LOANS
The Company is permitted to invest in fixed and adjustable-rate
Mortgage Loans secured by first or second liens on single-family (one-to-four
unit) residential, multi-family residential, commercial or other real property
as part of its investment strategy. As of December 31, 1999, 4% the Company's
portfolio consisted of Mortgage Loans.
The Company may acquire Mortgage Loans directly from Mortgage Sellers
which include originators, and entities holding Mortgage Loans originated by
others throughout the United States, such as savings and loan associations,
banks, mortgage bankers, home builders, insurance companies and other mortgage
lenders. The Board of Directors of the Company has not established any limits
upon the geographic concentration of Mortgage Loans to be acquired by the
Company or the credit quality of the Mortgage Sellers.
OTHER FIXED-INCOME ASSETS
The Company is permitted to invest in fixed-income securities that are
not Mortgage Assets, including securities issued by corporations or issued or
guaranteed by the U.S. government or its agencies or instrumentalities, loan
participations, emerging market debt, non-investment grade high yield corporate
debt and collateralized bond obligations, denominated in U.S. dollars and
foreign currencies. In connection with the Company's investment in such
securities, particularly collateralized loan obligations and collateralized bond
obligations, the Company is permitted to pay fees to unrelated third-party
managers. A portion of these assets will be securities which are included in the
30% Asset Group. The Company will invest no more than 5% of its assets in such
fixed-income securities. In June 1998, at the peak of its portfolio, the Company
owned approximately $70 million of other fixed income assets. As of December 31,
1999, 4% of the Company's portfolio consisted of other fixed-income assets.
The Company has invested previously in debt securities issued or
guaranteed by foreign governments, including debt securities rated below
investment grade. Obligations of governments of emerging market countries are
often subject to, or may be adversely affected by, risks associated with
political and economic uncertainty, fluctuations of currency exchange rates,
lower levels of disclosure and regulation in foreign securities markets than in
the United States, risks of nationalization, expropriation and confiscatory
taxation, taxation of income earned in foreign nations or other taxes imposed
with respect to investments in foreign nations, foreign exchange controls and
uncertainties as to the status, interpretation and application of laws. As of
October 31, 1998, the Company sold all of its emerging market sovereign debt
securities for a net loss of approximately $(15.1) million.
The Company also is permitted to invest in non-investment grade high
yield corporate debt rated below investment grade, commonly known as junk bonds.
Junk bonds are generally unsecured, may be subordinated to other obligations of
the issuer and generally have greater credit and liquidity risk than is
typically associated with investment grade corporate obligations.
The Company also is permitted to acquire interests in non-real estate
loans. Such loan interests may be purchased either directly (by way of
assignment from the selling institution) or indirectly (by way of the purchase
of a participation interest from the selling institution). The purchaser of an
assignment of an interest in a loan typically succeeds to all rights and
obligations of the assigning selling institution and becomes a lender under the
loan agreement. Participations typically result in a contractual relationship
only with the selling institution, not with the borrower.
In addition, the Company is permitted to invest in asset-backed
securities which have structural characteristics similar to Mortgage Securities
but relate to assets other than Mortgage Assets, including credit card,
automobile and other receivables. Asset-backed securities may be rated or
unrated and, if rated, may be above or below investment grade. They may bear
coupons at a fixed or floating interest rate and also may be subject to
prepayment risk.
MANAGEMENT AGREEMENT WITH MARINER MORTGAGE MANAGEMENT, LLC
On November 1, 1999, the Company announced that Mariner agreed to
serve as the external manager of the Company and be responsible for day-to-day
management of the Company's investments. William J. Michaelcheck, the Chairman
of Mariner, was appointed President and Chief Executive Officer of the Company.
Upon completion of the transition to Mariner, the Company terminated its
consulting arrangement with BlackRock Financial Management, Inc. ("BlackRock")
and Robert J. Gartner, who was Vice President of the Company and responsible for
day-to-day investment decisions for the Company, resigned.
Under the Company's agreement with Mariner, Mariner is entitled to
receive an (1) annual base management fee payable monthly in cash equal to 0.45%
of the aggregate value of the Company's outstanding equity as of the end of such
month and (2) incentive fee payable annually in newly issued stock of the
Company. The incentive fee will equal:
o 10% of the amount by which the market price of the Company's
common stock (plus any distributions) at the end of 12
months exceed $3.63 per share (which approximates the
average closing price of the Company's common stock for the
fifteen days ended October 29, 1999) up to the equivalent of
$4.00 per share;
o 15% of amounts over $4.00 per share up to $4.50 per share;
and
o 20% of amounts over $4.50 per share.
The agreement has a one-year term, but is terminable by the Company without
cause or penalty on 30 days' notice. Mariner may terminate the agreement in
limited circumstances. In addition, Mariner is entitled to receive a minimum fee
if the Company adopts a plan of liquidation prior to the expiration of the
agreement.
As of December 31, 1999, the Company accrued approximately $42,000 in
management fees to Mariner.
EVENTS LEADING TO TERMINATION OF MANAGEMENT AGREEMENT WITH LASER ADVISERS INC.
AND ADOPTION OF PORTFOLIO MANAGEMENT STRATEGY
In late June 1998, the Company's Board of Directors was advised by
LASER Advisers Inc. (the "Former Manager") of certain pricing and other
irregularities in connection with Shetland Fund Ltd., one of the private
investment funds (the "Affiliated Funds") advised and managed by the Former
Manager which invested in Mortgage Securities. The reported irregularities
included the failure to obtain dealer quotes for securities, the failure to
obtain more than a single quote in certain instances, mispricing bids, misplaced
records, missing records and improperly identified securities in the portfolio.
In July 1998, the Company's Board of Directors was informed by the Former
Manager that the irregularities detected in the Affiliated Fund did not affect
the portfolio of securities held by the Company and that certain procedural
deficiencies existed at the Former Manager which allowed for the irregularities.
On July 29, 1998, the Former Manager announced certain administrative changes,
including the resignation of Michael L. Smirlock as Chief Executive Officer of
the Former Manager and the removal of Mr. Smirlock from trading and day-to-day
participation in the Former Manager's activities. Mr. Smirlock continued as
Chairman of the Board and a majority stockholder of the Former Manager.
On July 30, 1998, the Company's Board of Directors terminated the
employment of Michael L. Smirlock as Chief Executive Officer and President of
the Company and removed Mr. Smirlock as Chairman of the Board of the Company.
Mr. Smirlock remained a director of the Company through September 1999, although
the Board of Directors requested his resignation. The day-to-day portfolio
management decisions for the Former Manager on behalf of the Company from July
30, 1998 through March 2, 1999 were made jointly by Peter T. Zimmermann (until
his earlier resignation described below) and Robert J. Gartner, then officers of
the Former Manager. On July 30, 1998, the Company also accepted the resignation
of two of its directors, David A. Tepper and William Marshall, effective that
day. Both Mr. Tepper and Mr. Marshall advised the Company that they had resigned
due to other commitments. Mr. Tepper remained a director and minority
stockholder of the Former Manager. The Board elected Jonathan Ilany as a member
of the Company's Board of Directors.
On October 2, 1998, the Company's Board of Directors authorized its
financial advisor, Lehman Brothers Inc. ("Lehman Brothers"), promptly to solicit
offers to acquire the Company or all, or substantially all, of its assets.
Lehman Brothers, after soliciting offers to acquire the Company, did not receive
any firm bids. Lehman Brothers no longer is actively soliciting bids on behalf
of the Company, although it will receive for evaluation bids from interested
persons. Also on October 2, 1998, the Company's Board of Directors engaged
BlackRock as its consultant to review the Company's portfolio and to make
recommendations designed to reduce the portfolio's susceptibility to basis and
interest rate risk and to create additional liquidity. BlackRock recommended to
the Company that the Former Manager delever the Company's portfolio by selling
certain Mortgage Assets.
On December 15, 1998, the Company was informed by the Former Manager
of its resignation as investment adviser to four of the Affiliated Funds, Steed
Finance LDC, Quarter Horse Finance Ltd., Shetland Fund Ltd. and Trakehner Fund
L.P., and that it would continue to manage investments for Mustang Investment
Limited Partnership. All references to the Affiliated Funds herein relate to
Mustang Investment Limited Partnership and the other four Affiliated Funds
previously managed by the Former Manager.
On March 2, 1999, the Company announced that the Company and the
Former Manager terminated the agreement under which the Former Manager served as
the external manager of the Company, and that the Company had become advised
internally by Mr. Gartner, Vice President of the Company. Mr. Gartner had been
actively engaged in the management of the Company's portfolio by the Former
Manager since the Company's inception and had resigned his post at the Former
Manager to become a full-time employee of the Company. The Company also
announced that BlackRock had agreed to extend its consulting engagement with the
Company, that Thomas Jonovich, Chief Financial Officer and Treasurer of the
Company, and Jonathan Green, General Counsel of the Company, resigned effective
March 2, 1999, that Peter T. Zimmermann, Vice President and Chief Operating
Officer of the Company, resigned effective January 11, 1999 and that the Former
Manager agreed to assist the Company with the transfer of the advisory function
to the Company. Mr. Smirlock subsequently resigned as Director of the Company in
September 1999.
For the year ended December 31, 1999, consulting fees paid to
BlackRock were $1.1 million and management fees paid to the Former Manager were
$500,000.
FEDERAL INCOME TAX CONSIDERATIONS
GENERAL
Since its inception, the Company has elected to be taxed as a REIT
under the REIT Provisions of the Code for federal income tax purposes, and such
election has not been revoked. The Company currently expects that it will
continue to operate in a manner that permits the Company to maintain its
qualification as a REIT. This treatment will permit the Company to deduct
dividend distributions to its stockholders for Federal income tax purposes, thus
effectively eliminating the "double taxation" that generally results when a
corporation earns income and distributes that income to its stockholders in the
form of dividends.
There can be no assurance, however, that the Company will qualify as a
REIT in any particular taxable year, given the highly complex nature of the
rules governing REITs, the ongoing importance of factual determinations and the
possibility of future changes in the circumstances of the Company. If the
Company were not to qualify as a REIT in any particular year, it would be
subject to federal income tax as a regular, domestic corporation, and its
stockholders would be subject to tax in the same manner as stockholders of such
corporation. In this event, the Company could be subject to potentially
substantial income tax liability in respect of each taxable year that it fails
to qualify as a REIT, and the amount of earnings and cash available for
distribution to its stockholders could be significantly reduced or eliminated.
In addition in any year, the Company may be subject to a 4% federal excise tax
to the extent the Company does not distribute 85% of its REIT ordinary income
for such year and 95% of its REIT capital gain net income for such year.
REQUIREMENTS FOR QUALIFICATION
The following is a brief summary of certain technical requirements
that the Company must meet on an ongoing basis in order to qualify, and remain
qualified, as a REIT under the Code:
STOCK OWNERSHIP TESTS
The capital stock of the Company must be transferable stock held,
beginning with its January 1, 1998 taxable year, by at least 100 persons during
at least 335 days of a taxable year of 12 months (or during a proportionate part
of a taxable year of less than 12 months), and no more than 50% of the value of
such capital stock may be owned, directly or indirectly, by five or fewer
individuals (as defined in the Code to include certain entities) at any time
during the last half of the taxable year. If the Company did not know, or have
reason to know, that its capital stock was owned directly or indirectly by five
or fewer individuals, it will be treated as having more than five owners as long
as it complied with Treasury regulations that provide rules on ascertaining
actual ownership. Tax-exempt entities, other than private foundations, certain
unemployment compensation trusts and certain charitable trusts generally are not
treated as individuals for these purposes. In addition, the Charter provides
restrictions regarding the transfer of the Company's shares to assist in meeting
the stock ownership requirements. The President's budget proposal would provide
that generally no person can own 50% or more of the vote or value of all classes
of a REIT's capital stock. This proposal would be effective for entities
electing REIT status for taxable years beginning on or after the date of the
first Committee action.
ASSET TESTS
The Company must generally meet the following asset tests (the "REIT
Asset Tests") at the close of each quarter of each taxable year:
(a) at least 75% of the value of the Company's total assets must
consist of Interests in Real Property (as defined below), regular or
residual interests in a REMIC (except that, if less than 95% of the
assets of a REMIC consists of real estate assets (determined as if the
Company held such assets), the Company will be treated as holding
directly its proportionate share of the assets of such REMIC), shares
of other REITs, government securities and temporary investments in
stock or debt instruments during the one year period following the
Company's receipt of certain new capital, cash, and cash items (the
"75% Asset Test"). For purposes of the 75% Asset Test, the term
"Interest in Real Property" includes an interest in Mortgage Loans (to
the extent the principal balance of a mortgage does not exceed the
fair market value of the associated real property); and
(b) the value of securities held by the Company but not taken
into account for purposes of the 75% Asset Test must not exceed (1) 5%
of the value of the Company's total assets in the case of securities
of any one issuer, or (2) 10% of the outstanding voting securities of
any issuer (or, beginning January 1, 2001, 10% of the value of the
securities of any one issuer).
The Company expects that any Subordinate Interests, IOs, Inverse IOs,
and temporary investments that it acquires generally will be treated as
qualifying assets for purposes of the 75% Asset Test, except to the extent that
less than 95% of the assets of a REMIC in which the Company owns an interest
consists of real estate assets and the Company's proportionate share of those
assets includes assets that are nonqualifying assets for purposes of the 75%
Asset Test. In addition, the Company does not expect that the value of any
security of any one entity would exceed 5% of the Company's total assets, and
the Company does not expect to own more than 10% of any one issuer's securities.
The Company also may purchase regular interests in a Financial Asset
Securitization Investment Trust (a "FASIT") which will be treated as qualifying
assets for purposes of the 75% Asset Test, except to the extent that less than
95% of the assets of a FASIT consists of real estate assets, in which case the
Company's proportionate share of the FASIT's nonqualifying assets will be
treated as nonqualifying assets for purposes of the 75% Asset Test.
The Company will attempt to monitor the status of the assets that it
acquires to assure compliance with the REIT Asset Tests.
If the Company should fail to satisfy the REIT Asset Tests at the end
of a calendar quarter, such a failure would not cause it to lose its REIT status
if (1) it satisfied the REIT Asset Tests at the close of the preceding calendar
quarter and (2) the discrepancy between the value of the Company's assets and
the REIT Asset Test requirements arose from changes in the market values of its
assets and was not wholly or partly caused by the acquisition of one or more
nonqualifying assets. If the condition described in clause (2) of the preceding
sentence was not satisfied, the Company still could avoid disqualification by
eliminating any discrepancy within 30 days after the close of the calendar
quarter in which it arose.
GROSS INCOME TESTS
The Company must generally meet the following gross income tests (the
"REIT Gross Income Tests") for each taxable year:
(a) at least 75% of the Company's gross income must be derived
from certain specified real estate sources including interest income
on Mortgage Loans and gain from the disposition of Qualified Real
Estate Assets or "qualified temporary investment income," (I.E.,
income derived from "new capital" within one year of the receipt of
such capital) (the "75% Gross Income Test"); and
(b) at least 95% of the Company's gross income must consist of
income which qualifies for the 75% Gross Income Test, as well as other
interest and gains from the sale of stock or other securities
(including certain interest rate swap or cap agreements, options,
futures contracts, forward rate agreements, and similar financial
instruments entered into to reduce the interest rate risk with respect
to debt incurred to acquire Qualified Real Estate Assets) not held for
sale in the ordinary course of business (the "95% Gross Income Test").
For purposes of determining whether the Company complies with the 75%
and 95% Gross Income Tests, gross income does not include gross income from
"prohibited transactions." A "prohibited transaction" is one involving a sale of
dealer property, other than foreclosure property. Net income from "prohibited
transactions" is subject to a 100% tax. If the Company sells Mortgage Securities
that it creates through Mortgage Loan securitizations, the Company may recognize
income that, if sufficient to cause the Company to be treated as a dealer in
Mortgage Securities for federal income tax purposes, could constitute
"prohibited transaction" income. See "--Taxation of the Company."
Interest on obligations secured by mortgages on real property or on
Interests in Real Property is qualifying income for purposes of the 75% Gross
Income Test. Any amount includible in gross income with respect to a regular or
residual interest in a REMIC or a regular interest in a FASIT generally is
treated as interest on an obligation secured by a mortgage on real property. If,
however, less than 95% of the assets of a REMIC or a FASIT consists of real
estate assets (determined as if the Company held such assets), the Company will
be treated as receiving directly its proportionate share of the income of the
REMIC or the FASIT. In addition, if the Company receives interest income with
respect to a mortgage loan that is secured by both real property and other
property and the highest principal amount of the loan outstanding during a
taxable year exceeds the fair market value of the real property on the date the
Company purchased the mortgage loan, the interest income will be apportioned
between the real property and the other property, which apportionment may cause
the Company to recognize income that is not qualifying income for purposes of
the 75% Gross Income Test.
Most of the income that the Company recognizes with respect to its
investments in Mortgage Loans will be qualifying income for purposes of both the
75% and 95% Gross Income Tests. This generally will include interest, original
issue discount, and market discount income that the Company derives from its
investments in Subordinate Interests, IOs and Inverse IOs.
The Company may originate or acquire Mortgage Loans and securitize
such loans through the issuance of non-REMIC CMOs. As a result of any such
transactions, the Company will retain an equity ownership interest in the
Mortgage Loans that has economic characteristics similar to those of a
Subordinate Interest. In addition, the Company may resecuritize Mortgage
Securities (or REMIC or non-REMIC CMOs) through the issuance of non-REMIC CMOs,
retaining an equity interest in the Mortgage Securities used as collateral in
the resecuritization transaction. Such transactions will not cause the Company
to fail to satisfy the Gross Income Tests. Further, the Company intends to
structure such securitizations in a manner which does not result in treatment of
the REIT or issuing entity as a "taxable mortgage pool."
The Company may receive income that is nonqualifying income for either
the 75% Gross Income Test or both the 75% and 95% Gross Income Tests. For
example, (1) the loan amount of a Mortgage Loan may exceed the value of the real
property securing the loan, which will result in a portion of the income from
the loan being classified as qualifying income for purposes of the 95% Gross
Income Test, but not for purposes of the 75% Gross Income Test, (2) the Company
may hold an interest in a REMIC or in a FASIT less than 95% of the assets of
which consists of real estate assets (determined as if the Company held such
assets), in which case the Company's proportionate share of the income of the
REMIC or FASIT may include income that is not qualifying income for purposes of
the 75% or 95% Gross Income Tests and (3) the Company may recognize foreign
currency gain from non-dollar denominated loans which will not be qualifying
income for purposes of the 75% and 95% Gross Income Tests.
The Company has in the past, and it is possible that, from time to
time, the Company will continue to enter into hedging transactions with respect
to one or more of its assets or liabilities. Any such hedging transactions could
take a variety of forms, including interest rate swap contracts, interest rate
cap or floor contracts, forward contracts, and options. To the extent that the
Company enters into a contract to hedge indebtedness incurred to acquire or
carry real estate assets, any periodic income or gain from the disposition of
such contract should be qualifying income for purposes of the 95% Gross Income
Test, but not the 75% Gross Income Test. To the extent that the Company hedges
its capital assets, it is not clear how the income from those transactions will
be treated for purposes of the Gross Income Tests.
DISTRIBUTION REQUIREMENT
To avoid subjecting its income to tax at regular corporate rates
(without a deduction for dividends paid), the Company generally must distribute
to its stockholders an amount equal to at least 95% (90% after 2000) of the
Company's REIT taxable income (before deductions of dividends paid), excluding
net capital gain and certain non-cash income including original issue discount
and cancellation of indebtedness income.
The Company intends to make distributions to its stockholders to
comply with the Distribution Requirement. However, differences in timing between
the recognition of taxable income and the actual receipt of cash could require
the Company to borrow funds or sell assets on a short-term basis to satisfy the
Distribution Requirement. The requirement to distribute a substantial portion of
the Company's net taxable income could cause the Company to (1) sell assets in
adverse market conditions, (2) distribute amounts that represent a return of
capital, or (3) distribute amounts that would otherwise be spent on future
investments or repayment of debt.
Distributions by the Company will be treated as ordinary dividend
income to the extent of the Company's current or accumulated earnings and
profits (but not less than its distribution requirement under Section 4981 of
the Code, as described below). The dividends are not eligible for any corporate
dividends received deduction. To the extent a distribution exceeds the amount
treated as a dividend, such distribution will be treated as a return of capital
to the extent of the shareholder's basis, and then as gain from the sale or
exchange of such shareholder's stock.
TAXATION OF THE COMPANY
In any year in which the Company qualifies as a REIT, the Company
generally will not be subject to federal income tax on the portion of its REIT
taxable income or capital gain which is distributed to its stockholders. The
Company will, however, be subject to federal income tax at normal corporate
income tax rates upon any undistributed taxable income or capital gain.
Stockholders will be entitled to a credit against their federal income tax for
their allocable share of tax paid by the Company on undistributed long-term
capital gains so designated in a notice by the Company (which are treated as
having been distributed to and subject to tax in the hands of the stockholders).
Revenue Procedure 99-17 provides securities and commodities traders
with the ability to elect mark-to-market treatment for 1998 by including a
statement with their timely filed 1998 tax return. The election applies for all
future years as well unless revoked with the consent of the Internal Revenue
Service. The Company elected mark-to-market treatment as a securities trader,
and accordingly, will recognize gains and losses prior to the actual disposition
of its securities. Moreover, some if not all of these constructive gains and
losses, as well as some if not all gains or losses from actual dispositions of
securities, for both 1998 and beyond, will be treated as ordinary in nature, and
not capital, as they would be in the absence of this election. There is no
assurance, however, that the Company's election will not be challenged on the
ground that it is not in fact a trader in securities, or that it is only a
trader with respect to some, but not all, of its securities. As such, there is a
risk that the Company will not be able to mark-to-market its securities, or that
it will be limited in its ability to recognize certain losses.
Notwithstanding its qualification as a REIT, the Company also may be
subject to tax in certain other circumstances. If the Company fails to satisfy
either the 75% or the 95% Gross Income Test, but nonetheless maintains its
qualification as a REIT because certain other requirements are met, it generally
will be subject to a 100% tax on the greater of the amount by which the Company
fails either the 75% or the 95% Gross Income Test. The Company also will be
subject to a tax of 100% on net income derived from a "prohibited transaction,"
and if the Company has (i) net income from the sale or other disposition of
"foreclosure property" which is held primarily for sale to customers in the
ordinary course of business or (ii) other non-qualifying income from foreclosure
property, it will be subject to Federal income tax on such income at the highest
corporate income tax rate. In addition, pursuant to Section 4981 of the Code, if
the Company in any calendar year (current or prior) fails to distribute at least
the sum of (i) 85% of its REIT ordinary income for such year and (ii) 95% of its
REIT capital gain net income for such year, the Company would, in the current
year, be subject to a 4% Federal excise tax on the excess of the sum of such
required distribution for the current year and any undistributed amount of
ordinary and capital gain net income from the preceding taxable years over the
sum of the amounts actually distributed during the current taxable year and the
income of the Company subject to tax in the current year. The Company also may
be subject to the corporate alternative minimum tax, as well as other taxes in
certain situations not presently contemplated. The President's budget proposal
would (for years after 2000) require REITs to distribute 98% of their ordinary
income and capital gain each calendar year to avoid being subject to the 4%
excise tax.
Further, if the Company were to sell to customers Mortgage Assets or
hedging instruments on a regular basis, there is a substantial risk that such
assets would be deemed "dealer property" and that all of the profits from such
sales would be subject to tax at the rate of 100% as income from prohibited
transactions.
If the Company fails to qualify as a REIT in any taxable year and
certain relief provisions of the Code do not apply, the Company would be subject
to Federal income tax (including any applicable alternative minimum tax) on its
taxable income at the regular corporate income tax rates and may be subject to a
4% federal excise tax.
INFORMATION REPORTING REQUIREMENTS AND BACKUP WITHHOLDING
The Company reports to its U.S. stockholders and to the Service the
amount of distributions paid during each calendar year, and the amount of tax
withheld, if any. Under the backup withholding rules, a stockholder may be
subject to backup withholding at the rate of 31% with respect to distributions
paid unless such holder (i) is a corporation or comes within certain other
exempt categories and, when required, demonstrates this fact, or (ii) provides a
taxpayer identification number, certifies as to no loss of exemption from backup
withholding, and otherwise complies with the applicable requirements of the
backup withholding rules. A stockholder who does not provide the Company with
his correct taxpayer identification number also may be subject to penalties
imposed by the Service. Any amount paid as backup withholding will be creditable
against the stockholder's income tax liability. The Treasury Department has
issued regulations regarding the backup withholding rules as applied to non-U.S.
stockholders that unify and tighten current certification procedures and forms
and clarify reliance standards. These regulations will be generally effective
with respect to distributions made after December 31, 2000.
STATE AND LOCAL TAXES
The Company and its stockholders may be subject to state and local tax
in various states and localities, including those states and localities in which
it or they transact business, own property, or reside. The state and local tax
treatment of the Company and its stockholders in such jurisdictions may differ
from the federal income tax treatment described above. Consequently,
stockholders should consult their own tax advisors regarding the effect of state
and local tax laws on ownership of the Common Stock.
REPURCHASE OF SHARES AND RESTRICTIONS ON TRANSFER
Two of the requirements of qualification for the tax benefits afforded
by the REIT Provisions of the Code are that (i) during the last half of each
taxable year not more than 50% in value of the outstanding shares may be owned
directly or indirectly by five or fewer individuals (the "5/50 Rule") and (ii)
there must be at least 100 stockholders during 335 days of each taxable year of
12 months.
So that the Company may meet these requirements at all times, the
Charter prohibits any person from acquiring or holding, directly or indirectly,
shares of Common Stock in excess of 9.8% (in value or in number of shares,
whichever is more restrictive) of the aggregate of the outstanding shares of
Common Stock of the Company. For this purpose, the term "ownership" is defined
in accordance with the REIT Provisions of the Code and the constructive
ownership provisions of Section 544 of the Code, as modified by Section
856(h)(1)(B) of the Code.
For purposes of the 5/50 Rule, the constructive ownership provisions
applicable under Section 544 of the Code attribute ownership of securities owned
by a corporation, partnership, estate or trust proportionately to its
stockholders, partners or beneficiaries, attribute ownership of securities owned
by family members and partners to other members of the same family, treat
securities with respect to which a person has an option to purchase as actually
owned by that person, and set forth rules as to when securities constructively
owned by a person are considered to be actually owned for the application of
such attribution provisions (I.E., "reattribution"). Thus, a person will be
treated as owning not only shares of Common Stock actually or beneficially
owned, but also any shares of Common Stock attributed to such person under the
attribution rules described above. Accordingly, under certain circumstances,
shares of Common Stock owned by a person who individually owns less than 9.8% of
the shares outstanding nevertheless may be in violation of the ownership
limitations set forth in the Charter. Ownership of shares of the Company's
Common Stock through such attribution is generally referred to as constructive
ownership. The 100 stockholder test is determined by actual, and not
constructive, ownership.
The Charter further provides that any transfer of shares of Common
Stock that would result in disqualification of the Company as a REIT or that
would (a) create a direct or constructive ownership of shares of stock in excess
of the Ownership Limit, or (b) from and after December 2, 1997 (the "One Hundred
Stockholder Date"), result in the shares of stock being beneficially owned
(within the meaning Section 856(a) of the Code) by fewer than 100 persons
(determined without reference to any rules of attribution), or (c) result in the
Company being "closely held" within the meaning of Section 856(h) of the Code,
will be null and void, and the intended transferee (the "purported transferee")
will acquire no rights to such shares. Any purported transfer of shares that
would result in a person owning (directly or constructively) shares in excess of
the Ownership Limit (except as otherwise waived by the Board of Directors) due
to the unenforceability of the transfer restrictions set forth above will
constitute "Excess Securities." Excess Securities will automatically be deemed
to have been transferred by operation of law to a trust to be established by the
Company for the exclusive benefit of a charitable organization, until such time
as the trustee of the trust, which shall be a banking institution designated as
trustee by the Company, which is unaffiliated with either the Company or the
purported transferee, retransfers the Excess Securities. Subject to the
Ownership Limit, Excess Securities may be transferred by the trust to any person
(if such transfer would not result in Excess Securities) at a price not to
exceed the price paid by the purported transferee, the fair market value of the
Excess Securities on the date of the purported transfer), at which point the
Excess Securities will automatically cease to be Excess Securities. See
"--Requirements for Qualification."
Subject to certain limitations, the Board of Directors may increase or
decrease the Ownership Limit. In addition, to the extent consistent with the
REIT Provisions of the Code, the Board of Directors has the right, in its sole
discretion, pursuant to the Company's Charter to waive the Ownership Limit for,
and at the request of, a purchaser of the Common Stock. In connection with any
such waiver, the Company may require that the stockholder requesting such a
waiver enter into an agreement with the Company providing for the repurchase by
the Company of shares from the stockholder under certain circumstances to ensure
compliance with the REIT Provisions of the Code. Such repurchase would be at
fair market value as set forth in the agreement between the Company and such
stockholder. The consideration received by the stockholder in such repurchase
might be characterized as the receipt by the stockholder of a dividend from the
Company, and any stockholder entering into such an agreement with the Company
should consult its tax advisor in connection with its entering into such an
agreement.
The Board of Directors waived the Ownership Limit for Highfields
Capital Ltd. ("Highfields"), which, at February 16, 1999, reported its ownership
of 3,283,400 shares of Common Stock. Any subsequent transfer of the shares held
by Highfields will be subject to the Ownership Limit, unless specifically
exempted by the Company's Board of Directors.
Every owner of more than five percent (or such lower percentage as
required by the Code or the regulations promulgated thereunder) of all classes
or series of the Company's stock, within 30 days after the end of each taxable
year, is required by the Company's Charter to give written notice to the Company
stating the name and address of such owner, the number of shares of each class
and series of stock of the Company beneficially owned and a description of the
manner in which such shares are held. Each such owner shall provide to the
Company such additional information as the Company may request in order to
determine the effect, if any, of such beneficial ownership on the Company's
status as a REIT and to ensure compliance with the ownership limitations.
The provisions described above may inhibit market activity and the
resulting opportunity for the holders of the Company's Common Stock to receive a
premium for their shares or warrants that might otherwise exist in the absence
of such provisions. Such provisions also may make the Company an unsuitable
investment vehicle for any person seeking to obtain ownership of more than 9.8%
of the outstanding shares of Common Stock.
EMPLOYEES
The Company currently has two employees. Mariner provides various
administrative services to the Company as agreed upon.
ITEM 2. PROPERTIES.
The Company's executive offices are located at 65 East 55th Street,
New York, New York 10022.
ITEM 3. LEGAL PROCEEDINGS.
There have been no material administrative, civil or criminal actions
to which the Company, its officers and directors is a party or to which any
property of the Company is subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Common Stock began trading on the NYSE on November 27, 1997 under
the symbol "LMM." Prior to such date, no public market for the Company's Common
Stock existed. The following table sets forth, for the periods indicated, the
high and low bid prices and closing sales prices per share of Common Stock as
reported on the NYSE composite tape and the cash dividends and distributions
declared per share of Common Stock.
STOCK PRICES CASH DIVIDENDS/
------------ DISTRIBUTIONS
HIGH LOW CLOSE DECLARED PER SHARE
---- --- ----- ------------------
1997
Fourth Quarter (commencing November 27, 1997) $14.94 $13.56 $14.50 $0.13
1998
First Quarter $17.63 $14.13 $15.13 $0.43
Second Quarter $16.44 $ 9.44 $10.88 $0.38
Third Quarter $11.25 $ 6.25 $ 7.50 $0.38
Fourth Quarter $ 7.00 $ 3.56 $ 5.44 $1.00
1999
First Quarter $ 5.63 $4.63 $5.38 $2.00
Second Quarter $5.56 $3.19 $3.44 --
Third Quarter $3.94 $3.38 $3.94 --
Fourth Quarter $4.06 $3.50 $4.06 --
2000
First Quarter (through March 24, 2000) $4.06 $3.81 $3.94 --
As of March 24, 2000, the Company had 14,839,583 shares of Common
Stock issued and outstanding, which were held by 66 holders of record. The
Company believes it has more than 2,000 beneficial holders of Common Stock.
The Company distributes substantially all of its taxable income (which
generally does not ordinarily equal net income as calculated in accordance with
GAAP) to its stockholders each year to maximize the tax benefits of its REIT
status. The Company intends to make distributions on the Common Stock quarterly.
To the extent necessary to maintain its qualification as a REIT, for any year
the Company will make a fifth special distribution. The distribution policy is
subject to revision, and all distributions will be made by the Company, at the
discretion of the Board of Directors, and distributions will depend on, among
other things, the taxable earnings of the Company, the financial condition of
the Company, maintenance of REIT status and such other factors as the Board of
Directors deems relevant.
To qualify as a REIT under the Code, the Company must make
distributions to its stockholders each year in an amount at least equal to (i)
95% (90% after 2000) of its Taxable Income before deduction of dividends paid
(less any net capital gain), plus (ii) 95% (90% after 2000) of the excess of
the net income from foreclosure property over the tax imposed on such income by
the Code, minus (iii) any excess noncash income. The "Taxable Income" of the
Company for any year means the taxable income of the Company for such year
(excluding any net income derived either from property held primarily for sale
to customers or from foreclosure property) subject to certain adjustments
provided in the REIT Provisions of the Code.
Distributions to stockholders will generally be subject to tax as
ordinary income, although a portion of such distributions may be designated by
the Company as capital gain or may constitute a tax-free return of capital. The
Company will furnish annually to each of its stockholders a statement setting
forth distributions paid during the preceding year and their characterization as
ordinary income, capital gains or return of capital. For a discussion of the
federal income tax treatment of distributions by the Company, see "Federal
Income Tax Considerations."
The Company has adopted a Dividend Reinvestment Plan that allows
stockholders to reinvest their dividends and distributions automatically in
additional shares of Common Stock.
ITEM 6. SELECTED FINANCIAL DATA.
The information set forth below should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and all of the financial statements and the notes thereto and other
financial information included elsewhere herein.
YEAR ENDED YEAR ENDED PERIOD ENDED
DECEMBER 31, 1999 DECEMBER 31, 1998 DECEMBER 31, 1997
----------------- ----------------- -----------------
(in thousands, except share and per share data)
STATEMENTS OF OPERATIONS DATA:
Interest income:
Mortgage loans and securities............. $ 28,139 $ 182,733 $ 10,078
Cash and cash equivalents................. 1,805 4,053 811
----------- ------------- -----------
Total.................................. 29,944 186,786 10,889
----------- ------------- -----------
Interest expense:
Repurchase agreements..................... 16,812 154,757 8,489
----------- ------------- -----------
Net interest income............................. 13,132 32,029 2,400
(Loss) gain on sale of securities............... (19,829) (52,443) 588
Impairment loss on interest-only securities..... -- (51,474) --
General and administrative expenses............. 4,325 8,384 415
----------- ------------- -----------
Net (loss) income............................... $(11,022) $ (80,272) $ 2,572
=========== ============= ===========
Unrealized (loss) gain on securities:
Unrealized holding (loss) gain arising
during period........................... (17,506) (67,793) 1,192
Add: reclassification adjustment for loss
(gain) included in net (loss) income.... 19,829 52,443 (588)
------------ -------------- ------------
Other comprehensive (loss) income............... 2,323 (15,350) 604
------------ -------------- ------------
Comprehensive (loss) income..................... $ (8,699) $ (95,622) $ 3,176
============ ============== ============
Net (loss) income per share:
Basic..................................... $ (0.65) $ (4.16) $ 0.13
============ ============== ============
Diluted................................... $ (0.65) $ (4.16) $ 0.13
============= ============== ============
Weighted average number of shares outstanding:
Basic..................................... 16,925,143 19,313,865 20,019,999
========== ========== ============
Diluted................................... 16,925,143 19,313,865 20,019,999
========== ========== ============
AS OF AS OF AS OF
DECEMBER 31, 1999 DECEMBER 31, 1998 DECEMBER 31, 1997
----------------- ----------------- -----------------
BALANCE SHEET DATA:
Cash and cash equivalents....................... $16,065 $30,393 $ 82,627
Total assets.................................... 118,283 874,071 3,793,239
Total liabilities............................... 45,291 746,514 3,510,805
Stockholders' equity............................ 72,992 127,557 282,434
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
The Company has been delevering its portfolio by selling certain
securities and repaying borrowings in an attempt to reduce the portfolio's
susceptibility to basis and interest rate risk and to create additional
liquidity. During the year ended December 31, 1999, the Company reduced its
portfolio by approximately $721 million of Mortgage Assets, at a loss of
approximately $(19.8) million.
As of December 31, 1999, based upon "available-for-sale" accounting
treatment, the Company's net asset value per share was $4.91 per share. The net
asset value as of such date reflects sales of Mortgage Assets completed through
December 31, 1999. Mariner, on behalf of the Company, determines net asset value
based on valuations and other information obtained through multiple independent
dealer quotes. As of December 31, 1999, the Company estimates that its portfolio
was comprised of approximately $65 million of Agency Certificates, $19 million
of Subordinate Interests, $9 million of IOs, $4 million of Mortgage Loans and $5
million of other fixed-income assets.
On November 15, 1999, the Company announced that its Board of
Directors authorized management to conduct a competitive sale of its less liquid
portfolio assets as part of its ongoing program to reduce the volatility of the
Company's assets. As of February 29, 2000, the Company has approximately $11
million (based on December 31, 1999 estimated fair value) of these assets
remaining to be sold.
RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1999 AND
DECEMBER 31, 1998
NET LOSS SUMMARY
GENERAL. For the year ended December 31, 1999, the Company had a net
loss of $(11.0) million, or $(0.65) per weighted average share, the weighted
average number of shares of Common Stock outstanding was 16,925,143,
distributions were $2.00 per share, $35.6 million in total and return on average
equity was (9.8)%.
For the year ended December 31, 1998, the Company had a net loss
before giving effect to charges relating to the impairment of certain IOs of
$(28.8) million, or $(1.49) per weighted average share. After giving effect to
the impairment charges of $(51.5) million, or $(2.67) per weighted average
share, for the year ended December 31, 1998, the Company had a net loss of
$(80.3) million, or $(4.16) per weighted average share. For the year ended
December 31, 1998, the weighted average number of shares of Common Stock
outstanding was 19,313,865, distributions were $2.12 per weighted average share,
$41.0 million in total and return on average equity was (35.35)% (after giving
effect to the impairment charges).
LOSSES FROM INVESTMENT ACTIVITIES. For the year ended December 31,
1999, the Company realized a loss of $(19.8) million or $(1.17) per weighted
average share, as a result of losses incurred in sales of securities and early
terminations of long-term repurchase agreements.
For the year ended December 31, 1998, the Company realized a loss of
$(52.4) million or $(2.62) per weighted average share, as a result of losses
incurred in sales of securities and terminations of interest rate swaps and a
reduction in income from its Mortgage Securities due to a reduced investment
portfolio and increasing prepayments. In response to a difficult credit
environment, the Company raised cash by selling portfolio securities to meet
increased margin requirements.
LOSSES FROM IMPAIRMENT CHARGES. For the year ended December 31, 1998,
the Company treated its portfolio of adjustable rate IOs as impaired assets and
taken an impairment charge against operating of $(51.0) million or $(2.64) per
weighted average share. At the end of the second and third quarters of 1998, in
light of the continued flat yield curve, low levels of LIBOR and faster than
expected prepayment rates over an extended period of time, the Company decided
that the impairment in market value was a permanent impairment. Accordingly, in
the second and third quarters of 1998, the Company decided that an impairment
charge of $(28.0) million and $(21.0) million, respectively, should be realized
in current income. During the year ended December 31, 1999 no additional
impairment charges were taken.
Most of the Company's IOs were LIBOR-based floating rate IOs purchased
in December 1997. They were acquired to balance duration in the Company's
portfolio. This investment was made based on the Company's evaluation of the
then-current prepayments, the shape of the yield curve and the relative values
of similar investments.
In evaluating the impairment charge on the IOs, the Company employs
current estimates of future prepayments obtained from independent sources. For
IOs collateralized by fixed-rate pass-through mortgage securities issued by
FNMA, GNMA and FHLMC (collectively, "Agency Fixed Rate Pass-Throughs"), the
Company utilized the median lifetime projection prepayment speeds compiled and
reported by Bloomberg L.P. from a survey of leading dealers in the mortgage
market. For "private label" IOs (collateralized by non-government agency
mortgage securities), the Company employs prepayment estimates from at least one
independent dealer. The prepayment estimates typically take into consideration
the current level and shape of the yield curve.
As a result of the substantial decline in interest rates since the
purchase of the IOs, current estimates of prepayment speeds significantly exceed
the original prepayment speed estimates.
At the end of the first quarter of 1998, the majority of the Company's
IOs were floating rate IOs. Floating rate IOs are unique securities in that the
interest payments on these securities increase as one-month LIBOR increases. Due
to this characteristic of option value, floating rate IOs trade at much lower
yields than fixed rate IOs. At the end of the second and third quarter of 1998,
in light of the continued flat yield curve, low levels of LIBOR and faster than
expected prepayment rates actually occurring for an extended period of time, the
Company decided that the impairment in market value was other than temporary.
TAXABLE INCOME (LOSS) AND GAAP INCOME (LOSS)
For the years ended December 31, 1999 and 1998, a net operating loss
as calculated for tax purposes ("NOL") is estimated at approximately $(30.5)
million and $(52.4) million, respectively, or $(1.80) and $(2.65), respectively,
per weighted average share. NOLs generally may be carried forward for 20 years.
The Company believes that during 1999 it experienced an "ownership change"
within the meaning of Section 382 of the Code. Consequently, its use of NOLs
generated before the ownership change to reduce taxable income after the
ownership change will be subject to limitations under Section 382. Generally,
the use of NOLs in any year is limited to the value of the Company's stock on
the date of the ownership change multiplied by the long-term tax exempt rate
(published by the IRS) with respect to that date. The Company currently is
attempting to determine the amount of the annual limitation.
Taxable income (loss) requires an annual calculation; consequently,
for the year ended December 31, 1999, taxable income (loss) may be different
from GAAP income (loss) as a result of differing treatment of unrealized gains
and losses on securities transactions. For the Company's tax purposes,
unrealized gains (losses) will be recognized at the end of the year and will be
aggregated with operating gains (losses) to produce total taxable income (loss)
for the year. For the year ended December 31, 1999, the Company had unrealized
gains of approximately $2,323,111.
Taxable income and GAAP income (loss) could also differ for other
reasons. For example, the Company may take credit provisions which would affect
GAAP income whereas only actual credit losses are deducted in calculating
taxable income. In addition, G&A Expenses may differ due to differing treatment
of leasehold amortization, certain stock option expenses and other items. As of
December 31, 1999 and 1998, the Company had not taken credit provisions because
64% and 82%, respectively, of the Company's Investments were Agency
Certificates.
The distinction between taxable income and GAAP income (loss) is
important to the Company's stockholders because dividends or distributions are
declared on the basis of taxable income. While the Company does not pay taxes so
long as it satisfies the requirements for exemption from taxation pursuant to
the REIT Provisions of the Code, each year the Company completes a corporate tax
form wherein taxable income is calculated as if the Company were to be taxed.
This taxable income level helps to determine the amount of dividends the Company
intends to pay out over time.
INTEREST INCOME AND AVERAGE EARNING ASSET YIELD
The Company had average earning assets of $393.4 million for the year
ended December 31, 1999 compared to $2,881.1 million for the year ended December
31, 1998. The table below shows, for the years ended December 31, 1999 and 1998,
the Company's average balance of cash equivalents, loans and securities, the
yields earned on each type of earning asset, the yield on average earning assets
and interest income.
AVERAGE EARNING ASSET YIELD
(dollars in thousands)
Yield on Yield on
Average Yield on Average Average
Average Amortized Average Average Amortized Interest
Cash Cost of Earning Cash Cost of Earning Interest
Equivalents Securities Assets Equivalents Securities Assets Income
For the Year Ended
December 31, 1999 $34,990 $358,370 $393,360 5.22% 7.85% 7.61% $29,944
For the Year Ended
December 31, 1998 $44,770 $2,836,370 $2,881,140 5.80% 6.86% 6.84% $186,786
INTEREST EXPENSE AND THE COST OF FUNDS
For the year ended December 31, 1999, the Company had average borrowed
funds of $302.7 million and total interest expense of $16.8 million with an
average cost of funds of 5.60% compared to average borrowed funds of $2,684.3
million and total interest expense of $154.8 million with an average cost of
funds of 5.77% for the year ended December 31, 1998. The Company believes that
its largest expense is usually the cost of borrowed funds. Interest expense is
calculated in the same manner for tax and GAAP purposes. The Company expects
that changes in the Company's cost of funds closely correlate with changes in
one-month LIBOR, although the Company may choose to extend the maturity of its
liabilities at any time, subject to the lender's consent. The Company's average
cost of funds was 0.30% above one-month LIBOR for the year ended December 31,
1999 compared to 0.20% above one-month LIBOR for the year ended December 31,
1998. The Company generally has structured its borrowings to adjust with
one-month LIBOR. During the year ended December 31, 1999, average one-month
LIBOR, which was 5.30%, was 0.10% lower than average six-month LIBOR, which was
5.40%. During the year ended December 31, 1998, average one-month LIBOR, which
was 5.57%, was 0.03% higher than average six-month LIBOR, which was 5.54%.
The table below shows, for the years ended December 31, 1999 and 1998,
the Company's average borrowed funds and average cost of funds compared to
average one and six-month LIBOR.
AVERAGE COST OF FUNDS
(dollars in thousands)
Average Average Average
One-Month Cost of Cost of
LIBOR Funds Funds
Relative Relative Relative
to to to
Average Average Average Average Average Average Average
Borrowed Interest Cost of One-Month Six-Month Six-Month One-Month Six-Month
Funds Expense Funds LIBOR LIBOR LIBOR LIBOR LIBOR
For the Year Ended
December 31, 1999 $302,736 $16,812 5.60% 5.30% 5.40% (.10)% .30% .20%
For the Year Ended
December 31, 1998 $2,684,296 $154,757 5.77% 5.57% 5.54% .03% .20% .23%
During 1998, events in the financial markets (including the continued
flat yield curve, the dislocation in the market for fixed income securities, the
tightening of credit available for investment in securities and the increased
risk of interest rate sensitive prepayment on mortgages) had an adverse effect
upon the Company's earnings. A relatively flat yield curve caused financing
costs to be relatively high compared to the income earned on the Company's
Mortgage Assets. The dislocation in the fixed income securities market and the
increased risk of prepayments, which affected the value of the Company's
portfolio, together with the tightening of credit available for investment in
securities, adversely affected the Company's ability to employ leverage
profitably.
INTEREST RATE SWAPS
In December 1997, the Company entered into interest rate swaps with an
aggregate notional amount of $1,035 million. The Company used these interest
rate swaps to hedge its available-for-sale portfolio of fixed-rate Agency
Certificates. The primary objective of this hedging strategy was to change the
interest rate characteristics of these securities from fixed to variable rates,
to better correspond to the maturity and repricing characteristics of the
short-term repurchase agreements used by the Company to fund these investments.
This primary objective was the basis for the Company's hedge accounting
treatment. The Company continually monitored the swaps to ensure that they were
effective at changing the interest rate characteristics of the securities. A
secondary objective was to offset fluctuations in the fair value of the
securities caused by fluctuations in market interest rates.
In September 1998, the Company experienced margin calls and believed
it prudent to increase its liquidity, and therefore, liquidated a large portion
of its Agency Certificates. In conjunction with liquidating these securities
positions, the Company also discontinued hedge accounting for the related swaps
with an aggregate notional amount of $485 million. The Company recognized the
unrealized loss on these swaps as an element of the overall loss on the
liquidation of the securities of $(26.0) million. In October 1998, the Company
liquidated Agency Certificates in response to continued margin calls and the
need for liquidity. The overall October 1998 loss on the liquidation of Agency
Certificates, including losses recognized upon suspension of hedge accounting
for the remaining swap with a notional amount of $550 million, totaled $(35.0)
million. On the day of each suspension of hedge accounting, the affected swaps
were closed out without additional gain or loss.
The Company did not enter into any interest rate swaps during the year
ended December 31, 1999, after having used them extensively in 1997 and 1998.
The valuations and other information used by the Company to monitor
the effectiveness of its interest rate swap hedging strategy were obtained
through multiple independent dealer quotes. This same information was used to
record the investments and swaps in the Company's financial statements and to
determine the Company's net asset value. The Company has never purchased or
written options to enter into swaps. As part of the Company's investigation of
the potential impact of the pricing irregularities discovered at the Affiliated
Funds, the Company reviewed the pricing of its own securities and swaps and
concluded that the valuations used were accurate.
The Company has been concerned about the potential distortion of GAAP
income relative to taxable income caused by differences in the book and tax
accounting treatment for its hedging activities and about volatility in reported
earnings that would obscure the comparability of the Company with other mortgage
REITs. At the time of the Company's initial public offering, the Company
believed that some of these concerns would best be addressed by electing to
classify the Mortgage Securities as trading securities for financial statement
purposes. Upon further analysis, including analysis of the accounting for the
related borrowings, the Company concluded that this accounting election would
not achieve the results initially anticipated and that classifying the Mortgage
Securities as available-for-sale would likely result in closer conformity to the
tax accounting method upon which distributions are based and greater
comparability with other mortgage REITs. Therefore, as the Company purchased the
individual securities in its portfolio of Mortgage Securities, it did not
classify them as trading securities.
Because the Mortgage Assets were not voluntarily classified as trading
securities, they met the definition of available-for-sale securities of
paragraph 12(b) of Statement of Financial Accounting Standards No. 115 ("SFAS
No. 115"). Accordingly, the Company classified each Mortgage Security as
available-for-sale at its acquisition date and subsequently reported each
security at its fair value. Pursuant to paragraph 13 of SFAS No. 115, unrealized
holding gains of $3.7 million related to available-for-sale Mortgage Securities
were reported in other comprehensive income at December 31, 1997 following the
initial acquisition of most of the securities.
NET INTEREST INCOME
Net interest income, which equals interest income less interest
expense, totaled $13.1 million for the year ended December 31, 1999 compared to
$32.0 for the year ended December 31, 1998. Net interest rate spread, which
equals the yield on the Company's interest earning assets (excluding cash) less
the average cost of funds for the period was 2.25% for the year ended December
31, 1999 compared to 1.09% for the year ended December 31, 1998. The decrease in
net interest income for the year ended December 31, 1999 compared to the year
ended December 31, 1998 was because the Company's substantially reduced
investment portfolio. The net interest rate spread increased for the year ended
December 31, 1999 compared to the year ended December 31, 1998 because of the
mix of Mortgage Assets in the Company's investment portfolio, which contained a
greater percentage of less liquid securities which finance at higher spreads for
year ended December 31, 1999 compared to the year ended December 31, 1998.
The table below shows interest income by earning asset type, average
earning assets by type, total interest income, interest expense, average
repurchase agreements, average cost of funds, and net interest income for the
years ended December 31, 1999 and 1998.
NET INTEREST INCOME
(dollars in thousands)
Yield on
Average Interest Net Income Average Average
Amortized Interest Average Income on Total Interest Balance of Average Net
Cost of Income on Cash Cash Contractual Interest Earning Repurchase Interest Cost of Interest
Investment Investments Equivalents Equivalents Commitments Income Assets Agreements Expense Funds Income
For the Year
Ended
December 31, 1999 $358,370 $28,139 $34,990 $1,805 -- $29,944 7.61% $302,736 $16,812 5.60% $13,132
For the Year
Ended
December 31, 1998 $2,836,370 $195,462 $44,770 $4,053 $(12,729) $186,786 6.84% $2,684,296 $154,757 5.77% $32,029
CREDIT CONSIDERATIONS
The Company has not experienced credit losses on its investment
portfolio to date, but losses may be experienced in the future. At December 31,
1999 and 1998, the Company had limited its exposure to credit losses on its
portfolio by holding 73% and 84%, respectively, of its investments in Mortgage
Securities issued by FNMA, GNMA and FHLMC (including IOs, fixed/floating rate
mortgage securities, fixed rate pass-through mortgage securities and
principal-only mortgage securities).
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative expenses ("operating expense" or "G&A
expense") were $4.3 million for the year ended December 31, 1999, consisting of
consulting fees paid to BlackRock of $1.1 million, salary expense of $600,000,
management fees paid to the Former Manager of $500,000 and professional and
other miscellaneous expenses. There were no differences in the calculation of
G&A expense for taxable and GAAP income purposes. The "Efficiency Ratio" is the
G&A expense divided by the net interest income.
Operating expense was $8.4 million for the year ended December 31,
1998, consisting of management fees paid to the Former Manager of $2.4 million,
incentive fees paid to the Former Manager of $2.1 million, deferred stock
expense of $1.1 million and professional and other miscellaneous expenses.
G&A EXPENSE RATIOS
(dollars in thousands)
Total G&A Total G&A
Expense/ Expense/
Deferred Other Total Average Average Efficiency
Management Incentive Consulting Stock G&A G&A Assets Equity Ratio
Fees Fees Fees Expense Expense Expense (Annualized (Annualized) (Annualized)
For the Year Ended
December 31, 1999 $543 $-- $1,125 $-- $2,658 $4,326 1.09% 4.86% 32.94%
For the Year Ended
December 31, 1998 $2,407 $2,123 $-- $1,082 $2,772 $8,384 .27% 3.69% 26.18%
NET LOSS AND RETURN ON AVERAGE EQUITY
Net losses were $11.0 million for the year ended December 31, 1999
compared to $80.3 million for the year ended December 31, 1998. Return on
average equity for the year ended December 31, 1999 was (12.39)% compared to
(35.35)% for the year ended December 31, 1998. The table below shows for the
years ended December 31, 1999 and 1998 the Company's net interest income, gain
on sale of securities and G&A expense each as a percentage of average equity,
and the return on average equity.
COMPONENTS OF RETURN ON AVERAGE EQUITY
Net Interest Loss on Sale Impairment
Income/ of Securities Loss on
Average Average Interest-Only G&A Expense/ Return on
Equity Equity Securities Equity Average Equity
For the Year Ended December 31, 1999 14.76% (22.28)% -- 4.86% (12.39)%
For the Year Ended December 31, 1998 14.10% (23.09)% (22.67)% 3.69% (35.35)%
DISTRIBUTIONS AND TAXABLE INCOME
The Company has elected to be taxed as a REIT under the Code.
Accordingly, the Company intends to distribute substantially all of its taxable
income for each year to stockholders, including income resulting from gains on
sales of securities. For the years ended December 31, 1999 and 1998, the Company
determined that it had no taxable income and made return of capital
distributions of $35.6 million and $41.0 million, respectively.
RESULTS OF OPERATIONS FOR THE PERIOD ENDED DECEMBER 31, 1997
The Company's 1997 fiscal year commenced with the beginning of its
operations on November 26, 1997. The 36-day period from November 26, 1997 to
December 31, 1997 is referred to as the "period ended December 31, 1997."
NET INCOME. For the period ended December 31, 1997, the Company's net
income was $2,572,404, or $0.13 per share, based on 20,019,999 shares
outstanding.
NET INTEREST INCOME. Net interest income for the period ended December
31, 1997 totaled $2,399,546. Net interest income is comprised of the interest
income earned on the Company's Mortgage Assets less interest expense from
borrowings.
GAIN ON SALE OF SECURITIES. The Company recorded a gain on sale of
securities of $588,289.
GENERAL AND ADMINISTRATIVE EXPENSES. The Company incurred general and
administrative expenses of $415,431, consisting of management fees paid to the
Former Manager of $232,858, incentive fees paid to the Former Manager of $94,992
and professional and other miscellaneous fees.
The unannualized return on end of period equity for the period ended
December 31, 1997 was 0.91%.
For the period ended December 31, 1997, the Company's taxable income
was $2,602,600, or $0.13 per average share outstanding. The Company declared and
paid a dividend of $0.13 per share for its first quarter of operations.
FINANCIAL CONDITION
INVESTMENTS
As of December 31, 1999 and 1998, the Company's portfolio consisted
of:
AS OF DECEMBER 31,
------------------
1999 1998
---- ----
DOLLAR AMOUNT DOLLAR AMOUNT
SECURITIES (IN MILLIONS) PERCENTAGE (IN MILLIONS) PERCENTAGE
---------- ------------- ---------- ------------- ----------
Agency Certificates................ $ 65 64% $ 681 83%
Subordinate Interests.............. 19 19% 73 8%
IOs................................ 8 8% 26 3%
CMOs............................... -- -- 25 3%
Mortgage Loans..................... 4 4% 8 1%
Other fixed-income assets.......... 5 5% 13 2%
------ -----
Total........................... $ 101 $826
====== ====
The Company reduced its portfolio of Mortgage Assets during the years
ended December 31, 1999 and 1998 in an attempt to reduce the portfolio's
susceptibility to basis and interest rate risk and to create additional
liquidity in response to margin calls, amortization and prepayments.
Discount balances are accreted as an increase in interest income over
the life of discount investments and premium balances are amortized as a
decrease in interest income over the life of premium investments. At December
31, 1999 and 1998, the Company had on its balance sheet (excluding IOs) $26.1
million and $32.7 million, respectively, total unamortized discount (which is
the difference between the remaining principal value and the