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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED: DECEMBER 31, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 1-13447
ANNALY MORTGAGE MANAGEMENT, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
MARYLAND 22-3479661
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NUMBER)
INCORPORATION OF ORGANIZATION)
1211 AVENUE OF THE AMERICAS, SUITE 2902
NEW YORK, NEW YORK 10036
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(212) 696-0100
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
COMMON STOCK, PAR VALUE $.01 PER SHARE NEW YORK STOCK EXCHANGE
7.875% SERIES A CUMULATIVE REDEEMABLE PREFERRED STOCK NEW YORK STOCK EXCHANGE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
NONE.
INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED
TO BE FILED BY SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING
THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANT WAS
REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING
REQUIREMENTS FOR THE PAST 90 DAYS:
YES X NO
INDICATE BY CHECK MARK IF DISCLOSURE OF DELINQUENT FILERS PURSUANT TO ITEM 405
OF REGULATION S-K IS NOT CONTAINED HEREIN, AND WILL NOT BE CONTAINED, TO THE
BEST OF REGISTRANT'S KNOWLEDGE, IN DEFINITIVE PROXY OR INFORMATION STATEMENTS
INCORPORATED BY REFERENCE IN PART III OF THIS FORM 10-K OR ANY AMENDMENT TO THIS
FORM 10-K. [ ]
INDICATE BY CHECK MARK WHETHER THE REGISTRANT IS AN ACCELERATED FILER (AS
DEFINED IN RULE 12B-2 OF THE ACT). YES X NO
--- ---
AT JUNE 30, 2004, THE AGGREGATE MARKET VALUE OF THE VOTING STOCK HELD BY
NON-AFFILIATES OF THE REGISTRANT WAS $1,991,760,199
THE NUMBER OF SHARES OF THE REGISTRANT'S COMMON STOCK OUTSTANDING ON MARCH 1
2005 WAS 121,272,323.
DOCUMENTS INCORPORATED BY REFERENCE
THE REGISTRANT INTENDS TO FILE A DEFINITIVE PROXY STATEMENT PURSUANT TO
REGULATION 14A WITHIN 120 DAYS OF THE END OF THE FISCAL YEAR ENDED DECEMBER 31,
2004. PORTIONS OF SUCH PROXY STATEMENT ARE INCORPORATED BY REFERENCE INTO PART
III OF THIS FORM 10-K.
ANNALY MORTGAGE MANAGEMENT, INC.
- --------------------------------------------------------------------------------
2004 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PART I
PAGE
ITEM 1. BUSINESS 1
ITEM 2. PROPERTIES 25
ITEM 3. LEGAL PROCEEDINGS 25
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 25
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY
AND RELATED STOCKHOLDER MATTERS 26
ITEM 6. SELECTED FINANCIAL DATA 28
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS 30
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 46
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 48
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE 48
ITEM 9A. CONTROLS AND PROCEDURES 48
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT 49
ITEM 11. EXECUTIVE COMPENSATION 49
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
AND RELATED STOCKHOLDER MATTERS 49
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 49
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES 49
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K 50
FINANCIAL STATEMENTS F-1
SIGNATURES II-1
EXHIBIT INDEX II-2
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain statements contained in this annual report, and certain
statements contained in our future filings with the Securities and Exchange
Commission (the "SEC" or the "Commission"), in our press releases or in our
other public or shareholder communications may not be based on historical facts
and are "forward-looking statements" within the meaning of the Private
Securities Litigation Reform Act of 1995. Forward-looking statements, which are
based on various assumptions (some of which are beyond our control), may be
identified by reference to a future period or periods or by the use of
forward-looking terminology, such as "may," "will," "believe," "expect,"
"anticipate," "continue," or similar terms or variations on those terms or the
negative of those terms. Actual results could differ materially from those set
forth in forward-looking statements due to a variety of factors, including, but
not limited to, changes in interest rates, changes in yield curve, changes in
prepayment rates, the availability of mortgage-backed securities for purchase,
the availability of financing and, if available, the terms of any financing, and
risks associated with the investment advisory business of our wholly owned
subsidiary, Fixed Income Discount Advisory Company (which we refer to as FIDAC),
including the removal by FIDAC's clients of assets FIDAC manages, FIDAC's
regulatory requirements and competition in the investment advisory business. For
a discussion of the risks and uncertainties which could cause actual results to
differ from those contained in the forward-looking statements, please see the
information under the caption "Risk Factors" described in this Form 10-K. We do
not undertake, and specifically disclaim any obligation, to publicly release the
result of any revisions which may be made to any forward-looking statements to
reflect the occurrence of anticipated or unanticipated events or circumstances
after the date of such statements.
PART I
ITEM 1. BUSINESS
THE COMPANY
BACKGROUND
Annaly Mortgage Management, Inc. owns, manages, and finances a
portfolio of investment securities, including mortgage pass-through
certificates, collateralized mortgage obligations (or CMOs), agency callable
debentures, and other securities representing interests in or obligations backed
by pools of mortgage loans. Our principal business objective is to generate net
income for distribution to our stockholders from the spread between the interest
income on our investment securities and the cost of borrowings to finance our
acquisition of investment securities. We are a Maryland corporation that
commenced operations on February 18, 1997. We are self-advised and self-managed.
The Company acquired Fixed Income Discount Advisory Company ("FIDAC") on June 4,
2004 (See Note 2 to the Financial Statements). FIDAC is a registered investment
advisor and is a taxable REIT subsidiary of the Company.
We have financed our purchases of investment securities with the net
proceeds of equity offerings and borrowings under repurchase agreements whose
interest rates adjust based on changes in short-term market interest rates.
We have elected and believe that we are organized and have operated in
a manner that enables us to be taxed as a real estate investment trust (or REIT)
under the Internal Revenue Code of 1986, as amended (or the Code). If we qualify
for taxation as a REIT, we generally will not be subject to federal income tax
on our taxable income that is distributed to our stockholders. Therefore,
substantially all of our assets, other than FIDAC, our taxable REIT subsidiary,
consist of qualified REIT real estate assets (of the type described in Section
856(c)(5)(B) of the Code). We have financed our purchases of investment
securities with the net proceeds of equity offerings and borrowings under
repurchase agreements whose interest rates adjust based on changes in short-term
market interest rates.
As used herein, "Annaly," the "Company," "we," "our" and similar terms
refer to Annaly Mortgage Management, Inc., unless the context indicates
otherwise.
ASSETS
Under our capital investment policy, at least 75% of our total assets
must be comprised of high-quality mortgage-backed securities and short-term
investments. High quality securities means securities that (1) are rated within
one of the two highest rating categories by at least one of the nationally
recognized rating agencies, (2) are unrated but
1
are guaranteed by the United States government or an agency of the United States
government, or (3) are unrated but we determine them to be of comparable quality
to rated high-quality mortgage-backed securities.
The remainder of our assets, comprising not more than 25% of our total
assets, may consist of other qualified REIT real estate assets which are unrated
or rated less than high quality, but which are at least "investment grade"
(rated "BBB" or better by Standard & Poor's Corporation ("S&P") or the
equivalent by another nationally recognized rating agency) or, if not rated, we
determine them to be of comparable credit quality to an investment which is
rated "BBB" or better.
We may acquire mortgage-backed securities backed by single-family
residential mortgage loans as well as securities backed by loans on
multi-family, commercial or other real estate-related properties. To date, all
of the mortgage-backed securities that we have acquired have been backed by
single-family residential mortgage loans.
To date, all of the mortgage-backed securities that we have acquired
have been agency mortgage-backed securities which, although not rated, carry an
implied "AAA" rating. Agency mortgage-backed securities are mortgage-backed
securities for which a government agency or federally chartered corporation,
such as the Federal Home Loan Mortgage Corporation ("FHLMC"), the Federal
National Mortgage Association ("FNMA"), or the Government National Mortgage
Association ("GNMA"), guarantees payments of principal or interest on the
securities. Agency mortgage-backed securities consist of agency pass-through
certificates and CMOs issued or guaranteed by an agency. Pass-through
certificates provide for a pass-through of the monthly interest and principal
payments made by the borrowers on the underlying mortgage loans. CMOs divide a
pool of mortgage loans into multiple tranches with different principal and
interest payment characteristics.
At December 31, 2004, approximately 62% of our investment securities
were adjustable-rate pass-though certificates, approximately 29% of our
investment securities were fixed-rate pass-through certificates or CMOs, and
approximately 9% of our investment securities were CMO floaters. Our
adjustable-rate pass-through certificates are backed by adjustable-rate mortgage
loans and have coupon rates which adjust over time, subject to interest rate
caps and lag periods, in conjunction with changes in short-term interest rates.
CMO floaters are tranches of mortgage-backed securities where the interest rate
adjusts in conjunction with changes in short-term interest rates. Our fixed-rate
pass-through certificates are backed by fixed-rate mortgage rates which do not
adjust over time. CMO floaters may be backed by fixed-rate mortgage loans or,
less often, by adjustable-rate mortgage loans. In this Form 10-K, except where
the context indicates otherwise, we use the term "adjustable-rate securities" or
"adjustable-rate investment securities" to refer to adjustable-rate pass-through
certificates, CMO floaters, and Agency debentures. At December 31, 2004, the
weighted average yield on our portfolio of earning assets was 3.43% and the
weighted average term to next rate adjustment on adjustable rate securities was
24 months.
We also invest in Federal Home Loan Bank ("FHLB"), FHLMC, and FNMA
debentures. We refer to the mortgage-backed securities and agency debentures
collectively as "Investment Securities." We intend to continue to invest in
adjustable-rate pass-through certificates, fixed-rate mortgage-backed
securities, CMO floaters, and Agency debentures. Although we have not done so to
date, we may also invest on a limited basis in mortgage derivative securities
representing the right to receive interest only or a disproportionately large
amount of interest. We have not and will not invest in real estate mortgage
investment conduit ("REMIC") residuals, other CMO residuals or any
mortgage-backed securities, such as inverse floaters, which have imbedded
leverage as part of their structural characteristics.
BORROWINGS
We attempt to structure our borrowings to have interest rate adjustment
indices and interest rate adjustment periods that, on an aggregate basis,
correspond generally to the interest rate adjustment indices and periods of our
adjustable-rate investment securities. However, periodic rate adjustments on our
borrowings are generally more frequent than rate adjustments on our investment
securities. At December 31, 2004, the weighted average cost of funds for all of
our borrowings was 2.46%, the weighted average original term to maturity was 211
days, and the weighted average term to next rate adjustment of these borrowings
was 111 days.
We generally expect to maintain a ratio of debt-to-equity of between
8:1 and 12:1, although the ratio may vary from time to time depending upon
market conditions and other factors that our management deems relevant. For
purposes of calculating this ratio, our equity is equal to the value of our
investment portfolio on a mark-to-market basis,
2
less the book value of our obligations under repurchase agreements and other
collateralized borrowings. At December 31, 2004, our ratio of debt-to-equity was
9.8:1.
HEDGING
To the extent consistent with our election to qualify as a REIT, we may
enter into hedging transactions to attempt to protect our investment securities
and related borrowings against the effects of major interest rate changes. This
hedging would be used to mitigate declines in the market value of our investment
securities during periods of increasing or decreasing interest rates and to
limit or cap the interest rates on our borrowings. These transactions would be
entered into solely for the purpose of hedging interest rate or prepayment risk
and not for speculative purposes. To date, we have not entered into any hedging
transactions.
COMPLIANCE WITH REIT AND INVESTMENT COMPANY REQUIREMENTS
We constantly monitor our investment securities and the income from
these securities and, to the extent we enter into hedging transactions in the
future, we will monitor income from our hedging transactions as well, so as to
ensure at all times that we maintain our qualification as a REIT and our exempt
status under the Investment Company Act of 1940, as amended.
MANAGEMENT
The following table sets forth certain information as of March 4, 2005
concerning our executive officers:
- ------------------------------------ -------------- ------------------------------------------------------------------
NAME AGE POSITION HELD WITH THE COMPANY
- ------------------------------------ -------------- ------------------------------------------------------------------
Michael A.J. Farrell 53 Chairman of the Board, Chief Executive Officer and President
- ------------------------------------ -------------- ------------------------------------------------------------------
Wellington J. Denahan-Norris 41 Vice Chairman of the Board and Chief Investment Officer
- ------------------------------------ -------------- ------------------------------------------------------------------
Kathryn F. Fagan 38 Chief Financial Officer and Treasurer
- ------------------------------------ -------------- ------------------------------------------------------------------
Jennifer S. Karve 34 Executive Vice President
- ------------------------------------ -------------- ------------------------------------------------------------------
James P. Fortescue 31 Senior Vice President and Repurchase Agreement Manager
- ------------------------------------ -------------- ------------------------------------------------------------------
Kristopher Konrad 30 Senior Vice President and Portfolio Mangager
- ------------------------------------ -------------- ------------------------------------------------------------------
Jeremy Diamond 41 Executive Vice President
- ------------------------------------ -------------- ------------------------------------------------------------------
Ronald Kazel 37 Executive Vice President--Business Development
- ------------------------------------ -------------- ------------------------------------------------------------------
Rose-Marie Lyght 31 Senior Vice-President and Portfolio Manager
- ------------------------------------ -------------- ------------------------------------------------------------------
R. Nicholas Singh 45 Executive Vice President, General Counsel, Secretary and Chief
Compliance Officer
- ------------------------------------ -------------- ------------------------------------------------------------------
Mr. Farrell and Ms. Denahan-Norris have an average of 24 years
experience in the investment banking and investment management industries where,
in various capacities, they have each managed portfolios of mortgage-backed
securities, arranged collateralized borrowings and utilized hedging techniques
to mitigate interest rate and other risk within fixed-income portfolios. Ms.
Fagan is a certified public accountant and, prior to becoming our Chief
Financial Officer and Treasurer, served as Chief Financial Officer and
Controller of a publicly owned savings and loan association. Mrs. Karve has
worked for us since December 1996. Mr. Diamond joined Annaly in March 2002. From
1990 to 2002 he was President of Grant's Financial Publishing. Mr. Kazel is in
charge of business development for FIDAC and Annaly and Mr. Kazel joined Annaly
in December 2001. Prior to joining FIDAC and Annaly, Mr. Kazel was a Senior
Vice-
3
President in Friedman Billings Ramsey's financial services investment banking
group. Ms. Lyght joined Annaly in April 1999. Mr. Singh joined Annaly in
February 2005. Prior to that, he was a partner in the law firm of McKee Nelson
LLP, and prior to that, a partner in Sidley Austin Brown & Wood LLP. We had 30
full-time employees at December 31, 2004.
DISTRIBUTIONS
To maintain our qualification as a REIT, we must distribute substantially
all of our taxable income to our stockholders for each year. We have done this
in the past and intend to continue to do so in the future. We also have declared
and paid regular quarterly dividends in the past and intend to do so in the
future. We have adopted a dividend reinvestment plan to enable holders of common
stock to reinvest dividends automatically in additional shares of common stock.
BUSINESS STRATEGY
GENERAL
Our principal business objective is to generate income for distribution
to our stockholders, primarily from the net cash flows on our investment
securities. Our net cash flows result primarily from the difference between the
interest income on our investment securities and borrowing costs of our
repurchase agreements and from dividends we receive from FIDAC. To achieve our
business objective and generate dividend yields, our strategy is:
o to purchase mortgage-backed securities, the majority of which we
expect to have adjustable interest rates based on changes in
short-term market interest rates;
o to acquire mortgage-backed securities that we believe:
- we have the necessary expertise to evaluate and manage;
- we can readily finance;
- are consistent with our balance sheet guidelines and risk
management objectives; and
- provide attractive investment returns in a range of scenarios;
o to finance purchases of mortgage-backed securities with the
proceeds of equity offerings and, to the extent permitted by our
capital investment policy, to utilize leverage to increase
potential returns to stockholders through borrowings;
o to attempt to structure our borrowings to have interest rate
adjustment indices and interest rate adjustment periods that, on
an aggregate basis, generally correspond to the interest rate
adjustment indices and interest rate adjustment periods of our
adjustable-rate mortgage-backed securities;
o to seek to minimize prepayment risk by structuring a diversified
portfolio with a variety of prepayment characteristics and through
other means; and
o to issue new equity or debt and increase the size of our balance
sheet when opportunities in the market for mortgage-backed
securities are likely to allow growth in earnings per share.
We believe we are able to obtain cost efficiencies through our
facilities-sharing arrangement with FIDAC and by virtue of our management's
experience in managing portfolios of mortgage-backed securities and arranging
collateralized borrowings. We will strive to become even more cost-efficient
over time by:
o seeking to raise additional capital from time to time in order to
increase our ability to invest in mortgage-backed securities;
4
o striving to lower our effective borrowing costs over time by
seeking direct funding with collateralized lenders, rather than
using financial intermediaries, and investigating the possibility
of using commercial paper and medium term note programs;
o improving the efficiency of our balance sheet structure by
investigating the issuance of uncollateralized subordinated debt,
preferred stock and other forms of capital; and
o utilizing information technology in our business, including
improving our ability to monitor the performance of our investment
securities and to lower our operating costs.
MORTGAGE-BACKED SECURITIES
GENERAL
To date, all of the mortgage-backed securities that we have acquired
have been agency mortgage-backed securities which, although not rated, carry an
implied "AAA" rating. Agency mortgage-backed securities are mortgage-backed
securities where a government agency or federally chartered corporation, such as
FHLMC, FNMA or GNMA, guarantees payments of principal or interest on the
securities. Agency mortgage-backed securities consist of agency pass-through
certificates and CMOs issued or guaranteed by an agency.
Even though to date we have only acquired securities with an implied
"AAA" rating, under our capital investment policy, we have the ability to
acquire securities of lower quality. Under our policy, at least 75% of our total
assets must be high quality mortgage-backed securities and short-term
investments. High quality securities are securities (1) that are rated within
one of the two highest rating categories by at least one of the nationally
recognized rating agencies, (2) that are unrated but are guaranteed by the
United States government or an agency of the United States government, or (3)
that are unrated or whose ratings have not been updated but that our management
determines are of comparable quality to rated high quality mortgage-backed
securities.
Under our capital investment policy, the remainder of our assets,
comprising not more than 25% of total assets, may consist of mortgage-backed
securities and other qualified REIT real estate assets which are unrated or
rated less than high quality, but which are at least "investment grade" (rated
"BBB" or better by S&P or the equivalent by another nationally recognized rating
organization) or, if not rated, we determine them to be of comparable credit
quality to an investment which is rated "BBB" or better. We intend to structure
our portfolio to maintain a minimum weighted average rating (including our
deemed comparable ratings for unrated mortgage-backed securities) of our
mortgage-backed securities of at least single "A" under the S&P rating system
and at the comparable level under the other rating systems.
Our allocation of investments among the permitted investment types may
vary from time-to-time based on the evaluation by our board of directors of
economic and market trends and our perception of the relative values available
from these types of investments, except that in no event will our investments
that are not high quality exceed 25% of our total assets.
We intend to acquire only those mortgage-backed securities that we
believe we have the necessary expertise to evaluate and manage, that are
consistent with our balance sheet guidelines and risk management objectives and
that we believe we can readily finance. Since we generally hold the
mortgage-backed securities we acquire until maturity, we generally do not seek
to acquire assets whose investment returns are attractive in only a limited
range of scenarios. We believe that future interest rates and mortgage
prepayment rates are very difficult to predict. Therefore, we seek to acquire
mortgage-backed securities which we believe will provide acceptable returns over
a broad range of interest rate and prepayment scenarios.
At December 31, 2004, our mortgage-backed securities consist of
pass-through certificates and collateralized mortgage obligations issued or
guaranteed by FHLMC, FNMA or GNMA. We have not, and will not, invest in REMIC
residuals, other CMO residuals or mortgage-backed securities, such as inverse
floaters, which have imbedded leverage as part of their structural
characteristics.
5
DESCRIPTION OF MORTGAGE-BACKED SECURITIES
The mortgage-backed securities that we acquire provide funds for
mortgage loans made primarily to residential homeowners. Our securities
generally represent interests in pools of mortgage loans made by savings and
loan institutions, mortgage bankers, commercial banks and other mortgage
lenders. These pools of mortgage loans are assembled for sale to investors (like
us) by various government, government-related and private organizations.
Mortgage-backed securities differ from other forms of traditional debt
securities, which normally provide for periodic payments of interest in fixed
amounts with principal payments at maturity or on specified call dates. Instead,
mortgage-backed securities provide for a monthly payment, which consists of both
interest and principal. In effect, these payments are a "pass-through" of the
monthly interest and principal payments made by the individual borrower on the
mortgage loans, net of any fees paid to the issuer or guarantor of the
securities. Additional payments result from prepayments of principal upon the
sale, refinancing or foreclosure of the underlying residential property, net of
fees or costs which may be incurred. Some mortgage-backed securities, such as
securities issued by GNMA, are described as "modified pass-through." These
securities entitle the holder to receive all interest and principal payments
owed on the mortgage pool, net of certain fees, regardless of whether the
mortgagors actually make mortgage payments when due.
The investment characteristics of pass-through mortgage-backed
securities differ from those of traditional fixed-income securities. The major
differences include the payment of interest and principal on the mortgage-backed
securities on a more frequent schedule, as described above, and the possibility
that principal may be prepaid at any time due to prepayments on the underlying
mortgage loans or other assets. These differences can result in significantly
greater price and yield volatility than is the case with traditional
fixed-income securities.
Various factors affect the rate at which mortgage prepayments occur,
including changes in interest rates, general economic conditions, the age of the
mortgage loan, the location of the property and other social and demographic
conditions. Generally prepayments on mortgage-backed securities increase during
periods of falling mortgage interest rates and decrease during periods of rising
mortgage interest rates. We may reinvest prepayments at a yield that is higher
or lower than the yield on the prepaid investment, thus affecting the weighted
average yield of our investments.
To the extent mortgage-backed securities are purchased at a premium,
faster than expected prepayments result in a faster than expected amortization
of the premium paid. Conversely, if these securities were purchased at a
discount, faster than expected prepayments accelerate our recognition of income.
CMOs may allow for shifting of prepayment risk from slower-paying
tranches to faster-paying tranches. This is in contrast to mortgage pass-through
certificates where all investors share equally in all payments, including all
prepayments, on the underlying mortgages.
FHLMC CERTIFICATES
FHLMC is a privately-owned government-sponsored enterprise created
pursuant to an Act of Congress on July 24, 1970. The principal activity of FHLMC
currently consists of the purchase of mortgage loans or participation interests
in mortgage loans and the resale of the loans and participations in the form of
guaranteed mortgage-backed securities. FHLMC guarantees to each holder of FHLMC
certificates the timely payment of interest at the applicable pass-through rate
and ultimate collection of all principal on the holder's pro rata share of the
unpaid principal balance of the related mortgage loans, but does not guarantee
the timely payment of scheduled principal of the underlying mortgage loans. The
obligations of FHLMC under its guarantees are solely those of FHLMC and are not
backed by the full faith and credit of the United States. If FHLMC were unable
to satisfy these obligations, distributions to holders of FHLMC certificates
would consist solely of payments and other recoveries on the underlying mortgage
loans and, accordingly, defaults and delinquencies on the underlying mortgage
loans would adversely affect monthly distributions to holders of FHLMC
certificates.
FHLMC certificates may be backed by pools of single-family mortgage
loans or multi-family mortgage loans. These underlying mortgage loans may have
original terms to maturity of up to 40 years. FHLMC certificates may be issued
under cash programs (composed of mortgage loans purchased from a number of
sellers) or guarantor programs (composed of mortgage loans acquired from one
seller in exchange for certificates representing interests in the mortgage loans
purchased).
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FHLMC certificates may pay interest at a fixed rate or an adjustable
rate. The interest rate paid on adjustable-rate FHLMC certificates ("FHLMC
ARMs") adjusts periodically within 60 days prior to the month in which the
interest rates on the underlying mortgage loans adjust. The interest rates paid
on certificates issued under FHLMC's standard ARM programs adjust in relation to
the Treasury index. Other specified indices used in FHLMC ARM programs include
the 11th District Cost of Funds Index published by the Federal Home Loan Bank of
San Francisco, LIBOR and other indices. Interest rates paid on fully-indexed
FHLMC ARM certificates equal the applicable index rate plus a specified number
of basis points. The majority of series of FHLMC ARM certificates issued to date
have evidenced pools of mortgage loans with monthly, semi-annual or annual
interest adjustments. Adjustments in the interest rates paid are generally
limited to an annual increase or decrease of either 100 or 200 basis points and
to a lifetime cap of 500 or 600 basis points over the initial interest rate.
Certain FHLMC programs include mortgage loans which allow the borrower to
convert the adjustable mortgage interest rate to a fixed rate. Adjustable-rate
mortgages which are converted into fixed-rate mortgage loans are repurchased by
FHLMC or by the seller of the loan to FHLMC at the unpaid principal balance of
the loan plus accrued interest to the due date of the last adjustable rate
interest payment.
FNMA CERTIFICATES
FNMA is a privately-owned, federally-chartered corporation organized
and existing under the Federal National Mortgage Association Charter Act. FNMA
provides funds to the mortgage market primarily by purchasing home mortgage
loans from local lenders, thereby replenishing their funds for additional
lending. FNMA guarantees to the registered holder of a FNMA certificate that it
will distribute amounts representing scheduled principal and interest on the
mortgage loans in the pool underlying the FNMA certificate, whether or not
received, and the full principal amount of any such mortgage loan foreclosed or
otherwise finally liquidated, whether or not the principal amount is actually
received. The obligations of FNMA under its guarantees are solely those of FNMA
and are not backed by the full faith and credit of the United States. If FNMA
were unable to satisfy its obligations, distributions to holders of FNMA
certificates would consist solely of payments and other recoveries on the
underlying mortgage loans and, accordingly, defaults and delinquencies on the
underlying mortgage loans would adversely affect monthly distributions to
holders of FNMA.
FNMA certificates may be backed by pools of single-family or
multi-family mortgage loans. The original term to maturity of any such mortgage
loan generally does not exceed 40 years. FNMA certificates may pay interest at a
fixed rate or an adjustable rate. Each series of FNMA ARM certificates bears an
initial interest rate and margin tied to an index based on all loans in the
related pool, less a fixed percentage representing servicing compensation and
FNMA's guarantee fee. The specified index used in different series has included
the Treasury Index, the 11th District Cost of Funds Index published by the
Federal Home Loan Bank of San Francisco, LIBOR and other indices. Interest rates
paid on fully-indexed FNMA ARM certificates equal the applicable index rate plus
a specified number of basis points. The majority of series of FNMA ARM
certificates issued to date have evidenced pools of mortgage loans with monthly,
semi-annual or annual interest rate adjustments. Adjustments in the interest
rates paid are generally limited to an annual increase or decrease of either 100
or 200 basis points and to a lifetime cap of 500 or 600 basis points over the
initial interest rate. Certain FNMA programs include mortgage loans which allow
the borrower to convert the adjustable mortgage interest rate of the ARM to a
fixed rate. Adjustable-rate mortgages which are converted into fixed-rate
mortgage loans are repurchased by FNMA or by the seller of the loans to FNMA at
the unpaid principal of the loan plus accrued interest to the due date of the
last adjustable rate interest payment. Adjustments to the interest rates on FNMA
ARM certificates are typically subject to lifetime caps and periodic rate or
payment caps.
GNMA CERTIFICATES
GNMA is a wholly owned corporate instrumentality of the United States
within the Department of Housing and Urban Development ("HUD"). The National
Housing Act of 1934 authorizes GNMA to guarantee the timely payment of the
principal of and interest on certificates which represent an interest in a pool
of mortgages insured by the Federal Housing Administration ("FHA") or partially
guaranteed by the Department of Veterans Affairs and other loans eligible for
inclusion in mortgage pools underlying GNMA certificates. Section 306(g) of the
Housing Act provides that the full faith and credit of the United States is
pledged to the payment of all amounts which may be required to be paid under any
guaranty by GNMA.
At present, most GNMA certificates are backed by single-family mortgage
loans. The interest rate paid on GNMA certificates may be a fixed rate or an
adjustable rate. The interest rate on GNMA certificates issued under GNMA's
standard ARM program adjusts annually in relation to the Treasury index.
Adjustments in the interest rate are
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generally limited to an annual increase or decrease of 100 basis points and to a
lifetime cap of 500 basis points over the initial coupon rate.
SINGLE-FAMILY AND MULTI-FAMILY PRIVATELY-ISSUED CERTIFICATES
Single-family and multi-family privately-issued certificates are
pass-through certificates that are not issued by one of the agencies and that
are backed by a pool of conventional single-family or multi-family mortgage
loans. These certificates are issued by originators of, investors in, and other
owners of mortgage loans, including savings and loan associations, savings
banks, commercial banks, mortgage banks, investment banks and special purpose
"conduit" subsidiaries of these institutions.
While agency pass-through certificates are backed by the express
obligation or guarantee of one of the agencies, as described above,
privately-issued certificates are generally covered by one or more forms of
private (i.e., non-governmental) credit enhancements. These credit enhancements
provide an extra layer of loss coverage in the event that losses are incurred
upon foreclosure sales or other liquidations of underlying mortgaged properties
in amounts that exceed the equity holder's equity interest in the property.
Forms of credit enhancements include limited issuer guarantees, reserve funds,
private mortgage guaranty pool insurance, over-collateralization and
subordination.
Subordination is a form of credit enhancement frequently used and
involves the issuance of classes of senior and subordinated mortgage-backed
securities. These classes are structured into a hierarchy to allocate losses on
the underlying mortgage loans and also for defining priority of rights to
payment of principal and interest. Typically, one or more classes of senior
securities are created which are rated in one of the two highest rating levels
by one or more nationally recognized rating agencies and which are supported by
one or more classes of mezzanine securities and subordinated securities that
bear losses on the underlying loans prior to the classes of senior securities.
Mezzanine securities, as used in this Form 10-K, refers to classes that are
rated below the two highest levels, but no lower than a single "B" rating under
the S&P rating system (or comparable level under other rating systems) and are
supported by one or more classes of subordinated securities which bear realized
losses prior to the classes of mezzanine securities. Subordinated securities, as
used in this Form 10-K, refers to any class that bears the "first loss" from
losses from underlying mortgage loans or that is rated below a single "B" level
(or, if unrated, we deem it to be below that level). In some cases, only classes
of senior securities and subordinated securities are issued. By adjusting the
priority of interest and principal payments on each class of a given series of
senior-subordinated mortgage-backed securities, issuers are able to create
classes of mortgage-backed securities with varying degrees of credit exposure,
prepayment exposure and potential total return, tailored to meet the needs of
sophisticated institutional investors.
COLLATERALIZED MORTGAGE OBLIGATIONS AND MULTI-CLASS PASS-THROUGH
SECURITIES
We may also invest in CMOs and multi-class pass-through securities.
CMOs are debt obligations issued by special purpose entities that are secured by
mortgage loans or mortgage-backed certificates, including, in many cases,
certificates issued by government and government-related guarantors, including,
GNMA, FNMA and FHLMC, together with certain funds and other collateral.
Multi-class pass-through securities are equity interests in a trust composed of
mortgage loans or other mortgage-backed securities. Payments of principal and
interest on underlying collateral provide the funds to pay debt service on the
CMO or make scheduled distributions on the multi-class pass-through securities.
CMOs and multi-class pass-through securities may be issued by agencies or
instrumentalities of the U.S. Government or by private organizations. The
discussion of CMOs in the following paragraphs is similarly applicable to
multi-class pass-through securities.
In a CMO, a series of bonds or certificates is issued in multiple
classes. Each class of CMOs, often referred to as a "tranche," is issued at a
specific coupon rate (which, as discussed below, may be an adjustable rate
subject to a cap) and has a stated maturity or final distribution date.
Principal prepayments on collateral underlying a CMO may cause it to be retired
substantially earlier than the stated maturity or final distribution date.
Interest is paid or accrues on all classes of a CMO on a monthly, quarterly or
semi-annual basis. The principal and interest on underlying mortgages may be
allocated among the several classes of a series of a CMO in many ways. In a
common structure, payments of principal, including any principal prepayments, on
the underlying mortgages are applied to the classes of the series of a CMO in
the order of their respective stated maturities or final distribution dates, so
that no payment of principal will be made on any class of a CMO until all other
classes having an earlier stated maturity or final distribution date have been
paid in full.
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Other types of CMO issues include classes such as parallel pay CMOs,
some of which, such as planned amortization class CMOs ("PAC bonds"), provide
protection against prepayment uncertainty. Parallel pay CMOs are structured to
provide payments of principal on certain payment dates to more than one class.
These simultaneous payments are taken into account in calculating the stated
maturity date or final distribution date of each class which, as with other CMO
structures, must be retired by its stated maturity date or final distribution
date but may be retired earlier. PAC bonds generally require payment of a
specified amount of principal on each payment date so long as prepayment speeds
on the underlying collateral fall within a specified range.
Other types of CMO issues include targeted amortization class CMOs (or
TAC bonds), which are similar to PAC bonds. While PAC bonds maintain their
amortization schedule within a specified range of prepayment speeds, TAC bonds
are generally targeted to a narrow range of prepayment speeds or a specified
prepayment speed. TAC bonds can provide protection against prepayment
uncertainty since cash flows generated from higher prepayments of the underlying
mortgage-related assets are applied to the various other pass-through tranches
so as to allow the TAC bonds to maintain their amortization schedule.
A CMO may be subject to the issuer's right to redeem the CMO prior to
its stated maturity date, which may diminish the anticipated return on our
investment. Privately-issued CMOs are supported by private credit enhancements
similar to those used for privately-issued certificates and are often issued as
senior-subordinated mortgage-backed securities. We will only acquire CMOs or
multi-class pass-through certificates that constitute debt obligations or
beneficial ownership in grantor trusts holding mortgage loans, or regular
interests in REMICs, or that otherwise constitute qualified REIT real estate
assets under the Internal Revenue Code (provided that we have obtained a
favorable opinion of our tax advisor or a ruling from the IRS to that effect).
ADJUSTABLE-RATE MORTGAGE PASS-THROUGH CERTIFICATES AND FLOATING RATE
MORTGAGE-BACKED SECURITIES
Most of the mortgage pass-through certificates we acquire are
adjustable-rate mortgage pass-through certificates. This means that their
interest rates may vary over time based upon changes in an objective index, such
as:
o LIBOR OR THE LONDON INTERBANK OFFERED RATE. The interest rate that
banks in London offer for deposits in London of U.S. dollars.
o TREASURY INDEX. A monthly or weekly average yield of benchmark
U.S. Treasury securities, as published by the Federal Reserve
Board.
o CD RATE. The weekly average of secondary market interest rates on
six-month negotiable certificates of deposit, as published by the
Federal Reserve Board.
These indices generally reflect short-term interest rates. The underlying
mortgages for adjustable-rate mortgage pass-through certificates are
adjustable-rate mortgage loans ("ARMs").
We also acquire CMO floaters. One or more tranches of a CMO may have
coupon rates that reset periodically at a specified increment over an index such
as LIBOR. These adjustable-rate tranches are sometime known as CMO floaters and
may be backed by fixed or adjustable-rate mortgages.
There are two main categories of indices for adjustable-rate mortgage
pass-through certificates and floaters: (1) those based on U.S. Treasury
securities, and (2) those derived from calculated measures such as a cost of
funds index or a moving average of mortgage rates. Commonly utilized indices
include the one-year Treasury note rate, the three-month Treasury bill rate, the
six-month Treasury bill rate, rates on long-term Treasury securities, the 11th
District Federal Home Loan Bank Costs of Funds Index, the National Median Cost
of Funds Index, one-month or three-month LIBOR, the prime rate of a specific
bank, or commercial paper rates. Some indices, such as the one-year Treasury
rate, closely mirror changes in market interest rate levels. Others, such as the
11th District Home Loan Bank Cost of Funds Index, tend to lag changes in market
interest rate levels. We seek to diversify our investments in adjustable-rate
mortgage pass-through certificates and floaters among a variety of indices and
reset periods so that we are not at any one time unduly exposed to the risk of
interest rate fluctuations. In selecting adjustable-rate mortgage pass-through
certificates and floaters for investment, we will also consider the liquidity of
the market for the different mortgage-backed securities.
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We believe that adjustable-rate mortgage pass-through certificates and
floaters are particularly well-suited to our investment objective of high
current income, consistent with modest volatility of net asset value, because
the value of adjustable-rate mortgage pass-through certificates and floaters
generally remains relatively stable as compared to traditional fixed-rate debt
securities paying comparable rates of interest. While the value of
adjustable-rate mortgage pass-through certificates and floaters, like other debt
securities, generally varies inversely with changes in market interest rates
(increasing in value during periods of declining interest rates and decreasing
in value during periods of increasing interest rates), the value of
adjustable-rate mortgage pass-through certificates and floaters should generally
be more resistant to price swings than other debt securities because the
interest rates on these securities move with market interest rates.
Accordingly, as interest rates change, the value of our shares should
be more stable than the value of funds which invest primarily in securities
backed by fixed-rate mortgages or in other non-mortgage-backed debt securities,
which do not provide for adjustment in the interest rates in response to changes
in market interest rates.
Adjustable-rate mortgage pass-through certificates and floaters
typically have caps, which limit the maximum amount by which the interest rate
may be increased or decreased at periodic intervals or over the life of the
security. To the extent that interest rates rise faster than the allowable caps
on the adjustable-rate mortgage pass-through certificates and floaters, these
securities will behave more like fixed-rate securities. Consequently, interest
rate increases in excess of caps can be expected to cause these securities to
behave more like traditional debt securities than adjustable-rate securities
and, accordingly, to decline in value to a greater extent than would be the case
in the absence of these caps.
Adjustable-rate mortgage pass-through certificates and floaters, like
other mortgage-backed securities, differ from conventional bonds in that
principal is to be paid back over the life of the security rather than at
maturity. As a result, we receive monthly scheduled payments of principal and
interest on these securities and may receive unscheduled principal payments
representing prepayments on the underlying mortgages. When we reinvest the
payments and any unscheduled prepayments we receive, we may receive a rate of
interest on the reinvestment which is lower than the rate on the existing
security. For this reason, adjustable-rate mortgage pass-through certificates
and floaters are less effective than longer-term debt securities as a means of
"locking in" longer-term interest rates. Accordingly, adjustable-rate mortgage
pass-through certificates and floaters, while generally having less risk of
price decline during periods of rapidly rising interest rates than fixed-rate
mortgage-backed securities of comparable maturities, have less potential for
capital appreciation than fixed-rate securities during periods of declining
interest rates.
As in the case of fixed-rate mortgage-backed securities, to the extent
these securities are purchased at a premium, faster than expected prepayments
would accelerate our amortization of the premium. Conversely, if these
securities were purchased at a discount, faster than expected prepayments would
accelerate our recognition of income.
As in the case of fixed-rate CMOs, floating-rate CMOs may allow for
shifting of prepayment risk from slower-paying tranches to faster-paying
tranches. This is in contrast to mortgage pass-through certificates where all
investors share equally in all payments, including all prepayments, on the
underlying mortgages.
OTHER FLOATING RATE INSTRUMENTS
We may also invest in structured floating-rate notes issued or
guaranteed by government agencies, such as FNMA and FHLMC. These instruments are
typically structured to reflect an interest rate arbitrage (i.e., the difference
between the agency's cost of funds and the income stream from specified assets
of the agency) and their reset formulas may provide more attractive returns than
other floating rate instruments. The indices used to determine resets are the
same as those described above.
MORTGAGE LOANS
As of December 31, 2004, we have not invested directly in mortgage
loans, but we may from time-to-time invest a small percentage of our assets
directly in single-family, multi-family or commercial mortgage loans. We expect
that the majority of these mortgage loans would be ARM pass-through
certificates. The interest rate on an ARM pass-through certificate is typically
tied to an index (such as LIBOR or the interest rate on Treasury bills), and is
adjustable periodically at specified intervals. These mortgage loans are
typically subject to lifetime interest rate caps and periodic interest rate or
payment caps. The acquisition of mortgage loans generally involves credit risk.
We may obtain credit
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enhancement to mitigate this risk; however, there can be no assurances that we
will able to obtain credit enhancement or that credit enhancement would mitigate
the credit risk of the underlying mortgage loans.
CAPITAL INVESTMENT POLICY
ASSET ACQUISITIONS
Our capital investment policy provides that at least 75% of our total
assets will be comprised of high quality mortgage-backed securities and
short-term investments. The remainder of our assets (comprising not more than
25% of total assets), may consist of mortgage-backed securities and other
qualified REIT real estate assets which are unrated or rated less than high
quality but which are at least "investment grade" (rated "BBB" or better) or, if
not rated, are determined by us to be of comparable credit quality to an
investment which is rated "BBB" or better.
Our capital investment policy requires that we structure our portfolio
to maintain a minimum weighted average rating (including our deemed comparable
ratings for unrated mortgage-backed securities) of our mortgage-backed
securities of at least single "A" under the S&P rating system and at the
comparable level under the other rating systems. To date, all of the
mortgage-backed securities we have acquired have been pass-through certificates
or CMOs issued or guaranteed by FHLMC, FNMA or GNMA which, although not rated,
have an implied "AAA" rating.
We intend to acquire only those mortgage-backed securities that we
believe we have the necessary expertise to evaluate and manage, that we can
readily finance and that are consistent with our balance sheet guidelines and
risk management objectives. Since we expect to hold our mortgage-backed
securities until maturity, we generally do not seek to acquire assets whose
investment returns are only attractive in a limited range of scenarios. We
believe that future interest rates and mortgage prepayment rates are very
difficult to predict and, as a result, we seek to acquire mortgage-backed
securities which we believe provide acceptable returns over a broad range of
interest rate and prepayment scenarios.
Among the asset choices available to us, our policy is to acquire those
mortgage-backed securities which we believe generate the highest returns on
capital invested, after consideration of the following:
o the amount and nature of anticipated cash flows from the asset;
o our ability to pledge the asset to secure collateralized
borrowings;
o the increase in our capital requirement determined by our capital
investment policy resulting from the purchase and financing of the
asset; and
o the costs of financing, hedging, managing and reserving for the
asset.
Prior to acquisition, we assess potential returns on capital employed over the
life of the asset and in a variety of interest rate, yield spread, financing
cost, credit loss and prepayment scenarios.
We also give consideration to balance sheet management and risk
diversification issues. We deem a specific asset which we are evaluating for
potential acquisition as more or less valuable to the extent it serves to
increase or decrease certain interest rate or prepayment risks which may exist
in the balance sheet, to diversify or concentrate credit risk, and to meet the
cash flow and liquidity objectives our management may establish for our balance
sheet from time-to-time. Accordingly, an important part of the asset evaluation
process is a simulation, using risk management models, of the addition of a
potential asset and our associated borrowings and hedges to the balance sheet
and an assessment of the impact this potential asset acquisition would have on
the risks in and returns generated by our balance sheet as a whole over a
variety of scenarios.
We focus primarily on the acquisition of adjustable-rate
mortgage-backed securities, including floaters. We have, however, purchased a
significant amount of fixed-rate mortgage-backed securities and may continue to
do so in the future if, in our view, the potential returns on capital invested,
after hedging and all other costs, would exceed the returns available from other
assets or if the purchase of these assets would serve to reduce or diversify the
risks of our balance sheet.
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Although we have not yet done so, we may purchase the stock of mortgage
REITs or similar companies when we believe that these purchases would yield
attractive returns on capital employed. When the stock market valuations of
these companies are low in relation to the market value of their assets, these
stock purchases can be a way for us to acquire an interest in a pool of
mortgage-backed securities at an attractive price. We do not, however, presently
intend to invest in the securities of other issuers for the purpose of
exercising control or to underwrite securities of other issuers.
We may acquire newly issued mortgage-backed securities, and also may
seek to expand our capital base in order to further increase our ability to
acquire new assets, when the potential returns from new investments appears
attractive relative to the return expectations of stockholders. We may in the
future acquire mortgage-backed securities by offering our debt or equity
securities in exchange for the mortgage-backed securities.
We generally intend to hold mortgage-backed securities for extended
periods. In addition, the REIT provisions of the Internal Revenue Code limit in
certain respects our ability to sell mortgage-backed securities. We may decide
however to sell assets from time to time, for a number of reasons, including our
desire to dispose of an asset as to which credit risk concerns have arisen, to
reduce interest rate risk, to substitute one type of mortgage-backed security
for another, to improve yield or to maintain compliance with the 55% requirement
under the Investment Company Act, or generally to re-structure the balance sheet
when we deem advisable. Our board of directors has not adopted any policy that
would restrict management's authority to determine the timing of sales or the
selection of mortgage-backed securities to be sold.
We do not invest in principal-only interests in mortgage-backed
securities, residual interests, accrual bonds, inverse-floaters, two-tiered
index bonds, cash flow bonds, mortgage-backed securities with imbedded leverage
or mortgage-backed securities that would be deemed unacceptable for
collateralized borrowings, excluding shares in mortgage REITs.
As a requirement for maintaining REIT status, we will distribute to
stockholders aggregate dividends equaling at least 90% of our REIT taxable
income (determined without regard to the deduction for dividends paid and by
excluding any net capital gain) for each taxable year. We will make additional
distributions of capital when the return expectations of the stockholders appear
to exceed returns potentially available to us through making new investments in
mortgage-backed securities. Subject to the limitations of applicable securities
and state corporation laws, we can distribute capital by making purchases of our
own capital stock or through paying down or repurchasing any outstanding
uncollateralized debt obligations.
Our asset acquisition strategy may change over time as market
conditions change and as we evolve.
CREDIT RISK MANAGEMENT
We have not taken on credit risk to date, but may do so in the future.
In that event, we will review credit risk and other risk of loss associated with
each investment and determine the appropriate allocation of capital to apply to
the investment under our capital investment policy. Our board of directors will
monitor the overall portfolio risk and determine appropriate levels of provision
for loss.
CAPITAL AND LEVERAGE
We expect generally to maintain a debt-to-equity ratio of between 8:1
and 12:1, although the ratio may vary from time-to-time depending upon market
conditions and other factors our management deems relevant, including the
composition of our balance sheet, haircut levels required by lenders, the market
value of the mortgage-backed securities in our portfolio and "excess capital
cushion" percentages (as described below) set by our board of directors from
time to time. For purposes of calculating this ratio, our equity (or capital
base) is equal to the value of our investment portfolio on a mark-to-market
basis less the book value of our obligations under repurchase agreements and
other collateralized borrowings. At December 31, 2004, our ratio of
debt-to-equity was 9.8:1.
Our goal is to strike a balance between the under-utilization of
leverage, which reduces potential returns to stockholders, and the
over-utilization of leverage, which could reduce our ability to meet our
obligations during adverse market conditions. Our capital investment policy
limits our ability to acquire additional assets during times when our
debt-to-equity ratio exceeds 12:1. Our capital base represents the approximate
liquidation value of our investments and approximates the market value of assets
that we can pledge or sell to meet over-collateralization requirements for our
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borrowings. The unpledged portion of our capital base is available for us to
pledge or sell as necessary to maintain over-collateralization levels for our
borrowings.
We are prohibited from acquiring additional assets during periods when
our capital base is less than the minimum amount required under our capital
investment policy, except as may be necessary to maintain REIT status or our
exemption from the Investment Company Act of 1940, as amended (the "Investment
Company Act"). In addition, when our capital base falls below our risk-managed
capital requirement, our management is required to submit to our board of
directors a plan for bringing our capital base into compliance with our capital
investment policy guidelines. We anticipate that in most circumstances we can
achieve this goal without overt management action through the natural process of
mortgage principal repayments. We anticipate that our capital base is likely to
exceed our risk-managed capital requirement during periods following new equity
offerings and during periods of falling interest rates and that our capital base
could fall below the risk-managed capital requirement during periods of rising
interest rates.
The first component of our capital requirements is the current
aggregate over-collateralization amount or "haircut" the lenders require us to
hold as capital. The haircut for each mortgage-backed security is determined by
our lenders based on the risk characteristics and liquidity of the asset.
Haircut levels on individual borrowings generally range from 3% for certain
FHLMC, FNMA or GNMA mortgage-backed securities to 20% for certain
privately-issued mortgage-backed securities. At December 31, 2004, the weighted
average haircut level on our securities was 3.95%. Should the market value of
our pledged assets decline, we will be required to deliver additional collateral
to our lenders to maintain a constant over-collateralization level on our
borrowings.
The second component of our capital requirement is the "excess capital
cushion." This is an amount of capital in excess of the haircuts required by our
lenders. We maintain the excess capital cushion to meet the demands of our
lenders for additional collateral should the market value of our mortgage-backed
securities decline. The aggregate excess capital cushion equals the sum of
liquidity cushion amounts assigned under our capital investment policy to each
of our mortgage-backed securities. We assign excess capital cushions to each
mortgage-backed security based on our assessment of the mortgage-backed
security's market price volatility, credit risk, liquidity and attractiveness
for use as collateral by lenders. The process of assigning excess capital
cushions relies on our management's ability to identify and weigh the relative
importance of these and other factors. In assigning excess capital cushions, we
also give consideration to hedges associated with the mortgage-backed security
and any effect such hedges may have on reducing net market price volatility,
concentration or diversification of credit and other risks in the balance sheet
as a whole and the net cash flows that we can expect from the interaction of the
various components of our balance sheet.
Our capital investment policy stipulates that at least 25% of the
capital base maintained to satisfy the excess capital cushion must be invested
in AAA-rated adjustable-rate mortgage-backed securities or assets with similar
or better liquidity characteristics.
A substantial portion of our borrowings are short-term or variable-rate
borrowings. Our borrowings are implemented primarily through repurchase
agreements, but in the future may also be obtained through loan agreements,
lines of credit, dollar-roll agreements (an agreement to sell a security for
delivery on a specified future date and a simultaneous agreement to repurchase
the same or a substantially similar security on a specified future date) and
other credit facilities with institutional lenders and issuance of debt
securities such as commercial paper, medium-term notes, CMOs and senior or
subordinated notes. We enter into financing transactions only with institutions
that we believe are sound credit risks and follow other internal policies
designed to limit our credit and other exposure to financing institutions.
We expect to continue to use repurchase agreements as our principal
financing device to leverage our mortgage-backed securities portfolio. We
anticipate that, upon repayment of each borrowing under a repurchase agreement,
we will use the collateral immediately for borrowing under a new repurchase
agreement. At present, we have entered into uncommitted facilities with 32
lenders for borrowings in the form of repurchase agreements. We have not at the
present time entered into any commitment agreements under which the lender would
be required to enter into new repurchase agreements during a specified period of
time, nor do we presently plan to have liquidity facilities with commercial
banks. We may, however, enter into such commitment agreements in the future. We
enter into repurchase agreements primarily with national broker-dealers,
commercial banks and other lenders which typically offer this type of financing.
We enter into collateralized borrowings only with financial institutions meeting
credit standards approved by our board of directors, and we monitor the
financial condition of these institutions on a regular basis.
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A repurchase agreement, although structured as a sale and repurchase
obligation, acts as a financing under which we effectively pledge our
mortgage-backed securities as collateral to secure a short-term loan. Generally,
the other party to the agreement makes the loan in an amount equal to a
percentage of the market value of the pledged collateral. At the maturity of the
repurchase agreement, we are required to repay the loan and correspondingly
receive back our collateral. While used as collateral, the mortgage-backed
securities continue to pay principal and interest which are for our benefit. In
the event of our insolvency or bankruptcy, certain repurchase agreements may
qualify for special treatment under the Bankruptcy Code, the effect of which,
among other things, would be to allow the creditor under the agreement to avoid
the automatic stay provisions of the Bankruptcy Code and to foreclose on the
collateral agreement without delay. In the event of the insolvency or bankruptcy
of a lender during the term of a repurchase agreement, the lender may be
permitted, under applicable insolvency laws, to repudiate the contract, and our
claim against the lender for damages may be treated simply as an unsecured
creditor. In addition, if the lender is a broker or dealer subject to the
Securities Investor Protection Act of 1970, or an insured depository institution
subject to the Federal Deposit Insurance Act, our ability to exercise our rights
to recover our securities under a repurchase agreement or to be compensated for
any damages resulting from the lender's insolvency may be further limited by
those statutes. These claims would be subject to significant delay and, if and
when received, may be substantially less than the damages we actually incur.
Substantially all of our borrowing agreements require us to deposit
additional collateral in the event the market value of existing collateral
declines, which may require us to sell assets to reduce our borrowings. We have
designed our liquidity management policy to maintain a cushion of equity
sufficient to provide required liquidity to respond to the effects under our
borrowing arrangements of interest rate movements and changes in market value of
our mortgage-backed securities, as described above. However, a major disruption
of the repurchase or other market that we rely on for short-term borrowings
would have a material adverse effect on us unless we were able to arrange
alternative sources of financing on comparable terms.
Our articles of incorporation and bylaws do not limit our ability to
incur borrowings, whether secured or unsecured.
INTEREST RATE RISK MANAGEMENT
To the extent consistent with our election to qualify as a REIT, we
follow an interest rate risk management program intended to protect our
portfolio of mortgage-backed securities and related debt against the effects of
major interest rate changes. Specifically, our interest rate risk management
program is formulated with the intent to offset the potential adverse effects
resulting from rate adjustment limitations on our mortgage-backed securities and
the differences between interest rate adjustment indices and interest rate
adjustment periods of our adjustable-rate mortgage-backed securities and related
borrowings.
Our interest rate risk management program encompasses a number of
procedures, including the following:
o we attempt to structure our borrowings to have interest rate
adjustment indices and interest rate adjustment periods that, on
an aggregate basis, generally correspond to the interest rate
adjustment indices and interest rate adjustment periods of our
adjustable-rate mortgage-backed securities; and
o we attempt to structure our borrowing agreements relating to
adjustable-rate mortgage-backed securities to have a range of
different maturities and interest rate adjustment periods
(although substantially all will be less than one year).
We adjust the average maturity adjustment periods of our borrowings on
an ongoing basis by changing the mix of maturities and interest rate adjustment
periods as borrowings come due and are renewed. Through use of these procedures,
we attempt to minimize the differences between the interest rate adjustment
periods of our mortgage-backed securities and related borrowings that may occur.
Although we have not done so to date, we may purchase from time-to-time
interest rate swaps, interest rate collars, interest rate caps or floors,
"interest only" mortgage-backed securities and similar instruments to attempt to
mitigate the risk of the cost of our variable rate liabilities increasing at a
faster rate than the earnings on our assets during a period of rising interest
rates or to mitigate prepayment risk. We may hedge as much of the interest rate
risk as our management determines is in our best interests, given the cost of
the hedging transactions and the need to maintain our
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status as a REIT. This determination may result in our electing to bear a level
of interest rate or prepayment risk that could otherwise be hedged when
management believes, based on all relevant facts, that bearing the risk is
advisable.
We seek to build a balance sheet and undertake an interest rate risk
management program which is likely to generate positive earnings and maintain an
equity liquidation value sufficient to maintain operations given a variety of
potentially adverse circumstances. Accordingly, our interest rate risk
management program addresses both income preservation, as discussed above, and
capital preservation concerns. For capital preservation, we monitor our
"duration." This is the expected percentage change in market value of our assets
that would be caused by a 1% change in short and long-term interest rates. To
monitor duration and the related risks of fluctuations in the liquidation value
of our equity, we model the impact of various economic scenarios on the market
value of our mortgage-backed securities and liabilities. At December 31, 2004,
we estimate that the duration of our assets was 1.7%. We believe that our
interest rate risk management program will allow us to maintain operations
throughout a wide variety of potentially adverse circumstances. Nevertheless, in
order to further preserve our capital base (and lower our duration) during
periods when we believe a trend of rapidly rising interest rates has been
established, we may decide to enter into or increase hedging activities or to
sell assets. Each of these actions may lower our earnings and dividends in the
short term to further our objective of maintaining attractive levels of earnings
and dividends over the long term.
We may elect to conduct a portion of our hedging operations through one
or more subsidiary corporations, each of which we would elect to treat as a
"taxable REIT subsidiary." To comply with the asset tests applicable to us as a
REIT, we could own 100% of the voting stock of such subsidiary, provided that
the value of the stock that we own in all such taxable REIT subsidiaries does
not exceed 20% of the value of our total assets at the close of any calendar
quarter. A taxable subsidiary, such as FIDAC, would not elect REIT status and
would distribute any net profit after taxes to us and its other stockholders.
Any dividend income we receive from the taxable subsidiary (combined with all
other income generated from our assets, other than qualified REIT real estate
assets) must not exceed 25% of our gross income.
We believe that we have developed a cost-effective asset/liability
management program to provide a level of protection against interest rate and
prepayment risks. However, no strategy can completely insulate us from interest
rate changes and prepayment risks. Further, as noted above, the federal income
tax requirements that we must satisfy to qualify as a REIT limit our ability to
hedge our interest rate and prepayment risks. We monitor carefully, and may have
to limit, our asset/liability management program to assure that we do not
realize excessive hedging income, or hold hedging assets having excess value in
relation to total assets, which could result in our disqualification as a REIT,
the payment of a penalty tax for failure to satisfy certain REIT tests under the
Internal Revenue Code, provided the failure was for reasonable cause. In
addition, asset/liability management involves transaction costs which increase
dramatically as the period covered by the hedging protection increases.
Therefore, we may be unable to hedge effectively our interest rate and
prepayment risks.
PREPAYMENT RISK MANAGEMENT
We seek to minimize the effects of faster or slower than anticipated
prepayment rates through structuring a diversified portfolio with a variety of
prepayment characteristics, investing in mortgage-backed securities with
prepayment prohibitions and penalties, investing in certain mortgage-backed
security structures which have prepayment protections, and balancing assets
purchased at a premium with assets purchased at a discount. We monitor
prepayment risk through periodic review of the impact of a variety of prepayment
scenarios on our revenues, net earnings, dividends, cash flow and net balance
sheet market value.
FUTURE REVISIONS IN POLICIES AND STRATEGIES
Our board of directors has established the investment policies and
operating policies and strategies set forth in this Form 10-K. The board of
directors has the power to modify or waive these policies and strategies without
the consent of the stockholders to the extent that the board of directors
determines that the modification or waiver is in the best interests of our
stockholders. Among other factors, developments in the market which affect our
policies and strategies or which change our assessment of the market may cause
our board of directors to revise our policies and strategies.
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POTENTIAL ACQUISITIONS, STRATEGIC ALLIANCES AND OTHER INVESTMENTS
From time-to-time we have had discussions with other parties regarding
possible transactions including acquisitions of other businesses or assets,
investments in other entities, joint venture arrangements, or strategic
alliances. To date, except for the acquisition of FIDAC, none of these
discussions have gone beyond the preliminary stage. We have also considered from
time-to-time entering into related businesses, although to date we have not
entered into such businesses.
We may, from time-to- time, continue to explore possible acquisitions,
investments, joint venture arrangements and strategic alliances. Prior to making
any equity investment, we will consult with our tax advisors.
DIVIDEND REINVESTMENT AND SHARE PURCHASE PLAN
We have adopted a dividend reinvestment and share purchase plan. Under
the dividend reinvestment feature of the plan, existing shareholders can
reinvest their dividends in additional shares of our common stock. Under the
share purchase feature of the plan, new and existing shareholders can purchase
shares of our common stock. We have an effective shelf registration statement on
Form S-3 which initially registered 2,000,000 shares that could be issued under
the plan. We still sell shares covered by this registration statement under the
plan.
LEGAL PROCEEDINGS
There are no material pending legal proceedings to which we are a party
or to which any of our property is subject.
AVAILABLE INFORMATION
Our investor relations website is WWW.ANNALY.COM. We make available on
this website under "Financial Reports and SEC filings," free of charge, our
annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on
Form 8-K and amendments to those reports as soon as reasonably practicable after
we electronically file or furnish such materials to the SEC.
COMPETITION
We believe that our principal competition in the acquisition and holding
of the types of mortgage-backed securities we purchase are financial
institutions such as banks, savings and loans, life insurance companies,
institutional investors such as mutual funds and pension funds, and certain
other mortgage REITs. Some of our competitors have greater financial resources
and access to capital than we do. Our competitors, as well as of additional
competitors which may emerge in the future, may increase the competition for the
acquisition of mortgage-backed securities, which in turn may result in higher
prices and lower yields on assets.
RISK FACTORS
An investment in our stock involves a number of risks. Before making an
investment decision, you should carefully consider all of the risks described in
this Form 10-K. If any of the risks discussed in this Form 10-K actually occur,
our business, financial condition and results of operations could be materially
adversely affected. If this were to occur, the trading price of our stock could
decline significantly and you may lose all or part of your investment.
RISKS RELATED TO OUR BUSINESS
AN INCREASE IN THE INTEREST PAYMENTS ON OUR BORROWINGS RELATIVE TO THE INTEREST
WE EARN ON OUR INVESTMENT SECURITIES MAY ADVERSELY AFFECT OUR PROFITABILITY
We earn money based upon the spread between the interest payments we
earn on our investment securities and the interest payments we must make on our
borrowings. If the interest payments on our borrowings increase relative to the
interest we earn on our investment securities, our profitability may be
adversely affected.
The interest payments on our borrowings may increase relative to the
interest we earn on our adjustable-rate investment securities for various
reasons discussed in this section.
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o DIFFERENCES IN TIMING OF INTEREST RATE ADJUSTMENTS ON OUR INVESTMENT
SECURITIES AND OUR BORROWINGS MAY ADVERSELY AFFECT OUR PROFITABILITY
We rely primarily on short-term borrowings to acquire investment
securities with long-term maturities. Accordingly, if short-term interest rates
increase, this may adversely affect our profitability.
Most of the investment securities we acquire are adjustable-rate
securities. This means that their interest rates may vary over time based upon
changes in an objective index, such as:
- LIBOR. The interest rate that banks in London offer for deposits
in London of U.S. dollars.
- TREASURY RATE. A monthly or weekly average yield of benchmark U.S.
Treasury securities, as published by the Federal Reserve Board.
- CD RATE. The weekly average of secondary market interest rates on
six-month negotiable certificates of deposit, as published by the
Federal Reserve Board.
These indices generally reflect short-term interest rates. On December
31, 2004, approximately 71% of our investment securities were adjustable-rate
securities.
The interest rates on our borrowings similarly vary with changes in an
objective index. Nevertheless, the interest rates on our borrowings generally
adjust more frequently than the interest rates on our adjustable-rate investment
securities. For example, on December 31, 2004, our adjustable-rate investment
securities had a weighted average term to next rate adjustment of 24 months,
while our borrowings had a weighted average term to next rate adjustment of 111
days. Accordingly, in a period of rising interest rates, we could experience a
decrease in net income or a net loss because the interest rates on our
borrowings adjust faster than the interest rates on our adjustable-rate
investment securities.
o INTEREST RATE CAPS ON OUR INVESTMENT SECURITIES MAY ADVERSELY AFFECT OUR
PROFITABILITY
Our adjustable-rate investment securities are typically subject to
periodic and lifetime interest rate caps. Periodic interest rate caps limit the
amount an interest rate can increase during any given period. Lifetime interest
rate caps limit the amount an interest rate can increase through maturity of an
investment security. Our borrowings are not subject to similar restrictions.
Accordingly, in a period of rapidly increasing interest rates, we could
experience a decrease in net income or experience a net loss because the
interest rates on our borrowings could increase without limitation while the
interest rates on our adjustable-rate investment securities would be limited by
caps.
o BECAUSE WE ACQUIRE FIXED-RATE SECURITIES, AN INCREASE IN INTEREST RATES MAY
ADVERSELY AFFECT OUR PROFITABILITY
While the majority of our investments consist of adjustable-rate
investment securities, we also invest in fixed-rate mortgage-backed securities.
In a period of rising interest rates, our interest payments could increase while
the interest we earn on our fixed-rate mortgage-backed securities would not
change. This would adversely affect our profitability. On December 31, 2004,
approximately 29% of our investment securities were fixed-rate securities.
AN INCREASE IN PREPAYMENT RATES MAY ADVERSELY AFFECT OUR PROFITABILITY
The mortgage-backed securities we acquire are backed by pools of
mortgage loans. We receive payments, generally, from the payments that are made
on these underlying mortgage loans. When borrowers prepay their mortgage loans
at rates that are faster than expected, this results in prepayments that are
faster than expected on the mortgage-backed securities. These faster than
expected prepayments may adversely affect our profitability.
We often purchase mortgage-backed securities that have a higher
interest rate than the market interest rate at the time. In exchange for this
higher interest rate, we must pay a premium over the market value to acquire the
security. In accordance with accounting rules, we amortize this premium over the
term of the mortgage-backed security. If the mortgage-backed security is prepaid
in whole or in part prior to its maturity date, however, we must expense all or
a part of the remaining unamortized portion of the premium that was prepaid at
the time of the prepayment. This adversely
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affects our profitability. On December 31, 2004, approximately 98% of the
mortgage-backed securities we owned were acquired at a premium.
Prepayment rates generally increase when interest rates fall and
decrease when interest rates rise, but changes in prepayment rates are difficult
to predict. Prepayment rates also may be affected by conditions in the housing
and financial markets, general economic conditions and the relative interest
rates on fixed-rate and adjustable-rate mortgage loans.
We may seek to reduce prepayment risk by acquiring mortgage-backed
securities at a discount. If a discounted security is prepaid in whole or in
part prior to its maturity date, we will earn income equal to the amount of the
remaining discount. This will improve our profitability if the discounted
securities are prepaid faster than expected. On December 31, 2004, approximately
1% of the mortgage-backed securities we owned were acquired at a discount.
We also can acquire mortgage-backed securities that are less affected
by prepayments. For example, we can acquire CMOs, a type of mortgage-backed
security. CMOs divide a pool of mortgage loans into multiple tranches that allow
for shifting of prepayment risks from slower-paying tranches to faster-paying
tranches. This is in contrast to pass-through or pay-through mortgage-backed
securities, where all investors share equally in all payments, including all
prepayments. As discussed below, the Investment Company Act of 1940 (or the
Investment Company Act) imposes restrictions on our purchase of CMOs. On
December 31, 2004, approximately 27% of our mortgage-backed securities were CMOs
and approximately 73% of our mortgage-backed securities were pass-through or
pay-through securities.
While we seek to minimize prepayment risk to the extent practical, in
selecting investments we must balance prepayment risk against other risks and
the potential returns of each investment. No strategy can completely insulate us
from prepayment risk.
AN INCREASE IN INTEREST RATES MAY ADVERSELY AFFECT OUR BOOK VALUE
Increases in interest rates may negatively affect the market value of
our investment securities. Our fixed-rate securities, generally, are more
negatively affected by these increases. In accordance with accounting rules, we
reduce our book value by the amount of any decrease in the market value of our
investment securities.
OUR STRATEGY INVOLVES SIGNIFICANT LEVERAGE
We seek to maintain a ratio of debt-to-equity of between 8:1 and 12:1,
although our ratio may at times be above or below this amount. We incur this
leverage by borrowing against a substantial portion of the market value of our
investment securities. By incurring this leverage, we can enhance our returns.
Nevertheless, this leverage, which is fundamental to our investment strategy,
also creates significant risks.
o OUR LEVERAGE MAY CAUSE SUBSTANTIAL LOSSES
Because of our significant leverage, we may incur substantial losses if
our borrowing costs increase. Our borrowing costs may increase for any of the
following reasons:
- short-term interest rates increase;
- the market value of our investment securities decreases;
- interest rate volatility increases; or
- the availability of financing in the market decreases.
o OUR LEVERAGE MAY CAUSE MARGIN CALLS AND DEFAULTS AND FORCE US TO SELL
ASSETS UNDER ADVERSE MARKET CONDITIONS
Because of our leverage, a decline in the value of our investment
securities may result in our lenders initiating margin calls. A margin call
means that the lender requires us to pledge additional collateral to
re-establish the ratio of the value of the collateral to the amount of the
borrowing. Our fixed-rate mortgage-backed securities generally are more
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susceptible to margin calls as increases in interest rates tend to more
negatively affect the market value of fixed-rate securities.
If we are unable to satisfy margin calls, our lenders may foreclose on
our collateral. This could force us to sell our investment securities under
adverse market conditions. Additionally, in the event of our bankruptcy, our
borrowings, which are generally made under repurchase agreements, may qualify
for special treatment under the Bankruptcy Code. This special treatment would
allow the lenders under these agreements to avoid the automatic stay provisions
of the Bankruptcy Code and to liquidate the collateral under these agreements
without delay.
o LIQUIDATION OF COLLATERAL MAY JEOPARDIZE OUR REIT STATUS
To continue to qualify as a REIT, we must comply with requirements
regarding our assets and our sources of income. If we are compelled to liquidate
our investment securities, we may be unable to comply with these requirements,
ultimately jeopardizing our status as a REIT.
o WE MAY EXCEED OUR TARGET LEVERAGE RATIOS
We seek to maintain a ratio of debt-to-equity of between 8:1 and 12:1.
However, we are not required to stay within this leverage ratio. If we exceed
this ratio, the adverse impact on our financial condition and results of
operations from the types of risks described in this section would likely be
more severe.
o WE MAY NOT BE ABLE TO ACHIEVE OUR OPTIMAL LEVERAGE
We use leverage as a strategy to increase the return to our investors.
However, we may not be able to achieve our desired leverage for any of the
following reasons:
- we determine that the leverage would expose us to excessive risk;
- our lenders do not make funding available to us at acceptable
rates; or
- our lenders require that we provide additional collateral to cover
our borrowings.
o WE MAY INCUR INCREASED BORROWING COSTS WHICH WOULD ADVERSELY AFFECT OUR
PROFITABILITY
Currently, all of our borrowings are collateralized borrowings in the
form of repurchase agreements. If the interest rates on these repurchase
agreements increase, it would adversely affect our profitability.
Our borrowing costs under repurchase agreements generally correspond to
short-term interest rates such as LIBOR or a short-term Treasury index, plus or
minus a margin. The margins on these borrowings over or under short-term
interest rates may vary depending upon:
- the movement of interest rates;
- the availability of financing in the market; or
- the value and liquidity of our investment securities.
IF WE ARE UNABLE TO RENEW OUR BORROWINGS AT FAVORABLE RATES, OUR PROFITABILITY
MAY BE ADVERSELY AFFECTED
Since we rely primarily on short-term borrowings, our ability to
achieve our investment objectives depends not only on our ability to borrow
money in sufficient amounts and on favorable terms, but also on our ability to
renew or replace on a continuous basis our maturing short-term borrowings. If we
are not able to renew or replace maturing borrowings, we would have to sell our
assets under possibly adverse market conditions.
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WE HAVE NOT USED DERIVATIVES TO MITIGATE OUR INTEREST RATE AND PREPAYMENT RISKS
Our policies permit us to enter into interest rate swaps, caps and
floors and other derivative transactions to help us mitigate our interest rate
and prepayment risks described above. However, we have determined in the past
that the cost of these transactions outweighs the benefits. In addition, we will
not enter into derivative transactions if we believe they will jeopardize our
status as a REIT. If we decide to enter into derivative transactions in the
future, these transactions may mitigate our interest rate and prepayment risks
but cannot insulate us from these risks.
OUR INVESTMENT STRATEGY MAY INVOLVE CREDIT RISK
We may incur losses if there are payment defaults under our investment
securities.
To date, all of our mortgage-backed securities have been agency
certificates and agency debentures which, although not rated, carry an implied
"AAA" rating. Agency certificates are mortgage pass-through certificates where
Freddie Mac, Fannie Mae or Ginnie Mae guarantees payments of principal or
interest on the certificates. Agency debentures are debt instruments issued by
Freddie Mac, Fannie Mae, or the FHLB.
Even though we have only acquired "AAA" securities so far, pursuant to
our capital investment policy, we have the ability to acquire securities of
lower credit quality. Under our policy:
- 75% of our investments must have a "AA" or higher rating by S&P,
an equivalent rating by a similar nationally recognized rating
organization or our management must determine that the investments
are of comparable credit quality to investments with these
ratings;
- the remaining 25% of our investments must have a "BBB" or higher
rating by S&P, or an equivalent rating by a similar nationally
recognized rating organization, or our management must determine
that the investments are of comparable credit quality to
investments with these ratings. Securities with ratings of "BBB"
or higher are commonly referred to as "investment grade"
securities; and
- we seek to have a minimum weighted average rating for our
portfolio of at least "A" by S&P.
If we acquire mortgage-backed securities of lower credit quality, we
may incur losses if there are defaults under those mortgage-backed securities or
if the rating agencies downgrade the credit quality of those mortgage-backed
securities.
WE HAVE NOT ESTABLISHED A MINIMUM DIVIDEND PAYMENT LEVEL
We intend to pay quarterly dividends and to make distributions to our
stockholders in amounts such that all or substantially all of our taxable income
in each year (subject to certain adjustments) is distributed. This enables us to
qualify for the tax benefits accorded to a REIT under the Code. We have not
established a minimum dividend payment level and our ability to pay dividends
may be adversely affected for the reasons described in this section. All
distributions will be made at the discretion of our Board of Directors and will
depend on our earnings, our financial condition, maintenance of our REIT status
and such other factors as our Board of Directors may deem relevant from time to
time.
BECAUSE OF COMPETITION, WE MAY NOT BE ABLE TO ACQUIRE MORTGAGE-BACKED SECURITIES
AT FAVORABLE YIELDS
Our net income depends, in large part, on our ability to acquire
mortgage-backed securities at favorable spreads over our borrowing costs. In
acquiring mortgage-backed securities, we compete with other REITs, investment
banking firms, savings and loan associations, banks, insurance companies, mutual
funds, other lenders and other entities that purchase mortgage-backed
securities, many of which have greater financial resources than us. As a result,
in the future, we may not be able to acquire sufficient mortgage-backed
securities at favorable spreads over our borrowing costs.
WE ARE DEPENDENT ON OUR KEY PERSONNEL
We are dependent on the efforts of our key officers and employees,
including Michael A. J. Farrell, our Chairman of the board of directors, Chief
Executive Officer, and President, Wellington J. Denahan-Norris, our Vice
Chairman and Chief Investment Officer, Kathryn F. Fagan, our Chief Financial
Officer and Treasurer, and Jennifer S. Karve, our
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Executive Vice President. The loss of any of their services could have an
adverse effect on our operations. Although we have employment agreements with
each of them, we cannot assure you they will remain employed with us.
WE AND OUR SHAREHOLDERS ARE SUBJECT TO CERTAIN TAX RISKS
o OUR FAILURE TO QUALIFY AS A REIT WOULD HAVE ADVERSE TAX CONSEQUENCES
We believe that since 1997 we have qualified for taxation as a REIT for
federal income tax purposes. We plan to continue to meet the requirements for
taxation as a REIT. Many of these requirements, however, are highly technical
and complex. The determination that we are a REIT requires an analysis of
various factual matters and circumstances that may not be totally within our
control. For example, to qualify as a REIT, at least 75% of our gross income
must come from real estate sources and 95% of our gross income must come from
real estate sources and certain other sources that are itemized in the REIT tax
laws. We are also required to distribute to stockholders at least 90% of our
REIT taxable income (determined without regard to the deduction for dividends
paid and by excluding any net capital gain). Even a technical or inadvertent
mistake could jeopardize our REIT status. Furthermore, Congress and the Internal
Revenue Service (or IRS) might make changes to the tax laws and regulations, and
the courts might issue new rulings that make it more difficult or impossible for
us to remain qualified as a REIT.
If we fail to qualify as a REIT, we would be subject to federal income
tax at regular corporate rates. Also, unless the IRS granted us relief under
certain statutory provisions, we would remain disqualified as a REIT for four
years following the year we first fail to qualify. If we fail to qualify as a
REIT, we would have to pay significant income taxes and would therefore have
less money available for investments or for distributions to our stockholders.
This would likely have a significant adverse effect on the value of our
securities. In addition, the tax law would no longer require us to make
distributions to our stockholders.
On October 22, 2004, President Bush signed the American Jobs Creation
Act of 2004 (the 2004 Act), which, among other things, amends the rules
applicable to REIT qualification. In particular, the 2004 Act provides that a
REIT that fails the quarterly asset tests for one or more quarters will not lose
its REIT status as a result of such failure if either (i) the failure is
regarded as a de minimis failure under standards set out in the 2004 Act, or
(ii) the failure is greater than a de minimis failure but is attributable to
reasonable cause and not willful neglect. In the case of a greater than de
minimis failure, however, the REIT must pay a tax and must remedy the failure
within 6 months of the close of the quarter in which the failure was identified.
In addition, the 2004 Act provides relief for failures of other tests imposed as
a condition of REIT qualification, as long as the failures are attributable to
reasonable cause and not willful neglect. A REIT would be required to pay a
penalty of $50,000, however, in the case of each failure. The above-described
changes apply for taxable years of REITs beginning after the date of enactment.
o WE HAVE CERTAIN DISTRIBUTION REQUIREMENTS
As a REIT, we must distribute at least 90% of our REIT taxable income
(determined without regard to the deduction for dividends paid and by excluding
any net capital gain). The required distribution limits the amount we have
available for other business purposes, including amounts to fund our growth.
Also, it is possible that because of the differences between the time we
actually receive revenue or pay expenses and the period we report those items
for distribution purposes, we may have to borrow funds on a short-term basis to
meet the 90% distribution requirement.
o WE ARE ALSO SUBJECT TO OTHER TAX LIABILITIES
Even if we qualify as a REIT, we may be subject to certain federal,
state and local taxes on our income and property. Any of these taxes would
reduce our operating cash flow.
o RECENT TAX LEGISLATION COULD AFFECT THE VALUE OF OUR STOCK
On May 28, 2003, President Bush signed the Jobs and Growth Tax Relief
and Reconciliation Act of 2003 (the "Act"), which, among other things, reduces
the rate at which individual stockholders are subject to tax on dividends paid
by regular C corporations to a maximum rate of 15%. Generally, REITs are tax
advantaged relative to C corporations because, unlike C corporations, REITs are
allowed a deduction for dividends paid, which, in most cases, allows a REIT to
avoid paying corporate level federal income tax on its earnings. The provisions
of the Act reducing the rate at which
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individual stockholders pay tax on dividend income from C corporations may serve
to mitigate this tax advantage and may cause individuals to view an investment
in a C corporation as more attractive than an investment in a REIT. This may
adversely affect the value of our stock.
o LIMITS ON OWNERSHIP OF OUR COMMON STOCK COULD HAVE ADVERSE CONSEQUENCES TO
YOU AND COULD LIMIT YOUR OPPORTUNITY TO RECEIVE A PREMIUM ON OUR STOCK
To maintain our qualification as a REIT for federal income tax
purposes, not more than 50% in value of the outstanding shares of our capital
stock may be owned, directly or indirectly, by five or fewer individuals (as
defined in the federal tax laws to include certain entities). Primarily to
facilitate maintenance of our qualification as a REIT for federal income tax
purposes, our charter will prohibit ownership, directly or by the attribution
provisions of the federal tax laws, by any person of more than 9.8% of the
lesser of the number or value of the issued and outstanding shares of our common
stock and will prohibit ownership, directly or by the attribution provisions of
the federal tax laws, by any person of more than 9.8% of the lesser of the
number or value of the issued and outstanding shares of any class or series of
our preferred stock. Our board of directors, in its sole and absolute
discretion, may waive or modify the ownership limit with respect to one or more
persons who would not be treated as "individuals" for purposes of the federal
tax laws if it is satisfied, based upon information required to be provided by
the party seeking the waiver and upon an opinion of counsel satisfactory to the
board of directors, that ownership in excess of this limit will not otherwise
jeopardize our status as a REIT for federal income tax purposes.
The ownership limit may have the effect of delaying, deferring or
preventing a change in control and, therefore, could adversely affect our
shareholders' ability to realize a premium over the then-prevailing market price
for our common stock in connection with a change in control.
o A REIT CANNOT INVEST MORE THAN 20% OF ITS TOTAL ASSETS IN THE STOCK OR
SECURITIES OF ONE OR MORE TAXABLE REIT SUBSIDIARIES; THEREFORE, FIDAC
CANNOT CONSTITUTE MORE THAN 20% OF OUR TOTAL ASSETS
A taxable REIT subsidiary is a corporation, other than a REIT or a
qualified REIT subsidiary, in which a REIT owns stock and which elects taxable
REIT subsidiary status. The term also includes a corporate subsidiary in which
the taxable REIT subsidiary owns more than a 35% interest. A REIT may own up to
100% of the stock of one or more taxable REIT subsidiaries. A taxable REIT
subsidiary may earn income that would not be qualifying income if earned
directly by the parent REIT. Overall, at the close of any calendar quarter, no
more than 20% of the value of a REIT's assets may consist of stock or securities
of one or more taxable REIT subsidiaries.
The stock and securities of FIDAC, our only taxable REIT subsidiary,
are expected to represent less than 20% of the value of our total assets.
Furthermore, we intend to monitor the value of our investments in the stock and
securities of FIDAC (and any other taxable REIT subsidiary in which we may
invest) to ensure compliance with the above-described 20% limitation. We cannot
assure you, however, that we will always be able to comply with the 20%
limitation so as to maintain REIT status.
o TAXABLE REIT SUBSIDIARIES ARE SUBJECT TO TAX AT THE REGULAR CORPORATE
RATES, ARE NOT REQUIRED TO DISTRIBUTE DIVIDENDS, AND THE AMOUNT OF
DIVIDENDS A TAXABLE REIT SUBSIDIARY CAN PAY TO ITS PARENT REIT MAY BE
LIMITED BY REIT GROSS INCOME TESTS
A taxable REIT subsidiary must pay income tax at regular corporate
rates on any income that it earns. FIDAC will pay corporate income tax on its
taxable income, and its after-tax net income will be available for distribution
to us. Such income, however, is not required to be distributed.
Moreover, the annual gross income tests that must be satisfied to
ensure REIT qualification may limit the amount of dividends that we can receive
from FIDAC and still maintain our REIT status. Generally, not more than 25% of
our gross income can be derived from non-real estate related sources, such as
dividends from a taxable REIT subsidiary. If, for any taxable year, the
dividends we received from FIDAC, when added to our other items of non-real
estate related income, represented more than 25% of our total gross income for
the year, we could be denied REIT status, unless we were able to demonstrate,
among other things, that our failure of the gross income test was due to
reasonable cause and not willful neglect.
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The limitations imposed by the REIT gross income tests may impede our
ability to distribute assets from FIDAC to us in the form of dividends. Certain
asset transfers may, therefore, have to be structured as purchase and sale
transactions upon which FIDAC recognizes taxable gain.
o IF INTEREST ACCRUES ON INDEBTEDNESS OWED BY A TAXABLE REIT SUBSIDIARY TO
ITS PARENT REIT AT A RATE IN EXCESS OF A COMMERCIALLY REASONABLE RATE, OR
IF TRANSACTIONS BETWEEN A REIT AND A TAXABLE REIT SUBSIDIARY ARE ENTERED
INTO ON OTHER THAN ARM'S-LENGTH TERMS, THE REIT MAY BE SUBJECT TO A PENALTY
TAX
If interest accrues on an indebtedness owed by a taxable REIT
subsidiary to its parent REIT at a rate in excess of a commercially reasonable
rate, the REIT is subject to tax at a rate of 100% on the excess of (i) interest
payments made by a taxable REIT subsidiary to its parent REIT over (ii) the
amount of interest that would have been payable had interest accrued on the
indebtedness at a commercially reasonable rate. A tax at a rate of 100% is also
imposed on any transaction between a taxable REIT subsidiary and its parent REIT
to the extent the transaction gives rise to deductions to the taxable REIT
subsidiary that are in excess of the deductions that would have been allowable
had the transaction been entered into on arm's-length terms. We will scrutinize
all of our transactions with FIDAC in an effort to ensure that we do not become
subject to these taxes. We cannot assure you, however, that we will be able to
avoid application of these taxes.
RISKS OF OWNERSHIP OF OUR COMMON STOCK
ISSUANCES OF LARGE AMOUNTS OF OUR STOCK COULD CAUSE THE MARKET PRICE OF OUR
COMMON STOCK TO DECLINE.
As of March 1, 2005, 121,272,323 shares of our common stock were
outstanding. If we issue a significant number of shares of common stock or
securities convertible into common stock in a short period of time, there could
be a dilution of the existing common stock and a decrease in the market price of
the common stock.
WE MAY CHANGE OUR POLICIES WITHOUT STOCKHOLDER APPROVAL.
Our board of directors and management determine all of our policies,
including our investment, financing and distribution policies. Although they
have no current plans to do so, they may amend or revise these policies at any
time without a vote of our stockholders. Policy changes could adversely affect
our financial condition, results of operations, the market price of our common
stock or our ability to pay dividends or distributions.
OUR GOVERNING DOCUMENTS AND MARYLAND LAW IMPOSE LIMITATIONS ON THE ACQUISITION
OF OUR COMMON STOCK AND CHANGES IN CONTROL THAT COULD MAKE IT MORE DIFFICULT FOR
A THIRD PARTY TO ACQUIRE US.
MARYLAND BUSINESS COMBINATION ACT
The Maryland General Corporation Law establishes special requirements
for "business combinations" between a Maryland corporation and "interested
stockholders" unless exemptions are applicable. An interested stockholder is any
person who beneficially owns 10% or more of the voting power of our
then-outstanding voting stock. Among other things, the law prohibits for a
period of five years a merger and other similar transactions between us and an
interested stockholder unless the board of directors approved the transaction
prior to the party's becoming an interested stockholder. The five-year period
runs from the most recent date on which the interested stockholder became an
interested stockholder. The law also requires a super majority stockholder vote
for such transactions after the end of the five-year period. This means that the
transaction must be approved by at least:
o 80% of the votes entitled to be cast by holders of outstanding
voting shares; and
o two-thirds of the votes entitled to be cast by holders of
outstanding voting shares other than shares held by the
interested stockholder or an affiliate of the interested
stockholder with whom the business combination is to be
effected.
As permitted by the Maryland General Corporation Law, we have elected
not to be governed by the Maryland business combination statute. We made this
election by opting out of this statute in our articles of incorporation. If,
however, we amend our articles of incorporation to opt back in to the statute,
the business combination statute could
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have the effect of discouraging offers to acquire us and of increasing the
difficulty of consummating any such offers, even if our acquisition would be in
our stockholders' best interests.
MARYLAND CONTROL SHARE ACQUISITION ACT
Maryland law provides that "control shares" of a Maryland corporation
acquired in a "control share acquisition" have no voting rights except to the
extent approved by a vote of the stockholders. Two-thirds of the shares eligible
to vote must vote in favor of granting the "control shares" voting rights.
"Control shares" are shares of stock that, taken together with all other shares
of stock the acquirer previously acquired, would entitle the acquirer to
exercise voting power in electing directors within one of the following ranges
of voting power:
o One-tenth or more but less than one third of all voting power;
o One-third or more but less than a majority of all voting
power; or
o A majority or more of all voting power.
Control shares do not include shares of stock the acquiring person is
entitled to vote as a result of having previously obtained stockholder approval.
A "control share acquisition" means the acquisition of control shares, subject
to certain exceptions.
If a person who has made (or proposes to make) a control share
acquisition satisfies certain conditions (including agreeing to pay expenses),
he may compel our board of directors to call a special meeting of stockholders
to consider the voting rights of the shares. If such a person makes no request
for a meeting, we have the option to present the question at any stockholders'
meeting.
If voting rights are not approved at a meeting of stockholders then,
subject to certain conditions and limitations, we may redeem any or all of the
control shares (except those for which voting rights have previously been
approved) for fair value. We will determine the fair value of the shares,
without regard to voting rights, as of the date of either:
o the last control share acquisition; or
o the meeting where stockholders considered and did not approve
voting rights of the control shares.
If voting rights for control shares are approved at a stockholders'
meeting and the acquirer becomes entitled to vote a majority of the shares of
stock entitled to vote, all other stockholders may obtain rights as objecting
stockholders and, thereunder, exercise appraisal rights. This means that you
would be able to force us to redeem your stock for fair value. Under Maryland
law, the fair value may not be less than the highest price per share paid in the
control share acquisition. Furthermore, certain limitations otherwise applicable
to the exercise of dissenters' rights would not apply in the context of a
control share acquisition. The control share acquisition statute would not apply
to shares acquired in a merger, consolidation or share exchange if we were a
party to the transaction. The control share acquisition statute could have the
effect of discouraging offers to acquire us and of increasing the difficulty of
consummating any such offers, even if our acquisition would be in our
stockholders' best interests.
REGULATORY RISKS
LOSS OF INVESTMENT COMPANY ACT EXEMPTION WOULD ADVERSELY AFFECT US.
We intend to conduct our business so as not to become regulated as an
investment company under the Investment Company Act. If we fail to qualify for
this exemption, our ability to use leverage would be substantially reduced, and
we would be unable to conduct our business as described in this Form 10-K.
The Investment Company Act exempts entities that are primarily engaged
in the business of purchasing or otherwise acquiring mortgages and other liens
on and interests in real estate. Under the current interpretation of the SEC
staff, in order to qualify for this exemption, we must maintain at least 55% of
our assets directly in these qualifying real estate interests. Mortgage-backed
securities that do not represent all of the certificates issued with respect to
an
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underlying pool of mortgages may be treated as securities separate from the
underlying mortgage loans and, thus, may not qualify for purposes of the 55%
requirement. Our ownership of these mortgage-backed securities, therefore, is
limited by the provisions of the Investment Company Act. In addition, in meeting
the 55% requirement under the Investment Company Act, we treat as qualifying
interests mortgage-backed securities issued with respect to an underlying pool
as to which we hold all issued certificates. If the SEC or its staff adopts a
contrary interpretation, we could be required to sell a substantial amount of
our mortgage-backed securities, under potentially adverse market conditions.
Further, in order to insure that we at all times qualify for the exemption from
the Investment Company Act, we may be precluded from acquiring mortgage-backed
securities whose yield is somewhat higher than the yield on mortgage-backed
securities that could be purchased in a manner consistent with the exemption.
The net effect of these factors may be to lower our net income.
COMPLIANCE WITH PROPOSED AND RECENTLY ENACTED CHANGES IN SECURITIES LAWS AND
REGULATIONS ARE LIKELY TO IN