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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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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, 1997
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
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COMMISSION FILE NUMBER: 1-13447
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ANNALY MORTGAGE MANAGEMENT, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS GOVERNING INSTRUMENTS)
MARYLAND 22-3479661
(STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER
OF INCORPORATION OF ORGANIZATION) IDENTIFICATION NUMBER)
12 EAST 41ST STREET, SUITE 700, NEW YORK, NEW YORK 10017
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
(201)696-0100
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
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SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
NAME OF EACH EXCHANGE
TITLE OF EACH CLASS ON WHICH REGISTERED
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COMMON STOCK, PAR VALUE NEW YORK STOCK EXCHANGE
$.01 PER SHARE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
NONE
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Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days: Yes [X] No [_]
Indicate by check mark 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. [X]
At March 24, 1998 the aggregate market value of the voting stock held by
non-affiliates of the Registrant was $138,542,380.
The number of shares of the Registrant's Common Stock outstanding on March
24, 1998 was 12,757,676.
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the Registrant's definitive Proxy Statement issued in connection
with the 1998 Annual Meeting of Stockholders of the Registrant to be held on May
18, 1998 are incorporated by reference into Parts I and III.
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ANNALY MORTGAGE MANAGEMENT, INC.
1997 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PAGE
----
PART I
ITEM 1. BUSINESS....................................................... 1
ITEM 2. PROPERTIES..................................................... 33
ITEM 3. LEGAL PROCEEDINGS.............................................. 33
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS............ 33
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER
MATTERS........................................................ 33
ITEM 6. SELECTED FINANCIAL DATA........................................ 35
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.......................................... 36
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.................... 45
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE........................................... 45
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............. 46
ITEM 11. EXECUTIVE COMPENSATION......................................... 46
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. 46
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................. 46
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-
K.............................................................. 46
FINANCIAL STATEMENTS..................................................... F-1
SIGNATURES............................................................... 55
EXHIBIT INDEX
i
PART I
ITEM 1. BUSINESS
THE COMPANY
Annaly Mortgage Management, Inc. (the "Company") was incorporated in the
State of Maryland on November 25, 1996. The Company commenced operations on
February 18, 1997 upon the consummation of its sale of 3,600,000 shares of
Common Stock in an offering exempt from registration under the Securities Act
and state securities laws (the "Private Placement"). The Company raised
additional capital on July 31, 1997 upon the consummation of the its sale of
87,800 shares of Common Stock to certain directors, officers and employees of
the Company (the "Direct Offering"). The Company completed its initial public
offering of 8,946,100 shares on October 14, 1997.
Annaly Mortgage Management, Inc. specializes in investing in Mortgage-Backed
Securities. Its principal business objective is to generate net income for
distribution to stockholders from the spread between the interest income on
its Mortgage-Backed Securities and the costs of borrowing to finance its
acquisition of Mortgage-Backed Securities. The Company has elected to be taxed
as a Real Estate Investment Trust ("REIT"). The Company is self-advised and
self-managed. The management of the Company manages the day-to-day operations,
subject to the supervision of the Company's Board of Directors.
Certain statements contained herein are not, and certain statements
contained in future filings by the Company with the Securities and Exchange
Commission (the "Commission") in the Company's press releases or in the
Company's 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
the Company's 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 such financing. For a discussion of the risks and
uncertainties which could cause actual results to differ from those contained
in the forward-looking statements, see "Risk Factors" commencing on page 23 of
this Form 10-K. The Company does not undertake, and specifically disclaims 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.
Reference is made to the Glossary commencing on page 48 of this report for
definitions of terms used in the following description of the Company's
business and elsewhere in this report.
BUSINESS STRATEGY
GENERAL
The Company's principal business objective is to generate income for
distribution to its stockholders, primarily from the net cash flows on its
Mortgage-Backed Securities which qualify as Qualified REIT Real Estate Assets.
The Company's net cash flows result primarily from the difference between (i)
the interest income on its Mortgage-Backed Security investments and (ii) the
borrowing and financing costs of the Mortgage-Backed Securities. To achieve
its business objective and generate dividend yields, the Company's strategy
is:
. to purchase Pass-Through Certificates, CMOs and other Mortgage-Backed
Securities, substantially all of which are expected to have adjustable
interest rates based on changes in short-term market interest rates;
1
. to acquire only those Mortgage-Backed Securities which the Company
believes it has the necessary expertise to evaluate and manage, which
can be readily financed and which are consistent with the Company's
balance sheet guidelines and risk management objectives and generally to
seek to acquire assets whose investment returns are attractive in more
than a limited range of scenarios;
. to finance purchases of Mortgage-Backed Securities with the proceeds of
equity offerings and, to the extent permitted by the Company's Capital
Investment Policy, to utilize leverage to increase potential returns to
stockholders through borrowings (primarily under repurchase agreements);
. to attempt to structure its borrowings to have interest rate adjustment
indices and interest rate adjustment periods that, on an aggregate
basis, generally correspond (within a range of one to six months) to the
interest rate adjustment indices and interest rate adjustment periods of
the adjustable and floating rate Mortgage-Backed Securities purchased by
the Company;
. to utilize interest rate caps, swaps and similar instruments to mitigate
the risk of the cost of its variable rate liabilities increasing at a
faster rate than the earnings on its assets during a period of rising
interest rates;
. to seek to minimize prepayment risk by structuring a diversified
portfolio with a variety of prepayment characteristics and through other
means; and
. to issue new equity or debt and increase the size of the balance sheet
when opportunities in the market for Mortgage-Backed Securities are
likely to allow growth in earnings per share.
The Company believes it is able to obtain cost efficiencies through its
facilities-sharing arrangement with Fixed Income Discount Advisory Company
("FIDAC") and by virtue of management's experience in managing portfolios of
Mortgage-Backed Securities and in arranging collateralized borrowings. The
Company will strive to become even more cost-efficient over time by:
. seeking to raise additional capital from time to time in order to
increase its ability to invest in Mortgage-Backed Securities as
operating costs are not anticipated to increase as quickly as assets and
because growth will increase the Company's purchasing influence with
suppliers of Mortgage-Backed Securities;
. striving to lower its effective borrowing costs over time through
seeking direct funding with collateralized lenders rather than using
financial intermediaries and investigating the possibility of using
commercial paper and medium term note programs;
. improving the efficiency of its balance sheet structure by investigating
the issuance of uncollateralized subordinated debt, preferred stock and
other forms of capital; and
. utilizing information technology to the fullest extent possible in its
business, which technology the Company believes can be developed to
improve the Company's ability to monitor the performance of its
Mortgage-Backed Securities, improve its ability to assess credit risk,
improve hedge efficiency and lower operating costs.
"Mortgage-Backed Securities" which may be acquired by the Company include
(i) securities (or interests therein) evidencing undivided ownership interests
in a pool of mortgage loans, the holders of which receive a "pass-through" of
the principal and interest paid in connection with the underlying mortgage
loans in accordance with the holders' respective, undivided interests in the
pool ("Pass-Through Certificates"), and (ii) adjustable- or fixed-rate debt
obligations (bonds) that are collateralized by mortgage loans or mortgage
certificates ("CMOs"). "Pass-Through Certificates" include mortgage
participation certificates issued by the Federal Home Loan Mortgage
Corporation ("FHLMC"), mortgage pass-through certificates issued by the
Federal National Mortgage Association ("FNMA"), fully modified pass-through
mortgage-backed certificates guaranteed by the Government National Mortgage
Association ("GNMA"), and privately-issued pass-through certificates
("Privately-Issued Certificates") issued by a third party issuer other than
FHLMC, FNMA and GNMA. The term "Qualified REIT Real Estate Assets" means
Mortgage-Backed Securities and other assets of the type described in section
856(c) (6)(B) of the Internal Revenue Code of 1986, as amended (the "Code").
2
The Company's "Capital Investment Policy" is a set of policies established
by the Company, including a majority of its independent directors,
establishing guidelines for management relating to asset acquisitions, credit
risk management, capital and leverage, interest rate risk management and
prepayment risk management.
MORTGAGE-BACKED SECURITIES
General
The Company's Capital Investment Policy provides that at least 75% of its
total assets will be comprised of High Quality Mortgage-Backed Securities and
High Quality Short-Term Investments. The term "High Quality" as used herein
means securities (i) which are rated within one of the two highest rating
categories by at least one of the nationally recognized rating agencies, (ii)
that are unrated but are either guaranteed by the United States government or
an agency of the United States government, or (iii) that are unrated or whose
ratings have not been updated but are determined to be of comparable quality
to rated High Quality Mortgage-Backed Securities on the basis of credit
enhancement features that meet the High Quality credit criteria approved by
the Company's Board of Directors. To date, all of the Mortgage-Backed
Securities acquired by the Company have been High Quality Mortgage-Backed
Securities which, although not rated, carry an implied "AAA" rating. The term
"Short-Term Investments" means short-term bank certificates of deposit, short-
term United States treasury securities, short-term United States government
agency securities, commercial paper, reverse repurchase agreements, short-term
CMOs, short-term asset-backed securities and other similar types of short-term
investment instruments, all of which have maturities or average durations of
less than one year.
In accordance with the Company's Capital Investment Policy, the remainder of
the Company's 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 Standard & Poors
Corporation ("S&P") or the equivalent by another nationally recognized rating
organization) or, if not rated, are determined by the Company to be of
comparable credit quality to an investment which is rated "BBB" or better. The
foregoing-described Mortgage-Backed Securities, comprising in the aggregate
not more than 25% of the Company's total assets, are sometimes referred to
herein as "Limited Investment Assets." The Company intends to structure its
portfolio to maintain a minimum weighted average rating (including the
Company's deemed comparable ratings for unrated Mortgage-Backed Securities
based on a comparison to rated Mortgage-Backed Securities with like
characteristics) of its Mortgage-Backed Securities of at least single "A"
under the S&P rating system and at the comparable level under the other rating
systems.
Allocation of the Company's investments among the permitted investment types
may vary from time-to-time based on the evaluation by the Company's Board of
Directors of economic and market trends and the Company's perception of the
relative values available from such types of investments, provided that in no
event will the Company's investment in Limited Investment Assets exceed 25% of
the Company's total assets.
To date, all of the Mortgage-Backed Securities acquired by the Company have
been Agency Certificates which carry an implied "AAA" rating. Prior to
acquiring any unrated securities, the Company intends to engage an independent
consultant with expertise in rating "investment grade" securities to assist
the Company in evaluating the creditworthiness of such securities and
determining whether such securities are qualified to be purchased under the
Capital Investment Policy. In making such evaluations, the Company will look
at similar criteria utilized by S&P and other nationally recognized rating
organizations. Such criteria may include a review of the cash flow and other
characteristic of the security, an analysis of the components of the security
and a valuation of comparable assets.
The Company acquires only those Mortgage-Backed Securities which the Company
believes it has the necessary expertise to evaluate and manage, which are
consistent with the Company's balance sheet guidelines and risk management
objectives and which the Company believes can be readily financed. Since the
intention of the Company is generally to hold its Mortgage-Backed Securities
until maturity, the Company generally does not seek to acquire assets whose
investment returns are only attractive in a limited range of scenarios. The
3
Company believes that future interest rates and mortgage prepayment rates are
very difficult to predict. Therefore, the Company seeks to acquire Mortgage-
Backed Securities which the Company believes will provide acceptable returns
over a broad range of interest rate and prepayment scenarios.
The Mortgage-Backed Securities acquired and to be acquired by the Company
consist of (i) Pass-Through Certificates, (ii) CMOs, and (iii) other Mortgage-
Backed Securities, including mortgage derivative securities representing the
right to receive interest only or a disproportionately large amount of
interest. It is expected that the Pass-Through Certificates acquired by the
Company for its investment portfolio will continue to consist primarily of
adjustable-rate Agency Certificates, which include adjustable-rate mortgage
participation certificates issued by FHLMC ("FHLMC Certificates"), mortgage
Pass-Through Certificates issued by FNMA ("FNMA certificates") and fully
modified Pass-Through Certificates guaranteed by GNMA ("GNMA Certificates").
To date, all of the Mortgage-Backed Securities acquired by the Company have
been FHLMC Certificates, FNMA Certificates or GNMA Certificates (collectively,
"Agency Certificates"). The Company has not and will not invest in REMIC
residuals, other CMO residuals or Mortgage-Backed Securities, such as inverse
floaters, which have imbedded leverage as part of their structural
characteristics.
Description of Mortgage-Backed Securities
The Mortgage-Backed Securities in which the Company invests provide funds
for mortgage loans made primarily to residential homeowners. These include
securities which represent interests in pools of mortgage loans made by
lenders such as savings and loan institutions, mortgage bankers and commercial
banks. Pools of mortgage loans are assembled for sale to investors (such as
the Company) by various governmental, government-related and private
organizations.
Interests in pools of 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 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 its residential mortgage loans, net of any fees paid to
the issuer or guarantor of such securities. Additional payments result from
prepayments of principal resulting from the sale of the underlying residential
property, refinancing or foreclosure, 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 or not the mortgagors actually make
mortgage payments when due.
The investment characteristics of pass-through Mortgage-Backed Securities
differ from those of traditional fixed-income securities. The major
differences include the payment of interest and principal on the mortgage-
backed securities on a more frequent schedule, as described above, and the
possibility that principal may be prepaid at any time due to prepayments on
the underlying mortgage loans or other assets. These differences can result in
significantly greater price and yield volatility than is the case with
traditional fixed-income securities.
The occurrences of mortgage prepayments are affected by factors including
the level of interest rates, general economic conditions, the location and age
of the mortgage and other social and demographic conditions. Generally
prepayments on pass-through mortgage-backed securities increase during periods
of falling mortgage interest rates and decrease during periods of rising
mortgage interest rates. Reinvestment of prepayments may occur at higher or
lower interest rates than the original investment, thus affecting the yield of
the Company's investments.
FHLMC Certificates
FHLMC is a privately owned government-sponsored enterprise created pursuant
to an Act of Congress (Title III of the Emergency Home Finance Act of 1970, as
amended, 12 U.S.C. (S)(S) 1451-1459), on July 24, 1970. The principal activity
of FHLMC currently consists of the purchase of conventional Conforming
Mortgage Loans
4
or participation interests therein and the resale of the loans and
participations so purchased in the form of guaranteed Mortgage-Backed
Securities. FHLMC guarantees to each holder of FHLMC Certificates the timely
payment of interest at the applicable pass-through rate and ultimate
collection of all principal on the holder's pro rata share of the unpaid
principal balance of the related Mortgage Loans, but does not guarantee the
timely payment of scheduled principal of the underlying Mortgage Loans. The
obligations of FHLMC under its guarantees are solely those of FHLMC and are
not backed by the full faith and credit of the United States. If FHLMC were
unable to satisfy such obligations, distributions to holders of FHLMC
Certificates would consist solely of payments and other recoveries on the
underlying Mortgage Loans and, accordingly, monthly distributions to holders
of FHLMC Certificates would be affected by delinquent payments and defaults on
such Mortgage Loans.
FHLMC Certificates may be backed by pools of Single-Family Mortgage Loans or
Multifamily Mortgage Loans. Such underlying Mortgage Loans may have original
terms to maturity of up to 40 years. FHLMC Certificates may be issued under
Cash Programs (composed of Mortgage Loans purchased from a number of sellers)
or Guarantor Programs (composed of Mortgage Loans purchased from one seller in
exchange for participation certificates representing interests in the Mortgage
Loans purchased). FHLMC Certificates may pay interest at a fixed rate or
adjustable rate. The interest rate paid on FHLMC ARM Certificates adjusts
periodically within 60 days prior to the month in which the interest rates on
the underlying Mortgage Loans adjust. The interest rates paid on FHLMC ARM
Certificates issued under FHLMC's standard ARM programs adjust in relation to
the Treasury Index. Other specified indices used in FHLMC ARM programs include
the 11th District Cost of Funds Index published by the Federal Home Loan Bank
of San Francisco, 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 ranging typically from 125 to 250 basis
points. In addition, 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 Mortgage Loans ("ARMs") which are converted into fixed-rate
Mortgage Loans are repurchased by FHLMC or by the seller of such loan to FHLMC
at the unpaid principal balance thereof plus accrued interest to the due date
of the last adjustable rate interest payment. An "ARM Certificate" means a
Mortgage-Backed Security that features adjustments of the underlying interest
rate at predetermined times based on an agreed margin to an established index,
such as LIBOR, the Treasury Index or the CD Rate. "LIBOR" means the London
Interbank Offered Rate as it may be defined, and for a period of time
specified, in a Mortgage-Backed Security or borrowing of the Company.
"Treasury Index" means the monthly/weekly average yield of the benchmark U.S.
Treasury securities, as published by the Board of Governors of the Federal
Reserve System. "CD Rate" means the weekly average of secondary market
interest rates on six-month negotiable certificates of deposit, as published
by the Federal Reserve Board in its Statistical Release H.15(519), Selected
Interest Rates.
FNMA Certificates
FNMA is a privately owned, federally chartered corporation organized and
existing under the Federal National Mortgage Association Charter Act (12
U.S.C. (S)1716 et seq.). 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 (at the rate provided by the FNMA Certificate) on the
Mortgage Loans in the pool underlying the FNMA Certificate, whether or not
received, and the full principal amount of any such mortgage loan foreclosed
or otherwise finally liquidated, whether or not the principal amount is
actually received. The obligations of FNMA under its guarantees are solely
those of FNMA and are not backed by the full faith and credit of the United
States. If FNMA were unable to satisfy such obligations, distributions to
holders of FNMA Certificates would consist solely of payments and other
recoveries on the underlying Mortgage Loans and, accordingly, monthly
distributions to holders of FNMA Certificates would be affected by delinquent
payments and defaults on such Mortgage Loans.
5
FNMA Certificates may be backed by pools of Single-Family or Multifamily
Mortgage Loans. The original terms to maturities of the Mortgage Loans
generally do not exceed 40 years. FNMA Certificates may pay interest at a
fixed rate or adjustable rate. Each series of FNMA ARM Certificates bears an
initial interest rate and margin tied to an index based on all loans in the
related pool, less a fixed percentage representing servicing compensation and
FNMA's guarantee fee. The specified index used in each such series has
included the Treasury Index, the 11th District 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 ranging
typically from 125 to 250 basis points. In addition, 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 its ARM to a fixed rate. ARMs which are converted into fixed-
rate Mortgage Loans are repurchased by FNMA or by the seller of such loans to
FNMA at the unpaid principal balance thereof 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"). Section 306(g) of
Title III of the National Housing Act of 1934, as amended (the "Housing Act"),
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 FHA under the Housing Act or Title V of the Housing Act of
1949, or partially guaranteed by the VA under the Servicemen's Readjustment
Act of 1944, as amended, or Chapter 37 of Title 38, United States Code 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 under this subsection." An
opinion, dated December 12, 1969, of an Assistant Attorney General of the
United States provides that such guarantees under section 306(g) of GNMA
Certificates of the type which may be purchased or received in exchange by the
Company are authorized to be made by GNMA and "would constitute general
obligations of the United States backed by its full faith and credit."
At present, most GNMA Certificates are backed by Single-Family Mortgage
Loans. The interest rate paid on GNMA Certificates may be fixed rate or
adjustable rate. The interest rate on GNMA Certificates issued under GNMA's
standard ARM program adjusts annually in relation to the Treasury Index.
Interest rates paid on GNMA ARM Certificates typically equal the index rate
plus 150 basis points. Adjustments in the interest rate are generally limited
to an annual increase or decrease of 100 basis points and to a lifetime cap of
500 basis points over the initial coupon rate.
Single-Family and Multifamily Privately-Issued Certificates
Single-Family and Multifamily Privately-Issued Certificates are Pass-Through
Certificates that are not issued by FHLMC, FNMA or GNMA (the "Agencies") and
that are backed by a pool of conventional Single-Family or Multifamily
Mortgage Loans, respectively. Single-Family and Multifamily Privately-Issued
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 such institutions.
While Agency Certificates are backed by the express obligation or guarantee
of one of the Agencies, as described above, Single-Family and Multifamily
Privately-Issued Certificates are generally covered by one or more forms of
private (i.e., non-governmental) credit enhancements. Such 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 and
6
result in Realized Losses. Forms of credit enhancements include, but are not
limited to, 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 multiple classes of Senior-Subordinated Mortgage-Backed
Securities. Such classes are structured into a hierarchy of levels for
purposes of allocating Realized Losses 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 Realized Losses prior to the classes of Senior
Securities. Mezzanine Securities for purposes of this Prospectus will refer to
any classes that are rated below the two highest levels but no lower than a
single "B" level under the S&P rating system (or comparable level under other
rating systems) and are supported by one or more classes of Subordinated
Securities which bear Realized Losses prior to the classes of Mezzanine
Securities. For purposes of this Prospectus, Subordinated Securities will
refer to any class that bears the "first loss" from Realized Losses or that is
rated below a single "B" level (or, if unrated, is deemed by the Company to be
below such level based on a comparison of characteristics of such class with
other rated Subordinated Securities with like characteristics). 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
Mortgage-Backed Securities in which the Company may invest may include
collateralized mortgage obligations ("CMOs") and multi-class pass-through
securities. CMOs are debt obligations issued by special purpose entities that
are secured by mortgage-backed certificates, including, in many cases,
certificates issued by government and government-related guarantors,
including, GNMA, FNMA and FHLMC, together with certain funds and other
collateral. Multi-class pass-through securities are equity interests in a
trust composed of mortgage loans or other mortgage-backed securities. Payments
of principal and interest on underlying collateral provide the funds to pay
debt service on the CMO or make scheduled distributions on the multi-class
pass-through securities. CMOs and multi-class pass-through securities may be
issued by agencies or instrumentalities of the U.S. Government or by private
organizations. The discussion of CMOs in the following paragraphs is similarly
applicable to multi-class pass-through securities.
In a CMO, a series of bonds or certificates is issued in multiple classes.
Each class of CMOs, often referred to as a "tranche," is issued at a specific
coupon rate (which, as discussed below, may be an adjustable rate subject to a
cap) and has a stated maturity or final distribution date. Principal
prepayments on collateral underlying a CMO may cause it to be retired
substantially earlier than the stated maturities or final distribution dates.
Interest is paid or accrues on all classes of a CMO on a monthly, quarterly or
semi-annual basis. The principal and interest on underlying mortgages may be
allocated among the several classes of a series of a CMO in many ways. In a
common structure, payments of principal, including any principal prepayments,
on the underlying mortgages are applied to the classes of the series of a CMO
in the order of their respective stated maturities or final distribution
dates, so that no payment of principal will be made on any class of a CMO
until all other classes having an earlier stated maturity or final
distribution date have been paid in full.
Other types of CMO issues include classes such as parallel pay CMOs, some of
which, such as Planned Amortization Class CMOs ("PAC Bonds"), provide
protection against prepayment uncertainty. Parallel pay CMOs are structured to
provide payments of principal on certain payment dates to more than one class.
These simultaneous payments are taken into account in calculating the stated
maturity date or final distribution date of each class which, as with other
CMO structures, must be retired by its stated maturity date or final
distribution date but may be retired earlier. PAC Bonds generally require
payment of a specified amount of principal on each payment date so long as
prepayment speeds on the underlying collateral fall within a specified range.
PAC Bonds are always parallel pay CMOs with the required principal payment on
such securities having the highest priority after interest has been paid to
all classes.
7
Other types of CMO issues include Targeted Amortization Class CMOs ("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.
CMOs may be subject to certain rights of issuers thereof to redeem such CMOs
prior to their stated maturity dates, which may have the effect of diminishing
the Company's anticipated return on its investment. Privately-Issued Single-
Family and Multifamily 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. The Company 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 (provided that the Company has obtained a favorable opinion
of its tax advisor or a ruling from the IRS to that effect).
One or more tranches of a CMO may have coupon rates which reset periodically
at a specified increment over an index such as LIBOR. These adjustable rate
tranches known as "floating rate CMOs" or "floaters" may be backed by fixed or
adjustable-rate mortgages. To date, fixed-rate mortgages have been more
commonly utilized for this purpose. Floating rate CMOs are typically issued
with lifetime caps on the coupon rate thereon. These caps, similar to the caps
on adjustable-rate mortgages described in "Floating Rate Mortgage-Backed
Securities" below, represent a ceiling beyond which the coupon rate on a
floating rate CMO may not be increased regardless of increases in the interest
rate index to which the floating rate CMO is geared.
Floating Rate Mortgage-Backed Securities
CMOs in which the Company may invest include floating rate CMOs
("Floaters"). The interest rates on Floaters are reset at periodic intervals
to an increment over some predetermined interest rate index. There are two
main categories of indices: (i) those based on U.S. Treasury securities, and
(ii) 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 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, the
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 rate level. The Company will seek to diversify its investments in
Floaters among a variety of indices and reset periods so that the Company is
not at any one time unduly exposed to the risk of interest rate fluctuations.
In selecting the type of Floaters for investment, the Company will also
consider the liquidity of the market for such Floaters.
The Company believes that Floaters are particularly well-suited to
facilitate its ability to accomplish the Company's investment objective of
high current income, consistent with modest volatility of net asset value,
because the value of the Floaters should remain relatively stable as compared
to that of traditional fixed-rate debt securities paying comparable rates of
interest. While the value of 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 Floaters should generally
be more resistant to price swings than other debt securities because the
interest rates of Floaters move with market interest rates. Accordingly, as
interest rates change, the value of the Company's shares should be more stable
than that of funds which invest primarily in securities backed by fixed-rate
mortgages or in other non-mortgage-backed debt securities, which do not
provide for adjustment in the interest rates thereon in response to change in
interest rates.
8
Floaters typically have caps, which limit the maximum amount by which the
interest rate may be increased or decreased at periodic intervals or over the
life of the Floater. To the extent that interest rates rise faster than the
allowable caps on Floaters, such Floaters will behave more like fixed-rate
securities. Consequently, interest rate increases in excess of caps can be
expected to cause Floaters 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 such caps.
Floaters, like other Mortgage-Backed Securities, differ from conventional
bonds in that principal is to be paid back over the life of Floaters rather
than at maturity. As a result, the holder of the Floaters (i.e., the Company)
receives monthly scheduled payments of principal and interest and may receive
unscheduled principal payments representing prepayments on the underlying
mortgages. When the holder reinvests the payments and any unscheduled
prepayments it receives, it may receive a rate of interest on the reinvestment
which is lower than the rate on the existing Floaters. For this reason,
Floaters are less effective than longer-term debt securities as a means of
"locking in" longer-term interest rates.
Floaters, while having less risk of price decline during periods of rapidly
rising rates than certain fixed-rate Mortgage-Backed Securities of comparable
maturities, could have less potential for capital appreciation than such
securities. In addition, to the extent Floaters are purchased at a premium,
mortgage foreclosures and unscheduled principal prepayments will result in
some loss of the holders' principal investment to the extent of the premium
paid. On the other hand, if Floaters are purchased at a discount, an
unscheduled prepayment of principal could increase total return and accelerate
the recognition of income to the Company and, as a result, could increase the
amount of income received by stockholders to the extent that the Company
distributes such income.
Other Floating Rate Instruments
The Company may also invest in structured floating rate notes issued or
guaranteed by government agencies, such as FNMA and FHLMC. Such 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 referred to under "--Floating Rate
Mortgage-Backed Securities" above.
Subordinated Interests
The Company may acquire Subordinated Interests which are classes of
Mortgage-Backed Securities that are junior to other classes of such series of
Mortgage-Backed Securities in the right to receive payments from the
underlying mortgages. The subordination is for credit enhancement and may be
for all payment failures on the Mortgage Loans securing or underlying such
series of Mortgage-Backed Securities. The subordination will not be limited to
those resulting from certain types of risks, such as those resulting from war,
earthquake or flood, or the bankruptcy of a mortgagor. The subordination may
be for the entire amount of the series of Mortgage-Backed Securities or may be
limited in amount. The Subordinated Interests held by the Company will be part
of its Limited Investment Assets that in the aggregate will not constitute
more than 25% of the Company's total assets.
It is anticipated that substantially all of the Subordinated Interests which
the Company may acquire will be rated at least investment grade by one of the
rating agencies. If not so rated, the Company will establish reserves against
future potential losses in an amount equivalent to the credit enhancement
required to achieve an investment grade credit rating.
Any Subordinated Interests acquired by the Company will be limited in amount
and bear yields which the Company believes are commensurate with the risks
involved. The market for Subordinated Interests is not extensive and may be
illiquid. In addition, the Company's ability to sell Subordinated Interests
will be limited by Sections 856 through 860 of the Code (the "REIT Provisions
of the Code"). Accordingly, the Company
9
intends to purchase Subordinated Interests for investment purposes only.
Although publicly offered Subordinated Interests generally will be rated, the
risks of ownership will be substantially the same as the ownership of unrated
Subordinated Interests because the rating does not address the possibility
that the Company might suffer a lower than anticipated yield or fail to
recover its initial investment. The Company will not purchase any Subordinated
Interests that do not qualify as Qualified REIT Real Estate Assets.
Mortgage Loans
The Company may from time to time invest a small percentage of its assets
directly in Single-Family, Multi-Family or Commercial Mortgage Loans. The
Company expects that substantially all of such Mortgage Loans acquired by it
would be ARMs. The interest rate on an ARM is typically tied to an index (such
as LIBOR or the interest rate on United States Treasury Bills), and is
adjustable periodically at various intervals. Such Mortgage Loans are
typically subject to lifetime interest rate caps and periodic interest rate
and/or payment caps. The acquisition of Mortgage Loans generally involves
credit risk. The Company may obtain credit enhancement to mitigate such risk;
however, there can be no assurances that the Company will able to obtain such
credit enhancement or that such credit enhancement will mitigate the credit
risk of the underlying Mortgage Loans.
POLICIES AND PROCEDURES
Capital Investment Policies
Under the Capital Investment Policy adopted by the Company, at least 75% of
the Company's total assets are comprised of "High Quality" Mortgage-Backed
Securities and "High Quality" Short-Term Investments. The term "High Quality"
as used herein means securities (i) which are rated within one of the two
highest rating categories by at least one of the nationally recognized rating
agencies, (ii) that are unrated but are either guaranteed by the United States
government or an agency of the United States government, or (iii) that are
unrated or whose ratings have not been updated but are determined to be of
comparable quality to rated High Quality Mortgage-Backed Securities on the
basis of credit enhancement features that meet the High Quality credit
criteria approved by the Company's Board of Directors. The remainder of the
Company's assets, comprising not more than 25% of 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 S&P or the equivalent by another nationally recognized rating organization
(each, a "Rating Agency")) or, if not rated, are determined by the Company to
be of comparable credit quality to an investment which is rated "BBB" or
better. Prior to investing in any unrated securities, the Company will follow
certain procedures described under "--Mortgage-Backed Securities--General."
See "Risk Factors--Operations Risks--Risks of Unrated Assets." Mortgage-Backed
Securities to be acquired by the Company may include, but will not be limited
to, Mortgage-Backed Securities backed by single-family residential mortgage
loans ("Single-Family Mortgage Loans") and Mortgage-Backed Securities backed
by loans on multi-family, commercial or other real estate-related properties.
At December 31, 1997, all of the Mortgage-Backed Securities held by the
Company were "Agency Certificates" which, although not rated, carry an implied
"AAA" rating. All such Agency Certificates held by the Company at December 31,
1997 were backed by Single-Family Mortgage Loans, of which at December 31,
1997, approximately 87% had coupon rates which adjust over time (subject to
certain limitations and lag periods) in conjunction with changes in short-term
interest rates, reflecting the Company's strategy of investing primarily in
adjustable-rate Mortgage-Backed Securities. The Company intends to continue to
invest primarily in adjustable-rate Mortgage-Backed Securities. The Company
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. The Company has 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. At December 31, 1997,
the weighted average yield on the Company's portfolio of earning assets was
6.57%, and the weighted average term to next rate adjustment was twenty-two
months.
10
The Company attempts to structure its borrowings to have interest rate
adjustment indices and interest rate adjustment periods that, on an aggregate
basis, correspond generally (within a range of one to six months) to the
interest rate adjustment indices and periods of the adjustable-rate Mortgage-
Backed Securities owned by the Company. However, the Company is subject to the
risk that periodic rate adjustments on borrowings may be less frequent than
rate adjustments on its Mortgage-Backed Securities. At December 31, 1997, the
weighted average cost of funds for all of the Company's borrowings was 6.16%
and the weighted average term to next rate adjustment of such borrowings was
16 days. See "Risk Factors--Operations Risks--Risks Associated with
Differences Between Mortgage-Backed Security and Borrowing Characteristics;
Rate Adjustment Caps."
The Company generally expects 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 deemed relevant by management of the
Company. For purposes of calculating this ratio, the Company's equity is equal
to the value of the Company's investment portfolio on a mark-to-market basis,
less the book value of the Company's obligations under repurchase agreements
and other collateralized borrowings. At December 31, 1997, the ratio of debt-
to-equity of the Company was 7:1.
To the extent consistent with its election to qualify as a REIT, the Company
may enter into hedging transactions to attempt to protect its portfolio of
Mortgage-Backed Securities and related borrowings against the effects of major
interest rate changes. Such hedging would be used to mitigate declines in the
market value of the Company's Mortgage-Backed Securities during periods of
increasing or decreasing interest rates and to limit or cap the rate on the
Company's borrowings. Such transactions would be entered into solely for the
purpose of hedging interest rate or prepayment risk and not for speculative
purposes. These hedging transactions may include interest rate swaps, the
purchase or sale of interest rate collars, caps or floors, and the purchase of
"interest only" Mortgage-Backed Securities. No hedging strategy can totally
eliminate interest rate risk and the Company's ability to enter into such
hedging transactions may be limited by provisions of the Code relating to
qualifying assets and qualifying income and transaction costs associated with
entering into such transactions. To date, the Company has not entered into any
hedging transactions. See "Capital Investment Policy" and "Certain Federal
Income Tax Considerations."
The Company constantly monitors its Mortgage-Backed Securities and the
income from such assets and, to the extent the Company enters into hedging
transactions in the future, will monitor income from its hedging transactions
as well, so as to ensure at all times that the Company maintains its
qualification as a REIT and its exempt status under the Investment Company Act
of 1940, as amended (the "Investment Company Act"). See "Certain Federal
Income Tax Considerations" and "Risk Factors--Legal and Other Risks."
Credit Risk Management
The Company has not taken on credit risk to date, but may do so in the
future. In such event, the Company will review credit risk and other risk of
loss associated with each investment and determine the appropriate allocation
of capital to apply to such investment under its Capital Investment Policy.
The Board of Directors will monitor the overall portfolio risk and determine
appropriate levels of provision for loss.
Capital and Leverage
The Company expects generally 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 deemed relevant by management,
including the composition of the Company's balance sheet, haircut levels
required by lenders, the market value of the Mortgage-Backed Securities in the
Company's portfolio and "Excess Capital Cushion" percentages (as described
below) set by the Board of Directors from time to time. For purposes of
calculating this ratio, the Company's equity is equal to the value of the
Company's investment portfolio on a mark-to-market basis less the book value
of the Company's obligations under repurchase agreements and other
collateralized borrowings. At December 31, 1997, the Company's ratio of debt-
to-equity was 7:1.
11
The Company's 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 the Company's ability to meet its
obligations during adverse market conditions. The Company's Capital Investment
Policy limits management's ability to acquire additional assets during times
when the Company's debt-to-equity ratio exceeds 12:1. In this way, the Company
intends that use of balance sheet leverage will be controlled. The actual
capital base as defined for the purpose of this policy is equal to the market
value of total assets less the book value of total collateralized borrowings.
The actual capital base, as so defined, represents the approximate liquidation
value of the Company and approximates the market value of assets that can be
pledged or sold to meet over-collateralization requirements for the Company's
borrowings. The unpledged portion of the Company's actual capital base is
available to be pledged or sold as necessary to maintain over-
collateralization levels for the Company's borrowings.
Management is prohibited from acquiring additional assets during periods
when the actual capital base of the Company is less than the minimum amount
required under the Capital Investment Policy (except when such asset
acquisitions may be necessary to maintain REIT status or the Company's
exemption from the Investment Company Act). In addition, when the actual
capital base falls below the risk-managed capital requirement, management will
be required to submit to the Board a plan for bringing the actual capital base
into compliance with the Capital Investment Policy guidelines. It is
anticipated that in most circumstances this goal will be achieved over time
without overt management action through the natural process of mortgage
principal repayments and increases in the market values of Mortgage-Backed
Securities as their coupon rates adjust upwards to market levels. Management
anticipates that the actual capital base is likely to exceed the risk-managed
capital requirement during periods following new equity offerings and during
periods of falling interest rates and that the actual capital base could fall
below the risk-managed capital requirement during periods of rising interest
rates.
The first component of the Company's capital requirements is the current
aggregate over-collateralization amount or "haircut" the lenders require the
Company to hold as capital. The haircut for each Mortgage-Backed Security is
determined by the lender based on the risk characteristics and liquidity of
that asset. Haircut levels on individual borrowings generally range from 3% to
5% for Agency Certificates to 20% for certain Privately-Issued Certificates,
and the Company anticipates that haircut levels will average 3% to 10% for the
Company as a whole. At December 31, 1997, the weighted average haircut level
on the Company's securities was 3.6%. Should the market value of the pledged
assets decline, the Company will be required to deliver additional collateral
to the lenders in order to maintain a constant over-collateralization level on
its borrowings.
The second component of the Company's capital requirement is the "Excess
Capital Cushion." The Excess Capital Cushion is an additional amount of
capital in excess of the haircut maintained by the Company in order to help
the Company meet the demands of the lenders for additional collateral should
the market value of the Company's Mortgage-Backed Securities decline. The
aggregate Excess Capital Cushion equals the sum of liquidity cushion amounts
assigned under the Capital Investment Policy to each of the Company's
Mortgage-Backed Securities. Excess Capital Cushions are assigned to each
Mortgage-Backed Security based on management's 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 management's ability to identify and weigh
the relative importance of these and other factors. Consideration is also
given 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 can be expected to arise from the interaction of the
various components of the Company's balance sheet. The Board of Directors thus
reviews on a periodic basis various analyses prepared by management of the
risks inherent in the Company's balance sheet, including an analysis of the
effects of various scenarios on the Company's net cash flow, earnings,
dividends, liquidity and net market value. Should the Board of Directors
determine that the minimum required capital base set by the Company's Capital
Investment Policy is either too low or too high, the Board of Directors may
raise or lower the capital requirement accordingly.
12
The Capital Investment Policy stipulates that at least 25% of the capital
base maintained to satisfy the Excess Capital Cushion shall be invested in
Agency Certificates, AAA-rated adjustable-rate Mortgage-Backed Securities or
assets with similar or better liquidity characteristics. To date, 100% of the
Company's Mortgage-Backed Securities are Agency Certificates, though this may
change in the future.
Pursuant to the Company's overall business strategy, a substantial portion
of the Company's borrowings are short-term or variable-rate. The Company's
borrowings are implemented primarily through repurchase agreements (a
borrowing device evidenced by an agreement to sell securities or other assets
to a third-party and a simultaneous agreement to repurchase them at a
specified future date and price, the price difference constituting interest on
the borrowing), 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. The Company enters into financing
transactions only with institutions that it believes are sound credit risks
and follows other internal policies designed to limit its credit and other
exposure to financing institutions.
It is expected that repurchase agreements will continue to be the principal
financing devices utilized by the Company to leverage its Mortgage-Backed
Securities portfolio. The Company anticipates that, upon repayment of each
borrowing in the form of a repurchase agreement, the collateral will
immediately be used for borrowing in the form of a new repurchase agreement.
To date, the Company has entered into uncommitted facilities with nineteen
(19) lenders for borrowings in the form of repurchase agreements. The Company
has 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 does the Company presently plan to have
liquidity facilities with commercial banks. The Company, however, may enter
into such commitment agreements in the future if deemed favorable to the
Company. The Company enters into repurchase agreements primarily with national
broker/dealers, commercial banks and other lenders which typically offer such
financing. The Company enters into collateralized borrowings only with
financial institutions meeting credit standards approved by the Company's
Board of Directors, and monitors the financial condition of such institutions
on a regular basis.
A repurchase agreement, although structured as a sale and repurchase
obligation, acts as a financing under which the Company effectively pledges
its 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, the Company is required to repay the loan and
correspondingly receives back its collateral. While used as collateral,
Mortgage-Backed Securities continue to pay principal and interest which inure
to the benefit of the Company. In the event of the insolvency or bankruptcy of
the Company, certain repurchase agreements may qualify for special treatment
under Title 11 of the United States Code (the "Bankruptcy Code") , the effect
of which is, among other things, to allow the creditor under such agreements
to avoid the automatic stay provisions of the Bankruptcy Code and to foreclose
on the collateral agreements 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 the Company's claim against the lender for damages therefrom 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, the Company's ability to exercise its rights to recover its 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 actually suffered by the Company.
Substantially all of the Company's borrowing agreements require the Company
to deposit additional collateral in the event the market value of existing
collateral declines, which may require the Company to sell assets to reduce
the Company's borrowings. The Company's liquidity management policy is
designed to maintain a cushion of equity sufficient to provide required
liquidity to respond to the effects under its borrowing
13
arrangements of interest rate movements and changes in market value of its
Mortgage-Backed Securities, as described above. However, a major disruption of
the repurchase or other market relied on by the Company for short-term
borrowings would have a material adverse effect on the Company unless the
Company were able to arrange alternative sources of financing on comparable
terms. See "Risk Factors--Operations Risks--Risks Associated with Leverage"
and "--Risk of Decrease in Net Interest Income Due to Interest Rate
Fluctuations."
The Company's Bylaws do not limit its ability to incur borrowings, whether
secured or unsecured.
Interest Rate Risk Management
To the extent consistent with its election to qualify as a REIT, the Company
follows an interest rate risk management program intended to protect its
portfolio of Mortgage-Backed Securities and related debt against the effects
of major interest rate changes. Specifically, the Company's interest rate risk
management program is formulated with the intent to offset the potential
adverse effects resulting from rate adjustment limitations on its Mortgage-
Backed Securities and the differences between interest rate adjustment indices
and interest rate adjustment periods of its adjustable-rate Mortgage-Backed
Securities and related borrowings. The Company's interest rate risk management
program encompasses a number of procedures, including the following: (i) the
Company attempts to structure its 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 the adjustable-rate Mortgage-Backed Securities purchased
by the Company, so as to limit any mismatching of such aggregates to a range
of one to six months, and (ii) the Company attempts to structure its 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). As a result, the Company
expects to be able to adjust the average maturity/adjustment period of such
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, the Company intends to minimize any differences between
interest rate adjustment periods of adjustable-rate Mortgage-Backed Securities
and related borrowings that may occur.
Although it has not done so to date, the Company may purchase from time to
time interest rate caps, interest rate swaps, interest rate collars, caps or
floors, "interest only" Mortgage-Backed Securities and similar instruments to
attempt to mitigate the risk of the cost of its variable rate liabilities
increasing at a faster rate than the earnings on its assets during a period of
rising interest rates or to mitigate prepayment risk. In this way, the Company
may hedge as much of the interest rate risk as management determines is in the
best interests of the stockholders of the Company, given the cost of such
hedging transactions and the need to maintain the Company's status as a REIT.
See "Certain Federal Income Tax Considerations--General--Gross Income Tests."
This determination may result in management electing to have the Company bear
a level of interest rate risk that could otherwise be hedged when management
believes, based on all relevant facts, that bearing such risk is advisable.
The Company seeks to build a balance sheet and undertake an interest rate
risk management program which is likely, in management's view, to enable the
Company to generate positive earnings and maintain an equity liquidation value
sufficient to maintain operations given a variety of potentially adverse
circumstances. Accordingly, the hedging program addresses both income
preservation, as discussed in the first part of this section, and capital
preservation concerns. With regard to the latter, the Company monitors its
"duration." This is the expected percentage change in market value of the
Company's 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 the Company's equity, the Company models the impact
of various economic scenarios on the market value of the Company's Mortgage-
Backed Securities, liabilities and interest rate agreements. See "Risk
Factors--Operations Risks--Risk of Decrease in Net Interest Income Due to
Interest Rate Fluctuations." At December 31, 1997, the Company estimates that
the duration of the Company's assets was 2%. The Company believes that the
Company's interest rate risk management program will allow the Company to
maintain operations throughout a wide variety of potentially adverse
circumstances. Nevertheless, in order to further
14
preserve the Company's capital base (and lower its duration) during periods
when management believes a trend of rapidly rising interest rates has been
established, management may decide to enter into or increase hedging
activities and/or sell assets. Each of these types of actions may lower the
earnings and dividends of the Company in the short term in order to further
the objective of maintaining attractive levels of earnings and dividends over
the long term.
The Company may elect to conduct a portion of its hedging operations through
one or more subsidiary corporations which would not be a Qualified REIT
Subsidiary and would be subject to Federal and state income taxes. "Qualified
REIT Subsidiary" means a corporation whose stock is entirely owned by the REIT
at all times during such corporation's existence. In order to comply with the
nature of asset tests applicable to the Company as a REIT, the value of the
securities of any subsidiary held by the Company (other than a Qualified REIT
Subsidiary) must be limited to less than 5% of the value of the Company's
total assets as of the end of each calendar quarter and no more than 10% of
the voting securities of any such subsidiary may be owned by the Company. See
"Certain Federal Income Tax Considerations--General--Asset Tests." A taxable
subsidiary would not elect REIT status and would distribute any net profit
after taxes to the Company and its other stockholders. Any dividend income
received by the Company from any such taxable subsidiary (combined with all
other income generated from the Company's assets, other than Qualified REIT
Real Estate Assets) must not exceed 25% of the gross income of the Company.
See "Certain Federal Income Tax Considerations--General--Gross Income Tests."
Before the Company forms any such taxable subsidiary corporation for its
hedging activities, the Company will obtain an opinion of counsel to the
effect that the formation and contemplated method of operation of such
corporation will not cause the Company to fail to satisfy the nature of assets
and sources of income tests applicable to it as a REIT.
The Company believes that it has 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 the Company
from interest rate changes, prepayment risks and defaults by counter-parties.
Further, as noted above, certain of the Federal income tax requirements that
the Company must satisfy to qualify as a REIT limit the Company's ability to
fully hedge its interest rate and prepayment risks. The Company monitors
carefully, and may have to limit, its asset/liability management program to
assure that it does not realize excessive hedging income, or hold hedging
assets having excess value in relation to total assets, which would result in
the Company's disqualification as a REIT or, in the case of excess hedging
income, the payment of a penalty tax for failure to satisfy certain REIT
income tests under the Code, provided such failure was for reasonable cause.
See "Certain Federal Income Tax Considerations--General." In addition,
asset/liability management involves transaction costs which increase
dramatically as the period covered by the hedging protection increases.
Therefore, the Company may be prevented from effectively hedging its interest
rate and prepayment risks.
Prepayment Risk Management
The Company seeks 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.
Prepayment risk is monitored by management and the Board of Directors through
periodic review of the impact of a variety of prepayment scenarios on the
Company's revenues, net earnings, dividends, cash flow and net balance sheet
market value.
15
CERTAIN FEDERAL INCOME TAX CONSIDERATIONS
GENERAL
The following discussion summarizes certain Federal income tax
considerations to the Company and holders of the Common Stock. This discussion
is based on existing Federal income tax law, which is subject to change,
possibly retroactively. The following summary does not purport to describe all
of the tax considerations that may be relevant to a prospective stockholder.
This discussion does not address tax considerations applicable to certain
types of investors subject to special treatment under the Federal income tax
laws (including financial institutions, insurance companies, broker-dealers
and, except to the extent discussed below, tax-exempt entities and foreign
taxpayers) and it does not discuss any aspects of state, local or foreign tax
law. This discussion assumes that stockholders hold their Common Stock as a
"capital asset" (generally, property held for investment) under the Code.
Stockholders are advised to consult their tax advisors as to the specific tax
consequences of purchasing, holding and disposing of the Common Stock,
including the application and effect of Federal, state, local and foreign
income and other tax laws.
The Company has elected to become subject to tax as a REIT, for Federal
income tax purposes, commencing with the taxable year ending December 31,
1997. The Board of Directors of the Company currently expects that the Company
will continue to operate in a manner that will permit the Company to maintain
its qualification as a REIT for the taxable year ending December 31, 1997, and
in each taxable year thereafter. This treatment will permit the Company to
deduct dividend distributions to its stockholders for Federal income tax
purposes, thus effectively eliminating the "double taxation" that generally
results when a corporation earns income and distributes that income to its
stockholders in the form of dividends.
The continued qualification and taxation of the Company as a REIT will
depend upon the Company's ability to meet, on a continuing basis, distribution
levels and diversity of stock ownership, and the various qualification tests
imposed by the Code as discussed below. If the Company were not to qualify as
a REIT in any particular year, it would be subject to Federal income tax as a
regular, domestic corporation, and its stockholders would be subject to tax in
the same manner as stockholders of such corporation. In this event, the
Company could be subject to potentially substantial income tax liability in
respect of each taxable year that it fails to qualify as a REIT, and the
amount of earnings and cash available for distribution to its stockholders
could be significantly reduced or eliminated.
The following is a brief summary of certain technical requirements that the
Company must meet on an ongoing basis in order to qualify, and remain
qualified, as a REIT under the Code:
Stock Ownership Tests
(i) The capital stock of the Company must be transferable, (ii) the capital
stock of the Company must be held by at least 100 persons during at least 335
days of a taxable year of 12 months (or during a proportionate part of a
taxable year of less than 12 months), and (iii) no more than 50% of the value
of such capital stock may be owned, directly or indirectly, by five or fewer
individuals (as defined in the Code to include certain entities) at any time
during the last half of the taxable year. Tax-exempt entities, other than
private foundations and certain unemployment compensation trusts, are
generally not treated as individuals for these purposes. The requirements of
items (ii) and (iii) above are not applicable to the first taxable year for
which an election to be taxed as a REIT is made. However, these stock
ownership requirements must be satisfied in the Company's second taxable year
and in each subsequent taxable year. The Company's Articles of Incorporation
provide restrictions regarding the transfer of the Company's shares in order
to aid in meeting the stock ownership requirements. See "Description of
Capital Stock--Restrictions on Ownership and Transfer."
16
Asset Tests
The Company must generally meet the following asset tests (the "REIT Asset
Tests") at the close of each quarter of each taxable year:
(a) at least 75% of the value of the Company's total assets must consist
of Qualified REIT Real Estate Assets, government securities, cash and cash
items (the "75% Asset Test"); and
(b) the value of securities held by the Company but not taken into
account for purposes of the 75% Asset Test must not exceed (i) 5% of the
value of the Company's total assets in the case of securities of any one
issuer, or (ii) 10% of the outstanding voting securities of any such
issuer.
At December 31, 1997, 100% of the Company's assets were Qualified REIT Real
Estate Assets. The Company expects that substantially all of its assets will
continue to be Qualified REIT Real Estate Assets. In addition, the Company
does not expect that the value of any security of any one entity would ever
exceed 5% of the Company's total assets, and the Company does not expect to
own more than 10% of any one issuer's voting securities.
The Company monitors closely the purchase, holding and disposition of its
assets in order to comply with the REIT Asset Tests. In particular, the
Company intends to limit and diversify its ownership of any assets not
qualifying as Qualified REIT Real Estate Assets to less than 25% of the value
of the Company's assets and to less than 5%, by value, of any single issuer.
If it is anticipated that these limits would be exceeded, the Company intends
to take appropriate measures, including the disposition of non-qualifying
assets, to avoid exceeding such limits.
Gross Income Tests
The Company must generally meet the following gross income tests (the "REIT
Gross Income Tests") for each taxable year:
(a) at least 75% of the Company's gross income must be derived from
certain specified real estate sources including interest income and gain
from the disposition of Qualified REIT Real Estate Assets or "qualified
temporary investment income" (i.e., income derived from "new capital"
within one year of the receipt of such capital) (the "75% Gross Income
Test");
(b) at least 95% of the Company's gross income for each taxable year must
be derived from sources of income qualifying for the 75% Gross Income Test,
dividends, interest, and gains from the sale of stock or other securities
(including certain interest rate swap and cap agreements entered into to
hedge variable rate debt incurred to acquire Qualified REIT Real Estate
Assets) not held for sale in the ordinary course of business (the "95%
Gross Income Test"); and
(c) less than 30% of the Company's gross income is derived from the sale
of Qualified REIT Real Estate Assets held for less than four years, stock
or securities held for less than one year (including certain interest rate
swap and cap agreements entered into to hedge variable rate debt incurred
to acquire Qualified Real Estate Assets) and certain "dealer" property (the
"30% Gross Income Test"). Pursuant to recently enacted legislation, the 30%
Gross Income tax has been repealed for taxable years beginning after
August 5, 1997. See "--Recent Legislation."
The Company intends to maintain its REIT status by carefully monitoring its
income, including income from hedging transactions and sales of Mortgage-
Backed Securities, to comply with the REIT Gross Income Tests. In particular,
the Company will treat income generated by its interest rate caps and other
hedging instruments as non-qualifying income for purposes of the 95% Gross
Income Test unless it receives advice from its tax advisor that such income
constitutes qualifying income for purposes of such test. Under certain
circumstances, for example, (i) the sale of a substantial amount of Mortgage-
Backed Securities to repay borrowings in the event that other credit is
unavailable or (ii) an unanticipated decrease in the qualifying income
17
of the Company which may result in the non-qualifying income exceeding 5% of
gross income or a breach of the 30% Gross Income Test, the Company may be
unable to comply with certain of the REIT Gross Income Tests. See "--Taxation
of the Company" for a discussion of the tax consequences of failure to comply
with the REIT Provisions of the Code.
Recent Legislation
Under legislation which was enacted as part of the Taxpayer Relief Act of
1997, the 30% Gross Income Test has been repealed, facilitating disposition of
Qualified REIT Real Estate Assets or other stock or securities held by the
Company. In addition, the categories of hedges of the Company's liabilities
(incurred to acquire Qualified REIT Real Estate Assets) which may produce
income or gain on sale qualifying under the 95% Gross Income Test has been
expanded to include options, futures contracts, forward rate agreements or
similar financial instruments. However, hedges of the Company's Qualified REIT
Real Estate Assets themselves would still not produce income qualifying under
either the 95% Gross Income Test or the 75% Gross Income Test, limiting the
Company's ability to hedge its interest rate and prepayment risks.
Under the recent legislation, a REIT may elect to retain, rather than
distribute, its net long-term capital gains and pay the tax on such gains,
while its stockholders include their proportionate share of the undistributed
long-term capital gains in income and receive a credit for their share of the
tax paid by the REIT.
This legislation is effective for taxable years of the Company beginning
after August 5, 1997.
Distribution Requirement
The Company must generally distribute to its stockholders an amount equal to
at least 95% of the Company's REIT taxable income before deductions of
dividends paid and excluding net capital gain.
Taxation of the Company
In any year in which the Company qualifies as a REIT, the Company will
generally not be subject to Federal income tax on that portion of its REIT
taxable income or capital gain which is distributed to its stockholders. The
Company will, however, be subject to Federal income tax at normal corporate
income tax rates upon any undistributed taxable income or capital gain.
Notwithstanding its qualification as a REIT, the Company may also be subject
to tax in certain other circumstances. If the Company fails to satisfy either
the 75% or the 95% Gross Income Test, but nonetheless maintains its
qualification as a REIT because certain other requirements are met, it will
generally be subject to a 100% tax on the greater of the amount by which the
Company fails either the 75% or the 95% Gross Income Test. The Company will
also be subject to a tax of 100% on net income derived from any "prohibited
transaction," and if the Company has (i) net income from the sale or other
disposition of "foreclosure property" which is held primarily for sale to
customers in the ordinary course of business or (ii) other non-qualifying
income from foreclosure property, it will be subject to Federal income tax on
such income at the highest corporate income tax rate. In addition, if the
Company fails to distribute during each calendar year at least the sum of (i)
85% of its REIT ordinary income for such year and (ii) 95% of its REIT capital
gain net income for such year, the Company would be subject to a 4% Federal
excise tax on the excess of such required distribution over the amounts
actually distributed during the taxable year, plus any undistributed amount of
ordinary and capital gain net income from the preceding taxable year. The
Company may also be subject to the corporate alternative minimum tax, as well
as other taxes in certain situations not presently contemplated.
If the Company fails to qualify as a REIT in any taxable year and certain
relief provisions of the Code do not apply, the Company would be subject to
Federal income tax (including any applicable alternative minimum tax) on its
taxable income at the regular corporate income tax rates. Distributions to
stockholders in any year in which the Company fails to qualify as a REIT would
not be deductible by the Company, nor would they generally be required to be
made under the Code. Further, unless entitled to relief under certain other
provisions of the Code, the Company would also be disqualified from re-
electing REIT status for the four taxable years following the year during
which it became disqualified.
18
The Company intends to monitor on an ongoing basis its compliance with the
REIT requirements described above. In order to maintain its REIT status, the
Company will be required to limit the types of assets that the Company might
otherwise acquire, or hold certain assets at times when the Company might
otherwise have determined that the sale or other disposition of such assets
would have been more prudent.
Taxable Subsidiaries
Hedging activities and the creation of Mortgage-Backed Securities through
securitization may be done through a taxable subsidiary of the Company. The
Company and one or more other entities may form and capitalize one or more
taxable subsidiaries. In order to ensure that the Company would not violate
the more than 10% voting stock of a single issuer limitation described above,
the Company would own only nonvoting preferred and common stock and the other
entities would own all of the voting common stock. The value of the Company's
investment in such a subsidiary must also be limited to less than 5% of the
value of the Company's total assets at the end of each calendar quarter so
that the Company can also comply with the 5% of value, single issuer asset
limitation described above under "--General--Asset Tests." The taxable
subsidiary would not elect REIT status and would distribute only net after-tax
profits to its stockholders, including the Company. Before the Company engages
in any hedging or securitization activities or forms any such taxable
subsidiary corporation, the Company will obtain an opinion of its tax advisor
to the effect that such activities or the formation and contemplated method of
operation of such corporation will not cause the Company to fail to satisfy
the REIT Asset and REIT Gross Income Tests.
Taxation of Stockholders; Common Stock
Distributions (including constructive distributions) made to holders of
Common Stock, other than tax-exempt entities, will generally be subject to tax
as ordinary income to the extent of the Company's current and accumulated
earnings and profits as determined for Federal income tax purposes. If the
amount distributed exceeds a stockholder's allocable share of such earnings
and profits, the excess will be treated as a return of capital to the extent
of the stockholder's adjusted basis in the Common Stock, which will reduce the
stockholder's basis in the Common Stock but not be subject to tax, and
thereafter as a gain from the sale or exchange of a capital asset.
Distributions designated by the Company as capital gain dividends will
generally be subject to tax as long-term capital gain to stockholders, to the
extent that the distribution does not exceed the Company's actual net capital
gain for the taxable year. Distributions by the Company, whether characterized
as ordinary income or as capital gain, are not eligible for the corporate
dividends received deduction. In the event that the Company realizes a loss
for the taxable year, stockholders will not be permitted to deduct any share
of that loss. Further, if the Company (or a portion of its assets) were to be
treated as a taxable mortgage pool, any "excess inclusion income" that is
allocated to a stockholder would not be allowed to be offset by a net
operating loss of such stockholder. Future Treasury Department regulations may
require that the stockholders take into account, for purposes of computing
their individual alternative minimum tax liability, certain tax preference
items of the Company.
Dividends declared during the last quarter of a taxable year and actually
paid during January of the following taxable year are generally treated as if
received by the stockholder on December 31 of the taxable year in which
declared and not on the date actually received. In addition, the Company may
elect to treat certain other dividends distributed after the close of the
taxable year as having been paid during such taxable year, but stockholders
will be treated as having received such dividend in the taxable year in which
the distribution is actually made.
Upon a sale or other disposition of the Common Stock, a stockholder will
generally recognize a capital gain or loss in an amount equal to the
difference between the amount realized and the stockholder's adjusted basis in
such stock, which gain or loss will be long-term if the stock has been held
for more than one year. Any loss on the sale or exchange of a share of Common
Stock held by a stockholder for six months or less will generally be treated
as a long-term capital loss to the extent of any long-term capital gain
dividends received by such stockholder with respect to such share of its
stock.
19
The Company is required under Treasury Department regulations to demand
annual written statements from the record holders of designated percentages of
its capital stock disclosing the actual and constructive ownership of such
stock and to maintain permanent records showing the information it has
received as to the actual and constructive ownership of such stock and a list
of those persons failing or refusing to comply with such demand.
In any year in which the Company does not qualify as a REIT, distributions
made to its stockholders would be taxable in the same manner discussed above,
except that no distributions could be designated as capital gain dividends,
distributions would be eligible for the corporate dividends received
deduction, the excess inclusion income rules would not apply to the
stockholders, and stockholders would not receive any share of the Company's
tax preference items. In such event, however, the Company could be subject to
potentially substantial Federal income tax liability, and the amount of
earnings and cash available for distribution to its stockholders could be
significantly reduced or eliminated.
Taxation of Tax-Exempt Entities
Subject to the discussion below regarding a "pension-held REIT," a tax-
exempt stockholder is generally not subject to tax on distributions from the
Company or gain realized on the sale of the Common Stock, provided that such
stockholder has not incurred indebtedness to purchase or hold its Common
Stock, that its shares are not otherwise used in an unrelated trade or
business of such stockholder, and that the Company, consistent with its
present intent, does not hold a residual interest in a REMIC that gives rise
to "excess inclusion" income as defined under section 860E of the Code. If the
Company were to be treated as a "taxable mortgage pool," however, a
substantial portion of the dividends paid to a tax-exempt stockholder may be
subject to tax as UBTI. Although the Company does not believe that the
Company, or any portion of its assets, will be treated as a taxable mortgage
pool, no assurance can be given that the IRS might not successfully maintain
that such a taxable mortgage pool exists.
If a qualified pension trust (i.e., any pension or other retirement trust
that qualifies under section 401(a) of the Code) holds more than 10% by value
of the interests in a "pension-held REIT" at any time during a taxable year, a
substantial portion of the dividends paid to the qualified pension trust by
such REIT may constitute UBTI. For these purposes, a "pension-held REIT" is
any REIT (i) that would not have qualified as a REIT but for the provisions of
the Code which look through qualified pension trust stockholders to the
qualified pension trust's beneficiaries in determining ownership of stock of
the REIT and (ii) in which at least one qualified pension trust holds more
than 25% by value of the interests of such REIT or one or more qualified
pension trusts (each owning more than a 10% interest by value in the REIT)
hold in the aggregate more than 50% by value of the interests in such REIT.
Assuming compliance with the Ownership Limit provisions it is unlikely that
pension plans will accumulate sufficient stock to cause the Company to be
treated as a pension-held REIT.
Distributions to certain types of tax-exempt stockholders exempt from
Federal income taxation under sections 501(c)(7), (c)(9), (c)(17), and (c)(20)
of the Code may also constitute UBTI, and such prospective investors should
consult their tax advisors concerning the applicable "set aside" and reserve
requirements.
State and Local Taxes
The Company and its stockholders may be subject to state or local taxation
in various jurisdictions, including those in which it or they transact
business or reside. The state and local tax treatment of the Company and its
stockholders may not conform to the Federal income tax consequences discussed
above. Consequently, prospective stockholders should consult their own tax
advisors regarding the effect of state and local tax laws on an investment in
the Common Stock.
Certain United States Federal Income Tax Considerations Applicable to Foreign
Holders
The following discussion summarizes certain United States Federal tax
consequences of the acquisition, ownership and disposition of the Common Stock
by a purchaser of the Common Stock that, for United States
20
Federal income tax purposes, is not a "United States person" (a "Non-United
States Holder"). For purposes of this discussion, a "United States person"
means: a citizen or resident of the United States; a corporation, partnership,
or other entity created or organized in the United States or under the laws of
the United States or of any political subdivision thereof; or an estate or
trust whose income is includible in gross income for United States Federal
income tax purposes regardless of its source. This discussion does not
consider any specific facts or circumstances that may apply to a particular
Non-United States Holder. Prospective investors are urged to consult their tax
advisors regarding the United States Federal tax consequences of acquiring,
holding and disposing of Common Stock, as well as any tax consequences that
may arise under the laws of any foreign, state, local or other taxing
jurisdiction.
Dividends
Dividends paid by the Company out of earnings and profits, as determined for
United States Federal income tax purposes, to a Non-United States Holder will
generally be subject to withholding of United States Federal income tax at the
rate of 30%, unless reduced or eliminated by an applicable tax treaty or
unless such dividends are treated as effectively connected with a United
States trade or business. Distributions paid by the Company in excess of its
earnings and profits will be treated as a tax-free return of capital to the
extent of the holder's adjusted basis in his Common Stock, and thereafter as
gain from the sale or exchange of a capital asset as described below. If it
cannot be determined at the time a distribution is made whether such
distribution will exceed the earnings and profits of the Company, the
distribution will be subject to withholding at the same rate as dividends.
Amounts so withheld, however, will be refundable or creditable against the
Non-United States Holder's United States Federal tax liability if it is
subsequently determined that such distribution was, in fact, in excess of the
earnings and profits of the Company. If the receipt of the dividend is treated
as being effectively connected with the conduct of a trade or business within
the United States by a Non-United States Holder, the dividend received by such
holder will be subject to the United States Federal income tax on net income
that applies to United States persons generally (and, with respect to
corporate holders and under certain circumstances, the branch profits tax).
Gain on Disposition
A Non-United States Holder will generally not be subject to United States
Federal income tax on gain recognized on a sale or other disposition of the
Common Stock unless (i) the gain is effectively connected with the conduct of
a trade or business within the United States by the Non-United States Holder,
(ii) in the case of a Non-United States Holder who is a nonresident alien
individual and holds the Common Stock as a capital asset, such holder is
present in the United States for 183 or more days in the taxable year and
certain other requirements are met, or (iii) the Non-United States Holder is
subject to tax under the FIRPTA rules discussed below. Gain that is
effectively connected with the conduct of a trade or business within the
United States by a Non-United States Holder will be subject to the United
States Federal income tax on net income that applies to United States persons
generally (and, with respect to corporate holders and under certain
circumstances, the branch profits tax) but will not be subject to withholding.
Non-United States Holders should consult applicable treaties, which may
provide for different rules.
The Company does not expect to hold assets that would be treated as "United
States real property interests" under the provisions of the Foreign Investment
in Real Property Tax Act of 1980 ("FIRPTA"). Therefore, the FIRPTA provisions
relating to certain distributions to foreign persons and to certain gains
realized by foreign persons on the sale of stock should not apply to non-
United States Holders of the Common Stock.
Information Reporting and Backup Withholding
Under temporary United States Treasury regulations, United States
information reporting requirements and backup withholding tax will generally
not apply to dividends paid on the Common Stock to a Non-United States Holder
at an address outside the United States. Payments by a United States office of
a broker of the proceeds of a sale of the Common Stock is subject to both
backup withholding at a rate of 31% and information reporting
21
unless the holder certifies its Non-United States Holder status under
penalties of perjury or otherwise establishes an exemption. Information
reporting requirements (but not backup withholding) will also apply to
payments of the proceeds of sales of the Common Stock by foreign offices of
United States brokers, or foreign brokers with certain types of relationships
to the United States, unless the broker has documentary evidence in its
records that the holder is a Non-United States Holder and certain other
conditions are met, or the holder otherwise establishes an exemption.
Backup withholding is not an additional tax. Any amounts withheld under the
backup withholding rules will be refunded or credited against the Non-United
States Holder's United States Federal income tax liability, provided that the
required information is furnished to the Internal Revenue Service.
These information reporting and backup withholding rules are under review by
the United States Treasury and their application to the Common Stock could be
changed by future regulations.
FUTURE REVISIONS IN POLICIES AND STRATEGIES
The Board of Directors has established the investment policies and operating
policies and strategies set forth in this Prospectus. The Board of Directors
has the power to modify or waive such policies and strategies without the
consent of the stockholders to the extent that the Board of Directors
determines that such modification or waiver is in the best interests of
stockholders. Among other factors, developments in the market which affect the
policies and strategies mentioned herein or which change the Company's
assessment of the market may cause the Board of Directors to revise the
Company's policies and strategies.
COMPETITION
The Company believes that its principal competition in the business of
acquiring and holding Mortgage-Backed Securities is financial institutions
such as banks and savings and loans, life insurance companies, institutional
investors such as mutual funds and pension funds, and certain mortgage REITs.
The existence of these competitive entities, as well as the possibility of
additional entities forming in the future, may increase the competition for
the acquisition of Mortgage-Backed Securities resulting in higher prices and
lower yields on such assets.
22
RISK FACTORS
OPERATIONS RISKS
General
The results of the Company's operations are affected by various factors,
many of which are beyond the control of the Company. The results of the
Company's operations depend on, among other things, the level of net interest
income generated by the Company's Mortgage-Backed Securities, the market value
of such Mortgage-Backed Securities and the supply of and demand for such
Mortgage-Backed Securities. The Company's net interest income varies primarily
as a result of changes in short-term interest rates, borrowing costs and
prepayment rates, the behavior of which involves various risks and
uncertainties as set forth below. Prepayment rates, interest rates and
borrowing costs depend on the nature and terms of the Mortgage-Backed
Securities, conditions in financial markets, the fiscal and monetary policies
of the United States government and the Board of Governors of the Federal
Reserve System, international economic and financial conditions, competition
and other factors, none of which can be predicted with any certainty. Since
changes in interest rates may significantly affect the Company's activities,
the operating results of the Company depend, in large part, upon the ability
of the Company to effectively manage its interest rate and prepayment risks
while maintaining its status as a REIT. See "--Risks Associated with Interest
Rate Changes and Hedging" and "Business Strategy--Capital Investment Policy--
Interest Rate Risk Management."
Risks Associated with Differences Between Mortgage-Backed Security and
Borrowing Characteristics; Rate Adjustment Caps
At December 31, 1997, all of the Mortgage-Backed Securities held by the
Company were Agency Certificates backed by Single-Family Mortgage Loans, of
which approximately 87% had coupon rates which adjust over time (subject to
certain limitations and lag periods) in conjunction with changes in short-term
interest rates, such adjustments being based on an objective index such as
LIBOR, the Treasury Index or the CD Rate. It is expected in the future that a
substantial portion of the Company's Mortgage-Backed Securities will consist
of adjustable-rate Pass-Through Certificates ("ARM Certificates") or floating
rate CMOs which also will be subject to periodic interest rate adjustments
based on such objective indices ("Floaters").
Interest rates on the Company's borrowings are expected to continue to be
based on short-term indices. To the extent any of the Company's Mortgage-
Backed Securities are financed with borrowings bearing interest based on or
varying with an index different from that used for the related Mortgage-Backed
Securities, so-called "basis" interest rate risk results. In such event, if
the index used for the Mortgage-Backed Securities is a "lagging" index that
reflects market interest rate changes on a delayed basis, and the rate borne
by the related borrowings reflects market rate changes more rapidly, the
Company's net interest income will be adversely affected in periods of
increasing market interest rates.
The Company's adjustable-rate Mortgage-Backed Securities are subject to
periodic rate adjustments which may not be matched precisely with increases or
decreases in rates borne by the borrowings or financings utilized by the
Company. Accordingly, in a period of increasing interest rates, the Company
could experience a decrease in net interest income or a net loss because the
interest rates on borrowings could adjust faster than the interest rates on
the Company's adjustable-rate Mortgage-Backed Securities.
Interest rates on the Company's Mortgage-Backed Securities are subject
typically to periodic and lifetime interest rate caps which limit the amount
an interest rate can change during any given period. The Company's borrowings
are not subject to similar restrictions. Hence, in a period of rapidly
increasing interest rates, the Company could also experience a decrease in net
interest income or a net loss because the interest rates on borrowings could
increase without limitation while the interest rates on the Company's
Mortgage-Backed Securities (consisting primarily of ARM Certificates and
Floaters) would be limited by caps. While the Company may hedge certain risks
associated with interest rate increases, no hedging strategy can insulate the
Company
23
completely from interest rate risk. To date, the Company has not entered into
any interest rate hedging agreements.
The Company expects that the net effect of these factors, all other factors
being equal, could be to lower the Company's net interest income or cause a
net loss during periods of rapidly rising market interest rates, which could
negatively impact the level of dividend distributions and reduce the market
price of the Common Stock. This reduction in net income, or net loss, could
occur in an increasing interest rate environment as a result of interest rate
increases in borrowings which are more rapid than interest rate increases on
the Company's Mortgage-Backed Securities or as a result of periodic and
lifetime interest rate caps on the Company's Mortgage-Backed Securities.
Prepayment Risks of Mortgage-Backed Securities
Prepayment rates on Mortgage-Backed Securities vary from time to time and
may cause changes in the amount of the Company's net interest income.
Prepayments of ARM Certificates and Floaters usually can be expected to
increase when mortgage interest rates fall below the then-current interest
rates on ARMs and decrease when mortgage interest rates exceed the then-
current interest rate on ARMs, although such effects are not predictable.
Prepayment experience also may be affected by the conditions in the housing
and financial markets, general economic conditions and the relative interest
rates on fixed-rate and adjustable-rate mortgage loans underlying Mortgage-
Backed Securities. Some Mortgage-Backed Securities are structured so that
certain classes are provided protection from prepayments for a period of time.
However, in a period of extremely rapid prepayments, during which earlier-
paying classes may be retired faster than expected, the protected classes may
receive unscheduled payments of principal earlier than expected and would have
average lives that, while longer than the average lives of the earlier-paying
classes, would be shorter than originally expected. The Company seeks to
minimize prepayment risk through a variety of means, including structuring a
diversified portfolio with a variety of prepayment characteristics, investing
in certain Mortgage-Backed Security structures which have prepayment
protection, and balancing assets purchased at a premium with assets purchased
at a discount. No strategy, however, can completely insulate the Company from
prepayment risks arising from the effects of interest rate changes. Prepayment
risk may be increased if the Company purchases interest-only strips to protect
against interest rate increases. Certain Mortgage-Backed Securities may have
underlying mortgage loans which are convertible to fixed-rate loans. Since
converted loans are required to be repurchased by the applicable Agency
(FHLMC, FNMA or GNMA) or servicer, the conversion of a loan results, in
effect, in the prepayment of such loan.
Changes in anticipated prepayment rates of Mortgage-Backed Securities could
affect the Company in several adverse ways. A portion of the Mortgage-Backed
Securities to be acquired by the Company may be recently originated and bear
initial interest rates which are lower than their "fully-indexed" rates (the
applicable index plus margin). In the event that such a Mortgage-Backed
Security is prepaid faster than anticipated prior to or soon after the time of
adjustment to a fully-indexed rate, the Company will experience an adverse
effect on its net interest income during the time it holds such Mortgage-
Backed Security compared with holding a fully-indexed Mortgage-Backed Security
and will lose the opportunity to receive interest at the fully-indexed rate
over the expected life of the Mortgage-Backed Security. In addition, the
faster than anticipated prepayment of any Mortgage-Backed Security that is
purchased at a premium by the Company would generally result in a faster than
anticipated write-off of any remaining capitalized premium amount and
consequent reduction of the Company's net interest income by such amount. At
December 31, 1997, a majority of the Company's Mortgage-Backed Securities had
been acquired at a premium. While the effects of prepayments may be mitigated
to the extent the Company acquires Mortgage-Backed Securities at a discount,
to date, a substantial majority of the Company's Mortgage-Backed Securities
have been acquired at a premium, rather than a discount.
Risks Associated with Leverage
The Company's financing strategy is designed to increase the size of its
Mortgage-Backed Security investment portfolio by borrowing a substantial
portion (which may vary depending upon the mix of the
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Mortgage-Backed Securities in the Company's portfolio and the application of
the Company's Capital Investment Policy requirements to such mix of Mortgage-
Backed Securities) of the market value of its Mortgage-Backed Securities. If
the coupon income on the Mortgage-Backed Securities purchased with borrowed
funds fails to cover the cost of the borrowings, the Company will experience
net interest losses and may experience net losses. Such losses could be
increased substantially as a result of the Company's substantial leverage.
The Company expects generally 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 deemed relevant by management.
However, the Company is not limited under its Bylaws in respect of the amount
of its borrowings, whether secured or unsecured, and the debt-to-equity ratio
could at times be greater than 12:1. For purposes of calculating the debt-to-
equity ratio, the Company's equity equals the value of the Company's
investment portfolio on a mark-to-market basis less the book value of the
Company's obligations under repurchase agreements and other collateralized
borrowings. At December 31, 1997, the debt-to-equity ratio of the Company was
7:1.
The ability of the Company to achieve its investment objectives depends on
its ability to borrow money in sufficient amounts and on favorable terms.
Through increases in haircuts (i.e., the over-collateralization amount
required by a lender), decreases in the market value of the Company's
Mortgage-Backed Securities, increases in interest rate volatility, changes in
the availability of financing in the market, conditions then applicable in the
lending market and other factors, the Company may not be able to achieve the
degree of leverage it believes to be optimal, which may cause the Company to
be less profitable than it would be otherwise. In addition, as a result of the
Company's intention to structure its investment portfolio to qualify for an
exemption from regulation as an investment company, the Company may be limited
in the types and amounts of Mortgage-Backed Securities it can purchase which,
in turn, may affect the ability of the Company to achieve the degree of
leverage it believes to be optimal.
Risk of Decline in Market Value of Mortgage-Backed Securities; Margin Calls
and Defaults
Although, at December 31, 1997 and as of the date hereof, none of the
Company's Mortgage-Backed Securities were or are cross-collateralized to
secure multiple borrowing obligations of the Company to a single lender, the
Company's Mortgaged-Backed Securities may be cross-collateralized in the
future. A decline in the market value of such assets may limit the Company's
ability to borrow or result in lenders initiating margin calls (i.e.,
requiring a pledge of cash or additional Mortgage-Backed Securities to re-
establish the ratio of the amount of the borrowing to the value of the
collateral). The Company's fixed-rate Mortgage-Backed Securities generally are
more susceptible to margin calls as increases in interest rates tend to more
negatively affect the market value of fixed-rate Mortgage-Backed Securities
than adjustable-rate Mortgage-Backed Securities. This remains true despite
effective hedging against such fluctuations as the hedging instruments may not
be part of the collateral securing the collateralized borrowings.
Additionally, it may be difficult to realize the full value of the hedging
instrument when desired for liquidity purposes due to the applicable REIT
Provisions of the Code. The Company could be required to sell Mortgage-Backed
Securities under adverse market conditions in order to maintain liquidity.
Such sales may be effected by the Company when deemed necessary in order to
preserve the capital base of the Company. If these sales were made at prices
lower than the amortized cost of the Mortgage-Backed Securities, the Company
would experience losses. A default by the Company under its collateralized
borrowings could also result in a liquidation of the collateral, including any
cross-collateralized assets, and a resulting loss of the difference between
the value of the collateral and the amount borrowed.
Additionally, in the event of a bankruptcy of the Company, certain
repurchase agreements may qualify for special treatment under the Bankruptcy
Code, the effect of which is, among other things, to allow the creditors under
such agreements to avoid the automatic stay provisions of the Bankruptcy Code
and to liquidate the collateral under such agreements without delay.
To the extent the Company is compelled to liquidate Mortgage-Backed
Securities qualifying as Qualified REIT Real Estate Assets to repay
borrowings, the Company may be unable to comply with the REIT Provisions