Back to GetFilings.com
As filed with the Securities and Exchange Commission on March 31, 1999
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------------
FORM 10-K
(Mark One)
[X]ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
For the period ended December 31, 1998; or
[_]TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the transition period from to
Commission File No. 001-13709
----------------
ANWORTH MORTGAGE ASSET CORPORATION
(Exact name of Registrant as specified in its charter)
Maryland 52-2059785
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
1299 Ocean Avenue, #200, Santa Monica, California 90401
(Address of principal executive offices)
Registrant's telephone number, including area code: (310) 394-0115
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of exchange on which registered
------------------- ------------------------------------
Common stock, par value $0.01 per share American Stock Exchange
----------------
Indicate by a 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 shorter period that the registrant was
required to file such reports), and (2) has been subject to filing
requirements for the past 90 days. Yes [X] No [_]
Indicate by a check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Annual Report on Form
10-K or any amendment to this Annual Report on Form 10-K. [_]
At March 5, 1999 the aggregate market value of the voting stock held by non-
affiliates of the Registrant was $10,890,263, based on the closing price of
the common stock on the American Stock Exchange.
As of March 5, 1999, 2,317,100 shares of Common Stock, $0.01 par value per
share were issued and outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement which the Company
intends to issue within 120 days of the end of the fiscal year, are
incorporated by reference into Part III.
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
ANWORTH MORTGAGE ASSET CORPORATION
1998 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
Page
----
PART 1.................................................................. 1
ITEM 1. BUSINESS................................................... 1
ITEM 2. PROPERTIES................................................. 39
ITEM 3. LEGAL PROCEEDINGS.......................................... 40
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........ 40
PART II................................................................. 40
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
SHAREHOLDER MATTERS....................................... 40
ITEM 6. SELECTED FINANCIAL DATA.................................... 41
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS................................. 42
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK...................................................... 48
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................ 48
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE.................................. 48
PART III................................................................ 49
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT......... 49
ITEM 11. EXECUTIVE COMPENSATION..................................... 49
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT................................................ 49
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS............. 49
PART IV................................................................. 49
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON
FORM 8-K.................................................. 49
GLOSSARY
FINANCIAL STATEMENTS
SIGNATURES
EXHIBITS
i
INTRODUCTORY NOTE
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
applicable federal securities laws. 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," "intend," "should,"
"expect," "anticipate," "estimate" or "continue" or the negatives thereof or
other comparable terminology. Forward-looking statements included herein
regarding the actual results, performance and achievements of the Company are
dependent on a number of factors. The Company's actual results could differ
materially from those anticipated in such forward-looking statements as a
result of certain 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 28 of this Annual Report on 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 51 of the report for
definitions of terms used in the following description of the Company's
business and elsewhere in this report.
PART 1
ITEM 1. BUSINESS
SUMMARY OF THE COMPANY
General
The Company was formed in October 1997 to invest in mortgage assets,
including mortgage pass-through certificates, collateralized mortgage
obligations, mortgage loans and other securities representing interests in, or
obligations backed by, pools of mortgage loans which can be readily financed
and short-term investments. On March 17, 1998, the Company completed its
initial public offering of 2,200,000 shares raising $18,414,000 in proceeds.
In connection with the underwriters' over-allotment allowance, approximately
one month later, an additional 127,900 shares of Common Stock were sold
raising $1,071,000 in proceeds. The Company utilized the equity capital raised
in its offering and short term borrowings to generate income based on the
difference between the yield on its mortgage assets and the cost of its
borrowings. The Company will elect to be taxed as a REIT under the Code, and
therefore is not generally subject to federal taxes on its income to the
extent it distributes its net income to its stockholders and maintains its
qualification as a REIT. See "Federal Income Tax Considerations--Requirements
for Qualification as a REIT--Distribution Requirement."
The goal of the Company is to generate a competitive yield through its use
of leverage and active management of the asset/liability yield spread.
The Company acquires mortgage assets primarily in the secondary mortgage
market through its manager, Anworth Mortgage Advisory Corporation (the
"Manager"). The Manager manages the day-to-day operations of the Company,
pursuant to the policies established by the Company's Board of Directors and
the authority delegated to the Manager under the Management Agreement. The
Manager is under common control with Pacific Income Advisers, Inc. ("PIA"), an
investment advisory firm which began operations in 1986. The Manager's
management team are selected members of PIA's management. The Company is
externally managed by the Manager, taking advantage of the economies of scale
associated with the Manager while avoiding duplicate
1
administrative functions and incurring the costs of creating a new
administrative infrastructure. The Company has no ownership interest in the
Manager.
The Company's mortgage assets consist primarily of mortgage securities
("Mortgage Securities") bearing interest rates that adjust periodically based
on changes in short-term interest rates. The Company uses short-term
borrowings utilizing its Mortgage Assets as collateral to acquire additional
Mortgage Assets, while generally maintaining a debt-to-equity ratio of between
8:1 and 12:1, although the ratio may vary from time to time based upon market
conditions and other factors deemed relevant by the Manager and the Company's
Board of Directors. The Company manages actively, on an aggregate basis, both
the interest rate indices and interest rate adjustment periods of its
borrowings against the interest rate indices and interest rate adjustment
periods on its Mortgage Assets.
While at least 70% of the total assets acquired by the Company must be
Primary adjustable-rate Mortgage Securities and Short-Term Investments
(investments with an average life of one year or less), all of the assets
acquired to date by the Company have been Primary adjustable rate Mortgage
Securities. "Primary" as used herein means either (i) securities that are
rated within one of the two highest rating categories by at least one of
either Standard & Poor's Rating Services, a division of The McGraw-Hill
Companies, Inc. ("Standard & Poor's") or Moody's Rating Service, Inc.
("Moody's" and together with Standard & Poor's, the "Rating Agencies"), or
(ii) securities that are unrated but are either obligations the United States
or obligations guaranteed by the United States government or an agency or
instrumentality of the United States government.
The remainder of the Company's investment portfolio, comprising not more
than 30% of its total assets, may consist of Mortgage Assets which are
unrated, or, if rated, are less than Primary, including (i) Mortgage Loans
secured by first liens on single-family (one-to-four units) residential
properties, (ii) Mortgage Securities backed by loans on single-family, multi-
family, commercial, or other real estate-related properties which are rated at
least Investment Grade (rated at least "BBB" or "Baa" by Standard & Poor's or
Moody's, respectively) or (as to single-family and multi-family Mortgage
Securities) the equivalent, if not rated, (iii) fixed-rate Mortgage Assets,
including the acquisition of such assets for the purpose of being combined
with hedging instruments to obtain investment characteristics similar to
adjustable-rate Mortgage Assets, and (iv) Other Mortgage Securities. "Other
Mortgage Securities" as used herein means securities representing interests
in, or secured by Mortgages on, real property other than Pass-Through
Certificates and CMOs and may include non-Primary certificates and other
securities collateralized by single-family loans, Mortgage Warehouse
Participations, Mortgage Derivative Securities, Subordinated Interests,
securities of other REITs and other mortgage-backed and mortgaged
collateralized obligations.
Summary of Strategy
The principal business objective of the Company is to generate a competitive
yield through its use of leverage and active management of the asset/liability
yield spread. Following is the Company's strategy to achieve its business
objective:
Investment Strategy
The Company applies a disciplined approach to managing its investments in an
attempt to achieve competitive yields while managing portfolio risk. The
Company utilized the proceeds of its initial public offering and short-term
borrowings to generate income based on the difference between the yield on its
Mortgage Assets and the cost of its borrowings. The Company seeks to minimize
prepayment risk by structuring a diversified portfolio with a variety of
prepayment characteristics and by analyzing the prepayment risk of the
Mortgage Assets, as well as the deviations between projected and realized
prepayment rates.
Financing Strategy
The Company employs a strategy of attempting to increase profitability
through growth in Mortgage Asset volume achieved by leverage based upon short-
term borrowings, primarily reverse repurchase agreements and
2
dollar-roll agreements. The Company generally maintains a debt-to-equity ratio
of between 8:1 and 12:1, although the ratio varies from time to time depending
on market conditions and other factors deemed relevant by the Manager and the
Company's Board of Directors. Depending on the different cost of borrowing
funds at different maturities, the Company varies the maturities of its
borrowed funds to attempt to produce lower borrowing costs. The Company's
borrowings are short-term and the Company attempts to actively manage, on an
aggregate basis, the interest rate indices and interest rate adjustment
periods of its borrowings against the interest rate indices and interest rate
adjustment periods on its Mortgage Assets.
Although it has not yet done so, over time, to the extent the Company
believes it can lower its cost of funds or increase its return to investors,
it may seek to raise additional capital through accessing the capital markets.
In addition, to the extent the Company develops appropriate infrastructure, it
may access the securitization market to raise additional funds for operations.
Risk Management Strategy
Interest Rate and Volatility Risk. If the general level of interest rates
increases or the expected level of volatility of interest rates increases, the
Company's assets are likely to decline in value. The Company uses mathematical
modeling and quantitative analysis to monitor the interest rate sensitivity of
its Mortgage Asset portfolio. The analysis includes the use of mathematical
assumptions regarding the effect of mortgage loan prepayments and interest
rate caps incorporated in most adjustable-rate mortgage securities, as well as
interest rate volatility on its portfolio of Mortgage Assets. Comparison of
interest rate sensitivity factors to the quantitative and qualitative nature
of the Company's borrowings provides the Company with a qualitative measure of
the impact that interest rate movements could have on the Company's net
interest income. Management evaluates continually these mathematical
assumptions and, if necessary, adjusts its Mortgage Asset portfolio
accordingly.
Credit Risk. The Company has invested in Mortgage Assets, primarily mortgage
pass-through certificates and short-term investments. Although it has not yet
done so, the Company may also invest in collateralized mortgage obligations,
mortgage loans and other securities representing interests in or obligations
backed by pools of mortgage loans which can be readily financed. If an issuer
of a security owned by the Company defaults, the value of the security is
likely to decline, either temporarily or permanently. The Company continually
monitors the credit quality of its Mortgage Assets and maintains appropriate
capital levels for allowances and possible credit losses. The Company manages
the credit risk of its Mortgage Assets through, among other activities,
(i) complying with the Company's policies with respect to credit risk
concentration, (ii) actively monitoring the ongoing credit quality and
servicing of its Mortgage Assets and (iii) maintaining appropriate capital
levels and allowances for possible credit losses.
Hedging. Although it has not yet done so, the Company may enter into hedging
transactions designed to protect itself to varying degrees against interest
rate changes. The Company may purchase interest rate caps and interest rate
swaps to mitigate the risk of its short-term borrowings increasing at a
greater rate than the yields on its Mortgage Assets during a period of rising
interest rates. The Company may also, to the extent consistent with its
qualifications as a REIT and Maryland law, utilize financial futures contracts
and put and call options on financial futures contracts and trade forward
contracts as a hedge against future interest rate changes. However, no hedging
strategy can completely insulate the Company from interest rate risks and
market movement, and the federal tax laws applicable to REITs may
substantially limit the Company's ability to engage in hedging transactions.
Additionally, hedging strategies have significant transaction costs and the
Company will not be able to significantly reduce or eliminate the risk
associated with its investment portfolio without reducing or perhaps even
eliminating the return on its investments.
There can be no assurance that the Company will successfully implement its
strategies. See "Risk Factors" for a discussion of factors that could affect
the Company's ability to successfully implement its strategy.
3
The Manager
The Manager implements the Company's business strategy on a day-to-day basis
and performs certain services for the Company, pursuant to policies
established by the Company's Board of Directors and the authority delegated to
the Manager under the Management Agreement. The Manager is responsible
primarily for two areas of activity: (i) asset/liability management, which
consists of the acquisition, disposition, financing, hedging and management of
Mortgage Assets and includes credit and prepayment risk management; and
(ii) capital management, which consists of structuring, analysis, capital
raising and investor relations activities. With respect to the Company's
investment strategy, the Manager employs mortgage analytical tools to
generally construct a diversified Mortgage Asset portfolio. With respect to
the Company's financing strategy, the Manager arranges for various types of
financing for the Company and manages actively the interest rate structure of
the Company's assets and liabilities and monitors the Company's portfolio
leverage. With respect to the Company's risk management strategy, the Manager
monitors the projected change in the portfolio's value based upon assumed
changes in interest rates and, if necessary, attempts to adjust the portfolio
accordingly. The Manager monitors the credit quality of each asset in the
Company's portfolio and seeks to ensure that the overall credit quality of the
portfolio is in keeping with the Company's credit policies as adopted by the
Company's Board of Directors. The Manager evaluates the Company's interest
rate risk levels and performs such analyses as may be required to determine
what types and amounts of hedging transactions are advisable for the Company
given the configuration of its portfolio and seeks to execute trades to
maintain hedges. The Manager is also be required to perform the following
services for the Company: (i) providing regular reports regarding the Company
to the Board of Directors, (ii) monitoring the Company's status as a REIT from
tax and compliance standpoints and (iii) providing managerial, administrative
and management information systems support for the Company.
Prior to its association with the Company, the Manager had not previously
managed a REIT. In particular, the Manager had not previously managed a
highly-leveraged pool of Mortgage Assets or utilized hedging instruments, nor
did the Manager have experience in complying with the asset limitations
imposed by the REIT Provisions of the Code. Although management of the Company
and the Manager have investment management experience, there can be no
assurance that the past experience of the executive officers of the Company
and the Manager is appropriate to the business of the Company. Further, the
experience of the officers of the Manager and PIA should not be viewed as a
reliable gauge of the potential success of the Company. See "Risk Factors--
Lack of Prior Experience."
The Company has entered into a management agreement (the "Management
Agreement") between the Company and the Manager for an initial term of five
years from the date of the closing of the Company's initial public offering.
Pursuant to the Management Agreement with the Manager, the Company pays the
Manager an annual base management fee based on Average Net Invested Assets,
payable monthly in arrears, equal to 1% of the first $300 million of Average
Net Invested Assets, plus 0.8% of the portion above $300 million of Average
Net Invested Assets. Average Net Invested Assets is generally defined as total
assets less total debt incurred to finance assets; accordingly, incurring debt
to finance asset purchases does not necessarily increase Average Net Invested
Assets.
The Company also pays the Manager, as incentive compensation for each fiscal
quarter, an amount equal to 20% of the Net Income of the Company, before
incentive compensation, in excess of the amount that would produce an
annualized Return on Equity equal to the Ten Year U.S. Treasury Rate (average
of weekly average yield to maturity for U.S. Treasury securities (adjusted to
a constant maturity of 10 years), as published weekly by the Federal Reserve
Board during a quarter) plus 1%. A deduction for the Company's interest
expenses for borrowed money is taken in calculating Net Income. "Return on
Equity" is computed on Average Net Worth and has no necessary correlation with
the actual distributions received by stockholders. The incentive compensation
calculation and payment to the Manager is made quarterly in arrears before any
income distributions are made to stockholders for the corresponding period.
After the expiration of the initial five-year term, the Management Agreement
will be automatically renewed for additional one-year terms unless terminated
by the Company or the Manager upon written notice. Except in
4
the case of a termination or non-renewal by the Company for cause, upon
termination or non-renewal of the Management Agreement by the Company, the
Company is obligated to pay the Manager a termination or non-renewal fee equal
to the fair market value of the Management Agreement without regard to the
Company's termination or non-renewal right as determined by an independent
appraisal. The selection of the independent appraiser shall be subject to the
approval of the Unaffiliated Directors. The payment of such a termination or
non-renewal fee by the Company would adversely affect the cash available for
distribution to the Company's stockholders and may have a material adverse
effect on the Company's operations.
OPERATING POLICIES AND PROGRAMS
Asset Acquisition Policy
The principal business objective of the Company is to earn a competitive
yield through the management of Mortgage Assets and their risks, the use of
leverage, the active management of the asset/liability yield spread, and the
employment of the Company's risk management strategies. In addition, the
Company's structure provides investors with a vehicle to participate in the
mortgage securities market. The Company's Mortgage Assets are held primarily
for investment. The Company generally buys and holds Mortgage Assets to
maturity and, therefore, has a low portfolio turnover rate. The Company's
ability to sell Mortgage Assets for gain is restricted by the REIT Provisions
of the Code and the rules, regulations and interpretations of the Service
thereunder. See "Federal Income Tax Considerations--Requirements for
Qualification as a REIT--Gross Income Tests."
At least 70% of the total assets acquired by the Company are Primary
adjustable-rate Mortgage Securities and Short-Term Investments (investments
with maturities of one year or less). "Primary" as used herein means either
(i) securities that are rated within one of the two highest rating categories
by at least one of either Standard & Poor's or Moody's, or (ii) securities
that are unrated but are either obligations the United States or obligations
guaranteed by the United States government or an agency or instrumentality of
the United States government.
The remainder of the Company's investment portfolio, comprising not more
than 30% of its total assets, may consist of Mortgage Assets which are
unrated, or, if rated, are less than Primary, including (i) Mortgage Loans,
(ii) Mortgage Securities backed by loans on single-family, multi-family,
commercial, or other real estate-related properties which are rated at least
Investment Grade (rated at least "BBB" or "Baa" by Standard & Poor's or
Moody's, respectively) or (as to single-family and multi-family Mortgage
Securities) the equivalent, if not rated, (iii) fixed-rate Mortgage Assets,
including the acquisition of such assets for the purpose of being combined
with hedging instruments to obtain investment characteristics similar to
adjustable-rate Mortgage Assets, and (iv) Other Mortgage Securities. "Other
Mortgage Securities" as used herein means securities representing interests
in, or secured by Mortgages on, real property other than Pass-Through
Certificates and CMOs and may include non-Primary certificates and other
securities collateralized by single-family loans, Mortgage Warehouse
Participations, Mortgage Derivative Securities, Subordinated Interests,
securities in other REITs and other mortgage-backed and mortgaged
collateralized obligations.
The Company has not acquired and generally will not acquire Inverse
Floaters, Remic Residuals or First Loss Subordinated Bonds. The Company may
acquire mortgage derivative securities, including, but not limited to,
interest only, principal only or other Mortgage Securities that receive a
disproportionate share of interest income or principal, either as an
independent stand-alone investment opportunity or to assist in the management
of prepayment and other risks (collectively, "Mortgage Derivative
Securities"), but only on a limited basis due to the greater risk of loss
associated with Mortgage Derivative Securities. See "Risk Factors--Failure to
Successfully Manage Interest Rate Risks May Adversely Affect Results of
Operations."
The Company's Board of Directors has adopted the investment policies set
forth in the Company's Prospectus as its initial investment policies. The
policies may be changed at any time, and have been modified slightly during
the reporting period, by the Board of Directors (subject to approval by a
majority of Unaffiliated
5
Directors) without the consent of stockholders. The Company's Board of
Directors will establish and approve (including approval by a majority of
Unaffiliated Directors) at least annually the investment policies of the
company, which will include investment criteria that each Mortgage Asset must
satisfy to be eligible for investment by the Company. The Company will not
purchase any Mortgage Assets from its Affiliates other than Mortgage
Securities that may be purchased from a taxable subsidiary of the Company that
may be formed in connection with the securitization of Mortgage Loans.
Capital and Leverage Policy
The Company financed its purchase of Mortgage Assets initially through
equity from the proceeds of its initial public offering and thereafter
primarily by borrowing against existing Mortgage Assets and using the proceeds
to acquire additional Mortgage Assets. The borrowings are in the form of
reverse repurchase agreements and dollar-roll agreements and may, in the
future, be in the form of loan agreements, lines of credit and other credit
facilities. The Company's borrowings are secured by Mortgage Assets owned by
the Company.
The Company employs a leveraging strategy to increase its investment assets
by borrowing against existing Mortgage Assets and using the proceeds to
acquire additional Mortgage Assets. The Company generally maintains a debt-to-
equity ratio of between 8:1 and 12:1, although the ratio may vary from time to
time depending on market conditions and other factors deemed relevant by the
Manager and Company's Board of Directors. The Company believes that this will
leave an adequate capital base to protect against interest rate environments
in which the Company's borrowing costs might exceed its interest income from
Mortgage Assets. For example, these conditions could occur when the interest
adjustments on Mortgage Assets lag behind interest rate increases in the
Company's short-term borrowings or when the interest rate of the Company's
short-term borrowings are mismatched with the interest rate indices of the
Company's Mortgage Assets. See "Risk Factors--Failure to Successfully Manage
Interest Rate Risks May Adversely Affect Results of Operations" and "Risk
Factors--Interest Rate Fluctuations May Decrease Net Interest Income." The
Company enters into the collateralized borrowings described herein only with
financially sound institutions meeting credit standards approved by the
Company's Board of Directors, including approval by a majority of Unaffiliated
Directors and monitors the financial condition of such institutions on a
regular, periodic basis.
Depending on the different cost of borrowing funds at different maturities,
the Company varies the maturities of its borrowed funds to attempt to produce
lower borrowing costs. The Company's borrowings are short-term and the Company
manages actively, on an aggregate basis, both the interest rate indices and
interest rate adjustment periods of its borrowings against the interest rate
indices and interest rate adjustment periods on its Mortgage Assets.
Mortgage Assets are financed primarily at short-term borrowing rates through
reverse repurchase agreements (a borrowing device evidenced by an agreement to
sell securities to a third party and a simultaneous agreement to repurchase
them at a specified future date and price, the difference constituting the
borrowing rate) and dollar-roll agreements (an agreement to sell a security
for delivery on a specified future date and simultaneous agreement to
repurchase the same or substantially similar security on a specified future
date). In the future the Company may also employ borrowings under lines of
credit and other collateralized financings which the Company may establish
with approved institutional lenders. Currently reverse repurchase agreements
and dollar-roll agreements are the principal financing devices utilized by the
Company to leverage its Mortgage Assets portfolio. Generally, upon repayment
of each reverse repurchase agreement, or repurchase pursuant to a dollar-roll
agreement, the collateral is immediately pledged to secure a new reverse
repurchase agreement or is sold pursuant to a new dollar-roll agreement.
A reverse repurchase agreement, although structured as a sale and repurchase
obligation, effects a financing under which the Company pledges its Mortgage
Assets as collateral to secure a short term loan. Generally, the creditor will
make the loan pursuant to the repurchase agreement in an amount equal to a
percentage of the market value of the collateral, typically 80% to 98%. Given
the Company's investing activities since inception, this percentage has ranged
from 93% to 97% during the reporting period. At the maturity of the reverse
6
repurchase agreement, the Company is required to repay the loan pursuant to
the agreement and correspondingly receives back its collateral. Under reverse
repurchase agreements, the Company generally retains the incidents of
beneficial ownership, including the right to distributions on the collateral
and the right to vote on matters as to which certificate holders are entitled
to vote. Upon a payment default under a repurchase agreement, the lending
party may liquidate the collateral.
Similar to a reverse repurchase agreement as a method of financing Mortgage
Securities, a dollar-roll is a transaction in which the Company sells Mortgage
Securities for delivery on a specified future date and simultaneously
contracts to repurchase the same or substantially the same type of security on
a specified future date. During the roll period, the Company forgoes the
principal and interest payments on the Mortgage Securities. The Company,
however, is compensated by the interest earned on the cash proceeds of the
initial sale and by the typically lower repurchase price at the future date.
Because the roll provides funds to the Company for the period of the roll, its
value can be expressed in terms of an "implied financing rate." This method of
financing is favorable to the Company when the repurchase price is low enough
in comparison to the initial sale price so that the implied financing rate is
below other alternative short-term borrowing rates (e.g., the rate for reverse
repurchase agreements or other short-term borrowings). The Company's ability
to enter into dollar-roll agreements may be limited in order to maintain the
Company's status as a REIT and to avoid the imposition of tax on the Company.
See "Federal Income Tax Considerations--Requirements for Qualification as a
REIT" and "--Taxation of the Company."
Reverse repurchase agreements take the form of a sale of pledged securities
to the lender at a discounted price in return for the lender's agreement to
resell the same or similar securities to the borrower at a future date (the
maturity of the borrowing) at an agreed price. In the event of the insolvency
or bankruptcy of a lender during the term of a reverse repurchase agreement,
provisions of the Federal Bankruptcy Code, if applicable, may permit the
lender to consider the agreement to resell the securities to be an executory
contract that, at the lender's option, may be either assumed or rejected by
the lender. If a bankrupt lender rejects its obligation to resell pledged
securities to the Company, the Company's claim against the lender for the
damages resulting therefrom may be treated as simply one of many unsecured
claims against the lender's assets. 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.
Credit Risk Management Policy
The Company reviews credit risk and other risks of loss associated with each
investment. In addition, the Company seeks to diversify the Company's
portfolio of Mortgage Assets to avoid undue geographic, insurer, industry and
certain other types of concentrations. The Company seeks to reduce certain
risks from sellers and servicers through representations and warranties. The
Company's Board of Directors monitors the overall portfolio risk and
determines appropriate levels of provision for loss.
With respect to its Mortgage Securities, the Company is exposed to various
levels of credit and special hazard risk, depending on the nature of the
underlying Mortgage Assets and the nature and level of credit enhancements
supporting such securities. Agency Certificates are covered by credit
protection in the form of a 100% guarantee from a government sponsored entity
(GNMA, Fannie Mae or FHLMC). Privately Issued Certificates represent interests
in pools of residential mortgage loans with partial credit enhancement. Credit
loss protection for Privately Issued Certificates is achieved through the
subordination of other interests in the pool to the interest held by the
Company, through pool insurance or through other means. The degree of credit
protection varies substantially among Privately Issued Certificates.
The Company reviews the quality of Mortgage Loans at the time of acquisition
and on an ongoing basis. During the time it holds Mortgage Loans, the Company
is subject to risks of borrower defaults and bankruptcies and special hazard
losses (such as those occurring from earthquakes or floods) that are not
covered by standard hazard insurance. However, individual Mortgage Loans may
be covered by FHA insurance, VA guarantees or
7
private mortgage insurance and, to the extent securitized into Agency
Certificates, by such government sponsored entity obligations or guarantees.
Compliance with the Company's credit risk management policy guidelines is
determined at the time of purchase of Mortgage Assets (based upon the most
recent valuation utilized by the Company) and will not be affected by events
subsequent to such purchase, including, without limitation, changes in
characterization, value or rating of any specific Mortgage Assets or economic
conditions or events generally affecting any Mortgage Assets of the type held
by the Company.
Asset/Liability Management Policy
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 Assets and related debt
against the effects of major interest rate changes. Specifically, the
Company's interest rate management program is formulated with the intent to
offset to some extent the potential adverse effects resulting from rate
adjustment limitations on its Mortgage Assets and the differences between
interest rate adjustment indices and interest rate adjustment periods of its
adjustable-rate Mortgage Assets and related borrowings. The Company's interest
rate risk management program encompasses a number of procedures, including the
following: (i) monitoring and adjusting, if necessary, the interest rate
sensitivity of its Mortgage Assets compared with the interest rate
sensitivities of its borrowings; and (ii) attempting to structure its
borrowing agreements relating to adjustable-rate Mortgage Assets to have a
range of different maturities and interest rate adjustment periods (although
substantially all will be less than a 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 or are renewed. Through use of these
procedures, the Company attempts to reduce the risk of differences between
interest rate adjustment periods of adjustable-rate Mortgage Assets and
related borrowings.
Depending on market conditions and the cost of the transactions, the Company
may conduct certain hedging activities in connection with the management of
its Mortgage Asset portfolio, although it has not done so since inception. To
the extent consistent with the Company's election to qualify as a REIT, the
Company follows a hedging strategy intended to mitigate the effects of
interest rate changes and to enable the Company to earn net interest income in
periods of generally rising, as well as declining or static, interest rates.
Specifically, the Company's hedging program is formulated with the intent to
offset to some extent the potential adverse effects of (i) changes in interest
rate levels relative to the interest rates on the Mortgage Assets held in the
Company's investment portfolio, and (ii) differences between the interest rate
adjustment indices and periods of the Company's Mortgage Assets and the
borrowings of the Company. As part of its hedging strategy, the Company also
monitors on an ongoing basis the prepayment risks that arise in fluctuating
interest rate environments.
The Company's hedging policy encompasses a number of procedures. First, the
Company attempts to actively manage, on an aggregate basis, the interest rate
indices and interest rate adjustment periods of its borrowings against the
interest rate indices and interest rate adjustment periods on its Mortgage
Assets. In addition, the Company structures its reverse repurchase borrowing
agreements and dollar-roll agreements to have a range of different maturities
(although substantially all have maturities of less than one year). As a
result, the Company is able to adjust the average maturity of its borrowings
on an ongoing basis by changing the mix of maturities as borrowings come due
and are renewed. In this way, the Company reduces differences between the
interest rate adjustment periods of its Mortgage Assets and related borrowings
that may occur due to prepayments of Mortgage Loans or other factors.
The Company may hedge to some extent against the short-term indebtedness
incurred by the Company to finance its acquisition of Mortgage Assets to
mitigate the effects of interest rate fluctuations or other market movements.
With respect to assets, hedging can be used either to increase the liquidity
or decrease the risk of holding an asset by guaranteeing, in whole or in part,
the price at which such asset may be disposed of prior to
8
its maturity and may also be used to receive interest income in excess of
specified interest rate caps. With respect to indebtedness, hedging can be
used to limit, fix, or cap the interest rate on short-term indebtedness.
In a typical interest rate cap agreement, the cap purchaser makes an initial
lump sum cash payment to the cap seller in exchange for the seller's promise
to make cash payments to the purchaser on fixed dates during the contract term
if prevailing interest rates exceed the rate specified in the contract.
Financial futures contracts are the sale of a futures contract, typically on
Treasury Bills or Eurodollar contracts, creating a firm obligation to deliver
a specific financial instrument at a specified future date and price. Options
on financial futures contracts are similar to options on securities except
that a futures option gives the purchaser the right, in return for the premium
paid, to assume a position in a futures contract and obligates the seller to
deliver that position. Financial futures contracts and options on financial
futures contracts are classified as "commodities" under the federal Commodity
Exchange Act and may also be classified as "securities" for securities law
purposes. The Company does not intend to invest in any other types of
commodities and will not engage in commodities trading. The purchase of
Mortgage Derivative Securities and Excess Servicing Rights can be effective
hedging instruments in certain situations as these investments tend to
increase in value and their yields tend to increase as interest rates rise.
The Company intends to limit its purchases of Mortgage Derivative Securities
and Excess Servicing Rights to those investments qualifying as Qualified REIT
Real Estate Assets. Income from such investments qualifies for purposes of the
95% and 75% sources of income tests applicable to REITs. See "Federal Income
Tax Considerations--Requirements for Qualification as a REIT--Gross Income
Tests."
The Company may acquire Excess Servicing Rights, but only to the extent such
rights constitute a Qualified REIT Real Estate Asset. Excess Servicing Rights
would entitle the Company to receive the interest portion of monthly mortgage
payments not already allocated to either a pass-through certificate or the
administration of mortgage servicing. Because Excess Servicing Rights
represent interest only cash flows from mortgage loans, they behave in a
fashion similar to "interest only" Mortgage Derivative Securities. The Excess
Servicing Rights also will be subject to the general credit of the Servicer
(the entity performing the loan servicing function on Mortgage Loans or Excess
Servicing Rights owned by the Company) and the risk that the Servicer could be
terminated. As part of its loan servicing function, the Servicer collects and
is responsible for distributing the interest payments attributable to the
Excess Servicing Rights.
Fixed-rate Mortgage Assets may also be acquired for the purpose of being
combined with hedging instruments to obtain investment characteristics similar
to adjustable-rate Mortgage Assets.
These hedging transactions are designed to reduce the fluctuation in the
value of the Company's portfolio in changing interest rate environments. No
hedging strategy can completely insulate the Company from such risks, and
certain of the federal income tax requirements that the Company must satisfy
to qualify as a REIT limit the Company's ability to hedge. The Company intends
to carefully monitor and may have to limit its hedging strategies 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 "Federal
Income Tax Considerations--Requirements for Qualification as a REIT."
In addition, hedging involves transaction costs, and such costs increase
dramatically as the period covered by the hedging protection increases and
that may also increase during periods of rising and fluctuating interest
rates. Therefore, the Company may be prevented from effectively hedging or may
determine it is not advantageous to hedge its short-term indebtedness incurred
to acquire Mortgage Assets. Certain losses incurred in connection with hedging
activities may be capital losses that would not be deductible to offset
ordinary REIT income. In such a situation, the Company would have incurred an
economic loss of capital that would not be deductible to offset the ordinary
income from which dividends must be paid.
Prepayment Risk Management. The Company seeks to minimize the risk that
borrowers of mortgage loans underlying Mortgage Assets may prepay such loans
at a faster or slower than anticipated rate and the effects
9
caused by such prepayments by attempting to structure a diversified portfolio
with a variety of prepayment characteristics, investing in Mortgage Assets
with prepayment prohibitions and penalties, investing in certain Mortgage
Security structures that have prepayment protections, and balancing Mortgage
Assets purchased at a premium with Mortgage Assets purchased at a discount.
The Company invests in Mortgage Assets that on a portfolio basis do not have
significant purchase price premiums. Under normal market conditions, the
Company seeks to keep the aggregate capitalized purchase premium of the
portfolio to 3% or less. In addition, the Company may in the future purchase
Principal Only Derivatives to a limited extent as a hedge against prepayment
risks. Prepayment risk is monitored by Management and the Company's 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.
The Company believes that it has developed cost-effective asset/liability
management policies to mitigate 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
and prepayment risks. Management monitors carefully, and may have to limit,
its asset/liability management program to assure that the Company does not
realize excessive hedging income, or hold hedging Mortgage Assets having
excess value in relation Mortgage 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 "Federal
Income Tax Considerations--Requirements for Qualification as a REIT." In
addition, asset/liability management involves transaction costs that increase
dramatically as the period covered by the hedging protection increases and
that may increase during periods of fluctuating interest rates. Therefore, the
Company may be prevented from effectively hedging its interest rate and
prepayment risks.
Description of Mortgage Assets
The Company invests principally in the following types of Mortgage Assets
subject to the operating restrictions described in "--Operating Policies and
Programs" above. Within such operating restrictions there are no limitations
on the amount of each of the following Mortgage Assets the Company can
acquire.
Pass-Through Certificates
General. The Company's investments in Mortgage Assets are expected to be
concentrated in Pass-Through Certificates. The Pass-Through Certificates to be
acquired by the Company will consist primarily of pass-through certificates
issued by Fannie Mae, FHLMC and GNMA, as well as Primary privately issued
adjustable-rate mortgage pass-through certificates. The Pass-Through
Certificates acquired by the Company represent interests in mortgages that
will be secured primarily by liens on single-family (one-to-four units)
residential properties, or on multi-family, commercial or other real estate-
related properties.
The ARM Pass-Through Certificates acquired by the Company are subject to
periodic interest rate adjustments which may be less frequent than the
increases or decreases in the borrowings or financings utilized by the
Company. In a period of increasing interest rates, the Company could
experience a decrease in Net Cash Flow because the interest rates on its
borrowings could increase faster than the interest rates on ARM Pass-Through
Certificates owned by the Company. Additionally, ARMs backed by loans secured
by liens on single-family (one-to-four) residences are subject to periodic and
lifetime interest rate caps which limit the amount an ARM interest rate can
change during any given period. The Company's borrowings are generally not
subject to similar restrictions. The impact on Net Cash Flows of such interest
rate changes depends on the adjustment features of the Mortgage Assets owned
by the Company and the maturity schedules of the Company's borrowings.
Privately Issued ARM Pass-Through Certificates. Privately issued ARM Pass-
Through Certificates are structured similarly to the Fannie Mae, FHLMC and
GNMA pass-through certificates discussed below and are
10
issued by originators of and investors in Mortgage Loans, including savings
and loan associations, savings banks commercial banks, mortgage banks,
investment banks and special purpose subsidiaries of such institutions.
Privately issued ARM Pass-Through Certificates are usually backed by a pool of
conventional adjustable-rate Mortgage Loans and are generally structured with
credit enhancement such as pool insurance or subordination. However, privately
issued ARM Pass-Through Certificates are typically not guaranteed by an entity
having the credit status of Fannie Mae, FHLMC or GNMA guaranteed obligations.
Existing Fannie Mae ARM Programs. Fannie Mae is a federally chartered and
privately owned corporation organized and existing under the Federal National
Mortgage Association Charter Act (12 U.S.C. (S) 1716 et seq.). Fannie Mae
provides funds to the mortgage market primarily by purchasing Mortgage Loans
on homes from local lenders, thereby replenishing their funds for additional
lending. Fannie Mae established its first ARM programs in 1982 and currently
has several ARM programs under which ARM certificates may be issued, including
programs for the issuance of securities through REMICs under the Code.
Each Fannie Mae ARM Pass-Through Certificate issued to date has been issued
in the form of a Pass-Through Certificate representing a fractional undivided
interest in a pool of ARMs formed by Fannie Mae. The ARMs included in each
pool are fully amortizing conventional Mortgage Loans secured by a first lien
on either one-to-four family residential properties or multifamily properties.
The original terms to maturities of the Mortgage Loans generally do not exceed
40 years. Currently, Fannie Mae has issued several different series of ARMs.
All of Fannie Mae's series of ARMs are in its lender (or Swaps) mortgage-
backed securities program where individual lenders swap pools of Mortgage
Loans that they originated or purchased for a Fannie Mae security backed by
those same Mortgage Loans. Each series bears an initial interest rate and a
margin tied to an index based on all Mortgage Loans in the related pool, less
a fixed percentage representing servicing compensation and Fannie Mae's
guarantee fee. The specified index used in each series has included the One-
Year U.S. Treasury Rate published by the Federal Reserve Board, the 11th
District Cost of Funds Index published by the Federal Home Loan Bank of San
Francisco and other indices. In addition, the majority of series of Fannie Mae
ARMs issued to date have had a monthly, semi-annual or annual interest rate
adjustment.
Adjustments to the interest rates on Fannie Mae ARMs are typically subject
to lifetime caps. In addition, some pools contain ARMs that are subject to
semi-annual or annual interest rate change limitations, frequently 1% to 2%,
respectively. Some pools contain ARMs that provide for limitations on the
amount by which monthly payments may be increased but have no limitation on
the frequency or magnitude of changes to the mortgage interest rate of the ARM
except for the lifetime cap. In cases where an increase in the rate cannot be
covered by the amount of the scheduled payment, the uncollected portion of
interest is deferred and added to the principal amount of the ARM. In such
cases, interest paid on the Fannie Mae Certificates is a monthly pass-through
of the amount of interest on each ARM rather than a weighted average pass-
through rate of interest.
Fannie Mae guarantees to the registered holder of a Fannie Mae Certificate
that it will distribute amounts representing scheduled principal and interest
(at the rate provided by the Fannie Mae Certificate) on the Mortgage Loans in
the pool underlying the Fannie Mae 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 Fannie Mae under its guarantees are solely those of Fannie
Mae and are not backed by the full faith and credit of the United States. If
Fannie Mae were unable to satisfy such obligations, distributions to holders
of Fannie Mae Certificates would consist solely of payments and other
recoveries on the underlying Mortgage Loans and, accordingly, monthly
distributions to holders of Fannie Mae Certificates would be affected by
delinquent payments and defaults on such Mortgage Loans.
Existing FHLMC ARM Programs. The Federal Home Loan Mortgage Corporation is a
corporate instrumentality of the United States created pursuant to an Act of
Congress (Title III of the Emergency Home Finance Act of 1970, as amended, 12
U.S.C. (S) 1451-1459), on July 24, 1970. The principal activity of FHLMC
currently consists of the purchase of Conforming Mortgage Loans or
participation interests therein and the resale of the loans and participations
so purchased in the form of guaranteed Mortgage Securities. FHLMC established
its first regular ARM program in 1986 and currently has several regular ARM
programs available for the issuance
11
of ARM certificates and a number of special programs that may be offered to
Mortgage Loan sellers. All of the Mortgage Loans evidenced by FHLMC
Certificates are conventional Mortgage Loans, and are not guaranteed or
insured by, and are not obligations of, the United States or any agency or
instrumentality thereof, other than FHLMC.
Each FHLMC Certificate issued to date has been issued in the form of a Pass-
Through Certificate representing an undivided interest in a pool of ARMs
purchased by FHLMC. The ARMs included in each pool are fully amortizing,
conventional Mortgage Loans with original terms to maturity of up to 40 years
secured by first liens on one-to-four unit family residential properties or
multi-family properties. An ARM certificate issued by FHLMC may be issued
under one of two cash programs (comprised of Mortgage Loans purchased from a
number of sellers) or guarantor programs (comprised of Mortgage Loans
purchased from one seller in exchange for participation certificates
representing interests in the Mortgage Loans purchased). The interest rate
paid on FHLMC Certificates adjusts on the first day of the month following the
month in which the interest rates on the underlying Mortgage Loans adjust. The
interest rates paid on ARM certificates issued under FHLMC's standard ARM
programs adjust annually in relation to the One-Year U.S. Treasury Rate as
published by the Federal Reserve Board. The specified index used in each FHLMC
series has also included the 11th District Cost of Funds Index published by
the Federal Home Loan Bank of San Francisco and other indices. Interest rates
paid on FHLMC 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 Mortgage Securities issued to date
have had a monthly, semi-annual or annual interest adjustment. Adjustments in
the interest rates paid are generally limited to an annual increase or
decrease of either 1% or 2% and to a lifetime cap of 5% or 6% over the initial
interest rate. Certain FHLMC programs include Mortgage Loans that allow the
borrower to convert the adjustable mortgage interest rate of his ARM to a
fixed rate. ARMs that are converted into fixed-rate Mortgage Loans are
repurchased by FHLMC or by the seller of such Mortgage Loans to FHLMC, at the
unpaid principal balance thereof, plus accrued interest to the due date of the
last adjustable rate interest payment.
Some FHLMC pools contain ARMs that provide for limitations on the amount by
which monthly payments may be increased but have no limitation on the
frequency or magnitude of changes to the mortgage interest rate of the ARM
except for the lifetime cap. In cases where an increase in the rate cannot be
covered by the amount of the scheduled payment, the uncollected portion of
interest is deferred and added to the principal amount of the ARM. In such
cases, interest paid on the FHLMC Certificates is a monthly pass-through of
the amount of interest on each ARM rather than a weighted average pass-through
rate of interest.
FHLMC guarantees to each holder of its ARM 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 ARMs, 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.
Existing GNMA ARM Programs. 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 that represent an interest in
a pool of Mortgage Loans 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, states that such guarantees under Section 306(g)
of mortgage-backed certificates of the type that may be purchased by the
Company or pledged as security for a series of
12
Mortgage Securities are authorized to be made by GNMA and "would constitute
general obligations of the United States backed by its full faith and credit."
The interest rate paid on the certificates issued under GNMA's standard ARM
program adjusts annually in relation to the One-Year U.S. Treasury Rate as
published by the Federal Reserve Board. Interest rates paid on GNMA
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 1% and to a lifetime cap of 5%.
CMOs
The Company may, from time to time, invest in variable-rate and short-term
fixed-rate CMOs. "CMOs" as used herein means variable-rate debt obligations
(bonds) that are collateralized by mortgage loans or mortgage certificates
other than Mortgage Derivative Securities and Subordinated Interests. CMOs are
structured so that principal and interest payments received on the collateral
are sufficient to make principal and interest payments on the bonds. Such
bonds may be issued by United States government agencies or private issuers in
one or more classes with fixed or variable interest rates, maturities and
degrees of subordination which are characteristics designed for the investment
objectives of different bond purchasers. The Company will only acquire CMOs
that constitute beneficial interests in grantor trusts holding Mortgage Loans,
or regular interests issued by REMICs, or that otherwise constitute Qualified
REIT Real Estate Assets (provided that the Company has obtained a favorable
opinion of counsel or a ruling from the Service to that effect).
CMOs ordinarily are issued in series, each of which consists of several
serially maturing classes ratably secured by a single pool of Mortgage Loans
or Pass-Through Certificates. Generally, principal payments received on the
mortgage-related assets securing a series of CMOs, including prepayments on
such mortgage-related assets, are applied to principal payments on one or more
classes of the CMOs of such series on each principal payment date for such
CMOs. Scheduled payments of principal of and interest on the mortgage-related
assets and other collateral securing a series of CMOs are intended to be
sufficient to make timely payments of interest on such CMOs and to retire each
class of such CMOs by its stated maturity.
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. The Company will not
acquire any CMOs that do not qualify as Qualified REIT Real Estate Assets.
Mortgage Warehouse Participations
The Company also may from time to time acquire Mortgage Warehouse
Participations as an additional means of diversifying its sources of income,
provided that such investments, together with the Company's investments in
Limited Investment Assets, will not in the aggregate exceed 30% of its total
Mortgage Assets. These investments are participations in lines of credit to
Mortgage Loan originators that are secured by recently originated Mortgage
Loans that are in the process of being sold to investors. Mortgage Warehouse
Participations do not qualify as Qualified REIT Real Estate Assets.
Accordingly, this activity will be limited by the REIT Provisions of the Code.
See "Federal Income Tax Considerations--Requirements for Qualification as a
REIT."
Other Mortgage Securities
General. The Company may acquire Other Mortgage Securities or interests
therein if it determines that it will be beneficial to do so and it will not
adversely affect qualification of the Company as a REIT. Such Other Mortgage
Securities may include non-Primary Mortgage Assets and other Mortgage
Securities collateralized by single-family Mortgage Loans, Mortgage Warehouse
Participations, Mortgage Derivative Securities, Subordinated Interests,
securities of other REITs and other mortgage-backed and mortgage-
collateralized obligations, other than Pass-Through Certificates and CMOs.
Mortgage Derivative Securities. The Company may acquire Mortgage Derivative
Securities on a limited basis as market conditions warrant, either as an
independent stand-alone investment opportunity or to assist in
13
the management of prepayment and other risks. Mortgage Derivative Securities
provide for the holder to receive interest only, principal only, or interest
and principal in amounts that are disproportionate to those payable on the
underlying Mortgage Loans. Payments on Mortgage Derivative Securities are
highly sensitive to the rate of prepayments on the underlying Mortgage Loans.
In the event of more rapid than anticipated prepayments on such Mortgage
Loans, the rates of return on interests in Mortgage Derivative Securities
representing the right to receive interest only or a disproportionately large
amount of interest ("Interest Only Derivatives") would be likely to decline.
Conversely, the rates of return on Mortgage Derivative Securities representing
the right to receive principal only or a disproportionate amount of principal
("Principal Only Derivatives") would be likely to increase in the event of
rapid prepayments.
The Company presently intends to acquire Mortgage Derivative Securities,
including Principal and Interest Only Derivatives. Interest Only Derivatives
may be an effective hedging device since they generally increase in value as
Mortgage Securities representing interests in adjustable-rate mortgages
decrease in value. The Company also may invest in other types of floating-rate
derivatives that are currently available in the market. The Company also may
invest in other Mortgage Derivative Securities that may in the future be
developed if the Board of Directors, including a majority of Unaffiliated
Directors, determines that such investments would be advantageous to the
Company. The Company will generally not acquire Inverse Floaters, Remic
Residuals or First Loss Subordinated Bonds. However, the Company may retain
residual interests in its own securitizations of Mortgage Loans. Moreover, the
Company will not purchase any Mortgage Derivative Securities that do not
qualify as Qualified REIT Real Estate Assets.
Subordinated Interests. The Company also may acquire Subordinated Interests,
which are classes of Mortgage Securities that are junior to other classes of
such series of Mortgage Securities in the right to receive payments from the
underlying Mortgage Loans. The subordination may be for all payment failures
on the Mortgage Loans securing or underlying such series of Mortgage
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 borrower. The subordination may be for the entire
amount of the series of Mortgage Securities or may be limited in amount.
Any Subordinated Interests acquired by the Company will be limited in amount
and bear yields that 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 the REIT Provisions of the Code. Accordingly, the Company
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 only purchase Subordinated
Interests that are consistent with its credit risk management policy and will
not purchase any Subordinated Interests that do not qualify as Qualified REIT
Real Estate Assets.
Mortgage Loans
General. In the future, following the development of an appropriate
infrastructure, the Company intends to acquire and accumulate Mortgage Loans
as part of its investment strategy until a sufficient quantity has been
accumulated for securitization into Primary Mortgage Securities. The Mortgage
Loans acquired by the Company and not yet securitized, together with the
Company's investments in Limited Investment Assets, will not constitute more
than 30% of its total Mortgage Assets at any time. All Mortgage Loans will be
acquired with the intention of securitizing them into Primary Mortgage
Securities. However, there can be no assurance that the Company will be
successful in securitizing the Mortgage Loans. After a pool of Mortgage Loans
has been securitized, the Mortgage Loans will no longer be considered Limited
Investment Assets. To meet the Company's investment criteria, the Mortgage
Loans to be acquired by the Company will generally conform to the underwriting
guidelines established by Fannie Mae, FHLMC or other credit insurers.
Applicable banking laws generally require that an appraisal be obtained in
connection with the original issuance of Mortgage Loans
14
by the lending institution. The Company does not intend to obtain additional
appraisals at the time of acquiring Mortgage Loans.
The Mortgage Loans may be originated by or purchased from various Suppliers
of Mortgage Assets throughout the United States, such as savings and loan
associations, banks, mortgage bankers, home builders, insurance companies and
other mortgage lenders. The Company may acquire Mortgage Loans directly from
originators and from entities holding Mortgage Loans originated by others. The
Board of Directors of the Company has not established any limits upon the
geographic concentration of Mortgage Loans to be acquired by the Company or
the credit quality of Suppliers of Mortgage Assets. See "Risk Factors--
Interest Rate Fluctuations May Decrease Net Interest Income."
The Company will acquire ARMs. The interest rate on ARMs is typically tied
to an index (such as the One-Year U.S. Treasury Rate published by the Federal
Reserve Board, the 11th District Cost of Funds Index published by the Federal
Home Loan Bank of San Francisco or LIBOR) and is adjustable periodically at
various intervals. Such Mortgage Loans may be subject to lifetime or periodic
interest rate or payment caps.
Conforming and Nonconforming Mortgage Loans. In the future, the Company may
acquire both Conforming and Nonconforming Mortgage Loans for securitization.
Conforming Mortgage Loans comply with the requirements for inclusion in a loan
guarantee program sponsored by GNMA, FHLMC or Fannie Mae. Under current
regulations, the maximum principal balance allowed on Conforming Mortgage
Loans ranges from $214,600 for one-unit residential loans ($321,000 for such
residential loans secured by mortgage properties located in either Alaska or
Hawaii) to $412,450 for four-unit residential loans ($618,875 for such
residential loans secured by mortgaged properties located in either Alaska or
Hawaii). Nonconforming Mortgage Loans are Mortgage Loans that do not qualify
in one or more respects for purchase by Fannie Mae or FHLMC under their
standard programs. The Company expects that a majority of Nonconforming
Mortgage Loans it purchases will be nonconforming primarily because they have
original principal balances which exceed the requirements for FHLMC or Fannie
Mae programs.
Commitments to Mortgage Loan Sellers. The Company may issue commitments
("Commitments") to originators and other sellers of Mortgage Loans who follow
policies and procedures that generally comply with Fannie Mae and FHLMC
regulations and guidelines and that comply with all applicable federal and
state laws and regulations for Mortgage Loans secured by single-family (one-
to-four units) residential properties. In addition, Commitments may be issued
for Agency Certificates as well as privately issued Pass-Through Certificates
and Mortgage Loans. Commitments will obligate the Company to purchase Mortgage
Assets from the holders of the Commitments for a specific period of time, in a
specific aggregate principal amount and at a specified price and margin over
an index. Although the Company may commit to acquire Mortgage Loans prior to
funding, all Mortgage Loans are to be fully funded prior to their acquisition
by the Company. Following the issuance of Commitments, the Company will be
exposed to risks of interest rate fluctuations similar to those risks on
adjustable-rate Mortgage Assets.
Securitization of Mortgage Loans. The Company anticipates that in the
future, if it obtains personnel with the appropriate expertise, it may create,
through securitization, Primary Mortgage Securities with all Mortgage Loans it
acquires. Such Securities would be structured as collateralized borrowing and
not as a sale for accounting purposes. The Company's decision at any time to
acquire Mortgage Loans for securitization will be based on the Company's
determination that it can earn a higher yield on the Mortgage Securities
created through securitization than on comparable Mortgage Securities
purchased in the market. In making this determination, the Company will
consider the demand for the Mortgage Securities to be created from such
Mortgage Loans, the cost of securitization, the relative strength of issuers
and other market participants active in such securities, Rating Agency
requirements and other factors affecting the structure, cost, rating and
benefits of such securities relative to each other and to other investment
alternatives.
The Company may elect to conduct its operations of acquiring and
securitizing Mortgage Loans through one or more taxable subsidiaries formed
for such purpose.
15
In connection with the creation of a new Mortgage Security through
securitization of Mortgage Loans, the issuer generally will be required to
enter into a master servicing agreement with respect to such series of
Mortgage Securities with an entity acceptable to the rating agency that
regularly engages in this activity (the "Master Servicer"). At the present
time, the Company does not engage in this business and no Affiliates of the
Company or the Manager will be appointed as a Master Servicer for any issue of
Mortgage Securities created by the Company.
To the extent that Management determines that it is not in the best
interests of the Company to securitize mortgage loans, it may engage in whole
loan sale transactions with respect to loans accumulated in its portfolio.
Protection Against Mortgage Loan Risks. It is anticipated that any Mortgage
Loan purchased will have a commitment for mortgage pool insurance from a
mortgage insurance company with a claims-paying ability in one of the two
highest rating categories by either of the Rating Agencies. Mortgage pool
insurance insures the payment of certain portions of the principal and
interest on Mortgage Loans. In lieu of mortgage pool insurance, the Company
may arrange for other forms of credit enhancement such as letters of credit,
subordination of cash flows, corporate guaranties, establishment of reserve
accounts or over-collateralization. The Company expects that any Mortgage
Loans acquired will be reviewed by a mortgage pool insurer or other qualified
Mortgage Loan underwriter to ensure that the credit quality of the Mortgage
Loans meets the insurer's guidelines. The Company intends to rely primarily
upon the credit evaluation of such third-party mortgage pool insurer or
underwriter issuing the commitment rather than make its own independent credit
review in determining whether to purchase a Mortgage Loan. Credit losses
covered by the pool insurance policies or other forms of credit enhancement
are restricted to the limits of their contractual obligations and may be lower
than the principal amount of the Mortgage Loan. The pool insurance or credit
enhancement will be issued when the Mortgage Loan is subsequently securitized,
and the Company will be at risk for credit losses on that loan prior to its
securitization.
In addition to credit enhancement, the Company anticipates that it will also
obtain a commitment for special hazard insurance on the Mortgage Loans, if
available at reasonable cost, to mitigate casualty losses that are not usually
covered by standard hazard insurance, such as vandalism, war, earthquake and
floods. This special hazard insurance is not in force during the accumulation
period, but is activated instead at the time the Mortgage Loans are pledged as
collateral for the Mortgage Securities. Accordingly, the risks associated with
such special hazard losses exist primarily between the times the Company
purchases a Mortgage Loan and the inclusion of such Mortgage Loan within a
newly created issue of Mortgage Securities.
It is expected that when the Company acquires Mortgage Loans, the seller
will generally represent and warrant to the Company that there has been no
fraud or misrepresentation during the origination of the Mortgage Loans and
generally agree to repurchase any loan with respect to which there is fraud or
misrepresentation. The Company will provide similar representations and
warranties when the Company sells or pledges the Mortgage Loans as collateral
for Mortgage Securities. If a Mortgage Loan becomes delinquent and the pool
insurer is able to prove that there was fraud or misrepresentation in
connection with the origination of the Mortgage Loan, the pool insurer will
not be liable for the portion of the loss attributable to such fraud or
misrepresentation. Although the Company will generally have recourse to the
seller based on the seller's representations and warranties to the Company,
the Company will be at risk for loss to the extent the seller does not perform
its repurchase obligations.
Other REITs
The Company may purchase securities in other REITs or stock in similar
companies when the Company believes that such purchases will yield fairly
attractive returns on capital employed. When the stock market valuations of
such companies are low in relation to the market value of their assets, the
Company believes that such stock purchases provide a method for the Company to
acquire an interest in a pool of Mortgage Assets at an attractive price. The
Company does not, however, presently intend to invest in the securities of
other issuers for the purpose of exercising control or to underwrite the
securities of other issuers. During the period ended December 31, 1998 the
Company acquired an approximately $500,000 position in Thornburg Mortgage
Asset Corporation preferred stock.
16
Other Policies
The Company intends to operate in a manner that will not subject it to
regulation under the Investment Company Act. The Company does not currently
intend to (i) originate loans, or (ii) offer securities in exchange for real
property.
Future Revisions in Policies and Strategies
The Board of Directors has established the investment policies, operating
policies and strategies set forth in the Company's 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 (including a majority of the Unaffiliated Directors) determines that
such modification or waiver is in the best interests of stockholders. Among
other factors, developments in the market that affect the policies and
strategies mentioned herein or which change the Company's assessment of the
market may cause the Company's Board of Directors to revise its policies and
strategies. However, if such modification or waiver relates to the
relationship of, or any transaction between, the Company and the Manager or
any Affiliate of the Manager, the approval of a majority of the Unaffiliated
Directors is also required.
The Company monitors closely its purchases of Mortgage Assets and the income
from such assets, including from its hedging strategies, so as to ensure at
all times that it maintains its qualification as a REIT and its exemption
under the Investment Company Act. The Company has engaged qualified
accountants and tax experts to assist in developing accounting systems and
testing procedures and to conduct quarterly compliance reviews designed to
determine compliance with the REIT Provisions of the Code and the Company's
exempt status under the Investment Company Act. See "Federal Income Tax
Considerations--Requirements for Qualification as a REIT" and "Risk Factors--
Failure to Maintain Exemption from the Investment Company Act Would Adversely
Affect Results of Operations" and "--Failure to Maintain REIT Status Would
Result in the Company Being Subject to Tax as a Regular Corporation and
Substantially Reduce Cash Flow Available for Distribution to Stockholders." No
changes in the Company's investment and operating policies, including credit
criteria for Mortgage Asset investments, may be made without the approval of
the Company's Board of Directors, including by a majority of the Unaffiliated
Directors.
DISTRIBUTION POLICY
The Company intends to distribute substantially all of its taxable income to
stockholders in each year (which does not ordinarily equal net income as
calculated in accordance with GAAP). The Company intends to declare four
regular quarterly distributions. In addition, taxable income, if any, not
distributed through regular quarterly dividends may be distributed annually,
at or near year end, in a special dividend. The distribution policy is subject
to revision at the discretion of the Board of Directors. All distributions
will be made by the Company at the discretion of the Board of Directors and
will depend on the earnings of the Company, the financial condition of the
Company, maintenance of REIT status and such other factors as the Board of
Directors deems relevant. See "Federal Income Tax Considerations--Requirements
for Qualification as a REIT--Distribution Requirement."
In order to qualify as a REIT under the Code, the Company must make
distributions to its stockholders each year in an amount at least equal to (i)
95% of its Taxable Income before deduction of dividends paid (less any net
capital gain), plus (ii) 95% of the excess of the net income from Foreclosure
Property over the tax imposed on such income by the Code, minus (iii) any
excess noncash income. The "Taxable Income" of the Company for any year means
the taxable income of the Company for such year (excluding any net income
derived either from property held primarily for sale to customers or from
foreclosure property) subject to certain adjustments provided in the REIT
Provisions of the Code.
It is anticipated that distributions generally will be taxable as ordinary
income to stockholders of the Company, although a portion of such
distributions may be designated by the Company as capital gain or may
constitute a return of capital. The Company will furnish annually to each of
its stockholders a statement setting
17
forth distributions paid during the preceding year and their characterization
as ordinary income, return of capital or capital gains. For a discussion of
the federal income tax treatment of distributions by the Company, see "Federal
Income Tax Considerations--Taxation of Stockholders."
COMPETITION FOR MORTGAGE ASSETS
In acquiring Mortgage Assets, the Company competes with other REITs,
investment banking firms, savings and loan associations, banks, mortgage
bankers, insurance companies, mutual funds, other lenders, GNMA, Fannie Mae,
FHLMC and other entities purchasing Mortgage Assets, most of which have
greater financial resources than the Company. In addition, there are several
REITs similar to the Company, and others may be organized in the future. The
effect of the existence of additional REITs may be to increase competition for
the available supply of Mortgage Assets suitable for purchase by the Company.
Increased competition for the acquisition of eligible Mortgage Assets or a
diminution in the supply could result in higher prices and, thus, lower yields
on such Mortgage Assets that could further narrow the yield spread over
borrowing costs.
The Company has been able to compete effectively and generate competitive
rates of return for stockholders by utilizing leverage through accessing
wholesale markets for collateralized borrowings and as a result of its
exemption from certain forms of regulation and the tax advantages of its REIT
status.
EMPLOYEES
As of December 31, 1998 the Company had no employees. The Manager carries
out the day to day operations of the Company, subject to the supervision of
the Board of Directors and under the terms of the Management Agreement.
FEDERAL INCOME TAX CONSIDERATIONS
General
The following discussion summarizes the material federal income tax
considerations that may be relevant to a holder of shares of Common Stock of
the company. This discussion is based on current law. the following discussion
is not exhaustive of all possible tax considerations. It does not discuss any
state, local or foreign tax considerations, nor does it discuss all of the
aspects of federal income taxation that may be relevant to a prospective
stockholder in light of such stockholder's particular circumstances or to
certain types of stockholders (including insurance companies, certain tax-
exempt entities, financial institutions, broker/dealers, foreign corporations
and persons who are not citizens or residents of the United States) subject to
special treatment under federal income tax laws.
Each stockholder and prospective stockholder of Common Stock of the Company
is urged to consult with his own tax advisor regarding the specific
consequences to him of the purchase, ownership and sale of stock in an entity
electing to be taxed as a REIT, including the federal, state, local, foreign
and other tax considerations of such purchase, ownership, sale and election
and the potential changes in applicable tax laws.
The Code provides special tax treatment for organizations that qualify and
elect to be taxed as REITs. The discussion below summarizes the material
provisions applicable to the Company as a REIT for federal income tax purposes
and to its stockholders in connection with their ownership of shares of Common
Stock. However, it is impractical to set forth in this Annual Report on Form
10-K all aspects of federal, state, local and foreign tax law that may have
tax consequences with respect to an investor's purchase of the Common Stock.
The discussion of various aspects of federal taxation contained herein is
based on the Code, administrative regulations, judicial decisions,
administrative rulings and practice, all of which are subject to change. In
brief, if certain detailed conditions imposed by the Code are met, entities
that invest primarily in real estate assets, including Mortgage
18
Loans, and that otherwise would be taxed as corporations are, with certain
limited exceptions, not taxed at the corporate level on their taxable income
that is currently distributed to their stockholders. This treatment eliminates
most of the "double taxation" (at the corporate level and then again at the
stockholder level when the income is distributed) that typically results from
the use of corporate investment vehicles. A qualifying REIT, however, may be
subject to certain excise and other taxes, as well as normal corporate tax, on
Taxable Income that is not currently distributed to its stockholders. See "--
Taxation of the Company" below.
The Company will elect to become subject to tax as a REIT, for Federal
income tax purposes, commencing with the taxable year ending December 31,
1998. 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, 1998, 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 elimination the "double taxation" that generally
results when a corporation earns income and distributes that income to its
stockholders in the form of dividends. It must be emphasized that the
Company's qualification and taxation as a REIT depends upon its ability to
meet on a continuing basis through actual annual operating results,
distribution levels and stock ownership, the various qualification tests
imposed under the Code that are discussed below. No assurance can be given
that the actual results of the Company's operations for any particular year
will satisfy such requirements.
Requirements for Qualification as a REIT
To qualify for tax treatment as a REIT under the Code, the Company must meet
certain tests which are described immediately below.
Stock Ownership Tests. For all taxable years after the first taxable year
for which a REIT election is made, the Company's shares of Common Stock must
be transferable and must be held by a minimum of 100 persons for at least 335
days of a 12 month year (or a proportionate part of a short tax year). The
Company must also use the calendar year as its taxable year. In addition, at
all times during the second half of each taxable year, no more than 50% in
value of the shares of any class of the stock of the Company may be owned
directly or indirectly by five or fewer individuals (as defined by the Code to
include certain entities). If, for any taxable year, the Company complies with
regulations requiring the maintenance of records to ascertain ownership of its
outstanding stock and the Company does not know or have reason to know that it
failed to satisfy this test, it will be treated as satisfying this test for
any such taxable year. In determining whether the Company's shares are held by
five or fewer individuals, the attribution rules of Sections 544 of the Code
apply. For a description of these attribution rules, see "Description of
Capital Stock." The Company's Charter impose certain repurchase provisions and
transfer restrictions to avoid more than 50% by value of any class of the
Company's stock being held by five or fewer individuals (directly or
constructively) at any time during the last half of any taxable year. Such
repurchase and transfer restrictions will not cause the stock not to be
treated as "transferable" for purposes of qualification as a REIT. The Company
intends to satisfy both the 100 stockholder and 50%/5 stockholder individual
ownership limitations described above for as long as it seeks qualification as
a REIT. The Company will use the calendar year as its taxable year for income
tax purposes.
Asset Tests. On the last day of each calendar quarter at least 75% of the
value of the Company's assets must consist of Qualified REIT Real Estate
Assets, government securities, cash and cash items (the "75% of Assets Test").
The Company expects that substantially all of its assets will be Qualified
REIT Real Estate Assets. Qualified REIT Real Estate Assets include interests
in real property, interests in Mortgage Loans secured by real property and
interests in REMICs.
On the last day of each calendar quarter, of the investments in securities
not included in the 75% of Assets Test, the value of any one issuer's
securities may not exceed 5% by value of the Company's total assets and the
Company may not own more than 10% of any one issuer's outstanding voting
securities. Hedging contracts (other than those which are Qualified REIT Real
Estate Assets) and certain types of other Mortgage Assets may be treated as
securities of the entity issuing such agreements or interests. The Company
will take measures to
19
prevent the value of such contracts, interests or assets issued by any one
entity to exceed 5% of the value of the Company's assets as of the end of each
calendar quarter. Moreover, pursuant to its compliance guidelines, the Company
intends to monitor closely (on not less than a quarterly basis) the purchase
and holding of the Company's assets in order to comply with the above assets
tests. In particular, as of the end of each calendar quarter the Company
intends to limit and diversify its ownership of hedging contracts and other
Mortgage Securities that do not constitute Qualified REIT Real Estate Assets
to less than 25%, in the aggregate, by value of its portfolio, to less than 5%
by value as to any single issuer, and to less than 10% of the voting stock of
any single issuer (collectively the "25% of Assets Test"). If such limits are
ever exceeded, the Company intends to take appropriate remedial action to
dispose of such excess assets within the 30-day period after the end of the
calendar quarter, as permitted under the Code.
When purchasing Mortgage Securities, the Company may rely on certain
opinions of counsel for the issuer or sponsor of such securities given in
connection with the offering of such securities, or statements made in related
offering documents, for purposes of determining whether and to what extent
those securities (and the income therefrom) constitute Qualified REIT Real
Estate Assets (and income) for purposes of the 75% of Assets Test (and the
source of income tests discussed below). If the Company invests in a
partnership, it will be treated as receiving its share of the income and loss
of the partnership and owning a proportionate share of the assets of the
partnership and any income from the partnership will retain the character that
it had in the hands of the partnership. If the Company forms a taxable
affiliate to conduct mortgage origination and other activities, it will obtain
an opinion of counsel that the proposed organization and ownership of an
interest in the taxable affiliate will not adversely affect the Company's
status as a REIT.
Where a failure to satisfy any of the asset tests discussed above results
from an acquisition of securities or other property during a quarter, the
failure can be cured by a disposition of sufficient non-qualifying assets
within 30 days after the close of such quarter. The Company intends to
maintain adequate records of the value of its assets to determine its
compliance with the asset tests, and intends to take such action as may be
required to cure any failure to satisfy the test within 30 days after the
close of any quarter.
Gross Income Tests. The Company must meet two separate income-based tests
for each year in order to qualify as a REIT.
1. The 75% Test. At least 75% of the Company's gross income (the "75% of
Income Test") for the taxable year must be derived from the following sources:
(i) rents from real property, (ii) interest (other than interest based in
whole or in part on the income or profits of any person) on obligations
secured by mortgages of real property or on interests in real property; (iii)
gains from the sale or other disposition of interests in real property and
real estate mortgages other than gain from stock in trade, inventory or
property held primarily for sale to customers in the ordinary course of the
Company's trade or business ("Dealer Property"); (iv) dividends or other
distributions on shares in other REITs and, provided such shares are not
Dealer Property, gain from the sale of such shares; (v) abatements and refunds
of real property taxes; (vi) income from the operation, and gain from the
sale, of property acquired at or in lieu of a foreclosure of the mortgage
secured by such property or as a result of a default under a lease of such
property ("Foreclosure Property"); (vii) income received as consideration for
entering into agreements to make loans secured by real property or to purchase
or lease real property (including interests in real property and interests in
mortgages on real property) (for example, commitment fees); (viii) gain from
the sale of other disposition of a real estate asset which is not a prohibited
transaction; and (ix) income attributable to stock or debt instruments
acquired with the proceeds from the sale of stock or certain debt obligations
("New Capital") of the Company received during the one-year period beginning
on the day such proceeds were received ("Qualified Temporary Investment
Income").
2. The 95% Test. In addition to deriving 75% of its gross income from the
sources listed above, at least an additional 20% of the Company's gross income
for the taxable year must be derived from those sources, or from dividends,
interest or gains from the sale or disposition of stock or other securities
that are not Dealer Property (the "95% of Income Test"). Income attributable
to Mortgage Warehouse Participations. Mortgage Securities (other than
Qualified REIT Real Estate Assets) that the Company holds directly, dividends
on stock
20
interest on any other obligations not secured by real property, and gains from
the sale or disposition of stock or other securities that are not Qualified
REIT Real Estate Assets will constitute qualified income for purposes of the
95% of Income Test only, but will not be qualified income for purposes of the
75% of Income Test. Income from mortgage servicing contracts, loan guarantee
fees (or other contracts under which the Company would earn fees for
performing services) and hedging (other than from Qualified REIT Real Estate
Assets) will not qualify for either the 95% or 75% of Income Tests. The
Company intends to severely limit such income and its acquisition of any
assets or investments the income from which does not qualify for purposes of
the 95% of Income Test. Moreover, in order to help ensure compliance with the
95% of Income Test and the 75% of Income Test, the Company limits
substantially all of the assets that it acquires to Qualified REIT Real Estate
Assets. The policy of the Company to maintain REIT status may limit the type
of assets, including hedging contracts, that the Company otherwise might
acquire. At December 31, 1998, over 95% of the Company's assets were Qualified
REIT Real Estate Assets.
For purposes of determining whether the Company complies with the 75% of
Income Test and the 95% of Income Test detailed above, gross income does not
include gross income from "Prohibited Transactions." A "Prohibited
Transaction" is one involving a sale of Dealer Property, other than
Foreclosure Property. Net income from Prohibited Transactions is subject to a
100% tax. See "--Taxation of the Company" below.
The Company maintains its qualifications for REIT status by carefully
monitoring its income, including income from hedging transactions, futures
contracts and sales of Mortgage Assets to comply with the 75% of Income Test
and the 95% of Income Test. In order to help assure its compliance with the
REIT Provisions of the Code, the Company will adopt guidelines the effect of
which will be to limit its ability to earn certain types of income. See
"Operating Policies and Policies." If the Company fails to satisfy one or both
of the 75% or 95% of Income Tests for any year, it may face either (a)
assuming such failure was for reasonable cause and not willful neglect, a 100%
tax on the greater of the amounts of income by which it failed to comply with
the 75% of Income Test or the 95% of Income Test, reduced by estimated related
expenses or (b) loss of REIT status. There can be no assurance that the
Company will always be able to maintain compliance with the gross income tests
for REIT qualification despite its periodic monitoring procedures. Moreover,
there is no assurance that the relief provisions for a failure to satisfy
either the 95% or the 75% of Income Tests will be available in any particular
circumstance.
Distribution Requirement. In order to be taxed as a REIT, the Company is
required to distribute dividends (other than capital gain dividends) to its
stockholders on a pro rata basis each year in an amount at least equal to (i)
95% of its Taxable Income before deduction of dividends paid and excluding net
capital gain, plus (ii) 95% of the excess of the net income from Foreclosure
Property over the tax imposed on such income by the Code, less (iii) any
excess noncash income (the "95% Distribution Test"). See "Distribution
Policy." The Company intends to make distributions to its stockholders in
amounts sufficient to meet this 95% distribution requirement. Such
distributions must be made in the taxable year to which they relate or, if
declared before the timely filing of the Company's tax return for such year
and paid not later than the first regular dividend payment after such
declaration, in the following taxable year. A nondeductible excise tax, equal
to 4% of the excess of such required distributions over the amounts actually
distributed will be imposed on the Company for each calendar year to the
extent that dividends paid during the year (or declared during the last
quarter of the year and paid during January of the succeeding year) are less
than the sum of (i) 85% of the Company's "ordinary income," (ii) 95% of the
Company's capital gain net income, and (iii) income not distributed in earlier
years.
The Service has ruled that if a REIT's dividend reinvestment plan allows
stockholders of the REIT to elect to have cash distributions reinvested in
shares of the REIT at a purchase price equal to at least 95% of fair market
value on the distribution date, then such cash distributions qualify under the
95% distribution test. The Company intends that the terms of its Dividend
Reinvestment Plan which it intends to adopt in the future will comply with
this ruling.
If the Company fails to meet the 95% Distribution Test as a result of an
adjustment to the Company's tax returns by the Service, the Company by
following certain requirements set forth in the Code, may pay a deficiency
dividend within a specified period that will be permitted as a deduction in
the taxable year to which
21
the adjustment is made. The Company would be liable for interest based on the
amount of the deficiency dividend. A deficiency dividend is not permitted if
the deficiency is due to fraud with intent to evade tax or to a willful
failure to file a timely tax return.
Recordkeeping Requirements. A REIT is required to maintain records regarding
the actual and constructive ownership of its shares, and other information,
and within 30 days after the end of its taxable year, to demand statements
from persons owning above a specified level of the REIT's shares (e.g., if the
Company has over 200 but fewer than 2,000 stockholders of record, from persons
holding 1% or more of the Company's outstanding shares of stock and if the
Company has 200 or fewer stockholders of record, from persons holding 1/2% or
more of the stock) regarding their ownership of shares. The Company must
maintain, as part of its records, a list of those persons failing or refusing
to comply with this demand. Stockholders who fail or refuse to comply with the
demand must submit a statement with their tax returns setting forth the actual
stock ownership and other information. The Company also is required to
maintain permanent records of its assets as of the last day of each calendar
quarter. The Company intends to maintain the records and demand statements as
required by these Treasury Regulations.
Termination or Revocation of REIT Status
The Company's election to be treated as a REIT will be terminated
automatically if it fails to meet the requirements described above. In that
event, the Company will not be eligible again to elect REIT status until the
fifth taxable year that begins after the year for which its election was
terminated unless all of the following relief provisions apply: (i) the
Company did not willfully fail to file a timely return with respect to the
termination taxable year, (ii) inclusion of incorrect information in such
return was not due to fraud with intent to evade tax, and (iii) the Company
establishes that failure to meet the requirements was due to reasonable cause
and not willful neglect. The Company may also voluntarily revoke its election,
although it has no intention of doing so, in which event it will be
prohibited, without exception, from electing REIT status for the year to which
the revocation relates and the following four taxable years.
If the Company fails to qualify for taxation as a REIT in any taxable year,
and the relief provisions do not apply, the Company would be subject to tax
(including any applicable alternative minimum tax) on its taxable income at
regular corporate rates. Distributions to stockholders of the Company with
respect to any year in which it fails to qualify as a REIT would not be
deductible by the Company nor would such distributions be required to be made.
In such event, to the extent of current and accumulated earnings and profits,
all distribution to stockholders will be taxable as ordinary income and
subject to certain limitations in the Code, stockholders may be eligible for
the dividends received deduction. Failure to qualify as a REIT would result in
a reduction of the Company's distributions to stockholders in order to pay the
resulting taxes. If, after forfeiting REIT status, the Company later qualifies
and elects to be taxed as a REIT again, the Company could face significant
adverse tax consequences.
Taxation of the Company
In any year in which the Company qualifies as a REIT, it generally will not
be subject to federal income tax on that portion of its Taxable Income or net
capital gain which is distributed to its stockholders. The Company will,
however, be subject to tax at normal corporate rates upon any Net Income or
net capital gain not distributed. The Company intends to distribute at least
95% of its Taxable Income to its stockholders on a pro rata basis in each
year. See "Distribution Policy."
Notwithstanding its qualification as a REIT, the Company will also be
subject to a tax of 100% of net income from any prohibited transaction and
will be subject to a 100% tax on the greater of the amount by which it fails
either the 75% or 95% of Income Tests, reduced by estimated related expenses,
if the failure to satisfy such tests is due to reasonable cause and not
willful neglect and if certain other requirements are met. The Company may be
subject to the alternative minimum tax on certain items of tax preference.
22
If the Company acquires any real property as a result of foreclosure, or by
a deed in lieu of foreclosure, it may elect to treat such real properly as
Foreclosure Property. Net income from the sale of Foreclosure Property is
taxable at the maximum federal corporate rate, currently 35%. Income from
Foreclosure Property will not be subject to the 100% tax on prohibited
transactions. The Company has the right determine whether to treat such real
properly as Foreclosure Property on the tax return for the fiscal year in
which such property is acquired.
If the Company itself were to sell Mortgage Securities on a regular basis,
there is a substantial risk that such Mortgage Securities would be deemed
Dealer Property with all of the profits from such sales subject to tax at the
rate of 100% as income from prohibited transactions. However, the Company,
subject to limitations, may invest in taxable subsidiaries which themselves
may securitize Mortgage Loans and sell such Mortgage Securities without being
subject to this 100% tax on income derived from prohibited transactions, as
such a tax is only applicable to a REIT. See "--Taxable Subsidiaries" below.
The Company may elect to retain and pay income tax on all or a portion of
its net long-term capital gains for any taxable year, in which case the
Company's stockholders would include in their income as long-term capital
gains their proportionate share of such undistributed capital gains. The
stockholders would be treated as having paid their proportionate share of the
capital gains tax paid by the Company, which amounts would be credited or
refunded to the stockholders.
The Company will also be subject to a nondeductible 4% excise tax if it
fails to make timely dividend distributions for each calendar year. See "--
Requirements for Qualification as a REIT--Distribution Requirement" above. The
Company intends to declare its fourth regular annual dividend, as well as a
fifth special dividend, if any, during the final quarter of the year and to
make such dividend distribution no later than 31 days after the end of the
year in order to avoid imposition of the excise tax. Such a distribution would
be taxed to the stockholders in the year that the distributions were declared,
not in the year paid. Imposition of the excise tax on the Company would reduce
the amount of cash available for distribution to its stockholders.
Taxable Subsidiaries
The Company may, in the future, cause the creation and sale of Mortgage
Securities through a taxable corporation. The Company and one or more persons
or entities will own all of the capital stock of that taxable corporation,
sometimes referred to as a "taxable subsidiary." In order to ensure that the
Company will not violate the prohibition on ownership of more than 10% of the
voting stock of a single issuer and the prohibition on investing more than 5%
of the value of its assets in the stock or securities of a single issuer, the
Company will own only shares of nonvoting preferred stock of that taxable
subsidiary corporation and will not own any of the taxable subsidiary's Common
Stock. The Company will monitor the value of its investment in the taxable
subsidiary on a quarterly basis to limit the risk of violating any of the
tests that comprise the 25% of Assets Test. In addition, the dividends that
the taxable subsidiary pays to the Company will not qualify as income from
Qualified REIT Real Estate Assets for purposes of the 75% of Income Test, and
in all events would have to be limited, along with the Company's other
interest, dividends, gains on the sale of securities, hedging income, and
other income not derived from Qualified REIT Real Estate Assets to less than
25% of the Company's gross revenues in each year. The taxable subsidiary will
not elect REIT status, will be subject to income taxation on its net earnings
and will generally be able to distribute only its net after-tax earnings to
its stockholders, including the Company, as dividend distributions. If the
taxable subsidiary creates a taxable mortgage pool, such pool itself will
constitute a separate taxable subsidiary of the taxable subsidiary. The
taxable subsidiary would be unable to offset the income derived from such a
taxable mortgage pool with losses derived from any other activities.
In the proposed Fiscal Year 2000 Budget released February, 1999, the Clinton
Administration recommended changing the 10% asset test to prohibit a REIT from
owning more than ten percent (10%) of vote or value of certain other
corporations. Such a provision has been included in President Clinton's prior
tax proposals but has not been enacted into law. Were such a proposal to
become law, the Company's continued qualification as a REIT might require
modification of the Company's current or future ownership of taxable
subsidiaries. Before the Company engages in any hedging or securitization
activities or forms any such taxable subsidiary
23
corporations, the Company will consult with its tax advisors to determine
whether such activities or the formation and contemplated method of operation
of such corporation would cause the Company to fail to satisfy the REIT asset
tests and REIT gross income tests as defined above.
Taxation of Stockholders
For any taxable year in which the Company is treated as a REIT for federal
income tax purposes, amounts distributed by the Company to its stockholders
other than tax-exempt entities out of current or accumulated earnings and
profits will be includable by the stockholders as ordinary income for federal
income tax purposes unless such distributions are properly designated by the
Company as capital gain dividends. In the latter case, the distributions will
be taxable to the stockholders as long-term capital gains. Any loss on the
sale or exchange of shares of the Common Stock held by a stockholder for six
months or less will be treated as a long-term capital loss to the extent of
any capital gain dividend received on the Common Stock by such stockholders.
All or a portion of any loss realized upon a taxable disposition of shares may
be disallowed if other shares are purchased within 30 days before or after
disposition. In general, any gain realized upon the taxable disposition of the
Company's Common Stock by a stockholder who is not a dealer in securities will
be treated as capital gain. Lower marginal tax rates for individuals may apply
in the case of capital gains, depending upon the holding period of the shares
that are sold.
Distributions by the Company will not be eligible for the dividends received
deduction for corporations. Stockholders may not deduct any net operating
losses or capital losses of the Company. Instead, such losses would be carried
over by the Company for potential offset against its future income (subject to
certain limitations). If the Company makes distributions to its stockholders
in excess of its current and accumulated earnings and profits, those
distributions will be considered first as a tax-free return of capital,
reducing the tax basis of a stockholder's shares until the tax basis in such
shares is zero. Thereafter, distributions in excess of the tax basis will be
taxable as gain realized from the sale of the Company's stock.
Taxable distributions from the Company and gain from the disposition of the
Company's Common Stock will not be treated as passive activity income and,
therefore, stockholders will not generally be able to apply any passive
activity losses against such income. In addition, taxable distributions from
the Company generally will be treated as investment income for purposes of the
investment interest limitation. Capital gains from the disposition of the
shares (or distributions treated as such) will be treated as investment income
only if the stockholder so elects, in which case such capital gains will be
taxed at ordinary income rates.
The Company will notify stockholders after the close of the Company's
taxable year as to the portions of the distributions which constitute ordinary
income and the portions that constitute either return of capital or capital
gain. Dividends and distributions declared in the last quarter of any year
payable to stockholders of record on a specified date in such month will be
deemed to have been received by the stockholders and paid by the Company on
December 31 of the record year, provided that such dividends are in fact paid
before February 1 of the following year.
The Company does not expect to acquire residual interests issued by REMICs.
Such residual interests, if acquired by a REIT, may generate excess inclusion
income. Excess inclusion income cannot be offset by net operating losses of a
stockholder. If the stockholder is a Tax-Exempt Entity, the excess inclusion
income is fully taxable as UBTI. If allocated to a foreign stockholder, the
excess inclusion income is subject to federal income tax withholding without
reduction pursuant to any otherwise applicable tax treaty. Potential
investors, and in particular Tax-Exempt Entities, are urged to consult with
their tax advisors concerning this issue.
The Company intends to finance the acquisition of Mortgage Assets by
entering into, among other things, reverse repurchase agreements, which are
essentially loans secured by the Company's Mortgage Assets. The Company may
enter into master repurchase agreements with secured lenders known as
"Counter-parties." Typically, such master repurchase agreements have cross-
collateralization provisions that afford the counter-party the right to
foreclose on the Mortgage Assets pledged as collateral. If the Service were to
successfully take
24
the position that the cross-collateralization provisions of the master
repurchase agreements result in the Company having issued debt instruments
(the reverse repurchase agreements) with differing maturity dates secured by a
pool of Mortgage Loans, a portion of its income could be characterized as
"excess inclusion income." See "Risk Factors--Risk of Adverse Tax Treatment of
Excess Inclusion Income."
Taxation of Tax-Exempt Entities
In general, a Tax-Exempt Entity that is a stockholder of the Company is not
subject to tax on distributions. The Service has ruled that amounts
distributed by a REIT to an exempt employees