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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED: MARCH 31, 2003 OR
| | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM _________________ TO _________________
COMMISSION FILE NUMBER: 001-11914
THORNBURG MORTGAGE, INC.
(Exact name of Registrant as specified in its Charter)
MARYLAND 85-0404134
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification Number)
150 WASHINGTON AVENUE
SANTA FE, NEW MEXICO 87501
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (505) 989-1900
(Former name, former address and former fiscal year,
if changed since last report)
Not applicable
Indicate by check mark whether the Registrant (1) has filed all documents and
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
(1) Yes |X| No | |
(2) Yes |X| No | |
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Securities Exchange Act of 1934).
Yes |X| No | |
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Common Stock ($.01 par value) 59,568,311 as of May 14, 2003
1
THORNBURG MORTGAGE, INC.
FORM 10-Q
INDEX
Page
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets at March 31, 2003 and December 31, 2002................. 3
Consolidated Income Statements for the three months ended
March 31, 2003 and March 31, 2002.................................................. 4
Consolidated Statement of Shareholders' Equity for the three months
ended March 31, 2003 and March 31, 2002............................................ 5
Consolidated Statements of Cash Flows for the three months ended
March 31, 2003 and March 31, 2002.................................................. 6
Notes to Consolidated Financial Statements.......................................... 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations........................................... 21
Item 3. Quantitative and Qualitative Disclosures About Market Risk.............................. 43
Item 4. Controls and Procedures................................................................. 43
PART II. OTHER INFORMATION
Item 1. Legal Proceedings....................................................................... 44
Item 2. Changes in Securities and Use of Proceeds .............................................. 44
Item 3. Defaults Upon Senior Securities ........................................................ 44
Item 4. Submission of Matters to a Vote of Security Holders..................................... 44
Item 5. Other Information....................................................................... 44
Item 6. Exhibits and Reports on Form 8-K........................................................ 44
SIGNATURES .......................................................................................... 45
CERTIFICATIONS....................................................................................... 46
EXHIBIT INDEX ....................................................................................... 49
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
THORNBURG MORTGAGE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands)
March 31, 2003
ASSETS (unaudited) December 31, 2002
-------------- -----------------
Adjustable-rate mortgage ("ARM") assets:
ARM securities $ 10,857,065 $ 9,335,643
Collateral for collateralized notes -- 289,783
ARM loans held for securitization 1,152,372 709,787
------------ ------------
12,009,437 10,335,213
------------ ------------
Cash and cash equivalents 308,639 122,220
Accrued interest receivable 52,986 47,435
Prepaid expenses and other 5,876 8,064
------------ ------------
$ 12,376,938 $ 10,512,932
============ ============
LIABILITIES
Reverse repurchase agreements $ 10,283,647 $ 8,568,260
Collateralized notes -- 255,415
Whole loan financing facilities 1,062,237 589,081
Payable for assets purchased -- 202,844
Accrued interest payable 18,896 17,234
Dividends payable 1,670 32,536
Accrued expenses and other 18,277 14,520
------------ ------------
11,384,727 9,679,890
------------ ------------
COMMITMENTS
SHAREHOLDERS' EQUITY
Preferred stock: par value $.01 per share;
Series A 9.68% Cumulative Convertible shares,
aggregate preference in liquidation $69,000,
2,760 shares authorized, issued and outstanding; 65,805 65,805
Series B Cumulative, 22 shares authorized,
none issued and outstanding -- --
Common stock: par value $.01 per share;
497,218 shares authorized, 59,071 and 52,763 shares
issued and outstanding, respectively 591 528
Additional paid-in-capital 1,001,090 878,929
Accumulated other comprehensive loss (105,813) (105,254)
Notes receivable from stock sales (7,337) (7,437)
Retained earnings 37,875 471
------------ ------------
992,211 833,042
------------ ------------
$ 12,376,938 $ 10,512,932
============ ============
See Notes to Consolidated Financial Statements.
3
THORNBURG MORTGAGE, INC. AND SUBSIDIARIES
CONSOLIDATED INCOME STATEMENTS (UNAUDITED)
(In thousands, except per share data)
Three Months Ended
March 31,
--------------------------
2003 2002
--------- --------
Interest income from ARM assets and cash equivalents $ 123,196 $ 79,427
Interest expense on borrowed funds (71,162) (47,803)
--------- --------
Net interest income 52,034 31,624
--------- --------
Fee income 304 5
Hedging expense (177) (314)
Management fee (2,485) (1,644)
Performance fee (6,187) (3,193)
Long-term incentive awards (1,669) (547)
Other operating expenses (2,746) (1,638)
--------- --------
NET INCOME $ 39,074 $ 24,293
========= ========
Net income $ 39,074 $ 24,293
Dividends on preferred stock (1,670) (1,670)
--------- --------
Net income available to common shareholders $ 37,404 $ 22,623
========= ========
Basic earnings per share:
Net income $ 0.67 $ 0.62
Average number of shares outstanding 55,631 36,417
========= ========
Diluted earnings per share:
Net income $ 0.67 $ 0.62
Average number of shares outstanding 58,391 36,417
========= ========
See Notes to Consolidated Financial Statements.
4
THORNBURG MORTGAGE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (UNAUDITED)
Three months ended March 31, 2003 and 2002
(In thousands, except share data)
Accum.
Other
Compre- Notes Compre-
Additional hensive Receivable Retained hensive
Preferred Common Paid-in Income From Earnings/ Income
Stock Stock Capital (Loss) Stock Sales (Deficit) (Loss) Total
--------- ----- ---------- --------- ----------- --------- --------- ---------
Balance, December 31, 2001 $65,805 $ 333 $ 515,516 $ (36,566) $ (7,904) $ (4,526) $ 532,658
Comprehensive income:
Net income -- -- -- -- -- 24,293 $24,293 24,293
Other comprehensive income:
Available-for-sale assets:
Fair value adjustment -- -- -- (5,319) -- -- (5,319) (5,319)
Swap Agreements and Eurodollar
Transactions:
Fair value adjustment, net of
amortization -- -- -- 26,220 -- -- 26,220 26,220
-------
Comprehensive income $45,194
=======
Issuance of common stock -- 76 140,796 -- -- -- 140,872
Interest and principal payments on
notes receivable from stock sales -- -- 76 -- -- -- 76
Dividends declared on preferred
stock - $0.605 per share -- -- -- -- -- (1,670) (1,670)
------- ----- ---------- --------- -------- -------- ---------
Balance, March 31, 2002 $65,805 $ 409 $ 656,388 $ (15,665) $ (7,904) $ 18,097 $ 717,130
======= ===== ========== ========= ======== ======== =========
Balance, December 31, 2002 $65,805 $ 528 $ 878,929 $(105,254) $ (7,437) $ 471 $ 833,042
Comprehensive income:
Net income -- -- -- -- -- 39,074 $39,074 39,074
Other comprehensive income:
Available-for-sale assets:
Fair value adjustment -- -- -- 3,850 -- -- 3,850 3,850
Swap Agreements and Eurodollar
Transactions:
Fair value adjustment, net of
amortization -- -- -- (4,409) -- -- (4,409) (4,409)
-------
Comprehensive income $38,515
=======
Issuance of common stock -- 63 122,090 -- -- -- 122,153
Interest and principal payments on
notes receivable from stock sales -- -- 71 -- 100 -- 171
Dividends declared on preferred
stock - $0.605 per share -- -- -- -- -- (1,670) (1,670)
------- ----- ---------- --------- -------- -------- ---------
Balance, March 31, 2003 $65,805 $ 591 $1,001,090 $(105,813) $ (7,337) $ 37,875 $ 992,211
======= ===== ========== ========= ======== ======== =========
See Notes to Consolidated Financial Statements.
5
THORNBURG MORTGAGE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)
Three Months Ended
March 31,
--------------------------
2003 2002
----------- -----------
Operating Activities:
Net Income $ 39,074 $ 24,293
Adjustments to reconcile net income to net cash provided
by operating activities:
Amortization 8,167 5,110
Hedging expense 177 314
Change in assets and liabilities:
Accrued interest receivable (5,551) (3,861)
Prepaid expenses and other 2,177 (1,150)
Accrued interest payable 1,662 1,477
Accrued expenses and other 3,757 4,499
----------- -----------
Net cash provided by operating activities 49,463 30,682
----------- -----------
Investing Activities:
Available-for-sale ARM securities:
Purchases (1,848,384) (1,805,247)
Proceeds on sales -- 50,106
Principal payments 1,138,208 871,186
Collateral for collateralized notes:
Principal payments 24,855 70,616
ARM loans:
Purchases (1,204,489) (599,357)
Proceeds on sales -- 3,711
Principal payments 9,403 4,011
----------- -----------
Net cash used in investing activities (1,880,407) (1,404,974)
----------- -----------
Financing Activities:
Net borrowings from reverse repurchase agreements 1,715,413 1,311,248
Repayments of collateralized notes (255,415) (70,268)
Net other borrowings 473,156 96,172
Payments (received) made on Eurodollar contracts (5,579) 102
Proceeds from common stock issued, net 122,153 140,872
Dividends paid (32,536) (19,987)
Payments on notes receivable from stock sales 171 9
----------- -----------
Net cash provided by financing activities 2,017,363 1,458,148
----------- -----------
Net increase in cash and cash equivalents 186,419 83,856
Cash and cash equivalents at beginning of period 122,220 33,884
----------- -----------
Cash and cash equivalents at end of period $ 308,639 $ 117,740
=========== ===========
Supplemental disclosure of cash flow information and non-cash activities is
included in Note 4.
See Notes to Consolidated Financial Statements
6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SIGNIFICANT ACCOUNTING POLICIES
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and
Rule 10-01 of Regulation S-X. Therefore, they do not include all of the
information and footnotes required by generally accepted accounting
principles for complete financial statements.
In the opinion of management, all material adjustments, consisting of
normal recurring adjustments, considered necessary for a fair presentation
have been included. The operating results for the quarter ended March 31,
2003 are not necessarily indicative of the results that may be expected
for the calendar year ending December 31, 2003.
BASIS OF PRESENTATION AND PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of
Thornburg Mortgage, Inc. (together with its subsidiaries referred to
hereafter as the "Company") and its wholly owned bankruptcy-remote
special purpose finance subsidiaries, Thornburg Mortgage Funding
Corporation ("TMFC") and Thornburg Mortgage Acceptance Corporation
("TMAC"), its wholly owned mortgage banking subsidiary, Thornburg
Mortgage Home Loans, Inc. ("TMHL"), and TMHL's two wholly owned
special purpose finance subsidiaries, Thornburg Mortgage Funding
Corporation II and Thornburg Mortgage Acceptance Corporation II. All
of the Company's subsidiaries are wholly owned qualified real estate
investment trust ("REIT") subsidiaries and are consolidated with the
Company for financial statement and tax reporting purposes. All
material intercompany accounts and transactions are eliminated in
consolidation.
CASH AND CASH EQUIVALENTS
"Cash and cash equivalents" includes cash on hand and highly liquid
investments with original maturities of three months or less. The
carrying amount of cash equivalents approximates their fair value.
ADJUSTABLE-RATE MORTGAGE ("ARM") ASSETS
The Company's ARM assets are comprised of ARM securities, ARM loans
and collateral for AAA notes payable, which consists of ARM loans.
All of the Company's ARM assets are either traditional ARM
securities and loans, which have interest rates that reprice in a
year or less ("Traditional ARMs"), or hybrid ARM securities and
loans that have a fixed interest rate for an initial period,
generally three to ten years, and then convert to Traditional ARMs
for their remaining terms to maturity ("Hybrid ARMs").
Management has designated all of its ARM securities as
available-for-sale. Therefore, they are reported at fair value, with
unrealized gains and losses reported in "Accumulated other
comprehensive income (loss)" as a separate component of
shareholders' equity.
The Company securitizes the loans it acquires and originates and
retains the resulting securities in its ARM securities portfolio.
Alternatively, the Company may issue the securities it creates to
third party investors, which provides an alternative form of
long-term financing for the Company's assets. The Company does not
sell any of the securities created from its securitizations to
generate gain on sale income. The securitization process benefits
the Company by either creating highly liquid assets that are readily
financeable in the reverse repurchase agreement market or enabling
the Company to enter into long-term secured debt financing
transactions where the Company is not subject to future recourse on
these financing transactions. The securitizations of the Company's
loans are not accounted for as sales and the Company does
7
not capitalize any servicing rights or obligations as a result of
this process. The fair value reflected in the Company's financial
statements for these securities is generally based on market prices
provided by certain dealers who make markets in these financial
instruments.
Management has the intent and ability to hold the Company's ARM
loans for the foreseeable future, and until maturity or payoff.
Therefore, these loans are carried at their unpaid principal
balances, net of unamortized premium or discount and allowance for
loan losses.
The collateral for the AAA notes payable consists of ARM loans,
which are accounted for in the same manner as ARM loans that are not
held as collateral.
Interest income on ARM assets is accrued based on the outstanding
principal amount and contractual terms of the assets. Premiums and
discounts associated with the purchase of the ARM assets are
amortized into interest income over the lives of the assets using
the effective yield method, adjusted for the effects of estimated
prepayments.
ARM asset transactions are recorded on the date the ARM assets are
purchased or sold. Purchases of new issue ARM securities and all ARM
loans are recorded when all significant uncertainties regarding the
characteristics of the assets are removed and, in the case of loans,
underwriting due diligence has been completed, generally shortly
before the settlement date. Realized gains and losses on ARM asset
transactions are determined on the specific identification basis.
CREDIT RISK
The Company limits its exposure to credit losses on its portfolio of
ARM securities by purchasing ARM securities that have an investment
grade rating at the time of purchase and have some form of credit
enhancement, or are guaranteed by an agency of the federal
government ("Ginnie Mae") or a government-sponsored or
federally-chartered corporation ("Fannie Mae" or "Freddie Mac"). An
investment grade security generally has a security rating of BBB or
Baa or better by at least one of two nationally recognized rating
agencies, Standard & Poor's, Inc. or Moody's Investors Service, Inc.
(the "Rating Agencies"). Additionally, the Company purchases and
originates ARM loans or purchases all classes of an ARM loan
securitization (including the classes rated less than Investment
Grade) and limits its exposure to credit losses by restricting its
whole loan purchases and originations to ARM loans generally
originated to "A" quality underwriting standards. The Company
further limits its exposure to credit risk by limiting its
investment in investment grade securities that are rated A or
equivalent, BBB or equivalent, or ARM loans originated to "A"
quality underwriting standards ("Other Investments"), including the
subordinate classes of securities retained as part of the Company's
securitization of loans or purchases of 100% of the classes from
other loan securitizations, to no more than 30% of the portfolio.
The Company, in general, securitizes all of its loans and retains
the resulting securities in its ARM portfolio. The Company may also
purchase an entire securitization backed by "A" quality loans. At
the time of securitization, the Company obtains a credit review of
the loans being securitized by one or more Rating Agency. Based in
part on this review, the Company makes a determination regarding the
expected losses to be realized in the future and adjusts the basis
of the securities to their expected realizable value. In doing so,
the Company establishes a basis adjustment amount to absorb the
expected credit losses. The Company then monitors the delinquencies
and losses on the underlying loans backing its ARM securities. If
the credit performance of the underlying loans is not as good as
expected, the Company records a provision for additional probable
credit losses at a level deemed appropriate by management to provide
for estimated losses inherent in its ARM securities portfolio. The
provision is based on management's assessment of numerous factors
affecting the Company's portfolio of ARM assets including, but not
limited to, current economic conditions, delinquency status, credit
losses to date on underlying loans and remaining credit protection.
The provision for ARM securities is made by reducing the cost basis
of the individual security for the decline in fair value (which is
other than temporary), and the amount of such
8
write-down is recorded as a realized loss, thereby reducing
earnings. Additionally, once a loan within one of these securities
is 90 days or more delinquent, or a borrower declares bankruptcy,
the Company adjusts the value of its accrued interest receivable to
what it believes to be collectible and stops accruing interest on
that portion of the security collateralized by the loan.
Loans that are not yet securitized are also reviewed for probable
losses. The Company's loans are held for securitization until an
appropriate size pool is created, which generally occurs within a
few months of acquisition or origination. As a result, although the
Company reviews its unsecuritized loans for probable losses, it is
unlikely a loan would incur a loss prior to securitization. If a
loss were estimated on an unsecuritized loan in excess of existing
reserves, the Company would record a provision, which would reduce
earnings, and adjust the loan loss reserve.
Provisions for credit losses do not reduce taxable income and thus
do not affect the dividends paid by the Company to shareholders in
the period the provisions are taken. Actual losses realized by the
Company do reduce taxable income in the period the actual loss is
realized and would affect the dividends paid to shareholders for
that tax year.
VALUATION METHODS
The fair values of the Company's ARM securities are generally based
on market prices provided by certain dealers who make markets in
these financial instruments, or by third-party pricing services. If
the fair value of an ARM security is not reasonably available from a
dealer or a third-party pricing service, management estimates the
fair value based on characteristics of the security that the Company
receives from the issuer and on available market information. The
fair values for ARM loans are estimated by the Company by using the
same pricing models employed by the Company in the process of
determining a price to bid for loans in the open market, taking into
consideration the aggregated characteristics of groups of loans such
as, but not limited to, collateral type, index, interest rate,
margin, length of fixed-rate period, life cap, periodic cap,
underwriting standards, age and credit. The fair values of the
Company's collateralized notes payable, interest rate swap
agreements and interest rate cap agreements are based on market
values provided by dealers who are familiar with the terms of the
notes, swap agreements and cap agreements. The fair value of futures
contracts is determined on a daily basis by the closing price on the
Chicago Mercantile Exchange. The fair values reported reflect
estimates and may not necessarily be indicative of the amounts the
Company could realize if these instruments were sold. Cash and cash
equivalents, interest receivable, reverse repurchase agreements,
other borrowings and other liabilities are reflected in the
financial statements at their amortized cost, which approximates
their fair value because of the short-term nature of these
instruments.
DERIVATIVE FINANCIAL INSTRUMENTS
All of the Company's derivative financial instruments (interest rate
cap agreements, interest rate swap agreements and Eurodollar futures
contracts) are carried on the balance sheet at their fair value. If
a derivative is designated as a "fair value hedge," the changes in
the fair value of the derivative instrument and the changes in the
fair value of the hedged item are both recognized in earnings. If a
derivative is designated as a "cash flow hedge," the effective
amount of change in the fair value of the derivative instrument is
recorded in "Other comprehensive income" and is transferred from
"Other comprehensive income" to earnings as the hedged item affects
earnings. The ineffective amount of all hedges is recognized in
earnings each quarter.
As the Company enters into hedging transactions, it formally
documents the relationship between the hedging instruments and the
hedged items. The Company has also documented its risk-management
policies, including objectives and strategies, as they relate to its
hedging activities. The Company assesses, both at inception of a
hedging activity and on an on-going basis, whether or not the
hedging activity is highly effective. If it is determined that a
hedge is not highly effective, the Company discontinues hedge
accounting prospectively.
9
INTEREST RATE SWAP AGREEMENTS AND EURODOLLAR FUTURES CONTRACTS
The Company enters into interest rate swap agreements ("Swap
Agreements") and Eurodollar futures contracts ("Eurodollar
Transactions") in order to manage its interest rate exposure when
financing its ARM assets. The Company generally borrows money based
on short-term interest rates, either by entering into borrowings
with maturity terms of less than one year, and frequently one to
three months, or by entering into borrowings with longer maturities
of one to two years that have an interest rate that is reset based
on a frequency that is commonly one to three months. The Company's
Traditional ARM assets generally have interest rates that reprice
based on frequency terms of one to twelve months. The Company's
Hybrid ARM assets have an initial fixed interest rate period of
three to ten years. As a result, the Company's existing and
forecasted borrowings reprice to a new rate on a more frequent basis
than do the Company's ARM assets. When the Company enters into a
Swap Agreement, it generally agrees to pay a fixed rate of interest
and to receive a variable interest rate, generally based on the
London InterBank Offer Rate ("LIBOR"). The Company also enters into
Eurodollar Transactions in order to hedge changes in its forecasted
three-month LIBOR-based liabilities. The notional balances of the
Swap Agreements and the total contract size of the Eurodollar
Transactions generally decline over the life of these instruments.
These Swap Agreements and Eurodollar Transactions have the effect of
converting the Company's variable-rate debt into fixed-rate debt
over the life of the Swap Agreements and Eurodollar Transactions.
These instruments are used as a cost effective way to lengthen the
average repricing period of the Company's variable rate and
short-term borrowings such that the duration of the borrowings
closely matches the duration of the Company's ARM assets.
All Swap Agreements are designated as cash flow hedges against the
benchmark interest rate risk associated with the Company's
borrowings. Although the terms and characteristics of the Company's
Swap Agreements and hedged borrowings are nearly identical, due to
the explicit requirements of Financial Accounting Standards No. 133
("FAS 133"), the Company does not account for these hedges under a
method defined in FAS 133 as the "shortcut" method, but rather the
Company calculates the effectiveness of these hedges on an ongoing
basis, and to date, has calculated effectiveness of approximately
100%. Eurodollar Transactions are also designated as cash flow
hedges and are accounted for in accordance with FAS 133
implementation issue No. G7, Method 1: Change in Variable Cash
Correspondent Method, and application of this method has resulted in
no measured ineffectiveness. All changes in the unrealized gains and
losses on Swap Agreements and the Eurodollar Transactions have been
recorded in "Accumulated other comprehensive income" and are
reclassified to earnings as interest expense is recognized on the
Company's hedged borrowings. If it becomes probable that the
forecasted transaction, which in this case refers to interest
payments to be made under the Company's short-term borrowing
agreements, will not occur by the end of the originally specified
time period, as documented at the inception of the hedging
relationship, or within an additional two-month time period
thereafter, then the related gain or loss in "Accumulated other
comprehensive income" would be reclassified to income. As of March
31, 2003, the net unrealized loss on Swap Agreements, deferred gains
from terminated Swap Agreements and deferred gains and losses on
Eurodollar Transactions recorded in "Accumulated other comprehensive
income" was a net loss of $153.4 million. The Company estimates that
over the next twelve months, $81.5 million of these net unrealized
losses will be reclassified from "Accumulated other comprehensive
income" to interest expense.
The loss on Swap Agreements is the discounted value of the remaining
future net interest payments expected to be made over the remaining
life of the Swap Agreements. Therefore, over time, as the actual
payments are made, the unrealized loss in "Accumulated other
comprehensive income" and the carrying value of the Swap Agreements
adjusts to zero and the Company realizes a fixed cost of money over
the life of the hedging instrument
The Company has terminated and/or replaced Swap Agreements in the
course of managing its liquidity and balance sheet. Since the
Company's adoption of FAS 133, realized gains and losses resulting
from the termination of Swap Agreements are initially recorded in
"Accumulated other comprehensive income" as a separate component of
equity. The gain or loss from the terminated
10
Swap Agreements remains in "Accumulated other comprehensive income"
until the forecasted interest payments affect earnings. If it
becomes probable that the forecasted interest payments will not
occur, then the entire gain or loss would be reclassified to income.
INTEREST RATE CAP AGREEMENTS
The Company purchases interest rate cap agreements ("Cap
Agreements") to manage interest rate risk on a portion of its
assets. In general, ARM assets have a contractual maximum interest
rate ("Life Cap"), which is a component of the fair value of an ARM
asset. Pursuant to the terms of the Cap Agreements, the Company will
receive cash payments if the interest rate index specified in any
such Cap Agreement increases above certain specified levels.
Therefore, such Cap Agreements have the effect of offsetting a
portion of the Company's borrowing costs, above a specified level so
that the net margin on the Company's ARM assets will be protected in
high interest rate environments.
The Company does not currently apply hedge accounting to its Cap
Agreements and, as a result, the Company records the change in fair
value of the Cap Agreements as hedging expense in current earnings.
The Company purchases Cap Agreements by incurring a one-time fee or
premium and carries them at fair value. The carrying value of the
Cap Agreements is included in "Prepaid expenses and other" on the
balance sheet.
ACCUMULATED OTHER COMPREHENSIVE INCOME
The Financial Accounting Standard Board's Statement 130, "Reporting
Comprehensive Income," divides comprehensive income into net income
and other comprehensive income, which includes unrealized gains and
losses on marketable securities defined as available-for-sale and
unrealized gains and losses on derivative financial instruments that
qualify for hedge accounting under FAS 133. Accumulated other
comprehensive income (loss) at March 31, 2003 and December 31, 2002
includes the following (dollar amounts in thousands):
March 31, 2003 December 31, 2002
-------------- -----------------
Net unrealized gain on available-for-sale ARM
assets $ 47,487 $ 43,489
Net unrealized loss on Swap Agreements and
Eurodollar Transactions (153,300) (148,743)
--------- ---------
Accumulated other comprehensive loss $(105,813) $(105,254)
========= =========
INCOME TAXES
The Company elected to be taxed as a REIT and believes it complies
with the provisions of the Internal Revenue Code of 1986, as amended
(the "Code") with respect thereto. Accordingly, the Company will not
be subject to Federal income tax on that portion of its income that
is distributed to shareholders, as long as certain asset, income and
stock ownership tests are met.
NET EARNINGS PER SHARE
Basic EPS amounts are computed by dividing net income (adjusted for
dividends declared on preferred stock) by the weighted average
number of common shares outstanding. Diluted EPS amounts assume the
conversion, exercise or issuance of all potential common stock
instruments, unless the effect is to reduce a loss or increase the
earnings per common share.
Following is information about the computation of the earnings per
share data for the three-month periods ended March 31, 2003 and 2002
(amounts in thousands except per share data):
11
Income Shares Earnings Per Share
-------- ------ ------------------
Three Months Ended March 31, 2003
Net income $ 39,074
Less preferred stock dividends (1,670)
--------
Basic EPS, income available to common shareholders 37,404 55,631 $ 0.67
======
Effect of dilutive securities:
Convertible preferred stock 1,670 2,760
-------- ------
Diluted EPS $ 39,074 58,391 $ 0.67
======== ====== ======
Three Months Ended March 31, 2002
Net income $ 24,293
Less preferred stock dividends (1,670)
--------
Basic EPS, income available to common shareholders 22,623 36,417 $ 0.62
======
Effect of dilutive securities:
Convertible preferred stock -- --
-------- ------
Diluted EPS $ 22,623 36,417 $ 0.62
======== ====== ======
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results
could differ from those estimates.
CURRENT ACCOUNTING PRONOUNCEMENTS
In November 2002, the FASB issued Interpretation No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"),
which is an interpretation of SFAS No. 5; "Accounting for
Contingencies," SFAS No. 57; "Related Party Disclosures," and SFAS
No. 107; "Disclosures About Fair Value of Financial Instruments."
FIN 45 clarifies the disclosure and liability recognition
requirements relating to guarantees issued by an entity. FIN 45 is
effective for new guarantees issued or modification of guarantees
made after December 31, 2002. The adoption of FIN 45`s measurement
requirements is not expected to have a significant impact on the
Company's financial position or results of operations. The Company
has no guarantees requiring disclosure under FIN 45.
In January 2003, the FASB issued FASB Interpretation No. 46,
"Consolidation of Variable Interest Entities" ("FIN 46"), which is
an interpretation of Accounting Research Bulletin No. 51,
"Consolidated Financial Statements." FIN 46 requires business
enterprises to consolidate variable interest entities which have one
or more of the following characteristics:
1. The equity investment at risk is not sufficient to permit the
entity to finance its activities without additional
subordinated financial support from other parties.
2. The equity investors lack one or more of the following
essential characteristics of a controlling financial interest:
12
a. The direct or indirect ability to make decisions about
the entity's activities through voting rights or similar
rights
b. The obligation to absorb the expected losses of the
entity if they occur
c. The right to receive expected residual returns of the
entity if they occur.
FIN 46 excludes qualifying special purpose entities subject to the
reporting requirements of SFAS 140. FIN 46 applies upon formation to
variable interest entities created after January 31, 2003, and to
all variable interest entities in the first fiscal year or interim
period beginning after June 15, 2003. The adoption of FIN 46 is not
expected to have an impact on the Company's financial statements.
In April 2003, the FASB issued SFAS 149, "Amendment of Statement 133
on Derivative Instruments and Hedging Activities", which amends SFAS
133 for certain decisions made by the FASB Derivatives
Implementation Group. In particular, SFAS 149 (1) clarifies under
what circumstances a contract with an initial net investment meets
the characteristic of a derivative, (2)clarifies when a derivative
contains a financing component, (3) amends the definition of an
underlying to conform it to language used in FIN 45, and (4) amends
certain other existing pronouncements. This Statement is effective
for contracts entered into or modified after June 30, 2003, and for
hedging relationships designated after June 30, 2003. In addition,
most provisions of SFAS 149 are to be applied prospectively. The
Company does not expect the adoption of SFAS 149 to have a material
impact on its financial position, cash flows or results of
operations.
13
NOTE 2. ADJUSTABLE-RATE MORTGAGE ASSETS
The following tables present the Company's ARM assets as of March
31, 2003 and December 31, 2002. The ARM securities classified as
available-for-sale are carried at their fair value, while the
collateral for collateralized notes and ARM loans are carried at
their amortized cost basis (dollar amounts in thousands):
March 31, 2003:
Available-for-Sale Collateral for
ARM Securities Collateralized Notes ARM Loans Total
------------------ -------------------- ----------- ------------
Principal balance outstanding $ 10,659,982 $ -- $ 1,146,475 $ 11,806,457
Net unamortized premium 131,913 -- 5,997 137,910
Basis adjustments/Allowance for losses (16,525) -- (100) (16,625)
Principal payment receivable 33,163 -- -- 33,163
------------ --------- ----------- ------------
Amortized cost, net 10,808,533 -- 1,152,372 11,960,905
Gross unrealized gains 80,833 -- 6,424 87,257
Gross unrealized losses (32,301) -- (1,245) (33,546)
------------ --------- ----------- ------------
Fair value $ 10,857,065 $ -- $ 1,157,551 $ 12,014,616
============ ========= =========== ============
Carrying value $ 10,857,065 $ -- $ 1,152,372 $ 12,009,437
============ ========= =========== ============
December 31, 2002:
Available-for-Sale Collateral for
ARM Securities Collateralized Notes ARM Loans Total
------------------ -------------------- ----------- ------------
Principal balance outstanding $ 9,162,747 $ 287,409 $ 706,965 $ 10,157,121
Net unamortized premium 108,565 5,613 2,922 117,100
Basis adjustments/Allowance for losses (11,384) (3,239) (100) (14,723)
Principal payment receivable 31,033 -- -- 31,033
------------ --------- ----------- ------------
Amortized cost, net 9,290,961 289,783 709,787 10,290,531
Gross unrealized gains 73,805 2,297 3,505 79,607
Gross unrealized losses (29,123) (120) (160) (29,403)
------------ --------- ----------- ------------
Fair value $ 9,335,643 $ 291,960 $ 713,132 $ 10,340,735
============ ========= =========== ============
Carrying value $ 9,335,643 $ 289,783 $ 709,787 $ 10,335,213
============ ========= =========== ============
The Company did not sell any ARM assets during the quarter ended
March 31, 2003. During the quarter ended March 31, 2002, the Company
sold one ARM security in the amount of $50.1 million for no gain or
loss. The ARM security sold was classified as "available-for-sale."
In addition, the Company sold $3.7 million of loans and realized a
gross gain of $6.0 thousand and a gross loss of $3.0 thousand.
During the quarter ended March 31, 2003, the Company securitized
$774.5 million of its ARM loans into a series of private-label
multi-class ARM securities. In keeping with the Company's portfolio
lending strategy, it retained for its ARM portfolio, all of the
classes of the securities created. The Company did not account for
this securitization as a sale and, therefore, did not record any
gain or loss in connection with the securitization. The Company
carries the securities at fair value, based primarily on market
value prices received from dealers familiar with similar securities.
As of March 31, 2003, $3.5 billion of the Company's ARM assets had
been created from the Company's loan securitization and retention
process.
14
As of March 31, 2003 and December 31, 2002, the Company had reduced
the cost basis of its securitized ARM loans by $15.2 million and
$13.8 million, respectively, due to estimated credit losses (other
than temporary declines in fair value). The reduction in the cost
basis recorded during the first quarter of 2003, in the amount of
$1.5 million, was recorded in connection with the Company's
securitization of $774.5 million of loans.
As of March 31, 2003 and December 31, 2002, the Company had reduced
the cost basis of other ARM securities by $1.3 million and $858.8
thousand, respectively, due to estimated credit losses (other than
temporary declines in fair value) related to ARM securities
purchased at a discount. The Company recorded a reduction in cost
basis of $435.8 thousand related to ARM securities purchased during
the quarter ended March 31, 2003 on which the Company has first loss
credit exposure. These securities were purchased as part of a
transaction in which the Company purchased all of the classes of a
loan securitization in the amount of $299.7 million, including the
subordinated classes. The Company also recorded realized losses on
purchased ARM securities in the amount of $49.1 thousand and
realized recoveries in the amount of $52.6 thousand during the first
quarter of 2003.
The Company has credit exposure on loans it has securitized and
loans held for securitization. All of the loans that were delinquent
as of March 31, 2003 and December 31, 2002 were loans the Company
had securitized. The following tables summarize ARM loan delinquency
information as of March 31, 2003 and December 31, 2002 (dollar
amounts in thousands):
March 31, 2003
Percent of ARM Percent of
Delinquency Status Loan Count Loan Balance Loans (1) Total Assets
---------- ------------ --------- ------------
60 to 89 days 3 $ 807 0.02% 0.01%
90 days or more 1 147 0.00% 0.00%
In foreclosure 6 3,807 0.08% 0.03%
------ ------ ------ ------
10 $4,761 0.10% 0.04%
====== ====== ====== ======
December 31, 2002
Percent of ARM Percent of
Delinquency Status Loan Count Loan Balance Loans (1) Total Assets
---------- ------------ --------- ------------
60 to 89 days 2 $ 270 0.01% 0.00%
90 days or more 1 159 0.00% 0.00%
In foreclosure 5 2,970 0.08% 0.03%
------ ------ ------ ------
8 $3,399 0.09% 0.03%
====== ====== ====== ======
(1) ARM loans include loans held for securitization and loans that
the Company has securitized and retained first loss credit
exposure for total amounts of $4.6 billion and $3.7 billion at
March 31, 2003 and December 31, 2002, respectively.
As of March 31, 2003, the Company has a $100.0 thousand reserve for
estimated losses on loans pending securitization. The Company
believes that its current level of reserves is adequate to cover any
estimated loss, should one occur, on loans pending securitization.
15
As of March 31, 2003, the Company had commitments to purchase or
originate the following amounts of ARM assets (dollar amounts in
thousands):
ARM securities $ 331,210
Whole loans - bulk purchase 202,282
Whole loans - correspondent 449,506
Whole loans - direct originations 119,220
----------
$1,102,218
==========
The Company has entered into transactions whereby the Company
expects to acquire the remaining balance of certain AAA rated Hybrid
ARM securities, at a price of par, between 2004 and 2007, when the
fixed-rate period of the Hybrid ARM securities terminates and the
securities convert into Traditional ARM securities with
characteristics similar to the ARM securities held in the current
portfolio. The Company views these as an alternative source of
Traditional ARM assets. The current balance of the Hybrid ARM
securities is approximately $3.4 billion, but is expected to be less
than 25% of that, and could be zero, at the time they convert into
Traditional ARM securities. If the Company decides not to acquire
the Hybrid ARM securities when they convert into Traditional ARM
securities, then it is committed to pay or receive the difference
between par and the fair value of the Traditional ARM securities at
that time, as determined by an auction of the Traditional ARM
securities. As of March 31, 2003, the Company has delivered $6.9
million of collateral in connection with these transactions.
NOTE 3. INTEREST RATE CAP AGREEMENTS
The fair value of the Cap Agreements at March 31, 2003 and December
31, 2002 amounted to $74.1 thousand and $84.7 thousand,
respectively, and is included in "Prepaid expenses and other" on the
balance sheet. Purchased Cap Agreements had a remaining notional
amount of $1.2 billion and $1.8 billion as of March 31, 2003 and
December 31, 2002, respectively. The notional amount of the Cap
Agreements purchased declines at a rate that is expected to
approximate the amortization of the Traditional ARM securities.
Under these Cap Agreements, the Company will receive cash payments
should the one-month or three-month LIBOR increase above the
contract rates of these hedging instruments, which range from 6.00%
to 12.00% and average 9.73%. The Cap Agreements had an average
maturity of 1.2 years as of March 31, 2003. The initial aggregate
notional amount of the Cap Agreements declines to $1.2 billion over
the period of the agreements, which expire between 2003 and 2005.
During the three-month periods ended March 31, 2003 and 2002, the
Company recognized expenses of $177.1 thousand and $313.6 thousand,
respectively, which is reported as "Hedging expense" in the
Company's Consolidated Income Statements.
NOTE 4. REVERSE REPURCHASE AGREEMENTS, WHOLE LOAN FINANCING FACILITIES,
COLLATERALIZED NOTES AND OTHER BORROWINGS
REVERSE REPURCHASE AGREEMENTS
The Company has arrangements to enter into reverse repurchase
agreements, a form of collateralized short-term borrowing, with 23
different financial institutions, and as of March 31, 2003, had
borrowed funds from 15 of these firms. Because the Company borrows
money under these agreements based on the fair value of its ARM
assets, and because changes in interest rates can negatively impact
the valuation of ARM assets, the Company's borrowing ability under
these agreements could be limited and lenders could initiate margin
calls in the event interest rates change or the value of the
Company's ARM assets declines for other reasons.
As of March 31, 2003, the Company had $10.1 billion of reverse
repurchase agreements outstanding with a weighted average borrowing
rate of 1.45% and a weighted average remaining maturity of 4.5
months. After including the $142.5 million carrying value of Swap
Agreements, the combined reverse repurchase agreements and Swap
Agreements outstanding of $10.3 billion as of March 31, 2003 had a
weighted average borrowing rate of 2.79% and a weighted average
remaining maturity of 1.8 years.
16
As of December 31, 2002, the Company had $8.4 billion of reverse
repurchase agreements outstanding with a weighted average borrowing
rate of 1.59% and a weighted average remaining maturity of 4.6
months. After including the $142.5 million carrying value of Swap
Agreements, the combined reverse repurchase agreements and Swap
Agreements outstanding of $8.6 billion as of December 31, 2002 had a
weighted average borrowing rate of 2.95% and a weighted average
remaining maturity of 1.7 years. As of March 31, 2003, $6.8 billion
of the Company's borrowings were variable-rate term reverse
repurchase agreements with original maturities that range from six
months to twenty-four months. The interest rates of these term
reverse repurchase agreements are indexed to either the one- or
three-month LIBOR rate and reprice accordingly. ARM assets with a
carrying value of $10.7 billion, including accrued interest and cash
totaling $68.9 million, collateralized the reverse repurchase
agreements at March 31, 2003.
At March 31, 2003, the reverse repurchase agreements, which includes
the carrying value of Swap Agreements, had the following remaining
maturities (dollar amounts in thousands):
Within 30 days $ 3,167,365
31 to 89 days 1,421,305
90 to 365 days 5,148,955
Over 365 days 403,517
-----------
10,141,142
Swap Agreements (carrying value) 142,505
-----------
$10,283,647
===========
WHOLE LOAN FINANCING FACILITIES
As of March 31, 2003, the Company had entered into three whole loan
financing facilities. The interest rates on these facilities are
indexed to one-month LIBOR and reprice accordingly. One of the whole
loan financing facilities has a committed borrowing capacity of $600
million and matures in January 2004. The other two financing
facilities have a committed borrowing capacity of $300 million each
and mature in November 2003 and March 2004. As of March 31, 2003,
the Company had $1.1 billion borrowed against these whole loan
financing facilities at an effective cost of 1.99%. As of December
31, 2002, the Company had $589.1 million borrowed against whole loan
financing facilities at an effective cost of 2.11%. The amount
borrowed on the whole loan financing agreements at March 31, 2003
was collateralized by ARM loans with a carrying value of $1.1
billion, including accrued interest.
The whole loan financing facility with a borrowing capacity of $300
million and maturing in March 2004, discussed above, is a
securitization transaction in which the Company transfers groups of
whole loans to a wholly owned bankruptcy-remote special purpose
subsidiary. The subsidiary, in turn, simultaneously transfers its
interest in the loans to a trust, which issues beneficial interests
in the loans in the form of a note and a subordinated certificate.
The note is then used to collateralize borrowings. This whole loan
financing facility works similarly to a secured line of credit
whereby the Company can deliver loans into the facility and take
loans out of the facility at the Company's discretion subject to the
terms and conditions of the facility. This securitization
transaction is accounted for as a secured borrowing.
COLLATERALIZED NOTES
On December 18, 1998, the Company, through a wholly owned
bankruptcy-remote special purpose finance subsidiary, issued $1.1
billion of notes payable ("Notes") collateralized by ARM loans and
ARM securities. As part of this transaction, the Company retained
ownership of a subordinated certificate in the amount of $32.4
million, which represents the Company's maximum exposure to credit
losses on the loans collateralizing the Notes. On January 25, 2003,
the Company called the Notes. The Company re-securitized the loan
collateral securitizing these notes payable in a loan securitization
in April 2003. (See Note 9.)
17
SWAP AGREEMENTS AND EURODOLLAR TRANSACTIONS
As of March 31, 2003, the Company was counterparty to Swap
Agreements and Eurodollar Transactions having an aggregate current
notional balance of $6.4 billion. In addition, the Company entered
into a delayed Swap Agreement with a notional balance of $500
million that becomes effective in August 2003. These Swap Agreements
and Eurodollar Transactions hedge the cost of financing Hybrid ARM
assets during their fixed rate term (generally three to ten years).
As of March 31, 2003, these Swap Agreements and Eurodollar
Transactions had a weighted average maturity of 2.7 years. In
accordance with the Swap Agreements, the Company will pay a fixed
rate of interest during the term of these Swap Agreements and
receive a payment that varies monthly with the one-month LIBOR rate.
The Company hedges the funding of its Hybrid ARM assets such that
the weighted average net duration of borrowed funds, hedges and
Hybrid ARM assets is less than one year. At March 31, 2003, the
financing and hedging of the Company's Hybrid ARM assets resulted in
a net duration of approximately 2 months. The carrying value of the
Swap Agreements, in the amount of $142.5 million as of March 31,
2003, is included in "Reverse repurchase agreements" in the
accompanying balance sheets. As of March 31, 2003, ARM assets with a
carrying value of $113.4 million, including accrued interest, and
cash totaling $11.3 million collateralized the Swap Agreements.
OTHER
The total cash paid for interest was $68.9 million and $45.7 million
during the quarters ended March 31, 2003 and 2002, respectively.
NOTE 5. FAIR VALUE OF FINANCIAL INSTRUMENTS AND OFF-BALANCE SHEET CREDIT RISK
The following table presents the carrying amounts and estimated fair
values of the Company's financial instruments at March 31, 2003 and
December 31, 2002 (dollar amounts in thousands):
March 31, 2003 December 31, 2002
------------------------------ ------------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
----------- ----------- ----------- -----------
Assets:
ARM assets $12,009,437 $12,014,616 $10,335,213 $10,340,735
Cap Agreements 74 74 85 85
Liabilities:
Reverse repurchase agreements 10,141,142 10,142,142 8,425,729 8,425,729
Collateralized notes -- -- 255,415 255,863
Whole loan financing facilities 1,062,237 1,062,237 589,081 589,081
Swap Agreements 142,505 142,505 142,531 142,531
The above Cap Agreements are included in the balance sheet under the
caption "Prepaid expenses and other." The carrying amount for
securities, which are categorized as available-for-sale, is their
fair value, whereas the carrying amount for loans, which are
categorized as held for the foreseeable future, is their amortized
cost.
NOTE 6. COMMON AND PREFERRED STOCK
During February 2003, the Company completed a public offering of
3,473,500 shares of common stock and received net proceeds of $65.9
million under its shelf registration statement on Form S-3 that was
declared effective by the Securities and Exchange Commission ("SEC")
on August 30, 2002. During the quarter ended March 31, 2003, the
Company also issued 1,449,300 shares of common stock in "at-market"
transactions under a controlled equity program under the August 2002
shelf registration statement and received net proceeds of $29.1
million. As of March 31, 2003, $25.1 million and $243.8
18
million of the Company's registered securities remained available
for future issuance and sale under its currently effective July 2001
and August 2002 shelf registration statements, respectively.
During the quarter ended March 31, 2003, the Company issued
1,384,846 shares of common stock under its Dividend Reinvestment and
Stock Purchase Plan (the "DRP") and received net proceeds of $27.2
million.
On December 17, 2002, the Company declared the fourth quarter 2002
dividend of $0.585 per share of common stock, which was paid on
January 24, 2003 to common shareholders of record as of December 31,
2002.
On March 14, 2003, the Company declared a first quarter dividend of
$0.605 per share to the shareholders of the Series A 9.68%
Cumulative Convertible Preferred Stock, which was paid on April 10,
2003 to preferred shareholders of record as of March 31, 2003.
On April 22, 2003, the Company declared the first quarter 2003
dividend of $0.60 per share of common stock, which will be paid on
May 16, 2003 to common shareholders of record as of May 2, 2003.
For federal income tax purposes, all dividends are expected to be
ordinary income to the Company's common and preferred shareholders,
subject to year-end allocations of the common dividend between
ordinary income, capital gain income and non-taxable income as
return of capital, depending on the amount and character of the
Company's full year taxable income.
NOTE 7. LONG-TERM INCENTIVE AWARDS
The Company's Board of Directors adopted the "Amended and Restated
2002 Long-Term Incentive Plan" (the "Plan"), effective September 29,
2002. The Board of Directors further amended the Plan in January
2003 to exclude the authorization of stock options. The amended Plan
authorizes the Company's Compensation Committee to grant Dividend
Equivalent Rights ("DERs"), Stock Appreciation Rights ("SARs") and
Phantom Stock Rights ("PSRs").
During the first quarter of 2003, the policy of the Compensation
Committee and the Board was to grant only PSR and DER awards under
the Plan. The PSRs are granted in lieu of stock options, based on
equivalent values as calculated by a Black Scholes option model. In
March 2003, the Compensation Committee suspended the award of DERs
related to equity issued subsequent to March 31, 2003 for the
remainder of 2003.
The PSRs, when received as a grant, generally vest over a three-year
period. The Company usually issues DERs under a formula at the same
time that other awards under the Plan are granted; however, the
Compensation Committee has suspended the formula-based awards of
DERs subsequent to March 31, 2003 for the remainder of 2003. The DER
and PSR participants may elect to reinvest their PSR and DER cash
dividends into additional PSRs at the price of the Company's common
stock on the related dividend payment date. The PSRs are expensed
over the applicable vesting period. The DERs are fully expensed on
the Company's income statement.
As of March 31, 2003, there were 1,331,758 DERs outstanding, of
which 1,303,597 were vested, and 502,255 PSRs outstanding, of which
303,606 were vested. The Company recorded an expense associated with
DERs and PSRs of $1.7 million and $547.4 thousand for the quarters
ended March 31, 2003 and 2002, respectively. Of the expense recorded
in the first quarter of 2003, $1.0 million was the amount of
dividend equivalents paid on DERs and PSRs, $422.7 thousand was the
amortization of unvested PSRs, and $210.0 thousand was the impact of
the increase in the Company's common stock price on the value of the
PSRs which was recorded as a fair value adjustment. Of the expense
recorded during the first quarter of 2002, $436.9 thousand was the
amount of dividend equivalents paid on DERs and PSRs, $20.3 thousand
was the impact of the increase in the Company's common stock price
on the value of the PSRs which was recorded as a fair value
adjustment, and $90.2 thousand was the
19
amortization of the value of restricted shares (all of which were
subsequently cancelled in April 2002 by the Company's Board of
Directors and replaced with PSRs of equal value), net of the effect
of cancelled restricted shares due to employment termination.
Notes receivable from stock sales arose from the Company financing a
portion of the purchase of shares of common stock by directors,
officers and employees through the exercise of stock options prior
to 2002. The notes mature in 2010 and accrue interest at a rate of
3.91% per annum. In addition, the notes are full recourse promissory
notes and are secured by a pledge of the shares of the common stock
acquired. Interest, which is credited to paid-in-capital, is payable
quarterly, with the balance due at the maturity of the notes. The
payment of the notes will be accelerated only upon the sale of the
shares of common stock pledged for the notes. The notes may be
prepaid at any time at the option of each borrower. As of March 31,
2003, there was $7.3 million of notes receivable outstanding from
stock sales. All of these notes were made prior to the enactment of
the Sarbanes-Oxley Act of 2002 (the "Act"). As a result of the Act,
the notes made to directors and executive officers of the Company
may not be modified and these individuals are not eligible to
participate in any such program in the future. In April 2002, the
Board approved a limited stock repurchase program for the repurchase
of shares of common stock at current market value that were acquired
pursuant to the exercise of stock options under the Company's
previous stock option plan. The Company will first apply the
proceeds from any such repurchases to the repayment of any
outstanding stock option notes receivable due from the holders. As
of March 31, 2003, no shares have been repurchased under this
program.
NOTE 8. TRANSACTIONS WITH AFFILIATES
The Company has no employees and is managed externally by Thornburg
Mortgage Advisory Corporation ("the Manager") a under the terms of a
Management Agreement (the "Agreement") that has been negotiated and
approved by the Board of Directors. Under the terms of this
Agreement, the Manager, subject to the supervision of the Company's
Board of Directors, is responsible for the management of all
operations of the Company and provides certain personnel and office
space. Certain defined expenses of the Manager and affiliates of the
Manager are reimbursed by the Company, principally expenses of TMHL,
the Company's mortgage banking subsidiary, related to mortgage loan
acquisition, selling, servicing and securitization activities,
including the personnel and office space attributed to these
activities. During the quarters ended March 31, 2003 and 2002, the
Company reimbursed the Manager and affiliates of the Manager $1.1
million and $457.4 thousand for expenses, respectively, in
accordance with the terms of the Agreement. As of March 31, 2003 and
2002, $850.0 thousand and $274.9 thousand, respectively, was payable
by the Company to the Manager for reimbursable expenses. The
Agreement has a ten-year term expiring July 15, 2009, and provides
for an annual review of the Manager's performance under the
Agreement by the unaffiliated directors of the Board of Directors.
The Company must pay a substantial cancellation fee if it terminates
the Agreement other than for cause.
The Company pays the Manager an annual base management fee based on
average shareholders' equity, adjusted for liabilities that are not
incurred to finance assets ("Average Shareholders' Equity" or
"Average Net Invested Assets" as defined in the Agreement), payable
monthly in arrears as follows: 1.20% of the first $300 million of
Average Shareholders' Equity, plus 0.88% of Average Shareholders'
Equity above $300 million. The Agreement also has a cost of living
clause that adjusts the base management fee formula by the change in
the Consumer Price Index over the previous twelve-month period,
effective as of each annual review of the Agreement. In addition,
the three wholly owned subsidiaries of the Company and the two
wholly owned subsidiaries of TMHL have entered into separate
Management Agreements with the Manager for additional management
services for a combined amount of $1.2 thousand per month, paid in
arrears.
For the quarters ended March 31, 2003 and 2002, the Company incurred
costs of $2.5 million and $1.6 million, respectively, in base
management fees in accordance with the terms of the Agreement. As of
March 31, 2003 and 2002, $872.1 thousand and $602.3 thousand,
respectively, was payable by the Company to the Manager for the base
management fee.
20
The Manager is also entitled to earn performance-based compensation
in an amount equal to 20% of the Company's annualized net income,
before performance-based compensation, above an annualized return on
equity equal to the ten year U.S. Treasury Rate plus 1%. For
purposes of the performance fee calculation, equity is generally
defined as proceeds from the issuance of common stock before
underwriter's discount and other costs of issuance, plus retained
earnings. For the quarters ended March 31, 2003 and 2002, the
Manager earned performance-based compensation in the amount of $6.2
million and $3.2 million, respectively, in accordance with the terms
of the Agreement. As of March 31, 2003 and 2002, $6.2 million and
$3.2 million, respectively, was payable by the Company to the
Manager for performance-based compensation.
Pursuant to an employee residential mortgage loan program approved
by the Board of Directors as part of the Company's residential
mortgage loan origination activities, certain of the directors,
officers and employees of the Company and of other affiliates of the
Company have obtained residential first lien mortgage loans from the
Company. In general, the terms of the loans and the underwriting
requirements are identical to the loan programs the Company offers
to unaffiliated third parties, except that participants in the
program, who are neither directors nor executive officers of the
Company, qualify for an employee discount on the interest rate. At
the time each participant enters into a loan agreement, such
participant executes an addendum that provides for the discount on
the interest rate that is subject to cancellation at the time such
participant's employment is terminated for any reason. Effective
with the enactment of the Sarbanes-Oxley Act of 2002 on July 30,
2002, any new loans made to directors or executive officers are not
eligible for the employee discount. As of March 31, 2003, the
aggregate balance of mortgage loans outstanding to directors and
officers of the Company, and to employees of the Manager and other
affiliates, amounted to $24.9 million, had a weighted average
interest rate of 4.38%, and maturities ranging between 2016 and
2033.
Pursuant to the terms of a Joint Marketing Agreement with Thornburg
Securities Corporation ("TSC"), a registered broker-dealer, TMHL
shall pay TSC an annual fee of $50.0 thousand in 2003, in quarterly
installments, as compensation for certain marketing, promotional and
advertising services and to provide marketing materials to brokers
and financial advisers. During the quarter ended March 31, 2003,
TMHL paid $12.5 thousand to TSC pursuant to this agreement.
NOTE 9. RECENT DEVELOPMENTS
On April 3, 2003, approximately $1.1 billion of mortgage loans from
our ARM loan portfolio were transferred to Thornburg Mortgage
Securities Trust 2003-2 and were securitized. Approximately $1.0
billion of the securities issued in connection with this
securitization were sold to third-party investors in the form of
AAA-rated floating rate pass-through certificates. This transaction
will be accounted for as a financing of our loans and represents
long-term secured non-marginable financing for our portfolio.
On May 15, 2003, the Company completed an unregistered offering of
$200.0 million in senior unsecured notes at par. The notes bear
interest at 8%, payable each May 15 and November 15, commencing
November 15, 2003, and mature on May 15, 2013. The notes are
redeemable, in whole or in part, beginning May 2008. The notes may
also be redeemed under limited circumstances on or before May 15,
2006.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Certain information contained in this Quarterly Report on Form 10-Q constitutes
"Forward-Looking Statements" within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended. You can identify such forward-looking statements by the presence of
forward-looking terminology such as "may," "will," "expect," "anticipate,"
"estimate," "plan," or "continue," or the negatives thereof, or similar
terminology. You should be aware that all forward-looking statements involve
risks and uncertainties including, but not limited to, risks related to the
future level and relationship of various interest rates, prepayment rates,
availability and cost of acquiring new assets, the timing of new programs and
the performance of third party, private-label relationships involved in the
origination and servicing of loans. The cautionary statements that you will find
in the "Risk Factors" section on pages 14 through 17 of our 2002 Annual Report
on Form 10-K identify important factors, including certain risks and
uncertainties, with respect to such forward-looking statements that could cause
our actual results, performance or achievements to differ materially from those
reflected in such forward-looking statements.
CORPORATE GOVERNANCE
We pride ourselves on maintaining an ethical workplace in which the highest
standards of professional conduct are practiced. Accordingly, we would like to
highlight the following facts relating to corporate governance:
- Our Board of Directors consists of a majority of independent
directors. The Audit, Nominating/Corporate Governance and
Compensation Committees of the Board of Directors are also composed
exclusively of independent directors.
- Our long-term incentive plan does not provide for the granting of
stock options. All long-term incentive awards are fully expensed in
our consolidated income statements and are fully disclosed in our
financial reports.
- We have established a formal internal audit function to further the
effective functioning of our internal controls and procedures. Our
internal audit plan is intended to provide management and the Audit
Committee with an effective tool to identify and address areas of
financial or operational concerns and ensure that appropriate
controls and procedures are in place.
- We have adopted both a Code of Business Conduct and Ethics and
Corporate Governance Guidelines that cover a wide range of business
practices and procedures, that apply to all of our employees,
officers and directors, and that foster the highest standards of
ethics and conduct in all of our business relationships.
- We have an Insider Trading Policy designed to prohibit any of the
directors or officers of the Company or any director, officer or
employee of the Manager from buying or selling our stock on the
basis of material nonpublic information, and to prohibit
communicating material nonpublic information to others.
Our Internet website address is www.thornburgmortgage.com. We make available
free of charge, through our Internet website, our annual report on Form 10-K,
our quarterly reports on Form 10-Q, our current reports on Form 8-K, and any
amendments to those reports that we file or furnish pursuant to Section 13(a) or
15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable
after we electronically file such material with, or furnish it to, the
Securities and Exchange Commission (the "SEC").
You may also find on our website our Code of Business Conduct and Ethics,
Corporate Governance Guidelines and the charters of the Audit Committee,
Nominating/Corporate Governance Committee and Compensation Committee of our
Board of Directors. These documents are also available in print to anyone who
requests them by writing to us at the following address: 150 Washington Avenue,
Suite 302, Santa Fe, New Mexico, 87501, or by phoning us at (505) 989-1900.
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Please note that the reference to our website address is an inactive textual
reference made only for purposes of complying with SEC rules.
CRITICAL ACCOUNTING POLICIES
Our financial statements are prepared in conformity with generally accepted
accounting principles, many of which require the use of estimates and
assumptions. In accordance with recent SEC guidance, those material accounting
policies that we believe are the most critical to an investor's understanding of
our financial results and condition and require complex management judgment have
been expanded and discussed below.
- - Fair Value. We record our adjustable and variable rate mortgage ("ARM")
securities, interest rate cap agreements ("Cap Agreements"), interest rate
swap agreements ("Swap Agreements") and Eurodollar futures contracts
("Eurodollar Transactions") at fair value. The fair values of our ARM
securities, Cap Agreements, Swap Agreements and Eurodollar Transactions
are generally based on market prices provided by certain dealers who make
markets in these financial instruments or third-party pricing services. If
the fair value of an ARM security or other financial instrument is not
reasonably available from a dealer or a third-party pricing service,
management estimates the fair value. This requires management judgment in
determining how the market would value a particular ARM security based on
characteristics of the security we receive from the issuer and available
market information. The fair values reported reflect estimates and may not
necessarily be indicative of the amounts we could realize in a current
market exchange.
- - Basis Adjustments on ARM Securities. In general, we securitize all of our
loans and retain the resulting securities in our ARM portfolio. At the
time of securitization, we obtain a credit review of the loans being
securitized by one or more of the Rating Agencies. Based on this review, a
determination is made, which requires management judgment regarding the
expected losses to be realized in the future and we adjust the basis of
the securities to their expected realizable value. This is referred to as
a "basis adjustment." In doing so, we establish an account, similar to a
loss reserve, to absorb the expected credit losses. The actual losses
could be more or less than the amount estimated by management at the time
of securitization. Therefore, we monitor the delinquencies and losses on
the underlying mortgage loans backing our ARM securities. If the credit
performance of the underlying mortgage loans is not as expected, we make a
provision for additional probable credit losses at a level deemed
appropriate by management to provide for estimated losses inherent in our
ARM securities portfolio. Any such provision is based on management's
assessment of numerous factors affecting our portfolio of ARM assets
including, but not limited to, current economic conditions, delinquency
status, credit losses to date on underlying mortgages and remaining credit
protection. The basis adjustment for ARM securities is made by reducing
the cost basis of the individual security for the decline in fair value,
which is other than temporary, and the amount of such write-down is
recorded as a realized loss, thereby reducing earnings.
- - Loan Securitization. For financial statement purposes, we do not account
for any of our loan securitizations as sales since we retain the
beneficial and economic interests of the loans. Since the securitizations
of our loans are not accounted for as sales, we do not record any
servicing assets or liabilities as a result of this process.
- - Revenue Recognition. Interest income on ARM assets is a combination of
accruing interest based on the outstanding balance and contractual terms
of the assets and the amortization of yield adjustments using generally
accepted interest methods, principally the amortization of purchase
premiums and discounts. Premiums and discounts associated with the
purchase of ARM assets are amortized into interest income over the lives
of the assets using the effective yield method adjusted for the effects of
estimated prepayments. Estimating prepayments and estimating the remaining
lives of our ARM assets requires management judgment, which involves
consideration of possible future interest rate environments and an
estimate of how borrowers will behave in those environments. The actual
lives could be more or less than the amount estimated by management at the
time of purchase of the ARMs.
For additional information on our significant accounting policies, see Note 1 to
the Consolidated Financial Statements.
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GENERAL
We are a single-family residential mortgage lender that originates, acquires and
retains investments in ARM assets comprised of traditional ARM securities and
ARM loans and hybrid ARM securities and loans, thereby providing capital to the
single-family residential housing market. Traditional ARM securities and loans
have interest rates that reprice in a year or less ("Traditional ARMs") and
hybrid ARM securities and loans have a fixed interest rate for an initial
period, generally three to ten years, and then convert to Traditional ARMs for
their remaining terms to maturity ("Hybrid ARMs"). ARM securities represent
interests in pools of ARM loans, which are publicly rated and include guarantees
or other credit enhancements against losses from loan defaults.
While we are not a bank or savings and loan institution, our business purpose,
strategy, method of operation and risk profile are best understood in comparison
to such institutions. We finance the purchases and originations of our ARM
assets with equity capital and borrowings such as reverse repurchase agreements,
whole loan financing facilities, long-term secured debt and other secured or
unsecured financings that we may establish with approved institutional lenders.
We consistently operate with an equity-to-asset ratio of greater than 8% based
on historical cost (excluding other comprehensive income) and generally
averaging 9%. Since all of the assets we hold are ARM assets and we pursue a
matched funding strategy, we believe our exposure to changes in interest rates
can be prudently managed. Moreover, we focus on acquiring primarily high quality
assets to ensure our access to financing. Similarly, we maintain strict credit
underwriting standards and have experienced cumulative credit losses of only
$174,000 on our loan portfolio over the last five years. Our lean operating
structure has resulted in operating costs well below those of our peers. We
believe our corporate structure differs from most lending institutions in that
we are organized for tax purposes as a real estate investment trust ("REIT")
and, therefore, substantially all of our earnings are paid in the form of
dividends to shareholders, without paying federal or state income tax at the
corporate level. We have five qualified REIT subsidiaries, all of which are
consolidated in our financial statements and federal and state income tax
returns. Two of these subsidiaries, Thornburg Mortgage Funding Corporation and
Thornburg Mortgage Acceptance Corporation, are involved in financing our
mortgage loan assets. Thornburg Mortgage Home Loans, Inc. ("TMHL"), our wholly
owned mortgage-banking subsidiary, conducts our mortgage loan acquisition,
origination, processing, underwriting, securitization, and servicing activities.
TMHL's two wholly owned special purpose subsidiaries, Thornburg Mortgage Funding
Corporation II and Thornburg Mortgage Acceptance Corporation II, facilitate the
financing of loans by TMHL.
We are an externally advised REIT and are managed under a management agreement
(the "Management Agreement") with Thornburg Mortgage Advisory Corporation (the
"Manager"), which manages our operations, subject to the supervision of our
Board of Directors.
Portfolio Strategies
Our business strategy is to acquire and originate ARM assets to hold in our
portfolio, fund them using equity capital and borrowed funds, and generate
earnings from the difference or spread between the yield on our assets and our
cost of borrowing. We originate ARM loans for our portfolio through our
correspondent lending program, which currently includes approximately 100
approved correspondents, and we originate loans direct to consumers through
TMHL. Currently, TMHL is authorized to lend in 43 states and the District of
Columbia. Additionally, we acquire ARM assets by purchasing ARM securities or
large packages of ARM loans that other mortgage lending institutions have
originated and serviced. We believe that diversifying our sources for ARM loans
and ARM securities will enable us to consistently find attractive opportunities
to acquire or create high quality assets at attractive yields and spreads for
our portfolio.
In addition to our direct origination efforts, we acquire ARM assets from
investment banking firms, broker-dealers and similar financial institutions that
regularly make markets in these assets. We also acquire ARM assets from other
mortgage suppliers, including mortgage bankers, banks, savings and loans,
investment banking firms, home builders and other firms involved in originating,
packaging and selling mortgage loans. We believe we have a competitive advantage
in the acquisition and investment of these mortgage securities and loans due to
the low cost of our operations relative to traditional mortgage investors, such
as banks and savings and loans.
We have a focused portfolio lending investment policy designed to minimize
credit risk and interest rate risk. Our mortgage assets portfolio may consist of
ARM pass-through securities guaranteed by an agency of the federal
24
government ("Ginnie Mae"), a government-sponsored corporation or
federally-chartered corporation ("Fannie Mae" or "Freddie Mac"), or privately
issued (generally publicly registered) ARM pass-through securities, multi-class
pass-through securities, floating rate classes of collateralized mortgage
obligations ("CMOs"), ARM loans, fixed rate mortgage-backed securities ("MBS")
with an expected duration of one year or less or short-term investments that
either mature within one year or have an interest rate that reprices within one
year. Agency securities ("Agency Securities") are MBS for which a U.S.
Government agency or a government-sponsored or federally chartered corporation,
such as Ginnie Mae, Fannie Mae or Freddie Mac, guarantees payments of principal
or interest on the certificates. Agency Securities are not rated, but carry an
implied AAA rating.
Our ARM assets also include investments in Hybrid ARM assets, which are
typically 30-year loans with a fixed rate of interest for an initial period,
generally 3 to 10 years, and then convert to an adjustable rate for the balance
of their term. In April 2003, our Board of Directors increased the limitation on
our ownership of Hybrid ARM assets with fixed rate periods of greater than five
years from 10% to 20% of our total assets. We also have a policy to fund our
Hybrid ARM assets with fixed rate borrowings such that the net duration of
Hybrid ARM assets and the corresponding borrowings and hedges is one year or
less. We use Swap Agreements and Eurodollar Transactions as hedges to fix the
interest rates on our short-term borrowing costs.
Our investment policy requires that we invest at least 70% of total assets in
High Quality ARM assets and short-term investments. High Quality means:
(1) Agency Securities; or
(2) securities which are rated within one of the two highest rating
categories by at least one of either Standard & Poor's Corporation
or Moody's Investors Service, Inc. (the "Rating Agencies"); or
(3) securities that are unrated or whose ratings have not been updated
but are determined to be of comparable quality (by the rating
standards of at least one of the Rating Agencies) to a High Quality
rated mortgage security, as determined by the Manager and approved
by our Board of Directors; or
(4) the portion of ARM loans that have been deposited into a trust and
have received a credit rating of AA or better from at least one
Rating Agency.
The remainder of our ARM portfolio, comprising not more than 30% of total
assets, may consist of Other Investment assets, which may include:
(1) adjustable or variable rate pass-through certificates, multi-class
pass-through certificates or CMOs backed by loans on single-family,
multi-family, commercial or other real estate-related properties so
long as they are rated at least Investment Grade at the time of
purchase. "Investment Grade" generally means a security rating of
BBB or Baa or better by at least one of the Rating Agencies; or
(2) ARM loans collateralized by first liens on single-family residential
properties, generally underwritten to "A" quality standards, and
acquired for the purpose of future securitization; or
(3) fixed rate mortgage loans collateralized by first liens on single
family residential properties originated for sale to third parties;
or
(4) real estate properties acquired as a result of foreclosing on our
ARM loans; or
(5) as authorized by our Board of Directors, ARM securities rated less
than Investment Grade that are created as a result of our loan
acquisition and securitization efforts or are acquired as part of a
loan securitization effected by third parties in which we purchase
all of the classes of the loan securitization and that equal an
amount no greater than 17.5% of shareholders' equity, measured on a
historical cost basis.
To mitigate the adverse effect of an increase in prepayments on our ARM assets,
we emphasize the purchase of ARM assets at prices close to or below par. We
amortize any premiums paid for our assets over their expected lives using the
level yield method of accounting. To the extent that the prepayment rate on our
ARM assets differs from expectations, our net interest income will be affected.
Prepayments generally increase when mortgage interest rates fall below the
interest rates on ARM loans. To the extent there is an increase in prepayment
rates, resulting in a shortening of the expected lives of our ARM assets, our
net income and, therefore, the amount available for dividends could be adversely
affected. Our portfolio of ARM assets is held at a book price, excluding
unrealized gains and losses, of 101.03% of par at March 31, 2003. The book
price, including unrealized gains and losses, was 101.44% at March 31, 2003,
compared to 101.45% at December 31, 2002.
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We believe that our status as a mortgage REIT makes an investment in our equity
securities attractive for tax-exempt investors, such as pension plans, profit
sharing plans, 401(k) plans, Keogh plans and Individual Retirement Accounts. We
do not invest in real estate mortgage investment conduit ("REMIC") residuals or
other CMO residuals that would result in the creation of excess inclusion income
or unrelated business taxable income.
Acquisition, Securitization and Retention of Traditional ARM and Hybrid ARM
Loans
We acquire and originate High Quality mortgage loans through TMHL from three
sources: (i) correspondent lending, which involves acquiring individual loans
from correspondent lenders or other loan originators who originate the
individual loans using our underwriting criteria and guidelines, or criteria and
guidelines that we have approved, (ii) direct retail loan originations, which
are loans that we originate, and (iii) bulk acquisitions, which involve
acquiring pools of whole loans, which are originated using the seller's
guidelines and underwriting criteria. The loans we acquire or originate are
financed through warehouse borrowing arrangements and securitized for our
portfolio, or, in the case of fixed rate loans, sold to third parties.
The loans acquired or originated by TMHL are first lien, single-family
residential Traditional ARM and Hybrid ARM loans with original terms to maturity
of not more than forty years and are either fully amortizing or are interest
only up to ten years, and fully amortizing thereafter. Interest-only loans
acquired or originated during the first quarter of 2003 represented 90.4% of
total loan production during that period. We believe interest-only loans do not
pose additional credit risk due to original effective loan-to-value ratios
averaging 66.5% and the credit strength of our borrowers.
All ARM loans that we acquire for our portfolio bear an interest rate tied to an
interest rate index. Most loans have periodic and lifetime constraints on how
much the loan interest rate can change on any predetermined interest rate reset
date. In general, the interest rate on each Traditional ARM loan resets monthly,
semi-annually or annually. The Traditional ARM loans generally adjust to a
margin over a U.S. Treasury index or a LIBOR index. The Hybrid ARM loans have a
fixed rate for an initial period, generally 3 to 10 years, and then convert to
Traditional ARM loans for their remaining term to maturity.
We acquire ARM loans for our portfolio with the intention of securitizing them
into pools of High Quality ARM securities and retaining them in our portfolio.
In order to facilitate the securitization of our loans, we generally create
subordinate certificates, which provide a specified amount of credit
enhancement. Upon securitization, we hold the High Quality ARM securities and
the subordinate certificates in our portfolio and then finance them in the
repurchase agreement market or through the issuance of securities in the capital
markets. Our investment policy limits the amount we may hold in our portfolio of
these below Investment Grade subordinate certificates, and subordinate classes
that we purchase in connection with a whole pool securitization effected by
third parties, to 17.5% of shareholders' equity, measured on a historical cost
basis.
We believe the acquisition and origination of ARM loans for securitization
benefits us by providing: (i) greater control over the quality and types of ARM
assets acquired; (ii) the ability to acquire ARM assets at lower prices, so that
the amount of the premium to be amortized will be reduced in the event of
prepayment; (iii) additional sources of new whole-pool ARM assets; and (iv)
generally higher yielding investments in our portfolio.
We offer a loan modification program on all loans we originate and certain loans
we acquire. We believe this program promotes customer retention and reduces loan
prepayments. Under the terms of this program, a borrower may choose to pay a fee
and modify the mortgage loan to any then-available hybrid or adjustable-rate
product that we offer at the offered interest rate plus 1/8%, at any time during
the life of the loan.
Financing Strategies
We finance our purchased or securitized ARM assets using equity capital and
borrowings, such as reverse repurchase agreements, lines of credit, and other
secured or unsecured financings that we may establish with approved
institutional lenders. We have established lines of credit and collateralized
financing agreements with twenty-three different financial institutions. We
generally expect to maintain an equity-to-assets ratio of between 8% and 10%, as
measured on a historical cost basis. This ratio may vary from time to time
within the above stated
26
range depending upon market conditions and other factors that our management
deems relevant, but cannot fall below 8% without the approval of our Board of
Directors.
We borrow primarily at short-term interest rates and in the form of reverse
repurchase agreements using our ARM securities as collateral. Reverse repurchase
agreements involve a simultaneous sale of pledged assets to a lender at an
agreed-upon price in return for the lender's agreement to resell the same assets
back to us at a future date (the maturity of the borrowing) at a higher price.
The price difference is the cost of borrowing under these agreements. We
generally enter into two types of reverse repurchase agreements: variable rate
term reverse repurchase agreements and fixed rate reverse repurchase agreements.
Variable rate term reverse repurchase agreements are financings with original
maturities ranging from six to 24 months. The interest rates on these variable
rate term reverse repurchase agreements are indexed to either the one- or
three-month LIBOR rate, and reprice accordingly. The fixed rate reverse
repurchase agreements have original maturities generally ranging from 30 to 180
days. Generally, upon repayment of each reverse repurchase agreement, we
immediately pledge the ARM assets used to collateralize the financing to secure
a new reverse repurchase agreement.
We have also financed the purchase of ARM assets by issuing long-term secured
debt obligations and collateralized notes in the capital markets, which are
collateralized by securitized pools of our ARM assets that are placed in a
trust. The trust pays the principal and interest payments on the debt out of the
cash flows received on the collateral. Using such a structure enables us to
issue debt that will not be subject to margin calls once the long-term secured
debt obligation has been issued.
We also enter into financing facilities for whole loans. A whole loan is the
actual mortgage loan evidenced by a note and secured by a mortgage or deed of
trust. We use these credit lines to finance our acquisition of whole loans while
we are accumulating loans for securitization.
Hedging Strategies
We attempt to mitigate our interest rate risk by funding our ARM assets with
borrowings whose maturities approximately match the interest rate adjustment
periods on our ARM assets. Accordingly, some of our borrowings have variable
interest rates or short term fixed maturities (one year or less) because, as of
March 31, 2003, 24.9% of our ARM assets were Traditional ARMs, which had
interest rates that adjust within one year. However, for the remaining portion
of our portfolio comprised of Hybrid ARM assets, which generally have fixed
interest rate periods of 3 to 10 years and, as of March 31, 2003, averaged a
4.1-year fixed rate period, we utilize Swap Agreements and Eurodollar
Transactions to, in effect, extend the fixed-rate of interest of our borrowings
such that the net duration of our Hybrid ARM assets and fixed-rate borrowings
and hedges funding our Hybrid ARM assets is no more than one year. By
maintaining a net duration of less than on