Back to GetFilings.com
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(Mark one)
(x) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998
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 No. 001-13937
ANTHRACITE CAPITAL, INC.
(Exact name of Registrant as specified in its charter)
MARYLAND 13-3978906
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
345 Park Avenue
29th Floor
New York, New York 10154
(Address of principal executive office) (Zip Code)
(212) 409-3333
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(g) of the Act: Not Applicable
Securities registered pursuant to Section 12(b) of the Act:
COMMON STOCK, $.001 PAR VALUE NEW YORK STOCK EXCHANGE (NYSE)
(Title of each class) (Name of each exchange on
which registered)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to
such filing requirements for the past 90 days. Yes x No o
Indicate by check mark if disclosure of delinquent filers pursuant to item
405 of Regulation S-K is not contained herein, and will not be contained,
to the best of the registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form
10-K or any amendment to this Form 10-K. o
Aggregate market value of the Common Stock, $.001 par value, held by
nonaffiliates of the registrant, computed by reference to the closing price
as reported on the NYSE as of the close of business on March 29, 1999:
$141,966,000 (for purposes of this calculation affiliates include only
directors and executive officers of the Company).
Number of shares of Common Stock, $.001 par value, outstanding as of March
29, 1999: 20,993,636 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the definitive Proxy Statement for the Annual Meeting of
Stockholders to be held on May 17, 1999 are incorporated by reference into
Part III, Items 10 through 13.
ANTHRACITE CAPITAL, INC.
1998 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PAGE
PART I
Item 1. Business.....................................................4
Item 2. Properties ................................................21
Item 3. Legal Proceedings ..........................................21
Item 4. Submission of Matters to a Vote of
Security Holders ...........................................21
PART II
Item 5. Market for the Registrant's Common Equity
and Related Stockholder Matters ............................22
Item 6. Selected Financial Data ....................................22
Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations ..............23
Item 7A. Quantitative and Qualitative Disclosures About
Market Risk ................................................34
Item 8. Financial Statements and Supplementary Data ................38
Item 9. Changes in and Disagreements with Accountants
on Accounting and Financial Disclosure .....................61
PART III
Item 10. Directors and Executive Officers of the Registrant .........62
Item 11. Executive Compensation .....................................62
Item 12. Security Ownership of Certain Beneficial
Owners and Management ......................................62
Item 13. Certain Relationships and Related Transactions .............62
PART IV
Item 14. Exhibits ...................................................63
Signatures .................................................64
Certain statements contained herein are not, and certain
statements contained in future filings by Anthracite Capital, Inc. (the
"Company") with the SEC, in the Company's press releases or in the
Company's other public or stockholder communications may not be, based on
historical facts and are "forward-looking statements" within the meaning of
the Private Securities Litigation Reform Act of 1995. Forward-looking
statements which are based on various assumptions (some of which are beyond
the Company's control), may be identified by reference to a future period
or periods, or by the use of forward-looking terminology, such as "may,"
"will," "believe," "expect," "anticipate," "continue," or similar terms or
variations on those terms, or the negative of those terms. Actual results
could differ materially from those set forth in forward-looking statements
due to a variety of factors, including, but not limited to, those related
to the economic environment, particularly in the market areas in which the
Company operates, competitive products and pricing, fiscal and monetary
policies of the U.S. Government, changes in prevailing interest rates,
acquisitions and the integration of acquired businesses, credit risk
management, asset/liability management, the financial and securities
markets and the availability of and costs associated with sources of
liquidity. 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.
PART I
ITEM 1. BUSINESS
General
Anthracite Capital, Inc. (the "Company"), a Maryland corporation,
was formed in November 1997 to invest in multifamily, commercial and
residential mortgage loans, mortgage-backed securities and other real
estate related assets in both U.S. and non-U.S. markets. The Company uses
its equity capital and borrowed funds to seek to achieve strong investment
returns by maximizing the spread of investment income (net of credit
losses) earned on a diversified portfolio of real estate assets over the
cost of financing and hedging these assets. The Company intends to elect to
be taxed as a real estate investment trust ("REIT") under the Internal
Revenue Code of 1986, as amended (the "Code"). The Company generally will
not be subject to Federal income tax to the extent that it distributes its
net income to its stockholders and qualifies for taxation as a REIT.
On March 23, 1998, the Securities and Exchange Commission (the
"SEC") declared effective the Company's Registration Statement on Form S-11
(File No. 333-40813) relating to the initial public offering of 20,000,000
shares of the Company's common stock. On March 27, 1998, the initial public
offering was consummated at a price of $15 per share and the Company
received proceeds of $279,000,000, net of underwriting discounts and
commissions. Concurrently with the initial public offering, the Company
sold 1,365,198 shares of its common stock in private placements at a price
of $13.95 per share for total proceeds of approximately $19,045,000.
The Company considers itself to be involved in the single business
segment of providing financial services and conducts a variety of business
activities within this segment. The Company's primary business activities
consist of the acquisition and management of REIT Real Estate Assets, as
defined under Sections 856 through 860 of the Code (the "REIT Provisions of
the Code"). The Company's business decisions will depend on changing market
factors, and the Company will pursue various strategies and opportunities
in different market environments.
The day-to-day operations of the Company are managed by BlackRock
Financial Management, Inc. (the "Manager" or "BlackRock"), subject to the
direction and oversight of the Company's Board of Directors. The Manager is
an indirect subsidiary of PNC Bank, National Association ("PNC Bank"),
which is itself a wholly owned subsidiary of PNC Bank Corp. Established in
1988, the Manager is a registered investment adviser under the Investment
Advisers Act of 1940 and is one of the largest fixed-income investment
management firms in the United States. The Manager, in its discretion,
subject to the supervision of the Board of Directors and to the REIT
Provisions of the Code, evaluates and monitors the Company's assets and how
long such assets should be held in the Company's portfolio. The Manager is
permitted to actively manage the Company's assets, and such assets may or
may not be held to maturity. Although the Company intends to manage its
assets actively, it does not intend to acquire, hold or sell assets in such
a manner that such assets would be characterized as dealer property for
Federal income tax purposes.
Investments
The Company's investment strategy is to seek to achieve strong
investment returns by maximizing the spread of investment income (net of
credit losses) earned on its portfolio of investments over the cost of
financing and hedging these investments. The Company's core strategy is to
engage in the acquisition, origination and syndication of non-investment
grade rated mezzanine debt in the form of mortgage loans and mortgage
backed-securities. This strategy is balanced by maintaining a portfolio of
liquid investment grade rated mortgage-backed securities and other
investments. The Company may pursue other strategies from time to time to
take advantage of market opportunities as they arise.
In creating and managing its investment portfolio, the Company
utilizes the Manager's expertise and significant business relationships
between the Manager and its affiliates, as well as unrelated participants
in the real estate and securities industries. The Manager, in its
discretion, subject to the supervision of the Board of Directors and to the
REIT Provisions of the Code, evaluates and monitors the Company's assets
and determines how long such assets should be held in the Company's
portfolio. The Manager is permitted to actively manage the Company's
assets, and such assets may or may not be held to maturity.
The Company takes an opportunistic approach to its investments.
The Company's policy is to acquire or originate those mortgage assets which
it believes are likely to generate the highest returns on capital invested,
after considering the amount and nature of anticipated cash flows from the
asset, the Company's ability to pledge the asset to secure collateralized
borrowings, the capital requirements resulting from the purchase and
financing of the asset, the potential for appreciation and the costs of
purchasing, financing, hedging and managing the asset. Prior to acquisition
or origination, potential returns on capital employed will be assessed over
the expected life of the asset and in a variety of interest rate, yield
spread, financing cost, credit loss and prepayment scenarios. In managing
the Company's portfolio, the Manager also will consider balance sheet
management and risk diversification issues.
Assets which the Company may acquire or originate from time to
time include: (i) mortgage-backed securities ("MBS") including commercial
mortgage-backed securities ("CMBS") and residential mortgage-backed
securities ("RMBS"); (ii) multifamily, commercial and residential term
mortgage loans ("Mortgage Loans"); (iii) non-U.S. Mortgage Loans and MBS;
(iv) multifamily and commercial real properties; and (v) other real estate
related assets.
The Company's investments by strategy at December 31, 1998 are
summarized as follows:
Estimated
Fair Value
Description (000s)
------------------------------------------------------------- ---------------
Core Strategy Operating Portfolio:
CMBS:
Non-investment grade rated subordinated
securities $248,734
Non-rated subordinated securities 24,284
Non-rated commercial mortgage loan 33,263
---------------
Total core strategy operating portfolio 306,281
---------------
Non-Core Strategy Liquidity Portfolio:
Cash and cash equivalents 1,087
Restricted cash equivalents 3,243
Single-family RMBS:
Agency adjustable rate securities 17,999
Agency fixed rate securities 13,023
Privately issued investment grade rated fixed
rate securities 157,753
Agency insured project loan 3,275
---------------
Total non-core strategy liquidity portfolio 193,105
---------------
Trading Strategies Portfolio:
Deposits with brokers as collateral for securities
sold short 276,617
U.S. Treasury securities 166,835
Securities sold short:
U.S. Treasury securities (223,757)
Agency fixed rate note (51,328)
---------------
Total trading strategies portfolio 168,367
---------------
Total - All Strategies $667,753
===============
At December 31, 1998, substantially all of the Company's
investments were pledged to secure its short-term borrowings and
obligations under securities sold short.
At December 31, 1998, the CMBS held by the Company consisted of
subordinated securities collateralized by adjustable and fixed rate
commercial and multifamily mortgage loans. The RMBS held by the Company
consisted of adjustable rate and fixed rate residential pass-through or
mortgage-backed securities collateralized by adjustable and fixed rate
single-family residential mortgage loans. The agency RMBS and the agency
fixed rate note held by the Company were issued by Federal Home Loan
Mortgage Corporation (FHLMC), Federal National Mortgage Association (FNMA)
or Government National Mortgage Association (GNMA). The privately issued
RMBS held by the Company were issued by entities other than FHLMC, FNMA or
GNMA. The agency insured project loan held by the Company consisted of a
participation interest in a mortgage loan guaranteed by the Federal Housing
Administration (FHA).
The commercial mortgage loan held by the Company at December 31,
1998 is secured by a second lien on five luxury hotels in London, England
and vicinity. The loan has a five-year maturity and may be prepaid at any
time. The loan is denominated in pounds sterling and bears interest at a
rate based upon the London Interbank Offered Rate (LIBOR) for pounds
sterling plus approximately 4%. The Company's investment in the loan is
carried at amortized cost in its financial statements and translated into
U.S. dollars at the exchange rate in effect on the reporting date.
At December 31, 1998, two of the mortgage loans underlying the
CMBS held by the Company were delinquent more than thirty days but not more
than sixty days. The two mortgage loans comprised 0.28% of the aggregate
principal balance of the mortgage loans underlying the Company's CMBS. The
Company believes its current loss estimates with respect to the delinquent
loans are appropriate. The Company's other investments were current in
payment status at December 31, 1998.
At December 31, 1998, the Company had several commitments
outstanding to acquire or originate investments. As part of its core
strategy, the Company had a commitment outstanding to originate a
$35,000,000 floating rate commercial real estate construction loan secured
by a second mortgage. The subject property is an office complex located in
Santa Monica, California. Upon completion of construction, the office
complex will consist of a five-story 275,000 square foot office building, a
six-story 325,000 square foot office building and 1,750 underground parking
spaces. Funding of the commitment is subject to satisfaction by the
borrower of various closing conditions. The Company received a $175,000
commitment fee relating to the commitment, which has been deferred and
included in other liabilities in the Company's statement of financial
condition at December 31, 1998. The fee will be added to the basis of the
related loan when it is funded.
During the first quarter of 1999, the Company applied a portion of
its cash on hand to fund approximately $4,400,000 of its construction loan
commitment. The Company intends to fund the remaining portion of the
commitment through a combination of existing cash on hand, new equity,
additional borrowings and/or syndication of a portion of the commitment.
As part of its short-term trading strategies, the Company had
commitments outstanding at December 31, 1998 to purchase or sell agency
RMBS. Information with respect to such commitments at December 31, 1998 is
summarized as follows (dollars in thousands):
Estimated
Principal Contract Fair Net
Amount of Price of Value of Gross Gross Unrealized
Subject Subject Subject Unrealized Unrealized Gains (Losses)
Description Securities Securities Securities Gains Losses
- ----------------------------------------------------------------------------------------------------------------------------
Forward commitments to
purchase $1,370,000 $1,356,210 $1,356,762 $2,133 $1,581 $552
Forward commitments to sell 980,000 970,302 971,204 335 1,237 (902)
==============================================
Total $2,468 $2,818 $(350)
==============================================
The gross unrealized gains and gross unrealized losses shown above
are included in other assets and other liabilities, respectively, in the
Company's statement of financial condition at December 31, 1998. In
instances where a forward commitment has been closed out with the same
counterparty and a right of setoff exists, only the net unrealized gain or
loss is reflected in other assets or liabilities.
At December 31, 1998, all the Company's forward commitments to
purchase agency RMBS related to delivery of such securities in January
1999. The Company generally closes out its forward commitments prior to the
date specified for delivery of the subject securities. In January 1999, the
Company took delivery of subject securities with respect to certain
matching forward commitments (that is, forward commitments to purchase and
sell agency RMBS with identical principal amounts, subject securities and
settlement dates) that were outstanding at December 31, 1998. The
securities had been sold prior to delivery and the resulting net realized
gain was not materially different from the net unrealized gain reflected in
the Company's financial statements as of and for the period ended December
31, 1998.
The Company's anticipated yields to maturity on its investments
are based upon a number of assumptions that are subject to certain business
and economic uncertainties and contingencies. Examples of these include,
among other things, the rate and timing of principal payments (including
prepayments, repurchases, defaults and liquidations), the pass-through or
coupon rate and interest rate fluctuations. Additional factors that may
affect the Company's anticipated yields to maturity on its subordinated
CMBS include interest payment shortfalls due to delinquencies on the
underlying mortgage loans, and the timing and magnitude of credit losses on
the mortgage loans underlying the subordinated CMBS that are a result of
the general condition of the real estate market (including competition for
tenants and their related credit quality) and changes in market rental
rates. As these uncertainties and contingencies are difficult to predict
and are subject to future events which may alter these assumptions, no
assurance can be given that the Company's anticipated yields to maturity
will be achieved.
The following is a summary of the types of assets, among others,
that the Company may invest in from time to time.
Mortgage Backed Securities. The Company acquires both investment
grade and non-investment grade classes of MBS, from various sources. MBS
typically are divided into two or more interests, sometimes called
"tranches" or "classes." The senior classes are often securities which, if
rated, would have ratings ranging from low investment grade "BBB" to higher
investment grades "A," "AA" or "AAA." The junior, subordinated classes
typically would include one or more non-investment grade classes which, if
rated, would have ratings below investment grade "BBB." Such subordinated
classes also typically include an unrated higher-yielding, credit support
class (which generally is required to absorb the first losses on the
underlying Mortgage Loans).
MBS are generally are issued either as "CMOs" or "Pass-Through
Certificates." CMOs are debt obligations of special purpose corporations,
owner trusts or other special purpose entities secured by commercial
Mortgage Loans or MBS. Pass-Through Certificates evidence interests in
trusts, the primary assets of which are Mortgage Loans. CMO Bonds and
Pass-Through Certificates may be issued or sponsored by agencies or
instrumentalities of the United States Government or private originators
of, or investors in, Mortgage Loans, including savings and loan
associations, mortgage bankers, commercial banks, investment banks and
other entities. MBS may not be guaranteed by an entity having the credit
status of a governmental agency or instrumentality and in this instance are
generally structured with one or more of the types of credit enhancement
described below. In addition, MBS may be illiquid.
The Company acquires both CMBS and RMBS. The mortgage collateral
supporting CMBS may be pools of whole loans or other MBS, or both. Unlike
RMBS, which typically are collateralized by thousands of single family
Mortgage Loans, CMBS are collateralized generally by a more limited number
of commercial or multifamily Mortgage Loans with larger principal balances
than those of single family Mortgage Loans. As a result, a loss on a single
Mortgage Loan underlying a CMBS will have a greater negative effect on the
yield of such CMBS, especially the subordinated MBS in such CMBS.
Mortgage Loans. The Company acquires or originates fixed and
adjustable-rate Mortgage Loans secured by senior, mezzanine or subordinate
liens on multifamily residential, commercial, single-family (one-to-four
unit) residential or other real property as a significant part of its
investment strategy.
Mortgage Loans may be originated by or purchased from various
suppliers of mortgage assets throughout the United States and abroad, such
as savings and loan associations, banks, mortgage bankers, home builders,
insurance companies and other mortgage lenders. The Company acquires
Mortgage Loans directly from originators and from entities holding Mortgage
Loans originated by others. The Company also originates its own Mortgage
Loans, particularly mezzanine financing of Mortgage Loan and real property
portfolios.
The Company may invest in or provide loans used to finance
construction, loans secured by real property and used as temporary
financing, and loans secured by junior liens on real property. The Company
may invest in multifamily and commercial Mortgage Loans that are in default
or for which default is likely or imminent or for which the borrower is
making monthly payments in accordance with a forbearance plan.
The Company may provide mezzanine financing on commercial property
that is subject to first lien mortgage debt. The Company's mezzanine
financing takes the form of subordinated loans, commonly known as second
mortgages, or, in the case of loans originated for securitization,
partnership loans (also known as pledge loans) or preferred equity
investments. For example, on a commercial property subject to a first lien
mortgage loan with a principal balance equal to 70% of the value of the
property, the Company could lend the owner of the property (typically a
partnership) an additional 15% to 20% of the value of the property.
Typically in a mezzanine Mortgage Loan, as security for its debt
to the Company, the property owner would pledge to the Company either the
property subject to the first lien (giving the Company a second lien
position typically subject to an inter-creditor agreement) or the limited
partnership and/or general partnership interest in the owner. If the
owner's general partnership interest is pledged, then the Company would be
in a position to take over the operation of the property in the event of a
default by the owner. By borrowing against the additional value in their
properties, the property owners obtain an additional level of liquidity to
apply to property improvements or alternative uses. Mezzanine Mortgage
Loans generally provide the Company with the right to receive a stated
interest rate on the loan balance plus various commitment and/or exit fees.
In certain instances, subject to the REIT Provisions of the Code, the
Company may negotiate to receive a percentage of net operating income or
gross revenues from the property, payable to the Company on an ongoing
basis, and a percentage of any increase in value of the property, payable
upon maturity or refinancing of the loan, or the Company will otherwise
seek terms to allow the Company to charge an interest rate that would
provide an attractive risk-adjusted return. Alternatively, the mezzanine
Mortgage Loans can take the form of a non-voting preferred equity
investment in a single purpose entity borrower with substantially similar
terms.
The Company may acquire or originate Mortgage Loans secured by
real property located outside the United States or acquire such real
property. The Company has no limitations on the geographic scope of its
investments in foreign real properties and such investments may be made in
a single foreign country or among several foreign countries as the Board of
Directors may deem appropriate. Investing in real estate related assets
located in foreign countries creates risks associated with the uncertainty
of foreign laws and markets and risks related to currency conversion. The
Company may be subject to foreign income tax with respect to its
investments in foreign real estate related assets. Any foreign tax credit
that otherwise would be available to the Company for Federal income tax
purposes will not flow through to the Company's stockholders.
Multifamily and Commercial Real Properties. The Company believes
that under appropriate circumstances the acquisition of multifamily and
commercial real properties may offer significant opportunities to the
Company. The Company's policy is to conduct an investigation and evaluation
of the real properties in a portfolio of real properties before purchasing
such a portfolio. Prior to purchasing real estate related assets, the
Manager generally will identify and contact real estate brokers and/or
appraisers in the relevant market areas to obtain rent and sale comparables
for the assets in a portfolio contemplated to be acquired. This information
is used to supplement due diligence performed by the Manager's employees.
The Company may acquire real properties with known material
environmental problems and Mortgage Loans secured by such real properties
subsequent to an environmental assessment that would reasonably indicate
that the present value of the cost of clean-up or rededication would not
exceed the realizable value from the disposition of the mortgage property.
The Company may invest in net leased real estate on a leveraged
basis. Net leased real estate is generally defined as real estate that is
net leased on a long-term basis (ten years or more) to tenants who are
customarily responsible for paying all costs of owning, operating, and
maintaining the leased property during the term of the lease, in addition
to the payment of a monthly net rent to the landlord for the use and
occupancy of the premises ("Net Leased Real Estate"). The Company will
focus on net leased real estate that is either leased to creditworthy
tenants or is real estate that can be leased to other tenants in the event
of a default of the initial tenant.
Other Real Estate Related Assets. The Company may invest in a
variety of other real estate related investments, the principal features of
which are summarized below.
FHA and GNMA Project Loans. The Company intends to invest in loan
participations and pools of loans insured under a variety of programs
administered by the Department of Housing and Urban Development ("HUD").
These loans will be insured under the National Housing Act and will provide
financing for the purchase, construction or substantial rehabilitation of
multifamily housing, nursing homes and intermediate care facilities,
elderly and handicapped housing, and hospitals.
Similar to CMBS, investments in FHA and GNMA Project Loans will be
collateralized by a more limited number of loans, with larger average
principal balances, than RMBS, and will therefore be subject to greater
performance variability. Loan participations are most often backed by a
single FHA-insured loan. Pools of insured loans, while more diverse, still
provide much less diversification than pools of single family loans.
FHA insured loans will be reviewed on a case by case basis to
identify and analyze risk factors which may materially impact investment
performance. Property specific data such as debt service coverage ratios,
loan-to-value ratios, HUD inspection reports, HUD financial statements and
rental subsidies will be analyzed in determining the appropriateness of a
loan for investment purposes. The Manager will also rely on the FHA
insurance contracts and their anticipated impact on investment performance
in evaluating and managing the investment risks. FHA insurance covers 99%
of the principal balance of the underlying project loans. Additional GNMA
credit enhancement may cover 100% of the principal balance.
Pass-Through Certificates. 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 FNMA, FHLMC and GNMA, as
well as privately issued adjustable-rate and fixed-rate mortgage
pass-through certificates. The Pass-Through Certificates to be acquired by
the Company will represent interests in mortgages that will be secured by
liens on single-family (one-to-four units) residential properties,
multifamily residential properties, and commercial properties. Pass-Through
Certificates backed by adjustable-rate Mortgage Loans are subject to
lifetime interest rate caps and to periodic interest rate caps that limit
the amount an interest rate can change during any given period. The
Company's borrowings are generally not subject to similar restrictions. In
a period of increasing interest rates, the Company could experience a
decrease in net income or incur losses because the interest rates on its
borrowings could exceed the interest rates on adjustable-rate Pass-Through
Certificates owned by the Company. The impact on net income of such
interest rate changes will depend on the adjustment features of the
mortgage assets owned by the Company, the maturity schedules of the
Company's borrowings and related hedging.
Privately Issued Pass-Through Certificates. Privately Issued
Pass-Through Certificates are structured similar to the FNMA, FHLMC and
GNMA pass-through certificates discussed below and are issued by
originators of and investors in Mortgage Loans, including savings and loan
associations, savings banks, commercial banks, mortgage banks, investment
banks and special purpose subsidiaries of such institutions. Privately
Issued Pass-Through Certificates are usually backed by a pool of
conventional Mortgage Loans and are generally structured with credit
enhancement such as pool insurance or subordination. However, Privately
Issued Pass-Through Certificates are typically not guaranteed by an entity
having the credit status of FNMA, FHLMC or GNMA guaranteed obligations.
FNMA Certificates. FNMA is a federally chartered and privately
owned corporation. FNMA provides funds to the mortgage market primarily by
purchasing Mortgage Loans on homes from local lenders, thereby replenishing
their funds for additional lending.
FNMA Certificates may be backed by pools of Mortgage Loans secured
by single-family or multi-family residential properties. The original terms
to maturity of the Mortgage Loans generally do not exceed 40 years. FNMA
Certificates may pay interest at a fixed rate or adjustable rate. Each
series of FNMA adjustable-rate certificates bears an initial interest rate
and margin tied to an index based on all loans in the related pool, less a
fixed percentage representing servicing compensation and FNMA's guarantee
fee. The specified index used in each such series has included the Treasury
Index, the 11th District Cost of Funds Index, LIBOR and other indices.
Interest rates paid on fully-indexed FNMA adjustable-rate certificates
equal the applicable index rate plus a specified number of basis points
ranging typically from 125 to 250 basis points. In addition, the majority
of series of FNMA adjustable-rate certificates issued to date have
evidenced pools of Mortgage Loans with monthly, semi-annual or annual
interest rate adjustments. Adjustments in the interest rates paid are
generally limited to an annual increase or decrease of either 100 or 200
basis points and to a lifetime cap of 500 or 600 basis points over the
initial interest rate. Certain FNMA programs include Mortgage Loans which
allow the borrower to convert the adjustable mortgage interest rate of its
adjustable-rate Mortgage Loan to a fixed rate. Adjustable-rate Mortgage
Loans which are converted into fixed rate Mortgage Loans are repurchased by
FNMA, or by the seller of such loans to FNMA, at the unpaid principal
balance thereof plus accrued interest to the due date of the last
adjustable rate interest payment.
FNMA guarantees to the registered holder of a FNMA Certificate
that it will distribute amounts representing scheduled principal and
interest (at the rate provided by the FNMA Certificate) on the Mortgage
Loans in the pool underlying the FNMA Certificate, whether or not received,
and the full principal amount of any such Mortgage Loan foreclosed or
otherwise finally liquidated, whether or not the principal amount is
actually received. The obligations of FNMA under its guarantees are solely
those of FNMA and are not backed by the full faith and credit of the United
States. If FNMA were unable to satisfy such obligations, distributions to
holders of FNMA Certificates would consist solely of payments and other
recoveries on the underlying Mortgage Loans and, accordingly, monthly
distributions to holders of FNMA Certificates would be affected by
delinquent payments and defaults on such Mortgage Loans.
FHLMC Certificates. FHLMC is a privately owned corporate
instrumentality of the United States created pursuant to an Act of
Congress. 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 MBS.
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 Mortgage Loans purchased by FHLMC. The Mortgage Loans 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.
FHLMC guarantees to each holder of its certificates the timely
payment of interest at the applicable pass-through rate and ultimate
collection of all principal on the holder's pro rata share of the unpaid
principal balance of the related Mortgage Loans, but does not guarantee the
timely payment of scheduled principal of the underlying Mortgage Loans. The
obligations of FHLMC under its guarantees are solely those of FHLMC and are
not backed by the full faith and credit of the United States. If FHLMC were
unable to satisfy such obligations, distributions to holders of FHLMC
Certificates would consist solely of payments and other recoveries on the
underlying Mortgage Loans and, accordingly, monthly distributions to
holders of FHLMC Certificates would be affected by delinquent payments and
defaults on such Mortgage Loans.
GNMA Certificates. GNMA is a wholly owned corporate
instrumentality of the United States within HUD. GNMA guarantees 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 and other loans
eligible for inclusion in mortgage pools underlying GNMA Certificates. GNMA
Certificates constitute general obligations of the United States backed by
its full faith and credit.
Collateralized Mortgage Obligations (CMOs). The Company may
invest, from time to time, in adjustable rate and fixed rate CMOs issued by
private issuers or FHLMC, FNMA or GNMA. CMOs are a series of bonds or
certificates ordinarily issued in multiple classes, each of which consists
of several classes with different maturities and often complex priorities
of payment, secured by a single pool of Mortgage Loans, Pass-Through
Certificates, other CMOs or other mortgage assets. Principal prepayments on
collateral underlying a CMO may cause it to be retired substantially
earlier than the stated maturities or final distribution dates. Interest is
paid or accrues on all interest bearing classes of a CMO on a monthly,
quarterly or semi-annual basis. The principal and interest on underlying
Mortgages Loans may be allocated among the several classes of a series of a
CMO in many ways, including pursuant to complex internal leverage formulas
that may make the CMO class especially sensitive to interest rate or
prepayment risk.
CMOs may be subject to certain rights of issuers thereof to redeem
such CMOs prior to their stated maturity dates, which may have the effect
of diminishing the Company's anticipated return on its investment.
Privately-issued single-family, multi-family and commercial CMOs are
supported by private credit enhancements similar to those used for
Privately-Issued Certificates and are often issued as senior-subordinated
mortgage securities. In general, the Company intends to only acquire CMOs
or multi-class Pass-Through certificates that represent beneficial
ownership in grantor trusts holding Mortgage Loans, or regular interests
and residual interests in REMICs, or that otherwise constitute REIT Real
Estate Assets.
Mortgage Derivatives. The Company may acquire Mortgage
Derivatives, including IOs, Inverse IOs, Sub IOs and floating rate
derivatives, as market conditions warrant. Mortgage Derivatives provide for
the holder to receive interest only, principal only, or interest and
principal in amounts that are disproportionate to those payable on the
underlying Mortgage Loans. Payments on Mortgage Derivatives are highly
sensitive to the rate of prepayments on the underlying Mortgage Loans. In
the event that prepayments on such Mortgage Loans occur more frequently
than anticipated, the rates of return on Mortgage Derivatives representing
the right to receive interest only or a disproportionately large amount of
interest, i.e., IOs, would be likely to decline. Conversely, the rates of
return on Mortgage Derivatives representing the right to receive principal
only or a disproportional amount of principal, i.e., POs, would be likely
to increase in the event of rapid prepayments.
Some IOs in which the Company may invest, such as Inverse IOs,
bear interest at a floating rate that varies inversely with (and often at a
multiple of) changes in a specific index. The yield to maturity of an
Inverse IO is extremely sensitive to changes in the related index. The
Company also may invest in inverse floating rate Mortgage Derivatives which
are similar in structure and risk to Inverse IOs, except they generally are
issued with a greater stated principal amount than Inverse IOs.
Other IOs in which the Company may invest, such as Sub IOs, have
the characteristics of a Subordinated Interest. A Sub IO is entitled to no
payments of principal; moreover, interest on a Sub IO often is withheld in
a reserve fund or spread account to fund required payments of principal and
interest on more senior tranches of mortgage securities. Once the balance
in the spread account reaches a certain level, excess funds are paid to the
holders of the Sub IO. These Sub IOs provide credit support to the senior
classes and thus bear substantial credit risks. In addition, because a Sub
IO receives only interest payments, its yield is extremely sensitive to the
rate of prepayments (including prepayments as a result of defaults) on the
underlying Mortgage Loans.
IOs can be effective hedging devices because they generally
increase in value as fixed-rate mortgage securities decrease in value. The
Company also may invest in other types of derivatives currently available
in the market and other Mortgage Derivatives that may be developed in the
future if the Manager determines that such investments would be
advantageous to the Company.
Other. The Company may invest in fixed-income securities that are
not mortgage assets, including securities issued by corporations or issued
or guaranteed by U.S. or sovereign foreign entities, loan participations,
emerging market debt, high yield debt and collateralized bond obligations.
Hedging Activities
The Company may enter into hedging transactions to protect its
investment portfolio from interest rate fluctuations and other changes in
market conditions. These transactions may include interest rate swaps, the
purchase or sale of interest rate collars, caps or floors, options,
Mortgage Derivatives and other hedging instruments. These instruments may
be used to hedge as much of the interest rate risk as the Manager
determines is in the best interest of the Company's stockholders, given the
cost of such hedges and the need to maintain the Company's status as a
REIT. The Manager may elect to have the Company bear a level of interest
rate risk that could otherwise be hedged when the Manager believes, based
on all relevant facts, that bearing such risk is advisable. The Manager has
extensive experience in hedging mortgages and mortgage-related assets with
these types of instruments.
Hedging instruments often are not traded on regulated exchanges,
guaranteed by an exchange or its clearing house, or regulated by any U.S.
or foreign governmental authorities. Consequently, there may be no
requirements with respect to record keeping, financial responsibility or
segregation of customer funds and positions. The Company will enter into
these transactions only with counterparties with long term debt rated "A"
or better by at least one nationally recognized statistical rating
organization. The business failure of a counterparty with which the Company
has entered into a hedging transaction will most likely result in a
default, which may result in the loss of unrealized profits and force the
Company to cover its resale commitments, if any, at the then current market
price. Although generally the Company will seek to reserve for itself the
right to terminate its hedging positions, it may not always be possible to
dispose of or close out a hedging position without the consent of the
counterparty, and the Company may not be able to enter into an offsetting
contract in order to cover its risk. There can be no assurance that a
liquid secondary market will exist for hedging instruments purchased or
sold, and the Company may be required to maintain a position until exercise
or expiration, which could result in losses.
The Company's hedging activities are intended to address both
income and capital preservation. Income preservation refers to maintaining
a stable spread between yields from mortgage assets and the Company's
borrowing costs across a reasonable range of adverse interest rate
environments. Capital preservation refers to maintaining a relatively
steady level in the market value of the Company's capital across a
reasonable range of adverse interest rate scenarios. However, no strategy
can insulate the Company completely from changes in interest rates.
The Company has not established specific policies as to the extent
of the hedging transactions in which it will engage. The Company will not
enter into these types of transactions for speculative purposes.
At December 31, 1998, the Company's hedging transactions
outstanding consisted of forward currency exchange contracts pursuant to
which the Company has agreed to exchange (pound)8,053,000 (pounds sterling)
for $13,323,000 (U.S. dollars) on March 31, 1999. These contracts are
intended to hedge currency risk in connection with the Company's investment
in a commercial mortgage loan denominated in pounds sterling. The estimated
fair value of the forward currency exchange contracts was a liability of
$(21,000) at December 31, 1998, which was recognized as a reduction of net
foreign currency gains.
During 1998, the Company entered into an interest rate swap
transaction that was, for accounting purposes, designated as being intended
to modify the interest rate characteristics of certain of the Company's
securities available for sale from fixed to variable rate. In connection
with the sale of a portion of the Company's portfolio of securities
available for sale, the swap transaction, which had a notional amount of
$100,000,000, was terminated later in the year at a loss of $(3,804,000).
The Company monitored the swap to ensure that it remained effective through
the date of its termination. The portion of the loss associated with
securities available for sale sold by the Company during 1998,
$(2,771,000), is included in the loss on sale of securities available for
sale in the statement of operations and comprehensive income (loss). The
remaining portion of the loss, $(1,033,000), which is associated with
certain of the Company's remaining securities available for sale, was added
to the cost basis of such securities and is being amortized as a yield
adjustment over the previously scheduled term of the swap transaction,
which was ten years.
Financing and Leverage
To date, the Company has financed its assets with the net proceeds
of the initial public offering and through short-term borrowings under
repurchase agreements and the line of credit discussed below. In the
future, operations may be financed by future offerings of equity securities
and borrowings, and the Company expects that, in general, it will employ
leverage consistent with the type of assets acquired and the desired level
of risk in various investment environments. The Company's governing
documents do not explicitly limit the amount of leverage that the Company
may employ. Instead, the Board of Directors has adopted an indebtedness
policy for the Company that gives the Manager extensive discretion as to
the amount of leverage to be employed, depending on the Manager's
assessment of acceptable risk and consistent with the nature of the assets
then held by the Company, subject to periodic review by the Company's Board
of Directors. At December 31, 1998, the Company's debt-to-equity ratio for
at-risk assets was approximately 2.0 to 1 and the Company anticipates that
it will maintain debt-to-equity ratios for at-risk assets of between 1.5 to
1 and 3.0 to 1 in the foreseeable future, although this ratio may be higher
or lower from time to time. The Company considers its at-risk assets to be
its core strategy operating portfolio and its non-core strategy liquidity
portfolio. The Company's indebtedness policy may be changed by the Board of
Directors in the future.
During 1998, the Company entered into a Master Assignment
Agreement, as amended, and related Note, which provide financing for the
Company's investments. The agreement, which is with Merrill Lynch Mortgage
Capital Inc., permits the Company to borrow up to $400,000,000 and
terminates August 20, 1999. The agreement requires assets to be pledged as
collateral, which may consist of rated CMBS, rated RMBS, residential and
commercial mortgage loans, and certain other assets. Outstanding borrowings
against this line of credit bear interest at a LIBOR based variable rate.
The Company is subject to various covenants in its line of credit,
including maintaining a minimum GAAP net worth of $140,000,000 and a
debt-to-equity ratio not to exceed 6.0 to 1, as well as a covenant that
after September 30, 1998 the Company's GAAP net worth will not decline by
more than 37 percent over any two consecutive fiscal quarters. At December
31, 1998, the Company was in compliance with all such covenants.
The Company's reverse repurchase agreements are collateralized by
most of the Company's securities available for sale and securities held for
trading (other than those pledged to secure borrowings under the line of
credit) and bear interest at rates that have historically moved in close
relationship to LIBOR.
Certain information with respect to the Company's short-term
borrowings at December 31, 1998 is summarized as follows (dollars in
thousands):
Reverse Total
Line of Credit Repurchase Short-Term
Agreements Borrowings
-------------------------------------------------
Outstanding borrowings $65,921 $420,143 $486,064
Weighted average borrowing rate 6.98% 5.57% 5.76%
Weighted average remaining maturity 232 days 15 days 45 days
Estimated fair value of assets pledged $98,331 $462,787 $561,117
At December 31, 1998, $23,014,000 of borrowings outstanding under
the line of credit were denominated in pounds sterling.
At December 31, 1998, the Company's short-term borrowings had the
following remaining maturities (dollars in thousands):
Reverse Total
Line of Credit Repurchase Short-Term
Agreements Borrowings
----------------- ---------------- -----------------
Within 30 days $ - $407,769 $407,769
31 to 59 days - - -
Over 59 days 65,921 12,374 78,295
====================================================
$65,921 $420,143 $486,064
====================================================
Under the line of credit and the reverse repurchase agreements,
the respective lender retains the right to mark the underlying collateral
to estimated market value. A reduction in the value of its pledged assets
will require the Company to provide additional collateral or fund margin
calls. From time to time, the Company expects that it will be required to
provide such additional collateral or fund margin calls.
Operating Policies
The Company has adopted compliance guidelines, including
restrictions on acquiring, holding and selling assets, to ensure that the
Company meets the requirements for qualification as a REIT and is excluded
from regulation as an investment company. Before acquiring any asset, the
Manager determines whether such asset would constitute a REIT Real Estate
Asset under the REIT Provisions of the Code. The Company regularly monitors
purchases of mortgage assets and the income generated from such assets,
including income from its hedging activities, in an effort to ensure that
at all times the Company's assets and income meet the requirements for
qualification as a REIT and exclusion under the Investment Company Act of
1940, as amended (the "Investment Company Act").
The Company's unaffiliated directors review all transactions of
the Company on a quarterly basis to ensure compliance with the operating
policies and to ratify all transactions with PNC Bank and its affiliates,
except that the purchase of securities from PNC and its affiliates require
prior approval. The unaffiliated directors rely substantially on
information and analysis provided by the Manager to evaluate the Company's
operating policies, compliance therewith and other matters relating to the
Company's investments.
In order to maintain the Company's REIT status, the Company
generally intends to distribute to stockholders aggregate dividends
equaling at least 95% of its taxable income each year.
Regulation
The Company intends to continue to conduct its business so as not
to become regulated as an investment company under the Investment Company
Act. Under the Investment Company Act, a non-exempt entity that is an
investment company is required to register with the SEC and is subject to
extensive, restrictive and potentially adverse regulation relating to,
among other things, operating methods, management, capital structure,
dividends and transactions with affiliates. The Investment Company Act
exempts entities that are "primarily engaged in the business of purchasing
or otherwise acquiring mortgages and other liens on and interests in real
estate" ("Qualifying Interests"). Under current interpretation by the staff
of the SEC, to qualify for this exemption, the Company, among other things,
must maintain at least 55% of its assets in Qualifying Interests. Pursuant
to such SEC staff interpretations, certain of the Company's interests in
agency pass-through and mortgage-backed securities and agency insured
project loans are Qualifying Interests. In general, the Company will
acquire subordinated CMBS only when such mortgage securities are
collateralized by pools of first mortgage loans, when the Company can
monitor the performance of the underlying mortgage loans through loan
management and servicing rights, and when the Company has appropriate
workout/foreclosure rights with respect to the underlying mortgage loans.
When such arrangements exist, the Company believes that the related
subordinated CMBS constitute Qualifying Interests for purposes of the
Investment Company Act. Therefore, the Company believes that it should not
be required to register as an "investment company" under the Investment
Company Act as long as it continues to invest primarily in such
subordinated CMBS and/or in other Qualifying Interests. However, if the SEC
or its staff were to take a different position with respect to whether the
Company's subordinated CMBS constitute Qualifying Interests, the Company
could be required to modify its business plan so that either (i) it would
not be required to register as an investment company or (ii) it would
comply with the Investment Company Act and be able to register as an
investment company. In such event, (i) modification of the Company's
business plan so that it would not be required to register as an investment
company would likely entail a disposition of a significant portion of the
Company's subordinated CMBS or the acquisition of significant additional
assets, such as agency pass-through and mortgage-backed securities, which
are Qualifying Interests or (ii) modification of the Company's business
plan to register as an investment company would result in significantly
increased operating expenses and would likely entail significantly reducing
the Company's indebtedness (including the possible prepayment of the
Company's short-term borrowings), which could also require it to sell a
significant portion of its assets. No assurances can be given that any such
dispositions or acquisitions of assets, or deleveraging, could be
accomplished on favorable terms. Consequently, any such modification of the
Company's business plan could have a material adverse effect on the
Company. Further, if it were established that the Company were an
unregistered investment company, there would be a risk that the Company
would be subject to monetary penalties and injunctive relief in an action
brought by the SEC, that the Company would be unable to enforce contracts
with third parties and that third parties could seek to obtain recission of
transactions undertaken during the period it was established that the
Company was an unregistered investment company. Any such results would be
likely to have a material adverse effect on the Company.
Competition
The Company's net income depends, in large part, on the Company's
ability to acquire mortgage assets at favorable spreads over the Company's
borrowing costs. In acquiring mortgage assets, the Company competes with
other mortgage REITs, specialty finance companies, savings and loan
associations, banks, mortgage bankers, insurance companies, mutual funds,
institutional investors, investment banking firms, other lenders,
governmental bodies and other entities. In addition, there are numerous
mortgage REITs with asset acquisition objectives 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. Many of the Company's
anticipated competitors are significantly larger than the Company, have
access to greater capital and other resources and may have other advantages
over the Company. In addition to existing companies, other companies may be
organized for purposes similar to that of the Company, including companies
organized as REITs focused on purchasing mortgage assets. A proliferation
of such companies may increase the competition for equity capital and
thereby adversely affect the market price of the Company's common stock.
Employees
The Company does not have any employees other than officers, each
of whom are full-time employees of the Manager, whose duties include
performing administrative activities for the Company.
Management Agreement
The Company is managed pursuant to a Management Agreement, dated
March 27, 1998, between the Company and the Manager, pursuant to which, the
Manager is responsible for the day-to-day operations of the Company and
performs such services and activities relating to the assets and operations
of the Company as may be appropriate. The Manager primarily engages in
three activities: (i) acquiring and originating Mortgage Loans and other
real estate related assets; (ii) asset/liability and risk management,
hedging of floating rate liabilities, and financing, management and
disposition of assets, including credit and prepayment risk management; and
(iii) capital management, structuring, analysis, capital raising and
investor relations activities. In conducting these activities, the Manager
formulates operating strategies for the Company, arranges for the
acquisition of assets by the Company, arranges for various types of
financing and hedging strategies for the Company, monitors the performance
of the Company's assets and provides certain administrative and managerial
services in connection with the operation of the Company. At all times, the
Manager is subject to the direction and oversight of the Company's Board of
Directors.
The Company may terminate, or decline to renew the term of, the
Management Agreement without cause at any time after the first two years
upon 60 days written notice by a majority vote of the unaffiliated
directors. Although no termination fee is payable in connection with a
termination for cause, in connection with a termination without cause, the
Company must pay the Manager a termination fee, which could be substantial.
The amount of the termination fee will be determined by independent
appraisal of the value of the Management Agreement for the next four years.
Such appraisal is to be conducted by a nationally-recognized appraisal firm
mutually agreed upon by the Company and the Manager.
In addition, the Company has the right at any time during the term
of the Management Agreement to terminate the Management Agreement without
the payment of any termination fee upon, among other things, a material
breach by the Manager of any provision contained in the Management
Agreement that remains uncured at the end of the applicable cure period.
Taxation of the Company
The Company intends to elect to be taxed as a REIT under the
Internal Revenue Code of 1986, as amended (the "Code"), commencing with its
taxable year ended December 31, 1998, and the Company intends to continue
to operate in a manner consistent with the REIT Provisions of the Code. The
Company's qualification as a REIT depends on its ability to meet the
various requirements imposed by the Code, through actual operating results,
asset holdings, distribution levels, and diversity of stock ownership.
Provided the Company qualifies for taxation as a REIT, it
generally will not be subject to Federal corporate income tax on its net
income that is currently distributed to stockholders. This treatment
substantially eliminates the "double taxation" (at the corporate and
stockholder levels) that generally results from an investment in a
corporation. If the Company fails to qualify as a REIT in any taxable year,
its taxable income would be subject to Federal income tax at regular
corporate rates (including any applicable alternative minimum tax). Even if
the Company qualifies as a REIT, it will be subject to Federal income and
excise taxes on its undistributed income.
If in any taxable year the Company fails to qualify as a REIT and,
as a result, incurs additional tax liability, the Company may need to
borrow funds or liquidate certain investments in order to pay the
applicable tax, and the Company would not be compelled to make
distributions under the Code. Unless entitled to relief under certain
statutory provisions, the Company would also be disqualified from treatment
as a REIT for the four taxable years following the year during which
qualification is lost. Although the Company currently intends to operate in
a manner designated to qualify as a REIT, it is possible that future
economic, market, legal, tax or other considerations may cause the Company
to fail to qualify as a REIT or may cause the Board of Directors to revoke
the Company's REIT election.
The Company and its stockholders may be subject to foreign, state
and local taxation in various foreign, state and local jurisdictions,
including those in which it or they transact business or reside. The state
and local tax treatment of the Company and its stockholders may not conform
to the Company's Federal income tax treatment.
ITEM 2. PROPERTIES
The Company does not maintain an office. It utilizes the offices
of the Manager, located at 345 Park Avenue, New York, New York 10154.
ITEM 3. LEGAL PROCEEDINGS
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company's Common Stock is traded on the New York Stock
Exchange under the symbol "AHR." The following table sets forth, for the
periods indicated, the high, low and last sale prices in dollars on the New
York Stock Exchange for the Company's securities as were traded during
these respective time periods.
1998 High Low Last Sale
- ---- ----- --- ---------
First Quarter*...................... 15 1/4 15 15
Second Quarter...................... 15 1/2 13 3/8 13 7/8
Third Quarter....................... 13 15/16 8 1/4 8 1/2
Fourth Quarter...................... 8 3/8 3 5/8 7 13/16
1999
First Quarter (through March 29).... 7 15/16 6 1/4 6 7/8
- --------------
* From March 24 to March 31.
On March 29, 1999, the closing sale price for the Company's Common
Stock, as reported on the New York Stock Exchange, was $6.875. As of March
29, 1999, there were approximately 82 record holders of the Common Stock.
This figure does not reflect beneficial ownership of shares held in nominee
name.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data set forth below for the period March 24, 1998
(commencement of operations) through December 31, 1998 has been derived
from the Company's audited financial statements. This information should be
read in conjunction with "Item 1. Business" and "Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations",
as well as the audited financial statements and notes thereto included in
"Item 8. Financial Statements and Supplementary Data".
For the Period
March 24, 1998 Through
(In thousands, except per share data) December 31, 1998
- ----------------------------------------------------------------------------
Interest income $46,055
Expenses $29,004
Other gains (losses) $(18,440)
Net loss $(1,389)
Net loss per share:
Basic $(0.07)
Diluted $(0.07)
Dividends declared per common share $0.92
Total assets $956,395
Total liabilities $774,666
Total stockholders' equity $181,729
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
General: The Company was organized in November 1997 to invest in a
diversified portfolio of multifamily, commercial and residential mortgage
loans, mortgage-backed securities and other real estate related assets in
the U.S. and non-U.S. markets. The Company expects to generate income for
distribution to its stockholders primarily from the net earnings derived
from its investments in real estate related assets. The Company intends to
operate in a manner that permits it to maintain its status as a REIT for
Federal income tax purposes.
In March 1998, the Company received $296.9 million of net proceeds from the
initial public offering of 20,000,000 shares and the private placement of
1,365,198 shares of its common stock, which the Company used to acquire its
initial portfolio of investments. The Company commenced operations on March
24, 1998.
The following discussion should be read in conjunction with the financial
statements and related notes included in "Item 8. Financial Statements and
Supplementary Data". Dollar amounts are expressed in thousands, other than
per share amounts.
Market Conditions: Market conditions were highly variable and unpredictable
during 1998. The Company's first full quarter of operations ending in June
1998 was a period of relative calm in the financial markets. Interest rates
and credit spreads remained relatively stable during that period, and the
outlook for the global economy appeared strong, with some uncertainty about
economic conditions in the Far East. During that period, the Company faced
increasing competition from finance companies, brokerage firms and other
REITs in its core strategy of acquiring and originating high yield loans
and securities backed by commercial real estate or commercial real estate
mortgages. Nevertheless, the Company was able to acquire approximately
$211,000 in subordinated commercial mortgage-backed securities ("CMBS") and
$832,000 in non-core liquid securities by the end of its first full quarter
of operations.
Spurred by Russia's technical default on its debt in August 1998 and
deterioration in the economic situation in the Far East, market conditions
during the third quarter of 1998 worsened and investor concerns over
creditworthiness became paramount. Credit spreads widened dramatically and
yields on U.S. Treasury securities fell, as investors sold off holdings of
credit-sensitive securities in favor of Treasuries. These factors combined
to cause a significant decline in the market value of the Company's
investment portfolio. The Company's holdings of subordinated CMBS were
particularly affected, inasmuch as they represent the first classes in a
securitization transaction to be affected by credit losses. The unrealized
gain (loss) on the Company's holdings of subordinated CMBS declined from
$3,012 at June 30, 1998 to $(39,543) at September 30, 1998.
The fourth quarter of 1998 saw continued spread widening in the credit
sensitive sectors of the debt markets and reduced liquidity in the
financing markets. As traditional sources of real estate funding sought to
protect their liquidity, financing for new real estate construction was
curtailed significantly. In October 1998, in response to market upheaval
and volatility, the Company sold approximately $663,000 of its holdings of
non-core liquid securities in order to reduce its leverage and enhance its
liquidity position, resulting in a realized loss of approximately $18,300
after termination of the related hedges.
By late November and during the month of December 1998, market conditions
had stabilized considerably but credit spreads remained at or near
historically wide levels. Mixed signals pervaded the U.S. economic outlook,
but there was consistent evidence of a trend toward slower growth. As a
result of market conditions, the value of the Company's investment
portfolio continued to decline during the fourth quarter. The unrealized
loss on the Company's holdings of subordinated CMBS increased from
$(39,543) at September 30, 1998 to $(79,137) at December 31, 1998. However,
real estate credit fundamentals remained solid and the Company believes
there has been no discernible change in the credit quality of its
portfolio.
The Company's earnings depend, in part, on the relationship between
long-term interest rates and short-term interest rates. The Company's
investments bear interest at fixed rates determined by reference to the
yields of medium- or long-term U.S. Treasury securities or at adjustable
rates determined by reference (with a lag) to the yields on various
short-term instruments. The Company's borrowings bear interest at rates
that have historically moved in close relationship to the London Interbank
Offered Rate (LIBOR). To the extent that interest rates on the Company's
borrowings increase without an offsetting increase in the interest rates
earned on the Company's investments, the Company's earnings could be
negatively affected.
From March 24, 1998, the date the Company commenced operations, to December
31, 1998, one-month LIBOR declined from 5.69% to 5.06% and the yield on
ten-year U.S. Treasury notes declined from 5.57% to 4.66%. The decline in
LIBOR during the period had a beneficial impact on the Company's financing
costs. The decline in the ten-year U.S. Treasury yield, a change that would
normally increase the value of the Company's portfolio of fixed income
securities, was more than offset by a significant widening of credit
spreads during the period, causing the value of the Company's portfolio to
decline.
During the first quarter of 1999, the ten-year U.S. Treasury yield
increased from its December 31, 1998 level. The Company expects that this
increase in interest rates will cause the value of the Company's portfolio
at March 31, 1999 to be less than its value at December 31, 1998.
Recent Events: On March 17, 1999, the Company declared distributions to its
stockholders of $0.29 per share, payable on April 15, 1999 to stockholders
of record on March 31, 1999. The Company also set May 17, 1999 as the date
for its annual stockholders meeting and March 31, 1999 as the record date
for stockholders that will be eligible to participate and vote at the
stockholders meeting.
During the first quarter of 1999, the Company applied a portion of its cash
on hand to fund approximately $4,400 of its commitment outstanding to
originate a $35,000 floating rate commercial real estate construction loan
secured by a second mortgage (see Note 11 to the accompanying financial
statements). The Company intends to fund the remaining portion of the
commitment through a combination of existing cash on hand, new equity,
additional borrowings and/or syndication of a portion of the commitment.
During the first quarter of 1999, the Company issued 1,008,538 shares of
common stock under its Dividend Reinvestment and Stock Purchase Plan and
received total proceeds of $6,726, which were used for general corporate
purposes.
On March 17, 1999, the Company's Board of Directors approved the grant of
options to purchase 270,000 shares of the Company's common stock to certain
officers and employees of the Company pursuant to the Company's 1998 Stock
Option Plan. The exercise price of these options is the greater of the
Company's GAAP net asset value per share or the closing price of the
Company's common stock on March 31, 1999.
Funds From Operations (FFO): Most industry analysts, including the Company,
consider FFO an appropriate supplementary measure of operating performance
of a REIT. In general, FFO adjusts net income for non-cash charges such as
depreciation, certain amortization expenses and gains or losses from debt
restructuring and sales of property. However, FFO does not represent cash
provided by operating activities in accordance with GAAP and should not be
considered an alternative to net income as an indication of the results of
the Company's performance or to cash flows as a measure of liquidity.
In 1995, the National Association of Real Estate Investment Trusts
("NAREIT") established new guidelines clarifying its definition of FFO and
requested that REITs adopt this new definition beginning in 1996. The
Company computes FFO in accordance with the definition recommended by
NAREIT. The Company believes that the exclusion from FFO of gains or losses
from sales of property was not intended to address gains or losses from
sales of securities as it applies to the Company. Accordingly, the Company
includes gains or losses from sales of securities in its calculation of
FFO.
The Company's FFO for the period March 24, 1998 through December 31, 1998
was $(1,389), which was the same as its reported GAAP net loss for the
period. The Company reported cash flows used in operating activities of
$141,801, cash flows used in investing activities of $611,175 and cash
flows provided by financing activities of $753,863 in its statement of cash
flows for the period March 24, 1998 through December 31, 1998.
Results of Operations
Net loss for the period March 24, 1998 through December 31, 1998 was
$(1,389), or $(0.07) per share (basic and diluted).
Interest Income: The following table sets forth information regarding the
total amount of income from interest-earning assets and the resultant
average yields. Information is based on daily average balances during the
period.
For the Period March 24, 1998
Through December 31, 1998
-----------------------------------------------------------------
Interest Average Annualized
Income Balance Yield
-----------------------------------------------------------------
-----------------------------------------------------------------
Securities available for sale $ 42,576 $749,396 7.33%
Commercial mortgage loan 1,432 16,548 11.16
Securities held for trading 1,368 46,669 3.78
Cash and cash equivalents 679 15,552 5.63
=================================================================
Total $ 46,055 $828,165 7.17%
=================================================================
Interest income on securities held for trading includes interest earned on
deposits with brokers as collateral for securities sold short. The Company
sold a substantial portion of its portfolio of securities available for
sale during the fourth quarter of 1998 and, as a result, the amount of the
Company's interest income for future periods may be significantly less than
the amounts reported above.
Interest Expense: The following table sets forth information regarding the
total amount of interest expense from short-term borrowings (including the
net amount paid under the Company's interest rate swap agreement allocated
pro rata to each category of short-term borrowings) and securities sold
short, and the resultant average yields. Information is based on daily
average balances during the period.
For the Period March 24, 1998
Through December 31, 1998
----------------------------------------------------------------
Interest Average Annualized
Expense Balance Yield
----------------------------------------------------------------
Reverse repurchase agreements $21,932 $482,409 5.86%
Line of credit borrowings 1,545 26,772 7.44
Securities sold short 1,288 33,320 4.99
----------------------------------------------------------------
Total $24,765 $542,501 5.89%
================================================================
The Company repaid a substantial portion of its borrowings under reverse
repurchase agreements during the fourth quarter of 1998 and, as a result,
the amount of the Company's interest expense for future periods may be
significantly less than the amounts reported above.
Net Interest Margin from Operating Portfolio: The Company considers its
operating portfolio to consist of its securities available for sale, its
commercial mortgage loan and its cash and cash equivalents because these
assets relate to its core strategy of acquiring and originating high yield
loans and securities backed by commercial real estate, while at the same
time maintaining a portfolio of liquid investment grade securities to
enhance the Company's liquidity. The Company considers its short-term
trading strategies to be distinct from its operating portfolio. Net
interest margin from the operating portfolio is annualized net interest
income from the portfolio divided by the average daily balance of
interest-earning assets in the portfolio. Net interest income from the
operating portfolio is total interest income from the portfolio less
interest expense (including the net amount payable under the interest rate
swap agreement) relating to short-term borrowings secured by investments in
the operating portfolio. For the period March 24, 1998 to December 31,
1998, total interest income from the operating portfolio was $44,687 and
total related interest expense was $20,734, resulting in net interest
income of $23,953 and net interest margin of 3.95% from the operating
portfolio for the period.
Other Expenses: Expenses other than interest expense consist primarily of
management fees and general and administrative expenses. Management fees of
$3,474 for the period March 24, 1998 through December 31, 1998 were
comprised solely of the base management fee paid to the Manager for the
period (as provided pursuant to the management agreement between the
Manager and the Company), as the Manager earned no incentive fee for such
period. Other expenses of $765 for the period March 24, 1998 through
December 31, 1998 were comprised of accounting agent fees, custodial agent
fees, directors' fees, fees for professional services, insurance premiums
and other miscellaneous expenses.
Other Gains (Losses): The loss on sale of securities available for sale of
$(18,262) for the period March 24, 1998 to December 31, 1998 consisted of a
loss of $(15,491) on the sale of securities available for sale and $(2,771)
of associated termination costs on an interest rate swap transaction. The
loss on securities held for trading of $(231) for the period March 24, 1998
to December 31, 1998 consisted primarily of realized and unrealized gains
and losses on U.S. Treasury and agency securities, forward commitments to
purchase or sell agency RMBS, and financial futures contracts. The foreign
currency gain of $53 for the period March 24, 1998 through December 31,
1998 relates to the Company's net investment in a commercial mortgage loan
denominated in pounds sterling.
Distributions Declared: On June 15, 1998, the Company declared
distributions to its stockholders totaling $5,769 or $0.27 per share. These
distributions were paid on July 15, 1998 to stockholders of record on June
30, 1998. On September 2, 1998, the Company declared distributions to its
stockholders totaling $7,195 or $0.36 per share. These distributions were
paid on October 15, 1998 to stockholders of record on September 30, 1998.
Distributions paid in 1998 represented approximately 89% of the Company's
undistributed tax basis net income for the period March 24, 1998 through
December 31, 1998. On December 10, 1998, the Company declared distributions
to its stockholders totaling $5,796 or $0.29 per share. These distributions
were paid on January 15, 1999 to stockholders of record on January 7, 1999.
On March 17, 1999, the Company declared distributions to its stockholders
of $0.29 per share, payable on April 15, 1999 to stockholders of record on
March 31, 1999. For Federal income tax purposes, the distributions paid on
July 15, 1998 and October 15, 1998 are expected to be taxable as ordinary
income to the Company's stockholders in 1998 and the distributions paid on
January 15, 1999 and payable on April 15, 1999 are expected to be taxable
as ordinary income to the Company's stockholders in 1999.
Tax Basis Net Income and GAAP Net Loss: Net income as calculated for tax
purposes (tax basis net income) was $14,518, or $0.70 per share (basic and
diluted), for the period March 24, 1998 through December 31, 1998, compared
to a net loss as calculated in accordance with generally accepted
accounting principles (GAAP) of $(1,389), or $(0.07) per share (basic and
diluted), for the period March 24, 1998 through December 31, 1998.
Differences between tax basis net income and GAAP net loss arise for
various reasons. For example, realized net losses on securities available
for sale, which are included in income for GAAP purposes, are not
deductible from tax basis income, but are carried forward as tax basis
capital losses that are available to offset future tax basis capital gains.
In computing income from its subordinated CMBS for GAAP purposes, the
Company takes into account estimated credit losses on the underlying loans
whereas for tax basis income purposes, only actual credit losses are taken
into account. Certain general and administrative expenses may differ due to
differing treatment of the deductibility of such expenses for tax basis
income. Unrealized net gains on securities available for trading, which are
included in income for GAAP purposes, are included in tax basis income only
when realized. In addition, loan commitment fees are recognized over the
life of the related loan for GAAP purposes but are included in tax basis
income upon receipt. Also, differences could arise in the treatment of
premium and discount amortization on the Company's securities available for
sale.
A reconciliation of GAAP net loss to tax basis net income is as follows:
For the Period March
24, 1998
Through
December 31, 1998
-----------------------
GAAP net loss $(1,389)
Net losses on securities available for sale 14,459
Subordinate CMBS income differentials 1,230
General and administrative expense differences 408
Unrealized net gains on securities held for trading (312)
Income from loan commitment fees 175
Other (53)
=======================
Tax basis net income $14,518
=======================
Changes in Financial Condition
Securities Available for Sale: At December 31, 1998, an aggregate of
$79,137 in unrealized losses on securities available for sale was included
as a component of accumulated other comprehensive income (loss) in
stockholders' equity.
The Company's securities available for sale, which are carried at estimated
fair value, included the following at December 31, 1998:
Estimated
Fair
Security Description Value Percentage
- ------------------------------------------------------------------------------------------------
Commercial mortgage-backed securities ("CMBS"):
Non-investment grade rated subordinated securities $248,734 53.5%
Non-rated subordinated securities 24,284 5.2
--------------------------------
Total CMBS 273,018 58.7
--------------------------------
Single-family residential mortgage-backed securities ("RMBS"):
Agency adjustable rate securities 17,999 3.9
Agency fixed rate securities 13,023 2.8
Privately issued investment grade rated fixed rate
securities 157,753 33.9
--------------------------------
Total RMBS 188,775 40.6
--------------------------------
Agency insured project loan 3,275 0.7
================================
Total securities available for sale $465,068 100.0%
================================
During 1998, the Company sold a substantial portion of its securities
available for sale for total proceeds of $736,744, resulting in a realized
loss of $(15,491). Substantially all of the sales occurred during the
fourth quarter of 1998 as part of the Company's efforts to reduce its
leverage and enhance its liquidity in response to reduced liquidity in the
financing markets and spread widening in the credit-sensitive sectors of
the debt markets. The proceeds from these sales were applied primarily to
reduce amounts borrowed under the Company's reverse repurchase agreements
and to increase its cash position.
Short-Term Borrowings: To date, the Company's debt has consisted of line of
credit borrowings and reverse repurchase agreements, which have been
collateralized by a pledge of most of the Company's securities available
for sale, securities held for trading and its commercial mortgage loan. The
Company's financial flexibility is affected by its ability to renew or
replace on a continuous basis its maturing short-term borrowings. To date,
the Company has obtained short-term financing in amounts and at interest
rates consistent with the Company's financing objectives.
Under the line of credit and the reverse repurchase agreements, the
respective lender retains the right to mark the underlying collateral to
market value. A reduction in the value of its pledged assets will require
the Company to provide additional collateral or fund margin calls. From
time to time, the Company expects that it will be required to provide such
additional collateral or fund margin calls.
The following table sets forth information regarding the Company's
short-term borrowings.
For the Period March 24, 1998
Through December 31, 1998
-----------------------------------------------------------------
Average Maximum Range of
Balance Balance Maturities
-----------------------------------------------------------------
Reverse repurchase agreements $482,409 $841,617 1 to 180 days
Line of credit borrowings 26,772 79,309 241 to 360 days
-----------------------------------------------------------------
Total $509,181 $920,926 1 to 360 days
=================================================================
The Company repaid a substantial portion of its borrowings under reverse
repurchase agreements during the fourth quarter of 1998.
Hedging Instruments: The Company has entered into forward currency exchange
contracts pursuant to which it has agreed to exchange (pound)8,053 (pounds
sterling) for $13,323 (U.S. dollars) on March 31, 1999. In certain
circumstances, the Company may be required to provide collateral to secure
its obligations under the forward currency exchange contracts, or may be
entitled to receive collateral from the counterparty to the forward
currency exchange contracts. At December 31, 1998, no collateral was
required under the forward currency exchange contracts. The estimated fair
value of the forward currency exchange contracts was a liability of $(21)
at December 31, 1998, which was recognized as a reduction of net foreign
currency gains.
During 1998, the Company entered into an interest rate swap transaction
that was, for accounting purposes, designated as being intended to modify
the interest rate characteristics of certain of the Company's securities
available for sale from fixed to variable rate. In connection with the sale
of a portion of the Company's portfolio of securities available for sale,
the swap transaction, which had a notional amount of $100,000, was
terminated later in the year at a loss of $(3,804). The Company monitored
the swap to ensure that it remained effective through the date of its
termination. The portion of the loss associated with securities available
for sale sold by the Company during 1998, $(2,771), is included in the loss
on sale of securities available for sale in the statement of operations and
comprehensive income (loss). The remaining portion of the loss, $(1,033),
which is associated with certain of the Company's remaining securities
available for sale, was added to the cost basis of such securities and is
being amortized as a yield adjustment over the previously scheduled term of
the swap transaction, which was ten years.
Capital Resources and Liquidity: Liquidity is a measurement of the
Company's ability to meet potential cash requirements, including ongoing
commitments to repay borrowings, fund investments, loan acquisition and
lending activities and for other general business purposes. The primary
sources of funds for liquidity consist of short-term borrowings, principal
and interest payments on and maturities of securities available for sale,
securities held for trading and the commercial mortgage loan, and proceeds
from sales thereof.
The Company's operating activities used cash flows of $141,801 during the
period March 24, 1998 through December 31, 1998. During the foregoing
period, cash flows from operating activities were used primarily to
purchase securities held for trading.
The Company's investing activities used cash flows totaling $611,175 during
the period March 24, 1998 through December 31, 1998. During the foregoing
period, cash was used in investing activities primarily to purchase
investments.
The Company's financing activities provided $753,863 during the period
March 24, 1998 through December 31, 1998 and consisted primarily of net
short-term borrowings and net proceeds from the issuance of 21,365,198
shares of common stock.
Although the Company's portfolio of securities available for sale was
acquired at a net discount to the face amount of such securities, the
Company has received to date and expects to continue to receive sufficient
coupon income in cash from its portfolio to fund distributions to
stockholders as necessary to maintain its REIT status.
The Company is subject to various covenants in its existing line of credit,
including maintaining a minimum GAAP net worth of $140,000 and a
debt-to-equity ratio not to exceed 6 to 1, as well as a covenant that after
September 30, 1998 the Company's GAAP net worth will not decline by more
than 37 percent over any two consecutive fiscal quarters. At December 31,
1998, the Company was in compliance with all such covenants.
The Company is currently negotiating additional financing facilities to
increase financing flexibility and provide capital to fund future growth.
There is no assurance that such negotiations will be concluded
successfully.
The Company's ability to execute its business strategy depends to a
significant degree on its ability to obtain additional capital. Factors
which could affect the Company's access to the capital markets, or the
costs of such capital, include changes in interest rates, general economic
conditions and perception in the capital markets of the Company's business,
covenants under the Company's current and future credit facilities, results
of operations, leverage, financial conditions and business prospects.
Current conditions in the capital markets for REITs such as the Company
have made permanent financing transactions difficult and more expensive
than at the time of the Company's initial public offering. Consequently,
there can be no assurance that the Company will be able to effectively fund
future growth. Except as discussed herein, management is not aware of any
other trends, events, commitments or uncertainties that may have a
significant effect on liquidity.
REIT Status: The Company intends to elect to be taxed as a REIT and to
comply with the provisions of the Internal Revenue Code of 1986, as
amended, with respect thereto. Accordingly, the Company generally will not
be subject to Federal income tax to the extent of its distributions to
stockholders and as long as certain asset, income and stock ownership tests
are met. The Company may, however, be subject to tax at corporate rates on
net income or capital gains not distributed.
Investment Company Act: The Company intends to conduct its business so as
not to become regulated as an investment company under the Investment
Company Act of 1940, as amended (the "Investment Company Act"). Under the
Investment Company Act, a non-exempt entity that is an investment company
is required to register with the Securities and Exchange Commission ("SEC")
and is subject to extensive, restrictive and potentially adverse regulation
relating to, among other things, operating methods, management, capital
structure, dividends and transactions with affiliates. The Investment
Company Act exempts entities that are "primarily engaged in the business of
purchasing or otherwise acquiring mortgages and other liens on and
interests in real estate" ("Qualifying Interests"). Under current
interpretation by the staff of the SEC, to qualify for this exemption, the
Company, among other things, must maintain at least 55% of its assets in
Qualifying Interests. Pursuant to such SEC staff interpretations, certain
of the Company's interests in agency pass-through and mortgage-backed
securities and agency insured project loans are Qualifying Interests. In
general, the Company will acquire subordinated interests in commercial
mortgage-backed securities ("subordinated CMBS") only when such mortgage
securities are collateralized by pools of first mortgage loans, when the
Company can monitor the performance of the underlying mortgage loans
through loan management and servicing rights, and when the Company has
appropriate workout/foreclosure rights with respect to the underlying
mortgage loans. When such arrangements exist, the Company believes that the
related subordinated CMBS constitute Qualifying Interests for purposes of
the Investment Company Act. Therefore, the Company believes that it should
not be required to register as an "investment company" under the Investment
Company Act as long as it continues to invest primarily in such
subordinated CMBS and/or in other Qualifying Interests. However, if the SEC
or its staff were to take a different position with respect to whether the
Company's subordinated CMBS constitute Qualifying Interests, the Company
could be required to modify its business plan so that either (i) it would
not be required to register as an investment company or (ii) it would
comply with the Investment Company Act and be able to register as an
investment company. In such event, (i) modification of the Company's
business plan so that it would not be required to register as an investment
company would likely entail a disposition of a significant portion of the
Company's subordinated CMBS or the acquisition of significant additional
assets, such as agency pass-through and mortgage-backed securities, which
are Qualifying Interests or (ii) modification of the Company's business
plan to register as an investment company would result in significantly
increased operating expenses and would likely entail significantly reducing
the Company's indebtedness (including the possible prepayment of the
Company's short-term borrowings), which could also require it to sell a
significant portion of its assets. No assurances can be given that any such
dispositions or acquisitions of assets, or deleveraging, could be
accomplished on favorable terms. Consequently, any such modification of the
Company's business plan could have a material adverse effect on the
Company. Further, if it were established that the Company were an
unregistered investment company, there would be a risk that the Company
would be subject to monetary penalties and injunctive relief in an action
brought by the SEC, that the Company would be unable to enforce contracts
with third parties and that third parties could seek to obtain recission of
transactions undertaken during the period it was established that the
Company was an unregistered investment company. Any such results would be
likely to have a material adverse effect on the Company.
Year 2000 Readiness Disclosure: The Company is currently in the process of
evaluating its information technology infrastructure and other systems for
Year 2000 compliance. Substantially all of the Company's infrastructure and
systems are supplied by the Manager. The Manager has advised the Company
that it is currently evaluating whether such systems are Year 2000
compliant. The Manager has advised the Company that it has established a
plan for minimizing the risks posed by the Year 2000 problem. For its
internal systems, the Manager established a plan to test systems for Year
2000 compliance, remediate such systems where necessary, and validate its
remediation efforts to confirm Year 2000 compliance. With respect to
products and services provided by third parties, the Manager established a
plan to learn from the third parties whether their products and services
are Year 2000 compliant and upgrade to Year 2000 compliant products and
services where necessary. In addition, the Manager will develop contingency
plans for all mission critical systems. Finally, the Manager and the
Company will participate in industry-wide Year 2000 testing of its systems
where available and appropriate.
The Manager has advised the Company that, as of December 31, 1998, it has
completed the testing, remediation and validation of its internal systems
for Year 2000 compliance. The Manager has advised the Company that it has
communicated with substantially all of the Manager's and the Company's
suppliers of products and services to determine their Year 2000 compliance
status and the extent to which the Manager or the Company could be affected
by any supplier's Year 2000 compliance issues. The Manager has received
responses from substantially all such suppliers with respect to their Year
2000 compliance. Some suppliers have indicated that an upgrade of their
products or services will be necessary in order to make such products or
services Year 2000 compliant. The Manager expects to complete such upgrades
for critical third party software by June 30, 1999 and for the remaining
third party software by September 30, 1999. Despite assurances from such
suppliers, however, there can be no assurance that the products and
services of such suppliers, who are beyond the Company's control, will be
Year 2000 compliant. In the event that any of the Company's significant
suppliers do not successfully and timely achieve Year 2000 compliance, the
Company's business or operations could be adversely affected.
The Manager has advised the Company that it expects to incur costs of up to
$500 to complete the evaluation and modification of its systems as may be
necessary to achieve Year 2000 compliance. The Company may be required to
bear a portion of the costs incurred by the Manager in this regard.
Approximately $250 has been expended by the Manager as of December 31,
1998. There can be no assurance that the costs will not exceed the amount
referred to above.
The Manager has advised the Company that it is in the process of preparing
a contingency plan for the possible Year 2000 failure of its mission
critical systems or suppliers. The Manager expects to complete the
contingency plan by March 31, 1999 and to implement the contingency plan
over the course of several months in mid-1999. In addition to the
contingency plan, the Manager has informed the Company that it intends to
develop a plan for checking its critical systems during the first two days
of the year 2000 to determine whether such systems will continue to operate
on Monday, January 3, 2000 when business resumes. There can be no assurance
that such a plan or the Manager's contingency plan will be successful in
preventing a disruption of the Company's operations.
The Manager has advised the Company that it does not anticipate any
material disruption in the operations of the Company as a result of any
failure by the Manager to achieve Year 2000 compliance. There can be no
assurance, however, that the Company will not experience a disruption in
operations caused by Year 2000 problems.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market Risk: Market risk is the exposure to loss resulting from changes in
interest rates, credit curve spreads, foreign currency exchange rates,
commodity prices and equity prices. The primary market risks to which the
Company is exposed are interest rate risk and credit curve risk. Interest
rate risk is highly sensitive to many factors, including governmental,
monetary and tax policies, domestic and international economic and
political considerations and other factors beyond the control of the
Company. Credit curve risk is highly sensitive to dynamics of the markets
for commercial mortgage securities and other loans and securities held by
the Company. Excessive supply of these assets combined with reduced demand
will cause the market to require a higher yield. This demand for higher
yield will cause the market to use a higher spread over the U.S. Treasury
securities yield curve, or other benchmark interest rates, to value these
assets. Changes in the general level of the U.S. Treasury yield curve can
have significant effects on the market value of the Company's portfolio.
The majority of the Company's assets are fixed rate securities valued based
on a market credit spread to U.S. Treasuries. As U.S. Treasury securities
are priced to a higher yield and/or the spread to U.S. Treasuries used to
price the Company's assets is increased, the market value of the Company's
portfolio may decline. Conversely, as U.S. Treasury securities are priced
to a lower yield and/or the spread to U.S. Treasuries used to price the
Company's assets is decreased, the market value of the Company's portfolio
may increase. Changes in the market value of the Company's portfolio may
affect the Company's net income or cash flow directly through their impact
on unrealized gains or losses on securities held for trading or indirectly
through their impact on the Company's ability to borrow. Changes in the
level of the U.S. Treasury yield curve can also affect, among other things,
the prepayment assumptions used to value certain of the Company's
securities and the Company's ability to realize gains from the sale of such
assets. In addition, changes in the general level of the LIBOR money market
rates can affect the Company's net interest income. The majority of the
Company's liabilities are floating rate based on a market spread to U.S.
LIBOR. As the level of LIBOR increases or decreases, the Company's interest
expense will move in the same direction.
The Company may utilize a variety of financial instruments, including
interest rate swaps, caps, floors and other interest rate exchange
contracts, in order to limit the effects of fluctuations in interest rates
on its operations. The use of these types of derivatives to hedge
interest-earning assets and/or interest-bearing liabilities carries certain
risks, including the risk that losses on a hedge position will reduce the
funds available for payments to holders of securities and, indeed, that
such losses may exceed the amount invested in such instruments. A hedge may
not perform its intended purpose of offsetting losses or increased costs.
Moreover, with respect to certain of the instruments used as hedges, the
Company is exposed to the risk that the counterparties with which the
Company trades may cease making markets and quoting prices in such
instruments, which may render the Company unable to enter into an
offsetting transaction with respect to an open position. If the Company
anticipates that the income from any such hedging transaction will not be
qualifying income for REIT income test purposes, the Company may conduct
part or all of its hedging activities through a to-be-formed corporate
subsidiary that is fully subject to federal corporate income taxation. The
profitability of the Company may be adversely affected during any period as
a result of changing interest rates.
The following tables quantify the potential changes in the Company's net
portfolio value and net interest income under various interest rate and
credit spread scenarios. Net portfolio value is defined as the value of
interest-earning assets net of the value of interest-bearing liabilities.
It is evaluated using an assumption that interest rates, as defined by the
U.S. Treasury yield curve, increase or decrease 300 basis points and the
assumption that the yield curves of the rate shocks will be parallel to
each other. Net interest income in this set of scenarios is calculated
using the assumption that the U.S. LIBOR curve remains constant.
Net interest income is defined as interest income earned from
interest-earning assets net of the interest expense incurred by the
interest bearing liabilities. It is evaluated using the assumptions that
interest rates, as defined by the U.S. LIBOR curve, increase or decrease by
200 basis points and the assumption that the yield curve of the LIBOR rate
shocks will be parallel to each other. Market value in this scenario is
calculated using the assumption that the U.S. Treasury yield curve remains
constant.
All changes in income and value are measured as percentage changes from the
respective values calculated in the scenario labeled as "Base Case". The
base interest rate scenario assumes interest rates as of December 31, 1998.
Actual results could differ significantly from these estimates.
Projected Percentage Change In Portfolio Net Market Value
Given U.S. Treasury Yield Curve Movements
Change in Projected Change in
Treasury Yield Curve, Portfolio
+/- Basis Points Net Market Value
------------------------------------------------------
-300 39.2%
-200 24.6%
-100 11.7%
Base Case 0
+100 (10.5)%
+200 (20.0)%
+300 (28.6)%
Projected Percentage Change In Portfolio Net Market Value
Given Credit Spread Movements
Change in Projected Change in
Credit Spreads, Portfolio
+/- Basis Points Net Market Value
------------------------------------------------------
-300 39.0%
-200 24.4%
-100 11.5%
Base Case 0
+100 (10.3)%
+200 (19.5)%
+300 (27.7)%
Projected Percentage Change In Portfolio Net Interest Income
Given LIBOR Movements
Projected Change in
Change in LIBOR, Portfolio
+/- Basis Points Net Interest Income
--------------------------------------------------------
-200 10.1%
-100 5.2%
Base Case 0
+100 (6.3)%
+200 (13.0)%
Asset and Liability Management: Asset and liability management is concerned
with the timing and magnitude of the repricing and or maturing of assets
and liabilities. It is the objective of the Company to attempt to control
risks associated with interest rate movements. In general, management's
strategy is to match the term of the Company's liabilities as closely as
possible with the expected holding period of the Company's assets. This is
less important for those assets in the Company's portfolio considered
liquid as there is a very stable market for the financing of these
securities.
The Company uses interest rate duration as its primary measure of interest
rate risk. This metric, expressed when considering any existing leverage,
allows the Company's management to approximate changes in the net market
value of the Company's portfolio given potential changes in the U.S.
Treasury yield curve. Interest rate duration considers both assets and
liabilities. As of December 31, 1998, the Company's duration on equity was
approximately 11 years. This implies that a parallel shift of the U.S.
Treasury yield curve of 100 basis points would cause the Company's net
asset value to increase or decrease by approximately 11%. Because the
Company's assets, and their markets, have other, more complex sensitivities
to interest rates, the Company's management believes that this metric
represents a good approximation of the change in portfolio net market value
in response to changes in interest rates, though actual performance may
vary due to changes in prepayments, credit spreads and the cost of
increased market volatility. Other methods for evaluating interest rate
risk, such as interest rate sensitivity "gap" (defined as the difference
between interest-earning assets and interest-bearing liabilities maturing
or repricing within a given time period), are used but are considered of
lesser significance in the daily management of the Company's portfolio. The
majority of the Company's assets pay a fixed coupon and the income from
such assets are relatively unaffected by interest rate changes. The
majority of the Company's liabilities are borrowings under its line of
credit or reverse repurchase agreements that bear interest at variable
rates that reset monthly. Given this relationship between assets and
liabilities, the Company's interest rate sensitivity gap is highly
negative. This implies that a period of falling short-term interest rates
will tend to increase the Company's net interest income while a period of
rising short-term interest rates will tend to reduce the Company's net
interest income. Management considers this relationship when reviewing the
Company's hedging strategies. Because different types of assets and
liabilities with the same or similar maturities react differently to
changes in overall mark