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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the year ended December 31, 2001
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______________ to ______________
Commission File Number: 1-13991
AMERICA FIRST MORTGAGE INVESTMENTS, INC.
(Exact name of registrant as specified in its charter)
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Maryland 13-3974868
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
399 Park Avenue, 36th Floor, New York, New York 10022
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (212) 935-8760
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Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on Which Registered
Common Stock, $0.01 par value New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K (229.405 of the chapter) 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.|_|
As of March 22, 2002, the aggregate market value of the voting common
stock held by non-affiliates of the Registrant on March 22, 2002, based on the
final closing price of the Company's common stock on the New York Stock Exchange
was $326,833,927.
The number of shares of the Registrant's common stock outstanding on March
22, 2002, was 35,823,601.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's proxy statement for the 2002 Annual Meeting of
Stockholders scheduled to be held on May 23, 2002 are incorporated by reference
into Part III of this Annual Report on Form 10-K.
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TABLE OF CONTENTS
PART I
Item 1. Business........................................................................................ 2
Item 2. Properties...................................................................................... 12
Item 3. Legal Proceedings............................................................................... 12
Item 4. Submission of Matters to a Vote of Security Holders............................................. 12
Item 4A. Executive Officers of the Company............................................................... 12
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters........................... 14
Item 6. Selected Financial Data......................................................................... 15
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations........... 16
Item 7A. Quantitative and Qualitative Disclosures About Market Risk...................................... 22
Item 8. Financial Statements and Supplementary Data..................................................... 26
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure............ 45
PART III
Item 10. Directors and Executive Officers of the Registrant.............................................. 45
Item 11. Executive Compensation.......................................................................... 45
Item 12. Security Ownership of Certain Beneficial Owners and Management.................................. 45
Item 13. Certain Relationships and Related Transactions.................................................. 45
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.................................. 45
SIGNATURES..................................................................................................... 47
1
PART I
Item 1. Business.
THE COMPANY
America First Mortgage Investments, Inc. (the "Company") is primarily
engaged in the business of investing in adjustable rate mortgage-backed
securities ("MBS"). The Company's investment portfolio consists primarily of MBS
guaranteed as to principal and interest by an agency of the U.S. Government,
such as, Ginnie Mae, Fannie Mae or Freddie Mac (collectively referred to as
"Agency Securities"), and, to a lesser extent, high quality MBS, rated in one of
the two highest rating categories by at least one nationally recognized rating
agency, which include, Moody's Investors Services, Inc., Standard & Poor's
Corporation or Fitch, Inc. (collectively the "Rating Agencies"). The Company's
investment strategy also provides for the acquisition of multifamily housing
properties, securities in real estate investment trust securities and high-yield
corporate debt and equity securities. The Company's principal business objective
is to generate net income for distribution to its stockholders resulting from
the spread between the interest and other income it earns on its investments and
the cost of financing such investments.
As of December 31, 2001, the Company held total assets on its balance
sheet valued at approximately $2.07 billion, of which approximately 97%
consisted of Agency MBS, other high quality MBS and cash. The Company also held
interests in corporate and partnership entities that owned six apartment
properties, containing a total of 1,473 rental units. Four of these apartment
properties are located in Georgia, one is located in North Carolina and one is
located in Nebraska. In addition, the Company held publicly-traded equity and
debt securities valued at approximately $10.4 million.
The Company has elected to be taxed as a real estate investment trust
("REIT") for federal income tax purposes. Pursuant to the current federal tax
regulations, one of the requirements of maintaining its status as a REIT is that
the Company must distribute at least 90% (which was decreased from 95% effective
January 1, 2001) of its annual taxable net income to its stockholders, subject
to certain adjustments. For additional information, see "Certain Federal Income
Tax Considerations."
The Company was incorporated in Maryland on July 24, 1997, and began its
business operations on April 10, 1998, when the Company consummated a merger
transaction (the "1998 Merger") with America First Participating/Preferred
Equity Mortgage Fund Limited Partnership ("PREP Fund 1" or the "Predecessor"),
America First PREP Fund 2 Limited Partnership ("PREP Fund 2") and America First
PREP Fund 2 Pension Series Limited Partnership ("Pension Fund") (collectively
referred to as the "PREP Funds"). As a result of the 1998 Merger, PREP Fund 1
and PREP Fund 2 were merged directly into the Company and Pension Fund became a
partnership subsidiary of the Company. In December 1999, Pension Fund was
liquidated and dissolved, and, as a result, the Company acquired approximately
99% of the assets of Pension Fund. The remaining assets, consisting solely of
cash, were distributed to the holders of Pension Fund securities who elected to
remain in place following the 1998 Merger. As a result of the 1998 Merger, the
Company issued a total of 9,035,084 shares of its common stock to the former
partners of the PREP Funds. Upon completion of the 1998 Merger, the Company
began implementing the investment strategy described below.
Following the completion of the 1998 Merger through December 31, 2001 ,
the Company was an externally advised and managed REIT. As such, the Company had
no employees and relied entirely on America First Mortgage Advisory Corporation
(the "Advisor") to perform all of the duties that are generally performed by
internal management. Pursuant to an agreement between the Company and the
Advisor (the "Advisory Agreement"), the Advisor provided the day-to-day
management of the Company's operations for a fee, which was calculated on a
quarterly basis. The Advisor was a subsidiary of America First Companies L.L.C.
("AFC"). For additional information regarding the Advisor, see Note 3 to the
accompanying financial statements included under Item 8.
On December 12, 2001, the Company's stockholders approved the terms of an
Agreement and Plan of Merger, dated September 24, 2001, among the Company, the
Advisor, AFC and the stockholders of the Advisor (the "Advisor Merger
Agreement",) which provided for the merger of the Advisor into the Company (the
"Advisor Merger"). The Advisor Merger became effective on January 1, 2002. As a
result of the Advisor Merger, the Company became a self-advised REIT and will no
longer be required to pay a fee to the Advisor under the Advisory Agreement, but
rather will directly incur all of the costs of operating the Company.
Accordingly, the employees of the Advisor became employees of the Company and
the Company assumed the employment contracts of these employees. The Company
also acquired all of the tangible and intangible business assets of the Advisor.
For additional information regarding the Advisor Merger, see Note 3 to the
accompanying financial statements included in Item 8.
2
BUSINESS AND INVESTMENT STRATEGY
The Company is primarily engaged in the business of investing in
high-grade adjustable rate MBS, which are secured by pools of adjustable rate
mortgage loans ("ARMs") on single family and multifamily residences. The
Company's investment strategy also provides for the acquisition of multifamily
housing properties, REIT securities and high-yield corporate securities. The
Company is not in the business of originating mortgage loans or providing other
types of financing to the owners of real estate.
The Company's investment policy requires that at least 50% of its
investment portfolio consist of adjustable rate MBS that are either (i) Agency
Securitiesor (ii) rated in one of the two highest rating categories by one of
the Rating Agencies. The remainder of the Company's assets may consist of (a)
direct investments (mezzanine or equity) in multifamily apartment properties,
(b) investments in limited partnerships or REITs or (c) other fixed-income
instruments (corporate debt or equity securities or MBS) that provide increased
call protection relative to the Company's investment portfolio of MBS. At
December 31, 2001, approximately 97% of the Company's assets consisted of Agency
Securities, high quality "AAA" rated MBS and cash. The Company's remaining
assets, comprising approximately 3% of the Company's assets at December 31,
2001, consisted of corporate debt and equity securities, investments in limited
partnerships owning real estate, and non-voting preferred stock of a corporation
that indirectly owns interests in real estate limited partnerships.
Included within the Company's investment portfolioof adjustable rate MBS
are hybrid MBS which are secured by mortgage loans that have an interest rate
that is fixed for an initial period of time, generally years, and thereafter
convert into ARMs that reprice annually for the remainder of the term of the
loan. Most adjustable rate and hybrid MBS (upon termination of the fixed rate
period) are indexed to the one-year constant maturity treasury ("CMT") rate with
interest rates that adjust annually. Other adjustable rate MBS are indexed to
the London Interbank Offered Rate ("LIBOR"), the six-month certificate of
deposit rate, the six-month CMT rate or the 11th District Cost of Funds Index.
Adjustable rate MBS that are indexed to the CMT are generally subject to a
limitation on the amount of the annual interest rate change. This limit is
usually 1% or 2% per year. Generally, all ARMs have lifetime limits on interest
rate increases over the initial interest rate. In general, such lifetime
interest rate caps do not exceed 600 basis points over the initial interest
rate. FINANCING STRATEGY
The Company intends to finance the acquisition of additional adjustable
rate MBS and other assets by borrowing against its portfolio of assets at
short-term borrowing rates and reinvesting the proceeds of such borrowings. In
addition, the Company may also finance the acquisition of additional assets with
the proceeds from capital market transactions. When fully invested, the
Company's policy is to maintain an assets-to-equity ratio of less than 11:1. As
of December 31, 2001, the Company's assets-to-equity ratio was approximately
10.2:1 and its debt-to-tangible equity ratio was 9.5x.
The Company's borrowings for mortgage and corporate securities are
financed primarily at short-term borrowing rates through the utilization of
repurchase agreements. A repurchase agreement, although structured as a sale and
repurchase obligation, operates as a financing (i.e., borrowing) under which the
Company pledges its MBS and corporate debt securities as collateral to secure a
short-term loan with a counterparty which is equal in value to a specified
percentage, generally not more than 97% at inception of the loan, of the market
value of the pledged collateral. Repurchase agreements take the form of a sale
of the pledged collateral to a lender at an agreed upon price in return for such
lender's simultaneous agreement to resell the same securities back to the
borrower at a future date (i.e., the maturity of the borrowing) at a higher
price. The price difference is the cost, or interest expense, of borrowing under
these repurchase agreements. The Company retains beneficial ownership of the
pledged collateral, including the right to distributions, while the counterparty
maintains custody of the collateral securities. At the maturity of a repurchase
agreement, the Company will be required to repay the loan and concurrently will
receive back its pledged collateral from the lender or will rollover such
agreement at the then prevailing financing rate. The repurchase agreements may
require the Company to pledge additional assets to the lender in the event the
market value of existing pledged collateral declines. Repayment of principal on
the pledged security will result in a corresponding reduction in the value of
such security. In addition, the pledged collateral may fluctuate in value based
on market changes in interest rates and the instruments credit quality. As of
December 31, 2001, the Company did not have any margin calls on its repurchase
agreements that it was not able to satisfy with either cash or additional
pledged collateral.
3
The Company's repurchase agreements generally range from one to 12 months
in duration. Should the providers of the repurchase agreements decide not to
renew them at maturity, the Company is required to either refinance or be in a
position to retire these obligations. If, during the term of a repurchase
agreement, a lender should file for bankruptcy, the Company might experience
difficulty recovering its pledged assets and may have an unsecured claim against
the lender's assets for the difference between the amount loaned to the Company
and the fair value of the security pledged by the Company as collateral.
To reduce its exposure, the Company enters into repurchase agreements only
with financially sound institutions whose holding or parent company's long-term
debt rating is "A" or better as determined by at least one of the Rating
Agencies, where applicable. If this minimum criterion is not met, the Company
will not enter into repurchase agreements with that lender without the specific
approval of its Board of Directors. In the event an existing lender is
downgraded below "A," the Company is required to seek the approval of its Board
of Directors before entering into additional repurchase agreements with that
lender. The Company generally seeks to diversify its exposure by entering into
repurchase agreements with at least four separate lenders with a maximum loan
from any lender of no more than three times the Company's stockholders' equity.
As of December 31, 2001, the Company had repurchase agreements with ten separate
lenders with a maximum exposure (the difference between the amount loaned to the
Company and the fair value of the security pledged by the Company as collateral)
to a single lender of approximately $22.6 million.
The Company may use derivative transactions and other hedging strategies
to help mitigate its prepayment and interest rate risks if it is determined that
the cost of these transactions is justified by their potential benefit. Through
December 31, 2001, the Company's use of hedge instruments has been limited to a
single hedge transaction in the form of a purchased interest rate cap ("Cap
Agreement"). A Cap Agreement is a contractual agreement whereby the purchaser
pays a fee in exchange for the right to receive payments equal to the principal
(i.e., notional amount) times the difference between a specified interest rate
and a future interest rate during a defined period "active" of time. Management
expects to enter into additional Cap Agreements to hedge against an increase in
interest rates on its anticipated future LIBOR-based repurchase agreements.
However, the extent to which the Company may enter into future hedging
transactions will depend on numerous market conditions, including, but not
limited to, the interest rate environment, management's assessment of the future
changes in interest rates and the market availability and cost of entering into
such hedge transactions.
Each of the Company's multifamily apartment properties is financed with a
long-term fixed rate mortgage loans. The borrowers on these mortgage loans are
separate corporations, limited partnerships or limited liability companies in
which the Company holds equity interests. Each of these mortgage loans is made
to the applicable ownership entity on a nonrecourse basis, which means that the
lender's only source of payment in the event of a default is the foreclosure of
the underlying property securing the mortgage loan. As of December 31, 2001, the
aggregate mortgage indebtedness secured by the Company's six multifamily
apartment properties was approximately $48.3 million.
The Company also uses repurchase agreements to finance its investments in
corporate debt securities, and may generally borrow up to 70% of the market
value. The Company has financed its investments in equity securities through
margin loans from a variety of broker-dealers, and pledges theequity securities
to secure such margin loans; generally borrowing up to 50% of the market value
of the equity securities.
RISK FACTORS
The results of the Company's operations are affected by various factors,
many of which are beyond the control of the Company. The results of the
Company's operations primarily depend on, among other things, the level of its
net interest income, the market value of its assets and the supply of and demand
for such assets. The Company's net interest income varies primarily as a result
of changes in short-term interest rates, borrowing costs and prepayment rates,
the behavior of which involves various risks and uncertainties as set forth
below. Prepayment rates and interest rates vary according to the type of
investment, conditions in financial markets, competition and other factors, none
of which can be predicted with any certainty. In addition to these factors,
borrowing costs are further affected by the credit worthiness of the borrower.
Since changes in interest rates may significantly affect the Company's
activities, the operating results of the Company depend, in large part, upon the
ability of the Company to effectively manage its interest rate and prepayment
risks while maintaining its status as a REIT. The Company also has risks
inherent in its other investments, including its debt and equity securities,
interests in multifamily real estate properties and hedging instruments. Because
these investments represented only 1.1% of its total assets at December 31, 2001
the Company's risk relating to these assets is limited, but nonetheless risks
associated with these investment have the
4
potential of causing a material impact of the Company's operating performance.
These risks, the Company's strategies to mitigate the risks and the limitations
of the strategies are discussed in further detail below.
Interest Rate Risks
While management believes that there is no strategy that would completely
insulate the Company from interest rate changes and related prepayments on
investments while achieving targeted profitability, the Company undertakes
certain strategies aimed at mitigating the potential negative effects of
interest rate changes. Among these strategies are: (a) investing predominantly
in adjustable rate and hybrid MBS with less than 36 months to reprice at time of
acquisition; (b) entering into interest rate Cap Agreements on anticipated
borrowings under repurchase agreements and (c) maintaining a portion of the
Company's assets in multifamily real estate investments, which do not strongly
react to changes in interest rates and in some cases may react positively in a
rising interest rate environment. Certain of these strategies and related assets
carry certain inherent risks other than interest rate risk and/or costs. The
Company finances the acquisition of additional MBS through borrowings under
numerous repurchase agreements, which subjects the Company to interest rate risk
in relationship to the corresponding assets. Interest rate risks and the
strategies incorporated to address those risks, along with their limitations and
other relevant risks are discussed below.
The cost of the Company's borrowings under its repurchase agreements is
based on the prevailing short-term market rates. The term of the Company's
repurchase agreements can be from one to 18 months.However, a substantial
majority of the Company's MBS have interest rates that reset only every 12
months. The Company's policy is to maintain an asset/borrowings repricing gap
(as measured by the average time period to assets repricing, less the average
time period to liability repricing) at less than 18 months. At December 31,
2001, the net of the weighted average months to reprice on the MBS portfolio
less the weighted average months to reprice on the repurchase agreements was
12.6 months, as a significant portion, approximately 49%, of the Company's
repurchase agreements were scheduled to mature in early 2002. This reflects
management's strategy to structure borrowings such that they are refinanced
after year-end in order to avoid the sometimes-volatile year-end LIBOR market
where rates sometimes spike.
The market determines the interest rates that the Company pays on
borrowings (i.e., its reverse repurchase agreements) to finance its MBS assets,
rendering borrowing costs essentially beyond control of the Company,
controllable only to the extent of the Company's credit standing and competitive
bargaining ability. However, the level of increase in rates on the Company's
interest earning assets is limited. The Company primarily invests in adjustable
rate MBS, which at December 31, 2001 comprised 92.6% of total assets and 99.4%
of total MBS. The amount by which the adjustable rate MBS can increase is
limited in connection with the rate increase limits on the underlying ARMs on
both an annual and lifetime basis. Generally, interest rates on ARMs can change
at either a maximum of 100 or 200 basis points per annum (i.e., an "annual cap")
and only up to 600 basis points from the initial interest rate over the term of
the ARMs (i.e., a "lifetime cap"), these limitations follow through to the
adjustable rate MBS, which these mortgages collateralize.
The cost of the Company's borrowings is generally LIBOR based while
interest rates on adjustable rate MBS are primarily based on one-year CMT rates.
Therefore, any increase in the LIBOR relative to the CMT rates will result in an
increase in the Company's borrowing cost that is not matched by a corresponding
increase in the interest earnings on its adjustable rate MBS portfolio. At
December 31, 2001, the one-year LIBOR was 2.44% and the one-year CMT was
approximately 2.20%.
In order to mitigate its interest rate risks, the Company intends to
continue to maintain a substantial majority of its assets invested in
adjustable rate and hybrid MBS, rather than fixed rate securities. These assets
allow the Company's interest income to increase during periods of rising
interest rates. However, given the lag to reset along with the annual and
lifetime interest rate limitations on adjustments to interest rates on its
adjustable rate MBS portfolio, relative to changes in the interest rates it pays
on its liabilities, net interest income can be negatively affected over the
short term in a rising interest rate environment. The ability of adjustable rate
MBS to adjust based on changes in interest rates helps to mitigate interest rate
risk more effectively over a longer time period than over the short term;
however interest rate risk is not eliminated under either time frame. The
overall declining interest rate environment experienced during 2001 was
extremely favorable to the Company, particularly in the latter part of the year.
In accordance with the Company's investment guidelines, it may enter into
Cap Agreements to hedge against anticipated future increases in interest rates
on the Company's anticipated repurchase agreements. The Company only enters into
interest rate Cap Agreements with financial institutions which have a debt
rating of "A" or better by one of the Rating Agencies, thereby securing, to the
greatest extent possible, receipt of payments under the Cap
5
Agreements. In the unlikely event that a counter party is unable to make
required payments pursuant to a Cap Agreement, the Company's loss would be
limited to any remaining unamortized premium paid for the specific Cap
Agreement. Management monitors the financial strength of all of its counter
parties on a regular basis; however, no assurance can be given that the Company
can eliminate risks related to third parties. As of December 31, 2001, the
Company had one interest rate Cap Agreement with a notional amount of $50.0
million that will be effective if LIBOR exceeds 5.75% during the period from
October 25, 2002 through October 25, 2004. The Company paid $350,000 for the Cap
Agreement, which had a fair value of approximately $513,000 as of December 31,
2001. Cap Agreements are extremely sensitive to changes in interest rates and
are therefore very volatile. Because the Company utilizes Cap Agreements solely
to mitigate interest rate risk, in the form of a liability hedge, changes in the
market value are reflected in other comprehensive income, provided that the
hedge remains effective.
As a part of its hedging strategy, the Company may engage in limited
amounts of the buying and/or selling of mortgage derivative securities or other
derivative products including interest rate swap agreements, financial futures
contracts and options. Although the Company has not historically used such
instruments, it is not precluded by its operating policies from doing so. In the
future, management may use such instruments as hedges against interest rate
risk. Management does not anticipate entering into derivatives for speculative
or trading purposes. Any use of derivatives and contemplated derivative
strategies are addressed with the Company's investment committee. It should be
noted, that no cost beneficial hedging strategy can completely insulate the
Company against interest rate risks. In addition, there can be no assurance that
any such hedging activities will have the desired impact on the Company's
results of operations or financial condition. Hedging typically involves
transaction costs, which increase dramatically as the period covered by the
hedge increases and which also increase during periods of rising or volatile
interest rates. Such hedging costs may cause the Company to conclude that a
particular hedging transaction is not appropriate for the Company, thereby
affecting the Company's ability to mitigate interest rate risk. As of December
31, 2001, the Company had not entered into any hedge transactions, other than
the Cap Agreement previously discussed.
Increases in short-term interest rates may cause the Company's financing
costs to increase faster than rates increase on its adjustable rate MBS. As a
result, the Company's net interest spread and net interest margin could decline
during such periods, the severity of which would depend on the asset/liability
structure at the time as well as the magnitude and duration of the interest rate
increase. In the case of a sudden and sustained increase in interest rates, the
net interest income could become negative. Accordingly, in such a period, the
Company could incur a net loss from operations. In addition, such an interest
rate environment would decrease the market value of the adjustable rate and
hybrid MBS, to a level that additional collateral could be required to secure
the borrowings under the Company's repurchase agreements. If such additional
collateral were not available, the lender could liquidate the securities
collateralizing the repurchase agreements, resulting in a loss to the Company.
Further, such a decrease in the Company's net interest income could negatively
impact dividend distributions made by the Company, which, in turn could reduce
the market price of the Company's common stock. The Company could also react to
such a scenario by reducing borrowings and assets, by selling assets or not
replacing MBS reductions due to scheduled amortization and prepayments, thereby
"shrinking the balance sheet." Such an action would likely reduce interest
income, interest expense and net income, the extent of which would be dependent
on the level of reduction in assets and liabilities as well as the amounts
realized on the sale of those assets.
Prepayment Risks
In general, residential borrowers of the mortgage loan securing the MBS in
the Company's portfolio could prepay such mortgage loans at any time without
penalty or premium. Prepayments result when a homeowner sells his home or
decides to either retire or refinance his existing mortgage loan. In addition,
defaults and foreclosures have the same effect as a prepayment in that no future
interest payments are earned on the mortgage. Prepayments usually can be
expected to increase when mortgage interest rates decrease significantly, as was
the case in 2001, and decrease when mortgage interest rates increase, although
such effects are not entirely predictable. Prepayment experience also may be
affected by the conditions in the housing and financial markets, general
economic conditions and the relative interest rates on fixed rate and adjustable
rate mortgage loans. During 2001, prepayments rates generally increased,
particularly in the last quarter of 2001. During 2001, monthly prepayments
ranged from as low as 15% in the first quarter to as high as approximately 30%
in the fourth quarter. This compares to monthly prepayments ranging from
approximately 15% to 20% during 2000.
Prepayments are the primary feature of MBS that distinguishes them from
other types of bonds. While a certain percentage of the pool of mortgage loans
underlying an MBS are expected to prepay during a given period of time, the
actual rate of prepayment can, and often does, vary significantly from the
anticipated rate of prepayment. Accordingly, the Company incurs a risk that its
MBS will prepay at a more rapid pace than anticipated. Prepayments
6
generally result in negative results for the Company, the severity of which
depends on, among other things, the amount of unamortized premium on the prepaid
securities, the reinvestment lag and the reinvestment risk.
One way the Company seeks to reduce its exposure to prepayment risk is to
purchase MBS trading closer to par and thus reduce the Company's earnings
exposure resulting from accelerated amortization of premiums. Adjustable rate
MBS securities can trade at significantly different prices depending on
seasoning and the interest rate. According to the Company's current policy, the
average purchase price of the MBS portfolio should be less than 103.5% of the
securities par value. The Company's premium as a percentage of par value of
total MBS was 1.99% and 1.54% at December 31, 2001 and 2000, respectively.
Another way the Company seeks to address this risk is to use less leverage in
less advantageous market environments. While this strategy may not maximize
earnings potential in the short term, it is aimed at obtaining more predictable
earnings with less potential risk to capital.
The Company seeks to minimize prepayment risk through a number of other
means, including structuring a diversified portfolio with a variety of
prepayment characteristics. An additional natural hedge to prepayment risk, in
which the Company is engaged to a relatively small extent, is ownership
interests in entities which own multifamily properties. These assets do not face
prepayment risk and may, although no assurance can be given, increase in value
in a declining interest rate environment where prepayments would have the
largest negative impact. However, general economic conditions in the markets in
which these properties are located generally affect the market value and
performance of rental real estate to a greater extent than do fluctuations in
interest rates. At December 31, 2001, 0.5% of assets were comprised of the
Company's indirect investments in multifamily rental real estate properties.
Risks Associated with Leverage
The Company's financing strategy is designed to increase the size of its
mortgage investment portfolio by borrowing against a substantial portion of the
market value of its MBS. If the interest income on the MBS purchased with
borrowed funds fails to cover the cost of the borrowings, the Company will
experience net interest losses and may experience net losses from operations.
Such losses could be increased substantially as a result of the Company's
substantial leverage.
The ability of the Company to achieve its investment objectives depends on
its ability to borrow money in sufficient amounts and on favorable terms
compared to the assets that the borrowings fund. Currently, all of the Company's
borrowings are collateralized borrowings in the form of repurchase agreements.
The ability of the Company to enter into repurchase agreements in the future
will depend on the market value of the MBS pledged to secure the specific
borrowings, the availability of financing, and other conditions existing in the
lending market at that time. The Company may effect additional borrowings
through the use of other types of collateralized borrowings, loan agreements,
lines of credit, dollar-roll agreements and other credit facilities with
institutional lenders or through the issuance of debt securities. The cost of
borrowings under repurchase agreements generally corresponds to LIBOR plus or
minus a margin, although such agreements may not expressly incorporate a LIBOR
index. The Company may also use other sources of funding which will generally
bear interest rates that refer or correspond to a short-term benchmark, such as
prime, plus or minus a margin. Through increases in haircuts (i.e., the
collateralization amount required by a lender), decreases in the market value of
the Company's MBS, increases in interest rate volatility, and changes in the
availability of financing in the market, the Company may not be able to achieve
the degree of leverage it believes to be optimal. As a result, the Company may
be less profitable than it would be otherwise.
Risks of Decline in Market Value
The value of interest-bearing obligations such as mortgages and MBS may
move inversely with interest rates. Accordingly, in a rising interest rate
environment, the value of such instruments may decline. Because the interest
earned on adjustable rate MBS may increase as interest rates increase subject to
a delay until each such security's next reset date, the values of these assets
are generally less sensitive to changes in interest rates than are fixed rate
instruments. Therefore, in order to mitigate this risk, the Company intends to
maintain a substantial majority of its MBS as adjustable rate MBS. At December
31, 2001, adjustable rate MBS constituted approximately 92.6% of total assets
and 99.4% of the Company's total MBS.
A decline in the market value of the Company's MBS assets may limit the
Company's ability to borrow or result in lenders initiating margin calls (i.e.,
requiring a pledge of cash or additional MBS to re-establish the ratio of the
amount of the borrowing to the value of the collateral). The Company could be
required to sell some of its MBS under adverse market conditions in order to
maintain liquidity. If these sales were made at prices lower than the amortized
cost (i.e., the carrying value) of the securities, the Company would incur
losses. A default by the
7
Company under its collateralized borrowings could also result in a liquidation
of the collateral, and a resulting loss of the difference between the value of
the collateral and the amount borrowed.
Also, to a lesser extent, the Company has investments in "high-yield"
corporate debt securities. While these securities offer more call protection
than adjustable rate MBS and generally increase in market value when interest
rates decline, they also carry significantly greater credit risk, which greatly
impacts their market value. Any deterioration in the credit assessment of the
debtor will generally reduce the value of these securities, as can a general
decline within the debtor's industry. Management performs detailed analysis on
the Company's corporate debt securities on a regular basis in order to determine
the course of action it considers appropriate.
As of December 31, 2001, the Company's had investments in corporate debt
securities carried at $9.8 million, which had gross unrealized losses of
approximately $3.4 million that were not reflected in the Company's results of
operations (i.e., income statement) or statement of financial condition (i.e.,
balance sheet) at December 31, 2001. Investments in RCN Corporation ("RCN"),
which were designated as available-for-sale and carried at its estimated fair
value, and Level 3 Communications ("Level 3"), which were designated as
held-to-maturity, accounted for approximately $2.1 million, and $6.6 million,
respectively, for an aggregate of $8.7 million, or 89% of total invested in
corporate debt securities. During 2001, the Company recognized gross losses of
approximately $3.6 million, on its investments in corporate debt securities, of
which approximately $3.3 million was attributable to the RCN debt securities.
Losses recognized on the RCN securities during 2001 were comprised of, (a) a
$2.5 million impairment charge made against the investment for an
other-than-temporary decline in the market value and (b) losses of $885,000
realized on sales and redemptions .
The Company's investment in debt securities of Level 3, which is
designated as held-to-maturity, had a carrying value of approximately $6.6
million and unrecognized losses of $3.2 million . As of December 31, 2001,
management's position was that the decline in the market value of the Level 3
debt securities was temporary. However, the investment in Level 3 debt
securities, or any of the Company's other investments in debt securities, could
result in future losses recognized, if management's assessment of the decline in
value were to adversely change, whereby the decline in market value is
considered other-than-temporary, or if management were to decide to sell such
debt security at a time when the carrying value was below the market value. For
additional information on the Company's corporate debt securities, see Note 5 to
the accompanying financial statements included in Item 8.
As with corporate debt securities, the Company's investments in equity
securities carry significantly greater credit risk than investments in Agency
Securities and high quality MBS. Management monitors the Company's equity
portfolio to determine appropriate investment strategy and to identify any
impairment that is other-than-temporary. If the market value of an equity
security were to decline below the cost of such security and a determination
were made that such decline was other-than-temporary, a charge would be made
against earnings and the carrying value reduced by such amount of decline that
is considered other-than-temporary. During 2001, the Company realized gains of
$1.2 million and losses of $588,000 on sales of equity securities. At December
31, 2001, the Company had investments in equity securities with an aggregate
carrying value of $4.1 million, which included unrealized gains of $710,000 and
no unrealized losses.
Credit Risks Associated with Investments
The holder of a mortgage or MBS assumes a risk that the borrowers may
default on their obligations to make full and timely payments of principal and
interest. The Company seeks to mitigate this credit risk by requiring that at
least 50% of its investment portfolio consist of adjustable rate MBS that are
either (i) Agency Securities or (ii) rated in one of the two highest rating
categories by one of the Rating Agencies. The remainder of the Company's assets
may be either (a) direct investment (mezzanine or equity) in multifamily
apartment properties; (b) investments in limited partnerships or REITs; or (c)
other fixed-income instruments (corporate debt or equity securities or MBS) that
provide increased call protection relative to the Company's MBS through
diversification. Currently, other fixed-income instruments in which the Company
has invested are below investment grade in quality. Below investment grade
fixed-income instruments constituted 0.5% of the Company's total assets as of
December 31, 2001. As of December 31, 2001, approximately 83% of the Company's
assets consisted of Agency Securities, approximately 10% consisted of high
quality MBS rated "AAA" or "AA" and approximately 5% consisted of cash and cash
equivalents; combined these assets comprised approximately 97% of the Company's
total assets.
Risks of Asset Concentration
Although the Company seeks geographic diversification of the properties
underlying its MBS, the Company does not set specific limitations on the
aggregate percentage of underlying properties which may be located in any one
geographical area. Consequently, properties underlying the Company's MBS may be
located in the same or a
8
limited number of geographical regions. Adverse changes in the economic
conditions of the geographic regions in which the properties securing MBS held
by the Company would likely have an adverse effect on real estate values,
interest rates, prepayment rates and increase the risk of default by the
obligors on the underlying mortgage loans. Accordingly, the Company's results of
operations could be adversely affected.
Investment Company Act
The Company at all times intends to conduct its business so as to not
become regulated as an investment company under the Investment Company Act of
1940 (the "Investment Company Act"). If the Company were to become regulated as
an investment company, then, among other things, the Company's ability to use
leverage would be substantially reduced. 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" (i.e.,
"Qualifying Interests"). Under the current interpretation of the staff of the
Securities and Exchange Commission, in order to qualify for this exemption, the
Company must maintain at least 55% of its assets directly in Qualifying
Interests. In addition, unless certain MBS represent an undivided interest in
the entire pool backing such MBS (i.e., "whole pool" MBS), such MBS may be
treated as securities separate from the underlying mortgage loan, thus, may not
be considered Qualifying Interests for purposes of the 55% exemption
requirement. Accordingly, the Company monitors its compliance with this
requirement in order to maintain its exempt status. As of December 31, 2001, the
Company determined that it was in and has maintained compliance with this
requirement.
CERTAIN FEDERAL INCOME TAX CONSIDERATIONS
The following discussion summarizes certain federal income tax
considerations to the Company and its stockholders. This discussion is based on
existing federal income tax law, which is subject to change, possibly
retroactively. This discussion does not address all aspects of federal income
taxation that may be relevant to a particular stockholder in light of each
personal investment circumstances or to certain types of investors subject to
special treatment under the federal income tax laws (including financial
institutions, insurance companies, broker dealers and, except to the extent
discussed below, tax-exempt entities and foreign taxpayers) and it does not
discuss any aspects of state, local or foreign tax law. This discussion assumes
that stockholders will hold their common stock as a "capital asset" (generally,
property investmentheld-for-investment) under the Internal Revenue Code of 1986,
as amended (the "Code"). Stockholders are advised to consult their tax advisors
as to the specific tax consequences to them of purchasing, holding and disposing
of the common stock of the Company, including the application and effect of
federal, state, local and foreign income and other tax laws.
General
The Company has elected to become subject to tax as a REIT, for federal
income tax purposes, commencing with the taxable year ended December 31, 1998.
Management currently expects that the Company will continue to operate in a
manner that will permit the Company to maintain its qualifications as a REIT.
This treatment will permit the Company to deduct dividend distributions to its
stockholders for federal income tax purposes, thus effectively eliminating the
"double taxation" that generally results when a corporation earns income and
distributes that income to its stockholders. There can be no assurance that the
Company will continue to qualify as a REIT in any particular taxable year, given
the highly complex nature of the rules governing REITs, the ongoing importance
of factual determinations and the possibility of future changes in the law
and/or the circumstances of the Company. If the Company failed to qualify as a
REIT in any particular year, it would be subject to federal income tax as a
regular, domestic corporation, and its stockholders would be subject to tax in
the same manner as stockholders of such corporation. In this event, the Company
could be subject to potentially substantial income tax liability in respect of
each taxable year that it fails to qualify as a REIT, and the amount of earnings
and cash available for distribution to its stockholders (which distributions
would not be required to be made) could be reduced or eliminated. The following
is a brief summary of certain technical requirements that the Company must meet
on an ongoing basis in order to qualify, and remain qualified, as a REIT under
the Code.
Stock Ownership Tests
Other than the first taxable year for which the Company elected to be
taxed as a REIT, the capital stock of the Company must be held by at least 100
persons during at least 335 days of each taxable year (or proportionate part of
a short taxable year) and no more than 50% of the value of such capital stock
may be owned, directly or indirectly, by five or fewer individuals at any time
during the last half of each taxable year. Under the Code, most tax-exempt
entities including employee benefit trusts and charitable trusts (but excluding
trusts described in 401(a) and exempt under 501(a)) are generally treated as
individuals for these purposes. These stock ownership requirements must be
9
satisfied by the Company each taxable year. The Company must solicit information
from certain of its shareholders to verify ownership levels and its Articles of
Incorporation provide restrictions regarding the transfer of the Company's
shares in order to aid in meeting the stock ownership requirements. If the
Company were to fail either of the stock ownership tests, it would generally be
disqualified from REIT status, unless, in the case of the "five or fewer"
requirement, the Company complies with the requirements for ascertaining its
share ownership and does not know or have reason to know that it failed such
requirement.
Asset Tests
The Company must generally meet the following asset tests (the "REIT Asset
Tests") at the close of each calendar quarter of each taxable year: (a) at least
75% of the value of the Company's total assets must consist of "real estate
assets" within the meaning of Section 856(c)(5)(B) of the Code, government
securities, cash, and cash items (the "75% Asset Test"); (b) the value of
securities held by the Company not qualifying under the 75% Asset Test must not
exceed (i) 5% of the value of the Company's total assets in the case of
securities of any one issuer, and (ii) 10% of the outstanding securities (by
vote or value) of any one issuer, other than "qualified REIT subsidiaries,"
"taxable REIT subsidiaries," and, in the case of the 10% value test, certain
"straight debt" securities; and (c) no more than 20% of the value of the
Company's assets may consist of securities of one or more "taxable REIT
subsidiaries."
The Company does not expect that the value of any non-qualifying security
of any one entity would ever exceed 5% of the Company's total assets, and the
Company does not expect to own more than 10% of any one issuer's voting
securities (by vote or value). The Company intends to monitor closely the
purchase, holding and disposition of its assets in order to comply with the REIT
Asset Tests. In particular, the Company intends to limit and diversify its
ownership of any assets not qualifying under the 75% Asset Test to less than 25%
of the value of the Company's assets and to less than 5%, by value, of any
single issuer. If it is anticipated that these limits would be exceeded, the
Company intends to take appropriate measures, including the disposition of
non-qualifying assets, to avoid exceeding such limits and if such limits are
exceeded, the Company will take such appropriate measures as are necessary to
avoid being disqualified from REIT status.
Gross Income Tests
The Company must generally meet the following gross income tests (the
"REIT Gross Income Tests") for each taxable year: (a) at least 75% of the
Company's gross income must be derived from certain specified real estate
sources including interest income from mortgages on and gain from the
disposition of "real estate assets" or "qualified temporary investment income"
(i.e., income derived from "new capital" within one year of the receipt of such
capital) (the "75% Gross Income Test") and; (b) 95% of the Company's gross
income for each taxable year must be derived from the same items of income that
qualify for the 75% Gross Income Test plus dividends or interest from any source
(the "95% Gross Income Test.") Thus, the 95% Gross Income Test requires income
to be derived from sources which, while passive, have less of a connection with
real estate activities than those sources mandated for the 75% Gross Income
Test. In addition, income qualifying for the 95% Gross Income Test (but not the
75% Gross Income Test) includes income from all hedges that reduce the interest
rate risk of REIT liabilities. Thus, any payment to a REIT under an interest
rate swap or cap agreement option, futures contract, forward rate agreement, or
any similar financial instrument entered into by the Company to hedge its
indebtedness incurred or to be incurred (and any gain from the sale or other
disposition of those instruments) are treated as qualifying income for purposes
of the 95% Gross Income Test.
The Company intends to maintain its REIT status by carefully monitoring
its assets and related income. Under certain circumstances, for example, (i) the
sale of a substantial amount of MBS to repay borrowings in the event that other
credit is unavailable or (ii) an unanticipated decrease in the qualifying income
of the Company which may result in the non-qualifying income exceeding 5% of
gross income, the Company may be unable to comply with certain of the REIT Gross
Income Tests. See "Taxation of the Company" below for a discussion of the tax
consequences of failure to comply with the REIT provisions of the Code.
Distribution Requirement
The Company must generally distribute to its stockholders an amount equal
to at least a certain percentage of the Company's REIT taxable income before
deductions of dividends paid and excluding net capital gain. Such percentage was
95% through December 31, 2000. As a result of the REIT Modification Act which
was effective January 1, 2001, the distribution requirement was changed from 95%
to 90%.
10
Taxation of the Company
In any year in which the Company qualifies as a REIT, the Company will
generally not be subject to federal income tax on that portion of its REIT
taxable income or capital gain which is distributed to its stockholders. The
Company will, however, be subject to federal income tax at normal corporate
income tax rates upon any undistributed taxable income or capital gain.
Notwithstanding its qualification as a REIT, the Company may also be subject to
tax in certain other circumstances. If the Company fails to satisfy either the
75% or the 95% Gross Income Test, but nonetheless maintains its qualification as
a REIT because certain other requirements are met, it will generally be subject
to tax on the greater of the amount by which 90% or 75% of the gross income of
the Company exceeds the gross income of the Company qualifying for either the
75% or the 95% Gross Income Test, respectively, multiplied by a fraction
intended to reflect the Company's profitability. The Company will also be
subject to a tax of 100% on net income derived from any "prohibited transaction"
(generally income from property held for sale in the ordinary course of a trade
or business) and if the Company has (i) net income from the sale or other
disposition of "foreclosure property" which is held primarily for sale to
customers in the ordinary course of business or (ii) other non-qualifying income
from foreclosure property, it will be subject to federal income tax on such
income at the highest corporate income tax rate. In addition, if the Company
fails to distribute during each calendar year at least the sum of (i) 85% of its
REIT ordinary income for such year and (ii) 95% of its REIT capital gain net
income for such year, the Company would be subject to a 4% federal excise tax on
the excess of such required distribution over the amounts actually distributed
during the taxable year, plus any undistributed amount of ordinary and capital
gain net income from the preceding taxable year. The Company may also be subject
to the corporate alternative minimum tax, as well as other taxes in certain
situations not presently contemplated. If the Company fails to qualify as a REIT
in any taxable year, and certain relief provisions of the Code do not apply, the
Company would be subject to federal income tax (including any applicable
alternative minimum tax) on its taxable income at the regular corporate income
tax rates. Distributions to stockholders in any year in which the Company fails
to qualify as a REIT would not be deductible by the Company, nor would they
generally be required to be made under the Code. Further, unless entitled to
relief under certain other provisions of the Code, the Company would also be
disqualified from re-electing REIT status for the four taxable years following
the taxable year in which it became disqualified.
The Company intends to monitor on an ongoing basis its compliance with the
REIT requirements described above. In order to maintain its REIT status, the
Company will be required to limit the types of assets that the Company might
otherwise acquire, or hold certain assets at times when the Company might
otherwise have determined that the sale or other disposition of such assets
would have been more prudent.
Taxation of Stockholders
Distributions (including constructive distributions) made to holders of
common stock (and not designated as capital gain dividends) will generally be
subject to tax as ordinary income to the extent of the Company's current and
accumulated earnings and profits as determined for federal income tax purposes.
If the amount distributed exceeds a stockholder's allocable share of such
earnings and profits, the excess will be treated as a return of capital to the
extent of the stockholder's adjusted basis in the common stock, which will not
be subject to tax, and thereafter as a taxable gain from the sale or exchange of
a capital asset.
Distributions designated by the Company as capital gain dividends will
generally be subject to tax as long-term capital gain to stockholders, to the
extent that the distribution does not exceed the Company's actual net capital
gain for the taxable year. Distributions by the Company, whether characterized
as ordinary income or as capital gain, are not eligible for the corporate
dividends received deduction. In the event that the Company realizes a loss for
the taxable year, stockholders will not be permitted to deduct any share of that
loss.
State and Local Taxes
The Company and its stockholders may be subject to state or local taxation
in various jurisdictions, including those in which it or they transact business
or reside. The state and local tax treatment of the Company and its stockholders
may not conform to the federal income tax consequences discussed above.
Consequently, prospective stockholders should consult their own tax advisors
regarding the effect of state and local tax laws on an investment in the common
stock.
11
COMPETITION
The Company believes that its principal competitors in the business of
acquiring and holding MBS of the types in which it invests are financial
institutions, such as banks, savings and loan institutions, life insurance
companies, institutional investors including mutual funds and pension funds and
other mortgage REITs. Such investors may not be subject to similar regulatory
constraints (i.e., REIT tax compliance or maintaining an exemption under the
Investment Company Act). In addition, many of the other entities purchasing
mortgages and MBS have greater financial resources and access to capital than
the Company. The existence of these competitive entities, as well as the
possibility of additional entities forming in the future, may increase the
competition for the acquisition of mortgages and MBS resulting in higher prices
and lower yields on such assets.
Item 2. Properties.
The Company does not directly own any material properties nor is it
obligated under any lease for physical properties.
Item 3. Legal Proceedings.
There are no material pending legal proceedings to which the Company is a
party, or, any of its assets are subject.
Item 4. Submission of Matters to a Vote of Security Holders.
At the Special Meeting of Stockholders on December 12, 2001, present in
person or by proxy were 14,690,687 of 27,034,850 shares of common stock of the
Company entitled to vote at such meeting, to consider and vote upon a proposal
to approve the issuance of shares of the Company's stock pursuant to, and the
other transactions contemplated by the Advisor Merger Agreement. The Advisor
Merger proposal was approved with votes cast as follows:
Shares Voted Percent
------------ ---------
For: 14,125,100 96.15%
Against: 340,283 2.32%
Abstain: 225,304 1.53%
Item 4A Executive Officers of the Company.
While the Company had no direct employees prior to consummation of the
Advisor Merger, effective January 1, 2001, officers of the Advisor performed
duties generally performed by an internal management team. Upon consummation of
the Advisor continued in their roles for the Company, but became direct
employees of the Company. Company's executive officers are as follows:
Name Position Held
- ---- -------------
Stewart Zimmerman President and Chief Executive Officer
William S. Gorin Executive Vice President, Chief Financial
Officer and Treasurer
Ronald A. Freydberg Executive Vice President and Secretary
Teresa D. Covello Senior Vice President/Controller
Stewart Zimmerman, 57, has served as President and Chief Executive officer
since 1997. Prior to that time, he was Executive Vice President of America First
Companies L.L.C from January 1989, during which time he has held a number of
positions: President and Chief Operating Officer of America First REIT, Inc. and
President of several America First mortgage funds including America First
Participating/Preferred Equity Mortgage Fund, America First PREP Fund 2, America
First PREP Fund II Pension Series Limited Partnership, Capital Source L.P.,
Capital Source II L.P.-A, America First Tax Exempt Mortgage Fund Limited
Partnership and America First Tax Exempt Fund 2 Limited Partnership. From
September 1986 to September 1988, he served as a Managing Director and Director
of Security Pacific Merchant Bank responsible for Mortgage Trading and Finance.
Prior to that time, he served as First Vice president of E.F. Hutton & Company,
Inc., where he was responsible for MBS trading and sales distribution, and Vice
President of Lehman Brothers, where he was responsible for the distribution of
mortgage products. From 1968 to 1972, Mr. Zimmerman was Vice President of Zenith
Mortgage Company and Zenith East
12
Inc., a national mortgage banking and brokerage company specializing in the
structuring and sales of MBS to the institutional financial community.
William S. Gorin, 43, serves as Executive Vice President, Chief Financial
Officer and Treasurer. He served as Executive Vice President since 1997 and was
appointed Executive Vice President, Chief Financial Officer and Treasurer in
2001. From 1998 to 2001, Mr. Gorin served as Executive Vice President and
Secretary of the Company. From 1989 to 1997, Mr. Gorin held various positions
with PaineWebber Incorporated/Kidder, Peabody & Co. Incorporated, New York, New
York, most recently serving as a first vice president in the Research
Department. Prior to that position, Mr. Gorin was Senior Vice President in the
Special Products Group. From 1982 to 1988, Mr. Gorin was employed by Shearson
Lehman Hutton, Inc./E.F. Hutton & Company, Inc., New York, New York, in various
positions in corporate finance and direct investments.
Ronald A. Freydberg, 41, serves as Executive Vice President of and
Secretary, which he was appointed to in 2001. From 1998 to 2001, he served as
Senior Vice President of the Company. From 1995 to 1997, Mr. Freydberg served as
a Vice President of Pentalpha Capital, in Greenwich, Connecticut, where he was a
fixed-income quantitative analysis and structuring specialist. In addition, he
worked with various financial institutions on the acquisition and sale of
residential, commercial and asset-backed securities. From 1988 to 1995, Mr.
Freydberg held various positions with J.P. Morgan & Co. in New York, New York.
From 1994 to 1995, he was with the Global Markets Group. In that position he was
involved in all aspects of commercial mortgage-backed securitization and sale of
distressed commercial real estate, including structuring, due diligence and
marketing. From 1985 to 1988, Mr. Freydberg was employed by Citicorp in New
York, New York.
Teresa D. Covello, 37, serves as Senior Vice President and Controller.
From May 2000 up to joining the Company in October 2001, Ms. Covello was a
self-employed financial consultant, concentrating in investment banking within
the financial services sector. From 1990 to 2000, she held progressive positions
(1997 to 2000 as Vice President; 1993 to 1996 as Assistant Vice President; 1990
to 1992 Officer and Assistant Controller) and was the Director of Financial
Reporting for JSB Financial, Inc. Ms. Covello's key responsibilities included
SEC reporting, implementing accounting standards, establishing policies and
procedures, managing asset/liability and interest rate risk policy and
reporting, and investor and regulatory communications. She was a member of the
strategic planning team. Ms. Covello began her career in public accounting in
1987 with KPMG Peat Marwick (now KPMG LLP), participating in and supervising
financial statement audits, compliance examinations, initial public offerings
and debt offerings. She is a Certified Public Accountant and has a Bachelors of
Science degree from Hofstra University in Public Accounting.
13
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
(a) Market Information The Company's common stock began trading on the New
York Stock Exchange on April 10, 1998, under the symbol "MFA." As of March 22,
2002, the last sales price for the Company's common stock on the New York Stock
Exchange was $9.46. The following table sets forth the high and low sale prices
per share for the Company's common stock for the 12 months ending December 31,
2001 and 2000.
2001 Sale Prices 2000 Sale Prices
-------------------- ---------------------
Quarter Ended High Low High Low
- ------------------ -------- -------- -------- ---------
March 31 $7.500 $5.063 $5.813 $4.500
June 30 $8.250 $6.750 $5.625 $4.500
September 30 $8.850 $7.250 $5.938 $4.938
December 31 $9.400 $7.650 $5.750 $4.750
(b) Investors
The approximate number of record holders of the Company's common stock as
of March 22, 2002 was 469; the total number of beneficial owners was
approximately 7,371.
(c) Dividends
The Company currently pays cash dividends on a quarterly basis. Total cash
dividends declared by the Company to sstockholders during the years ended
December 31, 2001 and 2000, were approximately $17,048,000 ($0.845 per share)
and $5,428,000 ($0.59 per share), respectively. In general, consistent with the
Company's underlying operational strategy, the Company's dividends will for the
most part be characterized as ordinary income to its stockholders for federal
tax purposes. However, a portion of the Company's dividends may be characterized
as capital gains or return of capital. All of the Company's dividends for 2001
were characterized as ordinary income and approximately $0.02 of the Company's
dividends for the year ended December 31, 2000 were characterized as capital
gains. (See Note 11 to the financial statements, included in Item 8, for
additional dividend information.)
The Company elected to be treated as a REIT for federal income tax
purposes beginning with its 1998 taxable year and, as such, has distributed and
anticipates distributing annually at least 90% (95% prior to January 1, 2001) of
its taxable income, subject to certain adjustments. Although the Company may
borrow funds to make distributions; cash for such distributions has generally
been and is expected to continue to be largely generated from the Company's
operations.
The Company declared the following dividends during the years ended
December 31, 2001 and 2000:
Dividend
Declaration Date Record Date Payment Date per Share
- -------------------- ------------------ ----------------- ---------
2001
February 12, 2001 April 16, 2001 April 30, 2001 $ 0.165
April 9, 2001 June 30, 2001 July 16, 2001 0.175
September 19, 2001 October 2, 2001 October 18, 2001 0.225
December 12, 2001 December 28, 2001 January 30, 2002 0.280
2000
March 17, 2000 April 14, 2000 May 17, 2000 $ 0.140
June 14, 2000 June 30, 2000 August 17, 2000 0.140
September 18, 2000 October 16, 2000 November 17, 2000 0.155
December 14, 2000 January 15, 2001 January 30, 2001 0.155
For tax purposes, a portion of each of the dividends declared on: December
12, 2001 and December 14, 2000, were treated as a dividend for stockholders in
the subsequent year. The dividend declared on December 16, 1999 and paid on
February 18, 2000 was treated in its entirety as a 2000 dividend for
stockholders.
Future dividends will be determined by the Company's Board of Directors
after considering the Company's available cash for distribution, financial
condition, ability to maintain its REIT status, and such other factors that may
be deemed relevant. See Item 7, Management's Discussion and Analysis of
Financial Conditions and Results of Operations, for information regarding the
sources of funds used for dividends and for a discussion of factors, if any,
which may adversely affect the Company's ability to pay dividends at the same
levels in 2002 and thereafter.
14
Item 6. Selected Financial Data.
Set forth below is selected financial data for the Company (for periods
after April 9, 1998) and the Predecessor (for periods up to April 9, 1998). The
information set forth below should be read in conjunction with the financial
statements and notes to the financial statements.
(1)
Predecesor
Company January (1)
(In Thousands, Except For the Year Ended April 10 to 1 to 1998
per Share Amounts) December 31, December 31, April 9, Total
------------------------------------ ------------ --------- --------
2001 2000 1999 1998
---------- -------- -------- ------------------------
Operating Data:
Interest income on MBS $ 53,387 $ 33,391 $ 24,302 $ 7,627 $ 614 $ 8,241
Corporate debt securities income 1,610 1,336 675 165 -- 165
Dividend income 666 928 331 -- -- --
Interest income on temporary cash
investments 842 645 366 440 149 589
Income from other investments (2) 3,137 3,670 3,013 582 145 727
Net gain (loss) on sale of
investments (438) 456 55 415 -- 415
General and administrative expenses (3) (5,355) (2,457) (2,672) (1,674) (421) (2,095)
Interest expense on borrowed
funds (35,073) (30,103) (18,466) (4,620) -- (4,620)
Other-than-temporary impairment
loss on debts ecurities (2,453) -- -- -- -- --
Costs incurred in acquiring external
advisor (12,539) -- -- -- --
Minority interest -- -- (4) (4) -- (4)
---------- -------- -------- --------- ------- -------
Net income $ 3,784 $ 7,866 $ 7,600 $ 2,931 $ 487 $ 3,418
========== ======== ======== ========= ======= =======
Net income, basic, per share $ 0.25 $ 0.89 $ 0.84 $ 0.32 N/A
========== ======== ======== ========= =======
Net income, diluted, per $ 0.25 $ 0.89 $ 0.84 $ 0.32 N/A
share ========== ======== ======== ========= ======
Net income per exchangeable unit -
basic N/A N/A N/A N/A $ 0.08
========== ======== ======== ======= =======
Net income per exchangeable unit - N/A N/A N/A N/A $ 0.08
diluted, ========== ======== ======== ======= =======
Dividends declared per common share
or cash distributions paid/accrued
per exchangeable unit $ 0.85 $ 0.59 $ 0.67 $ 0.80 $ 0.26 $ 1.06
========== ======== ======== ========= ======= =======
Balance Sheet Data: (At Period End)
MBS $1,926,900 $470,576 $475,720 $ 241,895
Corporate debt securities 9,774 15,666 8,020 4,673
Corporate equity securities 4,088 9,011 3,131 1,154
Total assets 2,068,933 522,490 524,384 264,669
Repurchase agreements 1,845,598 448,583 452,102 190,250
Total stockholders' equity 203,624 69,912 614 70,933
(1) For financial accounting purposes, PREP Fund 1 was considered the sole
predecessor to the Company and, accordingly, the historical operating
results presented in this report as those of the "Predecessor" are those
of PREP Fund 1. The 1998 Merger was accounted for as a purchase by PREP
Fund 1 of 100% of the assigned limited partnership interests (known as
"BUCs") of PREP Fund 2 and approximately 99% of the BUCs of Pension Fund.
As a result of this treatment, the Company, as the successor to PREP Fund
1, recorded all of the assets and liabilities of PREP Fund 1 at their book
value, but was required to record the assets of PREP Fund 2 and Pension
Fund at their fair value . The amount by which the fair value of the
Company's stock issued to the BUC holders of PREP Fund 2 and Pension Fund
exceeded the fair value of the net assets of PREP Fund 2 and Pension Fund
was recorded as goodwill by the Company. The Company began operations on
April 10, 1998; financial data of the Predecessor prior to 1998 is not
considered meaningful and, therefore, has been omitted.
(2) Includes gains of approximately $2.6 million, $2.6 million and $2.2
million resulting from the sale of the underlying real estate of
unconsolidated real estate limited partnerships for the years ended
December 31, 2001, 2000 and 1999, respectively. (See Note 7 to the
financial statements, included in Item 8.)
(3) Includes an incentive fees of approximately $511,000, $519,000 and
$433,000 earned by the Advisor in connection with the sales described in
(2) above for the years ended December 31, 2001, 2000 and 1999,
respectively.
15
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
GENERAL
America First Mortgage Investments, Inc. was incorporated in Maryland on
July 24, 1997. The Company began operations on April 10, 1998 when it merged
with the Prep Funds. Concurrent with the 1998 Merger, the Company entered into
the Advisory Agreement with the Advisor and adopted an investment policy that
significantly differed from that pursued by the Prep Funds.
Prior to the Advisor Merger, the Advisor provided advisory services to the
Company in connection with the conduct of the Company's business activities and
operations. The Company's principal investment strategy provides for leveraged
investing in adjustable rate and hybrid MBS. In addition, the Company's
investment strategy also provides for the acquisition of multifamily housing
properties, REIT securities and high-yield corporate securities.
The Company has elected to be subject to tax as a REIT for federal income
tax purposes beginning with its 1998 taxable year and, as such, the Company has
distributed, and anticipates in the future distributing, on an annual basis at
least 90% (95% prior to January 1, 2001) of its annual taxable net income to its
stockholders, subject to certain adjustments. Generally, cash for such
distributions is expected to be largely generated from the Company's operations,
although the Company may borrow funds to make distributions.
The following discussion should be read in conjunction with the Company's
Financial Statements and Supplementary Data and the notes thereto appearing
elsewhere in this Annual Report on Form 10-K.
ADVISOR MERGER
From the time of the 1998 Merger through December 31, 2001, the Company
was externally managed by the Advisor. The Company had no employees of its own
as an externally managed REIT and relied on the Advisor to conduct its business
operations. As such, the primary components of the Company's general and
administrative expenses were the base advisory and incentive compensation fees
paid to the Advisor.
Due to the increase in the Company's assets and stockholders' equity
during 2001, the Company's Board of Directors determined that it was in the best
interest of the Company that it should become a "self-advised" REIT.
Accordingly, on September 24, 2001, the Company entered into the Advisor Merger
Agreement pursuant to which the Advisor was to be merged with and into the
Company. In December 2001, the Company's stockholders approved the terms of the
Advisor Merger Agreement, which provided for the merger of the Advisor into the
Company effective 12:01 a.m. on January 1, 2002. As a result, the Company became
self-advised and commencing January 1, 2002 and thereafter will directly incur
the cost of all overhead expenses necessary to operate the company and will no
longer have any obligation to pay fees to the Advisor. As a result of the
Advisor Merger, the employees of the Advisor became employees of the Company.
Management of the Company believes that, under current market conditions,
the additional costs incurred in operating the Company on a self-advised basis
will be less than the amount of the fees that would have otherwise been payable
to the Advisor had the Company remained an "externally-advised" REIT. However,
there can be no assurance that the Company will incur lower expenses as a
self-advised REIT. In connection with the Advisor Merger Agreement, the Company
issued 1,287,501 shares of its common stock to the stockholders of the Advisor.
These shares represented approximately 4.5% of the total outstanding shares of
common stock immediately following the Advisor Merger. As a result, earnings per
share on the Company's common stock could decrease as a result of the Advisor
Merger, even though the Company's costs decline as a result of becoming
self-advised.
For accounting purposes, the Advisor Merger is not considered the
acquisition of a "business" for purposes of applying Accounting Principles Board
("APB") Opinion No. 16, "Business Combinations" and, therefore, the market value
of the common stock issued, valued as of the consummation of the Advisor Merger,
in excess of the fair value of the net tangible assets acquired was charged to
operating income rather than capitalized as goodwill for the year ended December
31, 2001.
RESULTS OF OPERATIONS
Year Ended December 31, 2001, Compared to Year Ended December 31, 2000
In comparing the results of operations for 2001 with 2000, the 2001
results are marked by two significant charges and a substantial growth in assets
funded by leveraging of the additional equity capital raised during the year.
Specifically, the Company incurred an expense of approximately $12.5 million, of
which approximately $11.3 million was non-cash, as a one-time cost in connection
with the Advisor Merger. In addition, the Company incurred
16
a charge of approximately $2.5 million taken against the corporate debt
securities portfolio for an other-than-temporary impairment against an
investment in corporate debt securities.
Total interest and dividend income increased by approximately $20.2
million, or 55.7%, to approximately $56.5 million compared to approximately
$36.3 million earned in 2000. The 2001 increase is directly attributable to the
growth in assets as a result of the investing, on a leveraged basis, the
proceeds from the sale of approximately 18.3 million shares of the Company's
common stock. The Company's "core assets" which consist of MBS, generated
approximately $53.4 million of income, reflecting approximately $20.0 million,
or 59.9%, increase from approximately $33.4 million for 2000. The increase in
MBS income reflects the growth in the Company's MBS portfolio of approximately
$1.456 billion, or 309.5%, from approximately $470.6 million as of December 31,
2000 to $1.927 billion as of December 31, 2001.
Lifetime interest rate caps on adjustable rate MBS could limit earnings on
the Company's assets. At December 31, 2001, approximately 19.9% of the Company's
adjustable rate MBS (18.5% of the total assets) had a 1% periodic (generally one
year) cap (annual limit for rate changes on the underlying mortgages) with the
remainder having a 2% annual cap. Management believes that the impact of
periodic caps on the operating results for 2002, if any, would be slight, given
that the weighted average coupon on these assets was 7.12% at December 31, 2001,
492 basis points greater than the one year CMT.
Income recognized on short-term investments in cash and cash equivalents
increased by $197,000, as funds generated through the sale of the Company's
common shares remain in interest earning cash investments until fully invested.
Further, significant growth in investments will, in general, due to the
reinvestment lag, result in an increase in temporary cash investments. Income
from corporate debt securities increased $274,000; however losses on sales of
such securities and losses recognized for other-than-temporary impairment on one
of the Company's corporate debt investments far exceeded the growth in income.
Slightly offsetting increases in interest income was a decrease in dividend
income on equity securities of $262,000 reflecting sales of equity securities.
The yield on the equity security portfolio decreased to 8.6% for 2001 from 15.0%
in 2000.
The Company's interest expense increased by approximately $5.0 million, or
16.5%, for the year ended December 31, 2001. The average borrowings under
repurchase agreements increased by approximately $434.7 million, or 96.5% from
approximately $450.3 million during 2000 to approximately $885.0 million during
2001, while the average cost of borrowings decreased from 6.68% to 3.96% for the
years ended December 31, 2000 and 2001, respectively.
Net interest and dividend income increased by approximately $15.2 million,
or 245.8%, from approximately $6.2 million to approximately $21.4 million for
the years ended December 31, 2000 and 2001, respectively. The Company's net
interest margin improved by 102 basis points to 2.24% for 2001 from 1.22% for
2000. Overall, the significant increase in the Company's net interest income can
be attributed to the significant balance sheet growth and the increase in the
interest rate spread and net interest margin during 2001. During 2001, interest
rates generally declined, resulting in an expansion (i.e., increase) in interest
rate spreads and margins. Should interest rates increase, as management expects
to occur during 2002, the Company's interest rate spread and net interest margin
would compress (i.e., decline,); the amount and timing of such compression will
be driven by, among other factors, the interest rate environment and thus cannot
be predicted with any uncertainty.
Income and gains from other investments decreased approximately $1.4
million, to $2.7 million for 2001, from $4.1 million for 2000. This decrease
reflects a decline in the performance and resulting net operating income
available for distribution to the Company on its real estate investments. As of
December 31, 2001, the Company had indirect interests in six multi-family
properties consisting of a total of 1,473 rental units, through investments in
four limited partnerships and one corporation as a preferred stockholder. These
investments, which had a net carrying value of $9,360,000 at December 31, 2001,
comprised less than 1% of the Company's total assets. During both 2001 and 2000,
the Company recognized gains of $2.6 million related to sales of real estate
properties through the Company's non-consolidated real estate investments.
The Company reported a net loss of $457,000 on the sale of corporate debt
and equity investments during 2001, comprised of; gross gains of approximately
$1.2 million on corporate equity securities and $81,000 on corporate debt
securities and MBS. These gains were more than offset by gross losses of
approximately $1.2 million on corporate debt securities and losses of $588,000
on the sale of equity securities. This compares to a net gain of $456,000
recognized during the year ended December 31, 2000 resulting from the sale of
corporate debt, equity and mortgage backed securities.
During 2001, the Company recognized an other-than-temporary impairment
loss of approximately $2.5 million on its investment in RCN debt securities. At
December 31, 2001, the Company held RCN debt securities, which
17
were carried at their estimated fair value of approximately $2.1 million. In
addition to the RCN debt securities, the corporate debt portfolio included other
debt securities designated as held-to-maturity that were carried at their
amortized cost of approximately $7.6 million, and had estimated gross unrealized
losses of approximately $3.4 million. The investment in Level 3 accounted for
approximately $3.1 million of the $3.4 million unrealized loss.
Management diligently monitors each debt and equity security investment,
in order to identify asset/credit quality issues on a timely basis. This enables
management to assess and, if necessary, change its position with regard to a
particular debt or equity security. Future other-than-temporary impairment
charges against investments, including the debt securities of Level 3, may be
recognized as a result of such assessments, the timing and amount of which would
be based on the facts and circumstances at the time. In general, the Company's
loss exposure due to credit issues related to debt and equity securities is
limited, given that these investments comprised less than 1% of the Company's
assets at December 31, 2001.
General and administrative expenses for the Company for the year ended
December 31, 2001, increased approximately $2.9 million as compared to 2000.
Such increase is primarily attributable to higher base management and incentive
compensation fees earned by the Advisor resulting from an increase in the
Company's stockholders' equity and an increase in income generated by the
Company.
The Company incurred costs in acquiring the Advisor of approximately $12.5
million, of which $11.3 million was a non-cash equity issuance, representing the
fair value of the Company's common stock issued in the Advisor Merger. The
Company and the Advisor merged effective 12:01a.m. on January 1, 2002. As a
result, the Company became self-advised and commencing January 1, 2002 and,
thereafter, will directly incur the cost of all overhead necessary to operate
the Company.
Year Ended December 31, 2000, Compared to Year Ended December 31, 1999
During the year ended December 31, 2000, total interest income earned by
the Company increased $10.6 million, or 41%, compared to total interest income
earned in 1999. This increase is primarily attributable to a 33% growth in the
Company's average interest earning assets from $382 million to $507 million for
the years ended December 31, 1999 and 2000, respectively. Also contributing to
the increase was a 6.4% growth in the yield on the Company's interest earning
assets from 6.72% per annum in 1999 to 7.15% per annum in 2000.
The Company's interest expense increased $11.6 million, or 63%, for the
year ended December 31, 2000 compared to 1999 due to a 40% increase in the
average repurchase agreement balance from $321 million in 1999 to $450 million
in 2000, as well as an increase in the average interest cost from 5.75% in 1999
to 6.68% in 2000. The Company had outstanding borrowings of $449 million at
December 31, 2000 compared to $452 million at December 31, 1999.
The Company's net interest margin was 1.22% for the year ended December
31, 2000 compared to 1.89% for the year ended December 31, 1999. As a result of
the narrowing of such margin, net interest and dividend income decreased $1.0
million, or 14%, from $7.2 million to $6.2 million for the years ended December
31, 1999 and 2000, respectively.
Income from other investments increased from $3.0 million to $3.7 million
for the years ended December 31, 2000 and 1999, respectively. Included in such
income for the year ended December 31, 2000 is a gain of approximately $2.6
million which resulted from the sale of the underlying real estate of an
unconsolidated real estate limited partnership. Included in such income for the
year ended December 31, 1999 is approximately $2.2 million attributable to a
gain recognized by a non-consolidated subsidiary's sale of its undivided
interests in the net assets of four assisted living centers. Excluding such
sales, income from other investments increased $225,000 due to higher income
generated by the Company's investments in unconsolidated real estate limited
partnerships.
During the year ended December 31, 2000, the Company realized a net gain
of $456,000 on the sale of investments compared to a net gain of $55,000 during
the year ended December 31, 1999. Such gains resulted from the sale of corporate
debt and equity securities and the sale and/or payoff of several pools of fixed
rate MBS.
General and administrative expenses of the Company decreased $215,000, or
8%, for the year ended December 31, 2000 compared to 1999. Approximately
$100,000 of such decrease is due to expenses incurred in 1999 by a consolidated
whichsubsidiary, which was liquidated in December 1999. The remainder of the
decrease is primarily attributable to net decreases in various general and
administrative expenses, including various servicing fees, filing fees and
printing costs.
18
CRITICAL ACCOUNTING POLICIES
Management has the obligation to insure that its policies and
methodologies are in accordance with generally accepted accounting principles.
During 2001 management reviewed and evaluated its critical accounting policies
and believes them to be appropriate.
The Company's financial statements include the accounts of the Company and
all majority owned and controlled subsidiaries. The preparation of financial
statements in accordance with generally accepted accounting principles requires
management to makes estimates and assumptions in certain circumstances that
affect amounts reported in the accompanying consolidated financial statements.
In preparing these financial statements, management has made its best estimates
and judgements of certain amounts included in the financial statements, giving
due consideration to materiality. The Company does not believe that there is a
great likelihood that materially different amounts would be reported related to
accounting policies described below. However, application of these accounting
policies involves the exercise of judgement and use of assumptions as to future
uncertainties and, as a result, actual results could differ from these
estimates.
The Company's accounting policies are described in Note 2 to the Company's
financial statements, included in Item 8. Management believes the more
significant of these to be as follows:
Revenue Recognition
The most significant source of the Company's revenue is derived from its
investments in MBS. The Company reflects income using the effective yield
method, which recognizes periodic income over the expected term of the
investment on a constant yield basis, as adjusted for actual prepayment
activity.Management believes the Company's revenue recognition policies are
appropriate to reflect the substance of the underlying transactions.
Other-than-temporary impairment of investments
The Company's accounting policies require that management review its
investment portfolio for potential "other-than-temporary" declines in vale on an
investment-by-investment basis. The majority of the Company's investments are in
MBS which are agency sponsored or credit enhanced and which management considers
it unlikely that these securities, because of their nature, will experience
substantial declines in value that are due to other-than-temporary market
fluctuations. For the companies other non-real estate investments, management
assesses on a quarterly basis significant declines in value which may be
considered other than temporary and, if necessary, recognizes and accounting
charge to write-down the carrying value of such investments. In making this
assessment, management takes into consideration a wide range of objective and
subjective information including but not limited to the following: the magnitude
and duration of historical decline in market prices, credit rating activity,
assessments of liquidity and public filings and statements made by the issuer.
Actual losses, if any, could ultimately differ from these estimates.
Impairment of Long-Lived Assets
Real estate investments held directly or through joint ventures represent
"long-lived" assets for accounting purposes. The Company periodically reviews
long-lived assets to be held and used in operations for impairment in value
whenever any events or changes in circumstances indicate that the carrying
amount of the assets may not be recoverable. In management's opinion, based on
this analysis, real estate assets and investments in joint ventures are
considered to be held for investment and are not carried at amounts in excess of
their estimated recoverable amounts.
Income Taxes
The Company's financial results generally do no reflect provisions for
current or deferred income taxes. Management believes that the Company has and
intends to continue to operate in a manner that will continue to allow it to be
taxed as a real estate investment trust and as a result does not expect to pay
substantial corporate level taxes. Many of these requirements, however, are
highly technical and complex. If the Company were to fail to meet these
requirements, the Company would be subject to Federal income tax.
New Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board ("FASB") issued
Financial Accounting Standards ("FAS") No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("FAS 133"). Certain provisions of FAS 133
were amended by Financial Accounting Standards No. 138, "Accounting for Certain
Derivative Instruments and Certain Hedging Activities" ("FAS 138") in June,
2000. These statements provide new accounting and reporting standards for the
use of derivative instruments. Prior the adoption of FAS 133, the Company did
not engage in hedging activities as defined in FAS 133 and FAS 138, although it
was not precluded from doing so, for
19
the purposes of managing interest rate risk. As of January 1, 2001, the Company
had no outstanding derivative hedging instruments nor any imbedded derivatives
requiring bifurcation and separate accounting under FAS 133, as amended.
Accordingly, there was no cumulative effect upon adoption of FAS 133, as
amended, on January 1, 2001. Subsequent to the adoption of FAS 133, as amended,
the Company has applied the provisions of FAS 133, as amended.
In September, 2000, the FASB issued FAS No. 140, "Accounting for Transfers
and Servicing of Financial Assets and Extinguishments of Liabilities" ("FAS
140"). This statement is applicable for transfers of assets and extinguishments
of liabilities occurring after March 31, 2001. The Company adopted the
provisions of this statement as required for all transactions entered into on or
after April 1, 2001. The adoption of FAS 140 did not have a significant impact
on the Company.
In July, 2001, the FASB issued FAS No. 141, "Business Combinations" and
FAS No. 142, "Goodwill and Other Intangible Assets" ("FAS 142") which provide
guidance on how entities are to account for business combinations and for the
goodwill and other intangible assets that arise from those combinations or are
acquired otherwise. These standards became effective for the Company on January
1, 2002.
FAS 142 requires that goodwill no longer be amortized, but instead be
tested for impairment at least annually. As of the date of adoption, the Company
had unamortized goodwill in the amount of approximately $7,189,000. Amortization
expense related to such goodwill was approximately $200,000 for the years ended
December 31, 2001 and 2000 and $187,000 for the year ended December 31, 19899.
The Company's adoption of FAS 142 effective January 1, 2002, did not have a
material effect on the Company.
In October, 2001, the FASB issued FAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets" ("FAS 144"). FAS 144 provides new
guidance on the recognition of impairment losses on long-lived assets to be held
and used or to be disposed of, and also broadens the definition of what
constitutes a discontinued operation and how the results of a discontinued
operation are to be measured and presented. The provisions of FAS 144 are
effective for the Company on January 1, 2002. The adoption of FAS 144 did not
have a significant impact on the Company.
Liquidity and Capital Resources
The Company's principal sources of liquidity consist of borrowings under
repurchase agreements, principal payments received on its portfolio of MBS, cash
flows generated by operations and proceeds from capital market transactions. The
Company's principal uses of cash include purchases of MBS and, to a lesser
extent, may include investments in corporate debt and equity securities and
hedge instruments; payments for operating expenses; and the payment of dividends
on the Company's common stock.
Repurchase agreements provided an additional $1.397 billion to finance
asset growth during 2001, this increase in leverage was facilitated by the
increase in the Company's capital as a result of the public stock offerings
completed in 2001. At December 31, 2001, borrowings under repurchase agreements
were $1.846 billion, compared to $448.6 million at December 31, 2000. At
December 31, 2001, repurchase agreements had a weighted average borrowing rate
of 2.91%, on loan balances of between $209,000 and $109.5 million. These
agreements generally have original terms to maturity ranging from one month to
12 months and interest rates that are typically based off of LIBOR. To date, the
Company has not had any margin calls on its repurchase agreements that it was
unable to satisfy with either cash or additional pledged collateral.
During the year ended December 31, 2001, the Company completed two public
offerings, as detailed below, of its common stock, in which it issued
approximately 18.3 million shares, and raised net proceeds of approximately
$126.8 million. The Company's 2001 equity offerings were as follows:
(1)
Price Per Gross Offering
Settlement Date Number of Shares Share Proceeds Expenses Net Proceeds
- ----------------- ----------------- -------------- -------------- ----------------- -----------------
June 27, 2001 10,335,214 (2) $ 7.00 $72.3 million $5.2 million $67.1 million (3)
Nov. 7, 2001 8,000,000 $ 8.00 $64.0 million $4.3 million $59.7 million (3)
(1) Include commissions, discounts and other offering expenses.
(2) Includes the full exercise of the underwriters' option to purchase up to
1,335,214 additional shares to cover over-allotments for the June 27, 2001
offering.
(3) Net proceeds were fully utilized to acquire additional adjustable rate MBS
on a leveraged basis during the year ended December 31, 2001.
On September 25, 2001, the Company filed a registration statement with the
Securities and Exchange Commission ("SEC") relating to $300 million of its
common stock and preferred stock that the Company may offer
20
from time to time for cash in a variety of transactions, including underwritten
public offerings (the "Shelf Registration"). The common stock offering completed
by the Company in November utilized a portion of the securities registered under
this registration. As of December 31, 2001, the Company had $236 million of
securities remaining on the Shelf Registration.
To the extent the Company raises additional equity capital from future
sales of common and/or preferred stock thispursuant to the Shelf Registration,
the Company anticipates using the net proceeds primarily to acquire additional
adjustable rate MBS. Management may also consider additional interests in
multifamily apartment properties and other investments consistent with its
operating policies. There can be no assurance, however, that the Company will be
able to raise additional equity capital at any particular time or on any
particular terms.
On January 18, 2002, the Company issued 7,475,000 shares of its common
stock, generating net proceeds of approximately $58.2 million in a public
offering. These shares were issued at $8.25 per share, generating gross offering
proceeds, before expenses, of approximately $61.7 million. The net proceeds were
fully invested and will be fully leveraged to acquire additional MBS during the
first quarter of 2002. Following the completion of the January 2002 equity
offering, the Company had approximately $174.3 million remaining on the Shelf
Registration.
During 2001, principal payments on MBS, generated cash of approximately
$293.6 million and operations provided a net of approximately $21.7 million in
cash. In addition, the Company also received proceeds of $15.1 million from the
sale of investments in corporate debt and equity securities during 2001.
As part of its core investing activities, during 2001, the Company
acquired $1.753 billion of MBS. Other uses of funds during the year ended
December 31, 2001, included $10.7 million for dividend payments on the Company's
common stock.
In order to reduce interest rate risk exposure on a portion of the
Company's LIBOR-based repurchase agreements, the Company entered into an
interest rate Cap Agreement, costing $350,000. (See "Quantitative and
Qualitative Disclosures About Market Risk"). Additional purchases of Cap
Agreements are expected during 2002, which will generate cash if interest rates
increase beyond the rate specified in the individual agreement. In addition, the
Company invested $392,000 in corporate equity securities during 2001.
The Company's restricted cash balance represents cash held on deposit with
certain counterparties (i.e., lenders) to satisfy margin calls on repurchase
agreements. The margin calls result from the decline in the value of the MBS
securing repurchase agreements, generally due to principal reduction in the MBS
from scheduled amortization and prepayments. At December 31, 2001, the Company
had approximately 49% of its repurchase agreements scheduled to roll (i.e., is
contractually mature and payable to the counterparty) within the first three
months of 2002, as reflected in the $39.0 million increase, comparing restricted
cash as of December 31, 2001 to December 31, 2000. At the time a repurchase
agreement rolls counterparty), the Company will apply the restricted cash
against the repurchase agreement, thereby reducing the borrowing.
Through December 31, 2001, the primary components of the Company's general
and administrative expenses were the base advisory and incentive fees paid to
the Advisor. Effective January 1, 2002, the Company became a self-advised REIT,
and thereafter will directly incur all cost associated with conducting the
Company's business. Management bbelieves that, under current market conditions,
the additional costs incurred in operating MFA on a self-advised basis will be
less than the amount of the fees that would be payable to the Advisor had the
Company remained an "externally-advised" REIT. However, there can be no
assurance that the Company's expenses will actually be lower as a self-advised
REIT.
The Company believes it has adequate financial resources to meet its
obligations as they come due and to fund committed dividends as well as to
actively pursue its investment policies.
INFLATION
Virtually all of the Company's assets and liabilities are financial in
nature. As a result, interest rates and other factors drive our performance far
more than does inflation. Changes in interest rates do not necessarily correlate
with inflation rates and changes in inflation rates. Our financial statements
are prepared in accordance with Generally Accepted Accounting Principles and our
dividends are based upon our net income as calculated for tax purposes; in each
case, our activities and balance sheet are measured with reference to historical
cost or fair market value without considering inflation.
OTHER MATTERS
The Company at all times intends to conduct its business so as to not
become regulated as an investment company under the Investment Act. If the
Company were to become regulated as an investment company, then,
21
among other things, the Company's ability to use leverage would be substantially
reduced. The Investment Act exempts entities that are "primarily engaged in the
business of purchasing or otherwise acquiring "Qualifying Interests. Under the
current interpretation of the staff of the SEC, in order to qualify for this
exemption, the Company must maintain at least 55% of its assets directly in
Qualifying Interests. In addition, unless certain securitiesMBS represent an
undivided interest in the entire pool backing such MBS (i.e., "whole pool" MBS),
such MBS may be treated as securities separate from the underlying mortgage loan
and, thus, may not be considered Qualifying Interests for purposes of the 55%
exemption requirement. Accordingly, the Company monitors its compliance with
this requirement in order to maintain its exempt status. As of December 31,
2001, the Company determined that it is in and has maintained compliance with
this requirement.
FORWARD LOOKING STATEMENTS
When used in this Annual Report on Form 10-K, in future SEC filings, or in
press releases or other written or oral communications, the words or phrases
"will likely result," "are expected to," "will continue," "is anticipated,"
"estimate," "project" or similar expressions are intended to identify
"forward-looking statements" for purposes of Section 27A if the Securities Act
of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as
amended and as such may involve know and unknown risks, uncertainties and
assumptions.
These forward-looking statements are subject to various risks and
uncertainties, including, but not limited to, those relating to: increases in
the prepayment rates on the mortgage loans securing the Company's MBS; changes
in short-term interest rates; the Company's ability to use borrowings to finance
its assets; risks associated with investing in real estate, including changes in
business conditions and the general economy; changes in government regulations
affecting the Company's business; and the Company's ability to maintain its
qualification as a REIT for federal income tax purposes. These risks,
uncertainties and factors could cause the Company's actual results to differ
materially from those projected in any forward-looking statements it makes.
All forward-looking statements speak only as the date they are made and
the Company does not undertake, and specifically disclaims, any obligation to
update any forward-looking statement to reflect events or circumstances after
the date of such statements. Readers are cautioned that the Company's actual
results could differ materially from those set forth in such forward-looking
statements.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
The Company seeks to manage the interest rate, market value, liquidity,
prepayment and credit risks inherent in all financial institutions in a prudent
manner designed to insure the longevity of the Company while, at the same time,
seeking to provide an opportunity to stockholders to realize attractive total
rates of return through stock ownership of the Company. While the Company does
not seek to avoid risk, it does seek, to the best of its ability, to assume risk
that can be quantified from historical experience, to actively manage such risk,
to earn sufficient compensation to justify the taking of such risks and to
maintain capital levels consistent with the risks it does undertake.
INTEREST RATE RISK
The Company primarily invests in adjustable rate and hybrid MBS. The
hybrid-MBS represent fixed rate coupons for a specified period, generally three
years, and thereafter converts to a variable rate coupon. The Company's debt
obligations are generally repurchase agreements of limited duration, which are
periodically refinanced at new market rates.
Most of the Company's adjustable rate assets are dependent on the one-year
CMT rate and debt obligations are generally dependent on LIBOR. These indexes
generally move in parallel, but there can be no assurance that this will
continue to occur.
The Company's adjustable rate investment assets and debt obligations reset
on various different dates for the specific asset or obligation. In general, the
repricing of the Company's debt obligations occurs more quickly than the
repricing of assets. Therefore, on average, the Company's cost of funds may rise
or fall more quickly than does its earnings rate on the assets. Further, the
Company's net income may vary somewhat as the yield curve between one-month
interest rates and six-and 12-month interest rate varies.
The following table presents the Company's interest rate risk using the
static gap methodology. The table presents the difference between the carrying
value of the Company's interest rate sensitive assets and liabilities at
December 31, 2001, based on the earlier of term to repricing or the term to
repayment of the asset or liability, scheduled principal amortization is not
reflected in the table. Further, the adjustable rate MBS can be prepaid before
22
contractual amortization and/or maturity, which is also not reflected in the
table. The table does not include assets and liabilities that are not interest
rate sensitive.
As of December 31, 2001, the Company's investment assets and debt
obligations will prospectively reprice based on the following time frames:
As of December 31, 2001
------------------------------------------------------------------------------
Two
Less than Three One Year Years to Beyond
Three Months to to Two Year Three
Months One Year Years Three Years Total
(In Thousands) --------- ----------- --------- -------- ------- ----------
Interest Earning Assets:
Adjustable Rate - MBS $ 281,498 $ 521,375 $ 522,344 $590,163 -- $1,915,380
Fixed-Rate - MBS -- -- -- -- 11,520 11,520
Debt Securities -- -- -- -- 9,774 9,774
Equity Securities 4,088 -- -- -- -- 4,088
--------- ----------- --------- -------- ------- ----------
Total interest-earning
assets 285,586 521,375 522,344 590,163 21,294 1,940,762
Interest Bearing Liabilities:
Repurchase agreements 912,361 933,237 -- -- -- 1,845,598
--------- ----------- --------- -------- ------- ----------
Total interest-bearing
liabilities 912,361 933,237 -- -- -- 1,845,598
Interest sensitivity gap $(626,775) $ (411,862) $ 522,344 $590,163 $21,294 $ 95,164
Cumulative interest
sensitivity gap $(626,775) $(1,038,637) $(516,293) $ 73,870 $95,164
The difference between assets and liabilities repricing or maturing in a
given period is one approximate measure of interest rate sensitivity. When more
assets than liabilities reprice during a period, the gap is considered positive
and it is anticipated that earnings will increase as interest rates rise and
earnings will decrease as interest rates decline. When more liabilities reprice
than assets during a given period, as is the case with respect to the Company
for periods less than one year, the gap is considered negative. With a negative
gap it is anticipated that income will decline as interest rates increase and
income will increase as interest rates decline. The static gap analysis does not
reflect the constraints on the repricing of adjustable rate MBS in a given
period resulting from periodic and life time cap features on these securities,
nor the behavior of various indexes applicable to the Company's assets and
liabilities.
To a limited extent, the Company uses interest rate Cap Agreements as part
of its interest rate risk management. The notional amounts of these instruments
are not reflected in the Company's balance sheet. The Cap Agreements that hedge
against increases in interest rates on the Company's LIBOR-based repurchase
agreements are not considered in the static gap analysis, as they do not effect
the timing of the repricing of the instruments they hedge, but rather to the
extent of the notional amount, cap the limit on the amount of interest rate
change that can occur relative to the applicable of the hedged liability.
MARKET VALUE RISK
Substantially all of the Company's investments are designated as
"available-for-sale" assets. As such, they are reflected at their estimated fair
value, with the difference between amortized cost and fair value reflected in
accumulated other comprehensive income, a component of stockholders' equity.
(See Note 13 to the accompanying financial s statements included in Item 8.) The
market value of the Company's MBS assets fluctuate primarily due to changes in
interest rates and other factors; however, given that these securities are
guaranteed by an agency of the U. S. Government, su