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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
(MARK ONE)
X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
--- EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED: DECEMBER 31, 1999
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
--- EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 001-11914
THORNBURG MORTGAGE ASSET CORPORATION
(DBA THORNBURG MORTGAGE, INC.)
(Exact name of Registrant as specified in its Charter)
MARYLAND 85-0404134
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
119 E. MARCY STREET 87501
SANTA FE, NEW MEXICO (Zip Code)
(Address of principal executive offices)
Registrant's telephone number, including area code (505) 989-1900
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Exchange on Which Registered
---------------------- -----------------------------------------
Common Stock ($.01 par value) New York Stock Exchange
Series A 9.68% Cumulative Convertible Preferred Stock ($.01 par value) New
York Stock Exchange
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
Regulation S-K is not contained herein, and will not be contained, to the best
of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
At February 29, 2000, the aggregate market value of the voting stock held by
non-affiliates was $166,836,664, based on the closing price of the common stock
on the New York Stock Exchange.
Number of shares of Common Stock outstanding at February 29 , 2000: 21,489,663
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the Registrant's definitive Proxy Statement dated March 27,
2000, issued in connection with the Annual Meeting of Shareholders of the
Registrant to be held on April 27, 2000, are incorporated by reference into
Parts I and III.
This Page Left Intentionally Blank
2
THORNBURG MORTGAGE ASSET CORPORATION
(dba THORNBURG MORTGAGE, INC.)
1999 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PART I
Page
----
ITEM 1. BUSINESS 4
ITEM 2. PROPERTIES 21
ITEM 3. LEGAL PROCEEDINGS 21
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 21
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY
AND RELATED SHAREHOLDER MATTERS 22
ITEM 6. SELECTED FINANCIAL DATA 23
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS 24
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE
ABOUT MARKET RISKS 44
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 44
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE 44
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
FINANCIAL STATEMENTS F-1
SIGNATURES
EXHIBIT INDEX
3
PART I
ITEM 1. BUSINESS
GENERAL
Thornburg Mortgage Asset Corporation, including subsidiaries, (the "Company") is
a mortgage acquisition company that primarily invests in adjustable-rate
mortgage ("ARM") assets comprised of ARM securities and ARM loans, thereby
indirectly providing capital to the single family residential housing market.
ARM securities represent interests in pools of ARM loans, which often include
guarantees or other credit enhancements against losses from loan defaults.
While the Company is not a bank or savings and loan, its business purpose,
strategy, method of operation and risk profile are best understood in comparison
to such institutions. The Company leverages its equity capital using borrowed
funds, invests in ARM assets and seeks to generate income based on the
difference between the yield on its ARM assets portfolio and the cost of its
borrowings. The corporate structure of the Company differs from most lending
institutions in that the Company is organized for tax purposes as a real estate
investment trust ("REIT") and therefore generally passes through substantially
all of its earnings to shareholders without paying federal or state income tax
at the corporate level. See "Federal Income Tax Considerations -- Requirements
for Qualification as a REIT". The Company has two REIT qualified subsidiaries
which are involved in financing its mortgage loan assets. The two financing
subsidiaries, Thornburg Mortgage Funding Corporation and Thornburg Mortgage
Acceptance Corporation, are consolidated in the Company's financial statements
and federal and state tax returns. In 1999, the Company formed a new REIT
qualified subsidiary, Thornburg Mortgage Home Loans, Inc., to originate loans
for the Company according to the Company's underwriting guidelines. This new
subsidiary did not commence any operations in 1999 but is expected to during the
first half of 2000.
Acquisition of FASLA Holding Company
On December 23, 1999, the Company and Thornburg Mortgage Advisory Corporation
(the "Manager") entered into an agreement to purchase FASLA Holding Company,
whose principal holding is First Arizona Savings, a privately held Phoenix-based
federally chartered thrift institution with six retail branch offices and, at
the time, approximately $138 million in assets. The cash purchase price is $15
million, subject to certain adjustments. The acquisition is subject to
regulatory approval which is expected to be received by mid-2000. Due to
ownership restrictions in the current Internal Revenue Code applicable to REITs,
the purchase has been structured such that the Company will pay 95% of the
purchase price for preferred stock of FASLA Holding Company which will represent
95% of the economic interests in FASLA Holding Company and the Manager will pay
5% of the purchase price for common shares with 100% of the voting rights of
FASLA Holding Company which will represent 5% of the economic value of FASLA
Holding Company. In this structure, FASLA Holding Company would be an
unconsolidated qualified taxable REIT subsidiary of the Company. During 1999,
legislation was enacted by the U.S. Congress, effective January 1, 2001, that
will permit REITs to have 100% ownership in qualified taxable subsidiaries,
subject to certain limitations, that would allow the Company and the Manager to
alter this structure such that FASLA Holding Company may become a wholly-owned
taxable subsidiary of the Company that would be consolidated for financial
statement purposes.
The primary purpose of this acquisition is to obtain nationwide lending
authority in order to expand the Company's acquisition channels for ARM loans.
As a federally chartered thrift institution, First Arizona Savings has the
authority to be a nationwide lender. The Company intends to initiate a mortgage
banking division within First Arizona Savings that would originate loans for
sale to the Company, based upon the Company's underwriting standards and ARM
product designs. It will also likely offer other standard loan products,
including fixed-rate loans, that would be originated and sold to third party
investors. The Company expects to avoid establishing an expensive
infrastructure involving substantial fixed costs generally associated with
operating a mortgage banking operation by utilizing private-label "fee based"
third-party vendors who (1) specialize in the underwriting, processing and
closing of mortgage loans and (2) a sub-servicer to provide the capability to
service the loans originated. The Company believes these third-party service
providers have developed both efficiencies and expertise through specialization
that afford the Company an opportunity to enter the mortgage origination and
loan servicing business in a cost effective manner with very little "up front"
investment.
4
The Company also expects to continue operating First Arizona Savings as a full
service community bank within its current local market areas. First Arizona
Savings has traditionally been an originator of single-family residential loans,
both permanent and construction, based on underwriting standards that are
similar to the Company's. First Arizona Savings has generally retained ARM and
Hybrid ARM loans for its portfolio and have sold a significant percentage of
their fixed-rate loan production to FHLMC. First Arizona's primary source of
funds has been retail deposits and a limited amount of Federal Home Loan Bank
advances. The Company believes this business model is a consistent extension of
the Company's existing business model that emphasizes high credit quality
lending and prudent interest rate risk management. Further, the Company
believes that by utilizing third-party service provider specialists for the
mortgage banking division, the Company will be able to operate very cost
effectively with minimal capital at risk consistent with the Company's existing
business model.
Thornburg Brand Development
In 1999, the Company instituted a new marketing approach in conjunction with
affiliates aimed at developing brand recognition of the Thornburg name. In the
process, the Company has refined its marketing message and updated the Company's
logo and corporate literature. The Company began doing business as ("dba")
Thornburg Mortgage, Inc. as of October 14, 1999. In conjunction with these
efforts, the Board of Directors approved an amendment to the Company's Articles
of Incorporation to formally change the name of the Company to Thornburg
Mortgage, Inc. which will be voted on by the shareholders at the Shareholders
Meeting scheduled for April 27, 2000. This new name more accurately reflects
the expanded business of the Company from purely an asset manager to a
value-added operating enterprise that originates and services mortgage loans as
well as manages a portfolio of high quality mortgage assets on a low cost
basis.
OPERATING POLICIES AND STRATEGIES
Investment Strategies
Historically, the Company has relied solely on an investment strategy to
purchase ARM securities and ARM loans originated and serviced by other mortgage
lending institutions. Increasingly, mortgage lending is being conducted by
mortgage lenders who specialize in the origination and servicing of mortgage
loans and then sell these loans to other mortgage investment institutions, such
as the Company. In 1999, the Company expanded its acquisition strategy to
include acquiring assets that meet Thornburg underwriting guidelines through a
new correspondent lending program which currently includes approximately thirty
financial institutions approved by the Company. By increasing its sources for
mortgage loans, the Company expects to enhance its ability to acquire high
quality assets at attractive prices.
The Company purchases ARM assets from broker-dealers and financial institutions
that regularly make markets in these assets. The Company also purchases ARM
assets from other mortgage suppliers, including mortgage bankers, banks, savings
and loans, investment banking firms, home builders and other firms involved in
originating, packaging and selling mortgage loans. The Company believes it has a
competitive advantage in the acquisition and investment of these mortgage
securities and mortgage loans because of the low cost of its operations relative
to traditional mortgage investors like banks and savings and loans. Like
traditional financial institutions, the Company seeks to generate income for
distribution to its shareholders primarily from the difference between the
interest income on its ARM assets and the financing costs associated with
carrying its ARM assets.
In 1998, the Company began investing in hybrid ARM assets ("Hybrid ARMs") which
are included in the Company's references to ARM securities and ARM loans.
Hybrid ARMs are typically 30 year loans that have a fixed rate of interest for
an initial period, generally 3 to 10 years, and then convert to an
adjustable-rate for the balance of the term of the Hybrid ARM. In keeping with
the Company's policy of minimizing interest rate risk in its portfolio, the
Hybrid ARMs are generally financed with fixed rate debt for the period in which
their interest rate is fixed. See "Hedging Strategies".
The Company's mortgage assets portfolio may consist of either agency or
privately issued securities (generally publicly registered) mortgage
pass-through securities, multiclass pass-through securities, collateralized
mortgage obligations ("CMOs"), collateralized bond obligations ("CBOs"),
generally backed by high quality mortgage backed securities, ARM loans, Hybrid
ARMs or short-term investments that either mature within one year or have an
interest rate that reprices within one year. The Company will not invest more
than 30% of its ARM assets in Hybrid ARMs and will limit its interest rate
repricing mismatch (the difference between the remaining fixed-rate period of a
Hybrid ARM and the maturity of the fixed-rate liability funding a Hybrid ARM) to
a duration of no more than one year. On June 15, 1999 the Company's Board of
5
Directors expanded the Company's investment policy to include the acquisition of
Hybrid ARMs with fixed-rate periods of up to ten years from the previous limit
of five years. Hybrid ARMs with fixed-rate periods of greater than five years
are further limited to no more than 10% of the Company's ARM assets. As with
all its Hybrid ARMs, the Company will hedge the interest rate risk of financing
the longer Hybrid ARMs consistent with its hedging strategies. See "Hedging
Strategies".
The Company's investment policy requires the Company to invest at least 70% of
total assets in High Quality adjustable and variable rate mortgage securities
and short-term investments. High Quality means:
(1) securities that are unrated but are guaranteed by the U.S. Government
or issued or guaranteed by an agency of the U.S. Government;
(2) securities which are rated within one of the two highest rating
categories by at least one of either Standard & Poor's or Moody's
Investors Service, Inc. (the "Rating Agencies"); or
(3) securities that are unrated or whose ratings have not been updated but
are determined to be of comparable quality (by the rating standards of
at least one of the Rating Agencies) to a High Quality rated mortgage
security, as determined by the Manager (as defined below) and approved
by the Company's Board of Directors; or
(4) the portion of ARM or hybrid loans that have been deposited into a
trust and have received a credit rating of AA or better from at least
one Rating Agency.
The remainder of the Company's ARM portfolio, comprising not more than 30% of
total assets, may consist of Other Investment assets, which may include:
(1) adjustable or variable rate pass-through certificates, multi-class
pass-through certificates or CMOs backed by loans on single-family,
multi-family, commercial or other real estate-related properties so
long as they are rated at least Investment Grade at the time of
purchase. "Investment Grade" generally means a security rating of BBB
or Baa or better by at least one of the Rating Agencies;
(2) ARM loans secured by first liens on single-family residential
properties, generally underwritten to "A" quality standards, and
acquired for the purpose of future securitization (see description of
"A" quality in "Portfolio of Mortgage Assets - ARM and Hybrid ARM
Loans"); or
(3) a limited amount, currently $70 million as authorized by the Board of
Directors, of less than investment grade classes of ARM securities
that are created as a result of the Company's loan acquisition and
securitization efforts.
Since inception, the Company has generally invested less than 15%, currently
approximately 4%, of its total assets in Other Investment assets, excluding
loans held for securitization. Despite the generally higher yield, the Company
does not expect to significantly increase its investment in Other Investment
securities. This is primarily due to the difficulty of financing such assets at
reasonable financing terms and values through all economic cycles.
The Company does not invest in REMIC residuals or other CMO residuals and,
therefore does not create excess inclusion income or unrelated business taxable
income for tax exempt investors. Therefore, the Company is a mortgage REIT
eligible for purchase by tax exempt investors, such as pension plans, profit
sharing plans, 401(k) plans, Keogh plans and Individual Retirement Accounts
("IRAs").
Acquisition of ARM and Hybrid ARM Loans
The Company acquires existing pools of ARM loans, acquires individual loans
directly from loan originators, and intends to begin offering mortgage loans on
a retail basis. All loans acquired are intended to be securitized and then held
in the ARM securities portfolio as high quality assets. Acquiring ARM loans for
securitization is expected to benefit the Company by providing: (i) greater
control over the quality and types of ARM assets acquired; (ii) the ability to
acquire ARM assets at lower prices so that the amount of the premium to be
amortized will be reduced in the event of prepayment; (iii) additional sources
of new whole-pool ARM assets; and (iv) potentially higher yielding investments
in its portfolio.
The Company acquires residential ARM and Hybrid ARM whole loans utilizing two
processes which the Company calls the Bulk Acquisition Method ("Bulk Method")
and the Flow Acquisition Method ("Flow Method"). The Bulk Method, which the
Company began utilizing in 1997, involves a number of the Company's established
relationships with mortgage originators, or mortgage aggregators, who sell the
Company pools of whole loans at market prices, with the servicing rights,
generally, remaining with the originator or seller. In cases where the Company
6
buys the servicing rights along with the loans, the Company contracts with a
qualified loan servicer to perform the loan servicing function for a fee. In
the Bulk Method, the loans are originated using the seller's loan products,
programs and underwriting guidelines Additionally, the credit review of the
borrower, the appraisal of the property and the quality control procedures are
performed by the originator. The Company generally only considers the purchase
of loans when all of the borrowers have had their incomes and assets verified,
their credit checked and appraisals of the properties have been obtained. The
Company then obtains an independent underwriter's review, performed by a third
party for the benefit of the Company, which entails a review of the application
processing and loan closing methodologies used by the originators in qualifying
a borrower for a loan. In addition, the Company utilizes its own personnel to
re-review some of the individual loans in order to insure the highest possible
loan quality. The Company generally does not review all of the loans in a bulk
package of loans, but rather selects loans for underwriting review based upon
specific criteria such as property location, loan size, effective loan-to-value
ratios, borrowers' credit score and other criteria the Company believes to be
important indicators of credit risk. Additionally, prior to the purchase of
loans, the Company obtains representations and warranties from each seller
stating that each loan meets the seller's underwriting standards and other
requirements. The breach of such representations and warranties in regards to a
loan can result in the seller having an obligation to repurchase the loan.
In the Flow Method, which the Company began utilizing in the first half of 1999,
the Company acquires mortgage loans from correspondent lenders using the
Company's internally developed loan programs and underwriting criteria. This
means that the correspondent originates the individual loans using the Company's
established credit and program guidelines. All correspondents are pre-qualified
by the Company to determine their financial strength and the soundness of their
own established in-house mortgage procedures. Each borrower's credit and the
value of each property is underwritten by the correspondents to the Company's
specifications. This is the same process used by originators/sellers in the
Bulk Method except that in the Flow Method all of the application processing,
loan underwriting, credit approval and appraisal guidelines have been developed
by the Company to meet the Company's own credit criteria and portfolio
requirements.
Prior to closing, all of the loans acquired in the Flow Method are then
subjected to further credit review by mortgage insurance companies that also use
the Company's guidelines to review the loans to insure product quality and
compliance with the Company's guidelines. The three mortgage insurance
companies chosen by the Company to perform this function use a two-step loan
approval process. After the credit review and quality control review are
performed by the originator/seller, but prior to the purchase of the loans by
the Company, all of the higher risk/higher LTV loans are placed through an
automated underwriting system created by Fannie Mae ("FNMA") called "Desktop
Underwriter." This is the same system used by Fannie Mae in connection with
all of their own loan purchases. Secondly, all loans are then screened by the
mortgage insurance company personnel to verify their compliance to the Company's
guidelines. After closing, a select number of these loans are then subjected to
an additional quality control review performed by a third party which again
verifies that the loan was properly underwritten and to confirm that the loan
documents are complete and properly executed. All of the loans acquired through
the Flow Method are assigned a "Risk Evaluation Score" or "Mortgage Score" by
each of the mortgage insurance companies. The risk score evaluates not only the
borrower's credit but also the geographic location of the property, the economic
viability of the area, the general market conditions and the loan product chosen
by the borrower. The Company believes that obtaining risk scores will help in
reducing the Company's securitization costs by insuring that the Company
purchases the highest quality mortgage loans with the lowest risk possible.
Mortgage loans acquired through the Flow Method are acquired, generally, with
the servicing rights remaining with the originator/seller. In cases where the
Company buys the servicing rights along with the loans, the Company contracts
with a qualified loan servicer to perform the loan servicing function for a fee.
The Company obtains representations and warranties from each seller or program
participant stating that each loan meets the Company's underwriting standards
and other requirements. The breach of such representations and warranties in
regards to a loan can result in the seller having an obligation to repurchase
the loan.
In both methods the Company uses its in-house staff as well as third party
credit underwriters to verify the credit quality of the borrowers as well as the
soundness of the mortgage collateral securing the individual loans. As added
security, the Company uses the services of a third party document custodian to
insure the quality and accuracy of all individual mortgage loan documents, which
are then held in safekeeping with the third-party document custodian. As a
result, all of the original individual loan documents that are signed by the
borrower, other than the original credit verification documents, are examined,
verified and held by the custodian.
7
The Company's retail lending strategy is to utilize technology to become the
mortgage lender of the future, which is a low cost, low overhead, efficient
lender that provides attractive and innovative mortgage products, competitive
mortgage rates, and a high level of customer service. By eliminating
intermediaries between the borrower and the Company, an investor in mortgage
assets, the Company expects to originate loans at attractive prices while still
offering borrowers attractive mortgage rates. In expanding into the retail
origination business, the Company intends to continue its strategy of acquiring
only "A" quality mortgages with the same emphasis on loan quality as in its
current loan acquisition activities.
In 2000, the Company expects to begin originating loans directly with borrowers
using two origination channels. One channel the Company expects to employ is to
originate loans using a telemarketing operation, where borrowers will be able to
call the Company, or its representatives, inquire about loan products and
interest rates, seek advice and counseling regarding qualifying for a loan and
the approval process. Prospective borrowers will be able to apply for a loan
over the telephone and receive pre-approval before the call is complete. A
completed mortgage loan application along with a request for additional
supporting documentation will be sent to the borrower for signature. Thornburg
Mortgage loan processors, or their third party agents, will be responsible for
working with the borrower to complete the processing of the loan application,
obtain a final loan approval and schedule the loan for closing.
The second channel the Company expects to employ is to originate loans through
the Company's website. In this instance, prospective borrowers will be able to
look up mortgage loan product and interest rate information through the
Company's website, seek an on-line pre-approval of their loan and submit a
mortgage loan application for processing, underwriting and closing. Once a
mortgage loan application has been submitted, a Thornburg Mortgage
representative will be assigned the responsibility for completing the loan
process on behalf of the borrower.
The Company expects to begin originating loans through one or both of these
channels during the first half of 2000. Initially, the Company intends to
originate mortgage loans through Thornburg Mortgage Home Loans, Inc., a newly
created subsidiary of Thornburg Mortgage, Inc. licensed to originate loans in
the state of New Mexico, and which is also able to originate loans in Colorado,
Utah and Texas. In the latter half of 2000, the Company intends to expand its
direct origination capability to a nationwide program upon approval and closing
of the Company's acquisition of First Arizona Savings. Once the First Arizona
Savings acquisition closes, the Company will then have a nationwide lending
license in order to pursue its objectives.
The mortgage origination process is a labor intensive, document intensive
business that requires significant back office systems and personnel. The
Company is in the process of contracting with a third party "back office"
mortgage service provider who would provide all of the loan processing,
underwriting, documentation and closing functions required to originate and
close mortgage loans. Additionally, this third party service provider will also
staff a mortgage loan call center for the benefit of Thornburg Mortgage. The
third party service provider will also build a "Thornburg Team" consisting of
loan counseling representatives, loan processors, underwriters and loan closers.
These services will be provided on a "private label" basis, meaning that all of
these representatives will identify themselves as being Thornburg Mortgage
representatives. The benefit to Thornburg Mortgage of this arrangement is that
the Company will pay for these services as it uses them, based on closed loans,
without a significant investment in personnel, systems, office space and
equipment.
For both of these origination channels, the Company expects that its prospective
borrowers will be able to track the progress of their mortgage loan application
as it makes its way through processing, underwriting and closing using the
Thornburg Mortgage website. In this way, prospective borrowers will be able to
stay fully informed regarding the status of their loan application.
The Company has also contracted with a third party to provide private label loan
servicing for loans which the Company originates. This third party sub-servicer
will collect mortgage loan payments, manage escrow accounts, provide coupon
payment books and notices to borrowers, offer on-line mortgage servicing
information and provide customer service, loan collection, loss mitigation,
foreclosure, bankruptcy and REO management services. The fees paid by the
Company for this service are based on a fixed rate schedule based on the number
of loans serviced. A third party service provider using the name Thornburg
Mortgage is providing all of these loan-servicing functions.
In addition, the Company is in discussions with providers of web-based mortgage
origination systems which are paid on a per closed loan basis. The Company
intends to offer mortgages online utilizing third party, private label web-based
origination systems that will offer the Company's mortgage products,
underwritten to the Company's guidelines, for sale to the Company.
8
Securitization of ARM Loans
The Company acquires ARM loans for its portfolio with the intention of
securitizing them in such a way as to maximize the amount of high quality
securities that can be created from an accumulation of the ARM loans. In order
to facilitate the securitization of its loans, the Company generally retains a
subordinate interest in the loans which provides a limited amount of credit
enhancement, and often purchases an insurance policy from a third party
financial guarantor that "wraps" the remaining balance of the loans to a credit
rating of AA or better. Upon securitization, the Company then owns the high
quality ARM securities and the subordinate certificates in its portfolio and
finances the high quality securities in the repurchase agreement market, or
issues debt obligations in the capital markets as an alternative financing
source to the repurchase agreement market.
In 1999, the Company began securitizing its conforming balance loans through a
program provided by FNMA. See "FNMA Loan Programs". The Company exchanged a
pool of its loans with balances no greater than $242,000 for a FNMA
Mortgage-Backed Security or MBS. As described in the "FNMA Loan Programs"
below, the Company receives an MBS which pays the Company interest and principal
derived from the interest and principal payments on the underlying mortgages
less a fee paid to the servicer of the loans and less a guaranty fee paid to
FNMA. In this way, the Company no longer has any credit exposure to the pool of
mortgages and has exchanged the pool of mortgages for a High Quality asset.
Financing Strategies
The Company employs a leveraging strategy to increase its assets by borrowing
against its ARM assets and then using the proceeds to acquire additional ARM
assets. By leveraging its portfolio in this manner, the Company expects to
maintain an equity-to-assets ratio between 8% and 10%, when measured on a
historical cost basis. The Company believes that this level of capital is
sufficient to allow the Company to continue to operate in interest rate
environments in which the Company's borrowing rates might exceed its portfolio
yield. These conditions could occur when the interest rate adjustments on the
ARM assets lag the interest rate increases in the Company's variable rate
borrowings or when the interest rate of the Company's variable rate borrowings
are mismatched with the interest rate indices of the Company's ARM assets. The
Company also believes that this capital level is adequate to protect the Company
from having to sell assets during periods when the value of its ARM assets are
declining. If the ratio of the Company's equity-to-total assets, measured on a
historical cost basis, falls below 8%, the Company will take action to increase
its equity-to-assets ratio to 8% of total assets or greater, when measured on a
historical cost basis, through normal portfolio amortization, raising equity
capital, sale of assets or other steps as necessary.
The Company's ARM assets are financed primarily at short-term borrowing rates
and can be financed utilizing reverse repurchase agreements, dollar-roll
agreements, borrowings under lines of credit and other secured or unsecured
financings which the Company may establish with approved institutional lenders.
Prior to 1998, reverse repurchase agreements had been the primary source of
financing utilized by the Company to finance its ARM assets. Since 1998,
however, the Company has diversified its financing sources by issuing debt in
the capital markets as described below. As of December 31, 1999, capital
markets debt represents 23% of the Company's total debt obligations. Generally,
upon repayment of each reverse repurchase agreement, the ARM assets used to
collateralize the financing will immediately be pledged to secure a new reverse
repurchase agreement. The Company has established lines of credit and
collateralized financing agreements with twenty-five different financial
institutions.
Reverse repurchase agreements take the form of a simultaneous sale of pledged
assets to a lender at an agreed upon price in return for the lender's agreement
to resell the same assets back to the borrower at a future date (the maturity of
the borrowing) at a higher price. The price difference is the cost of borrowing
under these agreements. In the event of the insolvency or bankruptcy of a
lender during the term of a reverse repurchase agreement, provisions of the
Federal Bankruptcy Code, if applicable, may permit the lender to consider the
agreement to resell the assets to be an executory contract that, at the lender's
option, may be either assumed or rejected by the lender. If a bankrupt lender
rejects its obligation to resell pledged assets to the Company, the Company's
claim against the lender for the damages resulting therefrom may be treated as
one of many unsecured claims against the lender's assets. These claims would be
subject to significant delay and, if and when payments are received, they may be
substantially less than the damages actually suffered by the Company. To
mitigate this risk the Company enters into collateralized borrowings with only
financially sound institutions approved by the Board of Directors, including a
majority of unaffiliated directors, and monitors the financial condition of such
institutions on a regular, periodic basis.
9
The Company also utilizes capital market transactions by issuing debt
collateralized by specific pools of ARM assets that are placed in a trust. The
financing of ARM assets in this way eliminates the risk of margin calls on the
financing of those ARM assets and limits the Company's exposure to credit risk
on the ARM and Hybrid ARM loans collateralizing such debt. The Company receives
a credit rating on the debt based on the quality of the ARM assets, amount of
any credit enhancement obtained and subordination levels of the debt proscribed
by the rating agency(ies), all of which affects the interest rate at which the
debt can be issued. The principal and interest payments on the debt are paid by
the trust out of the cash flows received on the collateral. By utilizing such a
structure, the Company can issue either floating rate debt indexed to various
indices that more closely matches the characteristics of the collateralized ARM
assets, depending upon market constraints and conditions, or fixed rate debt
that corresponds to the characteristics of collateralized Hybrid ARM loans.
The Company also enters into financing facilities for whole loans. The Company
uses these credit lines to finance its acquisition of whole loans while it is
accumulating loans for securitization or until more permanent financing is
arranged in a capital markets collateralized debt transaction. In 1998, the
Company utilized two whole loan financing facilities that provided the Company
with uncommitted lines of credit based on the market value of its whole loans.
Uncommitted lines of credit are generally less expensive than a committed line
of credit, but during periods of market turmoil, uncommitted lines of credit can
be terminated by the counterparty with little notice to the Company and at a
time when the Company would have difficulty in replacing the line of credit.
Therefore, beginning in 1999, the Company has decided to negotiate and pay a fee
for committed facilities as well as continue to utilize uncommitted facilities.
During January 2000, the Company renewed one committed facility in the amount of
$150,000,000, which the Company can increase to $300,000,000 for an additional
fee, and has other uncommitted facilities in place.
The Company mitigates its interest-rate risk from borrowings by selecting
maturities that approximately match the interest-rate adjustment periods on its
ARM assets. Accordingly, borrowings bear variable or short-term fixed (one year
or less) interest rates. Generally, the borrowing agreements require the
Company to deposit additional collateral in the event the market value of
existing collateral declines, which, in dramatically rising interest rate
markets, could require the Company to sell assets to reduce the borrowings.
The Company's Bylaws limit borrowings, excluding the collateralized borrowings
in the form of reverse repurchase agreements, dollar-roll agreements and other
forms of collateralized borrowings discussed above, to no more than 300% of the
Company's net assets, on a consolidated basis, unless approved by a majority of
the unaffiliated directors. This limitation generally applies only to unsecured
borrowings of the Company. For this purpose, the term "net assets" means the
total assets (less intangibles) of the Company at cost, before deducting
depreciation or other non-cash reserves, less total liabilities, as calculated
at the end of each quarter in accordance with generally accepted accounting
principles. Accordingly, the 300% limitation on unsecured borrowings does not
affect the Company's ability to finance its total assets with collateralized
borrowings.
Hedging Strategies
The Company makes use of hedging transactions to mitigate the impact of certain
adverse changes in interest rates on its net interest income. In general, ARM
assets have a maximum lifetime interest rate cap, or ceiling, meaning that each
ARM asset contains a contractual maximum rate. The borrowings incurred by the
Company to finance its ARM assets portfolio are not subject to equivalent
interest rate caps. Accordingly, the Company purchases interest rate cap
agreements ("Cap Agreements") to prevent the Company's borrowing costs from
exceeding the lifetime maximum interest rate on its ARM assets. These Cap
Agreements have the effect of offsetting a portion of the Company's borrowing
costs if prevailing interest rates exceed the rate specified in the Cap
Agreement. A Cap Agreement is a contractual agreement for which the Company
pays a fee, which may at times be financed, typically to either a commercial
bank or investment banking firm. Pursuant to the terms of the Cap Agreements
owned as of December 31, 1999, the Company will receive cash payments if the
applicable index, generally the one-month, three-month, six-month LIBOR index or
Prime, increases above certain specified levels, which range from 7.10% to
13.00% and average approximately 9.96%. The fair value of these Cap Agreements
also tends to increase when general market interest rates increase and decrease
when market interest rates decrease, helping to partially offset changes in the
fair value of the Company's ARM assets.
In addition, ARM assets are generally subject to periodic caps. Periodic caps
generally limit the maximum interest rate coupon change on any interest rate
coupon adjustment date to either a maximum of 1% per semiannual adjustment or 2%
10
per annual adjustment. The borrowings incurred by the Company do not have
similar periodic caps. The Company generally does not hedge against the risk of
its borrowing costs rising above the periodic interest rate cap level on the ARM
assets because the contractual future interest rate adjustments on the ARM
assets will cause their interest rates to increase over time and reestablish the
ARM assets' interest rate to a spread over the then current index rate. The
Company attempts to mitigate the effect of periodic caps in several ways.
First, the yield on the Company's ARM assets can change by more that the 1% or
2% per periodic interest rate adjustment limitation depending upon how
prepayment activity changes as interest rates change. Secondly, beginning in
1998, the Company began to acquire variable rate CMOs and CBOs ("Floaters"),
Hybrid ARMs and certain other ARM loans that do not have a periodic cap. As of
December 31, 1999, approximately $2.074 billion of the Company's ARM securities
and ARM loans did not have periodic caps or were Hybrid ARMs, representing
approximately 48% of total ARM assets.
The Hybrid ARMs have an initial fixed rate period, generally 3 to 5 years.
Since the Company's borrowings are generally short-term, the Company enters into
interest rate swap agreements that limits its interest rate repricing mismatch
(the difference between the remaining fixed-rate period of a Hybrid ARM and the
maturity of the fixed-rate liability funding a Hybrid ARM) to a duration of no
more than one year. In accordance with the terms of these swap agreements, the
Company pays a fixed rate of interest during the term of the agreements, and
receives a payment that varies monthly with the one month LIBOR Index. The
Company generally enters into a swap that amortizes at an agreed upon prepayment
rate based on the Company's estimate of the expected rate of principal
amortization of the Hybrid ARMs being financed. In similar fashion, the Company
has purchased Cap Agreements to limit the interest rate of financing Hybrid ARMs
during their fixed rate term, generally for three to ten years. In general, the
cost of financing Hybrid ARMs hedged with Cap Agreements is capped at a rate
that is 0.75% to 1.00% below the fixed Hybrid ARM interest rate.
The Company may also enter into interest rate swap agreements to manage the
average interest rate reset period on its borrowings. In accordance with the
terms of the swap agreements, the Company pays a fixed rate of interest during
the term of the agreements and receives a payment that varies monthly with the
one month LIBOR Index. These agreements have the effect of fixing the Company's
borrowing costs on a similar amount of swaps owned by the Company and, as a
result, the Company reduces the interest rate variability of its borrowings.
The Company may also use interest rate swap agreements from time to time to
change from one interest rate index to another interest rate index and thus
decrease further the basis risk between the Company's interest yielding assets
and the financing of such assets.
The ARM assets held by the Company were generally purchased at prices greater
than par. The Company is amortizing the premiums paid for these assets over
their expected lives using the level yield method of accounting. To the extent
that the prepayment rate on the Company's ARM assets differs from expectations,
the Company's net interest income will be affected. Prepayments generally
increase when mortgage interest rates fall below the interest rates on ARM
loans. To the extent there is an increase in prepayment rates, resulting in a
shortening of the expected lives of the Company's ARM assets, the Company's net
income and, therefore, the amount available for dividends could be adversely
affected. To mitigate the adverse effect of an increase in prepayments on the
Company's ARM assets, the Company has purchased ARM assets at prices at or below
par, however the Company's portfolio of ARM assets is currently held at a net
premium. The Company may also purchase limited amounts of "principal only"
mortgage derivative assets backed by either fixed-rate mortgages or ARM assets
as a hedge against the adverse effect of increased prepayments. To date, the
Company has not purchased any "principal only" mortgage derivative assets.
The Company also enters into hedging transactions in connection with the
purchase of Hybrid ARMs to minimize the impact of changes in financing rates
between the trade date and the settlement date. Generally, the Company hedges
the cost of obtaining future fixed-rate financing by entering into a commitment
to sell similar duration fixed-rate mortgage-backed securities ("MBS") on the
trade date and settles the commitment by purchasing the same fixed-rate MBS on
the purchase date. Realized gains and losses are deferred and amortized as a
yield adjustment to the financing over the fixed-rate period of the Hybrid ARMs.
The Company may enter into other hedging-type transactions designed to protect
its borrowings costs or portfolio yields from interest rate changes. The
Company may also purchase "interest only" mortgage derivative assets or other
derivative products for purposes of mitigating risk from interest rate changes.
The Company has not, to date, entered into these types of transactions, but may
do so in the future. In 1999, the Board of Directors approved an expansion of
the financial instruments with which the Company currently implements its
hedging strategies. In addition to the instruments described above, the Company
will also utilize from time to time futures contracts and options on futures
11
contracts on the Eurodollar, Fed Funds, Treasury bills and Treasury notes and
similar financial instruments. Utilization of these instruments is dependent
upon the Company being properly registered and receiving an exemption from being
classified as a "Commodity Pool Operator" by the Commodities and Futures Trade
Commission.
Hedging transactions currently utilized by the Company generally are designed to
protect the Company's net interest income during periods of changing market
interest rates. The Company does not intend to hedge for speculative purposes.
Further, no hedging strategy can completely insulate the Company from risk, and
certain of the federal income tax requirements that the Company must satisfy to
qualify as a REIT limit the Company's ability to hedge, particularly with
respect to hedging against periodic cap risk. The Company carefully monitors
and may have to limit its hedging strategies to ensure that it does not realize
excessive hedging income, or hold hedging assets having excess value in relation
to total assets. See "Federal Income Tax Considerations - Requirements for
Qualification as a REIT".
Operating Restrictions
The Board of Directors has established the Company's operating policies and any
revisions in the operating policies and strategies require the approval of the
Board of Directors, including a majority of the unaffiliated directors. Except
as otherwise restricted, the Board of Directors has the power to modify or alter
the operating policies without the consent of shareholders. Developments in the
market which affect the operating policies and strategies mentioned herein or
which change the Company's assessment of the market may cause the Board of
Directors (including a majority of the unaffiliated directors) to revise the
Company's operating policies and financing strategies.
In the event the rating of an ARM security held by the Company is reduced by the
Rating Agencies to below Investment Grade after acquisition by the Company, the
asset may be retained in the Company's investment portfolio if the Manager
recommends that it be retained and the recommendation is approved by the Board
of Directors (including a majority of the unaffiliated directors).
The Company has elected to qualify as a REIT for tax purposes. The Company has
adopted certain compliance guidelines which include restrictions on the
acquisition, holding and sale of assets. Prior to the acquisition of any asset,
the Company determines whether such asset will constitute a "Qualified REIT
Asset" as defined by the Internal Revenue Code of 1986, as amended (the "Code").
Substantially all the assets that the Company has acquired and will acquire for
investment are expected to be Qualified REIT Assets. This policy limits the
investment strategies that the Company may employ.
The Company closely monitors its purchases of ARM assets and the income from
such assets, including from its hedging strategies, so as to ensure at all times
that it maintains its qualification as a REIT. The Company developed certain
accounting systems and testing procedures with the help of qualified accountants
and tax experts to facilitate its ongoing compliance with the REIT provisions of
the Code. See "Federal Income Tax Considerations - Requirements for
Qualification as a REIT". No changes in the Company's investment policies and
operating policies and strategies, including credit criteria for mortgage asset
investments, may be made without the approval of the Company's Board of
Directors, including a majority of the unaffiliated directors.
The Company at all times intends to conduct its business so as not to become
regulated as an investment company under the Investment Company Act of 1940.
The Investment Company Act exempts entities that are "primarily engaged in the
business of purchasing or otherwise acquiring mortgages and other liens on and
interests in real estate" ("Qualifying Interests"). Under current
interpretation 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 mortgage assets represent all the
certificates issued with respect to an underlying pool of mortgages, such
mortgage assets may be treated as assets separate from the underlying mortgage
loans and, thus, may not be considered Qualifying Interests for purposes of the
55% requirement. The Company closely monitors its compliance with this
requirement and intends to maintain its exempt status. Up to the present, the
Company has been able to maintain its exemption through the purchase of whole
pool government agency and privately issued ARM securities and loans that
qualify for the exemption. See "Portfolio of Mortgage Assets - Pass-Through
Certificates - Privately Issued ARM Pass-Through Certificates".
The Company does not purchase any assets from or enter into any servicing or
administrative agreements (other than the Management Agreement) with any
entities affiliated with the Manager. Any changes in this policy would be
subject to approval by the Board of Directors, including a majority of the
unaffiliated directors.
12
PORTFOLIO OF MORTGAGE ASSETS
As of December 31, 1999, ARM assets comprised approximately 99% of the Company's
total assets. The Company has invested in the following types of mortgage
assets in accordance with the operating policies established by the Board of
Directors and described in "Business - Operating Policies and Strategies -
Operating Restrictions".
PASS-THROUGH CERTIFICATES
The Company's investments in mortgage assets are concentrated in High Quality
ARM pass-through certificates which account for approximately 77% of ARM assets
held. These High Quality ARM pass-through certificates consist of Agency
Certificates and privately issued ARM pass-through certificates that meet the
High Quality credit criteria. These High Quality ARM pass-through certificates
acquired by the Company represent interests in ARM loans which are secured
primarily by first liens on single-family (one-to-four units) residential
properties, although the Company may also acquire ARM pass-through certificates
secured by liens on other types of real estate-related properties. The Company
also includes in this category of assets a portion of the ARM and Hybrid ARM
loans that have been deposited in a trust and held as collateral for its notes
payable in the amount equivalent to the AAA portion of the debt issued by the
trust. The ARM pass-through certificates, including the ARM and Hybrid ARM
loans collateralizing notes payable, acquired by the Company are generally
subject to periodic interest rate adjustments, as well as periodic and lifetime
interest rate caps which limit the amount an ARM security's interest rate can
change during any given period.
The following is a discussion of each type of pass-through certificate held by
the Company as of December 31, 1999:
FHLMC ARM Programs
FHLMC is a shareholder-owned government sponsored enterprise created pursuant to
an Act of Congress on July 24, 1970. The principal activity of FHLMC consists
of the purchase of first lien, conventional residential mortgages, including
both whole loans and participation interests in such mortgages and the resale of
the loans and participations in the form of guaranteed mortgage assets. During
1999, FHLMC purchased $16.5 billion of ARM loans to securitize into ARM
13
certificates and as of December 31, 1999, there was $35.1 billion of all types
of FHLMC ARM certificates outstanding, of which FHLMC held $17.1 billion in its
own portfolio.
Each FHLMC ARM Certificate issued to date has been issued in the form of a
pass-through certificate representing an undivided interest in a pool of ARM
loans purchased by FHLMC. The ARM loans included in each pool are fully
amortizing, conventional mortgage loans with original terms to maturity of up to
40 years secured by first liens on one-to-four unit family residential
properties or multi-family properties. The interest rate paid on FHLMC ARM
Certificates adjust periodically on the first day of the month following the
month in which the interest rates on the underlying mortgage loans adjust.
FHLMC guarantees to each holder of its ARM Certificates the timely payment of
interest at the applicable pass-through rate and ultimate collection of all
principal on the holder's pro rata share of the unpaid principal balance of the
related ARM loans, but does not guarantee the timely payment of scheduled
principal of the underlying mortgage loans. The obligations of FHLMC under its
guarantees are solely those of FHLMC and are not backed by the full faith and
credit of the U.S. Government. If FHLMC were unable to satisfy such
obligations, distributions to holders of FHLMC ARM Certificates would consist
solely of payments and other recoveries on the underlying mortgage loans and,
accordingly, monthly distributions to holders of FHLMC ARM Certificates would be
affected by delinquent payments and defaults on such mortgage loans.
FNMA ARM Programs
FNMA is a federally chartered and privately owned corporation organized and
existing under the Federal National Mortgage Association Charter Act. FNMA
provides funds to the mortgage market primarily by purchasing home mortgage
loans from mortgage loan originators, thereby replenishing their funds for
additional lending. FNMA established its first ARM programs in 1982 and
currently has several ARM programs under which ARM certificates may be issued,
including programs for the issuance of assets through REMICs under the Code.
During 1999, FNMA issued $11.8 billion of FNMA ARM certificates and as of
December 31, 1999, FNMA held $13.4 billion in its own portfolio.
Each FNMA ARM Certificate issued to date has been issued in the form of a
pass-through certificate representing a fractional undivided interest in a pool
of ARM loans formed by FNMA. The ARM loans included in each pool are fully
amortizing conventional mortgage loans secured by a first lien on either
one-to-four family residential properties or multi-family properties. The
original term to maturity of the mortgage loans generally does not exceed 40
years. FNMA has issued several different series of ARM Certificates. Each
series bears an initial interest rate and margin tied to an index based on all
loans in the related pool, less a fixed percentage representing servicing
compensation and FNMA's guarantee fee.
FNMA guarantees to the registered holder of a FNMA ARM Certificate that it will
distribute amounts representing scheduled principal and interest (at the rate
provided by the FNMA ARM Certificate) on the mortgage loans in the pool
underlying the FNMA ARM Certificate, whether or not received, and the full
principal amount of any such mortgage loan foreclosed or otherwise finally
liquidated, whether or not the principal amount is actually received. The
obligations of FNMA under its guarantees are solely those of FNMA and are not
backed by the full faith and credit of the U.S. Government. If FNMA were unable
to satisfy such obligations, distributions to holders of FNMA ARM Certificates
would consist solely of payments and other recoveries on the underlying mortgage
loans and, accordingly, monthly distributions to holders of FNMA ARM
Certificates would be affected by delinquent payments and defaults on such
mortgage loans.
Privately Issued ARM Pass-Through Certificates
Privately issued ARM Pass-Through Certificates are structured similar to the
Agency Certificates discussed above but are issued by originators of, and
investors in, mortgage loans, including savings and loan associations, savings
banks, commercial banks, mortgage banks, investment banks and special purpose
subsidiaries of such institutions. Privately issued ARM pass-through
certificates are usually backed by a pool of non-conforming conventional
adjustable-rate mortgage loans and are generally structured with one or more
types of credit enhancement, including pool insurance, guarantees, or
subordination. Accordingly, the privately issued ARM pass-through certificates
typically are not guaranteed by an entity having the credit status of FHLMC or
FNMA.
Privately issued ARM pass-through certificates credit enhanced by mortgage pool
insurance provide the Company with an alternative source of ARM assets (other
than Agency ARM assets) that meet the Qualifying Interests test for purposes
maintaining the Company's exemption under the Investment Company Act of 1940.
Since the inception of the Company in 1993, most of the providers of mortgage
pool insurance have stopped providing such insurance. Although, in 1999, the
Company was successful in negotiating a new pool insurance policy for a one of
the privately-issued ARM Pass-Through Certificates it purchased. Since these
opportunities are rare, the Company has increased its investment in Agency ARM
securities and in whole loans as its primary sources of Qualifying Interests in
real estate.
COLLATERALIZED MORTGAGE OBLIGATIONS ("CMOS"), MULTICLASS PASS-THROUGH ASSETS AND
COLLATERALIZED BOND OBLIGATIONS ("CBOS")
CMOs are debt obligations, ordinarily issued in series and most commonly backed
by a pool of fixed rate mortgage loans or pass-through certificates, each of
which consists of several serially maturing classes. Multiclass pass-through
securities are equity interests in a trust composed of similar underlying
mortgage assets. Generally, principal and interest payments received on the
underlying mortgage-related assets securing a series of CMOs or multiclass
pass-through securities are applied to principal and interest due on one or more
classes of the CMOs of such series or to pay scheduled distributions of
principal and interest on multiclass pass-throughs.
The CBOs acquired by the Company, like CMOs, are debt obligations, but, in the
case of CBOs, are secured by security interests in portfolios of high quality,
low duration, mortgage-backed, asset-backed and other fixed and floating rate
securities managed by third-parties. The Company only acquires CBO's that have
portfolios that consist primarily of either real estate qualifying assets or
high quality mortgage backed securities. In a CBO transaction, principal and
interest payments are used to pay current period interest and any excess is
reinvested into the portfolio. The amount of proceeds at maturity, on the CBO
classes owned by the Company, is generally dependent upon the total rate of
return performance of the underlying collateral and can result in a final
redemption value that is less than the face value of the investment. CBOs
typically don't amortize monthly, rather they mature on a specific maturity
date.
14
Scheduled payments of principal and interest on the mortgage-related assets and
other collateral securing a series of CMOs, CBOs or multiclass pass-throughs are
intended to be sufficient to make timely payments of principal and interest on
such issues or securities and to retire each class of such obligations at their
stated maturity.
Multiclass pass-through securities backed by ARM assets or ARM loans owned by
the Company are typically structured into classes designated as senior classes,
mezzanine classes and subordinated classes. The Company also owns variable rate
classes of CMOs and CBOs that are backed by both fixed- and adjustable-rate
mortgages that are issued by FHLMC, FNMA and other private issuers.
The senior classes in a multiclass pass-through security generally have first
priority over all cash flows and consequently have the least amount of credit
risk since principal losses are generally covered by mortgage pool insurance
policies or are charged against the subordinated classes in order of
subordination. As a result of these features, the senior classes receive the
highest credit rating from Rating Agencies of the series of classes for each
multiclass pass-through security.
The mezzanine classes of a multiclass pass-through security generally have a
slightly greater risk of principal loss than the senior classes since they
provide some credit enhancement to the senior classes. In most, but not all,
instances, mezzanine classes participate on a pro-rata basis with senior classes
in their right to receive cash flow and have expected lives similar to the
senior classes. In other instances, mezzanine classes are subordinate in their
right to receive cash flow and have average lives that are longer than the
senior classes. However, in all cases, a mezzanine class has a similar or
slightly lower credit rating than the senior class from the Rating Agencies.
Generally, the mezzanine classes that the Company has acquired are rated High
Quality.
Subordinated classes are junior in the right to receive payment from the
underlying mortgages to other classes of a multiclass pass-through security.
The subordination provides credit enhancement to the senior and mezzanine
classes. Subordinated classes may be at risk for some payment failures on the
mortgage loans securing or underlying such assets and generally represent a
greater level of credit risk as they are responsible for bearing the risk of
credit loss on all of the outstanding loans underlying a CMO, CBO or multi-class
pass-through. As a result of being subject to more credit risk, subordinated
classes generally have lower credit ratings relative to the senior and mezzanine
classes.
The Subordinated classes which the Company has acquired were all rated at least
Investment Grade at the time of purchase by one of the Rating Agencies, and in
certain cases are High Quality, or were created as part of the Company's process
of securitizing whole loans. The Subordinated classes acquired by the Company
in the open market are limited in amount and bear yields which the Company
believes are commensurate with the increased risks involved. In general, the
Company acquires subordinated classes when they are seasoned and when the more
senior classes of the multi-class security have been paid down to levels that
mitigate the risk of non-payment on the subordinate classes.
The market for Subordinated classes is not extensive and at times may be
illiquid. In addition, the Company's ability to sell Subordinated classes is
limited by the REIT Provisions of the Code. The Company has not purchased any
Subordinated classes that are not Qualified REIT Assets. The Subordinated
classes acquired by the Company, which are not High Quality, together with the
Company's other investments in Other Investment assets, may not, in the
aggregate, comprise more than 30% of the Company's total assets, in accordance
with the Company's investment policy.
The variable rate classes of CMOs and CBOs, or Floaters, owned by the Company
generally float at a spread to the one-month LIBOR index and are backed by
mortgages that are either fixed-rate or are adjustable-rate mortgages indexed to
the one-year U. S. Treasury yield or a Cost of Funds index.
ARM AND HYBRID ARM LOANS
The ARM and Hybrid ARM loans the Company has acquired are all first mortgages on
single-family residential properties. Some have additional collateral in the
form of pledged financial assets. The Company acquires loans that are generally
underwritten to "A" quality standards. The Company considers loans to be "A"
quality when they are underwritten in such a way as to assure that the borrower
has adequate verified income to make the required loan payment, adequate
verified equity in the underlying property, and by the borrower's willingness
15
and ability to repay the mortgage as demonstrated by a good credit history. As
a result, the loans acquired by the Company are generally fully documented loans
to borrowers with good credit histories, adequate income to support the monthly
mortgage payment, adequate assets to close the loan, with 80% or lower effective
loan-to-value ratios based on independently appraised property values or are
seasoned loans with over five years or more of good payment history.
When acquiring ARM and Hybrid ARM loans, either originated specifically for the
Company or when the Company acquires pools of loans in bulk, the Company focuses
its attention on key aspects of a borrower's profile and the characteristics of
a mortgage loan product that the Company believes are most important in insuring
excellent loan performance and minimal credit exposure. The Company's loan
programs focus on larger down payments, excellent borrower credit history (as
measured by a credit report and a credit score) and a conservative appraisal
process. If an ARM or Hybrid ARM loan acquired has a loan-to-property-value
that is above 80%, then the borrower is required to pay for private mortgage
insurance providing additional protection to the Company against credit risk.
The loans acquired have original maturities of forty years or less. The ARM and
Hybrid ARM loans are either fully amortizing or are interest only for up to ten
years and fully amortizing thereafter. All ARM loans acquired bear an interest
rate that is tied to an interest rate index and some have periodic and lifetime
constraints on how much the loan interest rate can change on any predetermined
interest rate reset date. In general, the interest rate on each ARM loan resets
at a frequency that is either monthly, semi-annually or annually. The ARM loans
generally adjust based upon the following indices: a U.S. Treasury Bill index, a
LIBOR index, a Certificate of Deposit index, a Cost of Funds index or Prime.
The Hybrid ARM loans have an initial fixed rate period, generally 3 to 10 years,
and then they convert to an ARM loan with the features of an ARM loan described
above.
16
RISK FACTORS
FORWARD-LOOKING STATEMENTS
In accordance with the Private Securities Litigation Reform Act of 1995
(the "1995 Act"), the Company can obtain a "Safe Harbor" for forward-looking
statements by identifying those statements and by accompanying those statements
with cautionary statements which identify factors that could cause actual
results to differ from those in the forward-looking statements. Accordingly,
the following information contains or may contain forward-looking statements:
(1) information included in this Annual Report on Form 10-K, including, without
limitation, statements made regarding investments in ARM securities and ARM
loans, and Hybrid ARM loans, hedging, leverage, interest rates and statements in
Item 7, Management's Discussion and Analysis of Financial Condition and Results
of Operations, (2) information included in future filings by the Company with
the Securities and Exchange Commission including, without limitation, statements
with respect to growth, projected revenues, earnings, returns and yields on its
portfolio of mortgage assets, the impact of interest rates, costs, and business
strategies and plans, and (3) information contained in the Company's Annual
Report or other written material, releases and oral statements issued by or on
behalf of, the Company, including, without limitation, statements with respect
to growth, projected revenues, net income, returns and yields on its portfolio
of mortgage assets, the impact of interest rates, costs and business strategies
and plans.
The following is a summary of the factors the Company believes important
and that could cause actual results to differ from the Company's expectations.
The Company is publishing these factors pursuant to the 1995 Act. Such factors
should not be construed as exhaustive or as an admission regarding the adequacy
of disclosure made by the Company prior to the effective date of the 1995 Act.
Readers should understand that many factors govern whether any forward-looking
statement will be or can be achieved. Any one of those factors could cause
actual results to differ materially from those projected. No assurance is or
can be given that any important factor set forth below will be realized in a
manner so as to allow the Company to achieve the desired or projected results.
The words "believe," "except," "anticipate," "intend," "aim," "expect," "will,"
and similar words identify forward-looking statements. The Company cautions
readers that the following important factors, among others, could affect the
Company's actual results and could cause the Company's actual consolidated
results to differ materially from those expressed in any forward-looking
statements made by or on behalf of the Company.
- - A Dramatic Increase in Short-term Interest Rates
- - The Effectiveness of Using Various Interest Rate Derivative Instruments
for Hedging ARM Assets or Borrowing Costs
- - The Ability to Acquire Attractively Priced and Underwritten ARM and Hybrid
ARM Loans and Securities
- - Interest Rate Repricing Mismatch Between Asset Yields and Borrowing Rates
- - A Decline in the Market Value of ARM Securities, Which Would Result in
Margin Calls
- - Unanticipated Levels of Prepayment Rates
- - A Flattening or Inversion of the Yield Curve Between Short and Long-Term
Interest Rates
- - The Use of Substantial Borrowed Funds to Enhance Returns
- - Risk of Credit Loss Associated with Acquiring, Accumulating and
Securitizing ARM Loans
- - Interest Rate Risks Associated with any Future Unhedged Portion of the
Fixed Term of Hybrid ARMs
- - The Loss of Key Personnel
- - Fundamental Changes in Investment Policies and Strategies
- - Fluctuations or Variability of Dividend Distributions
- - Capital Stock Price Volatility
- - Uncertainty Associated With New Business Lines
- - Additional Investment in New Business Lines
17
COMPETITION
In acquiring ARM assets, the Company competes with other mortgage REITs,
investment banking firms, savings and loan associations, banks, mortgage
bankers, insurance companies, mutual funds, other lenders, FNMA, FHLMC and other
entities purchasing ARM assets, many of which have greater financial resources
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 ARM assets resulting in higher prices and
lower yields on such mortgage assets.
EMPLOYEES
As of December 31, 1999, the Company had no employees. Thornburg Mortgage
Advisory Corporation (the "Manager") carries out the day to day operations of
the Company, subject to the supervision of the Board of Directors and under the
terms of a management agreement discussed below.
THE MANAGEMENT AGREEMENT
On June 15, 1999, the Company renewed its management agreement with Thornburg
Mortgage Advisory Corporation (the "Management Agreement"), the Manager, for a
term of ten years, with an annual review required each year. In addition to
extending the term, the Management Agreement was amended to include a minimum
fee to be paid to the Manager upon termination. The Management Agreement also
provides that in the event a person or entity obtains more than 20% of the
Company's common stock, if the Company is combined with another entity, or if
the Company terminates the Agreement other than for cause, the Company is
obligated to acquire substantially all of the assets of the Manager through an
exchange of shares with a value based on a formula tied to the Manager's net
profits. The Company has the right to terminate the Management Agreement upon
the occurrence of certain specific events, including a material breach by the
Manager of any provision contained in the Management Agreement.
The Manager at all times is subject to the supervision of the Company's Board of
Directors and has only such functions and authority as the Company may delegate
to it. The Manager is responsible for the day-to-day operations of the Company
and performs such services and activities relating to the assets and operations
of the Company as may be appropriate.
The Manager receives a per annum base management fee on a declining scale based
on average shareholders' equity, adjusted for liabilities that are not incurred
to finance assets ("Average Shareholders' Equity" or "Average Net Invested
Assets" as defined in the Agreement), payable monthly in arrears. The Manager
is also entitled to receive, as incentive compensation for each fiscal quarter,
an amount equal to 20% of the Net Income of the Company, before incentive
compensation, in excess of the amount that would produce an annualized Return on
Equity equal to 1% over the Ten Year U.S. Treasury Rate. In addition, during
1999, the two wholly-owned REIT qualified subsidiaries of the Company entered
into separate Management Agreements with the Manager for additional management
services for a combined amount of $1,250 per calendar quarter, paid in arrears.
For further information regarding the base management fee, incentive
compensation and applicable definitions, see the Company's Proxy Statement dated
March 27, 2000 under the caption "Certain Relationships and Related
Transactions".
Subject to the limitations set forth below, the Company pays all operating
expenses except those specifically required to be paid by the Manager under the
Management Agreement. The operating expenses required to be paid by the Manager
include the compensation of the Company's officers and the cost of office space,
equipment and other personnel required for the Company's day-to-day operations.
The expenses that will be paid by the Company will include issuance and
transaction costs incident to the acquisition, disposition and financing of
investments, regular legal and auditing fees and expenses, the fees and expenses
of the Company's directors, the costs of printing and mailing proxies and
reports to shareholders, the fees and expenses of the Company's custodian and
transfer agent, if any, and reimbursement of any obligation of the Manager for
any New Mexico Gross Receipts Tax liability. The expenses required to be paid
by the Company which are attributable to the operations of the Company shall be
limited to an amount per year equal to the greater of 2% of the Average Net
Invested Assets of the Company or 25% of the Company's Net Income for that year.
The determination of Net Income for purposes of calculating the expense
limitation will be the same as for calculating the Manager's incentive
compensation except that it will include any incentive compensation payable for
such period. Expenses in excess of such amount will be paid by the Manager,
unless the unaffiliated directors determine that, based upon unusual or
18
non-recurring factors, a higher level of expenses is justified for such fiscal
year. In that event, such expenses may be recovered by the Manager in
succeeding years to the extent that expenses in succeeding quarters are below
the limitation of expenses. The Company, rather than the Manager, will also be
required to pay expenses associated with litigation and other extraordinary or
non-recurring expenses. Expense reimbursement will be made monthly, subject to
adjustment at the end of each year.
The transaction costs incident to the acquisition and disposition of
investments, the incentive compensation and the New Mexico Gross Receipts Tax
liability will not be subject to the 2% limitation on operating expenses.
Expenses excluded from the expense limitation are those incurred in connection
with the servicing of mortgage loans, the raising of capital, the acquisition of
assets, interest expenses, taxes and license fees, non-cash costs and the
incentive management fee.
FEDERAL INCOME TAX CONSIDERATIONS
GENERAL
The Company has elected to be treated as a REIT for federal income tax purposes.
In brief, if certain detailed conditions imposed by the REIT provisions of the
Code are met, electing entities that invest primarily in real estate and
mortgage loans, and that otherwise would be taxed as corporations are, with
certain limited exceptions, not taxed at the corporate level on their taxable
income that is currently distributed to their shareholders. This treatment
eliminates most of the "double taxation" (at the corporate level and then again
at the shareholder level when the income is distributed) that typically results
from the use of corporate investment vehicles.
In the event that the Company does not qualify as a REIT in any year, it would
be subject to federal income tax as a domestic corporation and the amount of the
Company's after-tax cash available for distribution to its shareholders would be
reduced. The Company believes it has satisfied the requirements for
qualification as a REIT since commencement of its operations in June 1993. The
Company intends at all times to continue to comply with the requirements for
qualification as a REIT under the Code, as described below.
REQUIREMENTS FOR QUALIFICATION AS A REIT
To qualify for tax treatment as a REIT under the Code, the Company must meet
certain tests which are described briefly below.
Ownership of Common Stock
For all taxable years after the first taxable year for which a REIT election is
made, the Company's shares of capital stock must be held by a minimum of 100
persons for at least 335 days of a 12 month year (or a proportionate part of a
short tax year). In addition, at all times during the second half of each
taxable year, no more than 50% in value of the capital stock of the Company may
be owned directly or indirectly by five or fewer individuals. The Company is
required to maintain records regarding the actual and constructive ownership of
its shares, and other information, and to demand statements from persons owning
above a specified level of the REIT's shares (as long as the Company has over
200 but fewer than 2,000 shareholders of record, only persons holding 1% or more
of the Company's outstanding shares of capital stock) regarding their ownership
of shares. The Company must keep a list of those shareholders who fail to reply
to such a demand.
The Company is required to use the calendar year as its taxable year for income
purposes.
Nature of Assets
On the last day of each calendar quarter at least 75% of the value of the
Company's assets must consist of Qualified REIT Assets, government assets, cash
and cash items. The Company expects that substantially all of its assets will
continue to be Qualified REIT Assets. On the last day of each calendar quarter,
of the investments in assets not included in the foregoing 75% assets test, the
value of securities issued by any one issuer may not exceed 5% in value of the
Company's total assets and the Company may not own more than 10% of any one
issuer's outstanding voting securities. Pursuant to its compliance guidelines,
the Company intends to monitor closely the purchase and holding of its assets in
order to comply with the above assets tests.
19
At present, REITs are generally limited to holding non-voting preferred stock in
taxable affiliates. The recently enacted REIT Modernization Act, effective for
2001 and thereafter, includes provisions that will allow REITs to own some or
all of the stock of taxable subsidiaries. In general, it limits the aggregate
value of businesses undertaken by a REIT through taxable subsidiaries to 20% or
less of the REIT's total assets. Existing taxable subsidiaries will have to be
converted to qualified taxable REIT subsidiaries after December 31, 2000, unless
the existing taxable subsidiary has been in place since July 12, 1999 and there
has been no material change in the taxable subsidiary's assets or business since
that time. As a result the Company will likely have to make an election on its
2001 tax return to treat FASLA Holding Company, Inc. as a qualified taxable
subsidiary. The Company may from time to time hold, through one or more taxable
subsidiaries, assets that, if held directly by the Company, could otherwise
generate income that would have an adverse effect on the Company's qualification
as a REIT or on certain classes of the Company's shareholders. The Company does
not reasonably expect that the value of such taxable subsidiaries, in the
aggregate, ever to exceed 20% of the Company's assets and therefore the Company
does not anticipate that the proposal, if enacted, would have a material effect
on the Company's operations.
Sources of Income
The Company must meet the following separate income-based tests each year:
1. THE 75% TEST. At least 75% of the Company's gross income for the
taxable year must be derived from Qualified REIT Assets including interest
(other than interest based in whole or in part on the income or profits of any
person) on obligations secured by mortgages on real property or interests in
real property. The investments that the Company has made and will continue to
make will give rise primarily to mortgage interest qualifying under the 75%
income test.
2. THE 95% TEST. In addition to deriving 75% of its gross income
from the sources listed above, at least an additional 20% of the Company's gross
income for the taxable year must be derived from those sources, or from
dividends, interest or gains from the sale or disposition of stock or other
assets that are not dealer property. The Company intends to limit substantially
all of the assets that it acquires (other than stock in certain affiliate
corporations as discussed below) to Qualified REIT Assets. The policy of the
Company to maintain REIT status may limit the type of assets, including hedging
contracts and other assets, that the Company otherwise might acquire.
Distributions
The Company must distribute to its shareholders on a pro rata basis each year an
amount equal to at least (i) 95% of its taxable income before deduction of
dividends paid and excluding net capital gain, plus (ii) 95% of the excess of
the net income from foreclosure property over the tax imposed on such income by
the Code, less (iii) any "excess noncash income". The Company intends to make
distributions to its shareholders in sufficient amounts to meet the distribution
requirement. As a result of legislation enacted in 1999 and effective for 2001
and thereafter, the Company will have to distribute an amount calculated by
substituting 90% for 95% in the foregoing formula.
The Service has ruled that if a REIT's dividend reinvestment plan (the "DRP")
allows shareholders of the REIT to elect to have cash distributions reinvested
in shares of the REIT at a purchase price equal to at least 95% of fair market
value on the distribution date, then such cash distributions qualify under the
95% distribution test. The Company believes that its DRP complies with this
ruling.
TAXATION OF THE COMPANY'S SHAREHOLDERS
For any taxable year in which the Company is treated as a REIT for federal
income purposes, amounts distributed by the Company to its shareholders out of
current or accumulated earnings and profits will be includable by the
shareholders as ordinary income for federal income tax purposes unless properly
designated by the Company as capital gain dividends. Distributions of the
Company will not be eligible for the dividends received deduction for
corporations. Shareholders may not deduct any net operating losses or capital
losses of the Company.
If the Company makes distributions to its shareholders in excess of its current
and accumulated earnings and profits, those distributions will be considered
first a tax-free return of capital, reducing the tax basis of a shareholder's
shares until the tax basis is zero. Such distributions in excess of the tax
basis will be taxable as gain realized from the sale of the Company's shares.
20
The Company will withhold 30% of dividend distributions to shareholders that the
Company knows to be foreign persons unless the shareholder provides the Company
with a properly completed IRS form for claiming the reduced withholding rate
under an applicable income tax treaty.
The provisions of the Code are highly technical and complex. This summary is
not intended to be a detailed discussion of all applicable provisions of the
Code, the rules and regulations promulgated thereunder, or the administrative
and judicial interpretations thereof. The Company has not obtained a ruling
from the Internal Revenue Service with respect to tax considerations relevant to
its organization or operation, or to an acquisition of its common stock. This
summary is not intended to be a substitute for prudent tax planning, and each
shareholder of the Company is urged to consult its own tax advisor with respect
to these and other federal, state and local tax consequences of the acquisition,
ownership and disposition of shares of stock of the Company and any potential
changes in applicable law.
ITEM 2. PROPERTIES
The Company's principal executive offices are located in Santa Fe, New
Mexico and are provided by the Manager in accordance with the
Management Agreement. The Company's two wholly-owned qualified REIT
subsidiaries have their principal offices in Santa Fe, New Mexico and
are leased from the Manager.
ITEM 3. LEGAL PROCEEDINGS
At December 31, 1999, there were no pending legal proceedings to which
the Company was a party or of which any of its property was subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company's shareholders
during the fourth quarter of 1999.
21
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER
MATTERS
The Company's common stock is traded on the New York Stock Exchange under the
trading symbol "TMA". As of February 3, 2000, the Company had 21,489,663 shares
of common stock outstanding which were held by 1,030 holders of record and
approximately 15,449 beneficial owners.
The following table sets forth, for the periods indicated, the high, low and
closing sales prices per share of common stock as reported on the New York Stock
Exchange composite tape and the cash dividends declared per share of common
stock.
Cash
Stock Prices Dividends
-------------------------------- Declared
1999 High Low Close Per Share
- ---- -------- ---------- ---------- ------------
Fourth Quarter ended December 31, 1999 9 3/16 7 15/16 8 1/4 $ 0.23 (1)
Third Quarter ended September 30, 1999 10 7/8 8 1/4 8 13/16 $ 0.23
Second Quarter ended June 30, 1999 11 3/8 7 9/16 10 $ 0.23
First Quarter ended March 31, 1999 10 7 7/16 8 5/8 $ 0.23
1998
- ----
Fourth Quarter ended December 31, 1998 9 1/2 5 5/8 7 5/8 $ 0.23
Third Quarter ended September 30, 1998 13 5/8 7 3/16 9 - (2)
Second Quarter ended June 30, 1998 16 1/8 10 1/2 11 7/8 $ 0.30
First Quarter ended March 31, 1998 18 1/2 14 3/4 15 7/8 $ 0.375
1997
- ----
Fourth Quarter ended December 31, 1997 22 1/4 15 7/8 16 1/2 $ 0.50
Third Quarter ended September 30, 1997 24 9/16 20 21 $ 0.50
Second Quarter ended June 30, 1997 22 1/8 17 3/4 21 1/2 $ 0.49
First Quarter ended March 31, 1997 22 7/8 18 3/4 19 $ 0.48
(1) The fourth quarter of 1999 dividend was declared in January 2000 and paid
in February 2000.
(2) On August 17, 1998, the Company's Board of Directors announced that
dividends on common stock, in the future, would be declared after each
quarter-end rather than during the applicable quarter.
The Company intends to pay quarterly dividends and to make such distributions to
its shareholders in such amounts that all or substantially all of its taxable
income each year (subject to certain adjustments) is distributed, so as to
qualify for the tax benefits accorded to a REIT under the Code. All
distributions will be made by the Company at the discretion of the Board of
Directors and will depend on the earnings and financial condition of the
Company, maintenance of REIT status and such other factors as the Board of
Directors may deem relevant from time to time.
DIVIDEND REINVESTMENT PLAN
The Company has a Dividend Reinvestment and Stock Purchase Plan (the "DRP") that
allows both common and preferred shareholders to have their dividends reinvested
in additional shares of common stock and to purchase additional shares. The
common stock to be acquired for distribution under the DRP may be purchased at
the Company's discretion from the Company at a discount from the then prevailing
market price or in the open market. Shareholders and non-shareholders also can
make additional purchases of stock monthly, subject to a minimum of $100 ($500
for non-shareholders) and a maximum of $5,000 for each optional cash purchase.
Continental Stock Transfer & Trust Company (the "Agent"), the Company's transfer
agent, is the Trustee and administrator of the DRP. Additional information
about the details of the DRP and a prospectus are available from the Agent or
the Company. Shareholders who own stock that is registered in their own name
and want to participate must deliver a completed enrollment form to the Agent.
Forms are available from the Agent or the Company. Shareholders who own stock
that is registered in a name other than their own (e.g., broker or bank nominee)
and want to participate must either request the broker or nominee to participate
on their behalf or request that the broker or nominee re-register the stock in
the shareholder's name and deliver a completed enrollment form to the Agent.
22
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data are derived from audited financial
statements of the Company for the years ended December 31, 1999, 1998, 1997,
1996 and 1995. The selected financial data should be read in conjunction with
the more detailed information contained in the Financial Statements and Notes
thereto and "Management's Discussion and Analysis of Financial Conditions and
Results of Operations" included elsewhere in this Form 10-K (Amounts in
thousands, except per share data).
OPERATIONS STATEMENT HIGHLIGHTS
1999 1998 1997 1996 1995
----------- ----------- ----------- ----------- -----------
Net interest income $ 34,015 $ 31,040 $ 49,064 $ 30,345 $ 13,496
Net income $ 25,584 $ 22,695 $ 41,402 $ 25,737 $ 10,452
Basic earnings per share $ 0.88 $ 0.75 $ 1.95 $ 1.73 $ 0.88
Diluted earnings per share $ 0.88 $ 0.75 $ 1.94 $ 1.73 $ 0.88
Average common shares 21,490 21,488 18,048 14,874 11,927
Distributable income per common share $ 0.99 $ 0.84 $ 1.98 $ 1.76 $ 0.92
Dividends declared per common share $ 0.92 $ 0.905 $ 1.97 $ 1.65 $ 0.93
Yield on net int.-earning assets (Portfolio Margin) 0.77% 0.64% 1.30% 1.29% 0.73%
Return on average common equity 5.81% 4.80% 12.72% 11.68% 5.81%
Noninterest expense to average assets 0.12% 0.13% 0.21% 0.21% 0.13%
BALANCE SHEET HIGHLIGHTS
As of December 31
1999 1998 1997 1996 1995
----------- ----------- ----------- ----------- -----------
Adjustable-rate mortgage assets $4,326,098 $4,268,417 $4,638,694 $2,727,875 $1,995,287
Total assets $4,375,965 $4,344,633 $4,691,115 $2,755,358 $2,017,985
Shareholders' equity (1) $ 394,241 $ 395,484 $ 380,658 $ 238,005 $ 182,312
Historical book value per share (2) $ 15.28 $ 15.34 $ 15.53 $ 14.67 $ 14.96
Market value adjusted book value per share (3) $ 11.40 $ 11.45 $ 14.42 $ 13.70 $ 13.16
Number of common shares outstanding 21,490 21,490 20,280 16,219 12,191
Yield on ARM assets 6.38% 5.86% 6.38% 6.64% 6.73%
(1) Shareholders' equity before unrealized market value adjustments.
(2) Shareholders' equity before unrealized market value adjustments, excluding
preferred stock, divided by common shares outstanding.
(3) Shareholders' equity, excluding preferred stock, divided by common shares
outstanding.
23
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
ACQUISITION OF FASLA HOLDING COMPANY
On December 23, 1999, the Company and the Manager entered into an agreement to
purchase FASLA Holding Company, whose principal holding is First Arizona
Savings, a privately held Phoenix-based federally chartered thrift institution
with six retail branch offices and, at that time, $138 million in assets. The
cash purchase price is $15 million, subject to certain adjustments. The
acquisition is subject to regulatory approval which is expected to be received
by mid-2000.
The primary purpose of this acquisition is to obtain nationwide lending
authority in order to expand the Company's acquisition channels for ARM loans.
The Company intends to initiate a mortgage banking division within First Arizona
Savings that would originate loans for sale to the Company, based upon the
Company's underwriting standards and ARM product design. It is also likely that
other standard loan products, including fixed-rate loans, would be originated
and sold to third party investors. The Company expects to avoid establishing an
expensive infrastructure involving substantial fixed costs generally associated
with operating a mortgage banking operation by utilizing a "fee based"
third-party vendor who specializes in private label loan underwriting,
application processing and the loan closing process and by utilizing a
sub-servicer to service the loans originated. The Company believes these
third-party service providers have developed both efficiencies and expertise
through specialization that afford the Company an opportunity to enter this
business in a cost effective manner with very little initial capital investment.
The Company also expects to continue operating First Arizona Savings as a full
service community bank within its current local market areas. First Arizona
Savings has traditionally been an originator of single-family residential loans,
both permanent and construction, based on underwriting standards that are
similar to the Company's and has generally retained ARM and Hybrid ARM loans for
its portfolio and have sold a significant percentage of their fixed-rate loan
production to FHLMC. First Arizona's primary source of funds has been retail
deposits and a limited amount of Federal Home Loan Bank advances. The Company
believes this business model is a consistent extension of the Company's existing
business model that emphasizes high credit quality lending and prudent interest
rate risk management. Further, the Company believes that by utilizing
third-party service provider specialists for the mortgage banking division, the
Company will be able to operate very cost effectively with minimal capital at
risk consistent with the Company's existing business model.
Due to the uncertainty of receiving regulatory approval and the timing of the
regulatory decision, the Company does not believe this acquisition will have a
material effect on the Company's operations during 2000. Further, the Company
believes that the combination of the existing community-bank style of operations
and the effect of the projected mortgage banking operations will have a positive
effect on the Company's overall operations beginning in 2001.
FINANCIAL CONDITION
At December 31, 1999, the Company held total assets of $4.376 billion, $4.326
billion of which consisted of ARM assets. That compares to $4.345 billion in
total assets and $4.268 billion of ARM assets at December 31, 1998. Since
commencing operations, the Company has purchased either ARM securities (backed
by agencies of the U.S. government or privately-issued, generally publicly
registered, mortgage assets, most of which are rated AA or higher by at least
one of the Rating Agencies) or ARM loans generally originated to "A" quality
underwriting standards. At December 31, 1999, 95.4% of the assets held by the
Company, including cash and cash equivalents, were High Quality assets, far
exceeding the Company's investment policy minimum requirement of investing at
least 70% of its total assets in High Quality ARM assets and cash and cash
equivalents. Of the ARM assets currently owned by the Company, 80.6% are in the
form of adjustable-rate pass-through certificates or ARM loans. The remainder
are floating rate classes of CMOs (15.5%) or investments in floating rate
classes of CBOs (3.9%) backed primarily by mortgaged-backed securities.
24
The following table presents a schedule of ARM assets owned at December 31, 1999
and December 31, 1998 classified by High Quality and Other Investment assets and
further classified by type of issuer and by ratings categories.
ARM ASSETS BY ISSUER AND CREDIT RATING
(Dollar amounts in thousands)
December 31, 1999 December 31, 1998
------------------------- -------------------------
Carrying Portfolio Carrying Portfolio
Value Mix Value Mix
------------- ---------- ------------- ----------
HIGH QUALITY:
FHLMC/FNMA $ 2,068,152 47.8% $ 2,072,871 48.6%
Privately Issued:
AAA/Aaa Rating 1,585,099(1) 36.6 1,398,659(1) 32.8
AA/Aa Rating 459,858 10.6 597,493 14.0
------------- ---------- ------------- ----------
Total Privately Issued 2,044,957 47.2 1,996,152 46.8
------------- ---------- ------------- ----------
------------- ---------- ------------- ----------
Total High Quality 4,113,109 95.0 4,069,023 95.4
------------- ---------- ------------- ----------
OTHER INVESTMENT:
Privately Issued:
A Rating 49,995 1.2 40,591 1.0
BBB/Baa Rating 84,929 2.0 88,273 2.1
BB/Ba Rating and Other 46,963(1) 1.1 44,120(1) 0.9
Whole loans 31,102 0.7 26,410 0.6
------------- ---------- ------------- ----------
Total Other Investment 212,989 5.0 199,394 4.6
------------- ---------- ------------- ----------
Total ARM Portfolio $ 4,326,098 100.0% $ 4,268,417 100.0%
============= ========== ============= ==========
(1) The AAA Rating category includes $781.8 million and $1.020 billion
of whole loans as of December 31, 1999 and 1998, respectively, that have been
credit enhanced to AAA by a combination of an insurance policy purchased from a
third-party and an unrated subordinated certificate retained by the Company in
the amount of $32.3 and $32.4 million as of December 31, 1999 and 1998,
respectively. The subordinated certificate is included in the BB/Ba Rating and
Other category.
As of December 31, 1999, the Company had reduced the cost basis of its ARM
securities by a total of $1,930,000 due to estimated credit losses (other than
temporary declines in fair value). The Company is providing for estimated
credit losses on two securities that have an aggregate carrying value of $9.9
million, which represent less than 0.3% of the Company's total portfolio of ARM
assets. Although both of these assets continue to perform, there is only
minimal remaining credit support to mitigate the Company's exposure to credit
losses.
Additionally, during 1999, the Company recorded a $1,404,000 provision for
estimated credit losses on its loan portfolio, although no actual losses have
been realized in the loan portfolio to date. As of December 31, 1999, the
Company's ARM loan portfolio included 11 loans that are considered seriously
delinquent (60 days or more delinquent) with an aggregate balance of $5.6
million. The ARM loan portfolio also includes two real estate properties
("REO") that the Company owns as the result of the foreclosure process in
connection with two loans that total $1.0 million. The average original
effective loan-to-value ratio of the 11 delinquent loans and two REO properties
is approximately 65% and the Company believes that its current reserves for
credit losses are more than adequate to cover probable credit losses from these
assets. The Company's credit reserve policy regarding ARM loans is to record a
provision based on the outstanding principal balance of loans (including loans
securitized by the Company for which the Company has retained first loss
exposure), subject to adjustment on certain loans or pools of loans based upon
factors such as, but not limited to, age of the loans, borrower payment history,
low loan-to-value ratios, historical loss experience, current economic
conditions and quality of underwriting standards applied by the originator.
25
The following table classifies the Company's portfolio of ARM assets by type of
interest rate index.
ARM ASSETS BY INDEX
(Dollar amounts in thousands)
December 31, 1999 December 31, 1998
---------------------- ----------------------
Carrying Portfolio Carrying Portfolio
Value Mix Value Mix
---------- ---------- ---------- ----------
ARM ASSETS:
INDEX:
One-month LIBOR $ 680,449 15.7% $ 556,574 13.0%
Three-month LIBOR 170,384 3.9 181,143 4.2
Six-month LIBOR 626,616 14.5 939,824 22.0
Six-month Certificate of Deposit 304,621 7.0 313,268 7.3
Six-month Constant Maturity Treasury 37,781 0.9 49,023 1.2
One-year Constant Maturity Treasury 1,359,229 31.4 1,479,054 34.7
Cost of Funds 213,800 5.0 268,486 6.3
---------- ---------- ---------- ----------
3,392,880 78.4 3,787,372 88.7
---------- ---------- ---------- ----------
HYBRID ARM ASSETS 933,218 21.6 481,045 11.3
---------- ---------- ---------- ----------
$4,326,098 100.0% $4,268,417 100.0%
========== ========== ========== ==========
The ARM portfolio had a current weighted average coupon of 7.08% at December 31,
1999. This consisted of an average coupon of 6.54% on the hybrid portion of the
portfolio and an average coupon of 7.22% on the rest of the portfolio. If the
non-hybrid portion of the portfolio had been "fully indexed," the weighted
average coupon would have been approximately 7.79%, based upon the current
composition of the portfolio and the applicable indices. As of December 31,
1998, the ARM portfolio had a weighted average coupon of 7.28%. This consisted
of an average coupon of 6.96% on the hybrid portion of the portfolio and an
average coupon of 7.32% on the rest of the portfolio. If the non-hybrid portion
of the portfolio had been "fully indexed," the weighted average coupon would
have been approximately 6.79%, based upon the composition of the portfolio and
the applicable indices at the time. The lower average coupon on the ARM
portfolio as of the end of 1999 compared to 1998 is reflective of the overall
lower interest rates in the U.S. economy during these respective periods,
although by the end of 1999, interest rates in the U.S. had risen above the
rates prevailing during most of 1998 and 1999 and the average interest rate on
the ARM portion of the portfolio is expected to rise during 2000 to the "fully
indexed" rate.
At December 31, 1999, the current yield of the ARM assets portfolio was 6.38%,
compared to 5.86% as of December 31, 1998, with an average term to the next
repricing date of 344 days as of December 31, 1999, compared to 253 days as of
December 31, 1998. The increase in the number of days until the next repricing
of the ARMs is primarily due to the hybrid ARMs acquired by the Company during
1999, which, in general, do not reprice for three to five years from their
origination date and have an average remaining fixed rate period of 3.9 years.
As of the end of 1999, hybrid ARMs comprised 21.6% of the total ARM portfolio,
up from 11.3% as of the end of 1998. The Company finances its hybrid ARM
portfolio with longer term borrowings such that the duration mismatch of the
hybrid ARMs and the corresponding borrowings is one year or less. The current
yield includes the impact of the amortization of applicable premiums and
discounts, the cost of hedging, the amortization of the deferred gains from
hedging activity and the impact of principal payment receivables.
The increase in the yield of 0.52% as of December 31, 1999, compared to December
31, 1998, is primarily due to the decreased rate of ARM portfolio prepayments as
of the end of 1999 compared to the end of 1998, the effect of owning the ARM
portfolio at a lower price as of the end of 1999 compared to the end of 1998,
and the higher level of overall U.S. interest rates as of the end of 1999 which
is used in the computation of the current yield to determine the appropriate
amount of net premium amortization. These favorable factors were partially
offset by the 0.20% decrease in the weighted average coupon discussed above.
During the fourth quarter of 1999 the rate of prepayments had slowed to 16%,
compared to the 29% CPR experienced during the fourth quarter of 1998. As of
the end of 1999, the net premium on the total ARM portfolio amounted to 1.95% of
the principal balance outstanding, compared to 2.47% as of the end of 1998. As
of the end of 1999, the Company's non-hybrid portion of its ARM portfolio was
less than "fully indexed" by 0.57%, compared to being more than "fully indexed"
at the end of 1998 by 0.53%. This resulted in less premium amortization as of
the end of 1999 in order to achieve the appropriate portfolio long-term yield,
which is a calculation based on current interest rates and the expected
26
remaining life of the portfolio. The lower level of prepayments decreased the
amount of premium amortization expense and decreased the impact of non-interest
earning assets in the form of principal payment receivables. These factors
increased the ARM portfolio yield by 0.72% as of the end of 1999 compared to the
end of 1998.
The following table presents various characteristics of the Company's ARM and
Hybrid ARM loan portfolio as of December 31, 1999. This information pertains to
loans held for securitization, loans held as collateral for the notes payable
and loans TMA has securitized for its own portfolio for which the Company
retained credit loss exposure.
ARM AND HYBRID ARM LOAN PORTFOLIO CHARACTERISTICS
Average High Low
--------- ----------- -------
Unpaid principal balance $273,989 $3,450,000 $7,587
Coupon rate on loans 7.22% 9.63% 5.00%
Pass-through rate 6.84% 9.23% 4.63%
Pass-through margin 1.90% 5.06% 0.48%
Lifetime cap 12.88% 16.75% 9.75%
Original Term (months) 339 480 72
Remaining Term (months) 316 359 33
Geographic Distribution (Top 5 States): Property type:
California 21.07% Single-family 65.26%
Florida 11.88 DeMinimus PUD 20.19<