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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, 2000
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
- --- EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
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COMMISSION FILE NUMBER: 001-11914
THORNBURG MORTGAGE, INC.
(Exact name of Registrant as specified in its Charter)
MARYLAND 85-0404134
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
119 E. MARCY STREET
SANTA FE, NEW MEXICO 87501
(Address of principal executive offices) (Zip Code)
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 ($.01 par value) New York Stock Exchange
Series A 9.68% Cumulative Convertible New York Stock Exchange
Preferred Stock ($.01 par value)
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 March 5, 2001, the aggregate market value of the voting stock held by
non-affiliates was $232,449,369, based on the closing price of the common stock
on the New York Stock Exchange.
Number of shares of Common Stock outstanding at March 5 , 2001: 21,719,178
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the Registrant's definitive Proxy Statement dated March 28,
2001, issued in connection with the Annual Meeting of Shareholders of the
Registrant to be held on April 26, 2001, are incorporated by reference
into Parts I and III.
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THORNBURG MORTGAGE, Inc.
2000 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. . . . . . . . . . . . . . . 25
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS. . . . 26
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE
ABOUT MARKET RISKS. . . . . . . . . . . . . . . . . 45
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. . . . . 45
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE. . . . . . . . . 45
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. 45
ITEM 11. EXECUTIVE COMPENSATION. . . . . . . . . . . . . . . 45
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT . . . . . . . . . . . . . . . . . . . . 45
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS . . 45
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND
REPORTS ON FORM 8-K . . . . . . . . . . . . . . . . 46
FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . . . . . . F-1
SIGNATURES
EXHIBIT INDEX
3
PART I
ITEM 1. BUSINESS
GENERAL
Thornburg Mortgage, Inc., 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 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 qualified REIT 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.
Thornburg Mortgage Home Loans, Inc.
The Company has formed Thornburg Mortgage Home Loans, Inc. ("TMHL") as a
wholly-owned REIT subsidiary to conduct the Company's mortgage loan acquisition
and mortgage loan origination activities. Retail mortgage origination is the
newest channel for acquiring ARM loans for the Company's portfolio. TMHL
commenced operations during the second quarter of 2000. In the fourth quarter
of 2000, all of the Company's ARM loans and servicing rights were transferred
to TMHL, as were the obligations to buy, finance and securitize all ARM loans.
Effective December 1, 2000, TMHL and its subsidiaries began operating as taxable
entities. To facilitate the securitization and financing of loans by TMHL, two
special purpose subsidiaries of TMHL have been created: Thornburg Mortgage
Funding Corporation II and Thornburg Mortgage Acceptance Corporation II.
TMHL acquires mortgage loans through three channels: bulk acquisitions,
correspondent lending and retail originations. TMHL finances the loans through
two warehouse borrowing arrangements, pools loans for securitization and sale to
the parent's REIT operation, and occasionally sells loans to third parties. As a
taxable REIT subsidiary, TMHL has more flexibility in trading and securitizing
assets than a REIT qualified subsidiary.
TMHL originates ARM loans based upon the Company's underwriting standards and
ARM product designs. It also offers other standard loan products, including
fixed-rate loans, that are 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 subservicer 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. This approach
also insulates the Company from the expenses and risks associated with mortgage
lending business cycles: hiring additional staff to meet heavy demand and then
laying off workers as lending activity declines.
4
Thornburg Brand Development and Company Name Change
The Company instituted a new marketing approach in conjunction with affiliates
aimed at developing brand recognition of the Thornburg name. As a part of
redefining its marketing message, the Company has formally changed its corporate
name to Thornburg Mortgage, Inc. 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 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. In 2000, the Company began
originating loans directly through its mortgage banking subsidiary, TMHL.
Currently, TMHL is licensed to lend in nineteen states but over the next two
years TMHL intends to be licensed to lend nationwide. In becoming an originator
of loans for its own portfolio, the Company offers its loan products to target
markets of higher quality, more sophisticated borrowers. This approach is
consistent with the Company's emphasis on acquiring high credit quality loans.
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, multi-class pass-through securities, collateralized
mortgage obligations ("CMOs"), collateralized bond obligations ("CBOs"),
generally backed by high quality mortgage backed securities, ARM loans, Hybrid
ARMs, fixed-rate mortgage-backed securities that have an expected duration of
one year or less or short-term investments that either mature within one year or
have an interest rate that reprices within one year. The Company will not
invest more than 30% of its ARM assets in Hybrid ARMs, increased to 35% by the
Company's Board of directors in January 2001, 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. 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
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(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 3%, 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
Through TMHL, the Company acquires existing pools of ARM loans, acquires
individual loans directly from loan originators, and originates mortgage loans
on a retail basis. All loans acquired from third parties and ARM loans
originated by the Company are intended to be securitized and then held in the
ARM securities portfolio as high quality assets. Acquiring and originating 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.
Mortgage Acquisitions
The Company acquires third-party originated 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 or
without the servicing rights. In many cases the Company buys the servicing
rights along with the loans and the Company then services the loans using its
third-party subservicer, who performs 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, underwriting 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
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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 largely 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. In select cases, some correspondents
sell their own loan products to the Company which are originated according to
the correspondents' pre-approved product specifications and underwriting
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 approved 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 or pre-approved 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 compliance review by either 1) by the Company's staff or 2)
mortgage insurance companies which use the Company's guidelines to review the
loans to insure product quality and compliance with the Company's guidelines.
The six mortgage insurance companies chosen by the Company to perform this
function use a two-step loan approval process. After the primary underwriting
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
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 or the Company's staff 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.
Historically, mortgage loans acquired through either the Bulk or Flow Method
were acquired, generally, with the servicing rights remaining with the
originator/seller. In the third quarter of 2000, the Company began purchasing
the servicing rights for most of the loans acquired. By owning the servicing
rights, the Company intends to provide borrowers with high quality customer
service along with loan modification and refinance opportunities. These efforts
are designed to lower prepayments speeds on the portfolio through customer
retention. In cases where the Company buys the servicing rights along with the
loans, the Company contracts with a qualified loan servicer, as subservicer, to
perform the loan servicing function for a fee. The subservicer performs the
servicing function on a "private label basis" or in the name of the Company.
For each loan purchase, the Company obtains representations and warranties from
the seller stating that each loan meets the Company's approved 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 closing
documents, which are then held in safekeeping with the third-party document
custodian. As a result, all of the original individual loan closing documents
that are signed by the borrower, other than the original credit verification
documents, are examined, verified and held by the custodian.
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Loan Origination
The Company originates mortgage loans through TMHL. As of February 20, 2001,
TMHL is licensed to originate loans in the following nineteen states and, by
2002, TMHL is expected to be licensed nationwide as a mortgage lender.
Alaska Kentucky New Mexico
Arkansas Louisiana North Carolina
Colorado Maryland Oklahoma
Connecticut Massachusetts South Carolina
Indiana Mississippi Texas
Iowa Missouri Utah
Kansas
The Company's retail lending strategy is to utilize its portfolio lending
capability, its competitive advantages and its 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 yields while still offering
borrowers competitive mortgage rates. In expanding into the retail origination
business, the Company intends to continue its strategy of acquiring only quality
mortgages with the same emphasis on loan quality as in its current loan
acquisition activities.
In 2000, the Company began originating loans directly with borrowers using one
of two origination channels. The Company started to originate loans using a
call center, where borrowers call the Company, inquire about loan products and
interest rates, seek advice and counseling regarding qualifying for a loan and
the approval process. This channel began operation on a pilot basis with
Company staff in 2000. In 2001, this channel will be expanded to employ
third-party call center specialists versed in mortgage loan origination where
prospective borrowers are able to apply for a loan over the telephone. A
completed mortgage loan application along with a request for additional
supporting documentation is sent to the borrower for signature. Thornburg
Mortgage loan processors, or their third-party agents, are 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.
By the second quarter of 2001, the Company also expects to offer mortgages
on-line utilizing third-party, private label web-based origination systems. In
this instance, prospective borrowers will be able to look up mortgage loan
product and interest rate information through the Company's website, submit an
application on-line and obtain a pre-approval of their loan. Once a mortgage
loan application has been submitted, a Thornburg Mortgage representative will be
assigned the responsibility of completing the loan process on behalf of the
borrower.
The mortgage origination process is a labor intensive, document intensive
business that requires significant back office systems and personnel. The
Company has contracted with a third-party "back office" mortgage service
provider to provide all of the loan processing, underwriting, documentation and
closing functions required to originate and close mortgage loans. Additionally,
another third-party service provider has staffed a mortgage loan call center for
the benefit of the Company. These services are provided on a "private label"
basis, meaning that all of these representatives will identify themselves as
being Thornburg Mortgage representatives. The benefit to the Company of this
arrangement is that the Company pays for these services as it uses them, without
a significant investment in personnel, systems, office space and equipment.
Regardless of the origination channel, the Company's 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 are 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 or purchases on a servicing
released basis. This third-party subservicer collects mortgage loan payments,
manages escrow accounts, provides monthly statements and notices to borrowers,
offers on-line mortgage servicing information and provides 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.
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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.
The Company also securitizes its conforming balance loans through a program
provided by Fannie Mae. See "Fannie Mae Loan Programs". The Company exchanges
pools of its loans with balances no greater than $252,000 in 2000 and $275,000
in 2001 for a Fannie Mae Mortgage-Backed Security or MBS. As described in the
"Fannie Mae 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 Fannie Mae. 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. The Company also negotiates with Fannie Mae
to securitize non-conforming products in this manner, although occasionally the
Company will retain the credit exposure for the pool.
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, 2000, capital
markets debt represents 16% 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-six 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 decided to negotiate and pay a fee for
committed facilities as well as continue to utilize uncommitted facilities.
During January 2001, 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 another committed facility for $150,000,000 which can also be
expanded to $300,000,000 for a fee. The Company also has one uncommitted
facility available.
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 and fair value
changes of its ARM assets. In general, ARM assets have a maximum lifetime
interest rate cap, or ceiling, meaning that each ARM asset contains a
contractual maximum rate. This lifetime interest rate cap is a component of the
fair value of an ARM asset and can effect the Company's net interest income.
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") and options on
interest rate futures ("Options Contracts") to prevent the Company's borrowing
costs from exceeding the lifetime maximum interest rate on its ARM assets.
These Cap Agreements and Options Contracts 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 or Options Contract. A Cap Agreement or
Option Contract 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 and Option
Contacts owned as of December 31, 2000 that hedge the lifetime maximum interest
rate on its ARM assets, 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 10.04%. The fair value of these Cap Agreements generally
increases when general market interest rates increase and decreases when market
interest rates decrease, helping to partially offset changes in the fair value
of the Company's ARM assets related to the effect of the lifetime interest rate
cap.
10
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%
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, 2000, approximately $2.315 billion of the Company's ARM securities
and ARM loans did not have periodic caps or were Hybrid ARMs, representing
approximately 56% of total ARM assets.
The Hybrid ARMs have an initial fixed rate period, generally 3 to 10 years.
Since the Company's borrowings are generally short-term, the Company enters into
interest rate swap agreements that 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. 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.
11
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
contracts on the Eurodollar, Fed Funds, Treasury bills and Treasury notes and
similar financial instruments. In order to utilize these instruments the
Company became registered and received an exemption from being classified as a
"Commodity Pool Operator" by the Commodities and Futures Trade Commission.
Effective January 1, 2001, the Company implemented Financial Accounting
Standards No. 133, Accounting for Derivative Instruments and Hedging Activities
("SFAS 133"). SFAS No. 133 established a framework of accounting rules that
standardizes accounting and reporting for all derivative instruments and
requires that all derivative financial instruments be carried on the balance
sheet at fair value. The Company expects to continue to use derivative
instruments to the extent the Company believes that the use of and the
accounting of the derivative instruments meets the Company's financial goals.
However, it is likely that the Company's future quarterly earnings will vary to
a greater degree than they might otherwise as a result of hedging with
derivative instruments.
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
made a taxable REIT subsidiary election with respect to TMHL, in order to
facilitate the origination, securitization, sale and servicing of residential
mortgage loans. In addition, 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.
12
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.
PORTFOLIO OF MORTGAGE ASSETS
As of December 31, 2000, 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 75% 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, 2000:
Freddie Mac ARM Programs
Freddie Mac is a shareholder-owned government sponsored enterprise created
pursuant to an Act of Congress on July 24, 1970. The principal activity of
Freddie Mac 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 2000, Freddie Mac purchased $21.2 billion of
ARM loans to securitize into ARM certificates and as of December 31, 2000, there
was $46.8 billion of all types of Freddie Mac ARM certificates outstanding, of
which Freddie Mac held $12.6 billion in its own portfolio.
Each Freddie Mac 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 Freddie Mac. 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 Freddie Mac
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.
13
Freddie Mac 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 Freddie Mac
under its guarantees are solely those of Freddie Mac and are not backed by the
full faith and credit of the U.S. Government. If Freddie Mac were unable to
satisfy such obligations, distributions to holders of Freddie Mac ARM
Certificates would consist solely of payments and other recoveries on the
underlying mortgage loans and, accordingly, monthly distributions to holders of
Freddie Mac ARM Certificates would be affected by delinquent payments and
defaults on such mortgage loans.
Fannie Mae ARM Programs
Fannie Mae is a federally chartered and privately owned corporation organized
and existing under the Federal National Mortgage Association Charter Act.
Fannie Mae provides funds to the mortgage market primarily by purchasing home
mortgage loans from mortgage loan originators, thereby replenishing their funds
for additional lending. Fannie Mae established its first ARM programs in 1982
and currently has several ARM programs under which ARM certificates may be
issued, including programs for the issuance of assets through REMICs under the
Code. During 2000, Fannie Mae purchased $18.1 billion of ARM loans to
securitize into ARM certificates and issued $25.7 billion of Fannie Mae ARM
certificates. As of December 31, 2000, Fannie Mae held $27.1 billion of ARM
certificates in its own portfolio.
Each Fannie Mae 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 Fannie Mae. 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. Fannie Mae 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 Fannie Mae's guarantee fee.
Fannie Mae guarantees to the registered holder of a Fannie Mae ARM Certificate
that it will distribute amounts representing scheduled principal and interest
(at the rate provided by the Fannie Mae ARM Certificate) on the mortgage loans
in the pool underlying the Fannie Mae 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 Fannie Mae under its guarantees are solely those of Fannie
Mae and are not backed by the full faith and credit of the U.S. Government. If
Fannie Mae were unable to satisfy such obligations, distributions to holders of
Fannie Mae ARM Certificates would consist solely of payments and other
recoveries on the underlying mortgage loans and, accordingly, monthly
distributions to holders of Fannie Mae 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 Freddie
Mac or Fannie Mae.
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.
14
COLLATERALIZED MORTGAGE OBLIGATIONS ("CMOS"), MULTI-CLASS 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. Multi-class 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 multi-class
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 multi-class 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 CBOs 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.
Scheduled payments of principal and interest on the mortgage-related assets and
other collateral securing a series of CMOs, CBOs or multi-class 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.
Multi-class 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 Freddie Mac, Fannie Mae and other private issuers.
The senior classes in a multi-class 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
multi-class pass-through security.
The mezzanine classes of a multi-class 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 multi-class 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.
15
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
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, generally with 80% or lower
effective loan-to-value ratios based on independently appraised property values
or are seasoned loans with 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 generally 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, generally 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 and Loans, 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, Fannie Mae, Freddie
Mac 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, 2000, 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
The Company has entered into a management agreement (the "Management Agreement")
with Thornburg Mortgage Advisory Corporation (the "Manager") for a ten-year
term, with an annual review required each year. Upon a termination by the
Company, other than for cause, the Management Agreement provides for a minimum
fee to be paid to the Manager. 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 base
management fee formula is subject to an annual increase based on any increase in
the Consumer Price Index over the previous twelve month period. 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, the
wholly-owned subsidiaries of the Company entered into separate Management
Agreements with the Manager for additional management services. The Management
Agreement also provides that expenses related to acquiring, securitizing,
selling, hedging, and servicing the Company's portfolio of ARM loans are
reimbursable to the Manager by the Company. For further information regarding
the base management fee, incentive compensation reimbursable expenses and
applicable definitions, see the Company's Proxy Statement dated March 28, 2001
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 personnel who are performing
management services for the Manager and the cost of office space, equipment and
other personnel required for the management of the Company's day-to-day
operations. The expenses that will be paid by the Company will include costs
incident to the acquisition, disposition, securitization and financing of
mortgage loans, compensation and expenses of the Company's operating personnel,
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
18
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 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
tax 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
19
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 securities (with an exception for a qualified electing
taxable REIT subsidiary). Under that exception, the aggregate value of
businesses undertaken by a REIT through taxable subsidiaries is limited to 20%
or less of the REIT's total assets. The Company believes that it has satisfied
this exception with respect to its ownership of TMHL. Pursuant to its compliance
guidelines, the Company monitors the purchase and holding of its assets in order
to comply with the above asset tests.
The Company may from time to time hold, through one or more taxable REIT
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, will ever exceed 20% of the Company's assets.
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.
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.
20
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 wholly-owned subsidiaries have
their principal offices in Santa Fe, New Mexico and are leased from
the Manager.
ITEM 3. LEGAL PROCEEDINGS
At December 31, 2000, 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 2000.
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 21, 2001, the Company had 21,719,178
shares of common stock outstanding which were held by 1,792 holders of record
and approximately 14,300 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
2000 High Low Close Per Share
- ---- -------- ------- ------ ------------
Fourth Quarter ended December 31, 2000 $ 9.81 $ 8.63 $ 9.06 $ 0.25 (1)
Third Quarter ended September 30, 2000 9.50 7.38 9.38 0.25
Second Quarter ended June 30, 2000 . . 8.88 7.19 7.19 0.23
First Quarter ended March 31, 2000 . . 9.13 7.06 7.38 0.23
1999
- ----
Fourth Quarter ended December 31, 1999 $ 9.19 $ 7.94 $ 8.25 $ 0.23 (2)
Third Quarter ended September 30, 1999 10.88 8.25 8.81 0.23
Second Quarter ended June 30, 1999 . . 11.38 7.56 10.00 0.23
First Quarter ended March 31, 1999 . . 10.00 7.44 8.63 0.23
1998
- ----
Fourth Quarter ended December 31, 1998 $ 9.50 $ 5.63 $ 7.63 $ 0.23
Third Quarter ended September 30, 1998 13.63 7.19 9.00 - (3)
Second Quarter ended June 30, 1998 . . 16.13 10.50 11.88 0.30
First Quarter ended March 31, 1998 . . 18.50 14.75 15.88 0.375
- -----------------
(1) The fourth quarter of 2000 dividend was declared in January 2001 and paid
in February 2001.
(2) The fourth quarter of 1999 dividend was declared in January 2000 and paid
in February 2000.
(3) 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
ADOPTION OF SHAREHOLDER RIGHTS AGREEMENT
On January 25, 2001, the Board of Directors adopted a Shareholder Rights
Agreement (the "Rights Agreement"). This summary description of the Rights does
not purport to be complete and is qualified in its entirety by reference to the
Rights Agreement.
Pursuant to the Rights Agreement, the Board of Directors declared a dividend
distribution of one Preferred Stock Purchase Right (a "Right") for each
outstanding share of common stock, par value $0.01 per share, of the Company
(the "Common Stock") to shareholders of record as of the close of business on
March 9, 2001 (the "Record Date"). In addition, one Right will automatically
attach to each share of Common Stock issued between the Record Date and the
Distribution Date (as defined herein). Each Right entitles the registered holder
thereof to purchase from the Company a unit (a "Preferred Unit") consisting of
one one-thousandth of a share of Series B Cumulative Preferred Stock, par value
$0.01 per share (the "Preferred Stock"), at a cash exercise price of $50.00 per
Preferred Unit (the "Exercise Price"), subject to adjustment.
Initially, the Rights are not exercisable and are attached to and trade with the
Common Stock outstanding as of, and all Common Stock issued after, the Record
Date. The Rights will separate from the Common Stock, separate certificates will
be distributed to holders of the Common Stock and the Rights will become
exercisable upon the earlier of (i) the close of business on the 10th calendar
day following the earlier of (a) the date of the first public announcement that
a person or a group of affiliated or associated persons has acquired beneficial
ownership of 9.8% or more of the outstanding Common Stock (an "Acquiring
Person"), or (b) the date on which the Company first has notice or otherwise
determines that a person has become an Acquiring Person (the earlier of (a) and
(b), the "Stock Acquisition Date"), or (ii) the close of business on the 10th
business day following the commencement of a tender offer or exchange offer that
would result, upon its consummation, in a person or group becoming the
beneficial owner of 9.8% or more of the outstanding Common Stock (the earlier of
(i) and (ii), the "Distribution Date"). The Rights Agreement exempts from the
definition of Acquiring Person any person who the Board of Directors determines
acquired 9.8% or more of the Common Stock inadvertently, if that person promptly
divests itself of enough Common Stock to reduce the number of shares
beneficially owned by that person to below the 9.8% threshold. The Rights
Agreement also exempts from the definition of Acquiring Person any person in
connection with which the Board of Directors approved the transaction which
otherwise would have resulted in that person becoming an Acquiring Person.
Until the Distribution Date (or the earlier redemption, exchange or expiration
of the Rights), (i) the Rights will be evidenced by the Common Stock
certificates and will be transferred with and only with those Common Stock
certificates, (ii) new Common Stock certificates issued after the Record Date
will include a notation incorporating the Rights Agreement by reference, and
(iii) the surrender for transfer of any certificate for Common Stock will also
constitute the transfer of the Rights associated with the Common Stock
represented by that certificate.
The Rights are not exercisable until the Distribution Date and will expire at
the close of business on January 25, 2011, unless previously redeemed or
exchanged by the Company as described below.
As soon as practicable after the Distribution Date, Right Certificates will be
mailed to holders of record of Common Stock as of the close of business on the
Distribution Date and, thereafter, the separate Right Certificates alone will
represent the Rights. Except as otherwise determined by the Board of Directors,
only Common Stock issued prior to the Distribution Date will be issued with
Rights.
If a Stock Acquisition Date occurs, provision will be made so that each holder
of a Right (other than an Acquiring Person or associates or affiliates thereof,
whose Rights will become null and void) thereafter has the right to receive upon
exercise that number of shares of Common Stock having a market value of two
times the exercise price of the Right (that right being referred to as the
"Subscription Right"). If, at any time following the Distribution Date: (i) the
Company consolidates with, or merges with and into, any Acquiring Person or any
associate or affiliate thereof, and the Company is not the continuing or
surviving corporation, (ii) any Acquiring Person or any associate or affiliate
thereof consolidates with the Company, or merges with and into the Company and
the Company is the continuing or surviving corporation of that merger and, in
connection with that merger, all or part of the Common Stock is changed into or
exchanged for stock or other securities of any other person or cash or any other
property, or (iii) 50% or more of the Company's assets or earning power is sold,
mortgaged or otherwise transferred, each holder of a Right will thereafter have
the right to receive, upon exercise, capital stock of the acquiring company
having a market value equal to two times the exercise price of the Right (that
right being referred to as the "Merger Right"). Each holder of a Right will
continue to have the Merger Right whether or not that holder has exercised the
Subscription Right, but Rights that are or were beneficially owned by an
Acquiring Person may (under certain circumstances specified in the Rights
Agreement) become null and void.
23
At any time after a Stock Acquisition Date occurs, the Board of Directors may,
at its option, exchange Common Stock or Preferred Units for all or any part of
the then outstanding and exercisable Rights (which excludes Rights held by an
Acquiring Person) at an initial exchange ratio of one share of Common Stock or
one Preferred Unit per Right. However, the Board of Directors generally will not
be empowered to effect any such exchange at any time after any person becomes
the beneficial owner of 50% or more of the Common Stock.
The Exercise Price payable, and the number of Preferred Units or other
securities or property issuable, upon exercise of the Rights are subject to
adjustment from time to time to prevent dilution (i) in the event of a share
dividend on, or a subdivision, combination or reclassification of, the Preferred
Stock, (ii) if holders of the Preferred Stock are granted certain rights or
warrants to subscribe for Preferred Stock or convertible securities at less than
the current market price of the Preferred Stock, or (iii) upon the distribution
to holders of the Preferred Stock of evidences of indebtedness or assets
(excluding regular quarterly cash dividends) or of subscription rights or
warrants (other than those referred to in (i) and (ii)).
With certain exceptions, no adjustment in the Exercise Price will be required
until cumulative adjustments amount to at least 1% of the Exercise Price. The
Company is not obligated to issue fractional Preferred Units. If the Company
elects not to issue fractional Preferred Units, in lieu thereof an adjustment in
cash will be made based on the fair market value of the Preferred Stock on the
last trading date prior to the date of exercise.
The Rights may be redeemed in whole, but not in part, at a price of $0.01 per
Right (payable in cash, Common Stock or other consideration considered
appropriate by the Board of Directors) by the Board of Directors only until the
earlier of the close of business on (i) the calendar day after the Stock
Acquisition Date, and (ii) the expiration date of the Rights Agreement.
Immediately upon any action of the Board of Directors ordering redemption of the
Rights, the Rights will terminate and thereafter the only right of the holders
of Rights will be to receive the redemption price.
The Rights Agreement may be amended by the Board of Directors in its sole
discretion until the earlier of the Distribution Date and the date on which the
rights become nonredeemable, as described above. After the earlier of those two
dates, the Board of Directors may, subject to certain limitations set forth in
the Rights Agreement, amend the Rights Agreement only to cure any ambiguity,
defect or inconsistency, to shorten or lengthen any time period, or to make
changes that do not adversely affect the interests of Rights holders (excluding
the interests of an Acquiring Person or associates or affiliates thereof).
Until a Right is exercised, the holder will have no rights as a shareholder of
the Company (beyond those as an existing shareholder), including the right to
vote or to receive dividends. While the distribution of the Rights will not be
taxable to shareholders or to the Company, shareholders may, depending upon the
circumstances, recognize taxable income if the Rights become exercisable for
Preferred Units, other securities of the Company or other consideration, or for
common stock of an acquiring company.
The Rights have certain anti-takeover effects. The Rights will cause
substantial dilution to a person or group that attempts to acquire the Company
in a transaction not approved by the Board of Directors. The Rights should not
interfere with any merger or other business combination approved by the Board of
Directors, since the Rights Agreement may be amended prior to the Distribution
Date, as described above, and the Rights may be redeemed until the calendar day
after a Stock Acquisition Date, as described above.
24
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, 2000, 1999, 1998,
1997 and 1996. 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
2000 1999 1998 1997 1996
-------- -------- -------- -------- --------
Net interest income . . . . . . . . . . . . . . . . $36,630 $34,015 $31,040 $49,064 $30,345
Net income. . . . . . . . . . . . . . . . . . . . . $29,165 $25,584 $22,695 $41,402 $25,737
Basic earnings per share. . . . . . . . . . . . . . $ 1.05 $ 0.88 $ 0.75 $ 1.95 $ 1.73
Diluted earnings per share. . . . . . . . . . . . . $ 1.05 $ 0.88 $ 0.75 $ 1.94 $ 1.73
Average common shares . . . . . . . . . . . . . . . 21,506 21,490 21,488 18,048 14,874
Distributable income per common share . . . . . . . $ 1.07 $ 0.99 $ 0.84 $ 1.98 $ 1.76
Dividends declared per common share . . . . . . . . $ 0.94 $ 0.92 $ 0.905 $ 1.97 $ 1.65
Yield on net int.-earning assets (Portfolio Margin) 0.86% 0.77% 0.64% 1.30% 1.29%
Return on average common equity . . . . . . . . . . 6.90% 5.81% 4.80% 12.72% 11.68%
Noninterest expense to average assets . . . . . . . 0.16% 0.12% 0.13% 0.21% 0.21%
BALANCE SHEET HIGHLIGHTS
As of December 31
---------------------------------------------------------------
2000 1999 1998 1997 1996
----------- ----------- ----------- ----------- -----------
Adjustable-rate mortgage assets. . . . . . . . $4,139,461 $4,326,098 $4,268,417 $4,638,694 $2,727,875
Total assets . . . . . . . . . . . . . . . . . $4,190,167 $4,375,965 $4,344,633 $4,691,115 $2,755,358
Shareholders' equity (1). . . . . . . . . . . $ 395,965 $ 394,241 $ 395,484 $ 380,658 $ 238,005
Historical book value per share (2). . . . . . $ 15.30 $ 15.28 $ 15.34 $ 15.53 $ 14.67
Market value adjusted book value per share (3) $ 11.67 $ 11.40 $ 11.45 $ 14.42 $ 13.70
Number of common shares outstanding. . . . . . 21,572 21,490 21,490 20,280 16,219
Yield on ARM assets. . . . . . . . . . . . . . 7.06% 6.38% 5.86% 6.38% 6.64%
- -----------------------------------------------
(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.
25
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
FINANCIAL CONDITION
At December 31, 2000, the Company held total assets of $4.190 billion, $4.139
billion of which consisted of ARM assets. That compares to $4.376 billion in
total assets and $4.326 billion of ARM assets at December 31, 1999. 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, 2000, 93.7% 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 owned by the Company at year-end, 80.3% are in
the form of adjustable-rate pass-through certificates or ARM loans. The
remainder are floating rate classes of CMOs (15.9%) or investments in floating
rate classes of CBOs (3.8%) backed primarily by mortgaged-backed securities.
The following table presents a schedule of ARM assets owned at December 31, 2000
and December 31, 1999 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, 2000 December 31, 1999
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Carrying Portfolio Carrying Portfolio
Value Mix Value Mix
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HIGH QUALITY:
Freddie Mac/Fannie Mae $2,187,180 52.9% $2,068,152 47.8%
Privately Issued:
AAA/Aaa Rating 1,309,584 (1) 31.6 1,585,099 (1) 36.6
AA/Aa Rating 351,499 8.5 459,858 10.6
----------- --------- ---------- ----------
Total Privately Issued 1,661,083 40.1 2,044,957 47.2
----------- --------- ---------- ----------
----------- --------- ---------- ----------
Total High Quality 3,848,263 93.0 4,113,109 95.0
----------- --------- ---------- ----------
OTHER INVESTMENT:
Privately Issued:
A Rating 13,724 0.3 49,995 1.2
BBB/Baa Rating 72,114 1.7 84,929 2.0
BB/Ba Rating and Other 40,947 (1) 1.0 46,963 (1) 1.1
Whole loans 164,413 4.0 31,102 0.7
----------- --------- ---------- ----------
Total Other Investment 291,198 7.0 212,989 5.0
----------- --------- ---------- ----------
Total ARM Portfolio $4,139,461 100.0% $4,326,098 100.0%
=========== ========= ========== ==========
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(1) The AAA Rating category includes $615.7 million and $781.8 million of whole
loans as of December 31, 2000 and 1999, 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 $32.1 and $32.3 million as of December 31, 2000 and 1999,
respectively. The subordinated certificate is included in the BB/Ba Rating
and Other category.
As of December 31, 2000, the Company had reduced the cost basis of its ARM
securities by $1,869,000 due to estimated credit losses (other than temporary
declines in fair value). The estimated credit losses for ARM securities relate
to Other Investments that the Company purchased at a discount that included an
26
estimate of credit losses and to loans that the Company has securitized for its
own portfolio. Additionally, during the year ended December 31, 2000, in
accordance with its credit policies, the Company provided for estimated credit
losses on the subordinated classes of its securitized loans in the amount of
$207,000 and recorded a $951,000 provision for estimated credit losses on its
loan portfolio. During 2000, the Company sold two REO properties for a combined
loss of $59,000. As of December 31, 2000, the Company's ARM loan portfolio
included 8 loans that are considered seriously delinquent (60 days or more
delinquent) with an aggregate balance of $4.4 million. The ARM loan portfolio
also includes one property ("REO") that the Company acquired as the result of a
foreclosure process in the amount of $0.6 million. The average original
effective loan-to-value ratio on these 8 delinquent loans and REO is
approximately 61%. As of December 31, 2000, the Company had an allowance for
estimated credit losses for loans and REO of $3.1 million. The Company believes
this level of allowances is adequate to cover estimated losses from these loans
and REO properties. 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.
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, 2000 December 31, 1999
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Carrying Portfolio Carrying Portfolio
Value Mix Value Mix
---------- ----------- ---------- -----------
ARM ASSETS:
INDEX:
One-mo