UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FORM 10-K
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ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
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For the fiscal year ended: December 31, 2002 |
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TRANSITION REPORT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
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For the transition period from to |
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Commission File Number: 001-13637
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APEX MORTGAGE CAPITAL, INC. |
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(Exact name of Registrant as specified in its Charter) |
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Maryland |
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95-4650863 |
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(State or
other jurisdiction of incorporation or |
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(I.R.S. Employer Identification |
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865 South Figueroa Street |
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90017 |
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(Address of principal executive offices) |
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(Zip Code) |
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Registrant’s telephone number, including area code (213) 244-0000 |
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Securities registered pursuant to Section 12(b) of the Act: |
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Title of Each Class |
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Name of Exchange Which Registered |
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Common Stock ($.01 par value) |
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American Stock Exchange |
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes ý No o
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 the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ý
On June 28, 2002, which was the last business day of Apex’s most recently completed second fiscal quarter, Apex’s public market value was approximately $445 million (based on 29,701,184 shares of common stock then held by non-affiliates and a closing price that day of $14.99 per share of Common Stock on the American Stock Exchange). These public market value calculations exclude shares held on the stated dates by Apex’s officers, directors and 5% or greater stockholders. (Exclusion from these public market value calculations does not imply affiliate status for any other purpose.)
At March 21, 2003, the aggregate market value of the voting stock held by non-affiliates was $196,040,024 based on the closing price of the Common Stock on the American Stock Exchange.
Number of shares of Common Stock outstanding at March 18, 2003: 29,857,000
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the Registrant’s definitive Proxy Statement to be filed pursuant to Regulation 14A within 120 days from December 31, 2002, are incorporated by reference into Part III.
SAFE HARBOR STATEMENT
UNDER
THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
CERTAIN INFORMATION CONTAINED IN THIS REPORT CONSTITUTES “FORWARD-LOOKING STATEMENTS” WHICH CAN BE IDENTIFIED BY THE USE OF FORWARD-LOOKING TERMINOLOGY SUCH AS “MAY,” “WILL,” “SHOULD,” “EXPECT,” “ANTICIPATE,” “ESTIMATE,” “INTEND,” “CONTINUE” OR “BELIEVES” OR THE NEGATIVES THEREOF OR OTHER VARIATIONS THEREON OR COMPARABLE TERMINOLOGY. SOME IMPORTANT FACTORS THAT WOULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE IN ANY FORWARD-LOOKING STATEMENTS INCLUDE CHANGES IN INTEREST RATES; DOMESTIC AND FOREIGN BUSINESS, MARKET, FINANCIAL OR LEGAL CONDITIONS; DIFFERENCES IN THE ACTUAL ALLOCATION OF THE ASSETS OF THE COMPANY FROM THOSE ASSUMED; AND THE DEGREE TO WHICH ASSETS ARE HEDGED AND THE EFFECTIVENESS OF THE HEDGE, AMONG OTHER FACTORS. IN ADDITION, THE DEGREE OF RISK IN THE COMPANY’S INVESTMENTS IS INCREASED BY THE COMPANY’S LEVERAGING OF ITS ASSETS.
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Apex Mortgage Capital, Inc.
2002 Form 10-K Annual Report
Table of Contents
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Certain capitalized
and other terms used herein shall have the meanings
assigned to them in the glossary at the end of this report.
The following description of our business should be read in conjunction with the information included elsewhere in this Annual Report on Form 10-K, including in the section “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in our financial statements and notes thereto which are included in this Annual Report on Form 10-K.
GENERAL
Apex Mortgage Capital, Inc. (the “Company”), a Maryland corporation, was formed on September 15, 1997, primarily to acquire United States agency and other highly rated, single-family real estate adjustable and fixed rate mortgage related assets. The Company commenced operations on December 9, 1997, following the initial public offering of the Company’s common stock. The Company’s principal executive offices are located at 865 South Figueroa Street, Suite 1800, Los Angeles, California 90017, and its telephone number is (213) 244-0000.
The Company uses its equity capital and borrowed funds to seek to generate income based on the difference between the yield on its mortgage related assets and the cost of its borrowings. The Company has elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Code”). The Company will not generally be subject to federal taxes on its income to the extent that it distributes its net income to its stockholders and maintains its qualification as a REIT.
The day-to-day operations of the Company are managed by an external management company, TCW Investment Management Company (the “Manager”), subject to the direction and oversight of the Company’s Board of Directors. A majority of the Board of Directors are unaffiliated with The TCW Group, Inc. (“TCW” and, together with its subsidiaries and affiliates, the “TCW Group”), or the Manager. The Manager is a wholly-owned subsidiary of TCW. The Manager was established in 1987, and the TCW Group began operations in 1971 through one of its affiliates. The Company’s investment management team are selected members of the TCW Group’s Mortgage-Backed Securities Group (the “MBS Group”), all of whom have over thirteen years of experience in raising and managing mortgage capital. The Company has elected to be externally managed by the Manager to take advantage of the existing operational systems, expertise and economies of scale associated with the Manager’s current business operations, among other reasons. The Manager’s key officers have experience in raising and managing mortgage capital, mortgage finance and the purchase and administration of mortgage related assets.
Website Access to Our Periodic SEC Reports
Our internet address is www.apexreit.com. We make our periodic SEC reports (Form 10-Q and Form 10-K) and current reports (Form 8-K) available free of charge through our website as soon as reasonably practicable after they are filed electronically with the SEC. We may from time to time provide important disclosures to investors by posting them in the investor relations section of our website, as allowed by SEC rules.
Materials we file with the SEC may be read and copied at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet Website at www.sec.gov that contains reports, proxy and information statements, and other information regarding our company that we file electronically with the SEC.
Dividend Declaration. On March 13, 2003, the Company’s Board of Directors declared a dividend distribution of $0.25 per share. The dividend is payable on April 30, 2003, to shareholders of record on March 28, 2003.
Appointment of Samuel P. Bell to Fill Board of Directors Vacancy. Subsequent to the Annual Meeting of Shareholders at which he was reelected, John C. Argue passed away after an eight-month battle with leukemia. The Board of Directors elected Samuel P. Bell to fill the vacancy. Mr. Bell has served as President of Los Angeles Business Advisors since 1996. Previously, Mr. Bell served as the Area Managing Partner of Ernst & Young for the Pacific Southwest Area.
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Exploration of Strategic Alternatives. On March 13, 2003, we announced that our Board of Directors has authorized our management to consider a full range of strategic alternatives for our Company in order to maximize stockholder value, including, but not limited to, the potential sale of the Company. In this context, our Board of Directors has appointed a special committee consisting of our independent directors. In the event of a sale of the Company, the Manager is entitled to receive a termination fee under the terms of our management agreement. For this purpose, in the event of a termination, the Manager and our Board of Directors have agreed to limit the termination fee to an amount less than the fair market value contemplated to be paid under the management agreement. In the event of a sale of the Company, the termination fee will be an amount up to 50% of the premium over book value of the management agreement, not to exceed $10 million.
Reporting Period. Unless otherwise noted, this report describes the Company’s operations and developments through the date hereof.
STRATEGY
To achieve its business objective and generate dividend yields that provide a competitive rate of return for its stockholders, the Company’s strategy is to:
• purchase primarily single-family real estate adjustable and fixed rate mortgage related assets;
• manage the credit risk of its mortgage related assets through, among other activities (i) carefully selecting mortgage related assets to be acquired, (ii) complying with the Company’s investment policy, (iii) actively monitoring the ongoing credit quality and servicing of its mortgage related assets, and (iv) maintaining appropriate capital levels and allowances for possible credit losses;
• finance purchases of mortgage related assets with the net proceeds of equity offerings and, to the extent permitted by the Company’s leverage policy, to utilize leverage to increase potential returns to stockholders through borrowings (primarily reverse repurchase agreements) with interest rates that will also reflect changes in short-term market interest rates;
• seek to structure its borrowings in accordance with its interest rate risk management policy;
• utilize interest rate swaps, forward contracts on U.S. Treasury notes, interest rate caps and similar financial instruments to mitigate interest rate risks;
• seek to minimize prepayment risk primarily by structuring a diversified portfolio with a variety of prepayment characteristics; and
• purchase equity and other securities issued by financial entities on an opportunistic basis.
There can be no assurance that the Company will be able to generate competitive earnings and dividends while holding primarily high quality mortgage related assets and maintaining a disciplined risk-control profile.
The Company may attempt to increase the return to stockholders over time by: (i) raising additional capital in order to increase its ability to invest in additional mortgage related assets; (ii) lowering its effective borrowing costs through direct funding with collateralized lenders, in addition to using Wall Street intermediaries, and investigating the possibility of using collateralized commercial paper and medium-term note programs; and (iii) improving the efficiency of its balance sheet structure by issuing uncollateralized subordinated debt and other forms of capital.
Management Policies and Programs
The Company is a financial company that uses its equity capital and borrowed funds to seek to generate net income based on the difference between the interest income on its assets and the cost of its borrowings. The Company has elected to be taxed as a REIT under the Code. The Company intends to operate in accordance with its operating policies as approved by the Company’s Board of Directors at least annually.
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The Company has established the following five primary operating policies to implement its business strategy of acquiring assets consisting primarily of United States agency and other highly rated single-family real estate mortgage securities and mortgage loans in order to seek to generate dividend yields that provide a competitive rate of return for its stockholders:
• Investment Policy;
• Leverage Policy;
• Interest Rate Risk Management Policy;
• REIT Compliance Policy; and
• Hedging Strategy Policy.
Compliance with the foregoing operating policies shall be determined by the Manager at the time of the Company’s purchase of the mortgage related assets (based on the most recent valuation thereof by the Company) and will not be affected by events subsequent to the purchase. Such events include, without limitation, changes in characterization, value or rating of any specific mortgage related assets or economic conditions or other events generally affecting any mortgage related assets of the type held by the Company.
Investment Policy
The Company intends to acquire investments that it believes will maximize returns on capital invested, after considering (i) the amount and nature of the anticipated returns from the investment, (ii) the Company’s ability to pledge the investment to secure collateralized borrowings, and (iii) the costs associated with financing, hedging, managing, securitizing and reserving for such investments.
The Company generally expects to primarily invest in mortgage related assets that may include Short-Term Investments, Mortgage-Backed Securities, High Credit Quality Mortgage Loans, Mortgage Derivative Securities and Other Investments.
The Company’s investment policy is intended to provide guidelines for the acquisition of its investments. Specifically, the investment policy provides that the Company intends to acquire a portfolio of investments that can be segregated into specific categories. Each category and its respective investment limitations are as follows:
50% Category
At least 50% of the Company’s total assets are expected to consist of (i) Short-Term Investments, (ii) Mortgage-Backed Securities that are either issued or guaranteed by an agency of the U.S. government, (iii) Mortgage-Backed Securities that are rated AAA by at least one nationally recognized rating agency or (iv) High Credit Quality Mortgage Loans that are funded with Committed Secured Borrowings.
75% Category
At least 75% of the Company’s total assets are expected to consist of investments that qualify for the 50% Category or other Mortgage-Backed Securities that have received an investment grade rating by at least one nationally recognized rating agency.
90% Category
At least 90% of the Company’s total assets are expected to consist of investments that qualify for the 75% Category or High Credit Quality Mortgage Loans that are not funded by Committed Secured Borrowings.
10% Category
Not more than 10% of the Company’s total assets are expected to consist of (i) Mortgage-Backed Securities rated below investment grade, (ii) Mortgage Derivative Securities or (iii) Other Investments.
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Leverage Policy
The Company generally anticipates utilizing leverage to increase returns to its stockholders. The Company’s goal is to strike a balance between the under-utilization of leverage, which reduces potential returns to stockholders, and the over-utilization of leverage, which could reduce the Company’s ability to meet its obligations during periods of adverse market conditions. The Company has established a leverage policy to control the type and amount of leverage used to fund the acquisition of its mortgage related assets. The Company’s leverage policy is intended to provide guidelines for utilizing secured borrowings in the form of Uncommitted Secured Borrowings and Committed Secured Borrowings.
Uncommitted Secured Borrowings
The Company expects a substantial portion of its borrowings may consist of Uncommitted Secured Borrowings, including reverse repurchase agreements, lines of credit, Dollar-Roll Agreements, and other types of financing transactions. Such funding sources generally do not commit the lender to continue to provide financing to the Company. The Company intends to limit the amount of Uncommitted Secured Borrowings to 92% of its total assets, less any assets that are funded with Committed Secured Borrowings, plus the market value of any related hedging transactions. If the amount of such borrowings exceeds 92%, the Manager will be required to submit to the Company’s Board of Directors a plan designed to bring the total amount of Uncommitted Secured Borrowings below the 92% limitation. It is anticipated that in many circumstances this goal will be achieved over time without active management through the natural process of mortgage principal repayments and increases in the market value of the Company’s total assets.
Reverse repurchase agreements are a form of borrowing which are evidenced by an agreement by the Company to sell Mortgage-Backed Securities (or other securities) to a third party, coupled with a simultaneous agreement by the Company to repurchase them at a specified future date and price. Basically, the reverse repurchase agreement is a collateralized loan. The difference between the purchase (repurchase) price and the sale price is the dollar cost of the loan. The Company anticipates that it will only enter into reverse repurchase agreements and other financing transactions with counterparties rated investment grade by a Rating Agency and primarily with national broker-dealers, commercial banks and other lenders that offer such financing.
Committed Secured Borrowings
The Company’s borrowings may consist of Committed Secured Borrowings, including the issuance of CMOs, structured commercial paper programs, secured term notes and other financing transactions. Such funding sources generally commit the lender to provide financing to the Company for a specified period of time or to provide financing to the Company to fund specific assets until the assets mature. The Company intends to limit the amount of Committed Secured Borrowings to 97% of the assets funded with such borrowings at the time any corresponding transaction is entered into.
Interest Rate Risk Management Policy
The Company has established an interest rate risk management policy that is intended to mitigate the negative impact of changing interest rates. The Company generally intends to mitigate interest rate risk by targeting the difference between the market weighted average duration on its mortgage related assets funded with secured borrowings to the market weighted average duration of such borrowings to one year or less, taking into account all hedging transactions. The Company generally does not intend to have any specific duration target for the portion of its mortgage related assets that are not funded by secured borrowings. There can be no assurance that the Company will be able to limit such duration differences and there may be periods of time when the duration difference will be greater than one year.
The Company may implement its interest rate risk management policy by utilizing various hedging transactions, including interest rate swaps, interest rate swaptions, interest rate caps, interest rate floors, financial futures contracts, options on financial futures contracts, and other structured transactions. The Company does not intend to enter into such transactions for speculative purposes.
REIT Compliance Policy
The Company intends to operate its business in compliance with the REIT Provisions of the Code. Accordingly, all of the provisions outlined in the Company’s investment, leverage and interest rate risk management policies are subordinate to the REIT Provisions of the Code if any conflicts arise.
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To qualify for tax treatment as a REIT, the Company must meet certain tests as fully described in sections 856 and 857 of the Code. A summary of the requirements for qualification as a REIT is described immediately below.
Stock Ownership Tests. The capital stock of the Company must be held by at least 100 persons and no more than 50% of the value of such capital stock may be owned, directly or indirectly, by five or fewer individuals at all times during the last half of the taxable year. Tax-Exempt Entities, other than private foundations and certain unemployment compensation trusts, are generally not treated as individuals for these purposes. The stock ownership requirements must be satisfied in the Company’s second taxable year and in each subsequent taxable year.
Asset Tests. The Company must generally meet the following asset tests at the close of each quarter of each taxable year. At least 75% of the value of the Company’s total assets must consist of Qualified REIT Real Estate Assets, U.S. Government securities, cash and cash items (the “75% Asset Test”). In general, the value of securities held by the Company but not taken into account for purposes of the 75% Asset Test must not exceed (i) 5% of the value of the Company’s total assets in the case of securities of any one impermissible issuer, or (ii) 10% of the outstanding voting securities or value of such securities of any such issuer. An exception is provided, however, for the Company’s interest in a Taxable REIT Subsidiary.
Income Tests. The Company must generally meet certain gross income tests for each taxable year. At least 75% of the Company’s gross income must be derived from certain specified real estate sources, including interest income and gain from the disposition of Qualified REIT Real Estate Assets or Qualified Temporary Investment Income (the “75% Gross Income Test”). At least 95% of the Company’s gross income for each taxable year must be derived from sources of income qualifying for the 75% Gross Income Test, dividends, interest unrelated to real estate, and gains from the sale of stock or other securities (including certain interest rate swap and cap agreements entered into to hedge variable rate debt incurred to acquire Qualified REIT Real Estate Assets) not held for sale in the ordinary course of business (the “95% Gross Income Test”).
Dividend Distribution Requirements. The Company must generally distribute to its stockholders an amount equal to at least 90% of the Company’s taxable income before deductions of dividends paid and excluding net capital gains. The Company has until January 31 following the end of the fiscal year in which the dividend is declared to pay the dividends to stockholders and is permitted to offer a special dividend in order to meet the 90% requirement.
Hedging Strategy Policy
The Company utilizes interest rate swaps and other similar financial instruments to mitigate the risk of the cost of its variable-rate liabilities exceeding the earnings on its mortgage related assets during the normal course of business. The Company has established a hedging strategy policy to provide and maintain the information required to support the processes and accounting for interest rate risk management activities subject to Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities and Statement of Financial Accounting Standards No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, and related Derivative Implementation Group pronouncements. The hedging strategy policy includes required documentation to be maintained for derivative hedging activities to qualify for hedge accounting including required description of the hedging relationship and the risk management objective and strategy for undertaking specific hedges.
Other Policies
The Company intends to operate in a manner that will not subject it to regulation under the Investment Company Act. The Company does not currently intend to (i) originate Mortgage Loans or (ii) offer securities in exchange for real property. The Company will not purchase any mortgage related assets from its Affiliates other than mortgage securities that may be purchased from a taxable subsidiary of the Company that may be formed in connection with the securitization of Mortgage Loans.
Future Revisions in Policies and Strategies
The Company’s Board of Directors has established the policies and strategies set forth in this report. The Board of Directors (subject to approval by a majority of unaffiliated directors) has the power to modify or waive such policies and strategies without the consent of our stockholders. The Company’s Board of Directors will at least annually establish and approve (including approval by a majority of unaffiliated directors) the policies and strategies of the Company.
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Description of Mortgage Related Assets
The Company invests principally in the following types of mortgage related assets, subject to the operating restrictions described in “Management Policies and Programs” above.
Primary Mortgage Securities
Pass-Through Certificates. Pass-Through Certificates are securities representing interests in “pools” of Mortgage Loans secured by residential real property in which payments of both interest and principal on the securities are generally made monthly, in effect “passing through” monthly payments made by the individual borrowers on the Mortgage Loans which underlie the securities (net of fees paid to the issuer or guarantor of the securities). Early repayment of principal on some mortgage related assets (arising from prepayments of principal due to sale of the underlying property, refinancing, or foreclosure, net of fees and costs which may be incurred) may expose the Company to a lower rate of return upon reinvestment of principal. This is known as prepayment risk. Also, if a security subject to prepayment has been purchased at a premium, the value of the premium would be lost in the event of prepayment. Like other fixed income securities, when interest rates rise, the value of a mortgage related asset generally will decline; however, when interest rates are declining, the value of mortgage related assets with prepayment features may not increase as much as other fixed income securities. The rate of prepayments on underlying mortgages will affect the price and volatility of a mortgage related asset, and may have the effect of shortening or extending the effective maturity of the security beyond what was anticipated at the time of purchase. When interest rates rise, the holdings of mortgage related assets by the Company can reduce returns if the owners of the underlying mortgages pay off their mortgages later than anticipated. This is known as extension risk.
Payment of principal and interest on some mortgage pass-through securities (but not the market value of the securities themselves) may be guaranteed by the full faith and credit of the U.S. Government (in the case of securities guaranteed by the Government National Mortgage Association (“GNMA”)) or guaranteed by agencies or instrumentalities of the U.S. Government (in the case of securities guaranteed by the federally chartered and privately owned corporation organized and existing under the Federal National Mortgage Association Charter Act (12 U.S.C., § 1716 et seq.), formerly known as the Federal National Mortgage Association (“Fannie Mae”), or the Federal Home Loan Mortgage Corporation (“FHLMC”)) which are supported only by the discretionary authority of the U.S. Government to purchase the agency’s obligations. Mortgage related assets created by non-governmental issuers (such as commercial banks, savings and loan institutions, private mortgage insurance companies, mortgage bankers and other secondary market issuers) may be supported by various forms of insurance or guarantees, including individual loan, title, pool and hazard insurance and letters of credit, which may be issued by governmental entities, private insurers or the mortgage poolers.
Collateralized Mortgage Obligations. Collateralized Mortgage Obligations (“CMOs”) are hybrid mortgage related instruments. Interest and pre-paid principal on a CMO are paid, in most cases, on a monthly basis. CMOs may be collateralized by whole Mortgage Loans, but are more typically collateralized by portfolios of mortgage pass-through securities guaranteed by GNMA, FHLMC, or Fannie Mae. CMOs are structured into multiple classes, with each class bearing a different stated maturity. Monthly payments of principal, including prepayments, are first returned to investors holding the shortest maturity class; investors holding the longer maturity classes receive principal only after the first class has been retired. CMOs that are issued or guaranteed by the U.S. Government or by any of its agencies or instrumentalities will be considered U.S. Government securities by the Company.
Other Mortgage Securities
General. The Company may acquire other mortgage securities such as non-High Quality mortgage related assets and other mortgage securities collateralized by single-family Mortgage Loans, mortgage warehouse participations, Mortgage Derivative Securities, subordinated interests and other mortgage-backed and mortgage-collateralized obligations, other than pass-through certificates and CMOs.
Mortgage Derivative Securities. The Company may acquire Mortgage Derivative Securities not to exceed 10% of its total assets. Mortgage Derivative Securities provide for the holder to receive interest only, principal only, or interest and principal in amounts that are disproportionate to those payable on the underlying Mortgage Loans. Payments on Mortgage Derivative Securities are highly sensitive to the rate of prepayments on the underlying Mortgage Loans. In the event of more rapid (slower) than anticipated prepayments on such Mortgage Loans, the rates of return on interests in Mortgage Derivative Securities representing the right to receive interest only or a disproportionately large amount of interest (“Interest Only Derivatives”) would be likely to decline (increase). Conversely, the rates of return on Mortgage
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Derivative Securities representing the right to receive principal only or a disproportionate amount of principal (“Principal Only Derivatives”) would be likely to increase (decrease) in the event of rapid (slow) prepayments.
The Company may also invest in Inverse Floaters, a class of CMOs with a coupon rate that resets in the opposite direction from the market rate of interest to which it is indexed, such as the London Inter-Bank Offered Rate (“LIBOR”) or the 11th District Cost of Funds Index (“COFI”). Any rise in the index rate (as a consequence of an increase in interest rates) causes a drop in the coupon rate of an Inverse Floater while any drop in the index rate causes an increase in the coupon of an Inverse Floater. An Inverse Floater may behave like a security that is leveraged since its interest rate usually varies by a magnitude much greater than the magnitude of the index rate of interest. The “leverage-like” characteristics inherent in Inverse Floaters are associated with greater volatility in their market prices.
The Company also may invest in other Mortgage Derivative Securities that may be developed in the future.
Subordinated Interests. The Company also may acquire subordinated interests, which are classes of mortgage securities that are junior to other classes of such series of mortgage securities in the right to receive payments from the underlying Mortgage Loans. The subordination may be for all payment failures on the Mortgage Loans securing or underlying such series of mortgage securities. The subordination will not be limited to those resulting from certain types of risks, such as those resulting from war, earthquake or flood, or the bankruptcy of a borrower. The subordination may be for the entire amount of the series of mortgage securities or may be limited in amount.
Mortgage Warehouse Participations. The Company also may from time to time acquire mortgage warehouse participations as an additional means of diversifying its sources of income. The Company anticipates that such investments, together with its investments in Other Mortgage Assets, will not in the aggregate exceed 10% of its total mortgage related assets. These investments are participations in lines of credit to Mortgage Loan originators that are secured by recently originated Mortgage Loans that are in the process of being sold to investors. Mortgage warehouse participations do not qualify as Qualified REIT Real Estate Assets. Accordingly, this activity is limited by the REIT Provisions of the Code.
Mortgage Loans
General. The Company may acquire and accumulate Mortgage Loans as part of its investment strategy until a sufficient quantity has been accumulated for securitization into High Credit Quality Mortgage Loans. The Company anticipates that the Mortgage Loans acquired by it and not yet securitized will not constitute more than 25% of the Company’s total mortgage related assets at any time. All Mortgage Loans will be acquired with the intention of securitizing them into High Credit Quality Mortgage Loans. However, there can be no assurance that the Company will be successful in securitizing the Mortgage Loans. To meet the Company’s investment criteria, the Mortgage Loans to be acquired by the Company will generally conform to the underwriting guidelines established by Fannie Mae, FHLMC or other credit insurers. Applicable banking laws generally require that an appraisal be obtained in connection with the original issuance of Mortgage Loans by the lending institution. The Company does not intend to obtain additional appraisals at the time of acquiring Mortgage Loans.
The Mortgage Loans may be originated by or purchased from various suppliers of mortgage related assets throughout the United States, such as savings and loan associations, banks, mortgage bankers, home-builders, insurance companies and other mortgage lenders. The Company may acquire Mortgage Loans directly from originators and from entities holding Mortgage Loans originated by others. The Board of Directors of the Company has not established any limits upon the geographic concentration of Mortgage Loans to be acquired by the Company or the credit quality of suppliers of mortgage related assets.
Conforming and Nonconforming Mortgage Loans. The Company may acquire both Conforming and Nonconforming Mortgage Loans for securitization. Conforming Mortgage Loans comply with the requirements for inclusion in a loan guarantee program sponsored by Fannie Mae, FHLMC or GNMA. Nonconforming Mortgage Loans are Mortgage Loans that do not qualify in one or more respects for purchase by Fannie Mae or FHLMC under their standard programs. The Company expects that a majority of Nonconforming Mortgage Loans it purchases will be nonconforming primarily because they have original principal balances that exceed the requirements for FHLMC or Fannie Mae programs.
Commitments to Mortgage Loan Sellers. The Company may issue commitments to originators and other sellers of Mortgage Loans who follow policies and procedures that generally comply with Fannie Mae and FHLMC regulations and guidelines and that comply with all applicable federal and state laws and regulations for Mortgage Loans secured by
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single-family (one-to-four units) residential properties. In addition, commitments may be issued for agency certificates as well as privately issued pass-through certificates and Mortgage Loans. Although the Company may commit to acquire Mortgage Loans prior to funding, all Mortgage Loans are to be fully funded prior to their acquisition by the Company. Following the issuance of commitments, the Company will be exposed to risks of interest rate fluctuations similar to those risks applicable to mortgage related assets.
Securitization of Mortgage Loans. The Company may acquire and hold Mortgage Loans until a sufficient quantity has been accumulated for securitization. During the accumulation period, the Company will be subject to risks of borrower defaults and bankruptcies, fraud losses and special hazard losses (such as those occurring from earthquakes or floods) that are not covered by standard hazard insurance. In the event of a default on any Mortgage Loan held by the Company, the Company will bear the risk of loss of principal to the extent of any deficiency between the value of the collateral underlying the Mortgage Loan and the principal amount of the Mortgage Loan. No assurance can be given that any such mortgage, fraud or hazard insurance will adequately cover a loss suffered by the Company. Also during the accumulation period, the costs of financing the Mortgage Loans through reverse repurchase agreements and other borrowings and lines of credit with warehouse lenders could exceed the interest income on the Mortgage Loans. It may not be possible or economical for the Company to complete the securitization for all Mortgage Loans that the Company acquires, in which case the Company will continue to bear the risks of borrower defaults and special hazard losses.
Protection Against Mortgage Loan Risks. The Company anticipates that each Mortgage Loan purchased will have a commitment for mortgage pool insurance from a mortgage insurance company with a claims-paying ability rated investment grade by either of the Rating Agencies. Mortgage pool insurance insures the payment of certain portions of the principal and interest on Mortgage Loans. In lieu of mortgage pool insurance, the Company may arrange for other forms of credit enhancement such as letters of credit, subordination of cash flows, corporate guaranties, establishment of reserve accounts or over-collateralization.
It is expected that when the Company acquires Mortgage Loans, the seller will generally represent and warrant to the Company that there has been no fraud or misrepresentation during the origination of the Mortgage Loans and generally agree to repurchase any Mortgage Loan with respect to which there is fraud or misrepresentation. The Company will provide similar representations and warranties when the Company sells or pledges the Mortgage Loans as collateral for mortgage securities. If a Mortgage Loan becomes delinquent and the pool insurer is able to prove that there was a fraud or misrepresentation in connection with the origination of the Mortgage Loan, the pool insurer will not be liable for the portion of the loss attributable to such fraud or misrepresentation. Although the Company will generally have recourse to the seller based on the seller’s representations and warranties to the Company, the Company will generally be at risk for loss to the extent the seller does not perform its repurchase obligations.
Other Investments. The Company may acquire Other Investments that include (i) equity and debt securities issued by other primarily mortgage related finance companies, (ii) interests in mortgage related collateralized bond obligations, (iii) other subordinated interests in pools of mortgage related assets, (iv) commercial mortgage loans and securities, and (v) residential mortgage loans other than High Credit Quality Mortgage Loans. Although the Company expects that its Other Investments will be limited to less than 10% of its total assets, there is no limit to how much of the Company’s stockholders’ equity will be allocated to Other Investments. There may be periods in which Other Investments represent a large portion of the Company’s stockholders’ equity.
Leverage Risk. The Company employs a leveraging strategy of generally borrowing up to 92% of its total assets, less any assets that are funded with committed secured borrowings, plus the market value of any related hedging transactions to finance the acquisition of additional mortgage related assets. The Company’s borrowings may, from time to time, exceed 92% of its total assets. In the event borrowing costs exceed the income on its mortgage related assets, the Company will experience negative cash flow and incur losses. Another risk of leverage is the possibility that the value of the collateral securing the borrowings will decline. In such event, additional collateral or repayment of borrowings would be required. The Company could be required to sell mortgage related assets under adverse market conditions in order to maintain liquidity. If these sales were made at prices lower than the carrying value of the mortgage related assets, the Company would experience losses.
Interest Rate Risk. There is the possibility that the value of the Company’s mortgage related assets may fall since fixed income securities generally fall when interest rates rise. The longer the term of a fixed income instrument, the more sensitive it will be to fluctuations in value from interest rate changes. Changes in interest rates may have a significant
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effect on the Company’s operations, because it may hold mortgage related assets with long terms to maturity. Rising interest rates will negatively impact the Company’s borrowings since the value of the collateral securing the borrowing will decline in value, requiring additional collateral or repayments of borrowing. This could reduce the level of borrowings and reduce returns. Also, when interest rates rise, the Company’s holdings of mortgage related assets can reduce returns if the owners of the underlying mortgages pay-off their mortgages later than anticipated. This is known as extension risk. When interest rates decline, the Company’s holdings of the mortgage related assets can reduce returns if the owners of the underlying mortgages pay-off their mortgages sooner than anticipated since the funds prepaid will have to be invested at the then lower prevailing rate. This is known as prepayment risk. In addition, when interest rates decline, not only can the value of mortgage related assets decline, but the yield can decline, particularly where the yield on the security is tied to interest rates, such as adjustable mortgages.
Liquidity Risk. There is the possibility that the Company may lose money or be prevented from realizing capital gains if it cannot sell a mortgage related asset at a time and price that is most beneficial to the Company. The Company is subject to liquidity risk because it invests in mortgage securities which have experienced periods of illiquidity.
Credit Risk. Credit risk is the possibility that the Company could lose money if an issuer is unable to meet its financial obligations, such as the payment of principal and/or interest on an instrument, or goes bankrupt. The Company may invest a portion of its assets in mortgage related assets which are not guaranteed by the U.S. Government or investment grade, which may make the Company subject to substantial credit risk. This is especially true during periods of economic uncertainty or during economic downturns.
Equity Risk. Equity risk is the possibility that the Company could lose money if its equity investments decline in value. Such a decline could be caused by a number of factors, including, but not limited to, overall market conditions, suspension or omission of dividends, bankruptcies and litigation. This is especially true during periods of economic uncertainty or during economic downturns.
Failure to Maintain REIT Status Risk. Failure to maintain REIT status risk refers to the possibility that the Company may become subject to federal income tax as a regular corporation. The Company intends at all times to maintain substantially all of its investments in, and otherwise conduct its business in a manner consistent with, the REIT Provisions of the Code. If the Company fails to qualify as a REIT, it would be treated as a regular corporation for federal tax purposes. This would result in the Company being subject to federal income tax that would further result in a substantial reduction of cash available for distribution to stockholders.
Failure to Maintain Investment Company Act Exemption Risk. The Company intends to conduct its business so as not to become a “regulated investment company” under the Investment Company Act. As a result, the Company’s ownership of certain mortgage related assets may be limited by the Investment Company Act. This could have the effect of harming the Company’s operations and returns to stockholders. In addition, if the Company fails to qualify for the exemption from registration as an investment company, its ability to use leverage would be substantially reduced. This could reduce income to the Company and returns to stockholders.
Risks Relating to Exploration of Strategic Alternatives. On March 13, 2003, we announced that our Board of Directors has authorized management to consider a full range of strategic alternatives for the Company in order to maximize stockholder value, including, without limitation, the potential sale of the Company. We are uncertain as to what strategic alternatives may be available to us or what impact any particular strategic alternative will have on our stock price if accomplished. Uncertainties and risks relating to our exploration of strategic alternatives include:
•the exploration of strategic alternatives may disrupt our operations and distract management, which could harm our operating results and the market price of our common stock;
•the process of exploring strategic alternatives may be more time-consuming and expensive than we anticipate;
•we may not be able to identify strategic alternatives that we believe are worth undertaking;
•we may not be able to successfully execute or achieve the benefits of a strategic alternative which is approved by the Board or the independent committee thereof formed for that purpose;
•we may incur significant financial advisory fees, legal and accounting fees and other general and administrative expenses associated with exploring and/or implementing various strategic alternatives, including possible termination or break-up fees with counter-parties; and
•we may terminate our management agreement with the Manager upon the consummation of any sale of the Company and, in such event, we will be obligated to pay the Manager a termination fee which could be substantial.
The following discussion summarizes certain federal income tax consequences for the Company. This discussion is based on current law. The following discussion is not exhaustive of all possible tax considerations. It does not give a detailed discussion of any state, local or foreign tax considerations, nor does it discuss all of the aspects of federal, state, local or foreign income taxation that may be relevant to a stockholder of the Company in light of such stockholder’s particular circumstances.
Prospective investors in the Company are urged to consult with their own tax advisors regarding the specific consequences to each of them of the purchase, ownership and sale of stock in an entity electing to be taxed as a REIT, including the federal, state, local, foreign and other tax considerations of such purchase, ownership, sale and election and the potential changes in applicable tax laws.
General
The Code provides special tax treatment for organizations that qualify and elect to be taxed as REITs. In brief, if certain specific conditions imposed by the Code are met, entities that invest primarily in real estate assets, including
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Mortgage Loans, that otherwise would be taxed as corporations are generally not taxed at the corporate level on their taxable income that is distributed to their stockholders. This treatment eliminates most of the “double taxation” (at the corporate level and then again at the stockholder level when the income is distributed) that typically results from the use of corporate investment vehicles. A qualifying REIT, however, may be subject to certain excise and other taxes, as well as normal corporate tax, on Taxable Income that is not currently distributed to its stockholders.
The Company has made an election to be taxed as a REIT under the Code commencing with its taxable year ended December 31, 1997. There can be no assurance, however, that all qualification requirements for such treatment will be met.
In the event that the Company does not qualify as a REIT in any year, it will be subject to federal income tax as a domestic corporation and its stockholders will be taxed in the same manner as stockholders of ordinary corporations. To the extent that the Company would, as a consequence, be subject to potentially significant tax liabilities, the amount of earnings and cash available for distribution to its stockholders would be red